The heady days of double-digit economic growth in China are almost certainly over, generating concern about the nation’s near- and medium-term economic prospects. But the gradual slowdown that China has experienced over the past eighteen months should in fact be welcomed. Growth in the coming years will likely be both robust and more sustainable, while the structural reforms that are central to the 12th Five Year Plan (2011–2015) will become somewhat easier to achieve.
On balance then, it appears that China’s economy is headed in the right direction. But key economic and political risks—including corruption, social inequality, and a lack of progress on political reform—must be addressed in order to safeguard long-term economic growth.
A Changing Growth Model
The extent of China’s recent slowdown depends in part on how it is measured. Conflicting assessments stem from different ways of measuring quarterly growth, the usual doubts about the reliability of China’s national accounts, and apparent discrepancies between reported GDP growth and electricity use. Another important factor is conflicting Purchasing Managers Indices (PMI)—key barometers of economic activity and leading economic indicators. The government’s PMI for March showed expansion over February for both manufacturing and nonmanufacturing activities, while the international bank HSBC’s measurements suggested the opposite. An even more confusing difference is the fact that HSBC’s manufacturing PMI for the first six months of 2012 was consistently below 50, while the government’s was consistently above 50.
Taking this into account, the government reported 7.6 percent year-over-year GDP growth for the second quarter of 2012, down from 8.1 percent year-over-year growth for the first quarter. Media reports have focused mainly on the fact that this was the lowest quarterly growth rate since early 2009, when the world was in the throes of financial crisis, suggesting that China’s near-term economic prospects are rather dim.
Seasonally adjusted quarter-on-quarter growth conveys a more optimistic picture. Both official and most private sector estimates show higher growth in the second quarter (see Chart 1). Thanks to a mild relaxation of monetary policy, a resumption of modest stimulus spending by the government, increased bank lending in June, and the expectation that commercial housing construction will soon revive, the recent uptick in growth is likely to persist during the second half of 2012.
But regardless of how GDP growth in China is measured, the long-term trend is clearly toward a slower, though still impressive pace. If current developments continue, China’s economy will eventually look more “normal” in its pattern of growth, and its GDP growth rate may stabilize around 7 to 8 percent for the next few years.
This shift is hardly to be lamented. Household consumption growth, a critical rebalancing objective, has continued to be brisk and is presently exceeding GDP growth. According to the World Bank, China’s unusually low household consumption/GDP ratio bottomed out in 2009 and increased marginally in 2010 and 2011 (see Chart 2). 1 In the first half of 2012, moreover, the contribution of consumption (including government consumption) to economic growth was almost 60 percent, more than 10 percentage points higher than in the first half of 2011. Further increases in the household consumption/GDP ratio are likely in future years.
While China’s investment/GDP rate remains very high by any international standard, it has been coming down since 2009 (see Chart 3). Reflecting greater reliance on consumption-driven growth, as opposed to export-driven growth, China’s current account surplus as a percent of GDP, which long signaled macroeconomic imbalance, has fallen sharply in recent years; in 2011, it was under 3 percent.
As for China’s slowing rate of growth, the country’s overall economic performance since the global financial crisis of 2008 is in fact remarkable given the slowdown in export growth and foreign direct investment inflows and increased production costs, which forced many manufacturing enterprises to close, relocate, or otherwise change their business model.
More Promising Signs
China is rebalancing in other ways as well. Since the renminbi was first unlinked from the dollar in July 2005, the nominal renminbi-dollar exchange rate has appreciated by a little over 30 percent. The real exchange rate has meanwhile appreciated by over 40 percent (see Chart 4). Beijing recently widened the renminbi’s trading band and has cautiously resumed many financial sector reforms that were stalled since 2004. China is also continuing to promote the international use of its currency for trade settlement and investment purposes. Renminbi internationalization—aimed at providing exchange rate protection to Chinese exporters and reducing dependence on the dollar for trade financing—became an explicit government objective in 2009.
China’s traditional east-west development gap is also shrinking as a result of the government’s aggressive “Go West” investment policies. In recent years, interior, not coastal, provinces have grown most rapidly. Agriculture, the main source of income for about 30 percent of the population, continued strong, and in recent years rural per capita income growth has exceeded urban income growth. (Individual income and wealth inequality, however, is believed to have increased.)
Finally, there are signs that China’s labor market is maturing. Wage increases are continuing, though at a slower rate than in 2009 and 2010. These are due in part to the fact that China’s total labor force is close to peaking and, moreover, its cohort of young workers is already shrinking. In addition, living conditions and job availability in rural areas, where most migrant workers traditionally come from, have improved. China is probably past the so-called “Lewis Point,” indicating the stage of a country’s development when cheap labor dries up, real wages increase, and consumer purchasing power rises. The government’s launch, in 2010, of a “National Talent Development Plan” is a clear sign that it recognizes the shifting economic winds and is committed to upgrading the quality of its labor force and increasing the innovative capacity of the economy.
Policy Has Enabled a Smooth Transition
Sound macroeconomic policy in China has played a key role in China’s smooth transition to a slower, but more sustainable growth path thus far.
In response to the 2008 financial crisis, China launched the world’s largest stimulus program relative to GDP—and arguably the most effective. Production losses as a result of the crisis were recouped in only three months. China’s growth in 2009 and 2010 remained extremely high—at 9.2 percent and 10.4 percent, respectively. And China’s weight in the global economy continued to grow—from 11.4 percent of global GDP in 2008 to 14.3 percent in 2011 according to the International Monetary Fund.
In hindsight, the credit expansion that China’s stimulus fueled was too large. The economy began to overheat in the second quarter of 2009, igniting inflation, setting back some of the 11th Five Year Plan (2006–2010) economic rebalancing objectives. (Many of the economic restructuring objectives at the center of the 12th Five Year Plan, in particular reducing reliance on exports and investment for GDP growth and increasing reliance on domestic consumption, were already included in the 11th Five Year Plan.) The overheating also fed a dangerous housing bubble in major cities. But the government was careful not to respond with a heavy hand, as it did in 2007 and the first half of 2008, and succeeded in engineering a milder slowdown in growth.
During the first quarter of 2012, Beijing again became concerned that growth was falling too quickly. It carefully reversed the direction of monetary policy—while resisting calls for a relaxation of house purchase restrictions in order to kill the housing bubble. (Some local governments have, in any case, relaxed some restrictions.)
By June, inflation had been conquered (see Chart 5) and the gradual decline in real estate prices that started in September 2011 appeared to have tapered off. The big challenge now will be to manage the expected revival of commercial housing markets in big cities without reigniting speculative bubbles.
Risks Remain
China’s economic adjustment after the 2008 global financial crisis has been impressive, but risks may, if anything, have intensified. These include corruption and social inequality; the possibility of financial instability due to the proliferation of many new, poorly supervised financial products (often kept off-balance-sheet) as well as increased corporate leverage; and falling profit margins, which have lowered business confidence. In addition, though the housing market in big cities seems to have stabilized, a large stock of vacant apartments continues to weigh on prices.
Widely reported overinvestment in basic infrastructure will, by contrast, probably turn out to be less of a problem than overinvestment in manufacturing and high-end real estate. In modern China, new infrastructure has often been created ahead of needs as part of the government’s strategy to stimulate new development opportunities.
The greatest risk facing China today is stagnant political reform, including the promotion of rule of law. Without progress on this front, the social inequality and perceived unfairness that the current political system has generated could jeopardize long-term economic prospects.
Pieter Bottelier, former chief of the World Bank’s resident mission in Beijing, is a nonresident scholar in Carnegie’s International Economics Program and senior adjunct professor of China Studies at the School of Advanced International Studies (SAIS) at Johns Hopkins University.
[1]. The World Bank’s figure for 2011 must be based on an estimate, as China’s official national accounts statistics based on expenditures for 2011 have not yet been released.