China's economy is again facing the spectre of a hard landing. Property bubbles, mounting local government debt, and wayward shadow-banking activities are generating considerable financial risk, complicating the government's efforts to address rising labour costs, excessive credit, overwhelming pollution, rampant corruption, an undeveloped tax system, and rising international competition. And additional risks seem to lurk at almost every turn.
Any strategy for mitigating the threat of a sharp slowdown must account for the dual nature of China's economy. On the one hand, Chinese cities are becoming increasingly modern and globally engaged. Indeed, China's 17 most dynamic cities - which together account for 11 per cent of the population and about 30 per cent of gross domestic product (GDP) - have already reached high-income status, as defined by the World Bank, and the country is set to overtake the United States as the world's top e-commerce market.
On the other hand, half of China's population remains rural, deriving a large share of income from agricultural activities. According to MasterCard, 25 per cent of consumer payments are still made in cash, implying that China's informal economy remains much more robust than believed.
This duality has positive implications for China's economic prospects. While its coastal manufacturing activities have fuelled much of the economy's growth over the last few decades, the country's rural, inland economies will remain strong drivers of growth as domestic consumption rises. In other words, China has an even larger and more diversified economic base than many realise - implying a degree of growth momentum that would be difficult to lose.
It helps that, with $3.8 trillion in foreign exchange reserves and a large (though declining) current account surplus, China's economy does not depend on foreign saving and investment. Local government liabilities and non-performing loans are, thus, a domestic problem, whose only real spillover effects would stem from debt redistribution efforts. Monetary and fiscal tightening aimed at curtailing credit expansion runs the risk of undermining GDP growth and reducing Chinese demand for commodities. This would hurt commodity-exporting emerging economies, many of which are already suffering from capital flight, owing to the US Federal Reserve's ongoing monetary policy reversal.
In this dualistic environment, China must calibrate its market-oriented reform strategy carefully to ensure that it does not create any new and unexpected systemic risks, while overcoming the vested interests that resist substantive reforms aimed at levelling the playing field.
Achieving this will require that China address another, more problematic dualism in its economy: the two-tiered credit system. Given excess domestic savings, a tightly controlled capital account, and rapid credit creation, interest rates have been low relative to demand since 2005. With the formal banking sector subject to strict controls on deposit and lending rates, large state-owned enterprises and local governments were the only entities that could access enough credit to finance large-scale investments like infrastructure projects.
After the 2008 global financial crisis weakened export growth, the private sector began to move towards non-tradable goods and services, particularly property. This shift - together with the declining current account surplus and massive infrastructure investment - put upward pressure on domestic interest rates. While the authorities could keep official interest rates under control, unofficial rates began to rise irrepressibly, fuelling the rapid expansion of shadow banking.
Easy credit caused property prices to skyrocket, from ¥2,291 ($374) per square metre, on average, in 2002 to ¥5,791 a decade later, as measured in 70 large and medium-size Chinese cities. The question now concerns the degree to which this increase reflected rising productivity and prosperity - as did comparable gains in newly industrialised economies like Japan, Hong Kong, Taiwan and Korea - rather than speculation motivated by easy credit.
Given that China's 17 top-performing cities are roughly one-third as productive as Hong Kong, where per capita GDP is three times higher, it is not surprising that their property prices amount to about one-third of Hong Kong's. But rapidly rising property prices in some of China's less dynamic cities are leading to outward labour migration, effectively turning them into shiny ghost towns.
In pursuing interest-rate liberalisation, China must unify formal and informal rates, which requires action at both the macro and micro levels. Specifically, China's leaders must reform micro-institutions to facilitate the market-driven process of creative destruction, such as through institutionalised bankruptcy processes that help to eliminate ghost cities and failed real estate projects, thereby minimising the associated macroeconomic disruption.
Furthermore, relying largely on tightening credit to limit risks also raises new complications. While broader structural economic change requires tighter monetary policy and lower inflation, excessively tight monetary policy, given continued high credit demand, could disrupt the adjustment process.
In fact, the slowdown in money supply growth - from roughly 25 per cent in 2009 to roughly 14 per cent today - has paralleled the shadow-banking sector's rapid expansion. As of the end of 2012, shadow banking accounted for 24 per cent of total credit, at interest rates 10 to 15 per cent higher than official rates. This has hurt the real economy by increasing the cost of capital. Unless inefficient borrowers exit the market or declare bankruptcy, they will continue to disrupt resource allocation, crowding out more productive firms.
The key to merging interest rates, thus, lies in reforming the credit allocation mechanism to provide more capital to well-performing projects and enforce hard budget constraints on poor-performing borrowers. While this will inevitably trigger some defaults and erode the quality of banks' loan portfolios, the end result - a more balanced and healthy economy - will be more than worth it.
The writers are at the Fung Global Institute, Hong Kong. Project Syndicate, 2014
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