China's drive for sustainable growth amidst a global slowdown

While facing huge domestic challenges in restructuring its economy to make growth sustainable, China has also to fight against the 'persistent stagnation' which has gripped the global economy in the post-2008-financial-crisis era.

Yu Yongding

AFTER 30 years of breakneck growth, the Chinese economy has entered a new stage characterised by a significant slowdown of its potential growth rate. The consensus among Chinese economists is that China's potential growth rate has fallen from about 10% to about 7%, or even lower. At the moment, the officially accepted growth figure is 6.5%.

China's growth rate of labour productivity has been falling steadily since the turn of the century. According to the Conference Board business research organisation, the growth rate has fallen from the double digits in the early 2000s to less than 4% in 2015. But most Chinese economists believe that the rate should be about 6% or higher.

With regard to the growth of labour supply, an extraordinary change is that China's working-age population has been shrinking since 2012. The reduction has been more than three million each year ever since. With a growth rate of labour productivity of around 6% and a slightly negative growth rate of labour supply, China's long-term growth rate is not very likely to be significantly higher than 6.5%, which is the government target for the next few years.

Noted Japanese economist Ryuichiro Tachi once remarked that the high savings rate and low capital-output ratio were the two most important factors responsible for Japan's high growth rate from the late 1950s to the early 1970s. In its high-growth period, Japan maintained a stable capital-output ratio lower than 1.5. In contrast, China's capital-output ratio has been rising steadily for many years. While its capital-output ratio is more than three at the moment, its incremental capital-output ratio (ICOR) is about seven. This means that China's marginal capital efficiency has been falling steadily. To maintain the past growth momentum, China has to further increase its pace of capital accumulation. However, China's investment rate is already as high as 46%, by far the highest in the world. To raise the investment rate further is bound to worsen China's capital efficiency and lower the growth rate.

To make China's growth sustainable, the Chinese government is trying to push for changes in the mode of growth and cultivate innovation and creativity in the economy. To achieve this objective, the government has drawn up comprehensive plans for reforms to the ownership system, financial system, and innovation and creativity support system. To what extent innovation and creativity will become a major driver of economic growth is hard to predict and measure. But we have seen many individual success stories in Shenzhen and elsewhere in China.

While facing huge domestic challenges in restructuring the economy to make growth sustainable, China also has to fight against the 'persistent stagnation' in the post-global financial crisis period. In the five years after the crisis flared up in 2008, the world economy grew by about 5% annually. However, the International Monetary Fund (IMF)'s World Economic Outlook report (published twice a year, last updated in October 2015) shows that the pace slowed to 3.1% in 2015 and will be 3.6% in 2016. Developed countries are expected to report 2% growth in 2015, their best figure since 2010, but developing countries will likely report 4% growth, well below the 5% growth in 2013 and 4.6% in 2014.

Among developed economies, the US is displaying the strongest momentum in terms of recovery from the 2008 crisis. In 2014, the IMF estimated that the US would reach a 2.6% growth rate in 2015. However, the US Federal Reserve has forecast a lower rate of 2.1%.

The eurozone began to enter a period of weak growth in the fourth quarter of 2013, accelerating to a more than 1% growth rate at times in 2015 before dipping back to slightly above zero last September.

Japan fared worst among the developed economies, with negative growth in both the second and third quarters of 2015.

Emerging economies are also struggling. Two of the five BRICS countries, Brazil and Russia, are already in recession, while South Africa is on the brink of recession. However, India is enjoying a positive forecast; it is predicted to sustain its speedy growth rate of 7% or higher, making it the only bright spot in the global economy.

The slowdown in nearly all major economies has placed developing economies that are commodity export-oriented in a difficult situation, making recession an unavoidable outcome for many of them.

Since 2008, almost all of the world's economies have undertaken expansive fiscal and monetary policies in order to stimulate growth. In spite of this, the world economy is still far from being back to pre-crisis conditions. This can only be explained by reasons that are more deep-rooted than insufficient effective demand. Possible reasons include the slower advancement of technology and a rapidly aging society.

Given this, the world economy's real recovery will not come about before new innovations and breakthroughs in technology improve the productivity of labour and capital inputs, and investment demand and lending rebound.

As the world's largest trader, China must get prepared for the persistent stagnation of the world economy.

In essence, the 2008 global financial crisis was a debt crisis. Developed countries, especially the US, had built their high spending on low savings, leading to an unprecedented internal and external debt burden. This is how their debt supercycle came into being.

In the aftermath of the collapse of the real estate bubble and the emergence of the subprime mortgage crisis, people in the US had no choice but to cut their debt ratios by foreclosing, defaulting or borrowing less. This then turned the subprime mortgage crisis into an economic recession. The US government adopted expansionary fiscal policy and lax monetary policy to defend the economy from being hit too hard by residents' efforts to reduce their debt. As a result, the US's public debt went up drastically while residents' debt decreased significantly.

Other developed economies shared a similar story. The global debt ratio is still high, with debt just moving around in different sectors. In other words, the longest and biggest debt supercycle in world history has not ended, which means the fuse that detonated the 2008 global financial crisis is still there.

If it is fair to say that the 2008 global financial crisis was triggered by the bursting of the US housing bubble, then a future crisis may likely be caused by the bursting of the US Treasury bond bubble. As the biggest overseas holder of US Treasury bonds, China should not overlook this risk.

We do not know how the US Federal Reserve will conduct its monetary policy in 2016. The spillover effect of the Fed policy will certainly have a serious impact on developing economies.

Quantitative easing in the US means printing money. Since the subprime mortgage crisis started, the US's money supply has risen from $800 billion to about $4 trillion in terms of currency in circulation (a definition of money supply termed 'M0'), from about $1.4 trillion to $3 trillion in terms of M1 (or 'currency held by the public and transaction deposits at depository institutions', as described by the US Federal Reserve), and from less than $8 trillion to more than $12 trillion in terms of M2 (M1 plus other deposits and financial market mutual funds). By any of these standards, the growth of the US's money supply far outpaced the growth of its GDP over the past few years.

However, this 'helicopter drop' of money, as described by Ben Bernanke, former chairman of the US Federal Reserve, has not translated into inflation in the US. (Bernanke earned the nickname 'Helicopter Ben' after a 2002 speech in which he cited this phrase of economist Milton Friedman's, which characterises fighting deflation with a loose monetary policy.) One possible reason for this is that excessive money did not enter into the real economy, but created various asset bubbles (in stock and bond markets, for example). Once prices of these assets stop rising, the bubbles will burst. Then the money will withdraw from the capital market and enter the real economy, leading to inflation.

From a long-term perspective, the US has been recording a current-account deficit since 1982 and has accumulated more than $7 trillion in net external debt. Rational investors outside the US have no reason to continue buying US dollar-denominated assets and keep the US dollar strong.

In the meantime, the US has the incentive to devalue the dollar to improve its international payment position and ease its external debt burden.

Given the uncertainty of the spillover effect of US monetary policy, China should strengthen, and not dismantle, the firewall against short-term capital flows in order to secure economic stability.

Capital flight and the ensuing drastic devaluation of local currencies is indeed a very big challenge for developing economies in the case of a strong US dollar. However, its impact will vary. For China, the value of yuan-denominated assets will weaken vis-…-vis US dollar-denominated assets. Other things being equal, this will very much dampen non-Chinese enthusiasm for yuan-denominated assets, which in turn will slow down the internationalisation of the yuan.˙

It is thus true that China faces severe challenges both internally and externally. However, after the Asian financial crisis and the 2008 global financial crisis, China is now in a better position and has more experience than ever to deal with these challenges.

Still, two questions should be asked: Will China's growth rate fall further in 2016? How low a rate can China tolerate? In my view, China's growth will fall further in 2016, because the economy is still in the grip of deflation. China's producer price index (PPI) has been falling for 48 months in a row and the GDP deflator has turned negative since the beginning of 2015.

Deflation means that there is a downward spiral of price and output. Without favourable shocks, deflation will make for a very protracted economic slowdown. In China, there are two types of deflation spirals currently at play in the economy:

*      The overcapacity-deflation spiral: falling PPI caused by overcapacity leads to falling profitability of corporates. In response, corporates have to deleverage and reduce investment, which in turn leads to more overcapacity and a further fall in PPI.

*      The debt-deflation spiral: falling PPI leads to rising real debt, which in turn leads to falling profitability of corporates. Corporates' responses will lead to similar results of further falls in PPI and output.

The primary cause of China's deflation is overcapacity. Since 2010 the government has implemented a series of measures to curb demand for property. As a result, real estate investment fell steadily, which immediately led to the surge of overcapacity in sectors such as steel, cement, aluminium, plate glass, coal, transportation, and so on. At this stage, therefore, the main link in the process of deflation is still overcapacity. However, as corporate debt levels are already very high, the increase in real debt may deal China a more serious blow in a later stage.

By the end of 2015, the unsold house floor space for the country as a whole was 700 million square metres, while the average annual sale of house floor space in normal times was 1.3 billion square metres. Faced with a double-digit growth in inventory, real estate developers cut investment deeply. By the end of 2015, the growth rate of real estate investment dropped to almost zero. One can be quite sure that in 2016 growth of real estate investment will fall significantly. Because the share of real estate investment in GDP is more than 10%, the direct and indirect impacts of the fall in real estate investment on growth of the economy will be very large indeed. At the same time, defaults by real estate developers have become a very serious concern of China's commercial banks.

To avoid a hard landing that will make structural adjustment difficult to implement, China needs to introduce another stimulus package of infrastructural investment. Because of its still relatively strong fiscal position, it is not only necessary but also affordable for China to adopt such a policy. The aim of the stimulus package should not be to prop up growth but to offset the negative impact of the fall in real estate investment so as to prevent a hard landing. Compared with the 2008 stimulus package, this new package should be more carefully designed and implemented. Fortunately, China is still a developing country, and the space for infrastructural investment is plentiful. Well-designed infrastructural investments will improve China's economic structure as well as eliminate overcapacity significantly.

In short, while recognising the absolute importance of structural adjustment and being prepared to bear the pain of adjustment, China should not refrain from pursuing expansionary fiscal policy and accommodative monetary policy to stimulate the economy. China has faced more serious challenges in the past, and on each occasion it muddled through. There is no reason China cannot muddle through this time.                            

Yu Yongding is a member of the Chinese Academy of Social Sciences (CASS), former Director-General˙of the Institute of World Economics and Politics, CASS, and President of the China Society of World Economics.

*Third World Resurgence No. 307/308, March/April 2016, pp 32-34