Growing Uncertainty About China’s Economy

By M. Isi Eromosele

Economically, China is in a balancing act at this time as it seeks to shift from an export-dependent model of growth to one based more on domestic consumption.

While the economy still has underlying strengths, there are imbalances in the economy that could slow the pace of that growth. Of particular note are remaining gaps in the social safety net that continue to drive high personal savings rates and the need to further reform the country’s financial system.

Today, doubts about the sustainability of China’s high growth of recent years have resurfaced. China optimists contend that high domestic savings, a surplus of cheap labor, strong foreign direct investment and a healthy central government balance sheet will

fuel growth for years to come.

China pessimists counter that overinvestment and excessive credit creation have resulted in a bubble in the real estate market that will cause a hard landing for the Chinese economy in 2013.

The truth probably lies somewhere between the above two extremes. Although a hard landing for the Chinese economy is not expected in 2013, there should be concern that the build-up of fundamental imbalances will slow the pace of economic growth.

The best hope China has of sustaining its high growth rates is to transition from its export/investment-led growth model to one driven by domestic consumption. China has made some progress on this front, but gaps in the social safety net continue to encourage households to save a disproportionately high share of their income.

Chinese leaders must make rebalancing the economy and reforming the financial sector top priorities if they are to prove the pessimists wrong.

Economic Underlying Strengths

China’s economic success has sustainable roots. These include high domestic savings; strong foreign direct investment lured by the size and growth of the Chinese market; substantial migration of workers from the relatively low productivity rural jobs to relatively high productivity urban jobs; general openness to international trade; low labor costs; a relatively strong central governmental balance sheet and an exceedingly entrepreneurial and ambitious people. Most of these supports to growth will remain.

Thus, the long-term economic growth prospects for China remain favorable, especially compared to the more troubled developed world.

However, demographics are changing as the population ages and the surplus of labor gradually diminishes; wages are on the rise, threatening China’s export competitiveness versus its Southeast Asian neighbors; Chinese financial markets remain relatively immature; capital is allocated by state agencies rather than the market and the environmental costs of rapid growth are becoming more obvious.

China has attempted to address these challenges in two ways. First, by rebalancing the economy away from exports and investment and toward domestic consumer spending and second, by introducing financial reforms aimed at gradually liberalizing interest rates and increasing the flexibility of the exchange rate.

Unfortunately, progress on these fronts has been slow, while the old growth model based on export and investment is gradually becoming less viable.

Phasing Out the Old Growth Model

The Chinese export machine is already slowing. While China still has a large positive

trade balance with the United States, its trade surpluses with the rest of the world have diminished. China’s competitiveness has declined as a result of the gradual appreciation of its currency, the Chinese Renminbi, higher inflation and faster wage growth.

Chinese exports have also been hurt by slowing global growth. Approximately

19 percent of demand for China’s goods comes from Europe and roughly 17 percent

from the United States.

Arguably, Europe is already be in recession and U.S. economic growth is slow. The contribution of net exports to China’s incremental GDP growth has been minimal over the past two to three years. All indications are that trade surpluses will shrink further and that net exports will not be a driver of GDP growth in the next few years.

The outlook for fixed asset investment is not much better. The Chinese government responded to the collapse of global demand in 2008 with a massive fiscal package aimed at infrastructure and property investment.

As a result, fixed asset investment increased at 20-30 percent annual rates, contributing 90 percent of GDP growth in 2009 and over 50 percent of 2010 growth. If it were not for fixed asset investment increases, Chinese economic growth in recent years would have been at rates of only 4-5 percent, not 9-10 percent.

Perhaps the most vulnerable segment of fixed asset investment is private property. Real estate markets are a huge driver of economic activity. Construction directly represents about 14-15 percent of China’s GDP and related activity probably contributes 25 percent of GDP.

An estimated 60-70 percent of household wealth is in private property. Residential real estate has been in a spectacular boom. According to the International Monetary Fund, property prices are up 60 percent in most areas since 2006. The boom is cooling. There could be a severe decline in the country’s real estate market.

The Vital Role of the Household Sector

The household sector can probably pick up some of the slack from the slowdown in investment and exports. There is strong indications that consumer spending is

both strong and less cyclically sensitive than other sectors. In fact, consumption

has contributed a consistent 4+ percentage points to annual Chinese GDP growth in recent years.

Forces supporting household spending growth include strong income, based in part on government-mandated wage increases, low household sector leverage and high savings rates.

Domestic consumption still represents only about 38 percent of GDP compared to an

average of 58 percent in other global middle income economies and close to 70% in the

United States.

Part of the problem is that Chinese households save a much higher portion of their income as a precaution against illness, to further the education of their children or for retirement. To counteract this penchant to save, China needs to expand its social safety net for its population.

The forecast for household consumption growth in China is generally good. However, given the cyclical fragility of other sectors of the economy, robust household consumption growth is no longer optional but mandatory to sustain the high growth of the Chinese economy.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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