Will China Slow Down?

China’s was the first major economy to begin to recover from the global recession. When the global crisis began to intensify in the fall of 2008, the Chinese authorities reacted with a double-barreled policy of drastic monetary easing and a massive stimulus package. The combined effect was a sharp uptick in growth — well above the pace that most external observers had expected. So why are many analysts now warning that the vaunted Chinese economic boom may be about to hit the skids?

The problem is that the monetary easing and the stimulus may have worked too well. “The key risk is that overheating and inflation will force the Chinese government to put on the brakes more quickly than it would like,” said Tom Miller, the Beijing-based managing editor of The China Economic Quarterly. If tightening measures are taken and the stimulus is withdrawn, said Stephen Joske, the director of the Economist Intelligence Unit’s forecasting service for China, that nation’s “growth will be slowing significantly from now on.”

Not only do many worry that the Chinese government’s policy whipsawing could cause convulsions in the system, but critics also argue that the initial monetary easing and stimulus will have a number of adverse consequences. In the short run, they may have created bubbles in the property and equity markets. In the medium term, they may lead to excess industrial capacity, putting pressure on prices and profits and leading to loan defaults. Also, the measures may have set back China’s much-needed efforts to rely more on consumption than on investment and exports for its growth.

Nicholas Lardy, a China expert and a senior fellow at the Peterson Institute for International Economics in Washington, believes such concerns, while legitimate, are exaggerated. In his March 2010 paper, “The Sustainability of China’s Recovery from the Global Recession,” he argues that critics fail to appreciate the advantages China will accrue as a result of coming through the crisis with strong growth momentum and that they also fail to acknowledge the steps China’s leaders have already taken to head off the potential adverse effects of the stimulus.

For example, Lardy said, Chinese authorities adopted initiatives to slow lending growth as early as mid-2009 and by early 2010 had reinstated mandatory lending quotas for banks, raised their required reserve ratios and required them to sell off large amounts of subordinated debt.

Lardy also pointed out that steps had already been taken to moderate a potentially overheating real estate market: the government reinstated a 40 percent minimum down payment for mortgages and lengthened to five years the period that investors must hold a property to avoid paying sales tax when it is sold. “These moves dramatically cut the pace of property sales and disincentivized speculators,” Lardy said. “It is also important to recognize that even a major property price correction in China would not have the systemic implications that it had in the United States” because “there is much less leverage in China’s property market and the share of debt devoted to the purchase of property is relatively small” among consumers.

Lardy sees China’s excess capacity as essentially a nonissue. First, he points out that Chinese firms have historically tended to hold on to outdated equipment, so Chinese data on excess capacity may overstate the case compared with other countries. Second, there is a substantial difference between excess capacity of, say, 20 percent in a mature economy growing at just 2 to 3 percent per year and in China, where growth has averaged about 10 percent for the past 30 years and any excess capacity is readily absorbed. The Chinese steel industry, for example, had excess capacity of 15 to 30 percent at the end of 2008; this was more in overcapacity than the next largest global steel producers — Japan and the United States — had in capacity. What seemed like massive excess to many observers was simply in line with China’s historical growth, which has required a 15 percent increase in steel production annually since 2000. Finally, Lardy emphasizes that China’s 2009 stimulus focused on financing fixed investment in infrastructure, and not on expanding production capacity in China’s traditional industries.

As for the charge that the stimulus program has set back China’s efforts to achieve more balanced growth by encouraging private consumption, Lardy offers a number of data points that would seem to disprove the contention. Although employment in export-oriented industries did suffer in 2009, the boom in construction-related employment created by the stimulus largely offset those losses. In addition, the government raised payments to 70 million of China’s lowest income citizens, increased pension payments to retirees and offered its own version of “cash for clunkers” for vehicles and other consumer durables. All these factors, along with a substantial increase in household borrowing, combined in 2009 to raise consumption expenditures in China well ahead of GDP growth for the first time in a decade.

While Lardy believes that China’s stimulus investments are likely to benefit the nation in the long term by creating an infrastructure for sustained economic growth and increased tax revenue, he readily concedes that the benefit will come at the cost of a substantial increase in government debt, equal to almost a fifth of China’s GDP. While China is certainly not alone in that predicament, it clearly cannot be considered an unqualified good thing. The Chinese, Lardy said, “recognize that flooding the economy with more credit is not the way forward and that they will have to take strong additional policy initiatives to sustain economic growth.”

To reduce the distortions that for much of the past decade have favored industry and exports over services and consumption, the Chinese will have to consider raising the prices of basic resources like water and electricity, levying environmental taxes and fees and adjusting, finally, the exchange rate for their undervalued currency. China has thus far shown little willingness to take such steps, however. Add to that its intransigence about reducing greenhouse gas emissions or imposing sanctions on Iran and throw in its reliance (like all other nations) on a tenuous global financial system, and you have ample reason to question the direction, economic or otherwise, that China may be taking in the near future.