Authored by Adair Turner, originally posted at Project Syndicate [12],
Last year, the global economy was supposed to start returning to normal. Interest rates would begin rising in the United States and the United Kingdom; quantitative easing would deliver increased inflation in Japan; and restored confidence in banks would enable a credit-led recovery in the eurozone. Twelve months later, normality seems as distant as ever – and economic headwinds from China are a major cause.
To spur economic growth and achieve prosperity, China has sought to follow the path forged by Japan, South Korea, and Taiwan, but with one key difference: size. With populations of 127 million, 50 million, and 23 million, respectively, these model Asian economies could rely on export-led growth to lift them to high-income levels. But the world market is simply not big enough to support high incomes for China's 1.3 billion citizens.
To be sure, the export-led model did work in China for some time, with the trade surplus rising to 10% of GDP in 2007, and manufacturing jobs absorbing surplus rural labor. But the flip side of China's surplus was huge credit-fueled deficits elsewhere, particularly in the US. When the credit bubble collapsed in 2008, China's export markets suffered.
In order to stave off job losses and sustain economic growth, China stimulated domestic demand by unleashing a wave of credit-fueled construction. As commodity imports soared, the current-account surplus fell below 2% of GDP.
China's own economy, however, became more unbalanced. Investment rose from 42% of GDP in 2007 to 48% in 2010, with property and infrastructure projects attracting the most funding. Likewise, credit swelled from 130% of GDP in 2007 to 220% of GDP in 2014, with 45% of credit extended to real estate or related sectors.
This property boom resembled Japan's in the late 1980s, which ended in a bust that led to a protracted period of anemic growth and deflation from which the country is still struggling to escape. With China's per capita income amounting to only a quarter of Japan's during its boom, the risks the country faces should not be underestimated.
The rejoinder is that China is relatively safe, because its per capita capital stock also remains far below Japan's in the 1980s, and much more investment will be needed to support its rapidly expanding urban population (set to increase from 53% of the total in 2013 to 60% by 2020). But counting on this investment may be excessively optimistic. Though China will indeed need more investment, its capital-allocation mechanism has produced enormous waste.
In fact, by establishing urbanization as an explicit objective – something that Japan, South Korea, and Taiwan never did – China has embedded a structural economic bias toward construction. With hundreds of cities competing with one another through infrastructure development, “ghost towns" will proliferate.
Making matters worse, China's local-government financing model could hardly be more effective at producing overinvestment and excessive leverage. Local governments use land as collateral to take out loans to fund infrastructure investment, then finance repayment by relying on revenues from subsequent land sales. As the property boom wanes, their debts become increasingly unsustainable – a situation that has already reportedly compelled some local governments to borrow money for land purchases to prop up prices. In the economist Hyman Minsky's terminology, simple “speculative" finance has given way to completely circular “Ponzi" activity.
As a result, though total credit in China continues to grow three times faster than nominal GDP, a major downturn is now underway. Property sales have fallen, particularly outside the largest cities, and slower construction growth has left heavy industry facing severe overcapacity. The latest survey data indicate a major slowdown in industrial activity. Last month, producer prices were down 4.3% year on year. The resulting decline in demand has caused commodity prices to fall considerably, undermining the growth prospects of other major emerging economies.
Meanwhile, China's current-account surplus has again soared. Though it seems significantly smaller than pre-crisis levels as a share of GDP – almost 4%, at the latest monthly rates, compared to 10% in 2007 – it has returned to its peak in absolute terms. And it is the absolute size of China's external surplus that determines the impact on global demand. In short, China is back to where it started, with its growth dependent on export demand, which is now severely constrained by debt overhangs in advanced countries.
As a result, China's downturn has intensified the deflationary headwinds holding back global recovery, playing a major role (along with increased supply) in driving down oil prices. Though lower oil prices will be a net boon for the world economy, the decline reflects a serious dearth of demand.
China now must find the solution to a problem that Japan, South Korea, and Taiwan never had to face: how to boost domestic demand rapidly and sustainably. Fortunately, 2014 brought some progress on this front, in the form of a slight uptick (albeit from a very low base) in household consumption as a percentage of GDP.
To accelerate consumption growth, China's leaders must implement a stronger and more comprehensive social safety net, thereby reducing the need for high precautionary savings. Higher dividends from state-owned enterprises could help to finance such an initiative, while removing incentives for overinvestment.
Demographic change – with the number of 15-to-30-year-olds, in particular, falling by 25% over the next decade – could also help. Though population stabilization could exacerbate the dangers of excessive property investment today, it will also tighten labor markets and stimulate wage increases.
China may well be able to meet the challenge ahead. But, as the investment-led phase of its development ends, a significant growth slowdown is certain – and will inevitably intensify deflationary forces in the world economy. Given this, 2015 may well prove to be another year in which hopes of a return to normality are disappointed.
