Guest Contribution: “China’s Slowdown”

Today we are fortunate to have a guest contribution written by Jeffrey Frankel, Harpel Professor of Capital Formation and Growth at Harvard University, and former Member of the Council of Economic Advisers, 1997-99. An earlier version was published by Project Syndicate.

Investors worldwide are closely watching the steep decline in China’s stock market. The Shanghai Stock Exchange Composite Index is down more than 40% since June 2015.

The reason observers are concerned is not because they themselves are invested: China’s stocks are overwhelmingly held by Chinese themselves. Rather, many are interpreting it as evidence that China’s economy is going down the tubes.

China’s growth rate has indeed slowed down and there are plenty of reasons to believe that the slowdown is not just temporary. But none of them have much to do with the stock market.

For one thing, market prices are still well above where they were in 2014. That was a time when many observers were bullish on China, proclaiming that its economy had just surpassed the US to become the world’s largest, on the basis of new PPP-based GDP statistics. But in fact the slowdown in Chinese growth began four years ago. According to the official statistics, growth averaged 10% over the three decades 1980-2010, but slowed down to the 7%-8% range in 2012-14.

Indeed, the reason that China’s stock market started to ascend toward the end of 2014 is that the People’s Bank of China began to cut interest rates in November, in an appropriate response to the slowdown in economic growth that was already evident. The market’s continuing rise took on the character of a credit-fueled bubble in the spring of 2015. The peak came on June 12, when the China Securities Regulatory Commission tightened margin requirements.

The bubble has now been reversed. That doesn’t necessarily convey much information about China’s growth prospects.

There are plenty of reasons not to be surprised that China’s growth has slowed down and not to expect it to return to 10%. The human instinct of some forecasters five years ago was simply to extrapolate the preceding three decades. But casting a wider statistical net would have revealed that a fourth decade at 10% would have been historically unprecedented.

So the Middle Kingdom is not exempt from the broader statistical regularities. Some see the slowdown as a case of the middle-income trap. Others find that the more relevant statistical pattern is regression to the mean in growth rates.

What are the economic forces behind the tendency for a rapidly growing country to slow down? There is a wide variety of possible economic interpretations. Six come to mind:

  • One is diminishing return to capital. China’s investment in transportation infrastructure and residential construction has become “too much of a good thing.”
  • Another interpretation is the observation that productivity growth is easier when it is a matter of copying the technologies, production processes, and management practices of the Western countries; when the gap between the economic frontier and the newcomers narrows, the latter countries have to do some of the innovating on their own.
  • A third explanation is that rural-urban migration has been a big source of China’s growth, but that the surplus labor has finally been used up, wages have risen, and the competitive advantage in labor-intensive manufactures has been lost. (The “Lewis turning point” has been reached.)
  • A fourth is that the population is ageing. The working-age population peaked in 2012. The ratio of retirement-age people to working-age population is rising. This demographic transition occurs naturally in advanced countries; but the one-child policy accelerated it prematurely in China.
  • A fifth is that urban land prices have been bid up and the “carrying capacity” of the environment has been exhausted.
  • A sixth is that the composition of the economy is shifting away from manufacturing and into services, which is appropriate but which entails slower growth because in all countries there is less scope for productivity growth in services than there is in manufacturing.

Thus a shift from 10 per cent growth in China to a more sustainable long-term 5-7 per cent trend is perfectly natural. The important question is whether the transition takes the form of a soft landing or a hard landing. In a soft landing China would continue to grow at the slower-but-sustainable trend rate. In a hard landing it would suffer a financial crisis and more severe economic recession.

High dependence on investment spending and debt financing can work well during a high-growth phase but then lead to excess capacity and financial crisis when the long-run growth rates slows down. Precedents include post-1980s Japan and 1997-98 Korea.

Some say that the official statistics seriously overstate GDP and that the true growth rate has already fallen well below the 6.9 per cent that the government has reported for 2015. It is indeed suspicious that official growth statistics seem in most years to come close to the numbers in plans that had been announced by the government ahead of time. So the skeptics reasonably turn to more tangible measures. They point out that energy consumption, freight railway traffic, and output of such industrial products as coal, steel, and cement have slowed sharply. (These are components of the so-called Keqiang Index.) But Nicholas Lardy persuasively argues that those statistics are also consistent with the interpretation that the composition of China’s economy has been shifting away from heavy manufacturing and toward services.

The shift away from manufacturing to services is one component of a desirable package of policies to smooth the transition to a sustainable growth rate. Another is a reduced reliance on investment spending and export demand, and a greater role for household consumption. Other desirable reforms include increasing the flexibility of land markets and labor markets. For example labor mobility is still impeded by insecure land rights in the countryside and the hukou system in the cities. More generally, the markets should continue to play a growing role in the economy. State-owned enterprises should be reined in. Reforms are also needed in health care, social security, and the tax system. And, of course, environmental regulation and the end of the one-child policy.

Chinese economists and leaders know all this. Indeed a very similar list of reforms was the outcome of the Communist Party’s Third Plenum in 2013. Beijing has taken some steps to implement them over the last two years. But there is still a long way to go and it is by no means guaranteed that the implementation will be fully successful. As Shang-Jin Wei of the Asian Development Bank points out, the fate of China’s economy depends a lot more on how well the reforms go than on anything about last year’s stock market bubble and its subsequent reversal.

This post written by Jeffrey Frankel.


19 thoughts on “Guest Contribution: “China’s Slowdown”

  1. Miguel Navascues

    this is not the question. The question is financial, how many debts are cumulated and cause negative expectation. Money is flying from China. Official Reserves are depleting rapidly. The devaluation forces accelerate the capital flying. See the last article of Gillian Tett in FT about these questions.

    1. The Rage

      Money is flying from China……… surprise there either. It had to leave. Think of it as a large inventory correction, one that will probably begin to ebb by spring by summer.

  2. The Rage

    As I have said several times, the market made error on this one. They should have been pulling back in 2012, instead they let their belief everything Sino was going to stay the same allowing the same general pattern since 2003 to linger 2 more years. ………so they blew the trade. Now we get a fat inventory correction. My guess 2016 much like 1996 is the transition year.

    1. Jeff Frankel

      I agree with this comment by “Rage”. The markets are reacting only now to an economic slowdown that began in China in 2012.
      I also think that the Chinese authorities should have increased genuine exchange rate flexibility back then, when money was still flowing in. Waiting until the currency is under strong downward pressure to exit a peg is always problematic. Compared to that mistake any stumbles they have made in communications strategy regarding the currency since August are relatively minor.

  3. BC

    China’s non-gov’t sector (gov’t spending at 25-30%/year for 2015 at ~14% of GDP) is in recession.

      1. PeakTrader

        If the Iraq war cost $4 trillion, the Vietnam war must have cost many times more.

        For example, there were 4,500 deaths in Iraq and 58,000 in Vietnam.

        Anyway, foreigners paid for the Iraq war, indirectly, through large trade deficits, unlike Vietnam.

      2. BC

        Steven, no slight intended whatsoever, if that is what I infer you imply. I highly value your insights and perspective, otherwise, I would not bother to respond.

        From my 25- to 30-year study of economic history and having lived and worked in Asia and visited China more than a dozen times since the late 1990s, I have contended since 2005-08, and consistently since, that China is a four-letter word: “Sell”.

        China has reached the so-called middle-income trap, but unlike when the US and Japan achieved respectively a similar situation in the 1930s and 1960s, the Middle Kingdom is facing conditions of Peak Oil per capita (the Chinese don’t have the luxury of the capacity of growing oil production for 40 years at 3% per capita that the US enjoyed, including being a net exporter); population overshoot; peak global industrial production per capita; global resource depletion per capita; excessive debt to wages and GDP; the end of growth of global “trade” (the Anglo-American imperial trade regime) and the debilitating, pernicious effects of extreme, Gilded Age-like wealth and income inequality that is one of many factors reducing reducing labor’s share and thus the trend rate of growth of productivity (80%+ of jobs created don’t permit workers to increase skills and working hours to increasing their productivity and thus enjoy increasing compensation and after-tax and -debt service purchasing power), investment, production, employment, and by definition the post-2007 rate of real GDP per capita, which is at ~0% vs. the long-term rate of 2.1% and 2.66% during growth phases.

        Same as it ever was . . .

        And so it goes . . .

  4. Anarchus

    Being pegged to the dollar, the Yuan appreciated and got very overvalued relative to China’s non-US trading partners when the dollar took off to the upside in the summer of 2014. Additionally, China now has a debt problem and a currency flight problem and went through $108 billion of reserves in December 2015, which is a lot for a single month even if you have $3.3 trillion total.

    There are estimates that it takes about $2 trillion in foreign currency reserves to keep China’s economy functioning smoothly . . . . .

    1. BC

      “There are estimates that it takes about $2 trillion in foreign currency reserves to keep China’s economy functioning smoothly . . . ”

      Anarchus, precisely, and do the math vs. China’s reported GDP, which implies a 1930s-like debt deflation and nominal GDP contraction (or generational loss of growth hereafter into the 2020s-30s) to restore the GDP to anything close to potential real GDP vs. population, labor force, productivity, labor share, profits, etc.

  5. PeakTrader

    China Labour Bulletin
    Wages and employment
    4 August, 2015

    Analysis and conclusion

    “China’s recent wage increases began from a very low base and actual wages are still far below those in major developed economies…Wealth inequality is regularly cited in opinion polls in China as the country’s most pressing social issue, along with corruption…as the manufacturing sector shrinks, factory workers have been laid-off without proper compensation or the social-insurance payments they were legally entitled to.

    The lack of social insurance coverage for China’s low-paid workers is one of the main reasons why wage increases have failed to really improve their lives. Without a pension or decent health insurance, workers often have to save whatever they can in bank deposits, wealth management schemes or the high-risk stock market in order to try to secure their future. This means that working families have little to spend on goods and services that could both improve their standard of living and boost the local economy through domestic consumption.

    In addition to a decent wage, workers need a safe working environment and a social welfare safety net to ensure that their entire life savings are not at risk when they retire, are badly injured or unemployed for a long period of time.”

    1. BC

      Peak, yes, China (and India and Africa) is (are) 80-100 years too late to becoming an oil-rich (until 1970-85 for the US), industrial, middle-income economy that can afford industry requirement costs that can support a value-added, services-based economy of ~80-85% of GDP.

      It ain’t gonna happen.

      1. PeakTrader

        BC, if compensation growth of China’s masses is too slow and saving remains high, shifting into services will be too slow, which makes a hard landing more likely.

    2. Anarchus

      China made a gross policy error when they launched the one child policy in 1979-1980.

      They’re about to hit the demographic wall that Japan ran into back in 1998 when their labor force peaked. Turns out it’s very difficult to get an economy to grow in the absence of an increasing labor force. All those fixed costs getting spread over a systematically decreasing base make productivity gains much, much harder to come by.

  6. Ben

    The most credible accounts on China’s economy I have come across so far are those from China’s President and PM.

  7. Steven Kopits

    Premier, yes. President, no.

    That’s the problem, Ben. The pros on the economy are sitting on the sidelines, and it’s just killing China right now.

    Bring back the Markit flash PMI, and much will be forgiven.

  8. Ben

    Steven, the fact is there are tens of thousands pros handling economy in China, from think tanks, institutions, civil service to commercial entities. PM Li is tasked with leading, executing and running the economy, while the president together with Li and relevant high level committees set high level policies and directions.

    1. Steven Kopits

      I have high regard for China’s technocrats. But are they calling the shots? Don’t think so. No technocrat ordered the pulling of the Markit flash PMI. That was a political decision.

      Also, let me qualify that statement just a bit. I think the guys at the PBoC are paralyzed just now–and not without cause. For the first time in history, China’s monetary policy is tossing around global capital markets like a toy boat on a stormy sea. I think these guys are shocked that they devalue the yuan and the DOW sheds 1,000 points and oil falls $10. They are discovering the limitations of a hegemon. Whatever you do affects everyone. Vietnam can afford to be careless. The Philippines can afford to be careless. Even Japan, to an extent, can afford to be careless. China cannot. It has far fewer degrees of freedom in policy-making than other regional economies.

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