The unpalatable choices that lie ahead for China's economy

The crisis year of 2008 was a turning point for the Chinese economy’s performance; until then, China had grown at an astonishing rate, with average quarterly GDP growth reaching 10.5%. But in the years following 2008, the engines of economic growth slowed down. Even the unprecedented €4bn (four trillion renminbi) stimulus package announced towards the end of that year to bolster economic growth, the Chinese economy was unable to avoid a soft landing, for by 2013 the annual growth rate dropped had to 7.5.

At first glance, the changes in China’s GDP are even more alarming. The share capital formation to GDP had been at a constantly high level before the worldwide crisis broke, and it even climbed from 41.6% in 2008 to 48.3% in 2012. The share of consumption to GDP, though, dropped from 56.9% in 2008 to 49.6% in 2012. By much the same token, net exports had been increasing quickly before the crisis, but plummeted by 2012.

The result has been that the contributions to China’s growth of investments, consumption and net exports changed substantially. The average contribution from consumption to annual growth rate saw a slight but nonetheless encouraging improvement between 2008 and 2012, while from investment it surged from 48.5% to 57.3%. But the contribution from next exports fell off the cliff, dropping from plus 11.8% to minus 6.2%. In other words, rather than shifting from investment-led to consumer-led growth, post-crisis China appears to be stuck on its investment-led growth track.

But consumption versus investment is only part of the rebalancing debate; the other part is promoting services over manufacturing industry. There’s greater cause for optimism here; back in the 1990s, the share of services output to total output was expanding greedily, from 31.6% in 1990 to 39.0% in 2000, and uninterrupted by the global financial crisis, increased steadily in 2013. The share of industrial sectors increased through the 1990s and peaked at 42.2% in 2006, and then declined to 37% by 2013. The share of construction, on the other hand, reached a record high in 2013. Agriculture and mining gradually dropped from 27.12% in 1990 to 10.7% in 2008, and then slid further to 10% in 2013. The accelerated growth of the services sector can be illustrated by the employment statistics, for in 2011 the services overtook the primary sector as China’s biggest source of jobs.

The rise of the services sector is important for many reasons. A major difference between the services and industrial sectors is that they belong to different types of market structure. The manufacturing sector is more like a perfect competitive market, while services sector resembles a monopolistic competitive one. Most enterprises in China’s manufacturing sector are privately owned and face fierce competition in both international and domestic markets. Many manufacturers find themselves competing in a near-perfect market. There are almost no barriers to entry, with unlimited producers and consumers at their disposal. Pricing is also flexible enough for companies to respond to changing market signals.

For the services sector, there are two main segments. One is dominated by private companies whose businesses are generally retail, wholesale, tourism or real estate. The other is dominated by state-owned enterprises (SOEs) with activities in transportation, telecommunications, finance, healthcare or education. Compared with the manufacturing sector, services companies deal with a more closed market, and are more likely to be haunted by government intervention. There are fewer competitors in the services market because companies can easily differentiate their products from one another. The market structure for China’s services sector therefore looks more like monopolistic competition.

The macroeconomic implications of these structural changes in the Chinese economy can be illustrated by a “New Keynesian” economics model. In a seminal 1987 paper, Olivier Blanchard and Nobuhiro Kiyotaki characterised the equilibrium of a monopolistic competition market, and compared it with the equilibrium under a perfect competition market. Their basic conclusion was that both the output and employment level in a monopolistically competitive equilibrium are lower than optimal.

Blanchard and Kiyotaki’s model provides a convenient conceptual framework for analysing China’s structural changes. If we can agree that the manufacturing sector is more like a perfect competitive market and the services sector is more a monopolistic competitive market, the expansion of the services sector and the decline of manufacturing suggest that China’s growth potential will continue to decline.

In this post-crisis period, China’s leaders have to face three daunting challenges in their management of the economy: First, they need to maintain stable economic growth if they are to avoid a crisis. Second, they need to create more, and better, jobs to avoid a social crisis. Third, they must pursue financial soundness to avoid a financial crisis. All three goals are all very important, but what might happen should they clash?

If China wants to boost economic growth, then the most effective way is through expansionary fiscal and monetary policies, as in 2008 and 2009. When external demand fell, domestic demand was expanded through government-led fiscal stimuli and credit expansion. In 2011, that policy of stimulus came to a halt when inflationary pressures emerged. But in 2012, the monetary authority took quite a benevolent attitude toward China’s bulging shadow-banking system, and the result is a marked expansion of credit, which is supporting infrastructure-building. This approach will result in a higher GDP in the short term, but with a much greater chance of a painful correction later on. Continued industrialisation and infrastructure-building cannot own their own provide enough job opportunities, and an uncontrolled increase in the supply of credit will fuel a housing bubble and, eventually, inflationary pressures that will see the more rapid accumulation of financial risks. What is more, stimulus policies can also make income distribution more uneven, favouring capital over labour and monopoly sectors over truly competitive ones. Domestic consumption, meanwhile, will be further depressed.

To create more job opportunities, China needs to unlock the huge potential of its services sector. Services are far more labour-intensive than heavy industry or construction, and their development would enable China to meet its job creation targets with much slower GDP growth than in the years past. It’s fair to say that unemployment has so far not been a burning issue for China, which is why the government is able to tolerate a fall-off in the growth rate. Demand for migrant workers is now greater than supply, and the economy is beginning to grapple with serious labour shortage. Wage levels for migrant workers are now rising at a yearly rate of 15-20%, and the overall job market shows no sign of being alarmed by this.

But is all this too good to be true? Take the example of Spain; when the Spanish economy was booming, unemployment was unthinkably low. But once the music stopped and the economy was hit by the financial crisis, the unemployment rate suddenly soared, especially among young people. China needs to be prepared for just such a situation. The shift from factory to services cannot, however, support a high growth rate, and with slower growth the financial sector will face more risks. It is therefore possible to predict for China a painful and prolonged period de-leveraging and a bearish financial market.

To reform its financial sector, China must restrain excessive credit growth while dealing with the thorny problems of shadow banking and local debt. The global financial crisis led in China to an extremely expansionary monetary policy with almost no restrains from the regulators. This caused the debt level to balloon in China, first through traditional bank lending and then through the opaque shadow banking sector. Over the last five years, debt levels in China have increased by 71%. Most of this debt was used to finance infrastructure, real estate and heavy industries, and there are now growing fears that the revenue that can be generated by these projects won’t be enough to repay the loans, resulting in defaults that will undermine confidence and perhaps trigger a financial melt-down.

What goes up must eventually come down, and China has to restrain credit growth and curb moral hazard. But cracking down too quickly on shadow banking risks causing panic, and would also starve private enterprises of working capital and so cause real harm to growth and employment. So how can China press ahead with its financial clear-up while avoiding a severe economic slowdown?

That’s the “trilemma” the Chinese economy faces, and it’s not so different to that of more open economies, or what Paul Krugman called the “eternal triangle”. This states that among the three goals of monetary autonomy, exchange rate stability and free capital flows, policymakers can at best choose two, but must give up on the third. China’s current situation is such, though, that it could well be that its policymakers can only choose one and must give up on the other two.

In the short term, maintaining an acceptable growth rate is still the most important goal for China, and imbalances that have accrued over the past decade cannot quickly be removed. Any attempts at a radical rebalancing might create a major slowdown in GDP growth, and that would also postpone market-oriented reform or even cause a backlash against it.

But nor does it seem useful to suggest another massive round of spending initiatives to counter the slowdown. In the long run, China’s growth potential is going to decline with or without a rebalancing. Such other factors as the dramatic change of China’s demographic profile will also affect the growth trajectory. Policymakers would therefore do better to accept it and put more emphasis on employment and other social goals. In this sense, a greater reliance on services will allow China to settle into a lower and more sustainable growth trajectory.

Financial stability is important, but given the fact that China’s financial system is relatively primitive and closed, and Chinese exports still give it a large current account surplus, the government has more leverage than its western counterparts. Modern China’s experience has been that it’s always better to “grow out” of its problems, and even if the most difficult problems are not solved, they can at least be forgotten for the time being.