Is China Growth Sustainable?

The following blog is a part of essay which was sent to an essay competition organised by ''The Diplomat"-A Japanese organisation.

Since the reform of 1978, China’s overall economic performance has been remarkable. The average annual GDP growth rate reached 9. 4% in 1978-2002. However, in the last few years, China’s economic growth rate has been questioned. A deflation was evident at the end of 1997. In spite of the Chinese government’s many efforts, the deflation has continued. A deflation in an economy in general is accompanied by stagnation or slow GDP growth. However, China’s GDP growth rate reached 7.8% annually during the deflation period in 1998-2002, which was the fastest growth rate in the world. Moreover, the energy consumption dropped in 1998 and 1999. The abnormality prompted some economists to question the reliability of China’s statistics. In the paper, the author will analyze why it was possible for China to maintain high growth with reduction of energy consumption during the deflation period and suggest the way for China to absorb excess capacity and get out of the deflation. We shalll also discuss the prospect for China’s long-term growth.

Investment Rush and China’s Deflation:

A deflation is an economic phenomenon characterized by continuous decline of general price level in the economy. Theoretically, a deflation is either due to an overall drop in demand in an economy, or due to a sharp increase in supply in the economy. Demand decline could come from the collapse of financial and real estate bubbles, a result of which national wealth shrinks, leading to a further decline in consumption. At the same time, the level of bad loans increases while credit contracts and investment demand decreases. As is well known, the 1929 Great Crash in the United States (US) and the consequent deflation, which continued throughout the Depression, were a result of the bursting of bubbles in the stock market and the breakdown of the financial system, leading to a sharp decline in consumption. The Japanese deflation since 1991 is also a result of the See Bordo and Redish (2001) for an interesting historical study on the effect of deflation on output.

The burst of bubbles in stock and real estate markets triggered the Great Depression in the US and the recent deflation in Japan, however, the Chinese stock and real estate markets work under a special institutional environment and are still relatively insignificant in the Chinese economy, and therefore their effects over the total demand should not be overestimated. But, China was not affected by deflation to the extent which other countries had to suffer.

Some Desired Changes:

Rural infrastructure construction needs to be implemented by local governments and grass-root organizations due to its small scale and scattered nature. The central government and local governments can invest jointly. The central government can allocate special funds and require local governments to add a certain matching fund. The exact way of funding can be explored in practice. It is unreasonable to depend on county, township and village-level governments to finance completely the rural infrastructure projects. If they are carried out in that way, the burden of financing those projects will unavoidably fall on rural households. In the past, the government provided funds for the construction of urban infrastructures but rural peasants had to finance the rural infrastructures by themselves. This has been the main reason for the backwardness of rural infrastructure due to the existence of unbearable burden on rural households.

Soaring prices

In “China bubble” predictions, Chinese property markets are typically portrayed as unitary or homogeneous. Yet, there is huge variation among cities and regions. In 2009, the urban GDP per capita was highest in Shenzhen reaching almost US$13,800 USD, whereas in Hefei it was about US$6,100.

Until recently, the concern for the soaring prices in the property markets has been focused primarily on the high-end segment of the first-tier cities. Since the 1980s, the economic ripple effect of the successful first-tier cities – such as Shenzhen, Beijing, and Shanghai – has been spreading into new generations of Chinese cities.

By the early 2000s, second-tier cities – from Suzhou and Shenyang to Chengdu and Chongqing - attracted significant attention with investments from global corporate giants. Third-tier cities – from Ningbo and Fuzhou to Wuxi and Harbin – have been following in the footprints, while inspiring still others, such as Kunming and Hefei.

Yet for the most part soaring prices characterize primarily residential properties - almost exclusively the high-end segment of the most prosperous first-tier cities.

In March, property prices in 70 Chinese cities soared by a record 11.7 percent from the previous year. In response, the government rolled out a series of measures to curb the domestic housing market amid concerns over asset bubbles.

In early May, the People’s Bank of China raised the reserve requirement ratio for major banks by half a percentage point. Property stocks were expected to face further decline. Following Beijing and Shenzhen, the Shanghai municipal government released regulations for the property sector to curb housing speculation and soaring prices.

Some observers worried that tightening policies may deter property developers from starting new projects and purchasing land, thereby cutting the supply and pushing up prices next year. And yet, despite these measures, housing prices rose 12.8 percent in April from a year earlier. At the same time, China's urban fixed-asset investment increased by 26.1 percent year-on-year to $684.63 billion. The growth rate was 4.4 percentage points lower from the same period of 2009.

As public concern over “skyrocketing housing prices” continued to simmer, the real estate tycoon Ren Zhiqiang was hit by a shoe at a forum in Dalian. The attacker was fuming over soaring housing prices.

Last month, home prices in 70 Chinese cities rose by 12.4 percent year-on-year. The growth rate was 0.4 percentage points lower than in April, as property sales in first-tier cities (including Beijing, Shanghai and Shenzhen) contracted following the string of government measures. New home prices rose 15.1 percent year-on-year, down 0.3 percentage points from April.

Toward new developments and new business models

In the West, the great urban centers – from Paris to New York City and Tokyo – evolved into great metropolises in a century or two. In China, the first-tier cities – such as Shenzhen, Beijing, and Shanghai – are morphing into global cities in barely decades.

Understandably, the residents of the first-tier cities would like to own an apartment in their home city. However, these cities also attract the wealthy across China, prosperous investors in East Asia and multinational property companies worldwide.

Additionally, the high price-to-rent ratios have been driven by speculation, the desire for long-term investment, and few investment instruments.

Even buyers contribute to soaring prices. To facilitate the marriage of their son or daughter, parents are often willing to devote their savings to real estate. As the young couple and their parents put income and savings into a purchase of a single apartment, excessive prices are driven even higher.

In addition to great demand, the soaring prices reflect supply dilemmas. Currently, residential real estate development is geared to high-end and high-margin properties, which ensure a significant cash flow for cities. In the leading cities, the direct and indirect GDP contribution by real estate can amount to some 25-35 percent of the GDP; in other cities, this contribution is relatively higher. Ironically, luxury developments support local incomes, which maintain economic growth nationwide.

As long as high-end real estate offers high margins where affordable housing does not, regional governments, which possess the land rights, have an incentive to prioritize luxury projects.

The government seeks to sustain real estate market development and thus to support growth critical for China’s economy. It also seeks to ensure affordable housing vital to Chinese people. As debt problems are escalating in the West, reconciling these goals – economic growth and affordable housing – poses a difficult challenge.

A shift towards affordable mass-market – reportedly only 10 percent of total residential sales – is critical. In the current business model, high margins come from a very narrow high-end segment of the market. This made sense in the early days of Chinese real estate when only few wealthy people could afford a home.

Today, far more Chinese are able and willing to acquire a home. A new era requires a new business model, which can be based on the broad middle-class segment of the market.

Conclusion: China is not Japan déjà vu

In China’s property markets, some argue that the risks are now so great that a decade of little or no growth, as Japan experienced in the 1990s, can no longer be dismissed. They see parallels with Japan in the late 1980s, when authorities responded to the export slump caused by the revaluation of the yen after the 1985 Plaza Accord. As Tokyo adopted a low interest rate policy to boost an expansion in domestic demand, it also created conditions for a massive economic bubble.

Yet, contemporary China’s situation is very different. First of all, in China, there remains a large shortage of residential property that meets new living standards.

In Japan, property price increases were more than 30 percent in the latter half of the 1990s. In China’s prosperous coastal cities, they have been around 12 percent in 2003-2009.

In Japan, the health of the banks deteriorated rapidly with the asset bubble. In China, the share of non-performing loans declined from almost 20 percent to less than 2 percent in the 2000s.

In Japan, the asset bubble occurred after the eclipse of the high-growth era. Instead of a potential growth rate of 3-4 percent, China, assuming stability in the international and domestic operating environment, may enjoy relatively high growth for another decade or two. In such circumstances, even rapid price fluctuations in the first-tier cities can be tolerable, even if they are not preferable.

Today, there are some 360 million urban residents in China. In the next three decades, the figure is expected to grow to 970 million. What Beijing is trying to achieve is unique in history – to create urban space to more than 610 million people, within a single generation.

In such an environment, periods of overheating will occasionally be accompanied by dramatic price increases.

China, the urbanization rate is about 45 percent, whereas in Japan and other advanced countries it is more than 80 percent. As these nations reflect very different levels of economic development and different levels of individual prosperity, their real estate markets are different as well.

Despite its rapid pace of expansion, China’s real estate is still at a very preliminary stage. The marketplace is so colossal that there are no precedents, no simple models.

Yet the prospects for a robust growth remain intact. The key will be not to allow that growth to become threatened by a property bubble – while providing affordable housing for the rapidly-expanding new middle-class.

It is very likely that China may maintain around 8 percent of GDP growth rate for another 20 to 30 years. This is because technological innovation is the most important determinant of economic growth. As a developing country, China’s technological level lags far behind that of developed countries. Therefore, China can rely on technological borrowing from advanced countries to achieve technological innovation at lower cost and make technological borrowing a driving force for its economic development. It is because of this reliant on borrowing technology from advanced countries that Japan and the four small East Asian Tigers were able to achieve dynamic growth for about 40 years after World War II.

As is shown in Table 5, all the major development indicators in China today are very similar to that of Japan in the early 1960s. China should have a similar technological potential as Japan had in the early 1960s. For this reason, I am confident that China could potentially achieve 8% annual GDP growth rate in the coming two or even three decades. If China can realize this potential it will be the largest economy in the world in the early 21st century.