The recent downturn in economic growth in China has led to a renewed focus on the sustainability of the Chinese model. China is commonly described as following an export-led growth model, yet for at least the past few years this has not been true. It has been investment, rather than exports, that has driven growth in recent years, particularly the explosive growth of investment in real estate. Understanding the sources of growth and their sustainability is the key to analyzing changes to the Chinese economy as a result of the crisis.
Trade is an important part of the Chinese economy, but its contribution to economic growth is often overstated. In fact, in 2011 slower growth in export and a rise in imports mean that trade actually subtracted .4 percent from the country’s growth.
Investment, rather than trade, has been the key driver of Chinese economic growth over the past decade. Investment as a share of GDP has increased rapidly, rising from 41 percent in 2001 to 49 percent in 2011. This rise in investment, in turn, has been driven primarily by the rapid growth of residential real estate investment, which has increased from 6 percent of GDP in 2003 to 11 percent in 2011. This is a spectacularly high number, greater than in the United States where the housing bubble peaked in 2006 and on par with the excesses reached in Spain and Ireland.
The rapid increase in real estate investment in China is not a random event. It can be traced back to China’s system of financial repression, a financial structure in which domestic savings are trapped within the domestic financial system and forced to subsidize borrowers by artificially low fixed interest rates. China has always had some level of financial repression, but the system became significantly more repressive after 2003 when the People’s Bank of China (PBoC) set the deposit rate to be below inflation on average.
The system of financial repression in China is a backdoor subsidy to the banks. China’s undervalued fixed exchange rate required massive intervention in foreign exchange markets by the PBoC, to the tune of almost 10 percent of GDP per year in the post-2003 period. These required offsetting measures, commonly referred to as sterilization, to prevent inflation. To engage in sterilization, the PBoC required banks to buy low-yielding central bank bills and place a large amount of their deposits in PBoC accounts, as much as 21.5 percent at the peak.
These measures constituted an implicit tax on banks’ profitability as the yield on central bank bills and required reserves were much lower than the prevailing lending rates. To compensate banks for this loss the central bank set a ceiling on deposit rates and a floor on lending rates, in effect giving banks access to a cheap funds and a guaranteed interest rate spread.
China’s closed financial system meant that depositors had few alternatives. Capital flows out of the country are strictly regulated and the stock market has not recovered from its peak in 2007 due to rampant speculation and insider trading. As a result, households increasingly channeled their savings into real estate where they could earn a much higher return. China’s property market boomed in this financially repressed environment, with rapidly increasing square footage per capita and more than one-fifth of all households purchasing additional properties as investments. Related industries, such as steel and cement, also enjoyed tremendous growth as a result.
High home prices have been the focus of China’s top leaders for half a decade now. It’s an issue that reaches beyond just the economic sphere and has a direct impact on social stability. Policymakers began tackling the issue in 2007 with a series aimed at reducing demand, including raising the required down payment and increasing interest rates on mortgages. These measures started to show results during 2008 but were quickly abandoned in the face of the global financial crisis.
China’s stimulus during the financial crisis was timely and effective, especially when compared to the alternative of a rapid decline in growth. Unfortunately it did little to change the underlying dynamics of economic imbalance. The boom in lending that was part of the stimulus quickly reflated the housing market and prices and real estate investment increased rapidly during 2009, 2010, and the first half of 2011.
At the end of 2009, Chinese policymakers again began taking measures to reduce real estate speculation. Increase in mortgage interest rates and down payments and restrictions on purchasing multiple properties took almost two years to gain traction, when housing prices started to decline at the end of 2011.
The Chinese economic growth model has now come to a crossroads. Government policies aimed at tamping down the real estate sector are starting to take hold. The growth of real estate investment is at its lowest rate since the global financial crisis. The slowdown in investment has had a significant impact on GDP growth, with the economy growing only 7.2 percent in the first quarter of 2012 on an annualized basis.
The considerations of the upcoming power transition in China later this year and ongoing concerns about social stability ensure that China’s leaders will take all measures available to ensure the continuation of rapid growth. However, China’s ability to stimulate the economy will be reduced compared to 2008 because of rising government debt, increasing household indebtedness, and a lack of good infrastructure projects to invest in after the massive building spree of the past few years. The social housing program will also come under pressure as local governments struggle to cope with lower revenues as a result of declining land sales. Measures like interest rate cuts and appliance purchase subsidies are likely to help in the short-term, but are not a sustainable foundation for future growth.
Given the weakness in China’s main export partners and the intention of policymakers of continuing the clamp down on the real estate market, the only sustainable path for China going forward is one where domestic consumption is the engine of growth. This will entail a whole series of structural reforms aimed at reducing the subsidies given to businesses at the expense of households. The recent announcement by the PBoC of increased upward flexibility on deposit rates is a hopeful sign that one of the main subsidies, negative real deposit rates, may gradually be eliminated. The global financial crisis has necessitated a change in China’s mode of economic development that will require a significant new wave of reforms.