Despite its enviable growth rates, China faces a raft of well-publicised economic and societal challenges. It recent 5-year plan did a good job of acknowledging these concerns but was less clear on how it would overcome them. With a leadership change in 2012, it will likely be some time before we see any significant policy changes.
Inflation, which rose to 6% last month, remains the primary concern among China’s policy makers at present. Keenly aware of its political implications, China has combined short-term measures such as price controls with a tightening of monetary policy. However China must walk a tight rope as its squeeze on credit may unduly hit small and medium sized enterprises (SME)s. Already faced with rising raw material and labour costs, SMEs also come a distant second to giant State Owned Enterprises (SOE)s when it comes to accessing loans.
Rebalancing a behemoth
The five-year plan is explicit about moving China away from its current export- and investment-dominated growth model to one that is increasingly driven by domestic consumption. Under its current model private consumption and employment growth have stagnated with the latter being exacerbated by China’s focus on capital-intensive industries and the sluggish growth of its services sector.
This imbalance was made worse during the recent financial crisis. Faced with declining exports, China instructed its state-owned banks to fund a lending spree of $1.5 trillion, much of which ended up in the hands of SOEs. Bolstered by subsidises for land and energy, this facilitated a massive investment boom, which accounted for 90% of GDP growth in 2009.
What is the danger of such a model? China is still a poor country and so in many cases large investment projects may yield considerable long-term benefits. However with so much capital being allocated so quickly, waste is likely. In addition there is the danger of excess capacity in industries such as steel and aluminium. Banks also fear a rash of non-performing loans, particularly among local governments.
So how can China rebalance its economy towards domestic consumption? Recent wage increases are a key step in making this happen. However to change consumption patterns, fundamental reforms in the areas of social security, healthcare and education are also crucial. Finally China must overcome its bête noire and allow a significant appreciation of its currency.
The RMB has appreciated by about 8% against the dollar, in inflation-adjusted terms, since June 2010. While this has helped to diffuse some political tensions, most analysts argue that the RMB is still hugely undervalued. For evidence, they point to China’s continuing rapid accumulation of foreign reserves. Allowing its currency to appreciate would help spur private consumption in China and free up its central bank to pursue a more conventional monetary policy, where it could focus on tackling inflation while maintaining stable economic growth.
However the benefits of currency appreciation have long been clear to Chinese officials, especially those in the People’s Bank of China (PBOC). The reason for their timidity has been the staunch political opposition of China’s Ministry of Commerce (MOFCOM), who rightly expect any major appreciation to hit China’s export industry.
Banks, real estate and bad loans
China’s 5 year plan also acknowledged that it must continue to modernise a repressed financial system, where savers face negative real interest rates. When you add to the fray a volatile stock market, tough capital controls and an anemic corporate bond market, this has left individuals and companies with limited investment options. One result of this has been a persistent boom in real estate prices.
In the housing market, cash-rich and choice-poor investors have fuelled a massive increase in luxury property sales. As a result developers no longer focus on building homes for customers who are looking to live in them. Rather, they build more and more luxury apartments. These apartments are sold to investors and often lie empty. This is not a conventional bubble and is not backed by leverage. Rather, as Patrick Chovanec has pointed out, it is an inefficient allocation of capital, with housing being used as a store of wealth. Beijing is well aware of this issue and has recently introduced property taxes in selected cities, to dissuade investors.
In commercial real estate, cash-rich SOEs have also been piling into real estate investments. Contrary to the housing market there is a leverage concern here, as many of these investments rely on loans from China’s state-owned banks. In addition many commercial loans in China use real estate as collateral and companies could suffer refinancing difficulties if real estate prices took a hit.
So is China’s banking system in trouble? The five major banks are well-capitalised on paper and recently enjoyed record profits. However there is growing concern among analysts that these banks are under-estimating their potential non-performing loans. While most analysts expect the government to mitigate any future crisis, a rash of bad loans could act as a drag on future lending and hold down Chinese growth.
The five year plan shows China’s clear ambition to upgrade its traditional strategic industries, such as shipbuilding and automobiles, and to establish new industrial giants in fields such as bio-tech, new-generation IT, and energy conservation. Foreign companies are both excited and worried about this move. While China will clearly be a huge growth market for the latter industries, there are also concerns about how intellectual property can be protected.
Will China’s ambitious goals be matched equally ambitious policies?
The goals of the plan are lofty and far-reaching. But then China has never had a problem in setting itself lofty goals. The real question is whether the political will exists to tackle vested interests and end the “growth at all costs” model. Most onlookers expect that key reforms will not take place until after the leadership transition in 2012. With Xi Jinping and Li Keqiang likely to enter the fray, they will need to quickly shore up the confidence and support of party elites if they are to tackle China’s challenges head-on.