China Needs a New Growth Model

Under the leadership of Deng Xiaoping, China transformed itself from a poor, agrarian nation to arguably a global superpower. For much of this growth trajectory, China followed the so-called “export-led growth” model – imitating the success story of their East Asian neighbours. But since around the last 10-15 years, China’s growth started to be increasingly propelled by investments, rather than exports. 

After 2008, the pace of investment-led growth accelerated on the back of rapid credit expansion. In 2011, Investments accounted for a whopping 48% of the Chinese GDP. This unfettered, uncontrolled debt-financed investment has helped create a huge property bubble which threatens China’s future growth prospects and has now become a huge headache for the Chinese Communist Party (CCP). In order to solve this problem, China needs to rebalance its economy and shift toward a consumption-led growth model from an investment-led model.

The Fallout in Real Estate 

In 2008, the US real estate market collapsed following a subprime mortgage crisis. The crisis soon spread to the financial markets all around the globe and brought the world closer to another Great Depression. When the crisis hit China, the government went all-out to help the economy. Fearing a slowdown in growth, the State Council initiated the largest stimulus package in the world back in late 2008. 4 trillion RMB were injected into the Chinese economy. Credit conditions were eased. Regulations in the property market were relaxed in an attempt to stimulate demand. As a result, the Chinese economy rapidly bounced back and was one of the very first countries in the world to emerge out of the crisis.

A significant amount of that stimulus money flowed into the real estate sector. Easy credit conditions and the massive stimulus saved the Chinese economy from the Great Recession but at the expense of creating another homegrown real estate bubble.

Exceedingly high demand sent housing prices through the roof. So much so that even the middle class were being priced out of buying homes. Yet, the share of empty buildings in the cities was growing at an alarming rate. Pretty soon Politburo realized that the excessive demand that they were seeing in the housing sector was not coming from actual homeowners but from speculative investors. China had developed a full-blown real estate bubble – ready to pop at any moment and take the whole economy with it.

Instead of letting the bubble go out of hand and crash the whole economy, China decided to pop the balloon early and then do damage control. Though this time they are not willing to throw money around to save everyone like the last time.

Nevertheless, the authorities will have to make a tough choice. If China doesn’t bail out the banks or the heavily debt-burdened and insolvent real estate investors, they run the risk of spreading the crisis to other sectors of the economy and it becoming a full-blown financial crisis, just like the US in 2008 and Japan in 1990. On the other hand, they don’t want to create moral hazard by rewarding the reckless investors by bailing them out.

China is not the first country to have a crisis like this. In fact, China’s situation eerily resembles that of  Japan in the 90s. In the 70s and 80s, Japan became the poster child of the export-led growth miracle. However, that growth rally, unfortunately, ended with a real estate crisis in the 90s. The aftermath of the crisis led to a protracted period of extremely low growth and deflation in Japan known as “the lost decade” from which the country has still not recovered. 

China doesn’t want a repeat of that in their economy. That’s why in addition to adopting short-term policies to put out the fire of the property sector, China also needs to rebalance their economy to truly address the deeply rooted imbalances in the economy that caused the crisis in the first place.

Rebalancing The Economy is The Only Long-Term Solution 

People still perceive China as an export-led economy. Indeed, the rising trade surplus of China is the key reason why US President Trump started the trade war with China. But, this is mostly a wrong idea. “From the beginning of the 2000s, China increasingly became an investment-led economy. After 2008, it became ever more reliant on credit expansion to drive growth” wrote George Magnus, a China expert and former Chief Economist at UBS. 

China’s investment rate, which peaked at 48 per cent of GDP in 2011, still remains around 40-45 percent of GDP which is extremely high compared to global standards. For example, the investment rate in the US and EU is 22% and 24.3% respectively.

For a long time, China was a poor and severely underdeveloped economy. When China started growing in the ’70s, they really needed a huge amount of investments in infrastructure and manufacturing capacity. So, China had a lot of room to productively absorb the investment. But after more than three decades of investment, China has now reached a stage where the available investment is more than the investment gap. “Now that it has more investment for its level of development than any other major economy, China is destroying an increasing amount of its wealth by diverting it into investment that produces no net benefits to the economy” wrote Michael Pettis who is a Finance Professor at Peking University

China is now investing more than it can productively absorb. These inefficient non-productive investments in the property sector for the last 10-15 years kept increasing the debt burden without adding much value to the overall economy and carry much of the blame for creating the property bubble.

Deflating the property bubble is not going to be enough to fix the economy in the long run. China has built their economy by exploiting low wages. So, the households of China receive very little share of the total national income. China needs to restructure its economy so that a significant share of total income goes to households. This will increase total consumption and boost domestic demand

The good news is politicians in China are well aware of this problem and how they can solve it. But actually implementing the policies that will ensure more household income and strong social protection remains a politically difficult job even for the CCP.

“Awareness has been evident since the 2010s and was reflected in the 13th Five-Year Plan (FYP) 2016–2020, which set out to address China’s ‘unbalanced, uncoordinated and unsustainable’ growth. The principal goal is to rebalance the economy away from increasingly inefficient investment-led growth towards a model that emphasises the contributions of consumption, innovation, social welfare and environmental protection.” Wrote George Magnus in his book Red Flags: Why Xi’s China Is In Jeopardy

China is now at a crossroads. It has two options: address the imbalances in the economy or let the status-quo prevail and increase the burden of debt which will inevitably lead to financial instability. The sooner Beijing makes the right decision, the better they will be able to adapt.

Author- Abrar Galib Fahad

The author is the Lead of Growth and Sustainability Cluster of Youth Policy Forum.