China’s new leadership is saying all the right things, but they have been saying these things for quite a while – nearly two years in the case of Li Keqiang, the new premier.
The constraints they face, however, have neither changed nor been addressed. First, any real rebalancing means much slower growth than Beijing seems willing to tolerate. Second, the groups – 'vested interests' – that have benefitted from the old growth model remain very powerful and very reluctant to allow any erosion of the benefits they have accrued.
Two weeks ago, in his last formal State of the Union speech as China’s premier, Wen Jiabao announced that the 2013 growth target for China’s economy was 7.5 per cent.
Until 2011 China’s economic growth easily exceeded the target set by the government, but something strange happened this year. For the first time that I can remember, after issuing the target growth rate for the year, Premier Wen seemed to warn that the target would be difficult to attain. More specifically, he acknowledged that there was “growing conflict between downward pressure on economic growth and excess production capacity”.
A few days later Zhang Ping, head of the National Development and Reform Commission, reiterated the concerns about overcapacity. According to Xinhua,
"The industrial sectors suffering most from overcapacity include steel, cement, electrolytic aluminium, plate glass and coal coke sectors, which are operating at 70 to 75 per cent of their total capacity … Zhang told a press conference.
"According to widely accepted international standards, normal market competition features 80 to 85 per cent utilisation of production capacity."
China, in other words, is producing far more of everything than it can absorb or export, but the only way to keep growth high has been to invest even more, at least part of which creates even greater production capacity. This is what will make attaining the growth target difficult. The policy with which Beijing has been able to keep growth high for so many years has itself become a problem.
Do you believe the GDP numbers?
Much lower growth in 2012 suggested that rebalancing the Chinese economy, a goal that has been actively proclaimed since at least 2005 but which had never happened until 2012, was proving to be more difficult than expected.
But even with the lower growth numbers throughout the year economists were puzzled by evidence that the economy was in fact growing more slowly than the official numbers suggested. Energy consumption in China, for example, usually grows more quickly than GDP, but surprisingly, in 2012 energy usage grew by only 5.5 per cent, well below the official growth rate of 7.8 per cent. Other indicators also indicated that growth may have been lower than the official numbers suggested.
A consensus is developing that China grew by less than 7.8 per cent in 2012. For example Stephen Green at Standard Chartered, one of my favourites of the sell-side economists, refigured his numbers and guesses that instead of 9.3 per cent for 2011 and 7.8 per cent for 2012 (the official numbers), actual growth might have been 7.2 per cent for 2011 and 5.5 per cent for 2012. Other economists are suggesting even lower numbers, closer to zero.
And if we look closely at how growth was distributed in 2012 we might get a better sense of how hard it is to generate healthy economic activity. I think nearly everyone agrees that the first half of the year generated far slower growth, or economic activity, however measured, than the second half.
In the first half the authorities had managed to slow the growth in debt, which has been rising at alarming rates in the past decade and especially since 2009. Perhaps just as importantly, the rapid decline in inflation at the end of 2011 caused real interest rates to soar in late 2011 and early 2012.
Demand is driven by borrowing
In a system in which almost all the growth is driven by increases in investment, and in which an increasing share of investment is being wasted on factories, bridges, real estate, airports, and other projects that have little or no economic value, rising debt can be a very worrying problem since the ability to service that debt is rising much more slowly than the debt. This is why Beijing has been so eager to slow the growth in debt.
But as they did so in the first half of 2011, growth seems to have dropped very sharply. By the middle of 2012 it seemed that growth had slowed so quickly, even if it did not fully show up in the official numbers, that Beijing may have gotten nervous and begun to allow credit to grow rapidly once again.
The result was a surge of growth in the second half of the year, a surge that has continued into 2013. But this growth came at a huge cost. Total debt in the system, especially in the unregulated pats of the financial system, has grown at a record-breaking pace. Here, for example, is Simon Rabinovich of the Financial Times on the subject:
"Chinese credit issuance surged to a record high in January on the back of a boom in shadow banking, stoking concerns that the economy could overheat. Total new financing in January reached Rmb2.5 trillion ($400 billion) – up more than 50 per cent from December and more than double the figure a year ago – eclipsing even the start of 2009 when China unleashed stimulus spending to battle the global financial crisis.
"…The explosion in financing was only partly driven by banks… The rest of the new credit – 60 per cent of the total – came from corporate bonds, loans by investment companies, direct lending from companies to other companies and bankers’ acceptances, a popular form of short-term financing in China. These non-bank sources of lending, which are collectively referred to as shadow banking in China, are controversial. Regulators say they have good oversight of the situation, but ratings agencies have cautioned that the risks are mounting."
It turns out that we’ve seen record growth in debt. Is it really a surprise then that the economy is still growing quickly?
This is what Premier Wen is referring to, I think, when he warns that achieving 7.5 per cent growth in 2013 is not going to be easy. Last year was tough, and may have actually been worse than the numbers suggests, but more importantly any growth there was seems to have been driven by near exponential increases in debt in the second half of the year. If Beijing wants growth without soaring debt, what exactly are they going to do?
There isn’t much they can do. And there are warnings coming fast and thick about debt.
We know what to do
Beijing cannot tolerate rapid credit growth and it cannot tolerate slow GDP growth. The problem is that it can only choose both or neither. There are no other options.
As credit concerns continue to rise, expect Beijing eventually to bite the bullet and stamp down on debt, in which case expect GDP growth rates to drop much, much more, in fact to well below anything we saw in 2012. The question is not whether this will happen, but when. Once Beijing is confident enough about its grip over vested interests and the consensus has developed within the leadership, growth rates will drop very sharply.
So this is probably why former Premier Wen is warning about the difficulty China faces in reforming the economy – a warning that he and Premier Li have made many times before but never more shrilly. Even newly-appointed President Xi seems worried. According to an article in the People’s Daily he is calling out for the “courage” to deepen reforms. “We must have the courage like gnawing at a hard bone and wading through a dangerous shoal,” said Xi.
Rebalancing has very difficult political implications, and these are the deep waters, I think, to which Xi is referring. More than ever I am convinced that if China is to rebalance its economy towards a more sustainable growth model – and rebalance it must if it is to avoid a financial crisis – its GDP growth rate will drop sharply with its average annual growth over the next decade unlikely to exceed 3-4 per cent. My forecast is still an outlier, but over the past six months even the optimists no longer see it as unthinkable.
I have said often enough that we will be able to judge how resolute Beijing is and how capable of overcoming vested interests by how quickly credit growth is constrained and, with it, GPD growth. I expect to see high GDP growth (close to 8 per cent) in the first half of the year but, if Beijing is able to move quickly, I expect growth to slow significantly in the second half.
The signals so far are good. Beijing and the various financial regulators are makings strong noises about constraining credit growth.
Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management.
He blogs at China Financial Markets, where a longer version of this article first appeared.