By Robert Hahn and Peter Passell
China, we've been hearing, is cruising for a bruising — that the economy is likely headed for a period of slow growth the country can ill afford. We agree, but think it's important to distinguish between the risks in short and long run.
Beijing has the means to fight the downturn with a few commands to the banks and the government bureaucracy — something the self-appointed pilots of the Chinese ship of state managed both in 2008 and during the Asian financial panic in 1998. The immediate question is whether the government has the will to act at a time of leadership uncertainty.
But looking down the road five or 10 years, China is going to have a tough time escaping another problem, the middle-income trap. To reach the living standard of, say, South Korea, China needs (among other things) a more sophisticated, market-based banking system and independent financial regulation, along with the will to redistribute purchasing power to lower- and middle-income consumers. No walk in the park.
Back to the near term. In 2008, Beijing acted decisively to counter free-falling demand for Chinese exports by ordering the banks to lend the equivalent of some $600 billion, mostly for infrastructure projects sponsored by provincial and local governments. The banks are going to lose a lot of money on those loans. But the government has bailed them out in the past after they've marched off fiscal cliffs on orders from above, and can surely do it again.
This time around, though, Beijing has yet to act, probably because it is distracted by the leadership succession issue and not prepared to speak with one voice on a policy that would further leverage the financial system. Another hint of dissention at the top that is undermining decisive policymaking: In spite of the importance of Japanese investment (that is only made more important by the current decline in private spending), the government allowed rioters to destroy Japanese property in the wake of the squabble over ownership of the worthless Senkaku Islands. Beijing has since put the lid on protests, but seems ambivalent about taking the pot off the burner.
All this suggests the government will wait too long to prevent a decline in the growth rate from the 8-10 percent China needs to keep its economic miracle on track, to perhaps 4-5 percent. That raises the further worry that China's virtually unregulated, overleveraged shadow banking system (which is, in fact, very closely tied to the formal, regulated banking system) will fail in a big way. If this were to happen, an economic pause could deteriorate into a genuine recession — a very big deal in a society held together by expectations of a better life ahead.
The Long-Term Consequences
Assume (probably correctly) that whistling past the graveyard does China no great harm this time around. The economy still faces big problems in making the transition to real affluence. For one thing, the government-directed bank cartel lacks the sophistication to channel China's immense household and corporate savings into investments with the highest returns. To date, the consequences have not been all that visible — China's answer to the question of what to invest in has been "everything." But as the economy moves toward high-tech, it's going to matter a lot. An increasing portion of savings is now being funneled to private lenders, who are probably better at allocating capital; however, the lack of regulation of these shadow banks will make China increasingly vulnerable to inflation, asset bubbles and systemic financial failure.
Another sticky long-term issue is how to refocus demand on goods and services for use at home. China plainly needs to reduce its dependence on exports that are subject to wide swings in demand. And, in any event, the Chinese people surely deserve a higher living standard — better housing, better medical care, better everything. But to get from here to there, China's industrial capacity has to be repurposed, and households must be convinced that they can afford to save less and consume more.
A first step would be to allow the currency to appreciate. But exporters, already facing demands for higher wages from a restive labor force and greater competition from other developing countries, would certainly resist. Equally important, lenders would have to shift gears to offer credit to the right sort of ventures, which would be a daunting challenge for banks accustomed to serving as passive conduits. And don't forget households' reluctance to consume more — rational behavior in a society almost wholly lacking in a public safety net that is also facing a scarcity of young to take care of the old.
Can China tiptoe its way through this minefield? Maybe. But the fact that China has been successful in traversing dangerous territory ever since Deng Xiaoping (allegedly) declared that to get rich is glorious doesn't mean it will never trip and fall.
Robert Hahn is director of economics at the Smith School, University of Oxford, and a senior fellow at the Georgetown Center for Business and Public Policy. Peter Passell is a senior fellow at the Milken Institute and editor of the Milken Institute Review.