China's Economic Future


and Its Implications


for the United States

Nicholas R. Lardy

As the world looks for help to sustain the fragile global economic recovery, China's policy responses both during and in the aftermath of the global crisis have enormous consequences, explains economic expert and scholar Nicholas Lardy.

03.14.12

Overview

Nicholas R. Lardy has been recognized for years as one of the United States' leading experts on China. His recent book, Sustaining China’s Economic Growth after the Global Financial Crisis, deals with a subject crucial to the future of the global economy.

Dr. Lardy spoke to a breakfast audience at The Chicago Council on March 14, 2012 China's policy responses both during and after the global financial crisis, then spoke with me about the questions these policies raise.

Lardy agrees with Premier Wen Jiabao that China’s growth is “unsteady, imbalanced, uncoordinated and unsustainable.” He feels that the Chinese economy, despite its growing global presence, remains dysfunctional in many ways—especially the “financial repression” embodied in its financial system and the unhealthy extent of the property boom. China’s economy needs reforms, Lardy maintains. These reforms, while delicate, will be less risky than holding to the current path. He says that residential housing is overbuilt and overpriced, but, as a result of relatively prudent banking policies, there is no true housing “bubble" (in the American sense), nor is a financial collapse likely as housing prices fall. China’s economic plan calls for the 2012 growth rate to fall from 8 percent to 7.5 percent, but Lardy sees this as a sign of strength and diversification. Continued strong Chinese growth is vital to the world economy, he concludes, but a 7.5 percent growth rate is perfectly adequate, so long as it doesn’t fall much further.

Q:

Richard Longworth

China recently announced plans to expand its economy by 7.5 percent this year, which is down from 8 percent and significantly lower than the double-digit performances of years past. How do we read this? As a sign of relative weakness? As the inability to retain the higher rates of years past? Or is it an attempt to increase domestic consumption while deemphasizing exports? In other words, is it a weakness? A strength? Or is it just maturity?

A:

Nicholas R. Lardy

Well, I think it’s primarily a strength that Premier Wen Jiabao was signaling we should put less emphasis on how high the headline growth number is and be more concerned about the quality, sustainability, and the structure of demand. So, I think he was saying that, as we transition to more of a domestic consumption-driven growth, we can have an overall rate of growth that’s slower, but people's welfare and living standards will still continue to go up at a fairly rapid rate.

Sometimes people try to encapsulate this in saying that it’s the quality of growth—not the absolute magnitude of growth—that’s important. This has been a tension in their system for quite some time. The central government puts out a number and most provinces try to exceed that. Wen Jiabao is trying to say that high growth at any cost is no longer the goal.

Q:

Richard Longworth

We read about a real estate bubble in China, especially in residential. Is this a real bubble like the one that preceded the American financial implosion? When Americans think real estate bubbles, we draw from our own experience. You’ve written that both banks and households may pull back, easing the risk and producing a soft landing. And I’m just wondering, is this likely? Is there such a bubble that has China facing an American-style real estate crisis, affecting its banks and possibly adding another bad economy to the long list of crippled ones?

A:

Nicholas R. Lardy

Well, obviously bubbles are very difficult to identify in advance. I sometimes say I’m not sure if there is a bubble in China, but if I were leading China and I wanted to create a bubble, I would have adopted many of the same policies we’ve seen in China over the past decade. These policies were not originally aimed at real estate, but they’ve had an effect on real estate. The most important of these, I think, is the fact that on average real deposit rates for savers have been negative now for eight consecutive years, so people have sought out housing as a better investment asset compared to bank deposits. 

The lesson of the financial crises everywhere is this: when you have financial distortions, you tend to get the buildup of asset positions that are not sustainable in the long run, and the correction can be painful. So I do think that there’s a macroeconomic risk. I don’t think it would be quite an American-style correction, because the leverage of Chinese households is less. People still have to make significant down payments to get a mortgage on a property, and so the loan-to-value ratios are much lower in China than they were in the United States in the middle part of the last decade.

In the United States, we had a lot of subprime loans with no down payments and weak documentation of income and so forth—in part because so many loans were securitized and sold to other investors. In China, they don’t do that. For the most part, the banks keep the loans on their books, so they have a strong vested interest in making sure that borrowers are going to be able to repay their loan. Additionally, in China they don’t do home equity loans, so if the price of your property goes up, you can’t convert that into ready cash to support extra consumption—vacations, for example. So, they’ve avoided some of the structural problems that we had in the United States.

Q:

Richard Longworth

But still you write that residential housing is the single most important economic driver in China. That’s accounting for a much higher percentage of Chinese GDP than the United States housing sector did at its peak. Slowing that down really sounds like a crash waiting to happen. If housing stops being the locomotive of the economy, what takes its place?

A:

Nicholas R. Lardy

Consumption, potentially. An increase in private consumption could offset a large part of any correction that occurs in reduction in housing investment. The question is whether the Chinese government is going to adopt policies that facilitate increased consumption. Concurrently, I think that’s the biggest challenge the regime faces.

I mean, if they’re not successful, or opposition from vested interests prevents them from moving ahead on some of these reforms, then I think the handwriting’s on the wall: they will grow much slower for several years.

Q:

Richard Longworth

That gets into the political question of vested interests—the heavy industry sector, the export sector, important parts of the party, some of the major cities that will be hotly opposed to any real reforms here. It sounds like they have a lot of clout in this area. Can they stop this? How much danger do politics pose in terms of fostering a serious economic downturn?

A:

Nicholas R. Lardy

Well, these vested interests have been able to thwart these reforms in the past. Interest rate reform is perhaps the most important of these. And this was a plank in the eleventh five-year plan, which ended in 2010. It’s a plank in the twelfth five-year plan that we’re now in. Market-oriented interest rate reform was a specific commitment on the part of the Chinese premier in his most important annual speech in 2009. 

The reformers get interest rate reform into the plans and into the official documents, recognizing the importance of it. But they actually have not been able to move ahead and follow through, because vested interests have been successful in blocking it. That’s the risk going forward—that vested interests will continue to block reform. Once it's clear that the alternative is a sustained period of much lower growth, I think maybe those vested interests will weaken and be overridden.

Q:

Richard Longworth

In any economy, nothing happens in isolation. I think one of the real strengths of your book is how you connect the dots here. You’ve made the point that the low inflation policy coupled with the need to keep the currency exchange rate low has led to this financial repression, which has led to pressure on the banks, which has led to the borrowing policy, which led to the housing bubble—one thing leading to another. But the United States has learned how a housing shock can ratchet down through the economy. What’s to keep that from happening in China?

A:

Nicholas R. Lardy

Well, to some extent a housing downturn will ratchet down growth in some sectors. If you move toward a more consumption-driven growth—the demand for steel is not going to grow at the pace that it has over the last five to seven years. The demand for a lot of other industrial products will be growing much more slowly. However, if your policies lead to more growth of consumption, the demand for services will pick up. The services sector in China has languished over the last seven or eight years.

When the structure of demand changes, this is not a frictionless, cost-free adjustment. There will be sectors that have reduced profits or some that will go into a loss-making position. Some sectors will do better. And for the entire economy, the GDP growth number can still stay fairly elevated if they carry out these reforms successfully. But underneath the surface there will be a rebalancing, and that inevitably implies that some sectors will suffer—if not in absolute terms, certainly in relative terms.

Q:

Richard Longworth

As you describe it, the Chinese financial system sounds really dysfunctional: the high capital reserve requirements, negative interest rates, potential bad loans on housing and stimulus projects, combined with the need to keep on lending to relatively inefficient state-owned firms. Now, it’s been said that if something can’t go on forever, it doesn’t go on forever. Do you see a banking crisis coming? Or, at the very least, a pretty wrenching restructuring?

A:

Nicholas R. Lardy

I think China can avoid a banking crisis. That doesn’t mean it couldn’t happen, but I do think it’s a low probability at this point. They have strengthened the banks very dramatically over the last ten years. There have been very significant reforms in terms of bank professionalization. However, there are these structural problems that you mentioned—distortions that need to be addressed. But banks currently have very strong levels of capital and therefore are somewhat protected.

They have provisioned a very high level for nonperforming loans. This will not be a situation like ten years ago where the government had to have a massive recapitalization program to keep the banks from going bankrupt. So, I think rebalancing will be challenging, and there will certainly be stresses on the system. But I don’t think that we’ll have a full-fledged banking crisis.

Q:

Richard Longworth

In your book you list some of China’s economic imbalances. This includes a heavy reliance on exports to generate growth in underdeveloped consumer markets, an outsized manufacturing sector, a relatively underdeveloped service sector, and a high level of personal savings. You add to this the generally inadequate social safety net and considerable trade protectionism, and frankly this doesn’t sound like the United States in 2007 so much as Japan in the late 1990s. Is it glib to compare the two systems and suggest that China might not be heading into a crash but a Japanese-style period of stagnation?

A:

Nicholas R. Lardy

Well, that’s a very good way of putting it, because I don’t think it necessarily is going to be a crash or the bubble’s going to burst. It could be a long, slow, painful slowdown as they wring out the excesses of the system. There are a lot of similarities between Japan from the late ’80s to the early 2000s and the current situation in China: high levels of investment, too much reliance on exports, undervalued currency, and a certain amount of financial repression. So I think it is a challenge for China to move ahead.

I think Chinese leaders will be more decisive than the Japanese. Japan has had a period of very, very slow growth for such a long period of time, in part because they were not willing to confront their economic problems. If I had to bet, I think in the end the Chinese will confront their economic problems. They will address the problems in the banking sector. They will move to get rid of these distortions so that they don’t fall into a decade-long growth slowdown like Japan.

Chinese leaders have to make these changes. When Japan ran into economic difficulty it was already a very rich society with very high living standards and levels of consumption. By comparison, China is a very, very low-income economy. Looking beyond per capita GDP, per capita disposable income of urban residents is only the equivalent of about $3,000, which is teeny compared to where Japan was fifteen years ago.

So the stability of the whole system and the continued dominant role of the Chinese Communist Party will ultimately depend on sustaining reasonably high rates of economic growth. Once its widely appreciated that there is risk of a sustained, long slowdown, I think Chinese leaders will mobilize support to overcome the vested interests and undertake the necessary reforms.

 

Q:

Richard Longworth

What does that mean to us? Japan hasn’t exactly disappeared, but it’s no longer the economic driver it was through the ’70s and ’80s. China is so important to the global economy that some slowdown, even if well handled, would seem to have a dampening effect on the global economy at a time when it really can’t stand any dampening effects.

A:

Nicholas R. Lardy

Right, but keep in mind that the economy has already slowed dramatically. In 2007 and then 2008 it was growing at well above 10 percent. In 2007, it was growing at 14 percent. Now China is growing at about 8 percent. And as you mentioned, the premier is talking about a target of 7.5 percent. So we’ve already seen a significant slowdown from the peaks of five or six years ago. 

I think the real question is: will the growth rate continue to slide, or will we be bottoming out over the next year or two and sustaining a long-term rate of growth of 8 or 9 percent? I think with China growing at 8 or 9 percent that would be a very substantial contribution to global recovery and sustained global economic growth. If they slide down further to seven, six, or five percent, it will be very adverse for the global economy. I think that’s one reason that the rest of the world does have an interest in China’s success in pushing ahead on reforms that would allow them to grow at 8 or 9 percent.

Q:

Richard Longworth

Food inflation in China, I gather it’s down a bit now, but it’s been running in double digits for some time. It’s a contentious issue there. And U.S. exports of corn and soybeans, mostly from the Midwest, have taken most of the blame. American farmers hotly deny that any diversion of corn to ethanol and other practices have anything to do with high food prices, but the Chinese seem unconvinced. What’s the impact of this food inflation in China? Is this a serious problem between our two countries?

A:

Nicholas R. Lardy

Well, food inflation did get very high in China in the second half of 2011. And it’s come down quite a bit in more recent months. But it could pick up again, and I think it has been a contentious issue. In the long run, China wants to maintain food price stability for political reasons. Keeping food prices down is going to lead to China depending more on the global market, and the United States will respond to the increased demand that’s emerging in China for food products, for feed for animals, and so forth. This is changing China’s trade patterns quite substantially.

It wasn’t too many years ago that China was not importing a significant amount of soybeans. Now they’re importing a huge fraction of global production, and it’s increasing their food supply and helping them control food price inflation. We seem to be moving into an environment where corn could be the next big product that they import on a very large scale. This will, however, push up global prices in the short run as suppliers adjust.

In the United States we still have a very substantial potential for increasing output. We’ll have a very positive supply response to higher prices, and China should move toward a pattern in which it relies more on imports from the United States, Brazil, and other major sources of global supply of key commodities like soybean and corn.

Q:

Richard Longworth

Yeah, they seem to be looking all over the world for commodities. Do they have alternate sources for corn? In other words, are we running the risk of pricing ourselves out of this very important market?

A:

Nicholas R. Lardy

I think one has to take into account that the cost of growing these things in China is going up. And I think that, compared to China, the United States is still a low-cost producer of many of these basic agricultural commodities. We have more acreage that can be brought under production, and we have the ability to increase yields to some extent, so we can expand supply significantly with only a moderate increase in prices.

Q:

Richard Longworth

We’re reading a lot right now about the re-shoring of manufacturing jobs that were outsourced from here to take advantage of low-wage Chinese rates. And we hear now that these wages are rising while industrial wages here are falling, which narrows this advantage—especially in light of higher American productivity. But your book says that Chinese productivity is going up fast enough to make up for these higher wages. So are Americans—especially Midwesterners, who are expecting manufacturing jobs to flow back here because of this—just kidding ourselves?

A:

Nicholas R. Lardy

Well, obviously one can point to certain examples where there has been some re-shoring, some production that’s been brought back onshore. But there always will be a few cases, and I’m a little bit doubtful that this is going to be a large-scale phenomenon. China’s wages have been going up by about 10 percent per year for more than a decade; nonetheless, their goods have continued to remain very competitive. 

That’s because labor productivity has been rising very rapidly. Unit labor costs, as we refer to them, have not gone up as much as you might expect. Productivity growth has been very high. If labor productivity slows down while wage growth continues to accelerate, China will lose some of its competitive edge. And we’re already seeing it, as some of the most labor-intensive sectors in China are losing their competitive edge. But not very many of those jobs are coming back to the United States. They’re going to Southeast Asia, to some extent to South Asia, and so forth. These are low-end manufacturing jobs—jobs that are never going to be competitively produced in the United States. The key thing to remember is: even as there have been some adjustments—and maybe some jobs coming back to the States—China’s exports are still growing faster than the growth of global trade (even though it’s slowed down quite a bit). That means China’s share of global trade is still growing, though maybe not in the same product categories as in the recent past. It means that the products in which they have a comparative advantage are changing and moving upmarket a little bit. So they’re still able to grow their exports more rapidly than the expansion of global trade. I don’t think they’re losing their competitive advantage, although the product mix will evolve over time.

Q:

Richard Longworth

Is this 10 percent wage increase across the country?  I’d always heard it was more in the eastern cities, and that there’s a vast army of the unemployed ready to be brought on-market.

A:

Nicholas R. Lardy

Yes, that 10 percent figure is a national average, and wages in the interior are much lower than they are on the coast. In part, that’s because the cost of living is lower there. We see that some large-scale foreign manufacturers that have been using China as an export platform have begun to move significant capacity away from locations on China’s southeast coast toward the interior of the country—even as far as Sichuan province and Chongqing in the southwestern part of China.

In part, that’s feasible because they’ve built up their infrastructure so much over the past few years that the cost disadvantage of away from the coast is much less than it was 5 or 10 years ago. The transportation costs have been addressed to a considerable extent, and there are lower wages in the interior. There's an adjustment process that’s going on now.

Q:

Richard Longworth

Chinese investment—certainly in North America—seems to be so small. Is that going to change?

A:

Nicholas R. Lardy

I think the outlook is that China will invest more overseas, including North America and in the United States. But Chinese overseas investment is starting from a very low base. The government’s official policy has been this so-called “go out” policy: supporting Chinese firms investing abroad. 

When China got started at this a few years ago, they had a couple of unfortunate experiences. Some high-profile investments were looked at rather unfavorably in Congress and in the review process supervised by the Treasury Department. That has created something of a problem for the United States in attracting Chinese investment.

I think there’s a very widespread perception in China that the United States is not very welcoming of foreign investment, especially Chinese investment, which I think is a mistaken impression. If you travel around the country and talk to governors and mayors, they’re very welcoming of foreign investments.

But some of these high-profile cases that involve takeover of American firms have become politically sensitive, which has created a misperception in China that we’ll have to overcome. We should be welcoming of foreign investment—just as we should be welcoming of domestic investment—because it creates jobs and improves economic performance in the United States. We should try to work to overcome this misperception.