Economists agree that the fact that China’s economy has grown over 10% on an annual basis over the past three decades, does not mean that it will continue to do so over the next three decades. Quite the opposite is true. The IMF is forecasting 8.2% growth for 2012, but this number will inevitably come down as China has ‘reaped the easy profits’. Meaning that, as China is ever less profiting from an enormous labor surplus on the one hand, and high demand for manufactured goods, coupled with easy-to-copy productivity-enhancing techniques from the West (produced with cheap labor) on the other hand, it will be impossible to keep the export and investment growth engines running at the historical speed.
Hence, there is widespread agreement on the fact that China needs a new growth model, driven by domestic demand for services especially, which also means future demand for commodities will grow much less rapidly than it has done for the past few decade. Thus, the high growth rate from the past cannot be extrapolated into the futures. However, that you cannot extrapolate a past trend is not accepted as widely for another, related development.
The Chinese people have accepted an undemocratic, one-party system ruled by the Chinese Communist Party (CCP) for the past decades. Meanwhile, in exchange for the accrued power, the CCP has delivered economic progress and lifted many out of poverty. The question is, can it be expected that the CCP will maintain its power and no democratization will take place in the future, as has been the case in the past?
A weakening government
While the CCP has accepted more interference in the party from academics and business leaders over the years, two recent political events have made it clear that this might not be sufficient anymore for the Chinese people. This has important economic consequences.
Firstly, the ousting of Bo Xilai from the party has thrown into question the ability of the CCP to select its leaders. This undermines the trust of the people in the one-party system, albeit this might be a very slow progress: a ‘political soft landing’. However, a ‘political hard landing’ might ensue if China’s new leaders fail to generate an ‘economic soft landing’ – discussed later in this report. Failure to steer the economy to a lower, but still reasonable growth path would create ever more dissent and social unrest. This makes the political turmoil very dangerous in an environment of a slowing global economy and uncertainty about the direction in which the Eurozone is headed.
The second important political event that underlines the emerging weakness of the Chinese government is the blind Chinese activist, Chen Guangcheng. He questioned the Chinese premier Wen Jiabao on the behavior of local government officials. Corruption among local governments in China has been a reason for concern for a long time, but while premier Wen has been a supporter of political and economic reforms (i.e. more democratization and Western market forces), he has not delivered on his promises to reform.
So while the power of the government is weakening, it becomes increasingly important to deliver sustainable economic growth (generate an ‘economic soft landing’, around 7.5% growth) to prevent social unrest that causes a ‘political hard landing’.
What are the prospects for an economic soft landing?
The most important risks for China’s economy are: a larger downturn in the construction sector than politicians aim for; bank losses resulting from the 2008-2010 credit boom and subsequent slowdown as credit is becoming scarcer and thus more expensive; and a fast eroding export market with the US and especially European economy in the doldrums.
How to avoid a hard economic landing
As a result, China can rely less on the ‘old drivers of growth’, but at the same time a transition to a new growth model is becoming more dangerous: The consumer sector is still too small to take over the role of investments and exports to generate growth. If reforms that favor the consumer sector but disadvantage the export and investment sectors are carried out too hastily, it would create economic disruptions and a hard economic landing. On the other hand, as the political risks rise the more growth is slowing, this would induce politicians to grab for the easy solutions to sustain economic momentum.
This is happening at the same time that we envisage intensifying market tensions surrounding the Eurozone economies in the coming months to quarters, with consequently a sustained period of risk-off for the global economy. This makes it all the more likely that China foregoes necessary reforms to avoid too much of a growth slowdown.
Hence, the result will be that politicians aim for a very gradual transition of the economy and true reforms will be postponed. Thereby, China will continue to rely to a large extent on investment and export growth. However, this creates over-investment and China will remain very dependent on the Western export markets. In turn, this means that the risks of a future hard landing increase, although not necessarily for the coming months.
For the near term, we feel that there still is sufficient potential to prevent growth from falling below the official growth target of 7.5%. For example, China’s leaders can demand state-owned banks to extend loans for investments in infrastructure and social housing. Also allowing less appreciation in the renminbi to support exporters and import-competing companies could help to offset some of the downward pressure on growth.
A hard landing will then be avoided, but the economic price China will pay for this economic and political calm is a growing chance of a hard economic landing in the future. The absence of a recession in China over the past thirty-odd years, therefore, cannot be extrapolated to the future.