Will internal and external threats for China will prove China bears right?

A growing group of – mostly Western – economists are predicting a hard landing for the Chinese economy. Although definitions of a ‘hard economic landing’ differ, a significant growth slowdown with 5% annual GDP growth can be considered a hard landing. The fear is that such an economic downturn will ignite social unrest and cause dangerous political instability, especially in a year in which a leadership transition is about to take place in China.

Fears for a hard landing come from difficulties that China is facing domestically, as well as from foreign threats.

Domestic difficulty 1: real estate bubble

Domestically, a real estate bubble could be on the brink of bursting. In the second half of 2011, the Chinese government has taken several measures to slow down the rapidly rising house prices (mainly in the largest cities). But fears are that these restrictions have been to harsh. Already consumers are complaining that the value of their apartments is coming down fast, causing a rapid deterioration in household wealth. Given that about 25% of China’s economy is somehow linked to real estate, a bursting bubble might inflict some serious damage. However, talk about a real estate bubble bursting and its damage for the Chinese economy could well be overdone. First of all, newspaper headlines of rapidly falling property prices mainly concern certain projects. Price drops elsewhere are much less pronounced. Secondly, there is still much demand for housing and the government seeks to provide many new social housing. Lastly, the contribution of real estate investment to China’s economy is possibly much below recent estimates. Although investment growth is the largest driver of China’s growth rate, real estate investment contributes only about 10% to total GDP.

Domestic difficulty 2: economic inequality and dissent

Another worry stems from economic inequality that has increased rapidly in the past few years, especially after the government’s unprecedented fiscal stimulus measures in a reaction to the 2008-2009 global financial crisis. These measures favored the export-oriented Eastern provinces, while leaving the inland regions behind. As a result, anger against current politics has increased particularly in the West. But also now that coastal regions have seen their basic economic needs fulfilled, they might require more political freedom. Nevertheless, the Chinese believe the current political set up is most suitable for China. Political deadlock and economic decline in the West have only confirmed these beliefs and the Chinese are in general happy with the political system. Dissent is by far not widespread, and unity should hold.

Other domestic difficulties

Inflation, environmental degradation, corruption (mostly at the local level), and rising debt levels with local and the central governments are other concerns. However, China’s recent five-year plan is a large step in the right direction in solving most of the remaining problems. Although some analysts believe that especially local debts have risen beyond sustainable levels, the fact is that China has still a lot of growth potential to ‘grow out of the debt problems’ – that is, given that the pace with which debt has soared after 2008 slows. Additionally, China’s trade partners (e.g. Japan) have indicated they are willing to invest in Chinese bonds as a higher-yielding alternative to US Treasuries.

A last possible domestic complication is the leadership transition that will take place later this year. China’s new leaders will face many challenges that need to be addressed in the short term. Historically, however, such transitions have not been destabilizing as they are carefully prepared and the action transition is a mere formality. Therefore, in 2012 will unlikely to be a year of political struggle. The juncture could come in 2013 or perhaps even 2014, as the new collective leadership (most likely Xi Jinping en Li Keqiang) will then be judged with regards to its political achievements.

Hence, despite these domestic challenges, China should not experience a hard landing in 2012 or even 2013.

Challenges from the situation abroad

On the other hand, there are external difficulties that China must deal with: the leadership vacuum in North Korea, a possible leadership change in Taiwan that will increase Taiwan’s demand for independence, a change in US-China relations – not for the better – if a Republican candidate wins the presidential elections in the US, etc. However, the most pressing issue is probably the Eurozone crisis. Even though I do not foresee the European Monetary Union breaking down this year, a much more severe recession in China’s largest trading partner (i.e. the EU) is very likely if European leaders do not get their act together shortly and make headway coming to a structural solution to the debt problems (i.e. structural reforms, more austerity, plans to prevent a build up of debts in the future, and more monetary easing). Thereby, China could face contagion through both declining exports and financial market turmoil that leads to money being withdrawn from a.o. China. A severe trade and credit crunch, and thus a hard landing, could be the result.