Ezrati’s Economic Outlook: China Bears

The Chinese economy is likely heading for a softer, rather than hard, landing.

The population of China bears seems to keep growing. The already large colony of doomsayers can point to any number of legitimate troubles facing China, from slowing exports growth to an aging population, from real estate excesses to a moribund consumer sector. They use this long list to conclude that the Chinese economy could easily face a cyclical stall, what some term a “hard landing.” But there is a problem with their approach. Many of the issues to which the bears point will take years to have an effect. Other, more immediate problems are already dissipating. For all of China’s very real difficulties, the country will likely experience a much softer landing than the bears fear.

Recent disappointing economic indicators have three roots, all cyclical in nature: (1) slow expansion in the United States and recession in Europe, (2) the legacy of China’s past monetary restraint, and (3) a drop in residential real estate prices along with building activity. These are the key considerations for China over the next 12 to 18 months. Its very considerable demographic issues and need to increase the consumer’s place in the economic mix, critical considerations though they are, will play out over a much longer time horizon and mean almost nothing for the outlook in 2012-2013.

Because exports are a primary engine of China’s growth, it could not help but suffer from the subpar American recovery and outright recession in Europe. The European Union is China’s largest export market, and the United States its second largest. So far this year, China’s exports have grown at an annualized rate just barely above 9%, well down from the average expansion in the high-teens in 2010 and 2011. Actually, given what is happening in Europe and the U.S., the recent export performance shows remarkable resilience. Still, the slowdown has affected more general economic indicators, such as industrial production, electricity generation and new purchase orders from Chinese industry.

There is little reason to expect much relief on the export front any time soon. Even with recent progress dealing with its debt crisis, Europe will take a long time to return to robust growth. At best, it will show very modest growth later in the year, and even that is in doubt. Nor does it look as if the United States will recapture rapid growth any time soon. But if there is no reason to look for much improvement on this front, neither is there reason to expect matters to get much worse. The probabilities suggest nothing more severe going forward than the present subpar performance.

If the export picture for China is still dim, things are improving on the policy front. Last year, fearing a rise in inflation toward 8% or more, Beijing ordered the People’s Bank of China (PBOC) to drain liquidity from the Chinese financial system. It did so several times by raising its benchmark interest rate and the reserves it requires banks to hold against their loans and deposits. The lingering effects of that restraint still weigh on the economy. But now, with inflation back down to a much more acceptable annual rate of 2% to 3%, the PBOC has begun to reverse its policy stance, cutting its benchmark interest rate and reducing required reserves. Some have expressed concern that the policy shift is too late and too little. They worry about a “liquidity trap” in which monetary easing loses its economic effect. But such fears are misplaced. Not only is there always a lag between a policy shift and its effect on the economy, but even as early as May, lending began to pick up in China, rising to 793 billion yuan ($125.6 billion) that month, fully 16% above April levels.

China’s real estate problems also show some signs of improvement. Prices are down some 25% from their peak a couple of years ago. Building activity is accordingly slow. But if the sector hardly adds to growth, it would be a mistake to draw parallels between China’s real estate problems and America’s. With Chinese law insisting on 20% down on a first residence and 50% on a second, Chinese homeowners are much less leveraged than Americans. China’s debt lies largely with local governments, and while that’s hardly welcome, it’s much easier for Beijing to cope with than the widespread subprime debt was for Washington. China can also look forward to faster work down of excessive housing inventories. Many Chinese have already begun to take advantage of now reduced mortgage rates, especially discounts of 15% for first-time homebuyers. More fundamentally, there are 11 million marriages a year in China and some 10 to 12 million people a year migrate to urban areas from the countryside. Major cities already report increased transactions, and recent month-to-month price figures show stability.

Longer term, China undoubtedly faces a difficult economic restructuring. Beijing is well aware that, quite aside from the recent export slowdown, it cannot sustain its past pace of export growth. That remarkable achievement reflected a tremendous increase in China’s share of the global market, from something negligible 20 years ago to some 12.5% of the global total last year. Since the country cannot hope to redouble this gain, Beijing increasingly has turned to domestic development as an additional engine of growth, especially aiming to enhance the consumer sector, which now amounts to a mere 40% of the economy (compared to 70% in the United States, for instance). Part of China’s massive infrastructure spending aims to serve this need. But it is clear that the transition itself will slow growth, and domestic development naturally proceeds less rapidly than export-led growth. If this fundamental adjustment works smoothly, the country can avoid too adverse an economic effect. Otherwise, the adjustment could cause major disruptions. Either way it will be a matter for the long term and has little to do with the economy’s immediate landing, hard or soft.

China’s demographic reality will also impinge on its longer-term prospects. Because the country has imposed a one-child policy on families for the last 30 years, the flow of young entrants to the workforce has slowed and will continue to do so in future years. This trend cannot help but hold back the pace of overall economic growth. But it would be a mistake to make too much of this problem too soon. The legacy of what was an extremely youthful population still leaves China with a greater abundance of young workers than the United States, for instance, and certainly more than in Europe and Japan. China today still has almost nine people of working age for each person over 65 years, compared to just over five of working age in the United States and just under three in Japan. Even by 2020, China, according to United Nations estimates, will still have almost six people of working age for each person over 65. The United States will have less than four and Japan will have barely two. It is a developing economic constraint to be sure, and will in time become severe, but it has little place in an assessment of the next 12 to 18 months.

Against such a background, there can be little doubt that China will grow at a slower pace this year and next for cyclical reasons and longer term for structural and demographic reasons. For the period immediately ahead, relief should come from the policy shift already in progress and because the worst of the residential real estate pressure seems to have passed. China looks likely to meet the official expectation of 7.5% to 8% annualized real GDP growth over the coming 12 to 18 months. More fundamental considerations should slow growth in subsequent years, though the great potential for domestic development still suggests that China can sustain growth of close to 6% a year. While all these expectations—short, intermediate, and longer term—fall far short of China’s past growth of 10% to 12% a year, investors and business people need to keep in mind that the anticipated pace still exceeds that expected for the United States near term by a factor of almost four. It is also most definitely a softer landing than the bears suggest.


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