The days of double-digit economic growth in China are over. Indeed, the annual growth rate, which has been lingering at about 7.5% since 2012, is predicted to fall to 7% this year—and is likely to go lower. This is China’s “new normal”, characterized, according to China’s leaders, by “medium-to-high-speed” growth.
But perhaps even this is optimistic. In the last two years, credit grew almost twice as fast as gross domestic product (GDP), and total social financing grew even faster. Yet GDP growth slowed considerably—from an annual average of 10.2% in 2002-11—suggesting that China may be moving closer to a medium-to-low-speed growth path. One possible explanation for the divergence between credit and GDP growth is that potential growth has already dropped to 7%.
But such a sharp decline in potential growth typically implies a powerful brake, in the form of an external shock or major internal adjustments. Under normal circumstances, an economy’s potential growth rate adjusts naturally and gradually, as structural change progresses. In fact, there is no definitive evidence that China’s potential growth rate has plunged. China weathered the 2008 global economic crisis better than other emerging economies.
And, though structural factors, including an ageing population and shrinking labour force, can certainly undermine potential growth, their effects are not sudden. So what explains the sharp decline in China’s economic output, in an environment of rapid credit expansion? The answer is simple: the way the credit is being used. Before the crisis, credit expansion in China kept pace with GDP growth. Since the end of 2008, however, credit amounting to 35% of GDP has been issued annually, causing the credit-to-GDP ratio to soar from less than 150% before the crisis to 250% today. That means that credit has become much less efficient.
The problem stems from the 4 trillion yuan ($660 billion) stimulus plan that the government launched in 2008, which fuelled the creation of about 14 trillion yuan worth of credit. When, in late 2009, the investment-intensive economy began to show signs of overheating, the government imposed strict macroeconomic controls, forcing investors to halt ongoing projects. Growth fell immediately. Meanwhile, debt continued to rise. Local governments, in particular, have struggled with a colossal volume of bad debt, which has undermined their capacity for capital expenditure and frozen out private demand for productive investment.
Stringent controls on the real estate market placed a heavy burden on the developers themselves, as well as related industries like steel. Yet China’s government failed to acknowledge the bad debts in a timely manner, instead allowing them to grow even larger. Given that the only way to enable borrowers to avoid default has been to provide an ever-increasing amount of liquidity, even banks facing liquidity constraints have remained willing to extend new loans.
Though China’s high national savings rate means that it does not have to borrow liquidity from abroad or print large amounts of money, the risks it faces should not be underestimated. With such a large share of the new liquidity being used to cover debt service, there is little left to finance new, growth-stimulating investment. Moreover, as debts grow ever larger, banks’ willingness to lend will decline, driving debtors to the unregulated shadow-banking sector, where interest rates are extremely high, for their liquidity needs.
The rising cost of financing will further undermine fixed-asset investment. China’s “new normal” is actually not normal at all. While the growth curve and structural changes in the East Asian economy from the 1960s to the 1990s suggest that China could experience medium-to-high growth rates for another decade, the country must address its debt problem first. The first step is to cut interest rates immediately, thereby reducing the burden on debtors and bolstering growth.
The government must also pursue a more active fiscal policy, rather than focusing on monetary policy. Furthermore, given that local governments and state-owned enterprises are responsible for the majority of China’s bad debts, write-offs, funded by central government bonds, will probably be necessary. Though the “debt swap” scheme that the finance ministry just introduced is a step in the right direction, it is far from adequate. With the central government enjoying such favourable fiscal conditions—its debt-to-GDP ratio stands at only about 20%—now is the ideal time to initiate a much larger debt-swap programme. Of course, curbing future debt accumulation is also vital to China’s long-term prosperity.
That is why China must reduce local governments’ dependence on banks to meet their financing needs, by nurturing bond and equity markets. The debt-induced distortions in China’s economy today are precisely that—distortions. They are not a fundamental feature of the economy, and they need not characterize China’s new normal. With the right strategy, the authorities can eliminate these distortions and allow the economy to reach its medium-to-high-speed growth potential over the next decade.