It has been five years since China's Premier, Wen Jiabao, characterized China's growth as unsteady, imbalanced, uncoordinated, and unsustainable. In the intervening years Premier Wen has outlined repeatedly the economic reforms that he regards as critical to transitioning from a model relying primarily on exports and investment to generate economic growth to one reliant primarily on consumption demand. Premier Wen has identified fiscal reform, financial reform, and pricing reforms as the critical policies to change the structure of demand.
Despite the Premier's efforts, the reforms critical to rebalancing the sources of China's economic growth remain stalled and, in certain respects, China's economic growth has become even more imbalanced and unsustainable. Thus there is a growing risk that China's economic growth could slow substantially in the medium term. This would not be the so-called hard landing, which implies a near term sharp slowdown followed by a v-shaped recovery, but rather a prolonged period of slow growth perhaps something around 4 percent, the onset of which might be within two to three years.
An understanding of the policy stasis must start with a quick description of the extreme financial repression that has emerged in China since 2004. Financial repression includes not only long standing policies, such as capital controls and an undervalued currency but, since the beginning of 2004 a negative real deposit rate. Financial repression has led to a substantial increase in the national savings rate, which in turn has contributed to a sharp decline in the real lending rate. Financial repression has led to major distortions in the domestic economy. With a substantially lower real cost of capital investment as a share of GDP soared from an average of 37 percent of GDP in 1997-2003 to an average of 45 percent in 2004-2011, reaching an all-time high of 49 percent of GDP in 2011. Not surprisingly the profit share of GDP rose substantially. This more capital intensive path of growth led to smaller increases in employment in the modern sector than in earlier years, contributing to a decline in the wage share of GDP. This latter trend was reinforced by lower real deposit rates, which pushed the growth of household interest income below that path it otherwise would have achieved. Somewhat counter intuitively, households also compensated for lower returns by increasing their saving from disposable income. The combined effect of these factors reduced household consumption from percent of 42 percent of GDP in 2003 to only 35 percent in 2011.
Distortions are also evident in the production side GDP data. From the early 1980s through about 2002 the services share of GDP rose steadily from 22 percent of GDP to 42 percent of GDP, much as one would expect in a rapidly growing emerging market. But since then China's service sector has stagnated, increasing its share of GDP by only one percentage point over the last decade. This unusual pattern is the result of three types of financial distortion. First, China's exchange rate became increasingly undervalued starting in 2002, increasing the profitability of tradable goods at the expense of services. As a result the share of investment flowing to manufactures rose, while the share flowing to services began to fall. Second, this tilt of investment towards manufactures was reinforced by the underpricing of capital beginning in 2004, which provided a major indirect subsidy to the more capital intensive manufacturing sector. Third, electricity and fuels became increasingly underpriced after 2003 as the pricing reforms initiated by Premier Zhu Rongji were largely abandoned by his successor. Since three-quarters of electricity and a large share of fuels are used in manufacturing, this too constituted an indirect subsidy to manufacturing.
But the most obvious manifestation of these distortions is in the residential property sector, which last year accounted for 10.7 percent of GDP up from 5.0 percent in 2003. China is now investing far more in residential property than either Taiwan or the US at their peaks in 1980 and 2005, respectively. The rise in property investment in China has stemmed not from urbanization, the pace of which has actually slowed since 2004, but rather by government policies that, perhaps inadvertently, have made residential real estate a preferred asset class. Bank deposits have had, on average, negative returns since 2004 while property prices have soared. Capital controls prevent most savers from buying higher yielding foreign currency denominated assets. And not only are stock prices on the Shanghai exchange highly volatile, the average nominal return in the past decade has been less than inflation. Not surprisingly households have piled into property, with one urban household in six now owning two properties and one urban household in 18 now owning three or more properties. Even in rural areas one household in seven owns two properties.
While the financial leverage associated with China's residential property boom is far less than in developed economies in the run up to the financial crisis, overinvestment in property constitutes a substantial macroeconomic risk. Property investment absorbs 40 percent of China's massive steel production and taking into account the linkages to other products, property accounts for more than one-quarter of final domestic demand. Thus even a slowdown in property investment, not to mention any absolute shrinkage, would dramatically reduce China's growth.
Several factors could lead to a slowdown in the pace of growth of property investment. First, Chinese household debt has almost doubled in the past three years and is multiple times larger relative to disposable income than in other emerging markets. Soon households may judge the risks of greater debt outweigh the potential returns from buying more property. This perception could be reinforced by the high share that property represents in total household wealth, 40 percent today compared to 20 percent a decade ago. Second, if banks are managing their risks appropriately they too soon may curtail the share of their loans going to developers plus mortgages, which has soared from 13 percent in 2004 to almost 20 percent last year. Third, financial reform, for example further opening of the capital account or the development of a significant domestic bond market, could eventually increase the range of financial assets available to Chinese savers, undermining the preferred asset class status of real estate.
To date the beneficiaries of the imbalanced economic growth caused by financial repression have been able to forestall reforms that would rebalance China's economic growth. Those opposed to reform include coastal provinces that have benefitted, at the expense of inland areas, from China's long export boom. The manufacturing sector, which produces the exports, has benefitted at the expense of the services sector. Property developers and local governments that confiscate property at below market prices and sell it to developers benefit at the expense of initial property owners and first time home buyers that face inflated property prices. Banks benefit enormously, at the expense of savers, from the cheap funding available to them as a result of the low ceiling that the central bank has set on deposits since 2003.
The key question is whether China's new political leadership, which begins assuming power in the fall of 2012, will be able to overcome the vested interests that have thus far successfully opposed reform and are able to implement the policies that will begin rebalancing the sources of economic growth. If they fail, a continuation of the current growth path implies urban residential property investment at an unsustainable 11 percent of GDP and overall investment at an extreme high of 52 percent of GDP by 2014, potentially setting the scene for a major multiple year economic slowdown.