How much worse will it get?

Feb 3rd 2009
From the Economist Intelligence Unit ViewsWire

China's economic growth in 2009 could be worse than expected

Until recently China was one of the bright spots of the world economy, but the country's prospects are now dimming so rapidly—amid plunging external demand—that its GDP growth rate for 2009 could be much worse than expected.

The outlook for China's economy continues to darken with the publication of each new statistical indicator. According to the latest data, economic growth slowed to 6.8% in the year to the fourth quarter of 2008, down from 9% in the third quarter and half its 13% pace in 2007. Although real GDP growth of 6.8% may still sound pretty robust, it was China's lowest rate of growth since the fourth quarter of 2001 and implied that growth on an annualised quarter-on-quarter basis was around just 2%. Other indicators also point to a significant downturn in economic activity. Industrial production grew by only 5.7% in the 12 months to December, compared with an 18% pace in late 2007. And the OECD’s leading indicator of economic activity in China has fallen to its lowest level in its 26-year history, lower even than during the slump in 1989—the year of the Tiananmen Square massacre.

Despite the increasingly gloomy data from China, the Economist Intelligence Unit has maintained a forecast of 6% growth in 2009. This, however, would be the slowest rate of growth since 1990, and would represent a hard landing for the Chinese economy. It would also be significantly below the government's own growth target of 8%, which according to an often-cited theory is what the economy needs to grow by to prevent rising unemployment and, in turn, social unrest. The main cause of the slowdown in 2009-10 is the very gloomy outlook for global demand, which will significantly curb export growth and will reduce investment by businesses in export-oriented coastal provinces. In addition to very weak global demand, China's domestic economy has entered a sharper-than-expected downturn, linked to a slowdown in the property-development sector that has cut construction-investment growth and reduced output of heavy-industrial goods such as steel and cement.

Our central forecast is based on the scenario that China's property sector will recover in the second half of 2009, which, when combined with the government's stimulus package and interest rate cuts, will thereafter begin to support investment growth. Although property prices did rise strongly across China in 2007, the country has not experienced the kind of massive housing bubble seen in the US and elsewhere. Moreover, given that the real-estate sector's slowdown was largely policy-induced, there is also a good chance that the policies now being implemented to boost housing demand (as well as interest rate cuts, which have improved affordability) will have the desired effect, enabling property investment to recover from late 2009.

Significant downside risks

Nevertheless, this outlook for 2009 has significant downside risks. Given the very gloomy external environment, it would not be difficult to imagine a scenario where growth slows to, say, 4%. The main risk to growth concerns the outlook for the external sector. We are currently forecasting that merchandise exports will shrink by 10% this year, compared with growth of 20%-plus in recent years. However, with import demand in China's biggest foreign markets forecast to contract by record amounts, Chinese exports will clearly suffer. Falling exports, in turn, are leading to a collapse in manufacturing investment (which accounts for approximately one-third of total investment), rising bankruptcies and increasing unemployment. A further deterioration in the prospects for China's main export markets, which is not unlikely given the current state of uncertainty in the global financial system and the continuing deterioration in economic prospects for most advanced economies, would result in even slower export growth for China, further depressing its manufacturing-investment growth.

There are real concerns that construction investment (which accounts for another one-third of total investment) could also suffer—if the government fails to engineer a recovery in China's property sector. Given the weak state of consumer confidence across the country and weakening property prices, potential buyers may be put off from entering the market in anticipation of further price falls. If the property sector remains weak for the whole year, the government's task of keeping growth at our core forecast of 6%, let alone meeting its own 8% target, will be much more difficult.

The final risk to our outlook concerns consumer spending. Consumer spending is likely to fall significantly this year, owing to rising unemployment, slower wage growth and weakening consumer confidence. Although retail-sales growth has remained remarkably robust, the retail-sales data are among the most unreliable statistical series published by the government. In fact, other indicators suggest that consumer spending is much weaker. Passenger-car sales, for example, fell in the final quarter of 2008, as did passenger-flight numbers. With the economic slowdown in China forecast to get worse before it gets better despite government attempts to kick-start the economy, consumer spending could fall much further.

What can be done

What can the Chinese government do to avoid the worst? The centrepiece of its efforts is a Rmb4trn (US$585bn) economic-stimulus package, consisting of fiscal spending and tax breaks. In a bid to support the ailing property market, interest rates have also been slashed and loan quotas have been removed. The government, though, has not exhausted all options. Additional measures to consider include:

* Increasing government spending. China's most likely next policy move would be a further increase in central-government spending. After all, the government's fiscal position remains healthy: the fiscal deficit for 2008 was an estimated 0.1% of GDP, while total government debt was equivalent to just 15.9% of GDP. However, by choosing to boost economic growth through a short-term drive to accelerate construction-related projects rather than by attempting to raise private consumption, the government would risk aggravating the economy's bias towards investment at the expense of consumption. There is also a risk that some local governments will indulge in wasteful projects, as caps on their spending are relaxed.

*Expanding credit availability. Another option would be to encourage even faster credit growth from the banking sector. Indeed, this is already happening. After policymakers abandoned the commercial banks' lending quotas at the end of 2008, credit growth has rebounded, reaching a four-year high in December of 19% year on year. Unlike most banks in the West, China's main commercial banks have not been on an irresponsible lending spree and are in a relatively healthy financial position. Of course, while such a strategy may support growth in the short term, there is a big risk that expanding loan growth at a time of a steep downturn in the domestic economy will result in many more loans going bad in the future. That would reverse the hard-earned progress Chinese banks have made in cleaning up their books in the past several years.

*Boosting consumer spending. The ideal solution for the government would be to promote higher consumer spending, by rebalancing the economy away from its dependence on exports and investment and towards private consumption. One way of doing that in the short term would be a tax rebate, which would put cash directly in people's pockets. However, a problem for any measure that raises consumers' disposable income is that a large chunk of the increase is likely to be saved. As a result, to achieve a true rebalancing of the economy, what is needed are government policies that reduce the incentive for households to save. Currently, fears of being forced to pay out-of-pocket for healthcare expenses, as well as the spiralling cost of education, are the main reasons why household-savings rates are so high. More investment in health and education is therefore desperately needed.

*Improving competitiveness. A less-ideal option for the government would be to attempt to boost exports by making them more competitive. This could be done by either reducing costs, or devaluing the currency. Costs could be cut by undoing some of the reforms the government has introduced over the past few years to move China up the value-added chain and reduce its dependence on low-value added goods. For example, authorities could relax the enforcement of the Labour Contract Law, which was introduced at the start of 2008. Although it was meant to provide greater protection to employees, the policy is widely acknowledged to have added approximately 20% to employers' labour costs. Currency devaluation would be a more controversial option. In 2008 the renminbi appreciated by 9.5% against the US dollar, and by even more against most of China's Asian neighbours, resulting in a significant loss of competitiveness for the Chinese economy. However, the reason why exports shrank in the final two months of 2008 was a slump in global demand rather than a loss of competitiveness caused by the stronger currency. A devaluation remains highly unlikely. But if the outlook for the domestic economy continues to deteriorate, the government may be tempted to allow the currency to weaken. Such a policy would be extremely risky, since it may encourage another round of regional currency depreciations and increase the chances of a trade war.

In the end, China is still in a better position than almost any other major economy in the world, thanks to the government's powerful fiscal position and a banking sector which has escaped relatively unscathed from the global financial crisis. However, the fact that 4% growth is now considered a serious possibility for the economy in 2009 underlines the depth and severity of the ongoing global recession. It also means Chinese policymakers will not be able to relax any time soon.