By Yu Yongding
China’s economic growth has been slowing for six years. Eager to stem the longer than expected slide, Chinese government officials and economists have sought an effective policy response. Last November, they officially placed the blame on long-term supply-side shortcomings, which they pledged to address with far-reaching structural reforms.
Although Chinese officials should be applauded for their commitment to implementing painful – and badly needed – structural reforms, the supply-side focus ignores the present. China faces two challenges: the long-term issue of a declining potential growth rate and the immediate problem of below-potential actual growth.
Among the long-term factors undermining potential growth are diminishing returns to scale, a widening income gap, and a narrowing scope for technological catch-up through imitation. Moreover, even as the country’s demographic dividend dissolves, its carrying capacity (the size of the population the environment can sustain) is being exhausted. Finally, and most important, the country is suffering from inadequate progress on market-orientated reform.
While some of these factors are irreversible, others can be addressed effectively. Indeed, the government’s supply-side reform strategy is a good first step. In the long run, the supply-side reforms will stabilize and raise China’s growth potential. But, contrary to popular belief, current reforms will not boost China’s growth rate today.
Why are so many economists convinced that a long-term reform strategy is all China needs? One reason is the widely held notion that today’s overcapacity reflects supply-side problems, not insufficient demand. According to this view, China should implement tax cuts to encourage companies to produce products for which there is genuine demand. That way, the government would not inadvertently sustain “zombie enterprises” that cannot survive without bank loans and support from local governments.
But only some of China’s overcapacity can be attributed to bad investment decisions. A large share emerged because of a lack of effective demand. This lack of demand is a result of the government’s effort to moderate real-estate investment, which has caused the sector’s annual growth to plunge from 38 percent in 2010 to 1 percent at the end of 2015.
With real-estate investment still accounting for more than 14 percent of GDP last year, plummeting growth in the sector has put considerable downward pressure on the economy as a whole and pushed China into a debt-deflation spiral. As overcapacity drives down the producer price index – which has now been falling for 51 consecutive months – real debt rises. This undermines corporate profitability, spurring companies to deleverage and reduce investment, and fuels further declines in PPI.
Trends from the first quarter of this year reflect the enduring importance of real estate investment to China’s economic growth. Despite being the slowest quarterly growth rate in seven years, the annual GDP growth of 6.7 percent exceeded market expectations. The unforeseen 6 percent increase in real estate investment contributed drove the higher than expected growth rate.
This is not to say that China needs more real-estate investment. According to the National Bureau of Statistics, China had 718 million square meters of unsold commercial and residential floor space at the end of 2015; when space under construction is factored in, inventory expands to more than five billion square meters. With an average of 1.2 billion square meters of housing being sold each year, the best way to reduce this supply glut is clear: limit future construction. The current rates of investments are unsustainable.
But not all investment is created equal. Infrastructure investment, in particular, may be the key to tackling China’s economic woes. After all, such investment, which grew at 19.6 percent in the first quarter of 2016, has already proved to be a driver of economic growth. Also, unlike real-estate investment, it has not worsened China’s resource allocation or set the stage for major imbalances.In an ideal world, domestic consumption would serve as the main engine of growth; under current circumstances, infrastructure investment is the most reliable option.
In the short term, when overcapacity and deflation are the main obstacles, infrastructure investment boosts growth through the economy’s demand side. In the long run, it operates through the supply side to boost productivity and raise growth potential. Given the strong demand for government bonds, China can fund such investment with fiscal deficits. Also, with China’s major banks still state-owned, and capital controls still in place, the risk of an imminent financial crisis is very low.
Of course, China’s government must uphold its commitment to implement structural reforms. But infrastructure investment is also badly needed, not just to prevent the economy from sliding further, but also to enable China to generate the sustained long-term growth that it requires to achieve developed-country status.
Yu Yongding is former President of the China Society of World Economics and Director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, and has also served on the Monetary Policy Committee of the People’s Bank of China.