It is very striking that western commentators and investors have become extremely sceptical about any good news emanating from the Chinese economy. This week, for example, official economic data showed growth in gross domestic product at a quarterly annualised rate of about 8 per cent, with industrial production bouncing back in September from a weak reading in August. Yet markets were unimpressed.
Although this latest news clearly reduced the danger that China is entering a hard landing as the property sector adjusts sharply, many headlines proclaimed, correctly, that the economy is now growing at the slowest pace since the last recession. So is China bouncing back from a weak patch of growth, or is it headed for a prolonged slowdown lasting many years?
Actually, both are probably true. Cyclical fluctuations are occurring around a clearly slowing long-term trend for growth, and this can defy simple good news/bad news interpretations. At present, it seems that the latest cyclical slowdown is being controlled, despite the property crash.
First, let us examine the latest fluctuations in the short-term cycle. According to the official data, real GDP growth has bounced back from its weakness at the start of the year, with two successive quarterly annualised growth rates at just above 8 per cent. Because the first-quarter of 2014 was extremely weak, however, the 12-month growth rate has slowed to about 7.3 per cent, which is fractionally lower than in the past couple of years.
The pessimists have focused on this, and on the fact that industrial production has slowed down more than real GDP. As usual, there is also widespread scepticism about the accuracy of official Chinese data, given that some series such as cement, steel and electricity production have plummeted.
The benign explanation for all this is that the industrial sectors closest to the property market are indeed suffering a hard landing, but this is being offset by firm growth in real retail sales, especially in the internet retail sector, which is up 50 per cent on last year. Growth in “new China” is offsetting the slowdown in “old China” in this interpretation. Another supportive factor has been firmness in exports, which is encouraging and somewhat surprising in view of growing pessimism about global economic activity.
The next few months will be crucial. The shake-out in the property sector will continue and, according to Goldman Sachs, this might reduce the contribution of housing investment to GDP growth from 1.8 per cent in 2013 to about 0.3 per cent by next year. This hit to growth has been met by a major easing in monetary conditions, which started in February and is still under way. Fiscal policy is also being fine tuned to ensure that the imploding housing sector does not cause a hard landing for the economy as a whole.
So far, so good, then on the latest cycle. But what about the longer term?
Until 2011, mainstream economic forecasters (such as the International Monetary Fund, for example) believed that the trend growth rate in China would remain in the 9-10 per cent region for as far ahead as the eye could see. Now almost no one thinks that. The IMF now seems to think that the trend growth rate is declining gradually to only about 6.3 per cent by about 2019. Others are more pessimistic. The Conference Board forecast this week that trend growth after 2020 would be only 4 per cent a year, and warned that this “long, soft fall” in growth would inevitably have painful patches.
The reasons given by forecasters for these large markdowns in China’s medium-term growth projections are familiar:
the need to reduce the rate of growth in credit/GDP ratio will slow the growth in investment;
as investment slows, the growth in industrial capacity, which has been the main source of expansion from the supply side, will drop;
the process of urbanisation will slow or even stop altogether, and the transport and housing infrastructure that is needed is already in place;
the reform of the financial sector will lead to higher interest rates and to much slower lending from shadow banks to the local government and other state-owned entities that have until recently been a prime source of growth.
This powerful set of factors underpins the much more cautious projections that have now become the norm for China’s medium-term growth rate. History has plenty of earlier examples of countries that have failed to live up to excessively optimistic extrapolations of spurts in GDP growth, including the Soviet Union in the 1980s, Japan in the 1990s and even Argentina a century ago.
Lawrence Summers and Lant Pritchett have just released an updated version of their fascinating study on the powerful nature of mean reversions in medium-term growth rates. These are replete in the historical database of economic growth rates. (See this excellent summary by David Keohane at FT Alphaville.)
Their key point is that high growth rates in the recent past do not offer much reason to believe that growth will be higher than the world average in the medium-term future. What goes up must come down, is the gist of the message. This applies in particular to growth spurts in emerging markets, and to situations in which there is a shift away from authoritarianism.
For China, they argue that “par” for the statistical course would involve a decline in the trend growth rate to only 5 per cent over the next 10 years, and to 3.9 per cent on average over the next two decades. The latest IMF and consensus forecasts for China’s medium-term growth rate have started to come more into line with the Summers/Pritchett norms, but they are not there yet.
In assessing Chinese growth data, investors therefore need to juggle with two different forces. First, the long-term trend growth rate is probably slowing from about 7.5 per cent now to, at best, 6 per cent by 2020 (with a lot of uncertainty around that). Second, there will be cyclical fluctuations around that trend, which the authorities will seek to smooth through policy changes.
Financial markets are likely to be sensitive not to the decline in the long-term trend, but to significant cyclical fluctuations below that trend (“hard landings”). The latest data are not indicative of a hard landing at present.