HONG KONG – For decades, rapid urbanization in China created clusters of
knowledge, manufacturing, and distribution in areas that benefited from well-
established connections to the global economy. But that growth model has reached
its end. With the share of people living in cities rising to 53 per cent in 2013, from 20
per cent in 1981, China is shifting to a “new normal.” According to President Xi
Jinping, the aim is to ensure annual economic growth of around 7 per cent, driven by
new opportunities in value-added manufacturing, information technologies, and
modernized agricultural production.
In moving toward this goal, however, China will face difficult balance-sheet
adjustments that cannot easily be managed by conventional fiscal and monetary
policies. A new Deutsche Bank study reports that, last year, China’s 300 cities faced
a 37 per cent drop in their land-sale revenues – a major setback, given that land
sales accounted for 35 per cent of total local-government revenues. Such revenues
had risen at an average annual rate of 24 per cent from 2009 to 2013.
Moreover, annual consumer and producer inflation dropped to 1.5 per cent and -3.3
per cent, respectively, last December, owing partly to the sharp decline in world oil
prices. China now faces deflation and an inhospitable external economic
environment, and its urban centers are struggling with the complex interaction of
solvency, liquidity, and structural issues.
But some cities are better equipped than others to weather these challenges. China’s
first- and second-tier cities are very wealthy, benefiting from high property values and
the continuous inflow of talent, capital, companies, and investment projects. Despite
a property-market slowdown, Beijing’s recent land auction concluded with record-
breaking prices of about CN¥38,000 (US$6,200) per square meter.
Third- and fourth-tier Chinese cities, however, face more challenging balance-sheet
adjustments, owing to falling asset prices, outflows of labor, and the need to define
new growth models. In the aftermath of the post-2008 debt-fueled infrastructure-
investment boom, these cities need to reform how revenue is shared with the central
government, increase the transparency and accountability of local budgets, and
overhaul the use of municipal-bond and public-private partnership models for local
infrastructure projects.
But, before such changes can be implemented, these cities must address the
overhang of poorly performing projects and loss-making state-owned enterprises
(SOEs). In fact, Chinese cities and local enterprises will need even more liquidity than
would be required in a classic case of deflation, credit tightening, and falling prices,
because infrastructure and property investments by local governments and SOEs are
still consuming funds. And, given state intervention, interest rates do not adjust
quickly enough to allocate resources efficiently.
Of course, the People’s Bank of China could lower the interest rate and relax its
liquidity policy. But it remains concerned that doing so would spark inflation and fuel
wasteful investment – and greater excess capacity – in the real-estate sector.
Maintaining relatively tight liquidity, however, also has serious consequences. For
starters, as long as external conditions remain relatively liquid, tighter conditions in
China put upward pressure on interest rates in the shadow-banking sector. Together
with the growth of the renminbi carry trade, this has pushed up the exchange rate at a
time when non-US dollar-linked currencies are largely depreciating.
Moreover, interest-rate volatility and uncertainty encourages arbitrage and
investment in socially costly rent-seeking and speculation, with central-bank liquidity
flowing to financial markets, instead of fulfilling its intended purpose of helping the
real sector. Despite slowing growth, China’s A-share market has risen by nearly 50
per cent since last July, and the banking sector’s margins remain exceptionally large.
Meanwhile, confidence in the non-financial private sector remains depressed, as
diminished demand leads to increased production costs.
China’s growth model hinges on a governance system in which regions, cities,
companies, and individuals compete within an increasingly market-oriented, but still
centrally regulated, economy. But, in a country as large and diverse as China, a one-
size-fits-all approach will not ensure that the market functions effectively. After all,
different local economies have different needs.
Consider the city of Foshan’s economy, which, driven by private-sector activity,
boasts a higher per capita GDP than Beijing or Shanghai. Given that Foshan’s ratio
of bank credit to GDP in 2011 was only 85 per cent – much lower than Shanghai’s
184 per cent and Beijing’s 221 per cent – the city could use land as collateral to
borrow money to expand investment. A tight national credit policy, though potentially
useful in some highly indebted areas, would impede such growth-enhancing activities
in Foshan.
More generally, most of the structural tools needed to strengthen market allocation –
including planning, zoning, environmental standards, property rights, and bankruptcy
procedures – are implemented at the local level. And, adding yet another layer of
variability, local economies may experience “creative destruction” as their growth
models change, potentially causing temporary slowdowns that drag down overall
growth.
Against this background, the best way to sustain China’s economic transition and
prevent a hard landing is to implement looser monetary and credit policies that enable
the most productive cities, companies, and industries to generate new added value.
With the risks of inflation and asset bubbles being mitigated by lower oil prices and
excess capacity, now is a good time to initiate this policy shift.
Of course, China will probably face some short-term headwinds, so the positive
effects of this shift will take some time to emerge. As the central government
consolidates its power through fiscal reform and an anti-corruption campaign,
orchestrating the next phase of structural reforms at the local level will require deft
coordination.
After decades of high-speed growth and policy experimentation, cyclical overshoots –
reflected in excess capacity, ghost towns, and local-debt overhangs – are no
surprise. Now it is time to address them. Only by confronting these structural issues
can China complete its shift to its new, more developed, and more equitable “normal.”
A version of this article appeared in Project Syndicate, 20 December 2014
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