China’s debt-fuelled growth is sputtering and a more severe economic deceleration may loom

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The crisis at China Evergrande Group, one of that country’s biggest property developers, points to a problem much bigger than unsold apartments in second-tier Chinese cities.

Like Evergrande, China’s debt-fuelled growth model is sputtering. During a brilliant three-decade run from 1978 to 2007, the country sprinted ahead, expanding its output at around 10 per cent a year. But since the financial crisis of 2007-09, its pace of growth has slowed considerably – to under seven per cent a year in the run-up to the pandemic.

A much more severe deceleration could loom ahead. If some prominent forecasters are right, growth in gross domestic product will slide to a near-standstill over the decade to come.

“If you look out 10 years, I would not be at all surprised to see growth at only one or two per cent a year,” Leland Miller, chief executive officer of analytics firm China Beige Book International, said in an interview.

“Our long-term forecast is that growth in China will slow to only two per cent in 2030,” Julian Evans-Pritchard, senior China economist at Capital Economics, declared at an online seminar this week.

Evergrande founder Hui Ka Yan is in the centre of China’s real estate storm

Stagnation in China would be bad news for businesses everywhere. In the years leading up to the pandemic, the Asian giant accounted for roughly a third of global growth, according to the World Economic Forum.

Raw-materials suppliers would be among the biggest victims if the pace of Chinese construction falters and the country’s appetite for iron, copper, nickel and zinc goes into a long-term funk. Automakers that dreamed of huge sales in China would also feel pain, as would investors who hoped for runaway growth in emerging market stocks.

Granted, Beijing could engineer a strong short-term recovery if it chooses to deliver massive fiscal stimulus. But in the long term, its ambitions for growth face at least three big headwinds: an economy that persistently misallocates capital, towering levels of debt and slowing productivity gains.

A slowdown would not surprise skeptics such as Michael Pettis, a professor of finance at Peking University in Beijing, who has argued for years that China’s growth numbers are less impressive than they appear.

Prof. Pettis warned in an essay last month that as much as half the country’s reported growth in GDP over the past decade is imaginary wealth that exists only on paper. It is “the bezzle,” to use the wonderful term invented by the late Canadian-born economist John Kenneth Galbraith. According to Prof. Pettis, much of this bezzle is associated with local governments’ desire to build big-ticket infrastructure projects that deliver little economic payoff.

“The way this works is straightforward,” he said. “Some entity, usually associated with the government and therefore lacking hard budget constraints, spends, say, $150 to build a bridge or a railroad that ultimately generates only $50 in additional economic benefits.”

So long as the builder of the project can carry the project on its financial statements at its original cost, the economy looks to be growing nicely. But because the project can’t justify its cost in reality, the growth is actually an illusion.

One consequence of bezzle is that debt keeps expanding because the returns from such projects can’t generate returns sufficient to pay down the funds borrowed to construct them. This helps to explain “the extraordinary surge in China’s debt ratios since the mid-2000s,” Prof. Pettis asserted.

Between 2008 and 2019, total private and public debt in the Chinese economy jumped from 169 per cent of GDP to 306 per cent, according to the Institute for International Finance. Despite this borrowing spree, growth slowed and productivity withered. Construction of unnecessary bridges, railways, airports and other superfluous infrastructure projects dragged on economic efficiency.

So did the country’s obsession with real estate. The property sector, broadly defined, now accounts for 30 per cent of value added in the economy, Citibank estimates. Yet this economic driver rests on squishy foundations. Supply has been running well ahead of demand for years and the surplus is growing as population growth grinds to a near halt. China now has enough empty houses and apartments to accommodate more than 90 million people, according to the economics researchers at the Rhodium Group.

Why has Beijing been so welcoming to questionable infrastructure projects and vacant apartment developments? One reason is that land sales make up a big chunk of most local governments’ revenue. In addition, infrastructure and real estate projects are handy ways to spur growth and create jobs. And both are ways to insulate China from shocks outside its borders.

Loren Brandt, a professor of economics at the University of Toronto and noted China watcher, says Beijing began redefining its relationship with the rest of the world around the time of the financial crisis. Leaders sought to promote self-reliance and “indigenous” innovation, while reducing vulnerability to external threats.

Their campaign has had a dampening effect on growth. Over the past 10 to 15 years, trade as a share of China’s GDP declined. Exports, which grew at a breakneck annual rate of 25.5 per cent between 2000 and 2007, inched ahead by only 2.1 per cent a year between 2013 and 2019. Productivity growth slowed to a crawl.

“Growth and dynamism in the Chinese economy has declined,” Prof. Brandt said in an interview. This is distinctly odd, he notes, because Chinese industry is far less productive than its peers in advanced economies and there is plenty of room for catch-up growth. But closing the productivity gap seems to have fallen well down Beijing’s agenda.

The country’s leadership is now primarily focused on cementing the primacy of the Chinese Communist Party (CCP), said Mr. Miller of China Beige Book. Beijing’s recent moves, such as cracking down on many of China’s big tech companies such as Tencent and Alibaba and reining in the country’s tutoring industry, signal that the CCP is no longer interested in boosting economic growth at all costs, he said.

Instead of lionizing business leaders, President Xi Jinping and his associates want to cast themselves as defenders of ordinary citizens – an important message given the growing economic inequality in Chinese society. Beijing intends to direct market forces, not the other way around. “They are making clear who is in charge,” Mr. Miller said.

Part of Beijing’s strategy to bring the economy under firmer control involves reducing the froth in the property sector. Its announcement last year that property developers would have to meet three key tests of creditworthiness – the “three red lines” – forced the sector to reduce its balance-sheet leverage and led directly to the crisis at Evergrande. “If you’re an optimist, you can argue all of this will lead to slower but healthier growth,” Mr. Miller said. The danger is that slower growth may turn out to be very slow indeed.

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