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April 10, 2014

China Faces Just What It Needs: A Hard Landing

By

Former Chinese leader Deng Xiaoping's famous expression "cross a river by feeling the stones" meant implementing economic reforms slowly and pragmatically.

During the early stages of reform, this approach worked fairly well. Today, however, it is seriously dated. Indeed, it has put China's economy in a precarious state.

The world's second-largest economy is headed for a hard landing, and that's precisely what the Middle Kingdom needs.

China's meteoric growth in the last 35 years has been supported largely by low wages for workers, low interest rates for household deposits, an undervalued currency that boosted exports and almost unlimited (albeit misallocated) credit for its large state-owned enterprises (SOEs).

This approach has resulted in a massive reallocation of resources from the household to the government sector. In fact, household share of GDP in China shrank dramatically over the past three decades, while the share retained by the state grew proportionately.

Income inequality in China is now among the most extreme in the world.

State-controlled financial institutions fed the growth, too, with an explosion in credit. After 2008, net exports were no longer a driving force for the economy. Investment took up the slack, running close to 50% of GDP in recent years.

Some estimate that, when the shadow banking system is factored in, total domestic credit could be as high as 200% of GDP. The soaring debt and growing inequities are putting enormous pressure on China to abandon its current economic model.

Beijing has announced ambitious plans to switch to an economic model that favors ordinary households rather than the elite. While we wish the Chinese luck in moving toward a more market-based economy, history offers no instance of an adjustment following a growth "miracle" that does not include an unusually sharp slowdown in growth.

In fact, there are at least five good reasons why these desirable economic reforms will inevitably slow China's growth.

First, because much of China's growth has been fueled by an excess reliance on credit, a protracted period of deleveraging would put credit growth below nominal GDP growth. An enormous deceleration in credit is needed because many important industries are already producing at less than 75% of capacity.

And, given the continued weakness in the global economy, the Chinese cannot export their way out of the situation. Deleveraging could easily lower gross investment's share of GDP from 50% to a more sustainable 30%. However, it could also cause a 15% decline in GDP.

Two, as Michael Pettis of the Carnegie Endowment for International Peace has pointed out, Chinese banks have failed to recognize on their books how misallocated investment has overstated GDP growth. Officially, nonperforming loans are almost nonexistent in the banking system; there have been no significant bankruptcies.

If Chinese banks have not correctly written down the bad debt, past GDP growth must be overstated by an amount equal to all the bad loans that have not been written down — a fairly large number that may amount to as much as 20% to 30% of GDP. This transfer must reduce future growth.

Third, if Beijing opens its economy to foreign competitors, inefficient SOEs will likely suffer, at least over the short run — and the suffering will necessitate layoffs.

Fourth, China's private sector is already relatively highly indebted. Any collapse in investment demand and activity is also likely to have a significantly negative impact on profits. It would damage corporate solvency and lower investment still further.

Lastly, what about the Chinese consumer? Would the economy rebalance quickly enough over the short run for demand to rebound?

It is highly unlikely. With slowing growth, rising bankruptcies and layoffs, the Chinese consumer is more likely to hunker down.

China has few good options. Any real reform would probably trigger a severe financial panic and recession. No reform, on the other hand, delays the inevitable, making the economy even more imbalanced and making the eventual pain more severe.

Either way, we are looking at a hard landing. The best outcome is that it happens as quickly as possible.

Recall that Japan had a soft landing in 1992, while South Korea had a very hard one in 1998 during the East Asian financial crisis. Japan has been stagnant for 20 years now and is still talking about restructuring.

South Korea's financial sector, by way of contrast, went through a rapid process of consolidation and recapitalization. It allowed bad companies to go bust and dramatically cut the government's role in the economy.

As today's Mandarins in China cross the river, they should take bolder steps over the jagged rocks. In time, the pain will be worth it.

 - William Wilson is a senior research fellow in the Heritage Foundation's Asian Studies Center.

Originally appeared in Investors Business Daily

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