Last week, the IMF made its contribution to the ongoing debate over Chinese economic performance. The growth forecasts included in the Fund's latest Article IV Staff Report on China – which see growth this year at around 7.75% and at 7.7% in 2014 – are right up at the optimistic end of current forecasts, most of which see the government struggling to hit its 7.5% target this year. Indeed, Beijing recently signaled that 7% is the new official 'floor' for growth this year, and Finance Minister Lou Jiwei had earlier indicated that a 6.5% rate might be tolerable.
Move away from the guessing games over growth numbers and the Fund's report becomes useful in giving a sense of the challenges now facing Beijing. Thus the IMF points out that 'progress with rebalancing has been limited and is becoming increasingly urgent', that 'the heavy reliance on credit and investment to sustain activity is raising vulnerabilities', that 'fiscal space is considerably more limited than headline data suggest' and that 'vulnerabilities have increased in the financial, government and real estate sectors'.
This is sobering stuff from an organisation often seen as having an embedded bias to optimism. In fact, the Fund does still conclude that 'China has the resources and capacity to maintain stability even in the face of an adverse shock', although it also adds 'the margins of safety are narrowing.'
This latest Fund assessment, combined with my own impressions from a recent visit to China, suggest the following:
1. It's clear that China's growth momentum has slowed. That slowdown is both the inevitable consequence of the current growth model running into sharply diminishing returns and a product of the current cyclical conjuncture. Certainly, the symptoms pointing to structural problems with the growth model (weaker productivity estimates, lots of excess capacity across a range of industries, sustained PPI deflation, and a declining rate of return on investment) are easy to find.
2. Working out what China's new potential growth rate might be is still very much a guessing game. The Fund thinks that average GDP growth could fall to around 6% over 2013-30, with growth driven by a combination of investment (2.3 percentage points) and productivity growth (3.3 percentage points):
But the IMF also uses its report to warn that if China sticks with its current growth model the 'convergence process would stall, with the economy slowing to around 4 per cent':
3. Even a China that is growing significantly slower than the double digit pre-crisis average still has the potential to be a major source of global and regional demand. The US dollar size of the Chinese economy in 2007 was about $3.5 trillion; last year it was about $8.2 trillion. In other words, lower growth rates could in theory be comfortably offset by a much larger base effect, assuming that the adjustment to the new, lower growth path is relatively smooth.
4. A potential complicating factor here is that maintaining macro stability might become increasingly challenging. This reflects the imbalances that are a byproduct of the old model, the challenges involved in the rebalancing process itself, and the consequences of a move (sometimes deliberate, sometimes inadvertent) to an economy subject to significantly less direct state control. June's 'Shibor shock' was a telling symptom of this development. Reforming the growth model requires pushing ahead with liberalisation, but that in turn may well involve some short-term loss of policy control.
5. Hence China risk right now is not just about working out how much slower economic growth is likely to be, but also about the potential for a significant increase in macro volatility as the economic transition proceeds. As the single largest contributor to global growth, a slower-growing and potentially more volatile Chinese economy will inevitably have important implications for China's trading partners. Australia is one of those most exposed on this metric (albeit less than many of the regional members of 'Factory Asia'):
One consequence is that we might be coming to the end of what has until recently been something of a free (Chinese) lunch for Australia.
Think of it this way. Back at the tail end of the previous century, we might have expected that deepening trade ties with China would deliver stronger growth (and higher incomes) but at the price of increased volatility. This would reflect the stylized fact that emerging market growth typically tends to be both higher than that of our developed country trading partners, but also more variable.
Yet what we actually ended up with was faster growth and relatively low volatility – the big growth shocks in recent years have occurred in the crisis-hit economies of the developed world. China, by contrast, has managed to deliver an extremely impressive combination of rapid growth and low volatility (admittedly, some of this low measured volatility might reflect the well-known quirks of Chinese data. But that seems unlikely to have been the whole story):
Unfortunately, there now seems to be a significant risk that our free lunch of higher growth at no cost in extra volatility might be coming to an end. China still seems likely to end up growing faster than our trading partners in the developed world, albeit at a rate much lower than in the pre-crisis period. But the ride may also be about to get a lot less smooth. In the future, Australia's Chinese takeaway may come with a higher price attached.