China: Balancing the risks of its rebalancing

23 February 2017 | Markets and Economy


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Qian Wang

Commentary by Qian Wang, Vanguard Chief Economist, Asia-Pacific.

I spent the Chinese New Year holiday in my hometown, the capital city of a province in southwest China. In many ways, the area is a microcosm of China.

The province is among China's poorest, yet also one of its fastest growing. Consumption in the urban area is strong and the provincial government has been pushing hard for a new growth strategy. The economy used to rely heavily on mining and manufacturing. Now, many of my cousins and friends work in big data, or at bio-environmental protection and pharmaceutical companies. Some have even started their own businesses.

Still, inequality between the urban and rural areas is significant and the burden from the past remains. Many state-owned enterprises in heavy manufacturing sectors are losing money, yet continue to survive thanks to support from state-owned banks.

My hometown has also seen a proliferation of massive construction projects. Most of the local people I meet own more than one apartment. Some are rented out for a pittance, while others are left vacant. While the rise in property prices make them rich on the paper, many locals are concerned about the "ghost towns" that have sprung up around them. They wonder what other assets they can invest in, including in other countries.

Like China as a whole, my home town has its shoots of green growth as it rebalances from an investment-driven economy to one based on consumption, service and innovation. But we're also left with an after-party hangover. While the government's "visible hand" continues to play a critical role, the old growth model has left us with significant over-capacity and surging financial leverage. Although economic growth stabilised in 2016 because of aggressive credit extensions and fiscal stimulus, these measures are not a cure for the secular and structural problems China is facing.

Indeed, despite the property market boom last year, housing inventory stayed elevated in third-tier cities like my hometown, which account for more than two-thirds of China's real estate investment. While this may not signal an immediate crisis, given the moderate leverage ratio in the household sector overall and continued urbanisation and migration, it would surely weigh on investment and economic growth down the road.

China's housing sector overcapacity will take years to unwind

Real estate inventory to sales ratio (in months):

Real estate inventory to sales ratio graphic

Sources: NDRC, PBoC, NBS, CREIS, Soufun, Wind and Vanguard, data as at 30 November 2016.

The risks ahead

China's policymakers have a wide range of monetary, fiscal and macro-prudential tools available to cushion a potential economic slowdown, so a hard landing in 2017 seems unlikely.

But the task isn't easy. Policymakers have to juggle multiple goals, including maintaining near-term growth and social stability and pushing forward supply-side reforms, while keeping financial risk at bay. External headwinds are also strong. The global economy is improving, but uncertainties around the United States-China relationship and increasing capital outflow amid higher US interest rates make their jobs more challenging.

Meanwhile, Chinese households and corporations still have strong incentive to diversify into foreign-currency assets in the medium term. Policymakers have responded with tighter controls on capital outflows, but this is not a permanent solution. In fact, if money gets trapped in China and the return on capital in the real economy is low, the leverage and bubble in the capital markets will only get higher and bigger.

China's delicate rebalancing act will continue in the new year. But the greatest risk lies beyond 2017.

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