Experts are predicting that China’s economy is going to enter a period of prolonged recession. Without doubt, the Chinese economy is encountering unprecedented difficulties. Similar problems have cropped up over the past several decades, and various remedies have been applied, with the most common solution being increased lending and government investments. This approach is now more and more ineffective as returns on investment has declined sharply. In this economic environment, the top-level strategy has changed and is focused on solving problems on the supply side rather than the demand side.
Here’s the logic: If the Chinese economy has slowed due to lack of demand, then a quantitative policy on the demand side—increasing money supply—might solve the problem. But if the slowdown is structural and a result of inefficiency, increasing money supply won’t help.
From a structural point of view, we see supply-side issues behind the weak demand. And these supply-side issues, in turn, go back to deeply rooted institutional problems that include production, consumption, and national savings. In my opinion, these are the three major obstacles China’s supply side reforms are facing, and they are the root cause of major distortions in the supply and demand structure of the world’s second largest economy.
In a society that is polarized between rich and poor, extreme income inequality often leads to a false picture of prosperity and distorted supply and demand. A typical example is China’s real estate market. Speculative real estate investments by the rich have pushed up overall housing prices to the extent that houses are unaffordable to the poor. Additionally, unrealistically high real estate costs have added pressure to the purchasing ability of the poor not only in houses, but in other areas as well.
According to the Chinese Academy of Social Sciences’ 2016 Blue Book, the top 1 percent of Chinese households now possess 33 percent of the country’s wealth, while the bottom 25 percent of households only own 1 percent.
With China’s high population and per capita income reaching mid-to-high levels, why is there insufficient domestic demand and hence strong dependence on overseas markets? One reason is China’s large income disparity. While a small fraction of Chinese live like people in wealthy countries, most have a living standard similar to people in developing and poor countries. This large income inequality is the cause of low internal consumption and serious distortions in China’s economic structure.
In recent years, China’s financial sector experienced an oversupply of money and extraordinary credit growth. New RMB loans during this year’s Q1 period are expected to reach 4.3 trillion yuan (US$653 billion), a record high. The ratio of M2 to GDP quickly climbed to 205.7 percent. In short, money supply is increasing at a pace far beyond the economic growth rate.
At the same time, economic growth keeps declining and credit funding is not able to flow into the real economy. Many enterprises that need capital can hardly obtain a loan from banks, while others, especially state owned enterprises, have banks lining up to provide capital. Why?
One answer is that a lot of money deposited in financial transactions never enters the business entities. Where does it go, then? There are two significant destinations for new money. The first is to maintain the debt cycle and Ponzi financing by mainly paying off old loans with new loans. The second destination for surplus money has been the stock market bubble from 2014 to Q1 of 2015; and in Q2 of 2015, excess credit pushed up the first and second-tier cities’ housing bubble.
The current finance structure, capital flows, and liability to asset ratios indicate that local financing platforms, real estate, and the oversupplied heavy chemical industry are the “black holes” swallowing up funding. Eventually this capital will turn into hard assets that will continue to consume resources, relying on more debt turnover, becoming part of the “Ponzi finance” pattern.
Huawei recently caused an uproar when it moved its handset production headquarters out of Shenzhen. Perhaps this is merely an example of production chain restructuring. But the outside world looks at it as a sign of economic woes—namely high rental costs causing enterprises to leave first-tier cities. Actually, the high cost of living has not only pushed Huawei out of Shenzhen, but many other companies, along with the entire real economy, have also left.
Housing and rental costs are base expenses in supply and industrial chains. Labor, logistics, warehousing, and other costs are also closely related to it. Rising labor costs, factor costs, and financing costs are among the biggest challenges Chinese enterprises are facing. Labor costs have increased 79 percent, financing costs 66 percent, and factor costs 54 percent, according to the 2015 National Report on Company Expenses.
China’s high growth model of the past 20 years that included large-scale investments and high demand was able to cover cost increases on the supply side. But with economic growth slowing and PPI dropping 47 consecutive months, rising costs have become the biggest constraint on China’s economy.
In Western countries, a real estate bubble is mainly reflected in the financial market and has a limited negative impact on certain industries. However, the situation in China is completely different. A highly inflated real estate market not only kidnaps banks and the entire financial system, but also fundamentally changes the ecological environment of industry and the nation’s entire economic development.
Think about it: while the manufacturing sector struggles to maintain an average 3 percent profit margin, those in real estate and finance can easily earn 30 percent on their money. This kills, or at least undermines, the mindset of entrepreneurs who are in it for long haul. When speculation in real estate, stocks, and other financial assets can reap such huge profits, nobody wants to invest and work in the real economy. This is the true reason why capital does not flow into the real economy. If supply-side economic reform does not solve these issues, the Chinese economy will just dry up, with nothing but a bunch of empty slogans.
Editor’s note: The term “supply-side reform” has been stressed as a central component of Chinese leader Xi Jinping’s economic reform plans since last November. Since May, Xi appears to have been sending clear signals, whether in his speeches or through headline articles in state media, that local officials have placed insufficient emphasis on these reforms. Apart from bureaucratic intransigence, there are major structural obstacles in the Chinese political economy for these supply-side reform measures. The Chinese economist Fan Di discusses them in this article.
Fan Di is an independent economist and part-time professor at Peking University and Sun Yat-sen University. He obtained a Ph.D. at the University of California–Berkeley, supervised by Li Yining of Peking University and Nobel Prize winner George Arthur Akerlof. Fan has been a senior executive and consultant at major banks, financial firms, and large companies. A version of this article was first published on his personal blog.