While the United States, Europe and Japan remain mired in sluggish recovery, China's economy has continued to boom. But serious questions are now surfacing about China’s own state-led economic management. Massive overcapacity in infrastructure, stubbornly high inflation and a pile of potentially bad bank loans are undermining historic economic reforms only half completed.
Chinese planners face a serious dilemma – should they continue with investment-led growth, or finally focus on building a robust middle class, a policy nearly a decade overdue. Either choice will have global implications.
Staying the course with investment focusing heavily on construction has starved other parts of the economy, costing the average Chinese citizen dearly. Forced relocation, runaway environmental degradation, and cash-strapped social programmes like education, healthcare, and social security systems have been tolerated for questionable projects, many with little practical use.
Entrepreneurial and middle-income business development, meanwhile, remains starved of resources, limiting domestic consumption. The public at large heavily finances the state-centric investment model with their interest losing bank deposits (yields below inflation) which are then lent out to state-owned enterprises at preferential rates. The net effect: a wealth gap widening into a chasm – and increasing government concerns over social stability.
Construction continues to play an oversized role in China’s economic expansion largely because it worked so well in the past. Twenty-five years ago Shenzhen was largely empty land. Now, the southern industrial powerhouse has a population of ten million. Massive building projects also offer a short-term fix by buffering against the loss of exports. Low-skilled workers remain employed in building projects, while favoured industries continue churning out cement, glass and steel.
The result, intended or otherwise, has been overcapacity on a scale never seen before, including vacant apartment towers, office buildings and shopping centres. The Mall of China, one of the world's largest, remains empty along with many other commercial projects from Inner Mongolia to purpose-built port cities outside of Shanghai. Despite trends in rural to urban migration, most in the struggling middle still can’t afford luxury apartments, villas, or high-end goods now widely available in first and second tier cities.
The lift that keeps the ‘build-it-and-they-will-come’ model going – largely policy inertia tied to a massive stimulus plan and tight relationships between banks, state-owned companies, and local governments – can’t defy economic gravity forever.
Warning signs have been evident for some time. Back in late 2009, Wang Shi, Chairman of one of China's largest development companies, China Vanke, warned that a significant bubble was forming. In August 2010, officials in Beijing's largest commercial district, Chaoyang, released figures showing half of vacant real estate had been empty for at least 3 years.
Domestic investor sentiment in the sector has dimmed as well. Along with the sideways drift of the Shanghai and Shenzhen markets over the past year, many of China's largest real estate development companies and banks have seen share values lose momentum or fall.
And real estate is only the most visible aspect of the recent building boom, which has also included transportation systems (roads, trains and airports) as well as power generation and transmission. Some of these have provided much-needed improvements, while others turn into wasteful extravagances. Large scale airports have cropped up in even the smallest of towns, yet hopes for an influx of tourists in many interior cities never materialized.
Even the much celebrated and wildly expensive train network, in addition to its safety concerns, may never be economically viable. Most migrant workers making up a significant portion of train ridership can’t afford the tickets. Businesspeople traveling from Beijing to Shanghai may utilize that route, but easing travel and increasing economic activity in interior, less populated cities remains far less certain. The excesses of Japan’s high-speed rail network and its limited impact on rural communities serves as a potent reminder.
The questionable returns on this building frenzy are beginning to affect the financial system. China’s banks are exposed to a variety of questionable and interdependent real estate financing schemes including off-book lending to skirt Beijing's attempts to reign in the sector. Fitch estimates a rise in non-performing loans to 30 percent in the next 3 years. UBS and Credit Suisse are voicing increasing concerns as well. Without accurate assessments of total liabilities firmer figures are hard to come by, adding to the sector’s uncertainty.
Government officials have instructed state-owned banks to re-evaluate their property exposure, one in a string of new policies over the last year to tamp down speculation, control inflation, and rein in massive outlays for spending on development projects.
Developers will eventually feel the profit squeeze caught between high land prices and dwindling returns from commercial projects gone wrong. Many are already chasing foreign capital to remain afloat. Local governments, borrowing heavily against land slated for construction – their major revenue producer – will need increased central government funding (official debts have reached $1.6 trillion with defaults estimated at 20 percent to 30 percent.)
A policy shift towards building the middle class would bring a host of benefits: Freeing up financial resources to capital-starved small- and medium-sized enterprises to create durable job growth; reduced cement and steel production, two of China’s most energy intensive industries, to help lower inflationary pressures in commodities like coal, oil, and iron ore while also cutting emissions; and a boost in domestic consumption to relieve trade tensions as personal incomes rise along with imports.
This will require a degree of political will unseen to date. Economic modernization now risks stalling at best, and reversing at worst, with increased government control.
If even half the resources devoted to internal security (now larger than the national defence budget) were directed at fighting corruption, enforcing environmental regulations, protecting intellectual property, and hiring more judges, many of China’s social pressures would be alleviated.
Without a true middle class revolution, China’s economic foundations will increasingly rest on shifting sands. Ghost towns will remain empty, property investors will see diminishing returns, and banks will struggle with increasing defaults. China may be a victim of its own success, arriving at an economic fork in the road sooner than expected – one path leads to enriching the masses, the other back to business as usual.
Brian P. Klein is writer and international economist. A former U.S. diplomat with service in China and India he was a 2008-2009 Council on Foreign Relations International Affairs Fellow based in Tokyo. His articles and commentary have appeared in Foreign Affairs, The International Herald Tribune/New York Times (online), Japan Times, South China Morning Post and Far Eastern Economic Review, among others.