How Much Slowdown Can Beijing Tolerate?

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How Much Slowdown Can Beijing Tolerate?

The notion of a bottom line for growth and stability is a myth. The truth is more complex.

The once-mighty Chinese economy is now headed in one direction only – downward. GDP growth was 7.5 percent in the second quarter of this year, down slightly from 7.7 percent in the first quarter. In the last quarter of 2012, the Chinese economy grew 7.9 percent. The deceleration from 7.9 to 7.5 percent may seem relatively minor – only 0.4 percentage point in six months. However, when annualized, this figure means that the Chinese economy has lost about one-tenth of its growth momentum since last year.

The question on the minds of most people is how much of a slowdown Chinese leaders can tolerate. Many people, including senior government officials in the West, seem to believe that Beijing will not allow its GDP growth per annum to fall below 8 percent (sometimes one also hears 7 percent as the magic number) because growth below that line is supposed to trigger social unrest. Typically, those who place a lot of faith in this number argue that unemployment will explode once growth stalls. For a government obsessed with domestic stability, that would be a nightmare.

While seemingly persuasive and plausible, the widespread notion that there is one magic growth number that will trigger panic in Beijing is simply a myth.

One reason to dismiss the purported connection between growth and unemployment-based social unrest is the divergence between growth and employment in the Chinese economy in recent years. Because of its investment-driven growth model, China’s economic expansion has been capital-intensive but labor-light. Modern power plants, steel mills, toll roads, and ports are expensive to build, but require a small number of workers to operate. As a result, each additional yuan invested in the Chinese economy is generating fewer jobs. This disconnect between investment-driven growth and job generation can be seen in these numbers. Between 2004 and 2009, Chinese investment in equipment and plants quadrupled, but the number of manufacturing jobs increased only by 15 percent.

Another factor that has greatly alleviated the pressure on employment is China’s aging population. The labor force is shrinking. Consequently, economic slowdown will not result in an instant increase in unemployment. Even in today’s environment of decelerating growth, China’s unemployment has not worsened.

To be sure, Chinese leaders would prefer balanced high growth to low growth. However, the current leadership is aware of the enormous risks of allowing highly distorted growth to continue. Since 2008, Beijing has maintained growth with a massive injection of credit, much of it invested in speculative real estate, excessive industrial capacity, and infrastructure with dubious financial viability. Continuing this disastrous policy would imperil the political future of new Chinese leaders, particularly Xi Jinping and Li Keqiang, who will be up for reappointment in 2017.

That is one of the main reasons Chinese leaders seem to tolerate persistent growth slowdown – so far.

But will they lose their calm if growth falls below a certain level?

The truth is that Chinese leaders themselves probably do not know the magic growth number that will force a decisive response. The factors that go into the political calculations of Chinese leaders are complex and dynamic. They are not as simple as the number of unemployed workers or the amount of bad loans in the banking system.

In all likelihood, the most important factor determining Beijing’s response to a slowing economy is the level of confidence and security of its top leaders. Typically, less confident and secure leaders tend to respond with panic whenever the economy shows signs of weakness, as we saw in 2008-2009. More confident and secure leaders are more likely to show a greater tolerance of subpar growth. In the wake of the East Asian financial crisis of 1997-1998, the Chinese economy stopped growing altogether, but the premier at that time, Zhu Rongji, did not react with undue alarm. Instead of throwing good money after bad, he proceeded with a massive restructuring of hundreds of thousands of moribund state-owned enterprises, resulting in 35 million lay-offs. Of course, the level of social unrest rose. But the Chinese Communist Party (CCP) weathered the storm, with plenty of help from its anti-riot police and security forces.

Another critical factor in influencing Beijing’s response is the effects of an economic slowdown on the ruling elites. Less informed observers give more weight to the CCP’s fear of mass uprising in economically distressful times. They overlook the regime’s enormous capacity for repression. Of course, social unrest may rise during recessions, but if the party can count on its repressive apparatus, such unrest is easily contained, as was the case during the mass layoffs at the end of the 1990s.

What Chinese top leaders really fear is the impact of a slowing economy on elite unity. In China’s investment-driven economy, slow growth means less investment, which in turn means fewer spoils to be divided among the ruling elites. Local officials with less money to build projects will lose corruption income and opportunities to burnish their record and advance their careers. Their anger and frustrations will be concentrated on the top leadership, which will be heavily lobbied to loosen credit and rekindle growth. In this case, economic policymaking at the top will be swayed not by the relationship between growth and employment, but by pure elite politics.

If there is one economic factor that truly worries top Chinese leaders, it is the systemic fallout from economic slowdown. More specifically, in a highly leveraged economy, as China is today, a significant deceleration could quickly lead to cascading financial defaults. Deeply indebted real estate developers, local governments, and state-owned enterprises will not pay their creditors (both banks and suppliers), thus triggering chain default. This could throw the entire economy into turmoil. We saw a little preview of this during the credit squeeze in June.

What this analysis shows is that many factors, some of them intangible, determine Beijing’s tolerance of slow growth. No magic number will make Chinese leaders think or behave differently.