Too Large To Grow So Fast

Anyone forecasting a hard landing for China's boom is typically met with the same skepticism that doomed the boy who cried wolf. But the lesson of the fable is that the wolf did come, the third time. Now, after two false alarms in 2004 and 2006, the slowdown is at the door. China has simply grown too big to keep expanding at the 10 percent rate it has sustained for 30 years, and is likely to slow to 8 percent at best next year and for the foreseeable future. The decisive end of the era of double-digit growth is here, with major implications for the nation and the world.

Until now, China had defied the traditional theories of how fast developing nations could grow, and for how long. Its economic growth has compounded at an annual average rate of 10 percent over the past 30 years, a record that has surpassed the other miracle economies, such as Japan and South Korea. Japan's growth rate downshifted significantly after 1973, when it reached a per capita income of $3,000—a level China hit earlier this year. Now the law of large numbers is catching up to China: in 1998, to grow its $1 trillion economy by 10 percent, it had to expand its economic activities by $100 billion and consume only 10 percent of the world's industrial commodities. Currently, to grow its $3.5 trillion economy that fast, it needs to expand by $350 billion a year and suck in nearly 30 percent of global commodity production. Even more important, there are clear signs in China's response to the slowdown that the leadership understands that this moment was inevitable—that it is abandoning its old growth-at-any-cost mentality, and will not try to artificially revive double-digit growth.

Until very recently, of course, the China headlines had remained entirely bullish. The red-hot expansion had shown only marginal signs of moderation through the first half this year, and most economists blamed weak growth in Western countries, which are China's best export customers. They had also assumed that sluggish exports could be offset by stronger domestic demand, powered by Beijing's big spending on infrastructure projects and the rising purchasing power of the Chinese consumer. However, the latest signs are that the Chinese domestic economy is not immune to slowdown: it is starting to falter, too, and the property sector is the heart of its troubles, as in many countries.

For the first time since the Chinese housing market was fully privatized in the late 1990s, a coordinated real-estate downturn has set in across all major provinces. The feeding frenzy of rising prices and increasing demand has given way to a vicious cycle of falling prices and slowing demand. Housing is increasingly unaffordable, as property prices doubled between 2000 and 2007, and authorities began raising interest rates last year in an attempt to prevent overheating. Still, for much of this year, developers have continued building with abandon, counting on demand to revive and refusing to lower prices, even as sales began to collapse and inventories mounted. Property sales started to drop in October 2007, turning negative in the second quarter of 2008.

Now there is widespread anecdotal evidence that a price war is breaking out from Beijing to Shenzhen. Discounts of 10 to 20 percent are increasingly common on existing residential projects. New construction activity is grinding to a halt. Auctions of apartments in new buildings are failing to attract bidders even in formerly hot coastal cities like Shanghai.

A bear market for real estate will have widely unforeseen ripple effects across the economy: while the consensus forecast is for still-robust growth of 9 to 10 percent in 2008 and 2009, down from 11.9 percent in 2007, those predictions factor in only falling export growth, which is expected to slip from the 20 percent pace of recent years to single digits next year, stalling a sector that accounts for a third of investment spending in China. Businesses in some of the most energetic export hubs, such as the Pearl River Delta and Yangtze River Delta regions, have been reporting a softening in demand for months now. But real-estate construction accounts for another third of total investment spending, and its collapse should lop off at least an additional percentage point from economic growth.

The downside risks don't end there.

Falling property prices will further discourage consumption, which was weakening anyway. Many Chinese are feeling decidedly less rich because the local stock market has fallen by two thirds from its peak in October 2007. And historically, as consumer confidence wanes, so too do both the real-estate and auto sectors. In a telling sign, passenger-car sales fell in August, down 10 percent from the same month last year.

Until late 2007, China had in fact been relatively immune to the travails of the U.S. economy, which began to slow dramatically from the middle of 2006. But then inflation started to pick up speed in China, and policymakers responded last November by getting tough, with a strict directive to banks to clamp down on excess lending. The aggressive tightening of monetary policy laid the seeds of the current housing slump in China and dashed hopes of any economic decoupling.

Shakeouts are always necessary to cleanse the system of excesses in prices and spending that accumulate during any bubble. But China's housing excesses are less dangerous than those in the United States and Britain. For one, China's urbanization process is in its early stages, so housing demand is likely to rebound strongly in the long term, and help to swiftly clear unsold inventory. With Chinese household income rising at 10 percent a year, housing will become increasingly affordable if home prices remain flat, even for a year. And unlike Americans, the Chinese are not deep in personal debt; mortgage loans equal 12 percent of China's economy, compared with more than 100 percent of the United States' economy. Banks in China also have relatively small exposure to real-estate developers, who hold just 7 percent of outstanding banks loans. The comparable figure in the United States is 53 percent. The Chinese housing-market-led slowdown poses no systemic risk to its financial system.

The more important questions are how long will the downturn last and where will China emerge at the end of this phase? Some policy help is already on the way. The People's Bank of China recently reduced its benchmark rate by 27 basis points, its first softening in six years. With consumer price inflation slowing, there is further scope for an easing of monetary policy. The government also has ample room to stimulate the economy by raising spending, since its fiscal accounts are almost balanced, and its total debt-to-GDP ratio is very low at 16 percent.

But there is growing disappointment in the Chinese investment community as to why the government is not stepping in more decisively to stabilize growth, particularly in the property sector. The government's reaction reveals a lot about the shifting priorities of the leadership. Following the rapid rise in property prices over the past few years, there was a general feeling in policymaking circles that the average buyer was being priced out of the market and that developers were raking in money like bandits. The government would consequently be happy to see a fall in property prices, possibly a part of its larger objective of achieving a "harmonious society" by dampening the widening income gap.

The government is also wary of turning on the monetary spigots too quickly. It wants to anchor inflationary expectations after the painful experience of the past year, when inflation stayed well above the tolerance limit of 5 percent. The danger with such a strategy is that once a deflationary psychology sets in, it's difficult to turn things around. Consumer price inflation has fallen sharply from a high of 8.7 percent in February to 4.9 percent in August. While the merits of slowly lowering interest rates are debatable, this incrementalist policy does suggest a nuanced shift in the government's growth-at-any-cost approach to a greater emphasis on balanced economic development.

In a way, the commodity-price-led inflation surge of the past year was a message from the marketplace that there are limits to China's growth potential. It is not feasible for an economy to keep growing at a double-digit pace once it achieves a certain critical mass.

The Japanese case is telling. Back in the 1970s, Japan was forced to allow domestic prices and its exchange rate to be more market-determined—all part of an economic evolution process, as larger economies require greater currency flexibility to better tailor domestic money and credit conditions to local needs. Productivity growth in Japan naturally slowed as the exchange rate became less globally competitive, and economic growth averaged 4 percent over the next 15 years.

To be sure, China is not likely to slow to 4 percent growth for some time. China has also moved toward greater exchange-rate flexibility, beginning in 2005, but more gradually than Japan, and it still has a long way to go before it achieves anywhere near the level of modernization that Japan had reached in 1973. China started its modernization drive from a much lower base in 1978, while Japan was already a relatively advanced industrial economy, with modern textile, steel and shipbuilding sectors, at the beginning of its high-growth period in 1955.

Furthermore, China's labor-productivity boom has been driven by the vast migration of rural workers to higher-value-added urban jobs. An estimated 12 million to 15 million people continue to shift from agricultural to manufacturing- and services-based jobs every year. While it is hard to estimate when this labor supply will be exhausted, some early signs suggest that incrementally higher wages are required to move workers to urban centers. This should chip away at productivity growth.

There are also signs that Chinese policymakers are focusing more on shoring up rural infrastructure. Following the food-price shortages of recent years, the government is promoting increased farm growth that will help stabilize prices and—as an unintended consequence—give rural workers less reason to migrate to cities. If that slows factory output, so be it. A further demonstration of the change in mind-set is the recent adoption of a new labor law that, among other things, sets a minimum wage ranging from anywhere between $60 and $110 a month based on the per capita income of each province.

China remains a great economic growth story and is on the path to converging with the industrialized world. But developments of the past year—from commodity-price-led inflation to the slight shift in the government's priorities—indicate that the pace of convergence is set to slow in the years ahead. The 11.9 percent growth rate recorded last year was probably the high-water mark of China's economic miracle; growth could slow to 8 percent or lower in 2009. While that will prompt stimulus measures from the government, it is unlikely that China's growth trajectory will return to the 10 percent-plus rate that it sustained with little inflation from 2003 to 2007. After all, when fixed investment has exceeded 40 percent of GDP for years, there's a limit to how many more new power plants and roads the government can help build.

The $3.5 trillion economy's potential growth rate is probably closer to 8 percent, a rate that hardly detracts from its reputation as an economic miracle. But the shift to a slower growth plane is likely to be painful for many economic agents—from property developers in China to commodity traders worldwide—for whom the idea that anything related to Chinese demand could be bid up to any price had been taken for granted. Although it is starting off as a cyclical downturn, the bigger story is that the law of economic gravity is catching up with China, too.