Article

Knockdown Prize

Shashank Mohan and Daniel H. Rosen November 8, 2011

The credit crisis, followed by a severe global recession, raised questions about the economic foundations of the 21st century. Doubts were expressed about everything from globalisation to financial innovation. Yet amid all the chaos, few seriously questioned that one phenomenon of the world economy had changed — the role and importance of China. If anything, it was assumed that China was destined to emerge as one of the big winners of the crisis.

The Chinese economy has not escaped the crisis unscathed. The annual GDP growth rate in 2008 was 9 per cent. Growth is down to 6.1 per cent in the first quarter of 2009 — a far cry from an annual average of above 11 per cent in 2003-2007. The government has had to provide both liquidity support, as well as a $590 billion stimulus package. Beijing’s unprecedented increase in bank lending, secured by government guarantees in the first half of 2009, is a key reason many have come to believe China is taking the lead in recovery.

And it is likely China will grow in the range of 8-9 per cent in 2009 rather than the dismal consensus of around 6-7 per cent. The optimistic view pins its hope on growth in investment — first government investment in infrastructure and then the private investment that should piggyback on the increased economic activity. But China may fall short of this rosy picture.

There are ample pointers in this direction. Bank officials are floating a target of 6-8 trillion renminbi (traditional Chinese people’s currency) for lending in 2009. But it is hard to imagine this will be 100 per cent of the investment story. Bank lending makes up just 15-25 per cent of total investment — the rest is “self-raised” funds and retained earnings.

A greater concern is whether this will buy anything worthy. The quality of use of those funds is poor. Reports are trickling in that some is going into the stock market or being re-deposited in banks. So a concern about nonperforming loans will rise.

The problem is that Beijing seems to have chosen to maximise its short-term opportunity rather than aggressively reform imbalances and the misguided incentives that led China to be a contributor to the global economic meltdown. For instance, only nominal attention is being paid to the structural bias in the stimulus design, and a recent tactic for inducing private investment was to permit real estate project originators to undertake projects based more on leverage and less on having their own capital at risk. This sounds similar to what we know about the US real estate market two years ago.

Second, any country with a modicum of control overs its banks can offset cyclical slowdown by guaranteeing and compelling banks to lend. That is what China has done. Paying an exorbitant cost to build a bridge to the other side of the economic crevasse is one thing, but what if there is no “other side”? In economic-speak, this slowdown is structural rather than limited-duration cyclical. If the former then this is a bridge to nowhere. What are the expected engines of growth once bank coffers are empty? If there is no compelling answer, then one cannot expect private and corporate investment — which is more than 65 per cent of fixed asset investment — back at the table.

The path that China will necessarily embrace to take it forward from the crisis is not the one it is on now. Today’s path sustains old line heavy industry. Tomorrow’s would be a more rebalanced path with a focus on competitive advantage and higher value-added production.

Similar hopes of structural change from India have never been higher. The Indian economy has shown resilience amid the meltdown. Given China’s potential to surprise on the downside over the next twelve months, and India’s potential to surprise on the upside, 2009-10 may well prove an exceptional moment in the debate over China and India as alternative growth stories.