A slowdown in China is the greatest threat to the global economy, Harvard economist Kenneth Rogoff told BBC in a curious interview in late September. "The [Chinese] economy is slowing down much more than the official figures show."
As the International Monetary Fund's former chief economist, Rogoff's comments can move markets. As U.S. financial media reported the story, CNBC called China the "biggest threat to the world economy right now."
After years of triple-digit growth, China's economy is slowing and the IMF expects China's GDP (gross domestic product) to grow by 6.6 percent this year. According to Rogoff, the Chinese economy is already amid a "pretty sharp landing."
Yet, the realities may be more complex, more nuanced.
Beware of austerity gurus
Among other things, Rogoff bases his view on China's debt-to-GDP gap. Recently, the Bank of International Settlements (BIS) reported that this gap – the amount of debt in an economy relative to annual growth – stood at 30.1 percent, increasing fears that China's economic boom was based on an unstable credit bubble.
Certainly, large gaps have been found to be a reliable early warning indicator (EWI) of banking crises or severe distress. Nevertheless, what the BIS reports neglected to mention is that, first, the ratio has also been criticized for measurement problems. Second, it has led to decisions that conflict with appropriate policy goals. Third, credit gap has not been an optimal early warning indicator for banking crises in emerging economies.
In the case of China, these qualifications should not be ignored. Moreover, the austerity advocates have a distressing track record. Amid the Great Recession, Rogoff, together with his colleague Carmela Reinhart, published the highly-awarded bestseller, "This Time It Is Different (2009)," which was initially considered the most comprehensive study of financial crises. It was also seized as the intellectual justification for neo-liberal austerity doctrines in major advanced economies, particularly in the United States and Europe.
However, as the debate intensified, three things ensued. First, critics, including Paul Krugman, showed that Rogoff and Reinhart had periodized their findings in a way that boosted their ideological views. Second, it soon became clear that austerity made economic challenges only worse boosting mass unemployment and extremist political groups in major advanced economies, particularly in Europe. Finally, in an embarrassing episode, a group of students showed that the Rogoff-Reinhart methods and data were flawed.
So when Rogoff applies his views on credit and leverage in the case of China, it may be only prudent to review the results with a grain of salt.
Hard landing as a theory, pretext and ideology
According to Rogoff, China is amid a "hard landing." Recently, he was seconded by Simon Baptist, chief economist of the Economist Intelligence Unit (EIU), whom I met in a China conference in Macao where we gave keynotes. Rogoff and Baptist believe that slowing growth in China translates to a hard landing. I believe the story is more complex.
First of all, while the concept of "hard landing" seems familiar, there is no consensual definition for it. Usually, it refers to an economic state wherein the economy is slowing down sharply or is tipped into outright recession after a period of rapid growth. Consequently, China's rapid economic growth has often given rise to speculation about the possibility of a hard landing.
Some neoconservative ideologues have been repeating this narrative for almost two decades, including Gordon G. Chang who has been predicting "The Coming Collapse of China" since 2001 and is still taken seriously in U.S. media. Others have made the same argument to cash on China's expected fall, including investor Jim Chanos who has been saying since 2009 that "China's bust will be a thousand times worse than Dubai." More recently, in April George Soros claimed that China's economy looks like the U.S. before the crisis seeking to short the yuan. However, the Chinese currency is not the British pound and 2016 is not 1992.
Now, assuming that China truly is amid the Rogoff's hard landing, let's look at the implications. Usually, such a landing is accompanied by central bank's rate hikes to slow growth; in China, on the contrary, the People's Bank of China (PBC) has been cutting rates down in the past. In October, PBC did raise an obscure interest rate to signal it is no longer willing to provide limitless cheap funds. However, the policy rate is 1.50 percent and likely to prevail in the foreseeable future.
Hard landing also implies rising inflation. In 2015-17, Chinese inflation is expected to increase or vary around 1.5-2.2 percent. Third, hard landing is predicated on a business cycle; yet, China's cyclical growth is stabilizing, but lower growth is predicated on its structural rebalancing. Finally, hard landing indicates slowdown or recession. Nevertheless, as long as Chinese growth is close to 6.5 percent – 3-4 times faster than in major advanced economies – it reflects structural deceleration, not recession.
In light of these facts, the hard landing theory is not fully persuasive.
Nevertheless, as long as China's credit target of 13 percent is almost twice the nominal GDP, Chinese growth will be fueled by reduced quality of growth. Indeed, continued excessive leverage would result in hard landing.
However, the challenges of credit-driven growth are only too well known in Beijing.
Credit-fueled growth is no longer an option
In early May, a top government source warned about excessive leverage in China. Without change, "systemic financial crisis" could ensue. So the source called for reform of the state-owned-enterprises (SOEs). That goal is vital. For instance, in the base case of Standard & Poor's, China's credit growth is expected to moderate by a third by 2020, but even then the problem credit to total could double to 10 percent from the 2015 estimate.
While China's central government agrees that overcapacity is no longer an option and that the reform of SOEs must proceed, the real question is "how." The steel industry is a case in point.
In the G20 summit in Hangzhou in early September, some world leaders had harsh words for China's steel overcapacity. Before the summit, President Barack Obama was urged by U.S. lawmakers, unions and trade associations to blame China's trade practices for U.S. mill closures and unemployment, which stressed the need for "aggressive enforcement of U.S. trade remedy laws." In Brussels, European Commission President Jean-Claude Juncker seconded U.S. concerns. In Japan, Prime Minister Abe called for structural reforms to address China's steel overcapacity.
Yet, as history shows, the first major steel crisis occurred already in the 1970s, thanks to policies in the U.S., EU and Japan.
Since the postwar era, crude steel production has grown in three phases. In the postwar era, global steel production grew a strong 5 percent annually. It was driven by Europe's reconstruction and industrialization, and catch-up growth by Japan and the former Soviet Union. As this growth period ended in the 1970s, a period of stagnation ensued and global steel demand increased barely by 1.1 percent annually. A third period ensued between 2000 and 2015 when China experienced massive expansion in steel production and demand, which drove annual output growth by 13 percent.
While China's urbanization will continue for years to come, the most intensive period of expansion is behind. So, once again, the sector is facing huge overcapacity and new stagnation. Four decades ago, the U.S. and Europe sought to protect their steel market through non-tariff barriers embracing protectionist external policies. Now, the two are urging Beijing to overcome overcapacity by allowing massive defaults.
In contrast, Beijing is opting for gradual SOE reforms, but the latter will be challenging as well. If current overcapacity is reduced by 30 percent in steel, coal mining and cement, up to 3 million workers will be laid off in China in the next two to three years. In the coal and steel sectors, Beijing is allocating US$15.4 billion in the next two years to help laid-off workers find new jobs.
Unlike U.S. and the EU four decades ago, China is eager not just to sustain globalization but to accelerate world trade and investment, as evidenced by the Hangzhou-hosted G20 Summit.
A long, bumpy landing
Cyclical stabilization seems to support the quest. China's economy grew 6.7 percent for a third consecutive quarter. Manufacturing and service sectors may have bottomed around 2015/16 and have risen since, while consumer price inflation is about 2 percent. After seasonal adjustments, exports and imports reflect stabilization as well.
In the first three quarters of the year, consumption accounted for 70 percent of GDP growth, almost twice as much as 37 percent attributed to investment.
What China is experiencing is structural deceleration, not a cyclical recession. After intensive industrialization, such deceleration has been typical to all maturing economies. In China, it is also the explicit goal of economic rebalancing. That virtually ensures a long and bumpy landing.