China’s Balancing Act

NEW YORK – China’s slowdown is the biggest short-term threat to global growth. Industrial value added fell in August, credit growth has slowed dramatically, and housing prices are falling, with sales down 20% year on year. Given stagnation in the eurozone and Japan’s uncertain prospects, a Chinese hard landing would be a big hit to global demand.

Much attention is focused on likely GDP growth this year relative to the government’s 7.5% target. But the bigger issue is whether China can rebalance its economy over the next 2-3 years without suffering a financial crisis and/or a dramatic economic slowdown. Some factors specific to China make this outcome more likely, but success is by no means certain.

Faced with the 2008 financial crisis, China unleashed a credit boom to maintain output and employment growth. from 150% of GDP in 2008 to 250% by mid-2014. Multiple forms of shadow bank credit supplemented rapid growth in bank loans.

The strategy worked, and China continued to create . But with investment rising from 40% to 47% of GDP, growth became dangerously unbalanced and heavily dependent on infrastructure construction and real-estate development. Narrowly defined, these activities account for 12% of Chinese value added. In fact, shows that 33% of China’s economic activity relies on the real-estate sector’s continued health.

China is now struggling with a dilemma common to all advanced credit booms. The longer the boom runs, the greater the danger of wasted investment, huge bad debts, and a major financial crisis. But simply constraining new credit supply and allowing bad loans to default can itself provoke crisis and recession.

This year has been one of seesawing policy responses. The discipline of default has been much discussed, but never quite applied. Despite a significant slowdown, the People’s Bank of China has resisted across-the-board cuts in interest rates or reserve requirements. But, in the second quarter of the year, Premier Li Keqiang reiterated the 7.5% growth target, which was then underpinned by several targeted stimulus measures – mainly new lending focused on railways, smaller banks, agriculture, and small businesses. Constraints on the property market, such as limiting multiple purchases or highly leveraged investments, have been tightened and then relaxed.

At least for now, the arguments for constraint and market discipline appear to have won the debate. That may partly reflect a subtle shift in emphasis about the most crucial objective. Recent speeches by both Li and policy experts have downplayed the importance of a specific growth target, focusing instead on job creation and low unemployment.