China’s New Normal

Those who remain hopeful about the future of the Chinese economy got some extra evidence to bolster their case on Oct. 21. The Chinese government announced that GDP in the third quarter rose by a slightly better-than-expected 7.3%.

But don’t get too excited. That 7.3% is the slowest quarterly pace in five years, since the depths of the recession that followed the 2008 Wall Street financial crisis. And it’s likely that stronger exports, not investment or consumption in the domestic economy, are responsible for much of the unanticipated buoyancy in China’s economy.

That shouldn’t be surprising. This is China’s new normal. The double-digit pace the global business community has come to expect is very likely a thing of the past. More and more economists are predicting that China’s growth rates will continue to slow over time. The International Monetary Fund sees growth dropping from 7.4% this year to 6.8% in 2016 and 6.3% in 2019.

There are too many factors slowing down the Chinese engine. No economy can grow 10% a year forever, not even China’s. The country is no longer the impoverished backwater it was in the early 1980s, when Beijing’s market reforms first sparked its growth miracle. It is now the second largest economy in the world, and the bigger China gets, the harder it becomes to post such large annual GDP increases.

There are also structural forces at work. China’s population of more than 1.3 billion is aging rapidly, thanks in part to Beijing’s restrictive one-child policy, and that will act as a long-term drag on growth. The workforce is already shrinking.

The only question is: How slow will China go? The answer depends on whether China’s current leaders can fix the very serious problems plaguing the economy.

Aspects of the growth model that have driven China’s exceptional performance—state-directed investment and easy credit—have now come to spawn all sorts of new risks. Debt levels at Chinese companies have risen precipitously, while money has been wasted on excess capacity and unnecessary construction. Bad loans at Chinese banks have been rising as a result, and the economy is paying the price.

A big reason behind the country’s slowdown today is the deteriorating property market, brought low by irrational exuberance and excessive building. Official data shows that the amount of unsold real estate has almost doubled over the past two years, and that has caused prices to fall and investment in new developments to dry up. The central bank recently loosened restrictions on mortgage lending to boost sluggish demand, but such moves likely won’t stimulate a rebound anytime soon. There are even concerns that China is following a pattern similar to Japan’s when that Asian giant had its serious financial crisis in the early 1990s.

The long-term solution to these problems requires nothing less than overhauling the way in which the Chinese economy works. The country’s leaders realize this—officials intend to make the economy more market-oriented by liberalizing finance and capital flows and withdrawing some state control. Such steps would probably lead to enhanced productivity, better allocation of finance and stronger innovation—all things China needs badly as its costs rise with its wealth.

But there’s been little progress so far. A free-trade zone in Shanghai, launched a year ago to experiment with freer capital flows, has never gotten off the ground. A series of questionable investigations into the business practices of multinationals operating in China has raised concerns about Beijing’s willingness to open up the economy further to foreign competition.

Of course, the liberalization Beijing has promised won’t happen overnight. But if the effort doesn’t progress, the economy will suffer. In a recent report, the Conference Board, a business research organization, predicted that growth would slow to 4% a year after 2020, in part because its economists remain skeptical that China’s leaders will reform the economy deeply or quickly enough. China’s development model “bore the potential for a deceleration at least as rapid as its acceleration,” they wrote.

The world may not be able to count on China upholding global growth in coming years as it has in the past, which will only further depress sentiment about the outlook for the world economy. But investors may just have to get used to the new normal—no matter how gloomy it may be.