China’s Unsustainable Growth Model: The Rising Risk of a Hard Landing After 2013 By Nouriel Roubini Aug 17, 2011

5:30:00 AM This paper presents the findings of my latest trip to China in the summer of 2011, following two trips in the spring. Here, I update and expand my previous analysis on the risks of a hard landing in China after 2013. Excessive investment—now close to 50% of GDP—has created a latent debt problem and massive overcapacity that eventually will slow down economic growth and could lead to a hard landing (i.e., a sharp slowdown in growth to 5% or lower). (See also "Chronicles of a Crash Foretold: Visualizing the Sequence of a Chinese Hard Landing.") Until the change in political leadership in 2012, China’s policy makers may be able to maintain high growth with investment, to ensure a smooth transition. But by 2013, China’s unbalanced growth model will start showing signs of strain. To stave off a hard landing in 2013-14, China needs to work toward a more balanced, sustainable growth model. We are somewhat pessimistic that China will be able to significantly increase the contribution of consumption to growth before the investment boom turns into a bust: The reasons that savings rates are high and consumption rates are low are structural, and decades of painful, politically difficult reforms are required to change these factors. THE DEMISE OF CHINA’S EXPORT-LED, HIGH-SAVINGS GROWTH MODEL While in the short run the Chinese economy is overheating—growing faster than potential and thus fanning inflationary flames—the biggest problem that the economy will face starting in 2012-13 will be overinvestment, triggered by a massive increase in fixed investment. Already, fixed investment is close to 50% of GDP. China’s traditional growth model was based on export-led industrialization, with a weak currency; large net export and fixed investment contributions to GDP; high corporate and household savings rates; and a very low consumption contribution to GDP. As consumption fell as a share of GDP from 52.0% in the 1980s to 33.8% in 2010, growth became increasingly dependent on net exports and fixed investment. Until 2008, the growth rate was predominantly a product of the sharp rise of net exports as a share of GDP: from effectively zero in the early 1990s to a peak of 9% in 2007. When the global recession caused China’s net exports to plummet from 7.7% of GDP in 2008 to 4.3% in 2009, China reacted not by raising the consumption share of GDP— which stayed stuck at 35% in 2008-09—but rather by further increasing the gross capital formation share of GDP from 44.0% to 47.5% in 2009 alone. Thus, the collapse of net exports in 2009 did not lead to a severe recession—as occurred in Japan, Germany, emerging Asia and other export-led economies—only because fixed investment surged beyond its already excessively high share of GDP. Consumption’s share continued to fall, to 33.8% in 2010, while that of fixed investment increased further in 2010-11 to a level closer to 50% of GDP, via infrastructure spending, commercial and residential real estate investment and cheap loans from state-owned banks to state-owned enterprises (SOEs). These SOEs were told to produce more, hire more and increase capacity, despite the existing glut of capacity in manufacturing (steel, cement, aluminum, autos, etc.).

and the country has to keep brand-new aluminum smelters closed to prevent global prices from plunging. The argument that China will eventually need all these infrastructures to support its urbanization and industrialization does not make sense. The only question is who in the public sector—state-owned banks. A growth rate of 5% or below would qualify as a hard landing as China needs a growth rate of about 8% to maintain its social and political stability. we consider alternative hard-landing scenarios in more detail. the People’s Bank of China (PBoC) and the Railway Ministry and those from last decade’s bank bailout. For a country with a per-capita GDP of . There is an excessive amount of infrastructure for China’s level of percapita GDP: brand-new empty airports. if the provincial governments cannot bear the additional burden of the debt. suggests that Chinese public debt is much higher than the central government’s official 17% of GDP. Meanwhile. With over a third of infrastructure projects having zero cash return rates. massive new government buildings and ghost towns. In a companion paper by RGE Research Analyst Adam Wolfe. Rising Public Debt The NPL problem in the banking system is hidden.No country in the world can be productive enough to take almost 50% of GDP and reinvest it into new capital stock without eventually facing massive overcapacity. the public debt figure becomes 77% of GDP in 2010 and rising. If instead the provincial governments support the SPVs. there is no doubt that many of these infrastructure projects will go bust. the massive increase in auto capacity has overshot auto sales. including RGE analysts. Including the debts of the provincial governments. according to RGE estimates. then the central government will have to provide the backstop. No matter what. some agent of the public sector will see its debt surge. we mean a scenario where Chinese growth falls for a significant period of time to a much lower level than China has experienced in the last 30 years. There is also excessive commercial and high-end residential investment and an excessive amount of capex. Overinvestment Boom: Manufacturing Capacity Infrastructure. infrastructural and property capital stock. Recent work by a number of scholars. The infrastructure needs of any country depend on its rates of per-capita income and labor productivity. for the time being. By hard landing. a nonperforming loan (NPL) problem for the banking system and a surge in public debt. China is rife with overinvestment in physical. Real Estate and Industrial and Excessive investment—now close to 50% of GDP—is also leading to massive overcapacity that eventually will slow down economic growth and could lead to a hard landing. as NPLs are being ever-greened and rolled over even if the underlying loans are nonperforming. THE PROBLEMS THAT LIE AHEAD Rising NPLs. sleek bullet trains (also empty) that will obviate the 45 planned airports. despite their surge. the state-owned banks will go bust. Keeping fixed investment at a level close to 50% of GDP is clearly unsustainable and eventually—most likely after 2013—would lead to a hard landing. as more infrastructure increases the productivity of labor. highways to nowhere. China has nearly half of global capacity in steel and cement. the central government or the provincial governments that implicitly or explicitly backstop the thousands of special purpose vehicles (SPVs) that financed these infrastructure projects—will pick up the tab when these projects implode. If provincial governments don’t explicitly backstop the SPVs. the losses will show up as provincial debt.

For the last 30 years. starting with the manufacturing and real estate sectors. Since the change in the stock of capital is equal to fixed investment (I). In contrast. . China needs to operate faster. While in the short run the investment boom will lead to resource-intensive growth. in the 1990s.000 miles of new highways or 45 new airports on top of the 50 just-built and semi-empty ones. as the recent episodes in the U. China’s average growth rate has been 10%. it makes no sense to build today what won’t be fully utilized for another 10-20 years. with no exception: from the Soviet Union in the 1960s-80s. 10. the gross marginal return on capital at the macro level has fallen from 28% in the 1980s. In a matter of a few years. Dividing both the numerator and denominator by real GDP (Y). now it takes almost 50% of GDP in fixed investment to achieve a growth rate of 9%. or dY/dK. likely at a quite rapid rate given the speed at which it was built. the macro marginal return to capital is also equal to dY/I. Ireland. and recently it has slowed to 9%. to East Asia in the 1990s. More importantly. to avoid a hard landing. especially because in the meantime the debts with which those investments were funded will come due. From a macroeconomic point of view. which always end with a crash and burn. It used to take 36% of GDP in fixed investment to get a growth rate of 10%.000—even on a purchasing-power-parity (PPP) basis—having infrastructure projects that are much larger per capita than those of advanced economies with per-capita incomes four to six times higher than China’s does not make sense. China’s overinvestment has caused a massive. In East Asia. with more fixed investment.just over US$8. to 26% in 2000-08.000 miles of new high-speed train tracks.S. Put simply. over time the overcapacity will cause serious deflationary pressures. Thus. literally all historical episodes of excessive investment have ended with a hard landing. the return on investment in an economy is equal to the change in the flow of output (dY) divided by the change in the stock of capital (dK). fixed investment peaked around 35% of GDP in 1997 at the onset of the financial crisis. The Lessons of History In the last 50 years. or the ratio of the growth rate of the economy and fixed investment as a share of GDP. to 49% in 2010. to 40% in 2000-08. like the microeconomic definition. China needs to reduce the GDP contributions of fixed investment and net exports and increase that of consumption. overheating and inflation. the result was a crash and a hard landing. China’s infrastructure is a depreciating asset. It is thus clear that. In China. to the U. thus. to Latin America in the 1970s-early 1980s. to achieve a lower growth rate. the investment growth rate has gone from 36% in the 1980s90s. The duplication and triplication of infrastructure projects is also illogical: China must decide if it needs 10. investment was already 40% before the 2007-09 global crisis and since then has surged to a level closer to 50% of GDP. In each episode. a financial crisis and/or a long period of low growth. UK. and the return on investment has fallen by almost 40% between the 1980s and 2010. to Japan in the 1980s.S. we see that it is also equal to (dY/Y)/(I/Y). Spain and Dubai show. the most relevant case study for China. Iceland.. even episodes of overinvestment in manufacturing and industrial capacity end in a hard landing. to 19% by 2010. Low and Falling Return on Investment and Additional Capital Stock Having investment at 50% of GDP is not only a source of excess capacity. rapid deterioration of the return on capital in the economy. it also implies a low and falling return on excess capital stock. And these hard landings have occurred not only in cases of housing booms.

have a similar savings rate to the much-richer economies of Japan and Germany? And what makes India’s household savings rate similar to that of the U.? The main difference is demographics. Conversely. households now have one child to take care of two parents and four grandparents. The underdevelopment of capital markets also has increased the savings rate. For example. This further distorts and increases the savings rate among young Chinese males. household savings rates are low in spite of good social security benefits. That can’t be the main explanation: U. Cross-country academic studies have shown a significant correlation between mortgage down payment rates (themselves correlated in part with the economy’s stage of financial development) and the savings rates of the household sector. take the argument that the Chinese save a lot because their pension benefits are very low. Thus. household savings rates historically have been high.S. Down payments on home purchases in China are very high compared to the U. the Chinese need to save a lot to be able to make the down payment. Other factors tend to exacerbate the high savings rate of Chinese households.S. The lack of property rights over land and the income/wealth uncertainty it creates also lead to higher savings. China. is much lower than that in China. Traditionally. while in Germany and Japan. a rise in investment and physical capital can artificially increase GDP. and households must save accordingly. But this social security system is breaking down in China for two reasons. and an excessive and unsustainable investment boom has done so for China. Paul Krugman’s famous 1994 critique of the East Asian growth model applies today to China: You can produce many more sausages that no one eats by quickly increasing the number of sausage-making machines. the product of incentives that will take over two decades of reform to change. limited public services like health and education) solve only part of the puzzle. Migrant workers are subject to movement and registration restrictions and do not benefit from the social services that formal residents of cities enjoy. Second. with its low per-capita income. agrarian community. in order to be able to purchase a first home. Traditional explanations of the high savings rate (lack of a social safety net. Germany and Japan are aging fast. thus they need to save more. So what makes China. with similarly high per-capita income and similarly generous pension systems. In economic terms. parents would have many children who could eventually take care of their elders. First. rather. urbanization has broken down the old model of parents living with their children in a rural. which has low per-capita income and limited pension benefits.S. the Asian model of social security was not a governmentsponsored pension system. limited social security.: typically 30-50% in the former compared to 20% (and unofficially close to 0% in the years of the subprime mortgage bubble) in the latter. given China’s imbalanced sex ratio (a product of selective abortions resulting from the one-child policy) young Chinese men need to own a home and a car to be able to find a suitable bride in a tough marriage market.S. the household savings rate in India. Moreover. And the entire system of consumer finance—not just mortgages . CHINA’S HIGH SAVINGS RATE: STRUCTURAL FACTORS AT WORK Demographic Factors Driving the Savings Rate The trouble is that the reasons the Chinese save a lot and consume little are structural. especially since a housing bubble has artificially boosted prices.These results are consistent with recent studies showing that the rate of total factor productivity growth in China is low and falling. while population growth is still robust in India and the U.

either directly via transfers or indirectly through provision of public goods. Several Chinese policies have led to a massive transfer of income from the politically weak household sector to the politically powerful corporate sector (SOEs. exporters). at barely 50%. China also would need to privatize the SOEs so that their profits become income for households and/or massively tax SOEs’ profits and then transfer those fiscal resources to the household sector. On top of household savings. liberalization of interest rates to increase the return on household savings and a much sharper increase in wage growth in excess of productivity growth. Singapore or Taiwan. thus leading to excessive corporate savings—are also evident in similar forms in other economies. The big difference between the Chinese in China and elsewhere is that the share of GDP going to China’s household sector is very low. they are all Confucian and all save about 30% of their disposable income. again. But privatizing the SOEs is not even on the reform agenda. most of which would be losing money if they had to borrow at higher market interest rates. What Do China. mostly SOEs. and policy proposals to tax some of the profits of the SOEs and transfer the income to households have languished for years in the face of political resistance from powerful SOE lobbies. leading to low rates of debt accumulation and high levels of savings by households. This tax on savings implies a transfer of income from households to SOEs. A weak currency reduces the purchasing power of households by making imports expensive and instead benefits import-competing SOEs and exporters by boosting their income/profits. But more importantly. In Germany and Japan. there is little left for consumption. transferring income from households to the corporate sector. After saving 30%.but also consumer lending. A policy of labor repression for the last 30 years has caused wages to grow much slower than productivity. the existence of large conglomerates (such as the Japanese keiretsu) and the cross-holding of shares among . including credit cards—is very underdeveloped. So China’s problem is excessive saving not by households but by the corporate sector. The High Savings Rate of the Chinese Corporate Sector There is a myth that Chinese cultural norms are to blame for the country’s high savings rate. But Chinese households in China don’t have a larger propensity to save than Chinese households in Hong Kong. creating a powerful incentive to overinvest. importcompeting firms. To change this repression of household income—and thus of household consumption—China would need much more significant appreciation of the RMB. which is why it contributes only about 34% of GDP. thus leading to the massive overinvestment in the economy. reducing unit labor costs and. Germany and Japan Have in Common? The pitfalls of Chinese corporate governance—state ownership of too many firms that leads to excessive retention of profits and not enough distribution of dividends to shareholders. And almost all of these retained earnings go into capital spending. there is another 25% of GDP represented by the savings (retained earnings) of the corporate sector. Low interest rates on deposits—well below the rising inflation rate—and low lending rates (negative in real terms) for corporates and developers imply that the massive savings of the household sector receive negative rates of return while the real cost of borrowing for SOEs is also negative.

no wonder each province has its own steel and aluminum mills. Germany and Japan share features—aging populations. local leaders have a powerful incentive to control state-owned banks. At the macro level. many SOEs would fail as their profits would disappear. plus. auto factories. stateowned banks—are powerful. even as the labor share of income rises. is one potential cause of a too-rapid and thus disruptive increase in nominal and real wages. Party officials at the provincial and city levels want to maximize the growth rates of their provinces as their political power—including the biggest prize of all. with profits mostly retained rather than distributed to shareholders. Thus. in the case of China. export lobbies. The decentralization of political power in China has exacerbated the problem of overinvestment. The consumer goods exported abroad may have a higher value added than those that the Chinese can consume at home. poor corporate ownership and governance structure and underdeveloped consumer finance—that cause high private and public savings rates. with the potential to fork into a hard landing.firms imply excessive corporate savings. But even if Chinese policy makers are able to accelerate the rebalancing of the economy. and the outcome would be lower labor income. in Germany and Japan. If investment remains at a high share of GDP. high corporate savings have led to high national savings and large current account surpluses. If the changes in wage. So China. and interfere in local SOEs to maximize capacity and employment growth. becoming one of the nine members of the Politburo Standing Committee. NPLs and public debt become excessive. from profits to wages and from the corporate sector to the household sector. high corporate savings have led to excessive capital spending and investment. any economic woes left behind become the headache of the next local leader. and overcapacity. a hard landing will occur. Change is necessary not only in the structure of demand (less from exports and fixed investment. exchange rate and interest rate policies were to occur too fast. more from consumption) but also in the structure of supply. create thousands of SPVs to finance overinvestment in infrastructure. electronics plants and cement factories. perilous road. textile and apparel plants. This leads to widespread duplication of investment projects across provinces. excessive fixed investment. including strikes and union militancy. the result is fixed investment comprising almost 50% of GDP. Labor strife. while households are weak. manage land use and sales to maximize revenues and ensure excessive real estate development. In China. Transformation of Demand and Supply Structure Likely to Be Bumpy and Risky This complex transition is a bumpy. The fall in SOE production would lead to a fall in employment. provincial governments. large current account surpluses and. the transition will still be risky for many reasons. where there is less investment in capital stock because of the lower return on capital. the top governing body in China— depends on it. industrial/manufacturing production needs to fall relative to . China’s political economy is such that the groups in favor of the status quo—SOEs. Once a Party secretary is promoted to a senior central government position. THE LONG ROAD TO CONSUMPTION-LED GROWTH Overcoming the Political Bias Toward Overinvestment at the Provincial Level Maximization of Growth and The transformation of the Chinese economy from reliance on exports and fixed investment toward a greater contribution from consumption requires a change in the distribution of income from capital to labor.

Political Management of Key Relative Prices Distorts Demand and Supply The distortions in the structure of aggregate demand and supply in China are exacerbated by the fact that the government controls three fundamental relative prices that determine this structure. the political path of least resistance is the status quo—export-led growth. Given the powerful contingents that are adverse to change and the inherent risks and costs. there are almost 100 automakers (down from 110 a few years ago). excessive investment and insufficient consumption—in spite of the stated goal in the new Five-Year Plan (like the previous ones) of raising the share of consumption in GDP. The cost of land relative to other goods and assets is too low. the new demand pattern needs to match a new and different supply structure pattern. The land is mostly controlled . The necessary consolidation and restructuring of the corporate sector requires closing down inefficient and/or unprofitable firms. Because this keeps the currency undervalued. The relative price of foreign to domestic goods is controlled by the government via the nominal exchange rate. This will disrupt regional and sectoral employment and capacity. in China today. Finally. has only three domestic car producers. which drives the short-term movement of the real exchange rate. while limiting the supply of non-traded goods and services. currency and interest rate policies) and the too-low cost of capital for the corporate sector implies excessive corporate savings and fixed investment. The government also controls and distorts the cost of capital relative to wages by allowing the protected corporate sector to borrow too cheaply (at a negative cost in real terms). leading to overinvestment in commercial and residential real estate. The reason there are so many auto firms—as well as steel. A change in productive structure requires a massive amount of corporate restructuring by closing unproductive and/or unprofitable firms to allow the consolidation and growth of stronger firms. as the cost of capital is too low for those firms—mostly SOEs— that have access to cheap financing from state-owned banks. while the U. in spite of relatively low wage rates. in a country with a massive surplus of labor. This distorts the distribution of aggregate demand (too many exports and too little consumption) and stimulates excessive production of exports and import-competing goods. These transformations require a difficult movement of labor and capital from declining sectors to expanding sectors. This distortion in the cost of capital is behind China’s overinvestment and excessive production of capital goods. For example. So. imports are expensive and consumption of imported goods is low. thus leading to employment problems. the reduction in labor use in declining sectors—heavy industry and manufacturing—may occur faster than the increase in employment in rising sectors such as services. textile and other firms—is that every province wants to have a few. which implies massive regional and sectoral labor shedding that will be politically difficult and involve transition costs for the laid-off workers. China’s growth model is highly capital-intensive.production of household services. The combination of the taxation of the household sector to transfer income to the corporate sector (via wage.S. many investment projects—from heavy industry to infrastructure—are highly capital-intensive. Paradoxically. cement. while production of exports and importcompeting goods is subsidized.

e. wages would have to grow much faster than productivity for many years to change the distribution of income between wages and profits.g. By aggressively controlling three key relative prices. This is not happening yet. in the last three years. encouraging excessive production of physical capital (machinery. who thus overinvest in high-end residential and commercial real estate. even nominal retail sales or nominal consumption growth rates of 15-16% per year imply that the consumption share of GDP has fallen to a low of less than 34%. This argument may be valid. fixed investment probably is overstated in GDP because land values and transfers are not adequately stripped out of the data. real estate and infrastructure) and insufficient production of consumer goods and services. First. like Goldman Sachs’ Jim O’Neill. tax . based on the macroeconomic data we have seen. amplifying real estate investment. two years do not make a trend. For that share to increase. But some argue that China may be able to transform itself into a consumption-based economy faster than we have argued here. Second. Third. Counterarguments to the View That Consumption Rates Cannot Rise Fast Enough to Avoid a Hard Landing The most sophisticated analysts acknowledge that the Chinese economy is imbalanced and that the share of consumption in GDP is too low.. this is balanced by other factors that cause the consumption share to be overestimated. the aforementioned reasons for the low household share of income aren’t only related to wage growth. Until these key relative prices are liberalized—with a more flexible exchange rate and market-determined deposit and lending rates and land prices—the distortions in the structure of aggregate demand and supply will remain. the amount of such household spending on unreported services may not be large enough to have a significant effect on the share of consumption in GDP. much higher than 15-16% per year. the rate of growth of nominal consumption has to be significantly higher than nominal GDP growth.by the government. and the reasons that household savings are high are numerous. Thus. expropriated from farmers and urban residents with little reward and sold at a highly subsidized rate to real estate developers. China distorts demand. have stressed that the micro and macro data point to very rapid growth in retail sales and consumption in China in recent years. consumption growth has been artificially boosted by temporary measures that have stolen demand from the future.e. it distorts the structure of aggregate supply. capex and exports while repressing consumption spending.. Also. But with the economy still growing at a real rate of 9-10% y/y and with inflation above 6%. Some note that wages in 2010 and 2011 grew faster than productivity for the first time in decades. complex and not reversible in a short period of time. such as the inclusion of some public-sector consumption with private consumption. contribute to a low level of household income and thus of consumption. thus increasing the labor share of income. Some. i. together with the repression of wage growth. And these distortions. At the same time. but its significance is limited by three factors. Also. the faster growth of wages in the last two years is a positive sign but not an indication that the household savings rate is set to shrink significantly any time soon. which are not easily measured. Personal spending on household services such as cleaning and educational help for children may underestimate the consumption share of GDP. Some suggest that the private consumption share of GDP is underestimated because of the recent rise of household spending on services in the underground economy. though some private consumption may go unreported. While this is true.

China’s unbalanced growth model will start showing signs of strain. they will tighten monetary and credit policy and utilize nonmarket measures. if not a hard landing. Young Chinese may or may not be less Confucian than their parents. even if I/GDP is lower and C/GDP is higher. forcing a slowdown in credit growth—if not an outright credit crunch—that will weigh on the economy. China will eventually become a consumer society. consumption growth may not occur fast enough to prevent a sharp economic slowdown. over time the savings rate may fall. Young Chinese may be more conscious of brands and fashion. RISING RISK OF A HARD LANDING IN 2013 AND BEYOND Until the change in political leadership in October 2012. education and health care. While over time the consumption share of GDP may increase. Note also that if fixed investment is overestimated and consumption is underestimated then GDP (absolute and per capita) is slightly smaller than officially estimated. But either way. The latter is still sharply constrained by the small share of GDP—about 50%—represented by household income. rather than later. So the chances of a hard landing before the end of 2012 are relatively small. they will accelerate infrastructure spending (including on the planned 10 million new units of public housing) and implement fiscal. China’s policy makers will do everything necessary to maintain a growth rate above 8% y/y and an inflation rate of 5-6% or below.rebates for the purchase of private cars (the Chinese equivalent of the U. If inflation accelerates. . with a lower per-capita GDP it is going to take longer for China to be able to fully utilize its existing. but the aspiration to spend is not the same as the ability to spend. Recognizing that overinvestment booms can last for a long period of time (take the case of the Soviet Union). we see several reasons that the risk of a hard landing in China will rise significantly in 2013-14. SOEs and private firms—but also on whether those losses are socialized directly by the provincial and central government or imposed first on the banks before they are recapitalized by the central government. the structural factors that constrain consumption growth will not radically change in the short run. once China reaches the overinvestment limit and slows down fixed investment.S. How much of a hit the banks take depends not only on the size of their NPLs—driven by bad loans to local governments. In the next two years. depreciating capital stock. like administrative tools. it would likely be in 2013 or 2014 but not much later. as well as an overall inflation rate that is probably higher than officially measured. thus. It has been argued that young Chinese are not as frugal as their parents. real estate developers. But in 2013. Thus. China’s policy makers may be able to maintain high growth by continuing with high levels of investment. Even middle-class Chinese youth face rising costs of housing. credit and monetary stimulus. As rigorous studies of young generations’ marginal propensity to spend and save have yet to be completed. “cash for clunkers” program) and government-subsidized appliances for rural populations. but they face the same constraints on income generation and the same necessity to save. the rise in NPLs will force banks to slow down the process of ever-greening their losses and start recognizing the holes in their balance sheets. Thus. the balance sheets and the profit-and-loss statements of the banks will take a hit. If the economy slows down too much. local government financing vehicles (LGFVs). Other factors suggest that this argument may not have a strong empirical base. the legitimacy of this argument is difficult to gauge. when the new president and premier will be chosen. but this is occurring at a snail’s pace. To ensure a smooth transition. as cultural mores have changed. If a hard landing is to occur.

U. the Railway Ministry is now effectively bankrupt after its borrowing spree to finance 10.S. once transfer payments are reduced and taxes are increased.000 miles of high-speed trains. There will be more bail-ins and orderly restructurings of public debt—in Ireland and Portugal after Greece. China will begin to find it increasingly hard to kick the can down the road and sustain a growth model based on excessive investment. SOEs will be forced to reduce their rates of capex. Also. together with the effective bankruptcy of the Railway Ministry. and possibly even in Italy and Spain. Opportunities for more infrastructure spending— particularly on transportation—will start to decline as these projects conclude and new ones become more expensive and less marginally beneficial to undertake. the fiscal squeeze on local government finances and LGFVs’ balance sheets will cut down on infrastructure binges. Private investment by exporters will slow down as the G3 economies’ anemic recovery limits the market for Chinese goods. The correction in commercial real estate investment will become significant when the excessive office space investment. even if its debts are effectively those of the sovereign. serious train accidents and malfunctions that have caused public outcry about safety. The probability of a U. thus limiting China’s ability to rely on exports for growth. these issues. plus. reaches its saturation point. And Japan will return to its long-term stagnation once the temporary boost from a modest fiscal stimulus package for postquake reconstruction fizzles out by 2013. Rising defaults on bonds issued by sub-national public-sector agents may increase credit spreads. Across the board.The rise in the size of the public debt will require a crackdown on local government borrowing and a slowdown of the debt buildup of other parts of the public sector. growth is already constrained by deleveraging. will trigger a slowdown in the pace of investment in new high-speed lines. especially by SOEs. Deflationary Effects of a Chinese Hard Landing and Risk of Trade Wars .S. These four factors suggest that in 2012 and especially in 2013. It will become increasingly unsustainable to maintain fixed investment near 50% of GDP. adding to the credit crunch. The eurozone (EZ) will become unable to kick the can down the road once the European Stability Mechanism is created in 2013. For example. especially if stressed banks have to limit credit creation. Political considerations will determine the timing of when the central government stops the credit and debt binge and accelerates reforms that eventually will increase the incentive to consume. rendering SOEs unable to put down more real estate as collateral for their bank borrowings. which are now at risk of losing market access—and more restructurings of banks’ unsustainable senior debts (starting with those in Ireland). and this serious weakness will accelerate in 2012-13. Economic stagnation will persist in the EZ periphery as fiscal austerity accelerates while the ECB normalizes policy rates. it is possible that the G3 economies will experience further economic slowdown (they are already at stall speed and at risk of double-dip recession). when fiscal austerity will imply more direct fiscal drag and will force another round of household deleveraging. By 2013. double dip over the next year is now close to 50%. the excessively fast buildup of the high-speed train system has led to repeated. The overinvestment in high-end residential and commercial real estate will end when a price correction causes a fall in speculative demand. especially once the new leadership is in place and ready to deal with the excessive borrowing and spending of the 2009-12 period. Larger fiscal deficits will emerge when the central government has to recognize the losses driven by an unsustainable borrowing binge at all levels of the public sector.

etc. there is so much overcapacity in China that a lot of its steel is exported abroad.. The economic and political forces in favor of the status quo—provincial governments. The new leadership that will run the country from 2013 on may decide to accelerate reforms to rebalance economic growth and make it more sustainable. On the supply side. export and import- . with excessive capacity constraining the pricing power of firms. with higher unemployment weighing on wage growth. in spite of the demand for steel for highways. Plus. Globally. this overinvestment in capital capacity may eventually lead to disinflationary if not deflationary pressures. in spite of major domestic and external economic and financial shocks. either massive global deflation or severe trade wars will result.While in the short run. CONCLUSION To stave off a hard landing in 2013. China would dump excess supply of industrial and manufactured goods— steel. the bursting of the real estate bubble would lead to home and commercial real estate price deflation after years of surging prices. as its investment boom heightened demand for raw materials. Of course. So one should not underestimate the ability and flexibility of Chinese policy makers to do what is necessary to maintain a high level of economic growth. apparel. a sharp slowdown of China’s growth would have a disinflationary effect via prices of traded goods. aluminum. hurting the market share and profitability of global steel producers. politically difficult reforms are required to resolve these issues. Commodity prices would plummet as Chinese demand would drop. hurting foreign producers of these traded goods. the excess capacity of steel. We are somewhat pessimistic that China will be able to significantly increase the contribution of consumption to growth before the investment boom turns into a bust: The reasons that savings rates are high and consumption rates are low in China are structural. The rest of the world is already concerned about China’s exports. aluminum and other manufactured goods will be sold on global markets. Even today. these trade tensions would escalate if China were to witness a plunge in domestic demand and dump the excess capacity in global markets. A sharp slowdown in economic growth would also increase the slack in the labor market. there is so much industrial overcapacity in China that the excess is already exported in global markets. If China has a hard landing. and in the goods market. real estate. while private consumption needs to sharply rise. cars.. China faces a problem of overheating and rising inflation. the U. and decades of painful.S. both within the country and globally. in the last few decades Chinese policy makers have shown flexibility and policy innovation that have allowed consistent growth of about 10%. fixed investment and savings need to fall as a share of GDP. cement. depressing prices. But there are enormous challenges standing in their way. sustainable growth model. Europe and other advanced economies as well as emerging markets would not sit idly and accept Chinese dumping of its overcapacity in global traded goods markets. Net exports. with growth still above 9%. airports. China must reduce its reliance on production of capital goods and exports and increase the production of consumer goods and services. Once China experiences a slowdown of growth. Within the country. consumer electronics. on top of real estate price deflation. On the other hand.—into global markets. SOEs. The most likely result would be protectionism and trade wars. For example. China needs to work toward a more balanced. railroads. etc.

Beijing.” the government offers a partial bailout to the banking sector to clean up the large default rate on local government debts. One is a full-blown “crash and burn. short of a real hard landing. The risk is that the reforms will be too little and too late to prevent the hard landing toward which the current growth model is heading. Another is a “muddle through” situation. Burden-sharing between local governments.competing sectors—are influential. SOEs and the banks results in a significant decline in investment and economic growth but prevents a full blown financial crisis. which smoothes over for a decade with a gradual fall in the investment rate and a weakening of economic growth. After the political transition. in which the central government offers a full bailout of local debts and the banking sector. . Certainly. it will be clear if the new leadership is committed to accelerating reforms to rebalance growth and prevent a hard landing. In a follow-up paper.” with a severe economic and banking crisis. In a third scenario. we will analyze in detail a variety of scenarios for China in 201314. it is likely that by 2013-14 the unsustainability of China’s current growth model will manifest itself. while Chinese households are politically weak. a “slow grind.

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