China should guard against economic growth driven by raising leverage, said Wang Qing, Morgan Stanley's chief economist in China, in a story published in Caijing, a well-known Chinese magazine. Edited as follows:
China's potential economic growth will obviously slow down in the next 10 years compared with the past two decades. In accordance with basic theories, economic growth in a country is decided by the labor population, capital stock and total factor productivity (TFP).
The United Nations predicts that the Chinese population will grow at an annual rate of 0.23 percent over the next decade, much lower compared with the 1.28 percent it has grown annually over the last 20 years.
Capital stock varies in accordance with the scale of investment in fixed assets. With China's efforts to rebalance its economic development, China's fixed assets investment growth will likely slow down to synchronize with the growth of gross domestic product, or even fall below it.
China, an emerging economy experiencing rapid structural change, needs to increase its TFP in two ways. The first is to shift surplus labor resources from rural areas to the high value-added manufacturing industry, while the second is to improve production efficiency through technological innovation.
But evidence shows that cheap surplus manpower in rural areas is declining, while technology-driven economic growth requires many years of hard work.
With the further progress of economic development and the fiercer competition among various social sectors, China can no longer launch bold and resolute reforms to its economic structure and operation mechanisms to the same extent it has over the past 30 years.
The experience of other East Asian countries such as Japan and the Republic of Korea indicates that following a prolonged period of high-speed economic growth, a country will experience a readjustment period followed by a period of gradually slowing growth.
It is necessary here to note that potential growth is decided by the factors of manpower, capital and total factor productivity. But the actual economic growth rate, in addition to the potential growth factors, is affected by market demand and policy decisions, as well as consumer and investor confidence and price signals like the exchange rate and interest rate.
Affected by these factors, actual growth may for a short term deviate from potential growth. But as long as there is no obvious inflation pressure, the actual growth rate may deviate from the potential growth track over a longer period due to a rising leverage ratio.
For example, manufacturers are often too optimistic about the future growth of their trades. Even in the face of current poor performance in sales volume, they continue to expand production scale by taking out loans. If they fail to sell their products on the domestic market, they manage to export them at the expense of earning no money.
Based on years of continuous improvement in their standard of living, Chinese consumers are confident that their incomes will rise. With no regard for their current income, they have bought high-priced houses valued at 10 times their annual income or more. If they expect their income to rise at an average annual rate of 15 percent, the ratio between their home price and their income will decline from 10:1 to 5:1in five years. High expectations for future income have thus spurred the demand for real estate assets, which in turn has contributed to current economic growth.
Under these conditions, real economic growth will exceed the potential growth rate thanks to the use of debt leverage and a rosy view of the future by entrepreneurs and households.
Both currency revaluation and a rising interest rate play a moderating role in liability-driven production, exports and investment expansion in the real estate market. But if the exchange rate and interest rate remain low for a fairly long period, they will, instead of playing a regulatory role, encourage exports and the frequent use of debt leverage.
Overdependence on exports combined with high debt leverage adds to the burden on monetary policymakers in terms of regulating the exchange rate and interest rate, because even a small change could threaten continued economic growth.
In the post-crisis age, developed countries are likely to see weak economic growth and global inflation pressure will be minimal. Against the backdrop of this world economic outlook, China's potential economic growth will slow down. Enterprises, policymakers and individual households should have realistic expectations for China's economy in the future, and should especially guard against high inertia actual growth by raising the leverage rate.
Economic growth that relies on a rising leverage rate means that an economy develops by borrowing money, which will not last long, since economic growth will slow while the loans are being repaid. China should draw lessons from the sub-prime mortgage crisis in the United States and the sovereign debt crisis in Greece and pay close attention to changes in China's debt ratio.