Safety in numbers?

Economic and social ills lurk behind China’s strong GDP data

Safety in numbers?

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The Chinese economic miracle just isn’t the same without the magic of high GDP growth. The economy struggled in the first nine months of the year, posting successive quarters of gradually slowing growth and causing many observers to question China’s economic staying power.

So when Beijing announced in mid-January that fourth quarter GDP rose to 7.9% – up from 7.4% in the third quarter – it appeared to be cause for jubilation. “Reporting from the ground in Beijing where we finally see some sunshine after a week of heavy smog,” Bank of America Merrill Lynch economists proclaimed in their note about the data release, as if a cloud had also been lifted from the Chinese economy. The data gave the stock market a much-welcomed boost, with the Shanghai Composite Index closing up nearly 1.5% the day of the announcement.

However, investors should find plenty of cause for caution among the data. First, annual growth of 7.8% last year is still a big drop from 9.3% in 2011, a reminder that the economy is headed into a difficult transition period in which it must find new sources of growth. Nearly across the board, economists warned that the upswing would likely evaporate by the second half of 2013.

To understand why, investors need only remember that Beijing still pulls all the strings in the Chinese economy. Government steps to ease both fiscal and monetary policy were at the heart of the upturn in GDP growth last year. Among other measures, the central government shelled out US$3.2 billion to expand the railway budget and approved US$156 million in new subways, supplemented by additional local government spending.

Much of the stimulus “spending” came in the form of loans, as regulators loosened the reins on banks. Beijing cut reserve requirement ratios and benchmark lending rates twice each in 2012, allowing banks to lend more and encouraging companies to borrow at the lower rates. Measuring credit expansion alone, last year’s stimulus package was likely about one-third of the massive 2008 stimulus, according to estimates by investment bank Standard Chartered.

But with stimulus comes the risk of overheating, which will likely lead Beijing to tighten fiscal and monetary policies later this year. China’s rapid growth over the last three decades has triggered bouts of high inflation, with the previous stimulus effort driving inflation to a heady 6.5% in June 2011. While the consumer price index subsided to 2.5% as of December, the recent growth in liquidity could spur a resurgence of inflation and boost the nascent recovery of home prices. Bank of America Merrill Lynch predicts that GDP growth will pick up to 8.3% in the first six months of this year before falling back to 8% in the second half, acknowledging that tighter policies could affect growth.

Beyond the headlines

What Beijing leaves out of the official figures is even more worrying than a slowdown in growth later this year. Lending, income inequality, unemployment and other less prominent indicators hint at lurking economic and societal ills that could drag down GDP in the long term. Perhaps most distressing is Beijing’s lack of progress in enacting reforms to head off these growing problems.

For example, figures on credit growth point to an alarming and unchecked rise in shadow banking, a less regulated and sometimes illegal form of non-bank lending. The share of aggregate financing that traditional banks supplied to the economy fell to a 10-year low of 55% in 2012. This indicates that state banks are losing ground to shadow banking, which services many small and medium enterprises that cannot obtain conventional loans. This less regulated form of lending could precipitate mounting, unseen bad debt (see “Danger and opportunity” on page 16). But the government has thus far avoided tough but necessary reforms that would bring SMEs into the official lending fold.

Independent statistics on China’s wealth gap indicate Beijing may be farther than it lets on from its goal of creating a vibrant middle class, one that drives a new consumer spending growth model. The Chinese Household Finance Survey (CHFS), conducted by Sichuan province’s Southwestern University of Finance and Economics, declared in December that the country’s Gini coefficient, a measure of income inequality, was an amazingly high 0.61 as of 2010. That contrasted sharply with the official 2012 figure of 0.474. (Scholars typically say any measure above 0.4 could lead to social instability and sluggish growth.) Despite the severity of the income gap, Beijing has thus far failed to issue a blueprint for income reform.

The government may even be tweaking more prominent indicators to hide underlying problems. CHFS calculated that the real unemployment rate was 8% in August, nearly twice the 4.1% official rate, indicating that the toll of China’s slowdown might be larger than thought. UBS, Goldman Sachs Group and Australia & New Zealand Banking Group expressed skepticism when China announced exports rose 14.1% in December, saying the figures did not add up with corresponding imports in East Asia, according to a Bloomberg report.

All of these examples point toward an economy that is worse off than headline GDP figures show and potentially foretell of renewed economic trouble in 2013 and beyond. Government reform could help to resolve mounting bad debt, lack of official SME financing, income inequality and flagging economic model. But such reforms appear unlikely in 2013, when China’s new government will merely be considering what to reform and amassing the political capital to institute policy changes.

Without instituting tough reforms, China’s unseen economic dysfunctions will eventually threaten to derail growth. The longer the government drags its feet, the more these factors could drag down headline GDP in the future.

Popular wisdom holds that statistics can be manipulated to prove any point. China has certainly proven that to be the case. But in the absence of needed reforms, even the ablest of statisticians won’t be able to cover up hidden problems for long.