Thursday, August 23, 2012

China lands

You may have heard someone ask: "Will China have a soft landing or a hard landing?" Those terms aren't well-defined, but the question is still at the very heart of the global economy. Something big is happening in China, and we should all be paying attention.

I think the most useful definition of "soft/hard landing" is whether the thing slowing China's growth is more about supply or more about demand. No country can sustain 10% growth forever. Eventually, the twin forces of Solow catch-up and slowing technology transfer will bring growth down. If China follows the pattern of history, it is due for a moderate slowdown, perhaps to 7% growth, as demonstrated in this paper by Barry Eichengreen and Kwanho Shin. In fact, the more sober economic forecasters have already assumed that 7-8% will be China's "trend" growth rate going forward. 7-8% is not bad at all; hence, a "soft landing".

The soft landing scenario is fundamentally a story about long-run supply. Hence, we should not expect unemployment to result. And indeed, for the past year, even as growth and investment slowed, Chinese unemployment stayed low.

In contrast, a "hard landing" would be the kind of thing the developed world saw in 2008 (and the developing U.S. saw in 1929) - a financial crisis, followed by a general flight to safe and liquid assets, a collapse in bank lending, and a rise in unemployment. This would bring growth down substantially below the 7-8% level. The "hard landing" is basically a gigantic aggregate demand shock.

In the case of China, the danger here is the combination of house prices and local government debt. House prices rose a lot in recent years, and many companies and local governments took out debt using the suddenly-more-valuable real estate as collateral, often making use of a "shadow banking" system (sound familiar?). If these debts default, banks will have to take big losses; since the banks are state-owned, they will certainly be bailed out by the federal government. Although China's federal deficit is low - bailouts will not bankrupt the government - we've seen how even a successful bailout is not generally sufficient to get banks lending again after a financial crisis. China would have to respond by cutting interest rates; if rates hit zero, a liquidity trap would result and the recession would be prolonged. 

The thing is, we just don't know how bad the debt situation is. Maybe nobody does. If the debt problem has been exaggerated by the Western press, then there's not much to fear; China will coast to a 7% growth rate and keep chugging along. But if the debt problem is worse than we think, China's economy may have a heart attack.

So, how do we know whether China is headed for a "hard landing"? It's hard to tell just from the growth numbers, since A) China's growth numbers are year/year numbers, which are harder to interpret than the annualized monthly growth numbers we in the U.S. are used to, and B) China's growth statistics are not reliable (see this Dallas Fed paper for more worrying numbers).

But if the difference between hard and soft landings is all about aggregate demand, then we can look at two other indicators to figure out whats happening: prices, and unemployment. Chinese inflation has slowed. However, prices in developing countries behave a bit differently than prices in developed countries, so this is a pretty difficult number to interpret, especially because it's not core inflation. 

How about unemployment? This is worrying. After looking fine for months, China's job market is beginning to tighten a bit, though not as much as in 2009. All in all, it may be too early to call. In addition, China has been easing monetary policy, and home prices appear to be rising again. So an incipient "hard landing" may have been averted or delayed.

But all eyes are now watching China. In the blogosphere, Tyler Cowen is on the case. He puts the probability of a major Chinese recession - a "hard landing" - at over 5%. My own gut says it's more like 20% - I think problems are often worse than the initial reports say - but I am not an expert. For rapid, high-quality reporting on the situation, see the blog of Also Sprach Analyst.

Anyway, even if my pessimistic take is right, 20% is not a big percent chance, and China's numbers still look mostly kinda-sorta OK. But beware those who tell you that "this time it's different" - that China's authoritarian government, or its high-saving hard-working culture, or some other special feature of its society makes it immune to hard landings. Keep your eyes peeled for increases in China's unemployment rate, waves of defaults on loans, drops in housing prices, and drops in core inflation.

Update: Inventory overhang also a bad sign.


  1. Anonymous6:02 PM

    I think the most useful definition of "soft/hard landing" is whether the thing slowing China's growth is more about supply or more about demand.

    That doesn't strike me as useful at all, since economists argue about supply vs. demand shocks even for the 2008 recession in the US. Why not say "soft landing" means a substantial slowdown (over 50% decline in the growth rate) to sub-trend but positive growth?

    1. Good question. Because qualitative differences are, IMO, more important than quantitative differences here. The data are poor. But the two scenarios I laid out would have very different, and pretty well-understood, consequences.

      Economists who say that the 2008-9 recession was due to supply shocks are just being silly.

  2. "7-8% will be China's "trend" growth rate going forward. 7-8% is not bad at all; hence, a "soft landing""

    7-8% means a real doubling every ten years -- which means China's economy is bigger than ours in ten years. And in about three decades they're bigger per capita. Exponential growth is very powerful in the 7% range -- which is, by the way, pretty steadily in major sub-periods, the growth rate of stocks for 200 years, just under 7% -- real! Very hard to beat a well diversified stock portfolio for the long run -- see Wharton's Jeremy Siegel's book.

    1. I think the 7% only holds for the next decade or so, then another drop to 5% the following decade and another drop after that, according most forecasts. More realistically there will be a hard landing somewhere in there in twenty years. In fact I'd put the odds of not having a hard landing at some point in China in the next twenty years at just below 20%.

  3. ?? That "5%" of Cowen's is his guess at a 'non-trivial' war in Asia in the next 20 years. Not really relevant to economic aviation this year.

  4. Regardless of what happens, we should all hope for the best, but at the same time, prepare for the worst. As someone who lives in Hong Kong, the economy here can feel something bad happening.

  5. Anonymous8:21 AM

    Just Google-it or Youtube - Ghost towns China and you will see the truth.

  6. Liqian Ren9:09 AM

    I agree with you that "this time is different" arguement or culture per se wouldn't work on China or any country facing potential slow down. but I do think that this year and next are different: Once every 10 years there is a major political transition in China and I do believe this factor alone could prevent a hard landing in the next 12-18 months. After that it all depends on how good the next President is on economic management.

    This kind of political timing factor was not unique to China. I believe there was once a paper on incumbent US presidents usually ramping up growth a bit before election. In China's case, since the president usually doesn't need to worry about re-election, the first 1-2 years are of major focus by the public in sizing up the man. On the other hand, I am going to China in 10 days so facts on the ground may change my perspectives.

  7. Correction: China's "central goverment" China is officially a unitary state (it is not a federation, so there is no "Chinese federal government".

    1. Anonymous7:07 PM

      N to the S is talking about the difference between the central government's budget and the provincial and sub-provincial budgets. The sub-central government budgets are primarily funded by land sales. In the 80s even the PBOC had a lot of trouble with this kind of set up because local PBOC branches would get into lend-money-for-land-sales game under the pressure from local party organizations. One of the big 'wins' of the re-organization under Zhu in the early 90s was for the PBOC to finally take control of its own branch operations.

  8. Anonymous2:47 AM

    One of your physicist almost-colleagues shredded the Eichengreen and Shin paper. See here:

    He concludes with:
    "I am not saying China will definitely continue growing at breakneck pace.... it seems very likely that so much growth in that large a country will trigger more big resource price shocks, which will slow China as well as everyone else.... What I'm saying instead is this: if they slowdown before something like 2025, it's very unlikely to be due to the fact that they've reached close enough to developed country productivity levels that they can no longer do fast catch-up growth. The reason will be different. "

    1. Anonymous6:07 PM

      Yes. Nothing shreds an argument like sprinkling in racism. After all we know dagos are lazy and Asiatics are all hardworking keeners! "The lower end of the spectrum is occupied by places like Portugal and Greece, where, how to say it, people place a higher value on quality of life, and less value on maximizing their economic production. The upper ranges find places like Japan and Singapore, where the occupants are driven and ambitious. "

  9. Anonymous8:11 PM

    Fair enough, he could have stated that better. In the case of Portugal, Greece, Japan & Singapore he talked about people, whereas the point he tried to make is about a society. He is right that China as a society is very driven and ambitious (scarily, if you've ever been there). And that Eichengreen and Shin is a case of applying stats to data without taking the time to understand the data. Not great science.

    1. Anonymous8:55 PM

      I understand what he is saying, I just find it bizarre because the same Chinese were doing nothing from 18th century to 1979. So it cant just be the magic of the Asiatic mind/the sloth of the dagos.

      And its true, his criticism on statistical cherry picking is quite valid, its unfortunate that he then turns around and does so himself by looking at small, city state sized economies like Hong Kong and Singapore that specialize in things that a whole nation cannot do, like money laundering and real estate speculation. If they keep in their sample all countries with populations above, lets say, 20 million, their data suggests a slow down is coming.

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  11. My understanding is that usually emerging market booms end in an equally violent bust. Look at Japan, the Russian crisis of '98, the Peso crisis of '94, the asian crisis of '97, and many others. Surely the probability of a hard landing for China is more like 80%? or is it different this time? if so, then why? China's competitive advantage was based on an undervalued Yuan vs the USD, and an abundant supply of cheap labour. Both of these advantages have been substantially eroded and the trend back the the US continues. You could say that China is analogous to the position of the US before WW2, but the US only 'emerged' after WW2 Bretton woods in 1944. At the moment surely the most likely outcome is a big crash and depression like Japan (which managed to develop advanced manufacturing and technology advantages which China has not)? your thoughts would be much appreciated! Thanks, Carl

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  13. Very nice post. Things are indeed worrying in China. If enough provinces in China has to be bailed out by the central government, the public debt level will rise sharply. I also have doubts if regulating the trading of housing market is the optimal policy to curb the housing bubble, if it exists. There might not be a bubble at all due to the large immigration from the rural to urban areas. The demand is there,sufficient to support the housing boom, if the "hu kou" barrier is abolished. The regulation on car purchases doesn't make too much sense either. Chinese people want to drive cars, it's the infrastructure of roads and highways that needs to be invested. Inventory over-hang in the durable goods market is partially due to the export market deteriation, but I think ill-advised government policy plays an important role.

  14. The soft landing scenario is fundamentally a story about long-run supply. Hence, we should not expect unemployment to result. And indeed, for the past year, even as growth and investment slowed, Chinese buy from china