You can almost hear the popping of champagne corks. In recent months, growth of China's real fixed investment, industrial value added, broad monetary aggregates, and bank lending all slowed from the breakneck pace of last year and the first quarter. But the growth of private consumption increased, so second-quarter gross domestic product growth was only a little below the figure for the first quarter and somewhat higher than growth for 2003 as a whole. Many observers have thus concluded that China's desired "soft landing" is imminent.
Based on China's experience in the unwinding of the last investment boom, we say: not so fast.
Capital investment as a share of GDP in 2003 hit 43 per cent-virtually the same as the peak in 1993 during the last investment boom. Fixed-asset investment apparently continued to grow more rapidly than GDP in the first eight months of this year. So the investment share has probably risen to an all-time high. There is nothing in the last 25 years to suggest that an investment share above 38 to 40 per cent of GDP is sustainable.
From the peak of the last cycle, real fixed investment growth slowed dramatically over a period of about five years. Likewise, from the trough of 1999 it has taken four to five years for investment growth to reach the overextended levels of 2003-04. Creating and unwinding investment booms in China is a multiyear phenomenon.
Faster growth of private consumption could potentially offset slowing investment. But when investment growth was declining from its 1993 peak, there was no sustained, upward movement in consumption. The record shows a positive correlation between growth of real fixed investment and real household consumption. We doubt that a big increase in real household consumption could be induced without creating other problems.
Government consumption has less than one-third the weight of investment in GDP, and the Chinese authorities have been reluctant to run budget deficits beyond a few percentages of GDP. Net exports have the smallest weight, and the rest of the world would no doubt call for a correction if China's net export balance climbed too sharply.
In the last cycle, from the peak investment share in 1993 to the trough late in the decade, the growth of real GDP dropped by 6 percentage points-a substantial decline, even if did take five years to occur.
Some argue that China's rapid industrialization and urbanization mean the sustainable rate of investment is likely to be much higher than it was a decade or so ago. Yet industrialization was well under way during the unwinding of the last boom, and both the investment share and overall GDP growth fell. True, housing in most cities is now private. But last year property investment as a share of GDP was already 50 per cent higher than the previous peak in 1993, suggesting future adjustment is more likely to be down rather than up. Neither the unprecedented aggregate lending boom in 2003 nor the investment excesses in steel, aluminum, cement, and property suggest to us that banking reform has progressed to the point where an investment share of 43 per cent can be profitable.
Taking a medium-term perspective also makes it clear why policy levers that produce impressive short-term results may not work over a period of several years. Continued use of the administrative controls introduced last year will bring mounting difficulties that can diminish their effectiveness. Provinces and ministries may complain that controls limit their ability to pursue "good" investment opportunities, thus reducing growth and job creation. Companies are likely to turn to unregulated sources of finance to evade the impact of tighter bank credit on investment. In addition, detailed instruction from Beijing on the pace and subsector allocation of bank lending is inconsistent with efforts to reduce state interference in lending decisions and with plans to privatize two of the four largest state-owned banks. But if "victory" on overheating is declared soon and administrative controls are relaxed, overheating could reappear quickly.
Administrative controls look less appealing in the medium term because they fail to address two other key factors of disequilibrium: real interest rates that are too low and a real renminbi exchange rate that is still significantly undervalued.The necessary unwinding of the current investment boom has barely begun, and it is premature to herald the arrival of a soft landing. Better to put the champagne back in the fridge until the mission really is accomplished.