Fault lines may hamper China growth

Why RAND''s economic growth forecasts for China are below consensus.

The consensus among many organizations, from supranationals to investment banks to think tanks, is that China's GDP growth rates will average 7-8% a year until 2015. These estimates are based on China's phenomenal track record, averaging 8.6% annual GDP growth since the late 1970s, a rate faster than Japan during its 'miracle' growth spurt throughout the 1970s and 1980s. At that rate, China will nearly reach America's GDP by 2025 (although even then its per capital GDP would be only 15% of the United States').

One forecaster, however, thinks the consensus is too rosy. Washington, DC-based RAND Corporation, a think tank, argues China's annual growth rates in that period will be more like 6%, because of the sheer number of risks, or "fault lines", as senior economic advisor and fellow Charles Wolf puts it.

In an address to the Asia Society in Hong Kong, Wolf outlined eight such risks and RAND's estimates of their potential impact on economic growth. RAND's analysis selected problems that China has already confronted with success, but could worsen. Wolf acknowledges the research didn't account for moves China could make to prevent or delay such problems. Indeed, he says the probability of all eight scenarios coming true is extremely small. "But so is the probability that none of these will occur," he says. Moreover, RAND looked at these scenarios in isolation, but many of them are interdependent, so if one comes true, there's a greater risk of others also dragging down Chinese economic growth.

His eight fault lines are:

1. Unemployment, poverty and social unrest: Although officially, unemployment in China is below 4%, disguised unemployment brings the real unemployment level as high as 23%. That is to say, a lot of workers could be sacked without any adverse impact on production output. The question is would this real rate get worse (assuming current high growth rates already factor in 23% unemployment). With a rising population, state-owned enterprise downsizing and the impact of WTO membership, rising unemployment and its side-effects such as growing social inequality are real risks. Should this worsen, it would reduce annual GDP growth rates by 0.3-0.8%.

Wolf says the current debate over whether China can arrange a 'soft' economic landing versus a 'hard' one overlook a deeper tension. Wolf thinks Beijing's moves to cool the economy from overheating are working. The problem is the conflict between two broad policy objectives regarding economic growth and employment growth for that 23% of workers.

He defines the rate of employment growth as the difference between GDP growth and labour productivity growth. Although it is commonly said that China boasts an inexhaustible source of cheap labour, the country is also meeting competitive threats by moving up the food chain into hi-tech, marketing and design, all of which require increased productivity.

The more labour productivity improves, the less additional employment China can generate. Wolf notes that from 1998 to 2003, China's rate of GDP growth was around 7.8-7.9% while labour productivity grew 6.8-6.9%. This means the increase in real employment rates no more than 1% during these boom years.

2. Economic effects of corruption: This is hard to measure, and China has grown rapidly with a high level of corruption. The question is, would corruption increase further? If so it could cost China 0.5% growth in GDP annually.

3. HIV/AIDS and epidemic diseases such as SARS: Wolf cited United Nations statistics saying HIV infections are growing 20-30% annually in China. Estimates vary a lot, but China may face 11-80 million carriers by 2015, at an annual healthcare cost of $7-48 billion, reducing GDP growth rates by 1.8-2.2%. Wolf says China's reporting about SARS doesn't bode well, suggesting healthcare-related costs are going to be higher than officials acknowledge. He notes that in Hong Kong, Taiwan and Canada, which also suffered from the SARS outbreak, the death toll relative to infections was two or three times the number reported in China, implying that China didn't report a lot of SARS deaths, and that its reports on AIDS are unreliable.

4. Water resources and pollution: China's ecological problems are well documented. Wolf says if the government makes transferring resources from the South to the North the priority, rather than emphasizing conservation and recycling, this will crimp GDP growth by 1.5-1.9% annually.

5. Energy consumption and prices: RAND's calculations were made when most analysts thought oil crude would cost $25/barrel. Even then, it expected a threefold price increase in the black stuff, hurting Chinese GDP growth by 1.2-1.4% annually. This risk is underlined by today's oil prices, now touching $50/barrel.

6. Financial fragility and SOEs: This area is familiar to Asia-based financiers: huge NPLs, weak bank balance sheets, and the risk of capital flight could knock off 0.5-1.0% from GPD growth.

7. Shrinking FDI: With China commanding the lion's share of global foreign direct investment, this seems a faint prospect, but Wolf says other countries could become attractive destinations of capital. Losing $10 billion of annual FDI flows would cost China 0.6-1.6% of GDP growth.

8. Possible military conflict: The scenarios are numerous. Looking at a possible conflict with Taiwan, the resultant loss of trade and investment, and the resources diverted into military requirements could reduce Chinese GDP growth by 1.0-1.3% annually.

If one of these eight scenarios is realized over the next decade, then those consensus GDP growth forecasts of 8% per annum will prove wrong, says Wolf. The leadership in Beijing is well aware of all of these risks and is acting on them. These preoccupations mean China will continue to avoid any external crises. The current mood of cooperation with the United States is therefore likely to continue, he concludes.