A casual visitor to major Chinese cities like Beijing will find little indication that one of the world’s biggest and longest economic booms may be nearing an end. Crowds still throng shopping districts like Wanfujing, a short walk from the Forbidden City. Construction in and around the capital remains active by world standards, and traffic congestion is getting worse.
But inside office towers at the China World Trade Center, the heart of the central business district and home to the China headquarters of numerous multinational companies, concerns about the economy and impending changes in the country’s leadership come up in nearly every conversation. Capital equipment orders and retail sales are slowing, even for luxury products that have seen nothing but steady growth. Soaring labor costs are causing multinationals to worry about their large long-term investments. Many wonder whether a slowdown in exports and a correction in the overheated property market mean that China is headed for a hard landing.
Our take on China’s economic future is nuanced: there is a short-term view, a medium-term view, and a long-term view.
Over the next year or two, a severe contraction seems rather unlikely. The era of 10 percent annual growth in GDP is definitely over, and 2012 and 2013 will be years of relatively slow expansion. But Beijing has many levers to pull to maintain growth in the 6 to 8 percent range. And with new leaders set to take the helm this fall at the 18th National Congress of the Communist Party of China, it will not hesitate to ensure economic "stability."
The Chinese government is in good financial shape to stimulate the economy, if that becomes necessary. Government debt is 67 percent of GDP, compared with 85 percent in the EU and 200 percent in Japan. The government has also signaled that it will continue to ease monetary policy by dropping reserve requirements for banks, making it easier for them to lend. By dropping the reserve ratio by another 200 basis points in 2012, the central bank could release some $250 billion into the economy. In addition, the government can reduce taxes for China’s consumers and exporters.
The bigger concern, and one that is raised in conversations with top executives of multinationals and of large Chinese corporations looking at a longer time horizon, is how the government will deal with economic challenges in the medium term.
Over the next two to five years, it is critical that China make progress in overhauling an economic model that served it well for a long time but is now clearly outdated. Half of China’s GDP is generated by investment in infrastructure, real estate, and industrial capacity, often financed by state-owned banks. That is one of the highest ratios in the world, if not the highest. In South Korea, gross investment accounts for 28 percent of GDP, in Japan 20 percent, and in the U.S. 12 percent. With investment in Chinese manufacturing rising by high double digits for the last five years, industries such as automobiles are becoming glutted with overcapacity.
For years, Chinese leaders have admitted that the country’s growth model is unsustainable and that the economy should increasingly be led by personal consumption. Beijing postponed that goal, arguably out of necessity, when it responded to the 2008 global financial crisis with a massive stimulus package that fueled an explosion of infrastructure investments and construction. Consumption, meanwhile, still accounts for only about one-third of China’s GPD, compared with 54 percent in South Korea and 72 percent in the U.S.
Now that the stimulus is winding down, investment in transportation and electrical-power infrastructure is leveling off—and new housing starts have plunged. At the same time, retail-sales growth slackened in 2011. Some of this slowdown can be attributed to anxiety, given that the main assets of the middle class—real estate investments—are dropping in value in many cities. The export manufacturing boom is cooling, too, because of sluggish demand in Europe and the U.S. and a shrinking cost advantage. This development suggests that China needs to change the mix of products that it exports, now mainly labor-intensive goods such as toys, shoes, and consumer electronics.
If China’s economic slowdown is sharper than expected, there is concern that its leaders will again be tempted to return to the traditional strategy of massive government-led investment—preventing the much-needed structural economic change.
The gravity of these concerns is hammered home in a paper that is circulating widely within Chinese economic and business circles. Titled China 2030, the 468-page report was published jointly this year by the World Bank and one of China’s most influential government think tanks, the Development Research Center of the State Council. It argues that China urgently needs a new development strategy.
Among other things, China 2030 calls for sharply scaling back the state’s role in the economy, promoting the private sector while commercializing state-owned banks, and building an economy driven by innovation. If it fails to make such adjustments, the report warns, the country could fall into the same “middle-income trap” that engulfed many other developing nations after they attained a certain level of development.
Over the long term, we are optimistic that China can meet all these challenges and continue its strong growth. The goal of achieving a more balanced economy led by consumption, services, and innovation is embedded in the nation’s most recent five-year plan. There is good reason to believe China can stay globally competitive in exports by relying increasingly on higher-value exports such as machinery, vehicles, and services. Total-factor productivity—which measures the efficiency of capital and labor—has been rising at around 4 percent per year in China for more than a decade, far faster than in other big emerging markets such as India, Brazil, and Thailand.
China’s biggest advantage is its rapidly growing, increasingly affluent middle class. By 2015, BCG projects that 20 percent of China’s population will have a household income of at least $10,000, compared with 13 percent today and just 7 percent in 2008. Demand for services such as health care, domestic tourism, and private education—sectors that are very underdeveloped in China—will rise tremendously.
Our general advice for foreign companies is to prepare for a China with less growth and higher labor costs. For the next year or so, they should perform a deep analysis of short-term trends in their industry, adapt to an environment of sluggish sales growth, and carefully consider the timing of investments. To prepare for the longer-term challenges, companies should work hard to improve the productivity of their China operations. They should also develop strategic game plans for a range of potential scenarios and think through the contingency plans for each one.
More broadly, however, this is a time when multinationals should take a step back and reassess their China operations after years of breakneck growth. For many companies, China is the biggest bet they are making. It has to be, given the market’s size. Some multinationals are investing billions of dollars. They are running risks by transferring core technologies and even relocating divisional executive teams here.
Given the size of their bets, companies need to do more to succeed in the long run—whatever the future holds. They should ask how many Chinese executives they have in their top management. How many research units have really deep footprints in China, and how often do they seriously analyze their Chinese competitors compared with their traditional Western rivals? Many top executives from multinational companies visit China regularly. But they should think about setting up a second office here.
The transition ahead will be tough for China, and whether it can be accomplished without a dip in employment and a property bust remains to be seen. But if it succeeds, China will be in a strong position to enjoy several more decades of strong growth. Companies that use this slowdown to upgrade the sophistication of their China operations will have the staying power to share in that growth.