Residential buildings under construction in Guangzhou on July 18. Infrastructure investment is a central part of China’s attempt to revive slowing growth, but returns on that investment are not as good as in previous decades. Photo: AFP
The View
by Yukon Huang
The View
by Yukon Huang

Slowing growth shows China’s old playbook of property and infrastructure investment needs an update

  • Beijing hopes its recent expansionary policies will lead to a rapid recovery, but the original 2022 growth target is no longer viable
  • Rather than more stimulus, the government needs to ease controls over resources that have created long-term declines in investment productivity
China’s second-quarter economic data confirmed the worst fears of market watchers. GDP grew by only 0.4 per cent in the second quarter year on year and shrank by 2.6 per cent compared to the first quarter, according to the National Bureau of Statistics. The reported second-quarter growth was well below the consensus forecast of 1.2 per cent.

Official commentary tended to paint a more positive picture, with headlines such as “China’s economy achieves positive growth in Q2 despite downward pressure” and noting that growth amounted to 2.5 per cent for the first half of 2022. External media coverage was more sobering, with headlines such as “Growth plunges to 0.4 per cent, lowest in two years after missing expectations”.

The reality is more complex, with uncertainty clouding forecasts for the remainder of the year and beyond. Beijing hopes that recent expansionary policies will lead to a rapid recovery, but the original 2022 target growth rate of “ around 5.5 per cent” is no longer viable. What is needed now is a major revamp of the state’s tight controls over the use of resources, which has resulted in a long-term decline in the productivity of investment.
The external growth environment has deteriorated amid slackening demand in the West, rising inflation and the Ukraine crisis. Internally, China’s troubled property market, unresolved mortgage financing issues and “zero-Covid” policies have damaged growth prospects. Unemployment has become politically sensitive, and household spending remains tepid.
But some indicators suggest the economic decline has bottomed out. The uptick in local government investment and retail sales in June marks a break from the sharp contraction induced by the Shanghai and Beijing lockdowns in April and May.

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Robust demand from the US continues to drive growth in exports. The labour market appears to be recovering, with the unemployment rate declining to 5.5 per cent in June after peaking at 6.1 per cent in April.

Financial institutions such as the International Monetary Fund have lowered their 2022 China GDP forecasts to around 4 per cent, implying expansion of around 6 per cent for the second half of the year. This outcome assumes a major programme to ratchet up provincial expenditure through increased bond financing and no more significant lockdowns.
The downside risks, however, have not disappeared. US-China tensions show no signs of abating, with the US Congress considering proposals to restrict foreign investment and delist Chinese companies.
Moreover, multinational firms are thinking more seriously about relocating out of China, given the escalating risks. If the US and Europe slip into a recession and China is unable to isolate itself from the new variants of Covid-19, growth could easily sink to 3 per cent or even lower, as noted by some financial forecasters.
China’s efforts to sustain growth continues to rely on more infrastructure investment – the returns on which are much lower than decades ago – and on expansionary monetary policies, including credit easing and lower interest rates.

Lost in the discussion is that the recent contraction is part of a longer-term structural decline in China’s growth rate from double-digit levels of the past decade. Part of that decline is the natural consequence of a maturing economy moving to upper-middle-income status, but the decline has been harsher than necessary because of policy distortions that have dampened investment returns.

China’s “ dual circulation strategy” recognises that, with an unfavourable external environment, more attention must be given to the domestic drivers of growth. The bulk of the attention has been on promoting consumption.

But consumption does not drive growth – rather, consumption is derived from growth. Sustained GDP growth comes from investment and, more importantly, the productivity of investment. The latter is the problem since China’s investment as a share of GDP is already high.

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Thus far, Beijing’s strategy to boost productivity is to promote innovation, largely in the form of new hi-tech product lines. Tensions with the US have led to ambitious programmes to become more self-sufficient in semiconductors or a global leader in artificial intelligence.

Such activities require considerable financing and experimentation, with uncertain returns and long gestation periods. As a result, the near-term returns on investments tend to be limited, exacerbating any growth slowdown.

To compensate, priority must be given to policies that will provide sustained returns without having to rely on debt-fuelled financing. The most obvious option lies in altering Beijing’s approach to urbanisation. The transfer of hundreds of millions of migrant rural workers to industrial jobs in the cities in recent decades has driven a dramatic increase in labour productivity.

The challenge now lies in increasing the productivity of already-urbanised workers. As indicated in a World Bank urbanisation report, productivity of workers in the largest cities is much higher than in smaller and medium-sized cities. If the hukou restrictions that limit the movement of labour to megacities were liberalised, productivity would significantly increase, with a commensurate surge in GDP growth rates.

Two migrant workers walk past a residential property construction site in Beijing, on March 21. Photo: EPA-EFE
Another option is to address the impediments that favour state-owned enterprises at the expense of private firms. Around 15 years ago, the rate of return on assets for state-owned firms was roughly the same as for private firms.

But, over the years, government policies gradually led to a widening differential such that the returns to private firms are now more than twice those of state-owned firms. The productivity gains from reforms that would close even half of this gap could well increase GDP growth by a full percentage point.

What these and other examples illustrate is that Beijing cannot continue to rely on stimulating property and infrastructure investment to support growth. Liberalising the state’s control over the allocation of resources needs to become the priority.

Yukon Huang is a senior fellow at the Carnegie Endowment for International Peace