A new study by Kenneth Rogoff of Harvard University and Yuanchen Yang of the International Monetary Fund presents new evidence of China’s heavy reliance on real estate and infrastructure construction as a central part of its economic growth. The report reveals that the share of these two sectors in China’s GDP far exceeds the levels found in the United States and Europe; only Spain in the run-up to its financial crisis came close.

The research also employs a newly constructed city-level database on the stock of housing in China to show that across city tiers, the country’s per capita housing stock rivals that of the UK and France, despite having much lower per capita income. As he explains, the interplay between China’s real estate market and slowing trend growth – due to demographics and deglobalisation, among other factors – poses a very difficult policy challenge.
The authors conclude:

‘The Chinese economy has outperformed for decades and perhaps will continue to. But its growth up to this point has been dependent on outsize investment in real estate and infrastructure. Now, after decades of construction, the country’s capital stock in these sectors rivals that of much wealthier advanced economies, even in many of China’s smaller and poorer cities.

‘Our evidence is consistent with the view that diminishing returns have set in, and the country must adapt accordingly. Aside from shifting and reorienting its labour force, the transition also poses financial challenges given the significant accumulation of local government debt that has accompanied the real estate boom. It will be important to address these issues in coming years.’

The report will be presented by Professor Rogoff at the invited policy session of the 78^th Economic Policy panel meeting at the Banco de España in Madrid on 19 October 2023. Following the presentation, there will be a panel discussion featuring Shang-Jin Wei of Columbia Business School and SIPA, and Kurt Mitman of CEMFI and the Institute for International Economic Studies, moderated by Daniel Santabárbara, Head of the Advanced and Systemic Economies Unit in the International Department, Banco de España

The introduction to the new report – ‘Rethinking China’s Growth’ – reads as follows:

‘After decades of investing in infrastructure and real estate at breakneck speed, China is likely to have reached the point of sharply diminishing returns – so much so that simply relaxing lending curbs is unlikely to make a long-lasting difference, and might exacerbate problems faced by highly-indebted local governments, especially counting indirect claims due to local government financing vehicles (LGFVs), which are estimated to be over 50% of GDP.

‘This is especially problematic given that local governments are disproportionately reliant on land sales for revenue, which in turn could collapse if real estate falters. The problems posed may not be unmanageable in theory, but they are certainly very challenging in practice.

‘The story of China’s inevitable growth slowdown has long been foretold, and yet has been even longer coming. There is no denying that Chinese officials have done a remarkable, indeed historic, job in stretching out the country’s extraordinary growth record. One can debate what the actual growth performance has been. According to official numbers, average growth over the period 1980-2012 was 8.9%, slowing down to a still very fast 6.4% in 2012-19.

‘The pace seems a bit less spectacular using the latest version of the Penn World Table data set that attempts to measure growth using international prices, 5.8% in 1980-2012 and 3.7% in 2013-19. But either way, China’s historic economic performance has lifted hundreds of millions of people out of poverty and into the global middle class, and transformed the country into one of the world’s two largest economies, almost triple the size of number three Japan. Recently, however, as China’s early recovery from the Covid years falters, signs of slowing medium-term growth are becoming more pronounced.

‘For many economists, it has long seemed clear that China’s growth rates had to eventually come down to earth, even if not necessarily crashing down. For one thing, China faces the similarly challenging demographics to Japan, Korea and most advanced economies, with a low birth rate exacerbated by its one child policy that prevailed from 1980 to 2016.

‘Moreover, China’s total factor productivity has slowed in recent years, and the country is confronted with significant challenges, which could further lower its medium- to long-term growth. Even without leading Western trade partners adopting ‘homeshoring’ policies, and many foreign firms diversifying production through ‘China plus one’ strategies, the country’s ability to grow through export expansion has become inevitably constrained by size limitations as China’s share of global GDP and exports has grown. Still, the continuing strength of the Chinese economy has continually surprised, mostly on the upside, throughout the past four decades.

‘Over the years, researchers have begun to recognise the full extent to which China has depended on real estate and infrastructure for growth and – very importantly – the extent to which the rate of return to new real estate and infrastructure investment might have fallen as cumulative construction equals or surpasses Western levels in many areas.

‘For 2021, the direct and indirect impact of real estate alone in China’s economy is 22% of GDP, 25% if one includes imported content. As estimates in the new report show, if one includes infrastructure on top of residential and commercial real estate, their combined share reached 31%, albeit down slightly from its pre-pandemic peak.

‘A slowing real estate sector, in particular, poses multiple financial challenges to China’s economy, even if the central government’s sweeping power to restructure and reallocate significantly reduces the chances of a Western-style systemic financial crisis. The rapid growth in real estate has been accompanied by a massive rise in local government debt, much of which is beneath the surface in the form of LGFVs. Previous analysis highlights that servicing this debt was already challenging even before the property market downturn. The combined income of LGFVs is barely sufficient to cover the interest payments.

‘Although there certainly are policies to address this problem, for example, instituting greater transfers of revenue to local governments from the central government, or allowing local property taxes, they are not necessarily straightforward in the context of a broadly slowing economy that may need to look to new sources of growth as real estate and infrastructure investment are scaled back. The fact that Chinese households’ wealth is overwhelmingly concentrated in real estate does not make the adjustment any easier.’

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Rethinking China’s Growth

Authors:
Kenneth Rogoff (Harvard University)

Yuanchen Yang (International Monetary Fund)