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What is the reason for the slowdown of the Chinese economy?

Recently, devaluation of Yuan by the Central Bank of China – People’s Bank of China (PBOC) – created havoc in the global economy. This incident not only affected the emerging economies like India but also developed economies like USA, UK, Japan, etc. Many feared that the recent devaluation process was because of the slowdown in the Chinese economy which was corroborated by the release of the Chinese export data showing around 8% decline year-on-year. Also, the fall in prices of crude oil is also attributed to the fall in demand due to slowdown in the global economy particularly in China.

On the other hand, Chinese Government and PBOC clarified that the devaluation was result of their efforts to link the value of Yuan to the market forces. This move will make the case strong for China to include Yuan in the SDR basket (explained below in detail) which is set to be reviewed in 2015 by the IMF.

In spite of the clarifications given by the Chinese authorities, it is quite evident that the Chinese economy is in the phase of a slowdown and is not set to perform up to the same level it has been doing for the past 3 decades.
It is said that China does not have any international friends; still slowdown in the Chinese economy is a matter of concern for the global fraternity including India.

To understand the situation it is important to know some terms and background of some recent developments that is responsible for the current situation.

China Real Estate Bubble
The deflation of the real estate bubble is one of the major causes of the economic slowdown. Many factors worked in tandem to inflate this bubble.
For the past 3 decades Chinese economy grew at an average of about 10% annually. Also, during this period the urban salaries grew 15% per year on an average. Notably, in 1990 only 17% of the households owned their homes, in 2005 this figure went up to 85%. In addition to this, Chinese people started to save more. Although majority of the people now owned their house, their aspirations increased to upgrade to a better one. The saving rate increased to 25% of gross income in 2012 from 17% in 1995.

Moreover, Chinese policy became more accommodative in 2000s. The loan rate was around 6% per annum, which is extremely low in an economy that is witnessing average 10% growth rate for three decades.

During this period of bubble local government relied on sale of land for their revenues (Nearly 50% of the revenues) and hence incentivized sale and purchase of land.

Limited access to foreign investment, Chinese people started to see real estate as a lucrative investment destination.

As a result of these significant investments in the real-estate sector, China consumed around 60% of the cement produced around the world and 43% of construction equipment, such as bulldozers and other heavy machinery. The construction sector consumed 40% of the steel produced in the country, representing 12% of GDP, and employed 14% of the active population in China.

There was large number of vacant or under-performing commercial and residential properties, an estimated 64 million vacant apartments. The high price-to-income ratios for real estate, such as in Beijing where the ratio was 27 to 1 years, five times the international average and high price-to-rent ratios for real estate, such as in Beijing where the ratio was 500:1 months compared to the global ratio of 300:1 months.

There was a weak secondary market for Chinese homes, with the ratio of secondary to primary residential property transactions at 0.26 for the first half of 2009. Comparably, Hong Kong had a ratio of 7.25, and the U.S. had a ratio of 13.45.

Contributing to the bubble were Chinese companies in the chemical, steel, textile and shoe industries opening real estate divisions, expecting higher returns than in their core businesses.  Residential housing investment as a share of China’s GDP tripled from 2% in 2000 to 6% in 2011, similar to the peak of the U.S. housing bubble.

Between 2010 and 2011, Chinese Government started to enact policies intended to curb the bubble from worsening. The Chinese Government announced in 2010 it would monitor capital flows to stop overseas speculative funds from jeopardizing China’s property market and also begin requiring families purchasing a second home to make at least a 40% down-payment.

Beijing banned the sale of homes to those who have not lived in Beijing for five years. Beijing also limited the number of homes a native Beijing family could own to two, and allowed only one home for non-native Beijing families. By July 2011, the Chinese Government raised interest rates for the third time that year. A new nationwide real estate sales tax was introduced in China in late 2009 as a measure to curb speculative investing.

The deflation of the bubble began in the summer of 2013, when home prices began to slow or fall in Chinese cities.

This end of the property bubble is seen as one of the primary causes for China’s declining economic growth in 2014.

Slowdown in the Allied Industries
The deflation of the property bubble lead to the slowdown in the allied sectors, like steel, cement, glass, furniture, construction equipment etc, supporting the real estate sector. These allied sectors also provided employment to a significant portion of population. So any adverse effect on the real estate sector affected the livelihood of people employed in the allied activities.

After the real estate prices started to fall, the real estate sector started to lose their profit margin affecting their ability to repay their loans.

Moreover, countries supplying raw material to China were also affected due to weakening demand. These countries were compelled to search for other markets in the world which was already reeling under the pressure of economic crisis.

Slowdown in Global Economy
Since 2007-08 Great Recession global economy was severely affected. Major blowback came to Europe which was not able to revive itself in spite of all the efforts of Government authorities and the European Central Bank. Greece, which received two bailout packages in 2010 and 2012 could not revive its economy and was on the verge of an exit from the European Union. United Kingdom, one of the major economies in the world was suffering from the deflationary trend.

This slowdown in the world and specifically in Europe affected the demand for the Chinese exports very badly. Any adverse effect on the Chinese export world would mean hurting the whole Chinese economy, which emerged as a “poster boy” for export oriented economic growth.


Inclusion of Yuan in SDR Basket
SDR stands for Special Drawing Rights and is used by IMF for accounting purposes. Its value is linked to 4 currencies – US Dollar, Pound Sterling, Euro and Japanese Yen. The inclusion of a country’s currency depends on the share of its trade in the global market and exercising globally excepted practices by the country. IMF provides a specific amount of SDR to its member nations according to their IMF quota. Member countries can use their share of SDR in building their reserves and exchange SDR with other countries to maintain their Balance of Payment.

Inclusion of country’ currency in the SDR basket provides the economic clout to that country. Also, that country will have more say in the global economy after the inclusion of its currency in the SDR basket.
Although China has emerged as one of the major players in the global economy in terms of trade, Yuan was not included in the SDR basket by IMF. Reason stated by the IMF was that China follows fixed exchange rate for Yuan and not the globally accepted practice of floating exchange rate. On daily basis, PBOC used to set an exchange rate and give traders a band of 2% above and below that value for operating. The composition of the basket of currencies used by the PBOC to decide the exchange rate for Yuan is unknown, but it is believed that the basket gives maximum weightage to US dollar. One of the plausible explanations is the appreciation of Yuan in tandem with the appreciation of US dollar. And this trend has been noticed widely since the coming back of US economy from the period of Great Recession (2007-08).

China wants Yuan to be included in the SDR basket as soon as possible to provide fillip to its effort of increasing its economic clout in the world and challenging the US Dollar in the future.

Yuan Devaluation
There were both international and domestic pressures on Chinese authorities to devalue its currency.

On the international front all the major economies, particularly USA, accused China of deliberately keeping the value of its currency at low level to make its exports competitive in the international market. On the domestic front, traders accused Chinese authorities of keeping the value of Yuan high and thus making their exports less competitive.

Ultimately China started Yuan devaluation. Although not stated explicitly by PBOC that Yuan devaluation was done to revive the falling exports and hence revive the Chinese economy, reason was pretty clear from the fact that devaluation was done after the release of weak Chinese export data.

Effect on Stock Markets
Yuan devaluation was not received well by the investors all over the world and resulted in capital flight from stock markets of developing as well developed countries which were dependent on Chinese economy directly or indirectly. Although the effect on Indian stock market was a bit delayed and subdued, capital flight eventually took place on the announcement of China allowing its 500 billion dollar pension funds – largest in the world – to invest in Chinese stock market. This announcement gave signal to the world that there is liquidity crunch in the Chinese stock market that is indicative of weak Chinese economy.

Effect on other Economies
In today’s intertwined world, no country can remain isolated from the deteriorating economy of other country. Countries which supplied raw material to China were the most effected by the turmoil created by the weak Chinese economy.

Almost 30% of the Australian export was consumed by China. So, slowdown in Chinese economy resulted in the decline in demand for the raw material. Hence, Australia was compelled to look for other markets having the capacity to absorb its exports.

Recently, China started to venture in the African continent to gain excess to the natural resources and minerals available that can fuel the growth in the Chinese economy. Slowdown resulted in the fall in demand for these natural resources. Due to the fall in demand commodity prices for goods such as copper ore, iron ore, etc started to get effected.

Similar effects were experienced in other countries whose exports were absorbed by China.

Fear of Deflationary Trend
Yuan devaluation made Chinese exports less costly as compared to goods of other countries. This would result in declining of prices in the countries importing Chinese exports. This was a bad news for major economies such as UK which was under the pressure of deflationary trend for the past few years and could even slip back to this trend following the Yuan devaluation. There were also speculations that the declining prices can also affect US which absorbs substantial part of Chinese exports and where inflation level is at a low level of around 2%.

Effect on India
India’s Current Account Deficit (CAD) with respect to China is under stress and is increasing for the past few years. Recent visit of Prime Minister Narendra Modi to China also stressed on the moves to reduce CAD. But fall in the prices of exports will increase India’s CAD with China. This is not good news for Indian Government that has vowed to revive Indian economy and has set a target of double digit growth in the near future.
Also, with decline in the prices of Chinese exports there is a fear that Chinese goods will be dumped in the Indian market. This situation can adversely affect domestic market by making Indian goods less competitive for the consumers.