China Loses Its “Animal Spirits”

10 Aug 2016


  • Debt-financed public spending has been sustaining China’s GDP growth since 2013 as private investment growth has been falling.  In other words, China’s private sector has lost its “animal spirits”, and the economic engine has mainly been running on “public fuel”.
  • While commodity price decline and policy failure to boost private incentive are identified as causes for the drop in private investment growth, the true cause of shrinking structural demand for what the investment sector produces has not been fully understood.
  • The key to understand this is the secular slowdown in China’s housing demand which is, in turn, due to structural changes in China’s growth model.  The revival of animal spirits needs adaptation by the private sector to the new China and genuine supply-side reforms to unlock private investment incentive.

China’s gross fixed capital formation has been falling since 2010, driven mainly by a steady decline in private investment (Chart 1).  Credit-fueled public infrastructure spending has replaced private investment (Chart 2) to keep GDP growth from falling significantly below 7% since the current economic down-cycle began in 2013.  The persistent weakness in private-sector investment on the back of rising credit growth is puzzling.  It prompted Beijing to send in May 2016 nine inspection teams across the country to find out why the private sector was not investing.

Cyclical and technical factors

After a two-month study, the investigators concluded that slowing macroeconomic growth momentum, favouritism towards state-owned enterprises (SOE), failure of the local governments to implement effective measures to boost private investment and corruption crackdown were the culprits for stymieing China’s “animal spirits”.

The global commodity price slump since mid-2014 has aggravated the weakness in China’s growth momentum and corporate profits by hitting China’s commodity producers hard.  Since commodity producers are big buyers of machinery and other industrial and capital goods, weak demand in this sector has also weakened pricing power for many manufacturers.  Meanwhile, the service sector, which has grown bigger than the manufacturing sector since 2013, is not that insulated from the weakness of the industrial sector because industrial firms are big customers for logistic, trade, financial and commercial services companies.

Some argue that the most important driver for the decline in private investment was declining profit growth.  This is not an explanation.  Profit growth is an endogenous variable that cannot be used to explain another endogenous variable, private investment growth.  We need to understand what lies behind the decline in profit growth in order to explain the loss of animal spirits.

The real estate super-cycle

While the cyclical and technical factors have been thoroughly discussed by the public and private circles, little attention has been paid to the underlying structural factor that is hurting private investment incentive. This is the weakening of the final demand for output produced by the investment or capital-intensive sector in China. The key to understand this puzzle is China’s housing market, which followed the growth pattern of the country’s supply-expansion development model until President Xi Jinping took office in 2013.

The substantial slowdown in the housing sector since 2013 explains most of the decline in investment growth because residential investment is a large part of total investment and it is primarily driven by private firms. Real estate and construction account for 27% of total investment. But if we include their spillover effect on related sectors such as metals and minerals, machinery and consumer goods (notably white goods, furniture and cars), real-estate-related investments account for more than 50% of total investment in the economy (Chart 3).

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