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Chinese Growth and the Question of Economic Rebalancing

Chinese Growth and the Question of Economic Rebalancing

As far back as 2007, then premier Wen Jiabao described the Chinese economy as “unstable, unbalanced, uncoordinated and unsustainable”. Although the statement raised eyebrows at the time, Mr. Wen’s words seem to have done little to temper the optimism-infused consensus on China’s expected growth rate in the coming years. 

One reason for this (apart from a massive investment boom) is the momentum sustaining the current high-powered growth status quo: investment houses selling freshly minted “China opportunity” funds, commodities producers – not to mention the current Chinese leadership – are all banking on high rates of growth extending into the distant future.

Especially in light of the Economic quagmire facing the developed West, ‘China as the engine of global growth’ has become a compelling story. According to official statistics, the Chinese growth rate has averaged over nine percent for the past three decades. Rapid, sustained economic expansion has lifted hundreds of millions out of poverty; in a “historic reversal of fortunes”, as a recent Chatham House paper put it, Chinese GDP per capita, by some measures, now exceeds that of the Soviet Union. The combined speed and magnitude of China’s economic rise has established a strong precedent for an optimistic view of China’s growth prospects – a view which the market seems hesitant to question – at least until recently.

While 2013 growth expectations for the Chinese economy have been repeatedly revised downward, it appears that the current market consensus – that average growth will hover around the 7 percent mark in the coming decade – is deeply entrenched.

Among the issues highlighted by Wen Jiabao in 2007 is a deep structural imbalance of China’s economy, the inevitable resolution of which stands out as perhaps the most pressing risk to future growth. Demand in an economy can come three sources: consumption, investment and net exports. China’s economy is widely recognised to be overly dependent on investment and exports to generate growth: investment accounts for an unusually high 48 percent of GDP, while consumption stands at a mere 34 percent, with China’s external sector making up the remainder.

The collapse in the consumption share of GDP over the past decade has been accompanied by a sustained rise in investment and exports. Why might this be an issue? As University of Virginia economist Dennis Yang explains, China’s “extraordinarily low consumption-to-GDP ratio implies that the rapid economic growth in China over the past decade has been mainly propelled by domestic investment and foreign demand. Thus, sustaining growth amid declining investment efficiency or negative shocks in external demand is challenging.”

Although the Chinese government has recognised the risks this poses, fixed-asset investment and growing export capacity have been systematically favoured over domestic consumption as a matter of state policy, particularly in the wake of China’s huge 2008 economic stimulus package. Since then, China has doubled down on an investment-driven growth model, leaving the economy overly dependent on sources of growth which, for outlined below, are unsustainable.

I: Why has China boomed?

Despite what some might claim, the Chinese approach to development is not unique, except perhaps in its scale. The Chinese have pursued a variant of the Asian development model – pioneered by Japan in the post-WWII era.

The hallmarks of the Asian development model include an activist state, guided by a policy framework in which investment is directed into manufacturing and infrastructure. This is usually achieved by policy measures which repress domestic consumption (thus boosting savings) in order to direct surplus funds into high productivity, capital-intensive sectors of the economy. In other words, the model seeks to promote rapid industrialization by reducing the cost of borrowing for the state and manufacturing sectors. Insofar as this applies to China, Peking University’s Michael Pettis observes that

the result of this enormously successful model is so much investment-driven and employment-generating growth that even with massive transfers from households, household income has nonetheless surged. In China, for the past decade, as the country was clocking in growth rates of 10-11 percent annually, household income, and with it household consumption, grew 7-9 percent annually.

In a sense it seems like a free lunch. Household income is taxed heavily in order to generate tremendous growth. The growth causes employment to surge, and as workers move from subsistence living in rural China to the factories and development sites of the cities, their income surges. So rapidly does household income grow that even after the huge hidden taxes are deducted the wealth and ability to consume of the average Chinese grows at a pace that is the envy of the world. So why not continue this growth model forever?

As mentioned earlier, the growth model pursued by China in recent decades has led to the build-up of huge imbalances within the Chinese economy. China is unlikely to be able to escape the constraints which other nations, who have adopted an investment-driven model of economic development, have faced in the past. Two of these constraints stand out as having particularly severe implications for China’s growth prospects: the long-term limits to state-driven debt-financed investment and the susceptibility of Chinese exports to external shocks in demand.

China’s success in transforming itself into a global manufacturing hub in recent decades has led many analysts to label the Chinese “growth story” as an export-driven miracle. Of course, there is little doubt that China has benefitted greatly from opportunities offered by the world market. But China’s success in generating huge export growth is only one piece of the puzzle. Although exports play an important role as a driver of economic growth, it would be a mistake to characterize the Chinese economy as “export driven”.

Since the late 1990s, investment has come to represent the primary driver of Chinese growth.  Consumption as a percentage of GDP has fallen from 52% in 1998 to 34% in 2011 – just over half of the global average. In the same period, investment has risen to almost 50% of GDP, a staggeringly high figure.

How has the Chinese government managed to induce such a high rate of investment for so many years? It is to this that we turn, for a brief overview of the transfer mechanisms that lie at the heart of the Chinese political economy.

II: A Closer Look at the Growth Model

The Chinese ‘growth model’ transfers funds from household sector to manufacturing and state sector implicitly via three mechanisms in particular – all with the aim of reducing the cost of capital for those willing to invest. Firstly, an undervalued exchange rate makes imports into China more expensive, while rendering Chinese exports more competitively priced in global markets. While this benefits exporters, it effectively constitutes a transfer of wealth away from the household sector by acting as a consumption tax.

Another form of implicit transfer takes the form of what economists call “financial repression”. Chinese savers have few options other than placing their savings in a state-owned bank, where depositors are paid very low rates on their savings. Borrowers, on the other hand (consisting mainly of the state sector and large manufacturers, to which most lending is directed) are able to access funds at artificially low interest rates. This dynamic boots production and investment while further restraining consumption. Although this may be beneficial for growth in the short-term, Dennis Yang reminds us that “preferential access to credit and heavily subsidized capital financing for giant corporations and the state sector has led to capital misallocation with the side effect of increased corporate savings.”

Finally, wage growth has lagged behind productivity growth. In the past decade worker productivity has tripled, while wages have only doubled. China expert Michael Pettis explains why this matters from the perspective of the growth model:

…lagging wage growth in China represented a transfer of wealth from workers to employers. An increasing share of whatever workers produced, in other words, accrued to employers, and this effective subsidy allowed employers to generate transferred profit or to cover real losses. The fact that productivity grew much faster than wages acted like a growing tax on workers’ wages, the proceeds of which went to subsidize employers.

These implicit transfer mechanisms combine to produce a powerful growth model. By greatly reducing the cost of capital for investors, a huge investment boom has been unleashed in recent years – which in turn has produced a surge in employment and output growth.

III: Constraints to Growth

While the growth model has been effective at boosting demand and output in the short and medium-term, growth becomes increasingly costly to maintain, as bad debt accumulates in the domestic banking system. Historical experience bears this out; other nations which have made use of the model have experienced a collapse in the rate of investment (as bad debt piled up to unsustainable levels) as seen in Brazil (mid 1970s), Taiwan (1980s) and Japan (post-1989).

China faces the additional problem of the constraint on its external account given this sheer size of the Chinese economy. Simply put, there is a limited capacity for the rest of the world to absorb China’s trade surplus, especially in the current environment of low growth and economic stagnation in China’s two principal export markets, the US and Europe.

The question of the debt-servicing capacity of the Chinese economy also acts as a constraint on investment-driven growth. China’s debt levels have been rising rapidly in recent years, with a huge wave of credit expansion seen since 2008. As Morgan Stanley’s Ruchir Sharma pointed out in a recent article in the Wall Street Journal, “since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year.”

Interestingly, as the academic literature on financial instability (which has flourished since the 2008 financial crisis) has demonstrated,  the rate of credit growth may be more important than absolute debt levels as a predictor of financial fragility. A recent chart by asset manager GMO illustrates this rather strikingly:

Credit Bubbles in the US, UK, Japan, Korea and China

China’s credit system has exhibited a number of signs associated with financial fragility, which may act as significant headwinds for growth in the coming years. Excessive credit growth, a real estate bubble, high levels of loan forbearance to state owned enterprises, increasing leverage; all do not bode well for growth in the medium term.

Where does this leave growth estimates? Certainly, 7-8% average growth in the coming decade – the current market consensus – appears overly optimistic. China is facing the same constraints which all countries that have pursued an investment-oriented growth model have faced in the past. A shift away from investment towards a more balanced growth model is likely to occur in a much lower growth environment.

In the coming decade, the Chinese will have little choice but to grapple with issues of malinvestment, a property bubble, slowing external demand – not to mention the economic cost of rising inequality and environmental degradation. This is not to say that economic collapse is on the horizon, however. As Michael Pettis notes, although “the picture for GDP growth is not so bright, it is not especially gloomy for household income growth or social stability. . . If the rebalancing is well managed, by definition household income will grow faster than GDP.”

1. Pettis, the Great Rebalancing, Chapter 4
2. Yang, Dennis T. ‘Aggregate Savings and External Imbalances in China’, Journal of Economic Perspectives, 2012, vol. 26, issue 4, p. 125-46. p. 126.
3. Pettis 2013, p. 75.
4. Yang 2012, p. 143.
5. Sharma, Ruchir. “China has its own debt bomb”, The Wall Street Journal, February 25, 2013
6. Chancellor & Monelly 2013, p. 2
Pettis, the Great Rebalancing, Chapter 4
Yang, Dennis T. ‘Aggregate Savings and External Imbalances in China’, Journal of Economic Perspectives, 2012, vol. 26, issue 4, p. 125-46. p. 126.
Pettis 2013, p. 75.
Yang 2012, p. 143.
Sharma, Ruchir. “China has its own debt bomb”, The Wall Street Journal, February 25, 2013
Chancellor & Monelly 2013, p. 2
Posted in: Asia, China, Featured Reports

About the Author:

William Oliver is Nabateans’ editor for international economics and Middle East current affairs. He obtained his degree in History from the School of Oriental and African Studies in London. While his studies focused on the Middle East in the 18th and 19th centuries, William has a long-standing interest in international finance and the political economy of development. William’s work is aimed at understanding how the Middle East integrates with the global economy, and into the wider geopolitical landscape.

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