A lack of balance
I’m in Beijing this week for a conference on Regional Financial and Regulatory Cooperation, which is starting tomorrow. Over the past two days I’ve met several colleagues to hear their views on the state of the Chinese economy and the Chinese financial sector. Most Chinese economist I talked to seem pretty optimistic regarding China’s growth prospects and the government’s ability to respond to potential disruptions in the banking sector. Hence it was refreshing to meet today with Michael Pettis, a Professor of Finance with Peking University’s Guanghua School of Management, who is very skeptical on China’s investment-driven and export-dependent growth model.
In his last FT column (“Wen is right to worry about China’s growth”), Martin Wolf summarises Michael’s argument as follows:
[…], between 1997 and 2009, [Chinese] gross investment rose from 32 per cent to 46 per cent of GDP, while household consumption fell from 45 per cent of GDP to a mere 36 per cent. This must be the lowest share of consumption in any significant economy ever. In a country with hundreds of millions of poor people, it is even shocking. Meanwhile, the rising investment rate has been the main driver of growth. In the early 2000s, “total factor productivity” – increases in output per unit of input – were also important. But the contribution of higher efficiency has been waning.This, Prof Pettis argues, is a “souped-up version” of the Asian development model we saw in Japan and South Korea in earlier decades. The characteristics of this production-oriented approach are: transfers from households to manufacturing, via low interest rates on savings, repressed wages and a depressed exchange rate; very high investment; rapid growth of exports; and high external surpluses. China is “Japan plus”: its investment rate is higher, trade surpluses larger, rate of consumption lower and exchange rate intervention bigger.
This has been an extraordinarily successful development model, but, notes Prof Pettis, it eventually runs into the constraints of “massive over-investment and misallocated capital”. He continues: “In every case I can think of it has been very difficult to change the growth model because too much of the economy depends on hidden subsidies.” Moreover, China’s scale will shift the price of imports, particularly raw materials, against it, so accelerating the decline in profits.
In China, a rising rate of investment is needed to maintain a given rate of economic growth. At some point, investment will stop rising and growth will slow. China will then face the Japanese challenge: how to sustain demand as the required rate of investment collapses. If, for example, the gross investment needed to sustain a 10 per cent rate of growth is 50 per cent of GDP, then the rate of investment required to sustain 6 per cent growth might be just 30 per cent of GDP. With its massive dependence on investment as a source of demand, any decline in expected growth threatens a huge recession.
One answer would be another government-driven investment surge, however low the returns. The more attractive answer is faster growth of consumption. There is evidence of that during the past two years. But, as Prof Pettis notes, for consumption to grow consistently faster than GDP, household disposable income must also do so. Yet if this is to happen, income must be shifted from the corporate sector. That implies a squeeze on profits, through higher interest rates, higher real wages or a higher exchange rate. But that increases the risk of an investment collapse, with dire consequences for demand. As Prof Pettis argues, in China “growth is high … because consumption is low”. Rebalancing the economy towards household consumption could undermine the ability to sustain growth itself. If so, China is on an investment treadmill.
We also discussed another aspect of China’s unsustainable growth strategy, namely environmental degradation and its hidden costs, which, if taken into account, would reduce the Chinese growth rate significantly. Arguably, environmental pollution has contributed to a lowering of the consumption rate since more pollution affects people’s health negatively, which is increasing the likely costs of future healthcare people have to cover themselves, hence driving up the savings rate.
I would have loved to download and read some of Michael’s recent papers on this, but it seems his website is not accessible in China, which means that I have to wait until I’m back in Berlin on Saturday.
Btw, Michael is also running a record label in Beijing, called MAYBE MARS which produces exiting Chinese bands. They have a couple of videos on the label website. My favourite one is for the song “Mogu Mogu” from a band called Carsick Cars.
Die 