China’s GDP growth target for 2013 was set at 7.5 percent in March, but just four months later, on July 11 at a press conference in Washington China’s newly established minister of finance, Lou Jiwei, seemed to suggest that Beijing no longer believed the country would hit the target. With his announcement that “the 7 percent goal should not be considered as the bottom line” for this year’s GDP growth, the finance minister set off a flurry of nervous excitement and commentary that, although it was not widely discussed in the mainland press, nonetheless caused the Shanghai stock market to fall.For years China’s reported GDP growth always substantially exceeded its officially targeted annual growth rate, but after two years of sharply declining growth, Lou’s comments appeared to imply that growth rates were set to drop even further. Within a day of Lou’s statement in Washington, however, China’s official Xinhua News Agency corrected and rephrased the quote. “There is no doubt,” Xinhua reported him as having said, “that China can achieve this year’s growth target of 7.5 percent.” Two days later, second-quarter data were released and, coincidentally or not, China’s second-quarter GDP grew by exactly 7.5 percent year on year (although quarter-on-quarter growth clocked in at just under 7 percent).
Whatever the reason for changing Lou’s earlier comments, China’s most thoughtful economists are increasingly skeptical about the need for high GDP growth rates. And they should be. GDP growth rates over the next several years of 7.5 or even 7 percent will prove to be impossible to achieve without a dangerous increase in debt on an already-fragile national balance sheet, and China already relies too heavily on debt-fueled investment to achieve high levels of GDP growth. This must change.
More importantly, China’s GDP does not need to grow at 7.5 percent. This is a myth that should be discarded. What matters is not high GDP growth rates but rather that ordinary Chinese households continue to improve their lives at the rate to which they are accustomed, and that the Chinese economy be restructured in a way that allows it to tackle its credit bubble.
For this to happen China must rebalance. Rapid consumption growth, not investment, must drive future growth, or else debt-capacity limits will cause a sharp contraction in GDP, and in so doing will rebalance China’s economy anyway.
Debt and Overinvestment
The good news about the recent data release is that unemployment does not yet seem to be a problem. According to Mark Williams at Capital Research, “migrant wages remain strong, with real growth rising from 9.5 percent y/y [year on year] to 10.5 percent. This suggests the labor market is healthy still despite the economic slowdown.” 1
The bad news is the declining share of consumption in the second-quarter GDP numbers. Consumption contributed only 45 percent of GDP growth, compared to investment’s 54 percent. Notes economist Long Chen in his blog, “overall consumption contributed 45.2 percent of GDP growth in the first six months of 2013. . . . 45.2 percent is the lowest proportion since 2010. Consumption contributed 55.5 percent and 51.8 percent of GDP growth in 2011 and 2012 respectively.”
A bit of history is necessary to understand why this is so problematic. For the last thirty years, high Chinese GDP growth has been driven primarily by high investment growth and even higher credit growth. In the 1980s and 1990s, vast expenditures on manufacturing capacity, infrastructure, and real estate development resulted in even greater increases in workers’ productivity, so that during this period, China became richer and more productive at an astonishing pace.
But contrary to conventional thinking, even among economists, the difference between advanced countries and less developed countries is not primarily the difference in the amount of capital stock per capita available to workers. What separates them is the difference in their abilities to absorb capital productively and efficiently—what I have referred to elsewhere as their levels of social capital.
As a very poor country with weak legal and financial frameworks, there was a limit to the amount of investment China could productively absorb. At some point in the late 1990s or the early part of the next decade, it seemed that China began to reach this limit, after which the continued rapid increase in Chinese investment could no longer generate the same sustainable increases in real worker productivity. As this happened it became increasingly evident that capital was being misallocated on a large and growing scale.
Despite this, official productivity numbers continued to rise. But the reported rise in productivity depended on prior, and ultimately circular, assumptions: it was assumed that the value of the investment that confirmed the rising productivity numbers was itself justified and exceeded its cost.
It now seems clear that at least part of the investments of the past decade or more, whose value to the economy was calculated as the cost of the inputs and not as the value of the outputs, resulted in overstated GDP. This means that the productivity numbers that justified the high investments were themselves overstated in the kind of circular mechanism typical of the nonmarket components of large economies. And as capital was increasingly poured into bad investments, almost by definition the total amount of debt generated by China’s central government, local and municipal governments, state-owned enterprises, and other large businesses grew faster than the country’s debt-servicing capacity.
Events in the last three years have suggested, as is now widely agreed, that debt levels in China are indeed extremely high and rising too rapidly. With so much of China’s investment now creating less economic value than the debt behind it, the country is left increasingly vulnerable to a chaotic adjustment if it runs into debt-capacity limits, as it eventually must if debt continues to rise faster than debt capacity.
With the world economy in weak shape or even on the verge of crisis, there is simply no way China can continue to grow quickly in its current, heavily unbalanced form. Rebalancing, consequently, is not an option. It will happen one way or the other. But it will happen either in an orderly way if engineered intelligently by Beijing, or in a disorderly way if rising debt pushes China up against its debt-capacity limits.
It is for this reason that the new administration under President Xi Jinping and Premier Li Keqiang has made it very clear that it will regain control of the economy and rein in credit expansion. But this very welcome determination on the part of the central government comes at a cost. GDP growth has already dropped considerably and will continue to drop to well below 7 percent. Not everyone agrees yet, of course, but it seems almost inevitable that growth expectations will continue to decline for many more years.
Households Care About Their Disposable Income
Ultimately, however, it will not matter if GDP growth rates are much lower than what most analysts believe are the politically and socially acceptable lower limits. GDP growth rates are the wrong target to consider. Besides being a very poor—and significantly overstated—measure of real wealth creation in China, GDP growth rates are not the relevant measure of economic activity that determines the social impact of growth.
To understand why, consider what it means for China to rebalance. With household consumption at an astonishingly low 35 percent of GDP, if China attempts to engineer a rebalancing so that in ten years, household consumption rises to 50 percent of GDP—which would still make it among the lowest of any major economy in the world—consumption growth must exceed GDP growth by nearly 4 percentage points every year. This is just arithmetic.
An average annual growth rate of 7.5 percent, in other words, requires growth in consumption to exceed an already extraordinarily high 11 percent just so China can rebalance by the absolute minimum that it and the rest of the world can sustainably support. Even for lower GDP growth rates, say 6 or 7 percent, to be consistent with a minimal amount of economic rebalancing, the arithmetic requires implausible assumptions. If China has ten years to bring its domestic consumption up to a level that will still make it among the most unbalanced major economies in the world, 6 to 7 percent GDP growth still implicitly assumes that household consumption will grow at rates of at least 10 to 11 percent a year for a decade. Those rates were hard to achieve even during the optimal periods of global and Chinese growth.
Of course achieving growth rates in consumption of 10–11 percent is not impossible in theory. It is rather alarming, however, that so many analysts are willing to accept the implicit assumption without explicitly detailing the mechanism that will generate such rapid growth in household consumption as investment and GDP growth rates continue to fall.
Moreover, such rates are not at all consistent with the growth rate of consumption during the 2012–2013 period, during which China has presumably begun the rebalancing process. In 2010 and 2011, consumption growth rates may have approached this level thanks in part to still-high credit growth, but in 2012 and 2013 year-to-date, it looks like consumption growth has slowed dramatically, perhaps to well below 9 percent.
And it isn’t clear that even current consumption growth rates can be maintained. As investment growth drops further, there may well be downward pressure on the growth rates of household income and consumption, as a recent study by the IMF suggests. This is especially worrying because consumption has to increase in order for China to grow without exacerbating the growing gap between growth and its debt-serving costs.
So why are consumption rates in China so low? For many years low consumption was mistakenly believed to be a consequence of the very high propensity of Chinese households to save, but by now it is widely understood that the reason for China’s very low household consumption share is the very low household income share of GDP. At around 50 percent, Chinese households retain among the lowest GDP shares ever recorded. For household consumption to rise as a share of GDP, so must household income.
Because the low household income share of GDP constrains the household consumption share, a minimal amount of rebalancing that is compatible with 7.5 percent GDP growth, or even 6 percent GDP growth, would require almost impossibly high growth in Chinese household income. On top of that, all this must happen as Beijing struggles to constrain credit growth, as investment growth in China is reduced sharply, and as China’s main export markets suffer from crisis or stagnation.
And this is why China should not and does not need to grow at 7.5 percent. Beijing’s determination to avoid the ballooning risk of a future debt shock by moving aggressively now to rebalance the economy toward a healthier growth model makes it almost impossible to keep GDP growth rates at anywhere near the current target. The arithmetic assumptions needed to make GDP grow in line with the current consensus while China rebalances are not impossible, but they are implausible and hard to explain convincingly.
But this does not mean China will face a social or political crisis. In recent decades, China’s disposable household income has grown at above 7 percent a year, which although much lower than China’s GDP growth rate is nonetheless a tremendous feat. This is the growth rate that must be maintained. Ordinary Chinese, like people everywhere, do not care about their per capita share of GDP. They care about their real disposable income, and so Beijing’s policies should aim for average growth in median annual household income of at least 6 or 7 percent. It should also continue to shift from capital-intensive to labor-intensive industries so slower GDP growth need not result in slower employment growth.
By taking these steps, Beijing would ensure social stability and would continue to drive China’s economy forward. This implies that as China rebalances, GDP will grow by “only” 3–4 percent a year during the decade of adjustment, but, although low by recent Chinese standards, this rate is still high enough. More importantly, it is consistent both with rapid growth in the income of ordinary Chinese and with a real and sustained rebalancing of the Chinese economy. It may even be consistent with almost-zero net investment growth and a sharply limited growth in credit.
If median Chinese household income can grow at 6–7 percent during the administration of President Xi and Premier Li, while the economy is weaned from its addiction to credit, it will be an extraordinary achievement. And it will be extraordinary even if it implies, as it must, that GDP growth rates will drop far below any of the numbers to which China and the world have become accustomed.
Reversing the Flows
But is it possible for China to experience much lower GDP growth rates—along the lines of 3–4 percent annual growth on average over the next decade—while maintaining household income growth rates of 7 percent or more? Clearly this will be difficult, but just as clearly it is not impossible. In a sense Beijing must reverse the process of the last three decades, during which time China’s GDP grew at a blistering pace, and household income grew much more slowly while governments and businesses grew much more quickly.
Whatever the GDP growth rate turns out to be, for the next decade or two, rebalancing means by definition that household income growth will exceed it—by at least 3 to 4 percentage points over the course of President Xi’s administration. And it means that business and (almost certainly) government growth will chug along at much lower rates.
How can Beijing maintain the current growth rate in median household income while GDP growth rates drop so sharply? It turns out that it is easy to explain the answer in theory, although no one should have any doubt that in practice the challenges are immense. To see how China can rebalance with high growth in household income it is necessary to consider what the mechanism was that caused household income growth to lag GDP growth for three decades while the growth of government outpaced that of GDP.
For many years—most of the past three decades—the same mechanism that caused rapid growth in China’s economy also caused the rising imbalances within the economy. China’s financial and institutional framework created a series of hidden transfers from the household sector that subsidized rapid growth. Although these transfers reduced the growth rate of disposable household income, the subsidies generated so much growth that Chinese household income still grew at very rapid rates.
These hidden transfers included such things as the dismantling of the old social safety network, environmental degradation, the application of eminent domain, and weak labor rights, all of which effectively goosed economic growth at the expense of Chinese households. The most important of these transfers, however, were three mechanisms borrowed from the Japanese model. These were lagging wage growth relative to productivity growth, an undervalued currency, and, most importantly, a system of financial repression that, because it kept deposit rates on household savings at well below the country’s inflation rate, meant that the value of savings deposits declined in real terms as borrowers benefitted from low interest rates.
If these various mechanisms are reversed, they will of course reduce the growth rate of the economy by eliminating the substantial hidden subsides to growth. But as this happens, rather than lag GDP growth significantly, as it has for the last thirty years, household income will begin to grow more quickly than GDP. Just as important, the elimination of the severe financial repression tax will reduce pressure for Chinese borrowers to overuse capital at the expense of labor, so lower GDP growth need not result in lower employment growth. In that regard it is already very heartening that in spite of slowing GDP growth, the recently released second-quarter data suggest that there continues to be upward pressure on workers’ wages.
As Beijing, in other words, focuses on improving the environment, shoring up the social safety network, increasing wages relative to productivity, revaluing the yuan, and, most importantly, reducing the gap between GDP growth and deposit rates, it will unquestionably slow the growth rate of GDP, but there will be two important benefits. First, the quality of Chinese growth will rise substantially and will be less dependent on out-of-control credit growth.
Second, as GDP growth rates slow, the gap between the growth of GDP and the growth of household income will automatically narrow and even reverse itself. As this happens, at some point, Chinese GDP growth can slow sharply, even to 3–4 percent a year, while the growth in household income can be maintained at current levels or slow marginally to 6–7 percent a year as large Chinese businesses shift out of capital as their cheapest input and into labor.
The Choice Is Clear
This will not be an easy process. No country in history has been able to make the kind of transition that China must make without great difficulty, and in China the imbalances have exceeded anything ever seen before. Ultimately the historical precedents suggest that the greatest impediments will be political, as a rebalancing and slowing China will put a tremendous burden on the growth of state sector assets and on the positions of the elite who benefit from control of state sector assets.
But Beijing almost certainly does not have a choice, and it is clear that China’s new leadership understands just how urgent it is to rebalance the economy. The important point to remember is that in a rebalancing China, the key metric is not the growth rate of GDP. It is the growth rate of median household income. It is this growth rate that will determine the social and political costs of rebalancing and the continued loyalty to the ruling party. Because rebalancing means that household income must grow much more quickly than GDP, it also means that Beijing can tolerate much slower GDP growth rates without in any way compromising its obligations to ordinary Chinese people or its urgent need to rebalance the economy away from its dangerous addiction to credit expansion.
Over the next few years, as the new administration tightens its grip on the most overheated parts of the economy and brings credit under control, it will be almost impossible to keep GDP growth rates at anywhere near current levels. But this does not necessarily mean that the great Chinese miracle will have ended, nor does it mean that social discontent will explode and undermine the achievements of the past thirty years.
If the transition is managed well, and if it overcomes the obvious opposition from a political elite used to spectacular gains in wealth and power, ordinary Chinese will hardly notice the sharp economic slowdown associated with the transition to a more sustainable growth model, and the risk of a credit crisis will be averted. A truly rebalancing China can and must tolerate much slower growth.
1 Mark Williams, “Imbalances Widen, Despite Slowdown,” Capital Research, July 15, 2012.