Surging China recently overtook Germany to become the world’s leading exporter and will soon eclipse Japan as the second-largest economy in the world. Although China has received a great deal of praise for its response to the financial crisis and the country’s economic rise contributes to its global power, there are fears that bubbles and growing economic imbalances could constrain future growth.
In a new video Q&A, Michael Pettis analyzes the strength of the Chinese economy on the heels of the global financial crisis. Pettis says while China is likely to enjoy solid growth again this year, there remains a serious conflict between the short-term and long-term policy objectives. Beijing perhaps properly addressed its short-term policy objectives, but likely has made the long-term rebalancing problem worse.
How successful was China’s stimulus package in response to the global financial crisis? How strong is the Chinese economy?
The question is what was the purpose of the stimulus package in response to the crisis of 2007 and 2008. There is a long-term view and a short-term view. If your number one concern is to rebalance the economy away from excessive reliance on investment and net exports, then the fiscal stimulus package didn’t work.
What it did was it took China from having the highest investment rate—probably in recorded history—and significantly increased it. It increased the importance of investment in China and it increased the probability that a lot of this investment wasn’t economically viable. What didn’t go into infrastructure investment went into expanding capacity in a world that doesn’t really need more capacity, it needs less capacity. So it went into expanding shipbuilding, steel production, chemicals, etc.
So from that point of view it hasn’t been very successful. Especially if you consider that there may be a significant increase in non-performing loans and in non-economically viable investment which must be paid for in the future by the household sector, probably in the form of very low interest rates, which means that it will act as a constraint on future household income growth and therefore a constraint on future consumption growth.
In a way, part of the expansion is going to push up production and part of it is going to constrain the growth of consumption. And China already produces more than they consume. So pushing them in the opposite directions is not going to help.
But, if you think the purpose of the fiscal and credit expansion was to address a short-term problem of a surge in unemployment in China, then it has been extremely successful. With the collapse in net exports, we should have seen the economy grind to halt and unemployment soar. The purpose of the fiscal stimulus program was to address specifically that problem.
Unfortunately, you have a conflict between the short-term policy objectives and the long-term policy objectives. The government, perhaps properly, addressed the short-term policy objectives. But that doesn’t mean that it resolved the long-term rebalancing problem—it probably made it worse, and China is going to have to rebalance one way or the other.
How can China rebalance its economy?
In the case of China, rebalancing has a very special meaning. It means that consumption must grow as a share of GDP. To give you an idea, five or six years ago private consumption was around 40 percent of GDP—that is an extraordinarily low number.
Among Asian countries that have traditionally had high savings and low consumption rates, Malaysia had private consumption in the low fifties, and at one point after the crisis it declined to around 45 percent of GDP before climbing back to up around 51, 52 percent. That 45 percent was an anomaly.
China, five or six years ago, was at 40 percent. You need to bear in mind that the larger the country, the less likely it is to be an outlier. 45 percent for China would have been worse than 45 percent for Malaysia. 40 percent for China was much, much lower.
The government at the time decided that it was very important to raise consumption as a share of GDP. But, because I believe they had the wrong model for thinking about it, what happened over the next five years was that consumption as share of GDP actually declined from 40 to 35 percent. It’s not easy to do.
What does China need to do it? My model, my way of thinking about it, suggests that consumption is a very low share because household income has been growing more slowly than national income—than total production which is equal to national income—and the reason for that is national income has been subsidized via low interest rates, via an undervalued currency, via sluggish wage growth, and to a lesser extent by the deterioration in the social safety net, environmental degradation, and one or two other things. But the first three are the most important.
All of those subsidies have to be paid for by somebody and they are paid for directly or indirectly by the household sector. That’s what has kept production growing faster than household income, which has meant production has grown faster than consumption. China needs to eliminate those transfers or better yet reverse the transfers. To do that means undermining the profitability of infrastructure investments and large companies in China—and undermining them to such an extent that they may be running fairly significant losses. It cannot be done quickly.
Can China reduce its trade surplus?
In order for China to reduce its trade surplus, it’s not that consumption needs to grow—everyone says that we need Chinese consumption to grow—Chinese consumption has been growing very quickly. In the past decade it’s grown around eight or nine percent a year which is a much faster growth rate than in any other major economy. But that’s not enough.
The problem is that Chinese production is growing faster than Chinese consumption and so the gap between the two is increasing. Why is it growing faster? I would argue that the reason it is growing faster is because Chinese consumption growth is more or less in line with the growth in Chinese household income.
So that national income—that is the total amount of stuff that China produces—is growing faster than household income. And the reason for that is that the development model that China has followed—the very successful Asian Development model—one of it’s key components is that the household sector via low interest rates on their bank deposits, via an undervalued currency, and via a number of other mechanisms are effectively forced to subsidize producers.
The simplest way to think about it is through interest rates. With interest rates so low on banking deposits, that means basically savers are getting a portion of their income taxed away. Those low banking deposits translate into very low lending rates—lending rates that are well below any definition of what the natural borrowing costs should be in China. So users of capital—which are mostly infrastructure investment and manufacturers—are getting very cheap capital and that cheap capital is being subsidized by the household sector. So unless China reverses this process of subsidy, it’s extremely difficult to get household incomes to grow much more quickly and therefore consumption to grow much more quickly.
And that’s the problem that we face, because if you do eliminate the subsidy—and even reverse the subsidy—the manufacturing sector—which is very heavily dependent on these subsidies—becomes unprofitable. So, we can’t do it quickly because if we do it quickly we’ll see a rise in unemployment in China. We have to do it slowly over six, seven, eight years.
It won’t be easy but if it’s stretched out over many years it can be done. The problem is if the trade deficit countries want a very quick resolution then China is in a very difficult position because they cannot resolve it quickly.
What are China's prospects for short-term and long-term economic growth?
We will probably see very good growth again this year. You can get any level of growth you want if you put in a significantly high investment. If the United States wanted to, it could achieve six percent growth next year.
The United States wouldn’t do that because it would involve a huge increase in debt and the growth itself would be inefficient. That increase in debt, since it must be repaid at some point in the future, will end up representing a contraction in the ability of U.S. households to consume. Whatever growth it gets today, it would give back more than 100 percent of it in the future, unless the investment is all appropriate and economically viable.
In the case of China, we are probably going to get another good year of growth. People talk about a significant contraction in the amount of lending—it’s not a contraction in the amount of lending. The typical amount of annual lending for the last five or six years has been between three and four trillion renminbi. Last year, it was above 10 trillion renminbi, an extraordinary number. This year the target is 7.5 trillion, which many people are hailing as a significant tightening of policy—it’s not a tightening of policy. It’s a very, very loose policy, but much less loose than what it was last year which was extraordinarily loose.
So the question is, how many years can they keep doing this? And that I would argue is really a function of debt capacity. Unfortunately, we don’t really know the true debt levels of the government, it’s something that we are all working on trying to understand. If government debt levels are sufficiently low that means we could do several years of this in the hopes that eventually the global economy recovers and China can once again use net exports as a way of absorbing all this capacity.
We’re not sure that is likely to happen. We’re not sure that the global economy will recover and, more importantly, that U.S. consumption will begin growing much faster than U.S. production. And we don’t know what the debt capacity is—how many more years we have of this.