While inflation dominated the news about last week’s National People’s Congress, a more interesting story may be the contentious internal debate about rebalancing Chinese growth from investment to consumption. It will prove a difficult task. The evolution of Chinese household consumption is one of the more striking economic stories of recent decades. In the 1980s household consumption comprised 50-52 per cent of China’s gross domestic product – low, but within range of other high-saving Asian countries.
Over the next decade as China’s economic growth outpaced consumption, household consumption declined slowly as a share of GDP, to reach a worrying 46 per cent in 2000. Such a low share left rising investment and trade surpluses as the main engines of Chinese growth. Both rose rapidly during the next decade, generating growth of more than 10 per cent annually.
In the next decade, however, thanks to the urgent need to repair China’s bankrupt banks, the divergence accelerated, and by 2005 consumption dropped to an unprecedented 40 per cent of GDP. Under Premier Wen Jiabao’s leadership Beijing resolved to rebalance the economy and increase the share of household consumption. But the low consumption share was not an accident. It is fundamental to the growth model and cannot be reversed without abandoning the model. Not surprisingly, Beijing was unwilling to do so, and household consumption declined further over the rest of the decade to an astonishing 35 per cent of GDP.
China’s breakneck economic growth was fuelled by vast transfers of household wealth, which subsidised the manufacturing and investment boom and paid for bad loans. The most important of these transfers is the very low interest rate set by the central bank, which takes at least 5-7 per cent of GDP every year from households to give to banks and borrowers. Lower household wealth, of course, means lower household consumption.
China’s investment-driven growth model is not unique. Many countries have used a version of this successful strategy, but all run into the same constraint. Rapidly expanding, politically directed investment tends to be misallocated. The losses are disguised, but not eliminated, by the huge hidden interest rate subsidies.
China is no exception. It is misallocating capital on an unsustainable scale. So now Beijing must allow households to increase their share of the vast wealth generated in recent decades so that consumption, and not more investment, can be the next great driver of growth. But here’s the catch. Rebalancing requires that China reduce investment growth. The more bad investment China piles up, the more it must transfer wealth from households to keep those investments viable. But lower investment will cause a dramatic drop in economic growth. Accelerating investment is the only way policymakers can maintain high growth rates.
This is why the debate within China has become so contentious. Reformers argue that the transition to a more sustainable growth model requires reduced investment – and slower GDP growth. Their opponents, concentrated in sectors that benefited from the growth model, do not see the link between rapid growth and low consumption. They argue for administrative steps to improve consumption without decelerating investment.
How quickly China resolves this debate is crucial. The historical precedents make it clear that once domestic imbalances are severe, the longer a country waits to adjust away from investment-driven growth, the more costly it is. But precedent also makes it clear how addictive the model can be. This is the challenge for China’s leadership. As long as investment grows quickly, it will require more subsidies from the household sector, and the household consumption share of GDP will stagnate. It is not until China makes the transition to a new growth model that rebalancing will begin.
The heated debate between the reformers, who are as unpopular as anyone who brings bad news tends to be, and those who see no reason to abandon a model that has generated such spectacular growth, has become one of the debates in the world. How quickly it is resolved will determine the pace and nature of China’s economic growth over the next several decades.