As China fitfully tries to rebalance its economy, a small but rising number of Chinese economists are beginning to predict sharply lower annual growth rates of 6% to 7% over the next few years. But the arithmetic of adjustment suggests growth is likely to be even lower, perhaps half that level.
China's growth over the past couple of decades was based on large increases in government-directed investment. As a consequence, it had to run large trade surpluses to absorb the resulting excess capacity in manufacturing.
This can't continue. Investment, especially in infrastructure and real estate, is increasingly wasteful. With Europe in crisis and Japan and the U.S. struggling with their debt, demand for China's exports will stagnate.
Can China rebalance away from investment and toward domestic consumption as the main engine of growth? Yes, but with great difficulty. Chinese households consume only about 35% of GDP, not much above half the global average and far less than any other country. Such a large domestic imbalance has no historical precedent.
Some in Beijing understand how lopsided their development has been. So over the next 10 years, policy makers have said that they will try to raise consumption to 50% of GDP. Even that is a low number; it would put China at the bottom of the group of low-consuming East Asian countries.
But achieving this goal is problematic, since it requires that household consumption grow four percentage points faster than GDP. In the past decade, Chinese household consumption has grown by 7% to 8% annually, while GDP has grown at an astonishing 10% to 11%. If one expects Chinese GDP to grow by 6% to 7%, Chinese household consumption would have to surge by 10% to 11%.
Such consumption growth is unlikely because powerful structural factors work against it. The Chinese growth model transfers income from households to the corporate sector, mainly in the form of artificially low interest rates. These sharply reduce borrowing costs for the state-owned companies that funnel this easy money into mega-investments. The easy financing also gooses banks' profit margins and allows them to resolve bad loans with ease.
This cheap borrowing comes at the expense of depositors. Low yields on deposits force them to sacrifice consumption, to save more. This results in a sharp decline in consumption's share of GDP. If China is to replace investment with consumption as the engine of growth, this process of financial repression has to be reversed. Households must get a rising share of overall growth.
This reversal is inevitable, but it will not come easily. Wasted investment and excess capacity translate into growing amounts of bank debt, meaning continued wealth transfers are necessary to keep the banking system viable. But if households continue to pay over the next few years, as they have in the past, China will be stuck in the same model.
The historical precedents of the debt buildup are worrying. Every country in modern history that has achieved many years of "miracle" growth has run into the problem of over-investment and then excessive debt. Just look at Japan. The need to resolve the debt has itself made domestic rebalancing difficult, and it has always taken far longer than even the most pessimistic forecasts.
Still, consider the price of delaying this reversal. Even if consumption manages to keep growing at the same rate it has during the past decade, when Chinese and global conditions were buoyant and debt levels much lower, China's growth must slow to 3-4% to achieve rebalancing. This is the impact, in other words, of the required reduction in investment, which will have to be sudden and sharp.
In the worst-case scenario, consumption growth slows down to less than what it was last decade—perhaps because of slower GDP growth—making rebalancing even harder. The only way to speed up the process would be for the government to recapitalize the banks with state assets.
China has some painful decisions to make if it is to reorient its economy away from investment. All the scenarios require that the economy stop growing as fast as it used to. Both Beijing and the world need to get used to this.