With China’s economy slowing faster than expected, Beijing is considering another stimulus program. While there are reports of “mega” investment projects being advanced as an option, some observers are pushing for a more modest consumption-driven approach. Hopes for such a program, however, are tempered by a much-publicized decline in the share of consumption in the country’s GDP from 50 percent to below 35 percent over the past fifteen years. This trend is deemed the clearest sign that China’s growth process is unbalanced, with consumption repressed and investment overdone.

But this perception is wrong. High investment rates in China are building off of a very low initial capital stock and have thus enabled China to sustain an extremely high GDP growth rate for three decades. The accompanying decline in consumption as a share of GDP is not cause for concern, as it is helping to lay the foundation for future prosperity and is typical of industrializing economies. China’s consumption share will rise as its economy matures; in fact, it is most likely already higher than generally supposed.

The Golden Rule

Edmund Phelps won the Nobel Prize in 2006 for his “golden rule of capital accumulation,” which proposed that a country should invest and consume so that present and future generations are treated equitably. In other words, one’s children should experience the same improvement in living standards as their parents. Phelps’ guidelines have been ingeniously used in the World Bank’s report Golden Growth to analyze the problems of the advanced eurozone economies—and provide a valuable lens for examining China’s economic development.

Phelps’ golden rule established that the optimal investment rate for an economy depends on the size of its capital stock relative to the economy and to the productivity of investment. Together, these determine the appropriate investment rate and sustainable growth of consumption across generations.

Countries that are overconsuming need to increase savings to support investment and accelerate growth. Those that are underconsuming should save less at the expense of future growth. The golden rule also reminds us that consumption and savings rates cannot be altered easily. Thus, short-term variations and countercyclical movements are less important than longer-term trends shaped by the evolving structure of the economy.

China is on Track

Applied to China, the golden rule suggests that the policy objective should not be to maximize consumption or consumption’s share of the economy in the short run but to maximize growth in consumption over time. By coincidence or design, China has been on the golden rule consumption path for most of its post-Mao reform era. Adhering to the golden rule required China’s consumption share to decline during its industrialization phase after 1979 as it built up its depleted capital stock.

As China’s economy opened up, the investment share increased from 30 percent of GDP in the early 1980s to over 40 percent by the turn of the millennium and surged above 45 percent with the 2008 stimulus program. Steadily rising investment levels have been critical for creating the capital base necessary for GDP growth averaging 10 percent over three decades despite several global financial shocks.

Why has the productivity of capital been so high despite such rapid investment growth? That trend is actually normal for a country that is still at a fairly early stage of economic development and in the process of industrializing. A key consideration is the size of the capital stock relative to GDP or labor—a measure of whether a country has been overinvesting or underinvesting. China’s stock of capital is still relatively low despite decades of high investment rates. Capital stock per worker, for example, is still less than 10 percent of U.S. levels. And its stock relative to the size of its economy was about 40 percent smaller than the average of other major East Asian economies in the two decades prior to the 2008 global financial crisis.

China may have a low capital stock now, but it has been catching up rapidly thanks to high rates of investment. Yet, China’s capital stock is still below the East Asian average, reflecting the deprivations of the Mao era. The country has a long way to go before its capital stock reaches a level that sustains high standards of living in most advanced industrialized countries.

Estimates of China’s “total factor productivity,” a measure of efficiency in the use of both labor and capital, moreover, place China among the strongest performers. This is corroborated by industrial profits as a share of GDP rising from 2 percent in 1998 to 12 percent by 2010 as reported by UBS. High total factor productivity demonstrates that China is still seeing large gains from investment and, therefore, not overinvesting.

High rates of investment have enabled China to maintain an extremely high GDP growth rate for decades and are building a foundation of prosperity for the next generation. The decline in consumption as a share of GDP, which accompanied and allowed for high rates of investment, should thus be seen as a virtue rather than a problem.

China’s growth trajectory is, moreover, not a historical outlier. A decline in consumption as a share of GDP typically accompanies the structural changes that take place in rapidly industrializing economies (see Charts 1 and 2). Japan, South Korea, and Taiwan each experienced declines of 20 to 40 percentage points during their industrialization phase. Even the United States experienced a decline of 45 percentage points in the first half of the twentieth century. China is no different and, as with these countries, its consumption share will eventually increase and then level off.

Finally, China’s actual consumption as a share of GDP may in fact be higher than the official numbers suggest. China’s National Bureau of Statistics has cautioned that its household consumption figures do not fully take into account cash and in-kind transactions—nor do they adequately capture the value of owner-occupied housing. The last revision of the national accounts in 2004 increased the share of services by an astounding 30 percent. Moreover household income is significantly underestimated. All this means that the share of consumption may be underestimated by perhaps as much as 10 percentage points of GDP.

And it is growing rapidly. Over the last two decades, household consumption has steadily increased by more than 8 percent annually—the highest sustained rate for any major economy. Recent indicators in fact suggest that consumption, more than investment, is beginning to drive demand—in part because the interior of the country with its higher consumption rates is expanding more rapidly than areas along the coast. This contradicts the notion that consumption is somehow being repressed.

Onward and Steady

Looking forward, most long-term projections show that China’s sustainable GDP growth rate is likely to decline gradually to between 6 and 7 percent over the next two decades. Yet with a renewed capital stock and eventually a steady increase in the share of household income to GDP as occurred in the other East Asian economies, consumption can continue to grow at its golden rule 8 percent rate for decades to come. Thus Beijing can be more relaxed in shifting to a slower but higher-quality growth path.

This is the context facing China’s policymakers as they consider moving forward with another stimulus program. There is recognition that the largely credit-financed and investment-focused 2008 stimulus program was excessive—resulting in unnecessary waste and an overheated property market—and that in the process, the economy has at least temporarily been pushed off the golden path. But the compensating benefit is that China avoided the sharp downturn that affected most other countries.

Reports of the possible scale and nature of some of the proposed new investments—including approval of a huge $10 billion steel plant in Guangdong when the industry has excess capacity—raise concerns about whether the process will be more disciplined this time. While some acceleration of vetted investment projects is sensible, emphasis should now be given to structural reforms that will encourage efficient growth supported by increased fiscal resources for social services since China ranks below the norm in these areas. These efforts would be consistent with China adhering to its golden rule consumption path.

Over time the share of consumption in the economy will gradually rise on a sustained basis. And while many will see this as a good sign, they need to be reminded that an increasing share is not the objective but the byproduct of a desired structural evolution as the economy matures.

Yukon Huang is a senior associate at the Carnegie Endowment for International Peace and a former country director for the World Bank in China.