China’s economic slowdown and proposals that growth needs to be more consumption driven have revived concerns about its policy options. The nearly universal view is that China’s growth is unbalanced and at risk. Household consumption as a share of GDP has declined to below 35%—the lowest of any major economy—while its investment share has risen to nearly 50%. Even former Premier Wen Jiabao falls in this camp with his oft-quoted statement that “China’s economy is unbalanced, uncoordinated and unsustainable.” Many respected scholars attribute this imbalance to financial repression or an undervalued exchange rate. And they argue that if China wants to escape the “middle-income trap,” it needs to rebalance its economy.
The problem with this argument is that it overlooks the primary reason why growth has been unbalanced: the impact of a generally successful urbanization and industrialization process. Over the past decade and a half, this caused household income to fall as a share of GDP and personal savings rates to soar. Together, these two factors largely explain the decline in household consumption as a share of GDP. In fact, unbalanced growth is often the by-product of a successful development path. Only a handful of developing economies, largely in East Asia, have succeeded in escaping the middle-income trap over the past half century—notably Japan, South Korea, Taiwan and Singapore. All of them experienced a rapid decline in their consumption share of GDP and an increase in their investment share during their high-growth periods. China’s recent growth trajectory is broadly similar.
Balanced, but still trapped
The “middle-income trap”—into which Chinese policy makers are so scared of falling—refers to the observation that many countries, particularly in Latin America, failed to boost per-capita incomes beyond the US$10,000-15,000 range in PPP-adjusted terms. They became stuck at this middle-income level when they could not shift to a growth process driven by increasing productivity. Yet the growth path of these “trapped” major Latin American economies is “balanced,” with shares of consumption and investment roughly constant over time—along with relatively lackluster growth. This same balanced approach can be seen in lagging East Asian performers like the Philippines and Indonesia.
Imbalances characterize a successful urbanization and industrialization process that promotes higher-value activities. This transformation was laid out in Arthur Lewis’ Nobel Prize-winning model that showed how the transfer of surplus workers from the rural sector to the modern economy, complemented by rising investment and a supportive trade and incentive regime, results in rapid development. The model also lays out the conditions when growth slows and becomes more balanced. Popularly referred to as the “Lewis turning point,” it is currently a topic of much speculation among Chinese academics.
This structural shift explains China’s unbalanced growth trajectory. Disposable income—the main determinant of consumption—sharply over the past decade or so as a share of GDP, triggering a decline in the share of consumption. But the reasons for this decline have been misunderstood and are generally benign. Decomposing this decline by region reveals a startling and counter-intuitive spatial pattern: China’s far west experienced a dramatic decline of about 40 percentage points in the share of household income to GDP during this period, while the central, east and northeast regions underwent a more gradual decline over several decades. The sharp decline in the west explains most of the overall decline for the country as a whole, even though this region accounts for less than 20% of GDP.
What is the cause of this regionally differentiated pattern? Financial repression or exchange rates cannot be the reason, since the pricing regime is similar nationwide. Instead, the explanation lies in the shift in China’s economy from a predominantly rural economy to a more urbanbased industrial and services economy. China’s urbanization ratio is now over 50%, compared with 20% three decades ago. As millions of workers moved from smallholder agriculture (where labor’s share of the value of production is around 90%) to industry or services (where it is closer to 50%), the net effect was to push down labor’s share of GDP. But this decline is hardly negative: migrant workers earn multiples more than they used to, firms are able to expand through increased labor absorption and rising profits, and the country benefits from higher productivity and double-digit growth rates.
Invest first, consume later
This transition from an agrarian to an urban-based economy explains most of the downward trend in the share of disposable income, and in turn consumption, across the country. But what explains the timing of the sharp decline in the western region beginning in the late 1990s? This turning point reflects both the rural backwardness of that region relative to the rest of the country and the impact of Beijing’s massive “Go West” development initiative, launched in 2000 to invest in infrastructure and income-generating activities. The result was a large shift of workers from more traditional activities into industry and services with much higher earnings potential.
China’s unbalanced growth pattern mirrors other successful emerging East Asian economies that went through a similar structural transition, although there are significant differences in magnitudes. Over several decades, the consumption share of GDP fell steadily by 20-30 percentage points of GDP, bottoming out at around 50% in Japan in 1970, Taiwan in 1986 and South Korea in 1988, at roughly similar PPP-adjusted per-capita income levels. The movement of the consumption share is mirrored by a sustained increase in the investment share of GDP in all three economies, peaking around 40%. The common thread linking all these successful East Asian countries is that widening imbalances are associated with sustained high growth rates that propelled these economies from middle- to high-income status, and eventually more balanced outcomes as their economies matured.
Why is China so Unbalanced?
China is not the only East Asian country to have an “unbalanced” economy: South Korea, Japan and Taiwan all follow a similar pattern. Yet China’s economy is the most lopsided, with the share of total consumption in GDP a full 15 percentage points lower and the share of investment 10 percentage points higher than any other country at their respective peaks and troughs. Why is China’s economy more unbalanced than those of other countries?
1) Global financial conditions. China invested more over the past few decades than South Korea, Japan and Taiwan did in the 1970s and 80s, because interest rates were lower and capital more abundant.
2) Historical circumstances. China began its structural transformation with a much lower share of consumption and higher share of investment than its East Asian counterparts. In part this was because the socialist state had provided a much larger share of consumption and enterprises often recorded expenditures as investment. In addition, China entered its reform era with lower levels of capital stock, which made more investment essential.
3) Statistical discrepancies. China’s national accounting system does not fully capture household consumption of tourism, online shopping, financial and social services, and especially housing. Morgan Stanley estimates that consumption is underestimated by more than 10 percentage points of GDP (although GK Dragonomics reckon it is closer to 3-4%). Moreover, the share of services relative to GDP has been growing less steeply than the share of the labor force employed in services, which suggests other statistical discrepancies. In both 1995 and 2005, national accountants revised the services contribution to GDP upward, and they may revise it up again after the 2013 national economic census. This would show growth more similar to the experience in other emerging Asian economies.
The process typically involves a prolonged investment push that draws workers out of lower productivity activities. In East Asia, the emphasis is on outward-oriented growth that takes advantage of rapidly increasing exports and typically strengthens the trade balance. Real export growth averaged 15% or more in Japan and Singapore during their takeoff periods, while Taiwan’s real export growth was over 20% and South Korea’s reached almost 35%. Externally oriented industrialization promotes the development of specialized manufacturing clusters and helps drive the relocation of workers from rural to urban areas. The shift of people slowed when the urbanization ratio reached 70% in the late 1980s for South Korea and Taiwan, or 75% in the early 1970s for Japan, indicating that the turning point for these economies coincided with the leveling off of a rapid urbanization process.
The experience of Taiwan, South Korea and Japan suggests that rapid urbanization is linked to services development. As people and activities concentrate in urban areas and real wages increase, demand for high-value services rises. While the growth of industrial output to GDP levels off, the services sector becomes increasingly important. In Taiwan’s case, a deliberate policy to shift manufacturing to the mainland and liberalize entry of lower-cost foreign workers generated rapid growth of both high-value and low-end personal services through 2000.
Household income and consumption shares begin to turn around as urbanization levels off, wages rise, consumption spending increases, and workers move into skilled services jobs. This virtuous circle completes the rebalancing process and eventually reorients the maturing economy toward domestic demand. This process needs to be supported by an incentive regime and fiscal and monetary policies to generate the resources needed to finance rising investment levels. Successful countries are those which make sensible investment decisions, while those that fail end up with a growing pool of underemployed urban workers often living in slums.
Urbanization—still a long way to go
From 1960-90, growth of real consumption expenditures in “balanced” economies like the Philippines, Mexico and Brazil ranged from 4.1-5.3%. Conversely, real consumption growth over the same period averaged 7.2% in South Korea and 9.0% in Taiwan. While their consumption share was declining, in other words, real consumption growth far and away outperformed the more “balanced” economies. Actual consumption expenditures in China have been increasing steadily by over 8% a year, led by rapid real wage growth. Thus the premise that more balanced growth means faster growth in consumption is simply not true.
China’s impressive growth rates for consumption could have been even higher, had its household registration policies not retarded the speed of urbanization and ensured the discriminatory treatment of migrant workers. At around 52%, China’s urbanization rate is below expectations for its level of development, indicating that large numbers of workers are still trapped in lower-productivity activities. Services’ share of output is also low—and the experience of successful East Asia countries suggests that repressed urbanization may be partly to blame.
Distortive migration policies and residency requirements have impeded the completion of China’s structural transition. Liberalizing residency requirements and allowing farmers to sell their land-use rights and move to the city would raise the urbanization rate. Because migrant workers are not able to access social services in cities where they work, they are forced to save a much higher proportion of their income than urban hukou holders. This factor, not low interest rates, largely explains why urban savings rates have been increasing over the past decade and rural savings rates have remained broadly unchanged. If migrant workers actually consumed at the same rate as established residents, China’s consumption share might be 2-3 percentage points higher as a share of GDP.
Current conditions suggest that imbalances in China may not reverse until 2020, when the urbanization process, particularly its impact on services, is more advanced. Services officially make up around 43% of GDP, but revisions to the national accounts may put it closer to the levels of South Korea, Japan and Taiwan at their turning points. Yet urbanization has yet to catch up. While South Korea, Japan and Taiwan had urbanization ratios closer to 70% at their turning points, China’s rate is more likely to be slightly more than 60% by 2020, given its larger size and economic circumstances.
Waiting for 2020
Many China observers are watching to see if China is already rebalancing. If growth slows substantially, this may happen—but it would not necessarily be a good sign. If Premier Li Keqiang’s new urbanization initiative succeeds and the economy is able to grow at a sustainable rate of around 7.5% for the remainder of this decade, the “turning point” may in fact be delayed because of the productivity benefits. China’s PPP-adjusted per-capita GDP of US$8,400 is behind that of Japan (US$14,100), South Korea (US$10,800) and Taiwan (US$10,600) when their respective consumption shares of GDP stopped falling. Assuming a 7-7.5% growth rate, China will reach the same per-capita income level as South Korea, Taiwan and Japan at their turning points sometime towards the end of this decade.
Taiwan is often cited as a model for transition from a heavy investment dependent system to a more consumption-driven growth model. Rising incomes and economic reforms in the 1980s and 90s successfully encouraged private-sector growth, reduced the role of state monopolies, introduced more competition into sectors like banking, and encouraged growth in services. Some have also suggested that political liberalization helped drive the consumer takeoff. Yet China’s transition may look more like South Korea’s than Taiwan’s. Instead of moving industry abroad, South Korea focused on moving up the value chain by creating hightech, globally competitive industries. China will also attempt to retain a large share of higher value manufacturing capability and will likely experience a more modest decline in its investment share of GDP when it eventually rebalances.
China’s unbalanced growth pattern has drawn so much negative attention in part because its economy is so much bigger than South Korea’s or Taiwan’s. Its huge trade surpluses seven years ago were generally seen as contributing to global imbalances, even if the root causes lay with the large fiscal deficits in the West. But with its trade surplus having fallen from 8% to around 2% of GDP, this is now less of an issue. More important for markets these days is whether China can sustain growth in the 7-8% range and create enough demand to benefit the world economy. The general premise is that China needs to encourage more consumption, but whether demand comes from investment or consumption should be less of a concern.
More important is the type of investment, since the 2009 stimulus induced distortions that pushed investment rates above sustainable financing levels and into wrong areas. Some decline in investment levels is needed, but the key is that new investment favors social and environmental needs supported by a more equitable and efficient urbanization process. This is more important than trying to stimulate consumption per se. A demand-driven urbanization strategy would rely less on converting rural land for urban development and more on encouraging concentration of activity and people in existing urban areas. This would facilitate continued growth in China’s megacities, which will be the source of future productivity increases.
Don't confuse the means with the end
Some analysts stress the need for Beijing to accept substantially lower growth to achieve rebalancing. But this view confuses means and end: the key challenge for China is implementing structural reforms that will allow it to escape the middle-income trap. Whether the share of consumption or investment to GDP is too low or too high is not the issue. At this juncture, policy makers need to make two broad reforms. First, curtail the misuse of resources by reducing incentives for local authorities to rely on land sales and property development for generating revenue. Second, reform the hukou system, which discourages migrant workers from consuming at the same rates as established residents.
Far from a threat to China’s stable development, macro imbalances are better seen as evidence of a successful structural transition that has lifted the country out of poverty. If China pursues the necessary structural reforms needed for a more efficient urbanization process, then rebalancing will eventually occur as a by-product of a sustainable growth path.
This article was originally published in the China Economic Quarterly.