There has been a lot of excited press commentary recently about China’s overtaking Japan as the world’s second largest economy. China’s GDP should be larger than Japan’s for the first time sometime this year, which in a similar context in 1987 the Italians called “il sorpasso”. For all the excited search for the deeper meaning of this event, however, I would argue that if we examine the change in relative position from the point of view of not just what happened to Chinese GDP in the past twenty years, but also what happened to Japanese GDP, there may be less cause for celebration than we might think.
Before getting into that, it’s worth noting an article that came out in Friday’s South China Morning Post. According to the article:
The head of China’s official carmakers’ association said full-year car sales will surpass 15 million units this year, a conservative forecast signalling a potential dramatic downturn in the coming months.
China Association of Automobile Manufacturers (CAAM) secretary general Dong Yang’s projection implies car sales in the world’s biggest car market will grow at least 10 per cent by volume this year. This is down sharply from 48 per cent growth in the first six months and last year’s 45 per cent rate.
More significantly, it signals a potential contraction of as much as 20 per cent in the second half of the year when compared with the strong, stimulus-fuelled sales volumes in the latter part of 2009.
Why does this matter? Because after growing 48% in the first half of 2010, and 45% last year, the sharp contraction in car sales in the second half of 2010 should intensify the debate over Chinese consumption growth.
As I have discussed before, in order to rebalance the economy China must sharply raise the consumption share of GDP. It has declined from 46% of GDP in 2000, which was already a very low number, although not quite unprecedented, to 41% in 2003, which is, I believe, an unprecedented number, at least for any large economy.
But that wasn’t the end of the story. Consumption declined further as a share of GDP to an astonishing 38% in 2006, finally to end under 36% in 2009. I don’t think we have ever seen anything close to this level before.
Policymakers are very aware of how urgent it is to reverse this decline, especially – rumor has it, and not surprisingly – the generation of leaders who will take control in 2012. Li Keqiang, widely believed to be the anointed premier after 2012, recently made just this point, according to an article Thursday in Bloomberg:
China’s past development has created an “irrational economic structure” and “uncoordinated and unsustainable development is increasingly apparent,” said Vice Premier Li Keqiang in a June article in the government-owned Qiu Shi magazine. Long-term dependence on investment and exports for growth “will grow the instability of the economy,” he said.
In order to reduce China’s excessive dependence on export surpluses and investment, it is vitally important that household consumption, which in China represents probably the lowest share of GDP ever recorded, rise significantly. To that end Beijing has implemented a number of policies aimed at boosting Chinese consumption. Are these policies working?
On the positive side, automobile sales surged last year. For most analysts, this was immensely good news and they argued that this increased demand signaled a major shift in the consuming and saving behavior of Chinese households.
Is consumption really rising?
But skeptics like me disagreed. We claimed that the surge in demand for automobiles was caused mainly by government subsidies, and that these were not sustainable. The same thing happened, by the way, to durable goods, which were also subsidized and which also saw a surge in retail sales. More importantly, we argued, any current increase in automobiles sales and durable goods would be reversed in the future as households absorbed the cost of the subsidies.
Remember that subsidies are not manna from heaven. They must be paid for, and ultimately it is the household sector that pays for them, usually in the form of higher taxes but sometimes, and certainly in the case of China, in the form of financial repression. The government, in other words, borrows from the household sector (via the banks) at artificially low interest rates, which implies continual government debt forgiveness paid for by the household sector. Either way, whether it is through taxes or debt forgiveness, as households pay for today’s subsidies out of tomorrow’s income, consumption will rise today and decline tomorrow.
Perhaps I am simply betraying my prejudices, but the recent news on automobile sales suggests that skeptics may have been right. If the growth in automobile and other consumption is indeed substantially weaker in the following months, as evidence seems to suggest, it should become increasingly clear that low consumption in China is not a discrete problem that can be resolved with administrative measures.
It suggests instead that the consumption problem is fundamental to China’s economic growth model and therefore cannot be resolved without a major change in the model. The same Bloomberg article, which quoted a number of skeptics, including me, on the ability of China to raise consumption levels, also included some objections from analysts who thought China would indeed see surging consumption. One true believer was much more confident than I am. According to the article:
Some economists argue that surging retail-sales figures and rising wages show China’s shift to greater consumer spending is on track. Dariusz Kowalczyk at Credit Agricole CIB in Hong Kong estimates consumption will account for 47 percent of GDP within 10 years.
I have seen lots of other people make similar claims about consumption at some point in the future being a much higher share of GDP, but I wonder on what basis these claims are made. Anyway whenever I see these numbers I am tempted to do the math. The latest official revisions have consumption representing 35.6% of GDP in 2009, so if consumption really does grow to 47% of GDP in ten years, we can easily calculate the average growth rate of consumption for any expected GDP growth rate.
The table below shows the necessary relationship between GDP growth and consumption growth that will get us to 47% in ten years:
|Avg GDP growth||Avg consumption growth|
OK, OK, ignore the spurious accuracy. There really was no need to go to two decimal places, but this kind of thing impresses people and anyway modern computing abilities make it very tempting to imply impossible levels of accuracy whenever you do the numbers.
But just look at what the table is implying. In order to get to 47% of GDP in ten years, consumption needs to do something it has never been able to do – grow faster than GDP by a huge margin – something like three full percentage points – every year for the next ten years.
The roots of lagging consumption growth
I don’t know what Mr. Kowalczyk’s GDP growth projections are for China, but it seems to me that the only way we can rebalance to anywhere near that extent is the way Japan did it: with a very sharp drop in GDP growth that is matched by a much slower drop in consumption growth. If China continues growing at 7-9% for the next decade, which is what many analysts seem to be projecting (very unlikely, I say), consumption must grow much faster than it ever has in post-reform Chinese history, even while China’s GDP grows more slowly than it ever has during that period.
It’s arithmetically possible, of course, but there are two schools of thought about how to do it. One school argues that relatively low consumption growth has to do with factors that can be changed without changing the fundamental growth model – perhaps demographics, or Confucian culture, or tax incentives, or lack of TV advertising, or the sex imbalance, or the lack of a social safety net, etc.
If they are right, then presumably Beijing can administratively address those issues while separately keeping GDP growth rates high. But if that’s what it takes, and since they have been determined since 2005-06 to drive up the consumption share of GDP, and during that time it has plummeted, you sort of wonder why they just don’t get on with it.
The other much smaller school (but growing rapidly, I think) argues that low consumption is a fundamental feature of the growth model because of the hidden taxes that channel household income into subsidizing growth. Growth is high, in other words, because consumption is low. This group has been arguing for the past five years that all the measures Beijing has taken to ensure more rapid consumption growth will fail because they do not address the underlying cause.
I guess we will just have to wait and see who is right, but I am confident enough to say that unless GDP growth plummets to below 5% annually on average, and probably even then, there is no way consumption will represent 47% of GDP in ten years. I say this with one caveat – if Beijing were to engineer a huge shift of state wealth to the household sector, say in a massive privatization program, it could boost household consumption significantly, but I suspect that this will be politically difficult to do.
So if Beijing really wants to increase consumption as a share of GDP, what must it do? The key, as I imply with my privatization comment above, is household income and wealth. Contrary to conventional thinking, the Chinese have no aversion to consuming. They are eager consumers, as even the most cursory visit to a Chinese shopping mall will indicate.
So why do they consume such a low share of national GDP – perhaps the lowest share ever recorded? The answer has to do with the level of household income as a share of GDP, also one of the lowest ever recorded.
Chinese households are happy to consume, but they own such a small share of total national income that their consumption is necessarily also a small share of national income. And just as the household share of national income has declined dramatically in the past decade, so has household consumption. This isn’t to say households are getting poorer. On the contrary, they are getting richer, but they are getting richer at a much slower speed than the country overall, which means their share of total income is declining.
The cost of over-investment
The point, then, is that if we want to increase the consumption share, we shouldn’t waste time and money trying to create additional incentives for consumption, to tinker with subsidies and taxes, to advertise more, or to change cultural habits. What is needed is a substantial increase in the share of national income that households take home. Give them more money, and they will spend it.
So how can their share rise? Here, the problem gets very difficult. The Chinese development model is mostly a souped-up version of the Asian development model, and shares fundamental features with Brazil during the “miracle” years of the 1960s and 1970. While it can generate tremendous growth early on, it also leads inexorably to deep imbalances.
At the heart of the model are subsidies for manufacturing and investment paid for by households. In some cases, as with Brazil in the 1960s and 1970s, the household costs are explicit – Brazil taxed household income heavily and invested the proceeds in manufacturing and infrastructure. The Asian variety relies on less explicit mechanisms to accomplish the same purpose. It channels wealth away from the household sector and uses it to subsidize growth by restraining wages, undervaluing the currency, and keeping the cost of capital extremely low.
This model, which some also refer to as the Japanese model, and which many countries have followed before China, has been extraordinarily successful in generating eye-popping rates of growth, but it always eventually runs into the same constraints: massive overinvestment and misallocated capital. And in every case I can think of it has been very difficult to change the growth model because too much of the economy depends on hidden subsidies to survive.
Unfortunately the longer we wait to make the transition, the more difficult the transition will be because the more debt there will be (and so, with more debt, the need to keep interest rates artificially low) and the more dependent growth will be on the subsidies. Ironically, since China is about to overtake Japan this year, Japan itself provides the most worrying example. It kept boosting investment to generate high growth well into the early 1990s, long after the true economic value of its investment had turned negative.
But for a long time the problem of misallocated investment, which was whispered about in Japan but not taken too seriously, didn’t seem to matter. After all, as nearly everyone knew, Japan’s leaders were extremely smart, with a deep knowledge of the very special circumstances that made Japan different from other countries and not subject to “western” economic laws, with real control over the economy, with a strong grasp of history and penchant for long-term thinking, and most of all with a clear understanding of what was needed to fix Japan’s problems.
And look what a great job they had already done: by the early 1990s Japan had generated so much investment-driven growth that it had grown from 7% of global GDP in 1970 to 10% in 1980, and then surged to nearly 18% at its peak in the early 1990s. In about twenty years Japan’s share of global GDP was two-and-a-half times its initial share. That is an extraordinary growth story and one that can only be explained as a function of a new kind of economic thinking, right?
But less than twenty years later, after a terribly long struggle to adjust to high debt levels and massive overinvestment, Japan is about to be overtaken by China with only 8% of global GDP. Japan, in other words, has given back in less than two decades almost the entire GDP share it had taken in the two astonishing decades that preceded it (while during the same period the US has maintained its share). What’s worse, it is hard to pick up a newspaper today and read about Japanese policymakers without getting the idea that they are a totally dysfunctional, narrowly ambitious, and not especially savvy lot, much like their US and European peers. As Mortimer Snerd used to say, who woulda thunk it?
So before we get too excited about China’s overtaking Japan, we should remember that this has as much to do with Japan’s astonishing decline as with China’s astonishing rise, and that there is at least some small chance that the policies responsible both for Japan’s breakneck rise and equally breakneck decline may be being replicated in China.
The sooner China begins the difficult transition, the less costly it will be, but in no circumstance is it likely to be easy. They key will be to get consumption to grow quickly relative to GDP, and China might simply not have the time to do it by reversing the household subsidies. I suspect that the only “easy” solution (economically, not politically) will be a massive transfer of wealth from the public sector to households, via, perhaps, privatization.
The latest economic data
Before finishing this already long entry I should mention two recent pieces of trade-related news and one piece of monetary news released this week. First, China’s July trade surplus was $28.7 billion. This is the kind of number we haven’t seen seen the halcyon days of world-record monthly trade surpluses. Here is what an article in yesterday’s People’s Daily says:
China’s exports rose 38.1 percent year on year to 145.52 billion U.S. dollars in July, but the growth rate was down from a 43.9-percent surge in June, the General Administration of Customs (GAC) said Tuesday. Imports increased 22.7 percent from a year earlier to 116.79 billion U.S. dollars. The pace of growth was slower than June’s 34.1-percent increase.
The Financial Times report was characteristically blunter:
China’s trade surplus jumped in July to its highest level in 18 months, raising new questions about whether the country’s currency remains undervalued despite government efforts to introduce a more flexible exchange rate. The trade surplus for July increased to $28.7bn, well ahead of the $20bn recorded the month before and significantly above analyst forecasts, according to data released on Tuesday.
The pace of increase in exports actually fell last month to 38.1 per cent, year-on-year, down from 43.9 per cent in June. However, import growth slowed even more, moving up 22.7 per cent against 34.1 per cent in June.
What does this suggest? Two things, to my mind. First, to return to my broken-record imitation, it is still meaningless to talk about a rebalancing of the Chinese economy away from exports and investment. It simply hasn’t happened yet – not even a little. Second, and speaking of mythical birds (my “halcyon” comment above, for those not keeping track) this is more evidence that consumption growth is anemic.
The second trade-related news has to do with Japan. Here is the Tuesday Financial Times article:
At first glance, the earnings results and forecasts delivered by Japanese companies over the past two weeks should have been great news for investors. Big names from Toyota to Sony outperformed in the quarter to June, and one in six listed groups raised its guidance. Yet Japanese stock prices have barely rebounded from their July lows – the Nikkei remains 15 per cent below its high for the year, set in April – and the mood among shareholders, policymakers and many executives is gloomy.
To see why, all it takes is a quick look at the yen. After surging during the financial crisis, the Japanese currency is on the rise again, trading close to last November’s 14-year high against the dollar of Y84.80.
…The yen’s strength compounded companies’ woes during the recent recession by making their exports less competitive just as foreign demand was shrinking rapidly.
The PBoC seems to be increasing its purchases of the yen, and that is causing the yen to rise. It is also causing very unwelcome weakness in the Japanese economy. Whenever people argue that the US wants and needs net Chinese investment in USG bonds, you should ask how that can possibly make sense when every country seems to be doing all it can to repel foreign capital inflows (or to increase their own net capital outflows, as in the case of China, Japan and Germany). The idea that the US or any other country “needs” foreign financing is total nonsense. Nearly every country in the world is trying to export capital and import demand. The world has no urgent need of capital. It needs consumption.
Away from trade, today the NBS released inflation statistics. CPI rose to 3.3% from 2.9% last month, and PPI declined from 4.8% from 6.4% (see thePeople’s Daily article). Other statistics released today suggest that the economy is slowing down further. Most China analysts seem to believe that the slowing is under control and that there won’t be a shift in policy soon. According to an article in today’s Financial Times, for example:
Most economists argue that China is witnessing a controlled slowing from the potential overheating of earlier in the year, rather than a new slump. “The key data point to a moderate slowdown rather than a sharp downturn,” said Brian Jackson at Royal Bank of Canada.
I am not so sure. My sense is that senior officials are already alarmed at the speed of the slowdown and we may be on the verge of panicking and switching policy back in the other direction. One piece of news that might contradict me is the rumor that the CBRC is demanding that banks put back on their balance sheets by the end of the year some of the stuff they tried to move off balance sheet in an attempt to evade loan quotas. Here is whatBloomberg says:
China’s banking regulator ordered banks to transfer off-balance-sheet loans onto their books and make provisions for those that may default, three people with knowledge of the situation said. The assets linked to wealth management products provided by trust companies must be shifted onto banks’ balance sheets by the end of 2011, the people said, declining to be identified as the matter isn’t public. Lenders should prepare provisions equal to 150 percent of potential losses, they said.
The CBRC is widely believed to be in favor of slowing growth and rebalancing, the economy — or at least that is effectively what it means to worry about deteriorating bank balance sheets. But will Beijing reverse course soon? The higher CPI inflation number complicates things, although perhaps this will be partially mitigated by the lower PPI inflation numbers. Higher CPI may prompt the PBoC to raise borrowing rates, but don’t overvalue what that might mean. Real interest rates have been declining, and the likelihood of even more wasted capital consequently rising. At this point an interest hike is not really contractionary. It simply reverses or reduces the expansionary impact of declining real interest rates.
My guess is that in spite of higher CPI, which is believed to be temporary, a lot of policymakers are very worried by the pace of the slowdown, and Beijing will loosen very soon. This probably won’t come about as a major change in announced policy so much as by stealth. They’ll simply stop putting pressure on the banks, and this will allow the combination of greed, cheap capital, and socialized credit risk to work its magic on loan growth.