Source: Financial Times

Even as Beijing announces the latest “mini-stimulus”, it should be clear that Chinese economic growth is far from having bottomed out. Over the next few years, the world’s second-biggest economy will slow to well below current expectations of 6-7 per cent. While most analysts believe that slower growth in gross domestic product must unleash social unrest, they may be focusing on the wrong numbers.

Simple logic shows that it is nearly impossible for China’s GDP to grow at current rates while rebalancing away from its dangerous over-reliance on exports and debt-fuelled investment. Consider what it means for China to rebalance. Household consumption, at an astonishingly low 35 per cent of GDP, is just over half the global average.

Attempts to engineer a rebalancing that lifts consumption over the next 10 years to, say, 50 per cent – which will still leave it with the lowest consumption share of any large economy in the world – would require consumption growth to exceed GDP growth by close to 4 percentage points every year. So an average annual GDP growth rate of 6 or 7 per cent requires average growth in consumption of nearly 10-11 per cent for a decade for China to rebalance meaningfully.

China was not able to achieve such high consumption growth rates even in the best of times, when it and the world were growing much more briskly, and it will prove near impossible for China to manage such high consumption growth under much weaker Chinese and global conditions.

The consumption rate is low mainly as a consequence of policies that systematically transferred resources from the household sector to subsidise rapid growth. This forced down the household income share of GDP which, at about 50 per cent, is among the lowest ever recorded in the world. There is no sustainable way to boost household consumption without boosting household income.

This suggests that consumption growth of 10-11 per cent requires similar growth in household income. In principle China could have this by paying workers much higher wages and sharply raising the deposit rates paid by banks. But since low wages and cheap capital are at the heart of China’s growth model, raising wages and deposit rates enough to rebalance the economy would cause growth to collapse. Only a continued, and ultimately self-defeating, surge in debt can get household income to grow quickly enough to accommodate both high GDP growth rates and a rebalancing economy.

This is why GDP growth rates must drop further. But after many years of annual GDP growth above 10 per cent, it would seem that a sharp drop in GDP growth rates to below 6-7 per cent would clash with the rising expectations of ordinary Chinese. Won’t slower growth lead to social unrest and perhaps political chaos? Not necessarily.

For China successfully to rebalance towards a healthier and more sustainable model without unrest, the growth rate that really matters, as a number of prominent Chinese economists have already noted, is that of median household income. Ordinary Chinese, like people everywhere, do not care about their per capita share of GDP. They care about their income.

In recent decades real disposable income has grown at well above 7 per cent a year on average. To ensure social stability, it should continue growing at this rate or close to it. But growth in household income and household consumption of about 6-7 per cent implies that, if China is to rebalance meaningfully, GDP must grow by “only” 3-4 per cent. This much lower rate is consistent, among other things, with almost zero investment growth.

China’s GDP, in other words, does not need to grow at 7 per cent or even 6 per cent a year in order to maintain social stability. This is a myth that should be discarded. What matters for social stability is that ordinary Chinese continue to improve their lives at the rate to which they are accustomed, and that the Chinese economy is restructured in a way that allows it to tackle its credit bubble.

If household income can grow annually at 6-7 per cent, income will double in 10 to 12 years, in line with the target proposed by Premier Li Keqiang in March during the National People’s Congress. What is more, if China can do this while the economy is weaned off its addiction to credit, it will be an extraordinary achievement, even if it implies, as it must, that GDP grows far more slowly that the growth rates to which we have become accustomed.

It will not be easy. A reduction in investment and GDP growth will almost certainly put pressure on employment and household income growth unless it is counterbalanced by a significant transfer of resources from the state sector to the household sector. This will be strongly opposed by members of the political elite who have benefited from the strong state sector, but it is not clear that China has many alternatives. The arithmetic of rebalancing does not otherwise work.

This piece originally appeared in the Financial Times.