Rebalancing and Growth: The Arithmetic of Chinese Adjustment

IMGXYZ3220IMGZYXIt is widely acknowledged that China must transform its growth model toward one more reliant on domestic consumption, and policy makers are warning that growth rates will slow sharply in the coming years to perhaps six to eight percent. Michael Pettis discussed China's process of adjustment and evaluated different estimates for growth as the country rebalances.  Carnegie’s Douglas Paal moderated.

Trade Surplus and Investment

Pettis explained the role that investment and the trade surplus play in China’s economy.

• GDP: The Chinese trade surplus represents the largest share of global GDP. 
   
• Connections: Low household consumption, recognized as a problem in many circles in Beijing, requires investment and the trade surplus to be high in order to maintain a balanced economy. 
   
• Investment problems: Investment rates in China are the highest ever, but Pettis argued that Chinese investments have been misallocated for a decade, leading to value destruction rather than value creation. Useful investment increases wealth and consumption rises, leading to a rebalanced economy. However, Pettis warned, if investments are not economically viable, this can lead to cascading problems.

Debt Creation

Financing through banking has caused an increase in debt creation in China that is widely acknowledged as rising at an unsustainable pace, Pettis explained. 

• Debt servicing costs: In addition to concerns about how to pay off increasing debt, Beijing must also worry about how to pay off debt servicing costs, Pettis said.
   
• GDP: Chinese GDP numbers are overstated, Pettis warned. As many Chinese investments are not economically viable, debt increase rates are not 6-7 percent but rather closer to 10-11 percent. 
   
• Options: Countries, unlike corporations, have various options for servicing and paying off debt, Pettis said. For example, privatization pulls from the private sector; alternatively, a country can pull from the housing sector.
   
• A hidden tax: Beijing has long used financial repression as an economic tool, which forces a decline in the deposit rate and results in a drain on household consumption, Pettis explained. China’s deposit rate is very low and most demand deposits earn 0 percent. Inflation is also very high, particularly food inflation, which disproportionately affects the poor, who spend a greater portion of their income on food. Pettis explained that with low interest rates and high food inflation, China’s citizens are basically suffering from a huge hidden tax. 

Household Consumption in China

Pettis argued that household consumption numbers in China are extraordinary. 

• Global norm: Globally, household consumption is about 65 percent of income, with about 35 percent going to investment, Pettis said.
   
• Regional norm: A number of countries in the region, known by economists as the Asian Miracle Countries, follow the Japanese model and use financial repression to keep interest rates low. Their consumption levels are around 55 percent, which is considered to be the lower limit of sustainable consumption levels. 
   
• China’s dropping consumption rates: In the 1980s, China’s consumption rate was comparable to the Asian Miracle Countries. However, by the next decade, China’s consumption level reached 46 percent of GDP by 2000. Beijing has recognized this as problem, Pettis said, but financial repression is fundamental to China’s growth model.
   
• Current consumption: In 2009, China’s consumption rate was down to 35 percent, and projections for consumption in 2010 and 2011 are believed to be even lower, Pettis said. 
   
• Confronting the problem: Pettis argued that Beijing would be hard pressed to increase household consumption to 50 percent of GDP, because increases in consumption in the previous period in Asia grew with increased consumption in the United States and peripheral Europe. 
   
• Returning to previous levels: Returning China to its 2000 consumption rate of 46 percent will be difficult, Pettis acknowledged, but could happen if consumption growth is greater than GDP growth. Currently, however, China has 6-8 percent consumption growth and 10-11 percent GDP growth.

GDP Growth Projections Tied to Consumption Growth Projections

Predictions about China’s future GDP growth vary widely, Pettis said. The general consensus among economists is that Chinese growth will continue at about 6-8 percent. 

• Lower GDP growth: Pettis argued that China’s GDP will grow at 3-4 percent, half of that predicted by other economists. To achieve 4 percent GDP growth, he explained, there has to be a 7.2 percent increase in consumption, which seems unlikely given historical levels of consumption.
   
• Consumption and higher GDP growth: A 6 percent GDP growth rate would require 9.3 percent consumption growth and an 8 percent GDP growth rate would need 12.1 percent consumption growth, Pettis added. A 10 percent GDP growth would need as high as 13.4 percent consumption growth.

Conclusion: Abandon the Growth Model

Pettis argued that if China wants higher GDP growth, it needs high consumption levels. To achieve that, he said, China must abandon its growth model, which relies on financial repression. However, debt problems and misallocation of investment make such a change difficult. Pettis noted that all growth miracles end in debt crises and that right now there is a surge in non-performing loans in China, which leads to downward pressure on consumption and only worsens the debt problem.