The recently completed U.S.-China Strategic and Economic Dialogue in Beijing underscored the prominence that each side has given to promoting consumption as a solution to China's economic slowdown.
As highlighted in a June 7 fact sheet released by the U.S. Department of the Treasury, a major dialogue theme dealt with "advancing policies to shift China's growth model to one driven by household consumption rather than by investment and exports."
Chinese policymakers at various times have given support to this objective. As far back as 2007, then-Premier Wen Jiabao expressed a related viewpoint in what's been an oft-quoted statement. He said at a March meeting of the National People's Congress that "China's economy is unstable, unbalanced, uncoordinated and unsustainable."
In using the word "unbalanced," Wen was referring to the fact that China's consumption as a share of gross domestic product was the lowest of any major economy, and that its investment share was the highest.
Yet this line of reasoning was and still is flawed. And the implied policy implications have been either misleading or wrong.
The basic principles of growth theory tell us that consumption does not drive growth but is the result of growth. Despite having the lowest share of consumption to GDP, consumption has not been repressed in China, despite what many believe. In fact, consumption has been increasing at a globally unmatched 10 percent annually for a decade – more than in any other major economy – and is likely to moderate, rather than increase, as GDP growth continues to decline in coming years. Please note this pair of charts:
China's Consumption Paradox
How does one explain that the steady decline in consumption share over more than a decade was followed by a leveling off and then slight rebound in recent years? Many analysts attributed these imbalances to low interest rates, supported by an undervalued currency. These factors were seen as repressing consumption and encouraging excess investment.
But the argument promoted by these analysts is flawed. The primary reason for these imbalances is not financial repression but a broadly successful urbanization-cum-industrialization process. This process has led to a fall in household income as a share of GDP and a rising savings rate, which together explain the steady and sharp decline in consumption as a share of GDP over the past decade and half.
During this period, some 150 to 200 million workers have shifted from jobs in rural areas to urban industrial employment. Because industry is more capital intensive than agriculture, labor's share of added value is much higher for rural economic activities than it is for the industrial sector. Thus, this rural-to-urban transfer of labor has led to a lower share of labor's income to GDP and, in turn, to consumption's lower share of GDP.
There's nothing wrong with this process, since migrant factory worker incomes are much higher than farmer earnings. And industrial firm investments have surged along with their profits.
As a result, China has enjoyed double-digit growth rates over the course of several decades. This explains why the share of consumption to GDP has fallen even while consumption per capita or per household has been increasing with rapid growth.
But why has the consumption share leveled off and even risen in recent years? One explanation is that the pace of urbanization has slowed, so the shift toward more capital-intensive activities has become less significant.
At the same time, more workers have been moving into services and away from manufacturing. Because service jobs are more labor intensive, labor's share of income (and consumption) has been higher relative to GDP.
But the consumption paradox works both ways: The increasing share of consumption is a byproduct of the growth slowdown, and slowing growth has affected household consumption levels.
In conclusion, it's illogical to promote a more consumption-driven growth process as a means to increase GDP growth. The result of such an effort will be the opposite.
The simplest and most powerful means by which China can make its growth process more efficient and more consumption-oriented would involve granting full, local residency rights to workers employed outside their home communities. Studies have shown that migrant workers without such rights save a much higher percentage of their incomes than households with full residency rights. Giving all migrants full residency rights would increase both consumption and investment, reflected by increased migrant demand for services and housing. This would lead to more rapid growth and raise consumption's share of GDP.
A real problem, though, is that investment's productivity in China has fallen significantly since the 2008 global financial crisis. Promoting more consumption will not resolve this problem.
Declining returns on investment are inevitable in a maturing economy. But China's decline has been too steep. Priority should be given to improving returns on investment.
The reforms that are now needed have been highlighted in debates over government policy. Proposals include strengthening state-owned enterprise performance, making the urbanization process more efficient, as discussed above, and curbing the kinds of wasteful investments that to date have been largely concentrated in China's interior and western regions.