Kevin Gentle: China's growth on an unsustainable path

A Guest Post in english By Kevin Gentle - By courtesy of The Institut Hayek of Brussels

Ever since China started opening up to the world in 1978, it has been praised for its achievements. In a mere 30 years, China has gone from a backward agrarian based economy plagued by inefficiency and mismanagement to a global industrial powerhouse flooding the world with its products. In the process, the country has lifted millions out of poverty and now looks to the future with unrestrained optimism.

Nonetheless, as the world looks to China to lead the global recovery, many tend to overlook the flaws and imbalances of the Chinese economy and underestimate the challenges that lie ahead. Following a brute force development model based on subsidized industry and manufacturing is one thing, but evolving into a 21st century knowledge based economy led by a vibrant private sector and a dynamic domestic market will require further efforts and far reaching reforms that will change the very core of the Chinese system.


This essay will argue that while china’s achievements have indeed been remarkable, it does not follow a sustainable growth path and needs to end its reliance on investment and export and develop its domestic consumer market in order to join the club of developed economies. We will also describe how counter crisis measures taken by the Chinese government have exacerbated China’s problems and do not constitute a long-term solution to the economy’s woes.


What's exactly the chinese model ?

Since 2004 china has devoted an average of 40% of its GDP to investment. This figure far exceeds that of South Korea or Taiwan at the height of their investment led development. These investments derive directly from China’s development strategy based on exports and manufacturing. All in all, industrial output accounts for nearly half of china’s GDP and services for a mere 40%. As of today, if we look at the structure of its economy, China looks more like a communist country than a capitalist one. What’s more, the stimulus plan is likely to raise the share of investment to over 50% of GDP in 2009, this accentuating the imbalances the government was trying to correct before the crisis started.

The high level of industrial investment is a direct corollary of China’s export led development. For years, the country has produced far more than it could consume and has acted as the world’s manufacturing base. Such a strategy was made possible by cheap credit, high debt levels and distorted financial markets in the west (especially in the USA). Ever since the 90’s, saving rates in the US have steadily declined until becoming negative before the crisis started in 2008. However, what can’t go on forever won’t.


Such a situation could only be ephemera and led to the current crisis. Thinking that exports will pick up and reach their previous levels is downright foolish. World demand will never play the same role than during the last decade and what is troubling is that China seems to have based its development on an abnormality. In the years to come, western consumers will scale down their debt and governments will be forced to massively slash deficits. Consumption will fall and China cannot count on western consumers to power its development. The fact that industry investment figures are still rising at a greater pace than domestic demand (especially consumer demand) raises questions as to whether China is prepared to change its development model.

Massive trade surpluses

As a result of its export oriented model, China been able to run massive trade surpluses in the last decade. Such surpluses created excess capital, which were reinvested in assets (mainly US treasury bonds) and fuelled the investment frenzy. However, a country’s importance rests on the size of its economy, not on that of its surpluses. Export strategies and trade surpluses did not shield Germany and Japan from the recession. Moreover, running huge surpluses and reinvesting them into foreign assets is a dubious strategy. Massive trade deficits do indeed exert a downward pressure on a country’s currency. As a result, if the Chinese accumulate surpluses and reinvest them into foreign assets, the value of these assets is likely to decline. Experience shows that surplus countries’ net external asset position is always far less than the sum of their surpluses over the years.

Now, as world demand picks up but looks unlikely to reach its previous levels, the spectre of spare capacity looms and domestic demand needs to absorb the extra production. In 2009, extra government demand generated by the stimulus plan has allowed China to avoid a downturn but stimulus measures won’t last forever and they are strong indications that China is experiencing artificial short term growth. In 2009, Chinese authorities have shown impressive determination in their efforts to ramp up internal demand and have, to some extent, been successful. Government measures have stimulated the automobile and household devices markets and retail sales have increased by 15,2% in the 12 months to May 2009. Nonetheless, retail sales include sales to government organization and do not reflect real consumer demand. In reality, consumption by urban households has increase by only 8,1%, less than income. These figures are not alarming but clearly show that China has a long way to go towards stimulating its domestic consumer market.

Wen Jiabao: "Enhance the role of domestic demand"

Premier Wen Jiabao himself has recently stated that “We should make greater efforts to enhance the role of domestic demand, especially consumption“. It is indeed troubling to see that household consumption represents a paltry 35% of GDP while this figure is 67% in India. If it is to join the club of advanced economies, China must go beyond industry and exports and evolve into a service-based economy relying on its domestic market.

These two changes go hand in hand. Indeed, as the Chinese grow richer, they will devote a larger share of their income to services. The shift towards a service economy will allow china the rebalance its system on two fronts. In order to achieve this transformation, China should, among other things, shift its taxation burden, allow RMB strengthening, liberalize labour markets and continue the process of liberalization of financial services. As of today, the burden of taxation is on consumption while many companies pay little taxes and thus over invest in new production capacities. Shifting the taxation burden would allow to increase disposable household income while stemming the investment frenzy.

RMB liberalization would put an end to an implicit export subsidy. Not only would it boost real income, and thus encourage consumption through imports, but it would also force companies to innovate and generate productivity gains to stay competitive, thus departing from the previous labour intensive production model generating low value added and razor thin margins. China’s rigid labour market makes it hard for workers to change jobs and thus keep real wages at a level incompatible with a consumer spending based economy. By putting an end to the Hukou system and making it easier for workers to move around and change jobs (mainly through the elimination of administrative authorizations), the Chinese government would allow real wages and consumer spending to rise. Recent talks by high-ranking officials to eliminate the Hukou system, or at least make it more flexible, are extremely encouraging and it looks like the Chinese government is moving towards greater flexibility in the labour market. Finally, reform of the financial system should encourage more lending to households and less lending to state owned companies. Indeed, real interest rates on loans to state owned companies are kept artificially low which encourages over investment in capital intensive industries and keeps consumer credit and mortgage markets underdeveloped. Here again signs or progress are encouraging and we have seen in the second semester of 2009 a sensible rise in consumer credit.

Stimulus and imbalances

Ever since the Chinese government announced its 4 trillion RMB stimulus plan, it has been praised for throwing the kitchen sink at the problem and injecting much needed confidence into financial markets. The short term results of the plan have indeed been staggering, China is expected to hit a 9 to 10% GDP growth rate in 2009 and people the world over look to China to lead the recovery. Nonetheless, the plan’s structure and ripple effect have aggravated in many ways china’s economy’s imbalances and put a stop the train of reforms.

First of all the plan has mainly benefited state owned enterprises at the expenses of the private sector. We are currently seeing a new wave of nationalization led from the bottom up, fuelled by cheap credit and motivated by local official’s vested interests. Business environment has been soured by signs that the government is not as committed to reforms as was previously though. Such moves delay the emergence of a real private sector and, if not reversed, may hamper China’s future development. Government meddling also means greater focus on industry and makes even more difficult the task of rebalancing the structure of China’s economy.

Then, the government has also addressed the crisis by ordering banks to lend virtually limitless amounts of money to SOEs. Analysts agree that considering the number and size of the loans granted, banks cannot have conducted proper risk analysis and will most likely find themselves with an increasing share of Non Performing Loans in their portfolios.

Massive lending also fuels investment bubbles. The threat is aggravated by the intrinsic volatility of China’s markets (the Shanghai stock market is often nicknames “the great lottery”). Lack of credible information from companies (especially state owned) and the government (many figures often differ whether you look at central government or local government figures) encourages blind speculation and makes many economists fret about the consequences of the investment boom.

Conclusion

In the end, the Chinese economy will, for better or worst, be the driving force of the 2010’s world economy. Its potential is enormous but so are the challenges it faces. As we know, China’s achievements during the last 3 decades have been truly unique and they is no reason to doubt that the Chinese government has the capacity to implement the changes necessary to rebalance the economy. Nonetheless the train of reforms must be put back on track very quickly and deep structural changes cannot wait long before these imbalances translate into more serious issues.

© 2010/09 - Kevin Gentle & Institut Hayek

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More China-nomics on Objectif Liberte (in French - By Vincent Benard)

• Chine : moteur de la reprise ou prochaine bulle ?
  
• Chine, USA, un bulletin économique pessimiste
• Ordos ville fantôme (vidéo)
• Chine, une bulle immobilière d'origine étatique
  

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Comments

[Rédigé par : ST]

Je reviens juste sur le point suivant :

> Such surpluses created excess capital, which
> were reinvested in assets
> (mainly US treasury bonds)

Pour rappel, la chine, si elle est le premier détenteur étranger en volume de bons du trésors américain (juste devant le japon), ne détient pour autant qu'une vingtaine de % de la dette publique américaine détenue par des étrangers, qui ne représente elle même que le quart de la dette publique américaine au total. Soit en fait 5% de la dette publique américaine. Et ce chiffre baisse désormais, en absolu comme en relatif (http://www.ustreas.gov/tic/mfh.txt).

Si l'on compare ce chiffre au déficit de la balance commerciale américaine avec la chine sur les 10 dernières années, on peut estimer qu'un peu moins de la moitié de l'excédent commercial chinois avec les Etats Unis a été converti en bon du trésors (http://www.census.gov/foreign-trade/balance/c5700.html).

Maintenant, un gouvernement comme la France refuse de communiquer sur la répartition par pays de ses créanciers étrangers. Pourtant, en France, la part de la dette publique détenue par des étrangers est bien supérieure à 60% et n'en finit pas de croitre. Quand on sait que le deficit commercial français avec la chine représente la moité de notre déficit commercial global alors que les produits chinois ne représentent que 7.5% de nos importations, on est en droit de se demander quel est le poids de la chine parmi les détenteurs de notre dette publique.