China can't grow out of its problems

Debates about GDP growth models, rebalancing and the like often miss the point of what economics – particularly in developing countries – is all about. This is especially true when it comes to China.

Take the debate about economic rebalancing in China, concerning whether China can move away from reliance on fixed investment, and put more emphasis on domestic consumption to generate growth. There are those like Michael Pettis who believe that rebalancing can only be achieved if there is a slowdown in economic growth since fixed investment will have to fall rapidly. There are others, such as former Ambassador to China Geoff Raby, who argue that a slowdown is not needed for rebalancing to occur and that China’s debt problems are anyhow exaggerated (Who’s afraid of China’s big bad rebalancing?January 31).

This article is not about which side of the debate is the more persuasive – although even a superficial perusal of my previous articles will quickly reveal that I am much more aligned with Pettis than Raby. This piece is more about why increasing domestic consumption in China matters, not only from an economic perspective but also in a social and even moral sense.

Let’s begin with the British philosopher, political-economist and parliamentarian John Stuart Mill, who once described the study of ‘political-economy’ as "the sources and conditions of wealth and material prosperity for aggregate bodies of human beings."

Compare Mill’s statement with the obsession about GDP growth which currently dominates commentary on China and misses much of why economic growth really matters. GDP calculation is merely an accountant’s device for annual expenditure and production. To wit, building a road, destroying it straight afterwards, and then rebuilding it again all contributes to the GDP figure. By itself, GDP figures say little about the impact of economic activity on the lives of people – the ‘sources and conditions of wealth and material prosperity for human beings.’ In other words, economic growth is socially and morally valued primarily because if it offers lifestyle improvements for the vast majority of the population, not because it is a double digit number.

Let’s focus on China.

The interest in ‘economic rebalancing’ arises because many economists believe that China invests too much, and consumes too little. The obvious question is how much investment is too much and how much consumption is too little.

Many economists will compare Chinese investment and consumption rates with other countries to make their point. For example, Chinese fixed investment has been hovering at above 50 per cent of GDP. This compares to highs of around 30-32 per cent in countries such as Taiwan, South Korea and Japan when these economies were rapidly developing. Similarly, Chinese domestic consumption as a proportion of GDP is around 32 per cent, which compares with around 70 per cent for America and 60 per cent for Japan.

In light of these figures, Chinese levels of fixed investment and domestic consumption are the highest and lowest respectively of any major economy in modern economic history. To be sure, such comparisons are striking. But they nevertheless fail to get at the heart of why these extraordinary Chinese numbers are worrisome for the Chinese people and therefore the Chinese Communist Party.

Unfortunately, economics has evolved into a complicated social science. In reality, it ought to be far more straightforward. Reduce the Chinese economy down to a small town of one hundred people, 80 of whom are still considered poor and 20 of whom are considered middle-class (with a few of these in the rich category.) Let’s call the town Lilliput.

The following is a statistically accurate depiction of those in the bottom 80 per cent of the Chinese economy.

Assume that the 80 poor people save around 25 per cent of their net income, with the rest of their income spent on essential needs such as food, clothing, and basic housing. Assume also that pretty much all of the 25 per cent of net income saved is deposited into a bank that is owned by the Lilliputian Council, since there is no other bank in town. In return for the deposits, the bank pays these savers a very low rate of interest – in fact, a rate that is lower than inflation. In other words, the value of savings actually decline over time.

Assume also that the 20 richest people in Lilliput control or else manage the two largest businesses, while the 80 poorest people own or work for the other 20 businesses in town. Further assume that the sole bank lends over 80 per cent of its loans to the two largest businesses at preferential interest rates, and reserves at most 10 per cent for the other 20 businesses.

These two large businesses – flushed with capital – build all manner of things: roads, ports, airports, railways… Many of the completed projects are barely used by Lilliputians. Indeed, about half of the projects offer zero or negative return on investment.

Even so, they continue to receive more and more capital, in order to repay previous loans that they otherwise would default on, or else to build more and more things. Recently, these two big businesses have even moved into building luxury apartments and dwellings, even though the 20 richest people already have their own well-appointed houses to live in. True, 40 of the bottom 80 poorest Lilliputians still live in the rural parts of town. But only one person is migrating to the urban region each year. Besides, there is no way that the 80 poorest Lilliputians – rural or urban – could ever afford to buy one of these luxury apartments. Subsequently, many of these luxury apartments are purchased by the 20 richest Lilliputians on speculation even if many of them remain empty and will for decades.

All the while, the economy of Lilliput is roaring along, with GDP expanding at 8-10 per cent each year. Fixed investment – fuelled by perfect savings capture – is growing at over 20 per cent each year. For outsiders supplying raw materials to the two large Lilliputian businesses, these figures make for good reading.

Now consider the perspective of the poorest 80 Lilliputians. Poor as they already are, the meagre returns on their savings are effectively being used to subsidise the investment activity of the two large businesses, much of it wasted and unproductive.

Denied access to cheap capital, and with their smaller businesses prevented from operating in the most lucrative sectors in Lilliput despite many being far more efficient than the two biggest businesses, the majority have been locked out of the best opportunities that the Lilliputian economy might otherwise offer. Most will never enjoy sufficient increases in their disposable incomes to dramatically increase their consumption of basic goods and services. Outside the top 20 richest town folk whose ilk increase by perhaps one person each year, consumption of luxury goods is certainly out of the question. Lilliput is not a system that efficiently enhances "the sources and conditions of wealth and material prosperity for aggregate bodies of human beings."

Lilliput is obviously an extremely simplistic and perhaps stylised representation of the Chinese political-economy. But it is not entirely inaccurate in terms of pointing out how state-owned-enterprises (and the CCP) entrench their interests within the system – at the expense of the majority of the country’s citizens. One clear consequence of the denial of opportunity to the majority is the rising estimate of China’s Gini-coefficient (where zero is perfect equality and one is perfect inequality.) Officially at 0.47, most independent researchers place it at around 0.55 – worrying for a country with a GDP per capita that is ten times less than America’s and with still around 400 million people living on less than $US2 per day. As a comparison, Japan’s, India’s and Indonesia’s are approximately 0.38, and America’s is approximately 0.45. To offer a historical comparison, the Gini-coefficients of South Korea and Taiwan from the 1960s to the 1990s hovered around 0.34 and 0.29 respectively, even as the economies of these countries were growing rapidly.

A final note on the social and moral need for rebalancing…

To say that China invests too much is really just saying that the wrong entities are getting too much of the country’s wealth too cheaply, and using capital in a way that is too wasteful, and building too many things that are unneeded. Put differently, China is pouring far too much of its national wealth into economic activity that does not enhance the material lifestyles of the vast majority of citizens.

Similarly, to say that China consumes too little is really just saying that too few people are sharing in the fruits of economic growth, and that the savings of the many are largely funding the wasteful investment of the few. The additional problem is that the more uncertain the future outlook for the majority of its citizens, they more they will save.

Rebalancing is therefore not just about finding the right number according to an economic or historical model. As China’s existing and next generation leaders now openly concede, the country and the CCP can no longer simply grow its way out of its problems.

Dr John Lee is the Michael Hintze Fellow and adjunct associate professor at the Centre for International Security Studies, Sydney University. He is also a non-resident senior scholar at the Hudson Institute in Washington DC and a director of the Kokoda Foundation in Canberra.