China's rebalancing is not what it seems

China’s shift from investment and exports to consumption is underway, but it's happening much slower than what the official figures suggest.

“New normal” is the hottest buzzword in China to describe the country’s economic development. Long gone are the days when China was able to grow at double digits on the back of investment and exports. Instead, the economy is humming along at a much slower pace of around about 7 per cent.

In a world where sluggish growth is still the norm, 7 per cent is still enviable. To put that into perspective, the new additional Chinese GDP created in 2013 was equivalent to the entire Chinese economy in 1994.

While analysts and commentators are still obsessed with the speed of China’s growth, a bigger underlying and potentially more significant trend taking place is the structural change in the economy.  For decades, China has pursued a mercantilist model that prizes production over consumption.

This has led to a relatively depressed consumption in the world’s second largest economy. But this is changing under China’s “new normal”.  Chinese President Xi Jinping told a gathering of APEC business leaders that consumption contributed to 48.5 per cent of economic growth in China during the first three quarters, exceeding investment.

In addition, the country’s services sector also overtook industrial sector to become the country’s most important engine of growth, representing 46.7 per cent of the country’s economic growth. Both high tech and capital goods manufacturing grew at 12.3 per cent and 11.1 per cent respectively during the first three quarters of 2014.

So these figures do seem to suggest that China’s re-balancing is finally taking place after years of empty talks.  During my recent trip to China, anecdotal observations do seem to support Beijing’s claim of strong consumer confidence. Many restaurants are packed even during the daytime, tourists are everywhere with airlines usually at full capacity and e-commerce is transforming people’s lives whether it’s with shopping to catching taxis.

However, Ryan Rutkowski, a researcher from the Peterson Institute for International Economics, a think tank in the US, casts doubts on these nominal Chinese figures. Rutkowski agrees that China’s rebalancing is directionally positive but he believes it’s happening slower than what the official figures suggest.

So let’s start with the services sector’s contribution to China’s GDP. Official figures tell us consumption accounts for 49.8 per cent of the economy last year. Rutkowski argues China’s figures look a lot less impressive when one takes into account inflation and deflation into account.

The services sector’s seemingly strong contribution to GDP is largely due to divergent price movements in the services and industrial sectors.  China’s industrial sector has been in deflation for the last two years. Prices for industrial goods have plummeted.  One of China’s most powerful steel tycoons has said the margin on a tonne of crude steel is less than that of a simple stir-fry dish.

For example, prices for Chinese industrial goods fell 1.4 per cent in the first half of 2014 compared with the same period last year. On the other hand, the prices for the services economy increased 3.3 per cent.  So in fact, the price increases in services and agriculture are saving China from deflation, a sustained reduction in the general level of prices, a problem that is arguably worse than inflation.

So once we take into account of inflation and deflation, the services share of GDP only increased 0.4 per cent between 2010 and 2013. That’s far less than the 2.9 per cent increase indicated by the nominal figures. On the other hand, the industrial sector’s share of GDP grew 0.6 per cent during the same period. But the official figures tell us the sector shrank by 2.8 per cent in nominal terms.

So once we strip out the effect of prices movement, the real picture is that the services sector is still smaller than the industrial sector. For example, when we adjusted these figures for inflation and deflation, the services sector only accounted for 43.7 per cent of the GDP compared with industrial sector’s 46.1 per cent.

As far as consumption is concerned, plummeting industrial prices have much less of an impact.  Once we adjust prices, consumption still contributed to 49.4 per cent of GDP in 2013, a touch smaller than the official figure of 49.8 per cent. However, fixed capital formation increased rather than declined  

The bad news is that China’s internal rebalancing is taking place slower than what official figures seem to suggest.  But the good news is the overall direction is encouraging -- especially on the consumption front.

As Rutkoswki argues “ If China is successful in pursuing additional structural reform such as demonopolization of the service sector and deregulation of interest rates, this should provide further impetus for real growth in services and ensure that services will eventually exceed secondary industry to become the largest real contributor to value added output.”