No matter how sincere its intentions, what Beijing says it will do over the next few years is meaningful only if its policies are both internally consistent and do not violate external constraints. In this article I will try to lay out as logically as possible the economic options available to Beijing, with some discussion of their limitations. Any decision made by Beijing that is not consistent with these options is not worth taking seriously as a prediction of the future.
To try to work out what these options might be I begin with two key assumptions. The first is that the fundamental imbalance in China is the very low GDP share of consumption. This low GDP share of consumption, I have always argued, reflects a growth model that systematically forces up the savings rate largely by repressing consumption, which it does by effectively transferring wealth from the household sector (in the form, among others, of very low interest rates, an undervalued currency, and relatively slow wage growth) in order to subsidise and generate rapid GDP growth.
As a consequence of this consumption-repressing growth model, Chinese growth is driven largely by the need to keep investment levels extraordinarily high. What’s more, the very high growth rate in investment, combined with significant pricing distortions, especially in the cost of capital, has resulted in massive overinvestment and an unsustainable increase in debt. China cannot slow the growth in debt and resolve its internal economic problems without raising the consumption share of GDP.
My second major assumption is that China must and will rebalance in the coming years – its imbalances, in other words, cannot get much greater and we will soon see a reversal. There are two reasons for saying this, neither of which has to do with the claims being made by Beijing that they are indeed determined to rebalance the economy.
The first reason is the debt dynamics. Every country that has followed a consumption-repressing investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led either to a debt crisis or to a "lost decade” of very low growth.
At some point the debt burden itself poses a limit to the continuation of the growth model and forces rebalancing towards a higher consumption share of GDP. How? When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. When this happens China will automatically rebalance, but it will rebalance through a collapse in GDP growth, which might even go negative, resulting in a rising share of consumption only because consumption does not drop as quickly as GDP.
Before any journalist reading this decides to write an article with the headline "Peking University Professor Predicts China Collapse,” I must stress that I am not saying that a collapse in growth must happen, or even that it is likely to happen. My argument here is only that if the unsustainable rise in debt isn’t addressed and reversed, China must eventually reach its debt capacity limit, and this will force a catastrophic rebalancing. One way or the other, in other words, debt will force China to rebalance.
The second reason for assuming that China will rebalance is because of external constraints. Globally, savings and investment must balance. This means that for any set of countries whose savings exceed investment, like China, there must be countries whose investment exceeds savings, like the US.
This adjustment won’t be easy, especially if Japan, as I argued two weeks ago, is attempting to resolve its excess debt problems by forcing up its savings rate. One way or the other, however, it must happen, either with a surge in consumption in the underconsuming countries or with a fall in production – both of which accomplish the same thing, albeit in very different ways. In fact, everyone from Premier Wen and Vice Premier Li on down has insisted that Beijing’s consumption imbalance has reached danger levels, and that China must and will rebalance.
Where some analysts might disagree with my second assumption is in the issue of timing. China bulls continue to argue that there isn’t yet a significant overinvestment problem in China, which implies that debt is not rising at an unsustainable pace, or if it is, that it can continue rising for many more years before the debt burden itself becomes unsustainable. This, for example, is the view of the folks at Dragonomics, and it is a view often expressed sympathetically in The Economist.
Five options for Beijing
As I see it, however, the rebalancing transfer can take place in one or more of five ways:
1. Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, the foreign exchange value of the currency, and wages, or by lowering income and consumption taxes.
2. Beijing can quickly reverse the transfers in the same way.
3. Beijing can directly transfer wealth from the state sector to the private sector by privatising assets and using the proceeds directly or indirectly to boost household wealth.
4. Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt.
5. Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
All of these options effectively have China doing the same thing: In each case the state share of GDP is reduced and the household share is increased. There are however very big differences in how the changes are distributed among various parts of the household sector and the state sector.
Notice also that the changing share of GDP tells us little or nothing about the actual GDP growth rate, or about the growth rate either of household wealth or of state wealth. It just tells us something very important about the relative growth rates. For example we can posit a case in which GDP grows by 9 per cent annually while household income grows by 12-13 per cent annually. In that case the rest of the economy would grow by roughly 5-6 per cent annually (household income is approximately half of GDP), and the distribution of this growth would be shared between the state sector and the business sector. This might be considered the "good case” scenario of rebalancing.
Alternatively, we can posit that annual GDP growth is 0 per cent. In that case the annual growth in household income might be 3-4 per cent while the state and business sectors contract at roughly 3-4 per cent. This would be the "bad case” scenario.
The political economy of rebalancing
It is worth making three points about these different scenarios. First, in both cases China rebalances, but the way in which it rebalances can have very different growth implications. Second, notice that even in the bad case, household income growth can be quite robust, which means that fears of social instability as Chinese growth slows are very exaggerated if a slowdown in Chinese growth occurs with real rebalancing.
But – and this is the third point – that’s not all. The real cost of the rebalancing, it turns out, falls on the state sector, and we will have to keep this in mind as we consider the choices that Beijing must make.
Even a scenario of very high GDP growth must result in much slower growth in the value of state sector income and assets. Of course if GDP growth actually slows sharply, which I expect it will, the growth in the value of state sector assets will collapse and perhaps even turn negative.
In my opinion this change in the growth rate of the state sector will be at the heart of the political economy choices, and difficulties, that Beijing will be forced to address in the next few years. It is likely to be much easier to keep political leaders happy when the value of the state sector is growing comfortably in the double-digit range than it is when it is growing in low single digits, or even contracting.
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.