I have been arguing for several years that once China begins the adjustment process, which I expect to characterize the ten-year period of the current administration, growth rates must slow significantly. My expectation for long-term growth is that it shouldn’t average much above 3-4 per cent annually. This is what it will take for household consumption to rise to roughly 50 per cent of GDP in a decade if consumption growth can be maintained at its historic rates of around 8 per cent.
But I always warn that this is likely to be an upper limit, not a lower limit, to growth. The key is whether or not it is possible to maintain current levels of consumption growth once investment growth is sharply reduced. A recent paper by the IMF on the topic is very interesting and not encouraging.
In the paper (“China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency”) Il Houng Lee, Murtaza Syed, and Liu Xueyan team up again to examine the impact of investment in different regions and sectors of the economy. The abstract of the paper is:
“This paper proposes a possible framework for identifying excessive investment. Based on this method, it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. By contrast, private consumption has become more self-sustaining in coastal provinces, in large part because investment here tends to benefit household incomes more than corporates.
“If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing increasing constraints due to dwindling land, labor, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles. Thus, investment should not be indiscriminately directed toward urbanization or industrialization of Western regions but shifted toward sectors with greater and more lasting spillovers to household income and consumption. In this context, investment in agriculture and services is found to be superior to that in manufacturing and real estate. Financial reform would facilitate such a reorientation, helping China to enhance capital efficiency and keep growth buoyant even as aggregate investment is lowered to sustainable levels.”
Among the interesting findings of the paper, one is not (to me) at all unexpected. The authors find that investment is much less efficient in the poorer inland provinces than in the richer coastal provinces. This shouldn’t be a surprise. The inland provinces have much lower levels of worker productivity and lower social capital. This means that they should be much less capable of absorbing high levels of capital than the coastal regions.
But this argument – so logical, at least to me – flies in the face of the single most widely-used argument that China bulls have made in favor of additional investment. They argue that because capital stock per capita is much lower in China than in the US, the automatic conclusion is that China has a near-infinite ability usefully to expand investment – at least until it begins to approach the frontier of US levels. If this argument is true, investment should be much more productive in the inland provinces than in the coastal provinces because the inland provinces have much lower capital stock per capita than the coastal provinces and so are further from the “frontier”.
But it isn’t, according to the IMF paper. It is even more wasteful. Richer, more productive economies with higher levels of social capital (which include property rights, a clear legal framework, education, minimal regulatory distortions, minimal government intervention, limited corruption, etc.), in other words, are better able to absorb investment than poorer less productive economies. The appropriate level of investment for a country that is much poorer than the US is much lower than the appropriate level in the US. China does not have infinite ability to expand investment productively, and in fact, I would argue, has long ago passed the point where investment in the aggregate is wealth creating.
And this applies within China. It simply isn’t true that the poorer the province, the more investment should be poured into the province. The poorer inland provinces simply are incapable of absorbing investment, and before the authorities pour money into these regions they will need to make the difficult legal and social reforms that improve underlying productivity and social capital. Until then, additional investment is even more likely to result in negative wealth creation in the inland provinces than in the coastal areas.
The other very interesting finding of the IMF paper is that – surprise! surprise! – consumption growth is itself dependent on investment growth, and this is more true in the inland provinces than in the coastal provinces. The more money you pour into investments, no matter how unnecessary, the more local households consume. This shouldn’t have been unexpected because local household income is so dependent on consumption, especially in regions in which government-led infrastructure spending is the only real source of economic activity – such as the poor inland provinces.
The conclusion, I think, is that it is going to be very hard for China to maintain the current level of consumption growth if investment stops growing, and if consumption can only create 4.2 percentage points of GDP growth at current levels, why would we assume China’s long-term growth rate is much above that unless we assume that China can keep investment levels growing for a long time? Another conclusion of the IMF paper – very useful from a policy point of view – is that certain kinds of investment, in agriculture and services, for example, have a much more positive effect on consumption than others (it is probably not a coincidence that these are likely to be the least wasteful investment areas). In that case it suggests that the brunt of the adjustment in investment growth should not occur in the agricultural and service sectors.
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, where a longer version of this article first appeared.