Night view of clusters of high-rise buildings in Shanghai, China, 13 December 2013. AAP
Although rising debt increases the probability of a hard landing, for now I expect neither outcome. More likely, I believe, is a ‘long landing’, during which growth rates will drop by roughly one to two percentage points every year for the rest of this decade. Implementing reforms will protect China from a hard landing. It will, however, force much lower (albeit healthier) growth rates.
In order to understand China’s growth prospects, we must recognise that while a growth model can deliver healthy growth for many years, this growth can itself transform conditions to the point where the model is no longer able to deliver. At that point, the economy must adjust to a new, more appropriate growth model.
The Chinese growth model is a version – in probably its most extreme form – of the investment-led growth model described by Alexander Gerschenkron 50 years ago. To simplify tremendously, growth in ‘backward’ economies is supported by policies that subsidise investment while suppressing consumption (usually by constraining household income growth). These ‘backward’ economies are ones in which the level of capital stock is much lower than the country’s social and institutional ability to absorb investment efficiently.
Early on, many years of high investment allowed China to catch up. Once it did, however, continuing to invest in the same way and to the same degree was no longer wealth-enhancing. At this point the economy needed institutional and social reforms to continue growing. The political logic of the system, however, forced – as it almost always does – continued high investment growth and increasing investment misallocation.
Debt began to rise faster than debt servicing capacity. This, clearly, was unsustainable, but of course it can go on for many years. It was as long ago as 2007 that former Premier Wen described the Chinese economy as “unsteady, unbalanced, uncoordinated and unsustainable”, but it proved politically very difficult for Beijing to implement the reforms his advisors suggested, and so the distortions associated with the growth model continued.
Debt surged even as the consumption imbalance deteriorated until late 2011. We have only seen in 2012-13 the beginning of any partial rebalancing, although during this time there has been at best only a deceleration in the growth rate of credit.
And yet the minimal amount of rebalancing that has occurred in the past three years has already lopped three percentage points off China’s GDP growth rate. China still has a long way to go to rebalance its economy. By my calculations, consumption growth must outpace GDP growth by 3-4 percentage points every year for at least a decade just to allow China to raise the household consumption share of GDP to a still-low 50 percent.
The proposed reforms will certainly unleash greater productivity, but they will also eliminate the very mechanisms that had previously turbo-charged economic activity and which showed up in the form of higher reported GDP growth rates. They will cause a sharp deceleration in economic activity, even though growth will be more productive than in the past. The fact that growth rates have dropped by almost a third even before the reforms were implemented suggests to me just how much further they must drop.
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.