This article is the first in a two-part series. The second half can be found here.
As analysts and official entities like the World Bank continue to downgrade their forecasts for medium-term growth in China, I have been asked increasingly often for the reasons why I believe that 3-4 per cent average annual growth rates are likely to be the upper limit for China during the adjustment period. In this article, I want to explain how I arrived at my numbers. The analysis is fairly straightforward.
Before beginning, I should make two points. First, for many years I assumed that the “adjustment” period would begin shortly after the beginning of the administration of President Xi Jinping and Premier Li Keqiang, that is, from 2013 or 2014, and would run through the presumed end of their term in 2023.
In fact, I may have been overly pessimistic. It now seems to me that China actually began adjusting economically (although in a very limited way) in 2012, when we first started to see growth slow as Beijing became increasingly worried about the astonishing increase in debt. This probably occurred because the big wage increases in 2010-11, which were counterbalanced by the sharp drop in real interest rates during that period, were finally able to take effect in 2012 when real interest rates rose sharply once again. Of course, whether the adjustment begins in 2012, 2013, or 2014 probably doesn’t matter much to the analysis, but it is good news, I think, that it may have started earlier than I originally expected.
There is, by the way, nothing especially important about ten years, except that it is a round number. If China adjusts much more aggressively than I expect, the adjustment period could easily occur within less than ten years, although this is unlikely to be the case because it will be politically difficult to pull off.
On the other hand, if the adjustment period is much longer than ten years, perhaps because the relationship between investment growth and consumption growth is highly positive or because political opposition is fiercer than expected, growth rates might be a little higher on average in the first few years. However, the period of stagnant growth would last longer than ten years and there would be a much higher risk of an economic collapse.
As for the second point, I don’t really think of my numbers as being growth predictions. More generally I do not like to make predictions, and frankly have no idea of how to go about doing so, especially if it is likely to involve the complex econometric models.
What I prefer to do, and find more useful at least for my way of thinking, is to try develop an understanding of the overall system under clearly specified (I hope) assumptions, and then work through the logic of the system to see what the various outcomes can be. I am not trying to predict what will happen, but simply to list the various scenarios that are consistent with the model and to state explicitly what are the assumptions needed for those scenarios to occur. If the assumptions are plausible, then so is the scenario. If not, then they are not.
As I see it, 3-4 per cent is what it takes for my arithmetic to work within plausible scenarios. It is, in other words, the upper limit of the average growth rate that allows me to work out arithmetically the growth in debt, consumption, investment and GDP needed for the amount of economic adjustment that will rebalance the economy by the minimal acceptable amount, without making some fairly implausible assumptions.
This means that depending on how aggressive Beijing is during the reform process, China’s actual growth might be higher if Beijing engineers a much more aggressive program than I think plausible of transferring resources from the state sector to the household sector, thereby forcing up the household income and household consumption shares of GDP. It will be lower if there are more adverse shocks to trade or the financial sector, or if political opposition to the reforms is fiercer than expected. I really think of 3-4 per cent average annual growth as the plausible upper limit of GDP growth, assuming no massive privatisation program.
Let me state my assumptions. As everyone recognises, rebalancing in China requires that consumption grow significantly as a share of GDP over the next decade or more. China currently reports household consumption as representing about 35 per cent of GDP, which is an almost surreally low number. By how much would consumption have to rise for meaningful rebalancing to have occurred?
Before answering, how meaningful is this 35 per cent number? A number of analysts have regularly argued that the official data seriously understates both income and consumption in China, and so China’s real household consumption is much higher. This may well be true, but I think there are at least three counterarguments. First, while it is true that some consumption is not included in the official data, at the same time there is quite a lot in there that should not count as consumption, or at least not for the purposes of understanding the rebalancing process.
For example, three of the fastest growing consumption categories year after year are gold and jewellery, household furnishings, and household appliances. I would argue that all of these should really count as investment, and certainly the latter two will drop dramatically as investment, especially in real estate, drops (and the former will probably drop as the financial repression tax is eliminated). As a rule, any item of consumption the demand for which is highly correlated to investment should be treated as investment for our purposes, not consumption.
So when analysts point out that a lot of consumption is paid for by businesses on behalf of employees, and so does not show up as consumption in the data, they are right. But they are also largely irrelevant. The consumption we care about is consumption unrelated to investment, because it is this consumption that must rise as investment drops.
Second, if both consumption and income are understated (as they may well be) this does not necessarily mean that the consumption share of GDP is more than 35 per cent. This would only be the case if the ratio of hidden consumption to hidden income is greater than 35 per cent.
If most of the hidden consumption and income belong to the rich or very rich, as is commonly assumed, it may well be that the true ratio is lower(not higher) than 35 per cent. Many analysts are muddled about the differences between absolute consumption levels and the consumption ratio, and so they believe that if they can show that consumption is higher than claimed by the National Bureau of Statistics, the imbalance is less of a problem. It isn’t. What matters is the consumption share of all that is produced, and if both GDP and total consumption are higher than the official numbers, China’s imbalance is not necessarily better. It may even be worse, and it is the imbalance that matters to China’s growth prospects.
Finally, we are not talking about small imbalances here. The reported consumption share of GDP is astonishingly low, perhaps the lowest ever recorded, and so the error in the data would have to be enormous for it to matter to the rebalancing debate. Even if it turns out that 20 per cent of Chinese consumption, and none of its income, were hidden and unrecorded in the NBS data, China would still easily have the lowest consumption rate of any major economy in the world.
What is the right level of consumption and investment?
Globally, consumption represents a fairly stable 65 per cent of GDP. Over the past decade, this average has encompassed a group of high-consuming countries, such as the United States and peripheral Europe, whose average consumption exceeded 70 per cent of GDP, as well as a group of low-consuming countries, mainly in Asia, whose average consumption (excluding China) ranged from 50 per cent to 58 per cent of GDP.
This distribution of over- and under-consumption should change in the next few years. It is unlikely that the high-consuming countries will be able to maintain their excessive levels of consumption for the rest of this decade, and indeed their consumption rates have already come down substantially, with more probably to come.
Peripheral Europe is in crisis, and the United States is taking steps to raise its savings rate so as to reduce its current account deficit. Japan, although already a relatively low-consuming country, is also likely to try to increase its savings rate so that its massive debt can be funded by patient domestic savers, rather than by impatient foreigners.
This means the rest of the low-consuming countries are also unlikely to be able to keep their consumption levels as low as they have in the past. A world with low-consuming countries requires high-consuming countries in order to balance.
If global consumption drops in the high consuming countries, with no corresponding rise in the low-consuming countries, it is unlikely that investment will rise quickly enough to replace it (why invest if no one is going to buy the output?), and so the global economy must respond with enough of a contraction in GDP to maintain consumption at roughly 65 per cent.
The great consumption and savings imbalances of the past that led to the current crisis, in other words, have to adjust. This means that if there are no longer large economies consuming 70 per cent of more of their national income, the world is unlikely to be able easily to accommodate large economies consuming just 50–58 per cent of their national incomes.
Let us assume nonetheless that the world can accommodate a minimal amount of Chinese rebalancing. Within a decade Chinese household consumption, according to this assumption, will rise to no more than 50 per cent of GDP, as difficult as it will be for the world to accept such low consumption from its second-largest economy. This will mean that China still produces far more than it absorbs — especially if investment growth were to come down sharply — and it would mean that the rest of the world would be forced to absorb excess Chinese production without resorting to trade intervention.
For the sake of completion, let us make a second assumption that, because the world is unable to accommodate such a low consumption level for the world’s second largest economy, global pressure forces an even more dramatic change in Chinese household consumption so that it rises to 55 per cent of GDP (instead of 50 per cent as in our first assumption) in ten years. Both of these assumptions can be modelled in a way that combines consumption and GDP growth to arrive at the desired outcomes, and I will ignore the possibility that if the world forces China to raise its consumption rate to 55 per cent in ten years, this will probably happen through negative growth and trade disputes, thus making all my numbers overly optimistic.
So much for our assumptions about the consumption rate; the second set of assumptions involves investment. Currently, China has the highest investment share of GDP in the world, with investment comprising 46 per cent of GDP or more, depending on how it is calculated. A 2012 IMF paper shows investment as high as 49 per cent of GDP, and it calculates excess investment (i.e. the spread between actual investment levels and the level predicted by an historical model, which began growing around the year 2000) as being 5-10 percentage points.
What is the appropriate level for a country like China? A number of studies have examined other high-investment developing countries during their growth miracle stages, and for most of these countries, investment peaked out briefly at 35-40 per cent of GDP. In Malaysia, Thailand and Singapore, investment did at one point exceed 40 per cent, but in each case only for a very brief period. In emerging markets, investment is typically around 30 per cent of GDP.
How should China compare to these countries? Some analysts argue that China, a very poor country, suffers from a capital stock that is too low, and so the optimal investment level should be much higher. This reasoning is based on a fallacy. The optimal amount of investment for any country depends not on how far it is from the capital frontier but rather on its level of social capital. This implies that very poor countries should optimally have lower levels of capital stock per capita than richer countries.
China’s capital stock per capita, for example, is higher than that of Mexico, and much higher than that of Russia and Brazil, three other large developing countries that are substantially richer than China and whose workers are more productive.
When analysts say that China’s capital stock is relatively low, they are completely befuddled. It is low compared to the richest and most productive countries in the world -- as it should be -- but it is high compared to other developing countries and even compared to developing countries with much higher levels of productivity.
Because investment shares in other developing countries peaked out at 35-40 per cent, some analysts argue that this is the appropriate level of investment for China. There are a number of problems with this argument, but two stand out especially.
First, the countries for which investment peaked out at 35-40 per cent of GDP nearly all had subsequent periods of very difficult adjustment, with burgeoning growth in debt and either sharp economic contraction or many years of very slow growth, during which periods the investment share of GDP dropped substantially.
It is not at all clear that, for these countries, 35-40 per cent was the optimal investment share of GDP. This was probably already too much investment because in many (if not most) cases, it was subsequently followed by many years of low or even negative growth, probably as the economy was forced to grind its way through the debt associated with the excess investment. The optimal level, in other words, was probably much closer to 30 per cent.
Second, even if 35-40 per cent was somehow the optimal level for China all along, investment in China has substantially exceeded this level for many years. So it seems obvious that an appropriate adjustment should mean not that investment drops from 46 per cent of GDP to 35-40 per cent, but rather that it drops to something well below 35 per cent for many years before returning to the “optimal” level. This, I think, is just common sense.
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.