Before the storm
Before the storm
With the prospect of a further recession looming in much of the developed world, China appears to be a safe haven. Clashes over bailouts for debt-ridden economies threaten to unravel the EU; in the US, stock markets swing wildly and unemployment remains near record highs. Economists who foresaw a quick recovery several years ago now warn that any global resurgence is a long way off. Meanwhile, China’s economy continues to grow at a clip of more than 9% annually, which has some commentators openly speculating whether an apparently vigorous China will help shoulder the recovery of the world economy.
But skeptics believe that China’s outward strength conceals internal illness. The country’s economic model, they say, continues to systematically misallocate – and sometimes waste outright – the nation’s wealth. The system leverages ¬China’s high household savings rate to provide cheap capital to local governments and state-owned enterprises, which then invest in assets and infrastructure. As a means to rapidly bootstrap China out of poverty, the strategy worked well, but critics claim it is now time to set it aside: It produces too much debt and too much waste, and it delays the arrival of a more sustainable form of growth in which consumers would play a larger role.
How the country will continue to grow, and by extension how and where it will drive the global economy, hinges largely on its internal policies. Those policies will be tested again in upcoming months as China looks to navigate a minefield of risks: softening markets for its exports, persistent consumer price inflation, overcapacity among manufacturers and froth in its property market.
If past performance indicates future results, the record of China’s economic planners does justify a degree of optimism. Over the past few years, Beijing has maneuvered quickly and effectively to sustain the country’s growth. As stock markets around the world plummeted in late 2008, the government swooped in with a US$586 billion stimulus package that dwarfed most policy responses in the West.
While an unknown amount of this spending was actually rolled over from previous projects, the huge price tag had its intended effect: Banks opened the floodgates to borrowers, and consumer confidence remained high. The plan was arguably better at boosting investment, especially in infrastructure and clean technology, than in spurring consumption, although it also included subsidies for cars and appliances. But then again, building infrastructure to better bind the nation’s interior to its more-developed coastline was unquestionably necessary.
The surge in spending helped to cushion the economic decline both within China and around the world. The Inter-American Development Bank estimates that the stimulus added 2.6 and 0.6 percentage points to China’s GDP growth in 2009 and 2010, respectively. The pick-up in construction and consumption also benefited countries like the US, Australia, Japan and Korea that export the products which China demands: high-value-added products, industrial commodities and agricultural goods.
This outpouring of liquidity had obvious benefits, but it also fueled inflation and sharply increased debt. Total government debt rose from just above 40% in 2008 to more than 50% of GDP in 2009 and 2010, ¬according to official data – which many analysts believe significantly underestimates the real volume of debt in the system.
But both those critics and fans of the 2008 stimulus package agree in one respect: China should not repeat the exercise. Some say another burst of stimulus would send both inflation and non-performing loans to unsustainable levels.
Stephen Roach, a board member of Morgan Stanley Asia who formerly served as the bank’s chief economist, believes a further round of fiscal or monetary stimulus is unlikely, given the continued need to tame inflation. Andy Rothman, China macro strategist at CLSA, says stimulus is unnecessary regardless: China is already insulated against a slowdown in developed markets, partly because it is less dependent on exports than it was three years ago.
“The biggest misconception people have about China is that it’s an export-led economy,” said Rothman. “It’s not. Exports right now are a trivial driver of GDP growth. Disproportionately important to employment, sure – I’m not saying exports don’t matter – but they’re not nearly as important as domestic consumption and domestic investment.”
It’s true that many of the world’s products are assembled in China’s factories, but the total value added to the products is usually just a fraction (often 5% or less) of the finished product price. In 2010, exports fueled just 9% of the country’s GDP growth, compared with 37% for consumption and 54% for investment. Export industries remain an important source of jobs, but that is also changing. In 2008, factory layoffs in China’s export coastal hubs incited riots. In 2011, those same factories are having trouble finding enough workers to run at capacity.
Because exports make up a minor part of the economy, China’s policy response to further weakness in the West is likely to be muted. “Only in the unlikely event that the world tips back into recession, would such [additional stimulus] be given serious consideration,” said Roach of Morgan Stanley. “In the event of a further global slowing, which is expected to stop short of recession, I would expect a more passive response from Chinese policy makers – namely, slowing the rate of renminbi appreciation and limiting any further hikes in policy interest rates.”
But that doesn’t mean Beijing can rest on its laurels. Skeptics argue that the stimulus package was only superficially a success – and that it may have even been counterproductive. By encouraging further investment growth, they say, China’s quick fix has actually exacerbated economic distortions that could encumber future growth.
At the heart of this debate lies a much-publicized initiative that China’s leaders have christened “rebalancing.” Rebalancing refers to a long-term shift in economic growth from a model that relies on investment and lower-end manufacturing toward one that is driven by domestic consumers and service industries.
President Hu Jintao often speaks about making growth more “inclusive,” a catchphrase for more moderate growth that will deliver more benefits to the lower and middle classes. Premier Wen Jiabao, meanwhile, has been an advocate for rebalancing since 2007, when he called the Chinese economy “unstable, unbalanced, uncoordinated and ultimately unsustainable.”
The 12th Five-Year Plan lays out initiatives for rebalancing investment-driven excesses, such as boosting the contribution of the services sector to GDP by four percentage points to 47% by 2015. This is a critical transformation for China’s model. Compared with manufacturing, the services sector typically pollutes less, consumes less resources, pays its workers more, and employs about 25% more people per unit of GDP created. The plan also includes steps to expand welfare services like pensions, healthcare, education and subsidized housing. These programs not only return wealth to lower-income people, but also encourage them to consume by relieving them of the need to save heavily in case of emergency.
Unfortunately, the stimulus package, which prioritized infrastructure, actually tipped China’s economy even further away from consumption – the very opposite of rebalancing. Since 2007, consumption has fallen as a share of GDP, as has labor’s share of GDP compared to that of capital. If regulators slow ¬currency appreciation and limit interest rate hikes to steady the economy in the coming months, as Roach of Morgan Stanley predicts, rebalancing will be further delayed.
So much for Robin Hood
Rebalancing is necessary, critics say, because China’s current economic model channels vast amounts of capital from households to governments and state-owned enterprises – effectively taking from the poor and giving to the rich.
Michael Pettis, a professor of finance at Peking University, argues that three main factors direct this flow of capital: wage levels, the value of the currency and interest rates, all of which have been held at artificially low levels. Until last year, for example, wages were growing more slowly than productivity; good for business, because the cost of labor has dropped, but bad for worker consumption. An undervalued currency, meanwhile, similarly acts a consumption tax, by making the value of goods Chinese people buy relatively expensive compared to the goods they produce.
Finally, suppressed interest rates ensure a steady flow of cheap money to businesses and other borrowers. Banks are now required to maintain a floor of 6.56% on lending rates and a ceiling of 3.5% on deposit rates. The system guarantees them a profit of 3% on their loans, which in turn gives them motivation to lend readily. But this cheap capital comes at the expense of households, who are limited to a nominal return of 3.5% on their saved wages. That’s far lower than the current inflation rate of 6% – meaning that most households are paying interest of 2.5% annually just for the privilege of lending their wealth to the bank.
All these factors mean households consume less. Worse, artificially low interest rates also encourage an unknown amount of bad investments. While interest rates are very low, non-performing loans are not immediately troubling – and inflation effectively drives down the real value of debt. However, the wealth such loans destroy will someday need to be subtracted from GDP numbers.
Pettis explained: “Let’s say I have two investments. In both cases I borrow US$100 and invest them, and in one case I create US$105 of value and in the other one I create US$95 of value. Both of those things will show up the same way in the GDP numbers, but in the first case I’m actually getting richer, and in the second case I’m actually getting poorer.” As soon as capital becomes more expensive, GDP growth will decrease – although by how much, no one knows.
A matter of timing
The implication is clear: Rebalancing must take place at some point, both to avoid a dangerous misallocation of loans and to reward Chinese people for their sacrifices. But economists are fiercely divided over the proper pace of reform. Raising wages, appreciating the renminbi, and hiking interest rates, if handled improperly, could push businesses into default or bankruptcy, causing a disastrous spike in unemployment.
“The risk is, if you adjust too quickly, you adjust via rising unemployment and negative growth, and of course that’s the one thing everyone wants to avoid,” said Pettis of Peking University. Rebalancing too slowly, however, would also be destructive, he said. “Any distortions that exist in the economy are going to keep growing, and the most dangerous distortion is an unsustainable increase in debt.”
In Pettis’ view, it may already be too late: He forecasts that GDP growth may decline as early as 2013 as non-¬performing loans begin to surface, and then slow to the low-single digits by the end of the decade.
More bullish commentators, however, see the system as sustainable, and argue that rebalancing can happen gradually. They expect growth to moderate in the coming years in line with central targets, but think further infrastructure investment and a roaring consumer economy can keep growth in the high single digits for years to come.
“I think the rebalancing part is just going to happen automatically as we go through the next phase in development,” said Rothman of CLSA. “Once infrastructure is largely built out, which is just about where we are now, the growth rate in that spending will slow down, and by default consumption will be a larger share of the economy.”
He disagrees with the idea that the consumer economy is suppressed, pointing out that retail sales are already growing rapidly. “How do you get retail sales to go faster than 17% year-on-year? Do you give out money on the street corner? Do you hand farmers credit cards? … This is already the world’s best consumption story.”
Zhang Jun, a professor of economics at Shanghai’s Fudan University, argued that infrastructure spending can continue to sustain the economy for years to come. The country has embarked on a massive urbanization plan that involves moving another 300 million rural residents to cities by 2025, and the country will need far more capital and infrastructure to accommodate that migration.
That is undoubtedly true, but it’s far from the full story, countered Damien Ma, an analyst at the Eurasia Group. “The point is not that more infrastructure spending is not good, it’s to make sure that each dollar is efficiently allocated, so you get more bang for your buck. The problem is if you’re just spending without concern for adequate returns because it’s easy, cheap money.”
There are points of relative consensus. For one, most agree that China is not nearly as dependent on exports as popular wisdom would suggest, and therefore economic weakness in the West won’t derail China in and of itself. Second, not even the most bullish of the bulls argues that the current growth model is sustainable indefinitely. Some sort of rebalancing must take place.
But the question is when that will happen, and how painful it will be. Regardless of their necessity, substantial changes seem unlikely in the near future. First, by discouraging investment, rebalancing threatens to trigger a sharp decline in growth. China’s economic planners are notoriously cautious, and seem unlikely to disturb domestic demand at a time when exports offer no growth alternative.
Secondly, rebalancing goes against the interest of some powerful factions that have gained wealth and power through the current system, including banks, property developers and manufacturers, as well as the ministries with ties to these industries. These groups are sure to oppose rebalancing, and there is no evidence as yet that Beijing is willing to sacrifice their interests.
“Of course the elites who have made their money over the past years are going to fight tooth and nail. They don’t want to give their money away, why should they?” said Ma of Eurasia Group.
This means that the Chinese consumer is unlikely to ride to the rescue of the global economy anytime soon – although the country will likely continue generating strong profits for consumer product companies with good strategies. “China cannot save the world, from an economic standpoint,” said Shaun Rein, managing director of China Market Research. “However, the Chinese consumer can save consumer product companies.”
Of course, not all of China’s trading partners mind its investment-heavy model. Resource-exporting countries around the world continue to benefit from it. But countries like Australia and Canada must prepare for the day when China’s resource demand begins to dry up.
Despite government rhetoric, economists say the numbers show no sign that China has made a substantial movement toward rebalancing yet. But if the task is as urgent as Beijing has said it is, then reforms will have to begin soon – whether leaders and businesses like it or not.
“If investment is being misallocated, then by definition debt is rising at an unsustainable pace,” said Pettis. “And as some economist or the other said [it was Herb Stein], if something is unsustainable, it will stop.”