Serious Money:The world's financial markets are focused on the US administration's negotiations to avoid the fiscal cliff, as well as policymakers' efforts in the euro zone to effect reform and draw a line under the region's ongoing crisis. What each means for economic growth in 2013 and beyond is of enormous concern, but more attention should be paid to China, the world's primary growth engine, as it addresses the urgent need to rebalance its lop-sided economy.
China has enjoyed spectacular growth since Deng Xiaoping set the economy on an export path in 1978. GDP growth has averaged close to 10 per cent a year over the past three decades, and living standards have increased by a factor of 13 over the same period.
The economic performance was fuelled by large-scale investment in physical capital, facilitated by high gross domestic savings rates channelled through state-owned banks, largely to state-owned enterprises. For most of the past three decades, the country’s investment rate has not been out-of-line with the precedent set by its high-achieving Asian neighbours during their corresponding periods of economic development.
The investment share of GDP averaged close to 35 per cent during the latter half of the 1970s through the 1980s, and increased to an average of 39 per cent in the 1990s. These figures are like the average investment rate of 33 per cent registered in Japan between 1961 and 1973, or the 32 per cent average recorded in South Korea from 1983 to 1991.
Spending boom
However, China’s capital spending boom gathered momentum during the most recent decade, as the investment share of GDP jumped from 35 per cent in 2000 to close to 50 per cent in each of the past two calendar years. The investment ratio has been above 40 per cent for 10 consecutive years, figures that are unprecedented in history. Investment never reached as high as 40 per cent of GDP in Japan or South Korea, and the highest ratios were not sustained beyond seven or eight years in either country. The limits to this investment-led growth model are reflected in both declining productivity and the increased credit-intensity of GDP growth. Indeed, growth in total factor productivity has dropped from 4 per cent in the 2000s to just 2 per cent in recent years, while the credit share of GDP has jumped from 150 per cent in 2007 to over 200 per cent now.
The need to rebalance the economy away from investment to consumption is obvious, but the transition is unlikely to be as smooth as most commentators believe. The consensus calls for an annual growth rate of roughly 8 per cent in the years ahead, but the reality could be closer to 5 per cent, and perhaps even lower.
China has reached the same level of economic development as Japan in the early-1970s and South Korea in the late-1980s, when their respective economies transitioned away from investment. However, the impact on growth was cushioned by consumption shares that were close to 60 per cent of GDP in both countries, as compared with China’s abnormally low ratio of just 33 per cent.
Simple arithmetic shows that China’s growth slowdown is likely to be far more pronounced than the 8 per cent growth rate currently anticipated. If investment growth slows to 5 per cent a year, then Chinese consumption would need to increase by an unprecedented 12 to 13 per cent a year simply to achieve consensus. That is five percentage points higher than 10-year average consumption growth, and appears wholly unrealistic.
Further, China’s credit-to-GDP ratio is far above the levels seen in both Japan and South Korea, when the structural transformation of their economies began, and the debt-fuelled investment boom unleashed by policymakers at the height of the global financial crisis is virtually certain to lead to a surge in credit losses in the years ahead. Should the fragile banking system need to be recapitalised, this will inevitably be funded by households through artificially low deposit rates, which will hinder the rebalancing process.
Measures required to boost consumption including higher wages and competitive deposit rates will have unintended consequences. Higher unit labour costs would erode export competitiveness and place downward pressure on the current account surplus, which has already dropped from a peak of 10 per cent of GDP in 2007 to below 3 per cent today.
The higher deposit rates required to reduce the high household savings rate would reduce the margins of an already-brittle state-owned banking system if not accompanied by increased lending rates. Time is fast running out for the Middle Kingdom to rebalance its economy. To quote the hedge fund manager, Jim Chanos, “China is on the treadmill to hell”.
