Over the past few months, China has been under the economic spotlight over the People’s Bank of China’s intervention in the foreign exchange markets, the first ever corporate bond default, and Beijing’s mini stimulus package in response to fears of a “hard landing” of the domestic economy due to the collapse in real estate prices and the credit freeze.
With most of the above fears now largely abated, this column wants to return to a larger, longer-term and a more structural question — that of China’s re-balancing act. It has long been argued that China must move from being an investment-driven economy towards one in which consumption also contributes a significant amount to GDP growth. The data has been encouraging on this front. Household consumption, as a percentage of GDP, has risen from 34.9 percent in 2010 to 36.2 percent last year, according to official data. This year, even with the government’s mini-stimulus (a burst of spending on railways and public housing unveiled in April), consumption has still accounted for over half of Chinese growth. If this trend continues, it will of course lead to a change in global trade dynamics – especially the export-oriented economies in the Asia Pacific. As The Economist points out, countries such as Australia – which supplied raw materials for China’s industrial boom – will be on the losing side while countries such as Taiwan – whose exports target the Chinese consumer (eg. mobile phones) – would be relatively shielded.
But is China’s re-balancing a dangerous obsession? China’s high national savings and investment ratios over the last three decades have often called for a switch towards consumption-led growth. A typical diagnosis states that China invests too much, as measured by the investment to GDP ratio of 48 percent, and that it consumes too little given an even higher national savings rate. The “new normal” for Chinese growth is pegged at around seven percent, well below the 10 percent growth it managed up until recently. So at this stage of its economic development, can it be the case that China is actually not investing enough? (Note that this is a contrarian view.)
In its research note, HSBC points out that the curious thing about the consumption-led growth model is that there is little theory or evidence behind it. Economists generally agree that sustained economic growth depends on supply-side fundamentals such as the stock of capital, technological innovation, trade policies and the structure of government taxation. Ultimately, it is productivity growth that drives GDP growth in the long run. The standard theory on economic growth is relatively straightforward on the relationship between the structure of aggregate demand and growth: higher investment leads to faster growth. A higher savings rate will mean less consumption, but it funds greater investment too. That ultimately allows poorer countries to catch up to higher per-capital GDP levels faster. Indeed, there is some evidence that a rising savings rate is also positively co-related with long-run growth. However, there is little in the academic literature that suggests a causal link between higher consumption and higher growth rates, according to HSBC. No theory of growth recommends that poor countries such as China lower their savings rates and increase consumption as a means of boosting growth.
The savings rate will also eventually fall naturally due to demographics. But that makes it even more important for China to invest now, while simultaneously pushing through financial reforms that create more sustainable funding models for investment.
China’s economic rise has been a role model for other emerging economies. In terms of Purchasing Power Parity (PPP), China’s economy will soon overtake that of the United States according to the World Bank. However, policymakers in Beijing must remember that China is still a poor country. Its development into a modern economy is also far from finished, and more infrastructure investment is needed to cope with the rapid pace of urbanization and industrialization. The great rebalancing of China’s economy is inevitable in the coming years. But it is too soon to take the foot off the investment accelerator.