In the last two decades, the Chinese economy has grown with an emphasis on infrastructure and exports. Household consumption has decreased. Household savings have gone up, but the savings have been invested in questionable projects. China has become uniquely vulnerable to a prolonged slowdown similar to the Japanese slowdown in the 1990s.
In a recent book Avoiding the Fall, Michael Pettis has analyzed the many problems that the Chinese economy faces. Most of the data in this article is from Pettis’s book.The Chinese economy is not as strong as is commonly claimed. It has excessive household savings, reduced household consumption, investments in infrastructure that may not deliver economic returns, and, industries getting stuck in the low end of the value chain. Each of these problems is being analysed below:
Repression of household consumption
In China in the 1980s, household consumption was 50-52% of GDP. By the end of the 1990s, the figure was at 46%, and by 2005, it had declined to around 40% of GDP. In 2011, the last year for which figures are available, household consumption was at 34-35% of GDP. As household consumption went down, savings went up. Savings started to rise as a percentage of disposable income from 1992 to 1998, stabilised at around 24-25%, and are now at 26%.
Household savings bankrolled the investments
Household savings earned low-interest rates in the banks. Thus, the industry obtained cheap credit. In the last decade, nominal lending rates have been fixed at 6% while the economy has grown from 14% to 16%. The lending rate has been 4-8% below the adjusted GDP growth rates, and household deposits at anywhere from 80-100% of GDP. The minimum spread between the deposit rate and the lending rate is set very high, guaranteeing the banks a steady return. This transfer can be assumed to be at 1% of GDP. The investment was around 23% of GDP in 1990, rose to 31% in 1992-94, stabilised at that level, and then climbed again in 1998 to reach around 50% in 2011. If imported commodities are added to investment, the figure would be higher.
Wage growth has been depressed. In the last decade, worker productivity has trebled, but the wages have doubled. Lagging wage growth is a wealth transfer from workers to employers. By subsidising the employers at the expense of workers, competitiveness of businesses has been increased, but consumption has been suppressed.
The extent of transfer from households
Lagging wage growth, undervalued currency, and repressed interest rates together effectively tax the households and pass the benefit to producers.
From 2000 to 2010, household consumption dropped from 46 percent of GDP to 34 percent. An International Monetary Fund (IMF) study estimates that households and small enterprises have been forced to subsidise growth at a cost to them that amounts to 4% of the GDP. With a household income that is only 50 percent of GDP, a transfer every year of 4% of GDP requires a massive growth in household income just to keep pace with GDP.
The total transfer from households to state-owned-enterprises (SOEs), infrastructure investors and other favoured investors amount to anywhere between 3-8% of GDP. Thus, there is a hidden tax of 4-9% of GDP on the households. The IMF estimates the ‘tax’ at 4% of GDP. This low cost of capital is a factor in China’s seemingly capital-intensive, rather than labour-intensive model.
Credits and Investments
As investments grow, the return eventually has to slow down. Chinese firms still show the profit, but that’s due to low-interest rates given to depositors. The credit to industries has gone up. In 2012, the Chairman of Bank of China said that China, which accounted for 11-12% of global economy, accounted for 40-50 % of total money creation.
China’s economic data has seen faster credit growth. 2012 would be the fourth year in a row that net new credit will exceed a third of GDP. However, eventually, deposits in banks would not grow fast enough to cover previous losses as well as fund new loans.
The low end of the value chain
There has been a media hype that China is challenging the US and Western Europe in even the higher end of the value chain. In their study, Rising Tide, Robert Z Lawrence and Lawrence Edwards have examined this claim. The authors did not any find evidence to support such hyperbole. An analysis of the Chinese exports at a disaggregated 6-digit level North American Industry Classification System (NAICS) was done. It revealed that the unit values of the Chinese products are lower than the US or OECD exports. For a 30 GB iPod, the value added by the Chinese factories was $4 out of a total value of $150.
These factors make China vulnerable. China may mimic Japan of the 1990s and Brazil of the 1970s. Most analysts agree that Brazil’s investment misallocation, which had already become a problem in the late 1960s and early 1970s, increased substantially over the rest of the decade. Rising unemployment and political instability forced Brazil to rebalance its economy and eliminate the consequences of years of misallocated investment. The same risks exist for China.
Due to increased dependency on exports, China is vulnerable to external shocks. The US could look at policies that drive up savings. There have been policy suggestions such as the Bradford X tax, which should improve savings in the US. If consumption goes down in the US due to increased savings, the shock may exacerbate Chinese economic problems.
To rectify, China may try to rebalance its economy.
The current level of investments is not sustainable if consumption goes down in the US or the EU. Ideally, investment should go down and domestic consumption should go up. But the mechanics of such a rebalancing has some risks.
Let us assume China maintains its current growth rate and brings down the share of investments from 50 percent to 40 percent of GDP. In such a case, calculations show, for a particular growth rate, investment needs to grow by at least 4.5 percentage point less than GDP. If the GDP grows by seven percent for the next five years, investment can only grow by 2.3 percent. If the GDP grows by five percent, investment must grow by 0.4 percent. If Chinese GDP grows by three percent, investment growth must actually contract by 1.5 percent.
Thus, although there is media hype about impending Chinese domination of the world, the reality may turn out to be different.