China Reforms Face Headwinds at Home and Abroad

Michael Pettis is a professor of finance at the Guanghua School of Management at Peking University in Beijing.
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In the late 1980s, University of Chicago professor Robert Aliber proposed, partly in jest, what he called the Andy Warhol theory of economic growth: “In the future every country will grow rapidly for 15 years.” He had in mind the plethora of so-called miracle economies that seemed to take off one after the other in the postwar era. In every case, decades of high growth, almost always driven by very high levels of investment, eventually faltered.

With the exception of South Korea, Taiwan, and perhaps Chile, none of these entities were able to break into the rich-country club. (Japan had already been a member when its growth miracle began.) Even among the “successful” economies, the period of growth was sooner or later interrupted either by a debt crisis and many years of negative growth, or by a lost decade of very slow growth and burgeoning debt.

Why were a few economies able to overcome the interruption in growth while most weren’t? The most obvious answer is that the success stories made necessary reforms before and during the various crisis periods -- and there were always more than one -- allowing them to rebalance and restructure their economies in ways that permitted further growth. In less successful cases, domestic distortions, often political in nature, prevented the kinds of economic changes that would have kept the economy growing in a healthy way.

Significant Distortions

China today faces a similar challenge. Rapid growth has come at the expense of significant distortions in interest rates, wages, currency and legal structures, along with political capture of the benefits of growth. An almost inevitable result has been a very distorted national balance sheet, marked by burgeoning debt and decreasing ability to finance that debt. It is now clear that China must come to terms with these distortions and reverse them, and that this task will prove difficult.

The fundamental imbalance in China is the very low share of gross domestic product from consumption. This low GDP share reflects a growth model that systematically forces up the savings rate, largely by repressing consumption growth. It does this by effectively transferring wealth from the household sector (in the form, among others, of very low interest rates, an undervalued currency, and relatively slow wage growth) in order to subsidize and generate rapid growth.

As a consequence of this consumption-repressing model, Chinese growth is driven largely by the need to keep investment levels extraordinarily high. What’s more, the very high growth rate in investment, combined with significant pricing distortions, especially in the cost of capital, has resulted in overinvestment, which in turn has led to an unsustainable increase in debt.

China can’t slow the growth in debt and resolve its internal economic problems without raising the consumption share of GDP. If it fails to do so, it probably faces the kind of crisis suffered by almost every other country that has followed a similar investment-driven growth model.

This rebalancing will happen either in a less painful and more orderly way -- as a consequence of specific steps enacted by Beijing -- or in a more painful and disorderly way, as a consequence of the imposition of constraints. But either way, it will happen. As Herb Stein, President Richard Nixon’s economic adviser, famously pointed out in the 1980s, “If something cannot go on forever, it will stop.”

Consider China’s debt dynamics. Every country that has followed a similar consumption-repressing, investment-driven growth model has ended up with an unsustainable debt burden. When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. As this occurs, China will automatically rebalance, but it will rebalance through a collapse in GDP growth that might even go negative. This would result in a rising share of consumption only because consumption doesn’t drop as quickly as GDP -- similar to what happened in the U.S. in the early 1930s.

Growing Awareness

I am not saying that a collapse in the Chinese economy is inevitable, or even likely. The good news is that because of the growing awareness of the costs of the imbalances and the risk of a debt crisis, the Chinese government will probably begin rebalancing before it reaches the debt capacity limit.

As they approach this task, however, Chinese leaders don’t have much room to maneuver. This is because of external constraints. Globally, savings and investment must balance. This means that for any set of countries whose savings exceed investment, as with China, there must be countries whose investment exceeds savings, like the U.S. To put it another way, the world can function with a group of underconsuming countries only if they are balanced by a group of overconsuming ones.

For the past decade the underconsuming countries of central Europe and Asia, of which China was by far the most important, were balanced by overconsuming countries in peripheral Europe and North America. Conditions are changing. North America and peripheral Europe are being forced to reduce their overconsumption (in the latter case) or are working toward reducing it (in the former case).

To the extent they succeed, by definition unless there is a surge in global investment -- which given the weak state of the world economy is very unlikely -- underconsuming countries must increase their total consumption rates, or the world economy won’t be able to balance savings and investment except through negative growth. Because China is by far the biggest source of global underconsumption, it is very hard to imagine a world that adjusts without a significant adjustment in China.

Thus far, Beijing is finding it impossibly hard to raise the consumption rate, and yet it is extremely important that it reduce the investment rate before debt levels become unsustainable. If investment rates drop more quickly than the savings rate, the result would be an increase in China’s current-account surplus. But, of course, there is a huge constraint here. Can the world accommodate China’s need to absorb more foreign demand in order to help it through its own transition?

Little Appetite

Here things seem unpromising. The big deficit countries have little appetite for rising imbalances. The U.S., for example, wants to reduce its trade deficit, and at the very least it will resist a rapid increase in imports relative to exports. As the external financing available to peripheral Europe dries up and turns to net capital outflows, their deficits will contract sharply and eventually become surpluses.

Part of the adjustment in Europe might be absorbed by a contraction in Germany’s surplus. But the Germans, concerned about their own rising debt, especially as a consequence of their tremendous bank exposure to peripheral Europe, are resisting as much as possible.

An even bigger problem may be Japan, which has an enormous debt burden that is manageable only because it is financed domestically at extremely low rates. Japan is clearly worried that it is running out of time to manage the debt, and indications are that it has finally become serious about reducing it.

How? One way is to ensure that the debt continues to be funded domestically, which means that Japan must force up its savings rate. The government is planning to further raise taxes, especially consumption taxes, and to use the proceeds to pay down the debt. In addition, the business community is applying pressure to lower wages in order to increase the competitiveness of the tradable goods sector. Raising consumption taxes and reducing wages will push the growth rate of disposable income down relative to GDP growth, and lower disposable income usually means lower consumption -- which is the same as higher savings.

These policies will probably also reduce the investment rate. Lower Japanese consumption, after all, should shrink business profits and so reduce the incentive for expanding domestic production; pressure for austerity, meanwhile, should restrain or even reduce government investment. By definition, because the current-account surplus is equal to the excess of savings over investment, more savings and less investment mean that Japan’s current-account surplus must rise.

Extremely Disappointed

So where does all this leave us? Of the two big trade deficit entities, neither the U.S. nor peripheral Europe can allow its deficit to rise. Of the three big surplus countries, Germany is reluctant to allow its surplus to decline by much, while Japanese reluctance to solve its debt problems by selling government assets to pay down the debt requires that it resolve them with an increase in the trade surplus. China’s surplus can decline only if we see a very improbable decline in its savings rate or a very unwelcome increase in its investment rate.

The refusal of the surplus countries to play a part in allowing the world to adjust has its counterpart in the refusal of the U.S. in the 1920s to do the same. Clearly, this isn’t going to work. And at least one of the above countries is going to be extremely disappointed.

(Michael Pettis is a senior associate at Carnegie Endowment for International Peace and a professor of finance at Peking University’s Guanghua School of Management, specializing in Chinese financial markets. This is the first of three excerpts from his new book, “Avoiding the Fall: China’s Economic Restructuring,” published this week by the Carnegie Endowment for International Peace.)

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