The Financial Times’ economics editor Martin Wolf takes up the theme treated at some length by China-based economist MIchael Pettis: that Chinas’ economy has moved into unknown and dangerous terrain. No sizeable economy has had investment and exports combined constitute nearly 50% of GDP, and that model is not sustainable. As we have indicted, there is evidence that investment is becoming less and less productive. China is taking $7 of debt to generate $1 of GDP, when the US at the tail end of the bubble needed a mere $4 to $5 of debt for each incremental $1 of growth.
We’ve often recapped Pettis here and are glad to see Wolf take up his analysis.
Wolf does recite the optimist case on China, with the biggest factor being that China has a long way to go in improving the incomes of its citizens, and that alone can give it a very long lasting growth trajectory.
On the risks, Wolf sets aside commodities scarcity and environmental issues to focus solely on the economics case. One is that of a so-called “middle income trap” in which countries find it hard to manage the transition to more sophisticated production. Only Taiwan, South Korea, Japan and Singapore have crossed this barrier since 1950.
This is the guts of Wolf’s summary of Pettis:
Professor Pettis argues that suppression of wages, huge expansions of cheap credit and a repressed exchange rate were all ways of transferring incomes from households to business and so from consumption to investment. Dwight Perkins of Harvard argued at the China Development Forum that the “incremental capital output ratio” – the amount of capital needed for an extra unit of GDP – rose from 3.7 to one in the 1990s to 4.25 to one in the 2000s. This also suggests that returns have been falling at the margin.
If this pattern of growth is to reverse, as the government wishes, the growth of investment must fall well below that of GDP. This is what happened in Japan in the 1990s, with dire results. The thesis advanced by Prof Pettis is that a forced investment strategy will normally end with such a bump. The question is when. In China, it might be earlier in the growth process than in Japan because investment is so high. Much of the investment now undertaken would be unprofitable without the artificial support provided, he argues. One indicator, he suggests, is rapid growth of credit. George Magnus of UBS also noted in the FT of May 3 2011 that the credit-intensity of Chinese growth has increased sharply. This, too, is reminiscent of Japan as late as the 1980s, when the attempt to sustain growth in investment-led domestic demand led to a ruinous credit expansion.
As growth slows, the demand for investment is sure to shrink. At growth of 7 per cent, the needed rate of investment could fall by up to 15 per cent of GDP. But the attempt to shift income to households could force a yet bigger decline. From being an growth engine, investment could become a source of stagnation.
What may not seem obvious is increasing consumption is not trivial. The interview we featured by Ha-Joon Chang discusses that you need infrastructure to consume, such accessible retail outlets with appealing goods and relatively easy and affordable means to get the purchase transported. And you also need space. Having spent a fair bit of time in Japan in the bubble years, one constraint on consumption was the famously small size of Japanese homes. A $5 million apartment in Tokyo in 1987 was a mere 900 square feet, and most apartments were smaller than that. Another was that the Japanese seemed to have internalized their history of having the most elaborate and sumptuary laws every recorded, with spying and snitching a major part of the enforcement mechanism. There seemed to be a cultural code as to what forms of conspicuous consumption were considered chic and too much (whatever “too much” was) would have been seen as trying to lord it over others (this isn’t quite the right cultural vibe but close enough for working purposes; the Japanese have a finely tuned sense of protocol on a number of social axes); overdoing it would have been tacky (while in the US, there seems to be no limit to excess).
As we often say, it is better if we were proven wrong, but the precedents suggest that China is going to have a tough time restructuring its economy as radically as it needs to.