Although various commentators (including our Marshall Auerback) have raised warning flags about the long-term viability of China’s growth model, the middle kingdom’s performance during the crisis seemed to prove skeptics wrong. Never mind that creditors like China tend to suffer most in the aftermath of major financial crises, or that no country has ever sustained such a high combination of exports plus investment (over 50% of GDP) for very long. And the ongoing reports of all those vacant cities seemed to be irrelevant.
The critics have been looking less off base of late. A report late last month in the New York Times discussed how the always unreliable Chinese official figures were looking even dodgier of late, reflecting an effort to mask flagging growth. Savvy investors had been using proxies for real economy activity, such as electricity consumption, to compensate for these shortcomings. But the officialdom has become so concerned about keeping up appearances that they’ve started to dress up those figures as well.
Michael Pettis, a long standing commentator on the Chinese economic model, provides a short summary as to why China is unlikely to have a soft landing. Remember that China has shown signs of overinvestment for years. On the eve of the financial crisis, it took $4 to $5 of investment in the US to produce $1 of GDP growth. In China, the ratio was closer to $7 to $8 of investment to $1 of growth. And recall that the way China came through the crisis relatively well was by massive spending….which again was weighted heavily toward investment.
I can see some readers shaking their heads. China is still a very underdeveloped country! There are still lots of opportunities for investment to bring more parts of the country up to a modern standard of living. True, but that does not mean it is economically productive. Pettis explains:
It also seems easy to justify intellectually the infrastructure upgrades. After all, rich countries have far more capital stock per person than poor countries, and those investments were presumably economically justified, so, according to this way of thinking, it will take decades of continual upgrading before China comes close to overbuilding.
The problem with this reasoning of course is that it ignores the economic reason for upgrading capital stock and assumes that capital and infrastructure have the same value everywhere in the world. They don’t. Worker productivity and wages are much lower in China than in the developed world.
This means that the economic value of infrastructure in China, which is based primarily on the value of labor it saves, is a fraction of the value of identical infrastructure in the developed world. It makes no economic sense, in other words, for China to have levels of infrastructure and capital stock anywhere near that of much richer countries since this would represent wasted resources – like exchanging cheap labor for much more expensive laborsaving devices.
Pettis later stresses that this problem is endemic in the “productive” sector of the economy as well:
The problem of overinvestment is not just an infrastructure problem. It occurs just as easily in manufacturing. When a manufacturer with privileged access to the banking system can borrow money at such a low rate that he effectively forces most of the borrowing cost onto household depositors, he doesn’t need to create economic value equal to or greater than the cost of the investment. Even factories that systematically destroy value can show high profits, and there is substantial evidence to suggest that in China the state-owned sector in the aggregate has probably been a value destroyer for most if not all the past decade, but is nonetheless profitable thanks to household subsidies.
And these subsidies are substantial. A mainland think tank, Unirule, estimated in 2011 that monopoly pricing and direct subsidies may have accounted for as much as 150 percent or more of total profitability in the state owned sector over the past decade. I calculate that repressed interest rates may have accounted for another 400 to 500 percent of total profitability over this period. Monopoly pricing, direct subsidies, and repressed interest rates all represent transfers from the household sector.
At some point, in other words, rather than create wealth, capital users begin to destroy wealth, but nonetheless show profits by passing more than 100% of the losses onto households. The very cheap capital especially means that a very significant portion of the cost – as much as 20-40% of the total amount of the loan – is forced onto depositors just in the form of low interest rates.
How? Because artificially lowering a coupon on a ten-year loan by 4 percentage points effectively represents debt forgiveness equal to 25% of the loan.
So thrifty Chinese savers are actually being ripped off by getting far too little interest on their funds and having the money channeled into businesses that would lose money if they had to operate without government subsidies and artificially cheap capital. Now he stresses that that still could be a good deal if the system produces a high enough level of growth. But he deems that unlikely to continue:
Under these circumstances it would take uncommonly heroic levels of restraint and understanding for investors not to engage in value destroying activity. This is why countries following the investment-driven growth model – like Germany in the 1930s, the USSR in the 1950s and 1960s, Brazil in the 1960s and 1970s, Japan in the 1980s, and many other smaller countries – have always overinvested for many years leading, in every case, either to a debt crisis or a “lost decade” of surging debt and low growth [The German experience, of course, ended in war, and not in a debt crisis, but according to Yale historian Adam Tooze, the German invasion of eastern Europe occurred three or four years earlier than the military command was prepared largely because the country was almost insolvent and could not afford to wait any longer. See Adam Tooze, The Wages of Destruction: The Making and Breaking of the Nazi Economy, London: Allen Lane, 2006]
The second constraint is that policies that force households to subsidize growth are likely to generate much faster growth in production than in consumption – growth in household consumption being largely a function of household income growth. In that case even with high investment levels, large and growing trade surpluses are needed to absorb the balance because, as quickly as it is rising, the investment share of GDP still cannot increase quickly enough to absorb the decline in the consumption share…
But by 2007 China’s trade surplus as a share of global GDP had become the highest recorded in 100 years, perhaps ever, and the rest of the world found it increasing difficult to absorb it. To make matters worse, the global financial crisis sharply reduced the ability and willingness of other countries even to maintain current trade deficits, and as we will see this downward pressure on China’s current account surplus is likely to continue.
So China has probably hit both constraints – capital is wasted, perhaps on an unprecedented scale, and the world is finding it increasingly difficult to absorb excess Chinese capacity. For all its past success China now needs urgently to abandon the development model because debt is rising furiously and at an unsustainable pace, and once China reaches its debt capacity limits, perhaps in four or five years, growth will come crashing down.
Marshall Auerback has pointed out that no country has managed the transition from export-led growth to consumption-led growth gracefully. Perhaps China will be the first, but the precedents bode ill.