How can China Rebalance from an Export and Investment Driven Economy to a Higher Consumption Share of GDP?

At the Australia Investment Conference in Sydney, Michael Pettis (pictured left), a professor at Peking University and senior associate at the Carnegie Endowment for International Peace, discussed China’s “rebalancing”, a current topic of interest and debate both inside and outside the country. Pettis began by saying that he does not consider himself a “China bear” at all; in fact, he is simply a “China skeptic”, and he believes that China will manage to rebalance. China’s consumption share of the GDP, standing at below 35%, is at a very low point in the country’s history and is substantially lower than most other countries.

Pettis stated that he believes the big challenge facing China’s policy makers is reducing the share of GDP associated with export and investment, and increasing the share associated with domestic consumption. Some of Pettis’ key points:

• Rebalancing at this stage requires a wealth transfer from the state sector to the household sector.
• Among the ways to transfer wealth, the most effective is through “privatizations”, which implies more corporate governance reform, the government giving up significant control of the credit system, etc.
• The imbalance between investment and consumption has long been a concern of Premier Wen and other Central Government officials, and the new incoming leadership, including Li Keqiang and others, appear to take the problem seriously and Pettis believes that they will take bold steps to implement solutions.

Pettis forecast that:

• China will substantially increase privatizations.  This is a popular topic inside China, where the debate is actually much more ferocious and interesting.
• Income growth will move up to the 5% to 6% range, and GDP growth will move down to average around 3% over the next decade. With higher income growth, a 3% GDP growth is not really a problem in his view. However, commodity-exporting countries such as Australia will experience significant contractions in non-food commodity exports.

Pettis expanded on this forecast by putting into historical perspective the current investment-focused model of growth in China that persisted in past decades. France first adopted this development model in the early 1800s through the credit immobilier. Then, Germany, Italy, the U.S.S.R, Brazil, and Japan subsequently adopted similar models, and each went through a phase of buoyant investment-led growth followed by a subsequent protracted stagnant period at various times over the last two centuries.

The lesson from these events, Pettis said, is that the investment-led development model is not sustainable. Initially, it is often very easy to find investment opportunities that have high returns, but these become exhausted after a period of time. At that point, pricing signals become distorted: real interest rates approach zero or negative, loans are increasingly rolled over and not repaid, incentives structures (e.g., promotion based on growth) are narrowly focused. The resulting misallocation of capital results in wealth being destroyed rather than created. Pettis indicated that wealth is being transferred from the household sector to the corporate sector, as discussed in the two Unirule Institute studies and the HKMA study.

The investment-driven growth model, and particularly the infrastructure build-out to stimulate the economy right after the global financial crisis of 2008, have resulted in an unsustainable rise in government debt, much of which is “located” at the regional and local government levels. According to Pettis, this had gone unnoticed until late 2009, when Victor Shih, a political scientist at Northwestern University, started publishing research findings on China’s total government debt at all levels. Shih’s findings were challenged by various parties and not taken seriously until May 2010, when the People’s Daily indicated agreement with the figures.

A measure called total social financing, which includes bankers’ acceptances, trust loans, collateralized loans, etc., was introduced in early 2011 to cover broader concepts of credit because the previous measure, RMB loans, was found to cover less than 60% of total credit only. Recently, the rating agency Fitch introduced an enhanced measure called adjusted total social financing for more comprehensive coverage.

To rebalance China’s economy, Pettis suggested that there are several possible measures:

1. Raise interest rates;
2. Let the RMB appreciate more;
3. Hike wages and benefits; or
4. Transfer wealth from the state to households.

He believes that it is politically difficult to raise interest rates and wages too quickly (as many state-owned enterprises and most other business sectors will experience solvency problems) and to let the RMB appreciate too fast (as exporting industries will find the adjustment too difficult).  The only viable measure appears to be privatization of state assets.  Pettis expects that this will be widely adopted by the Chinese central government to bring about the investment–consumption rebalancing. The path of GDP growth is determined politically, not economically, and if the imbalance keeps getting more extreme, the Chinese central government will lower growth expectations, possibly to as low as 3% as necessary. Since China’s share of global commodity demand is high, commodity prices will likely come down significantly should China move into a period of sustained slower growth in order to rebalance.