China’s current model of economic development produced high GDP growth for three and a half decades following the initiation of economic reforms by Deng Xiaoping at the end of 1978. It is no longer sustainable. Rebalancing has started, but will need major institutional changes if it is to be successful.
During the first three decades of the People’s Republic under Mao Zedong, capital was accumulated by ruthless exploitation of the peasants, who made up 80% of the population. Deng’s first reform measure was to abolish collective farming (the rural peoples’ communes), providing a massive one-off boost to agricultural productivity and rural incomes. This removed the danger of famine and increased household demand for consumer goods.
The return to private farming was followed by the opening of the economy to trade and foreign investment. Within only two decades China moved from being the world’s most closed economy to one of the world’s most open economies. “Urban reform” – dealing with inefficient state-owned industry – took longer and has left a legacy of large corporations dependent to varying degrees on state financing.
Economic development during the three and a half decades of reform depended on moving the surplus labour resulting from more efficient farming to the cities to build infrastructure and manufacture exports. China has thus provided the largest and purest example of W. Arthur Lewis’ hypothesis of “development with unlimited supplies of labour”, which involves workers moving from low-productivity subsistence agriculture to urban industry, where output per person – and therefore wages – are higher.
A crucial element of this model is high capital investment in labour-intensive, low-technology, low-wage export manufacturing, generating a persistent huge trade surplus and super-profits that accrue to a new class of state capitalists. This model has been successful in raising living standards throughout China, taking hundreds of millions out of people out of poverty and enriching the urban elite. This has been the basis of “political stability”.
This model is now no longer sustainable. Although GDP growth has been high – averaging around 10% per year in real terms in recent years – this has been achieved inefficiently and at the cost of growing inequality.
In a market economy, capital is rationed by interest rates. Investment projects, like building a factory or opening a chain of shops, are judged viable by comparing their discounted future earnings against the cost of capital measured as the interest rate paid for borrowed funds. In China, the cosy relationship between the big banks and the large state-owned enterprises has meant that interest rates have been artificially low or have been irrelevant because of constant refinancing.
This was possible because of the exceptionally high – and rising – rate of saving, mediated by a banking system that effectively taxed savers (by paying almost no interest) to provide cheap investment funds.
The result has been an investment glut, visible in factories with more equipment than they can use and towns with no inhabitants (20 “ghost cities” are built each year). Rather than cut back, an unprofitable state-owned enterprise is more likely to increase its capital investment to escape its predicament.
Over-investment has been exacerbated since 2008 by credit expansion aimed at defending against the global economic crisis. The result has been a seriously unbalanced economy. In 2011, fixed investment made up 46.2% of GDP, far higher than any other country. In developed countries, the rate was around 20% (France 20.1%, Germany 18.2%, Japan 20.7%, Russia 21.3%), while in emerging markets it was higher (India 35.5%, Indonesia 32.2%, Mexico 24.8%).
Correspondingly, household consumption is far lower in China than elsewhere, at 35% in 2011, compared, for example, to 65.2% in Hong Kong, 56% in India and 60.3% in Japan.
Over the past ten years, the “unlimited supply of labour” has started to dry up. As a result, wages have risen sharply, more than doubling since 2007, along with increases in employers’ social security contributions. Both Chinese and foreign investors have responded by moving their factories into China’s less developed hinterland, but also by moving production to lower-wage locations like Vietnam and Bangladesh.
A further problem is the abrupt ageing of the Chinese population as a result of the one-child policy adopted in 1980. The dependency ratio is increasing so that each worker will have to support many more retired people.
Productivity (output per worker and per unit of capital) needs to increase to pay for all this, yet since 2008 over-investment has depressed the rate of productivity growth.
Nor is the old model sustainable internationally. The United States and other trading partners complain about losing jobs to China and running constant trade deficits with it as a result of what is perceived as an undervalued currency; also about poor-quality, sometimes dangerous, Chinese exports.
Chinese economists have complained for years about the inefficiency of maintaining excessively high foreign-exchange reserves (USD 3.5 trillion at the end of June 2013). Worse, most of the reserves are kept in low-return investments such as US Treasury bonds.
China’s leaders have been trying to rebalance the economy away from labour-intensive export manufacturing for the past decade and a half. During and after the 2008-2009 crisis, they made further commitments at G20 meetings to intensify the process.
Rebalancing consists of several major elements. Private consumption is being boosted at the expense of investment. The work week was cut to five days in 1995. Public holidays have been expanded to “golden weeks”. Domestic tourism has mushroomed. Wages have risen. Yet household consumption still fell steadily from 46.4% of GDP in 2000 to 35% in 2011, so this essential element of rebalancing has hardly begun.
Following China’s accession to the World Trade Organisation in 2001, imports have accelerated. The shares of trade and current-account surpluses in GDP have shrunk. High-tech manufactures have increased as a share of exports. Eventually, foreign-exchange reserves will stabilise not far above the current level and more of the reserves will be invested in risk assets via the China Investment Corporation, China’s sovereign wealth fund.
Far more needs to be done.
The banking system needs to cut its ties to the state-owned enterprises and interest rates must be liberalised so that they can rise to rates at which they can ration capital efficiently. Restrictions on outward capital movement should be relaxed to allow an even greater expansion of China’s outward investment. Obstacles need to be removed to inward foreign investment in China’s services sector, allowing greater expansion of consumer choice and hence of consumer spending. Intellectual property rights need to be robustly protected to allow innovation and technical upgrading spearheaded by individuals and private firms.
Rebalancing can not be achieved overnight. It requires major institutional changes. The main beneficiary will be China.