This statement, perhaps shocking to many, is one of the arguments that made Michael Pettis a respected name among economic thinkers. In his book The Great Rebalancing, Professor Pettis devotes a long well-argued chapter to making his case of Unbalanced Growth in China. He argues that,
- “It is a mistake to characterize China as an export-driven economy. China is an investment-driven economy.”
In investment-driven economies, it is difficult for investors to “not engage in value-destroying activity”. This is why, he points out,
- “countries following the investment-driven growth model – like Germany in the 1930s, the Soviet Union in the 19503 and 1960s, Brazil in the 19603 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.”
What makes China unique is not its model. but the unprecedented scale of the Chinese model and the imbalances it has produced.
Scale in China – Unprecedented in history
The scale of China’s export activity is unprecedented. By 2007, “China’s trade surplus, as a share of GDP had become the highest recorded in one hundred years, perhaps ever”. China also runs a huge current account surplus. Chinese businesses behave, Prof. Pettis says, “not as if labor were the cheapest input they have but rather as if capital were the cheapest input.”
These anomalies imply China must also have “an exceptionally high savings rate.” In Chapter 4 of the Great Rebalancing, Pettis discusses the reasons for such high savings. Before getting to that discussion, Pettis makes one of his statements that go against popular consensus & beliefs.
- “It is important to note that an excessively high savings rate can be just as debilitating for an economy, perhaps even more so, as an excessively low savings rate.”
Can an investment growth miracle be sustained?
Prof. Pettis says no because that model as at least two constraints:
- “The first has to do with the constraint on debt-financed investment and,
- the second with the constraint on the external account,
- and one or both constraints have always eventually derailed the growth model.“
In fact, China has already hit both constraints, according to Prof. Pettis:
- “capital is wasted, perhaps on an unprecedented scale,”
- “world is finding it increasingly difficult to absorb excess Chinese capacity”
- 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”.
What about the 3rd leg of every economy – domestic consumption?
Household consumption – again unprecedented in history
The growth in China’s GDP has relied too heavily on net exports and investment and too little on domestic household consumption. The “most striking expression of the imbalance”, Pettis writes, “is the declining share of GDP represented by household consumption.”. He provides statistics to make his point:
- “In the 1980s household consumption represented about 50 to 52 percent of GDP.”
- “…as the country grew during the 1990s Chinese consumption declined further as a share of GDP.”
- “By 2005 household consumption in China had declined to around 40 per cent of GDP.”
- “For the next five years GDP growth continued to surge ahead of household consumption growth until by 2010,…, household consumption declined to an astonishing 34 percent of GDP. This level is almost surreal.”
This level, Pettis points out, is “not much above half the global average and far less than the rate in any other country… such as large domestic imbalance has no historical precedent.”
What China needs to do is easy to see and say – “China must raise wages, interest rates, and the value of the currency”. But it may be much harder to do:
- “if it does so quickly it could cause severe financial distress to businesses and projects heavily dependent on subsidized costs, and the resultant surge in unemployment could actually cause consumption to decline just as Chinese competitiveness aboard deteriorates.”
- “if it does so slowly, China will need continued accommodation from the external sector,….a slow adjustment means the imbalances and debt will continue to get worse for several years before they get better…”
Can China Adjust?
The historical precedents for this kind of adjustment are not encouraging, and the adjustment China needs to make dwarfs those of its predecessors. So will slower growth be a disaster for China, and will it lead to social instability? These questions, asked by Prof. Pettis, are of enormous importance to the global economy.
Fortunately, Pettis answers “Not necessarily.” and adds:
- “If the rebalancing is well managed, by definition household income and consumption will grow faster than GDP, and so the lost decade of growth will not be as painful for the household sector as one might imagine. For example, one can easily posit a case in which China’s GDP grows by 3 percent annually, Chinese household income grows at 5 percent and consumption at 5 or 6 percent”.
On this optimistic note, we will stop our disc
ussion of Chapter 4 of The Great Rebalancing by Michael Pettis. The above is but a window into the serious and important analysis the book provides. This is a book every serious reader should read and keep on their shelves.
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