With an annualized economic growth rate of over 9.5% per year for the last three and a half decades, China’s growth story has been dubbed nothing short of an economic miracle. But, in recent years there has been a lot of talk of the “Chinese Rebalancing” i.e. shifting the Chinese economic growth from being investment led to being consumption led. Whether or not this rebalancing will be “painful” or “painless” is a matter which is occupying the minds of many experts in this field. If stock markets are taken as an indicator then the rebalancing has been quite painful, especially over the last two years, the Shanghai Stock Exchange Composite Index has fallen by 49% since its peak in June of 2015, but then again Paul Samuelson famously said “the stock market has predicted nine of the last five recessions.” Thus, whether or not the transition will be painful or not can not be judged by the performance of the stock market.
But, this rebalancing has led to a wider debate as to why it is at all necessary after all the Chinese economy has grown rapidly for a very long time using this very model. In this article I aim the explain some of the reasons as to why this rebalancing has become necessary.
To first put things in perspective, let us look at the current shares of consumption and investment in the GDP of China.
The current GDP composition
Gross capital formation (which is a measure of investment) as a percentage of GDP stood at 46% in 2014, in comparison, the final consumption expenditure (consumption) as a percentage of GDP stood at 50.1% in 2014.
To put this data into context, the average gross fixed capital formation as a percentage of GDP for the top 10 countries by GDP (excluding China) is 20.6% (in 2014), while, the average final consumption expenditure for the top 10 countries is 78.6% of GDP (in 2014).
Thus, we can see from the above data that the rate of gross fixed capital formation far exceeds the average for the top 10 countries, while, the final consumption expenditure is far below the average for the top 10 countries.
Before I go into the reasons for the rebalancing, let us get familiar with the national income identity:
i.e. National income(Y) = Consumption(C) + Investment(I) + Government expenditure (G) + Net Exports (NX) (i.e. Exports – Imports).
So why would the government want to change a successful growth model?
Volatility of investment growth:
Gross fixed capital is the measure used to calculate the rate of investment in an economy. Looking at historical data, it can be observed that the annual rate of change in the rate of gross fixed capital formation in an economy is far more volatile than that of the rate of change of consumption expenditure.
From historical data taken between the years 1991 and 2014 for the top 10 countries by nominal GDP, it can be observed that the standard deviation of the annual rate of change in gross fixed capital formation is 7.7. Higher the standard deviation, higher is the volatility of the given data.
Thus, investment as a source of growth is very volatile.
Stability of consumption growth:
Final consumption expenditure is the measure used in calculating the the rate of consumption in an economy. Looking at historical data, it can be observed that the annual rate of change in final consumption expenditure is relatively stable when compared to gross capital formation.
Taking data for the top 10 countries by GDP between the years 1991 and 2014, it can be observed that the standard deviation of the rate of change of final consumption expenditure is 1.95, and as stated above, the lower the standard deviation, the lower is the volatility of the data.
Thus, consumption is a relatively stable source of growth.
Debt and investment:
While the above shows that consumption is a relatively stable source of growth, it fails to explain why China specifically has been growing rapidly for the last three and a half decades even though this growth has been fueled primarily by investment.
To know more about this let us look at the concept of growth targets in China
Every year, the Chinese central government sets a GDP growth target (for example the target for the year 2016 is 6.5%-7%), provincial governments are given the task of achieving these targets. Provincial governments in the hope of getting on the better side of the central leadership generally try and beat the given targets.
Now its not always possible for the targets to be met via honest profit and utility maximizing decisions by producers and consumers respectively. Thus, to augment growth, provincial governments undertake massive infrastructure projects to meet the shortfall in growth. These infrastructure projects are financed by debt i.e. borrowed money. Since the banks are under the ownership of the state, obtaining credit is not at all difficult for provincial governments. In addition, there are many large government owned enterprises which are willing to execute projects as per the wishes of their owners. The results of these projects can be seen in the form of massive “ghost cities” in China i.e. world class cities which have been built but have no occupants. An example of such a city is Ordos City, Inner Mongolia, China.
The above method has been used to a large extent in the aftermath of the 2008 recession.
In the year 2014, the total debt to GDP ratio for China stood at 282%, this is a growth of 79% from 2007 when the ratio stood at 158% of GDP. Thus, we can see that a huge amount of debt which has been taken up by the Chinese system to fund growth.
Ultimately this debt needs to be paid back to the banks. Now as stated above there was no underlying demand for these projects in the economy, they were only undertaken to boost GDP growth. Thus, with no one buying the output of these projects repayment of these loans have started becoming difficult, this can be seen by the sharp rise in non performing loans in China which has exceeded 1.6% of total loans given out at the end of 2015. In addition, another 3.8% of loans are at the risk of becoming non performing. In absolute terms, $183 billion worth of loans became non performing in the year of 2015.
Thus, it would be in the interest of the government to rebalance the economy in favor of consumption from the current investment bias to clear the unsold stock and inventory of these projects.
Slowing down of export markets:
USA and Europe have failed to regain the economic growth rates seen prior to the recession of 2008. The situation hasn’t been helped by the Eurozone Debt crisis or USA’s own debt crisis. This has depressed demand in the two regions.
The above two regions are the largest export markets for China, hence, a slowdown in these regions would adversely impact the Chinese economy. A fall in exports would cause large scale unemployment in the Chinese economy since exports accounted for 22.6% of GDP in 2014. Although this has fallen drastically from 35.7% of GDP in 2006.
Thus, it would be in the interest of the Chinese economy to boost domestic consumption so as to consume the products which are now not being sold in the world market.
Thus, from above we can see that growth in consumption is more stable than that in investment.
After 2008, growth in two components in the national income identity slowed down or turned negative, these two components were Investment and Net Exports.
To tackle with the fall in the above two components, the provincial governments in China started increasing both public investment (investment undertaken by the government) and investment by government owned corporation. All these investments were financed by debt (primarily bank loans), obtaining finance was not difficult since the banks are also owned by the government.
Since there was no domestic demand for this output, repaying the loans have started becoming difficult.
Thus, the government has now turned to another component in the national income identity to boost growth i.e. consumption. The hope is that in the short run the menace of non performing loans will be sorted out through this additional demand and in the long run, consumption would lead to a more stable source of growth.
China is the second largest economy in the world and hence it would be in the interest of the entire world for China to sort out its problems. Hopefully higher consumption in the economy would help fix the above problems.