Michael Pettis
As China emerges this month from the all-important 20th National Congress of the Chinese Communist Party (CCP), its leadership will have to confront the most difficult set of economic choices it has faced in decades. It can shift out of an economic growth model that has generated a great deal of wealth, albeit at the cost of escalating inequality, surging debt, and an increasing amount of wasted investment over the last decade. Or Beijing can choose to continue with its current economic model for a few more years until it is forced by these rising costs into an even more painful transition.
The problem facing China is one that the German American economist Albert Hirschman described many decades ago. All rapid growth is unbalanced growth, Hirschman noted, and a successful development model is one in which unbalanced growth addresses and reverses the existing imbalances in the economy. But as these are reversed and the economy develops, the model becomes increasingly irrelevant to the original set of imbalances and eventually begins to create a very different set of problems.
Unfortunately, Hirschman noted, it is difficult to abandon a successful development model. Its very success tends to generate a set of deeply embedded political, business, financial, and cultural institutions based on the continuance of the model, and there is likely to be strong institutional and political opposition to any substantial reversal.
That’s where China finds itself today. Its high-investment development model was designed to resolve China’s extraordinary investment deficiency, but nearly four decades later, it has left China with an excessively high investment rate. According to the World Bank, investment typically makes up around 25 percent of global GDP, ranging from 17 to 23 percent for more mature economies to 28 to 32 percent for developing economies in their high-growth stages. For a decade, however, China has invested an amount equal to 40 to 50 percent of its annual GDP every year. It must reduce this unusually high level by a lot, but with growth so dependent on investment, it probably cannot do so without a sharp slowdown in overall economic activity.
DEEPER INTO DEBT
High investment rates weren’t always a bad thing for China. When it began its era of “reform and opening up” in the late 1970s, after five decades that included war with Japan, civil war, and Maoism, the country was hugely underinvested in infrastructure, logistics, and manufacturing capacity. What it needed above all was a development model that prioritized rapid investment.
The approach it took over the next several years did just that. First, Beijing forced up the domestic savings share of GDP needed to fund investment. In any economy, everything produced that is not consumed is, by definition, saved, so forcing up the savings share of GDP just means forcing down the consumption share.
Beijing did this by systemically constraining the growth of the household share of GDP. A country’s total income is divided among households, businesses, and the government, and households, unlike businesses and government, consume most of what they earn. In practice, forcing down the consumption share meant ensuring that businesses and government retained a disproportionate share of what was produced, and households a declining share. The smaller the share that households retain of GDP, the lower the consumption share and the higher the savings share.
By the late 1990s, the domestic savings share of GDP reached 50 percent, the highest level ever recorded by any country. The banking system, which was China’s main intermediary for savings, made these enormous savings available for Chinese businesses, property developers, and local governments at artificially low, government-determined interest rates. The consequence was rapid growth driven by high levels of investment. That dynamic allowed China to close its underinvestment gap at an astonishing pace.
But like every other country that has followed a similar model, including the Soviet Union and Brazil in the 1950s and 1960s and Japan in the 1970s and 1980s, China faced a hidden trap: once China closed the gap between its level of capital stock and the level that its workers and businesses could productively absorb, it would need to shift to a different growth strategy that de-emphasized investment in favor of consumption. This gap was probably closed at least 15 years ago, when China’s debt burden began to rise rapidly.
This was not a coincidence. Normally, when an economy channels large amounts of debt into productive investment, the resulting rise in its GDP is likely to exceed the rise in debt, and the country’s debt burden remains low. But when debt is used to fund investment whose economic benefits are less than the cost of labor and resources employed (known as “nonproductive investment”), debt starts to rise faster than GDP. China’s debt burden began to surge around 2006 to 2008.
Since that time, China’s official debt ratio has risen from roughly 150 percent of GDP to nearly 280 percent of GDP—one of the fastest increases any country has ever experienced. The main sources of this rising debt burden were private investment in China’s property sector, including buildings filled with empty apartments that had been purchased for speculative reasons, and investment by local governments in excess infrastructure, such as overly ambitious rail systems, underutilized roads and highways, and trophy stadiums and convention centers.
While both the property and infrastructure sectors had contributed so much to China’s economic activity that they had become politically important to local elites, economic policymakers became increasingly concerned that the only way they could regain control of debt was by constraining nonproductive investment in these two sectors. But with these accounting for over half of all Chinese GDP growth in recent years—and a lot more than half during especially difficult periods for the economy—it was almost impossible to constrain them without causing a sharp drop in economic activity.
BURSTING THE BUBBLE
Regulators finally took an important first step in addressing the surge in debt last year, when they decided to clamp down on leverage by making it more difficult for the most indebted property developers to borrow. For years, these developers had been in a race to borrow as much as they could, not just from banks but also from customers, suppliers, and contractors. They had used these funds to acquire as much property as they could, and as long as real estate prices could be counted on to rise forever, they took little credit risk and were always able to sell at a profit.
But with the property sector accounting for 20 to 30 percent of all economic activity, it was inevitable that any sharp contraction in real estate would quickly become self-reinforcing and would lead to a substantial—and very unwelcome—slowdown in economic activity. What was perhaps unexpected after last year’s clampdown on the property sector’s borrowing was the extent to which financial distress spread to other parts of the economy. This was especially true for local governments, for which land sales were the largest single source of revenues; households, which suddenly began to worry that prices wouldn’t rise indefinitely; and businesses directly and indirectly affected by insolvency in the property sector.
With growing concerns about the pace of China’s economic slowdown, Beijing can respond only in limited ways. One option is to return to the days of rapid, debt-fueled growth, either by attempting to revive the property sector or by making up for its decline by significantly increasing spending on infrastructure. Local governments have been eager, almost desperate, to revive the property market, but it may be too late for that if homebuyers’ expectations that home prices in China can keep rising have been permanently punctured.
What is more, officials in Beijing seem very reluctant to return to the old ways of doing business in which developers took on enormous amounts of debt to finance speculative new projects. With Chinese residential real estate priced at roughly three times the comparable level in the United States, and with the property sector representing such an extraordinarily high share of total economic activity, most economic policymakers have long wanted to see the market cool down.
More likely is that the Chinese government will compensate for the adverse impact of a slower and smaller property market, at least partly, by stepping up spending on infrastructure. Beijing already seems willing to follow this path and has told local governments that they must accelerate or increase their infrastructure spending plans, or both.
But building more bridges and high-speed railway systems still means allowing growth to be driven mainly by nonproductive investment, as it has been during the past decade. This will cause China’s debt burden to continue to rise and resources to be misallocated until the economy can no longer sustain the consequences. When that has happened in previous cases, the result has usually been a very disruptive adjustment, often in the form of a financial crisis akin to Brazil’s in the early 1980s.
The second option for Beijing is to maintain high growth by rebalancing the economy increasingly toward consumption. Beijing has been trying to do this since at least 2007, but an increase in consumer spending requires an increase in the share that households retain of GDP. Ordinary people, in other words, would have to receive a larger share of what the economy produces in the form of higher wages, stronger pensions, more welfare benefits, and so on, and this would have to be paid for by Beijing and local governments by giving up some of their share of GDP.
Such an adjustment is extremely difficult to accomplish politically. The distribution of political power in China, as in any country, is partly the consequence of the distribution of economic power, and a major shift in the latter would almost certainly set off a commensurate shift in the former. That doesn’t mean it cannot happen, but so far there is no evidence that China will manage a rebalancing of the distribution of income that other countries with similar problems have been unable to achieve.
Finally, if Beijing is determined to act now to control the unsustainable increase in debt and is unable to rebalance the economy, the third option is simply for Beijing to allow GDP growth rates to fall sharply, probably to below three (or even two) percent. If handled correctly, most of the cost of this decline will fall on the government sector and not on households, so this won’t matter too much to ordinary people, but it does mean slower growth for the Chinese economy overall and especially in the state apparatus.
After almost three decades with the highest investment share of GDP in history, too much of China’s investment is directed, by necessity, to projects that create economic activity (and debt) but that do not create real economic value. That is why it is unlikely that China can still productively continue to invest anywhere near the same amount every year.
In that case, China’s only options are to bring down investment rapidly and accept the consequences of much lower growth or to maintain high levels of growth by forcing continued high rates of investment until the resulting surge in its debt burden makes it difficult or impossible to stay on that path. One way or another, in other words, Chinese growth will slow sharply, and the way in which it does will have profound consequences for the country, the CCP, and the global economy.
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