How to Rebalance China’s Unbalanced Growth Model

China’s recent extraordinary rise is no secret, transforming from a developing country with no real influence before 1990 to becoming the challenging superpower to US dominance today.

The growth model China followed has been undoubtedly powerful. The very mechanisms which made it so powerful, however, may have run their course making their rise unsustainable.

China’s Powerful Growth Model post-1990

In “Economic Backwardness in a Historical Perspective”, Gerschenkron Suggests that the more ‘Economically backward’ a country is, the higher the reliance on capital investment and the lower the reliance on household consumption. In addition to this, he predicts a large role of Government in supplying that Capital. We do indeed see these predictions with China’s economic development post-1990.

After 1990, Investment in Capital Increased through the suppression of household consumption. Investment in Capital is essential as it increases the efficiency of labour, thus allowing higher output per worker. The suppression of consumption to fund investment in Capital stems from a transfer of wealth from the consuming class (bottom 50%) to the investing class (top 1%). If a millionaire receives 10 dollars, they are less likely to use it for consumption and more likely to invest it than someone who earns 10 dollars per hour.

Some mechanisms China exploited to achieve this transfer of wealth included fostering a low standard of labour rights. The low standards reduced the collective bargaining power of workers, therefore, allowing employers to suppress wages. In addition to this, China’s regressive taxation system taxes consumption more than income, profit and capital gains tax. Most developed countries experience a reversed relationship; the comparative example being the US.

As a result of the low domestic demand but increased production, China developed a substantial current account (trade in goods and services) surplus, peaking at 9.15% of GDP in 2008.

Instead of financial outflows (reinvestment abroad using money received from a surplus of trade in goods and services) balancing this out as international economic theory predicts, financial inflows have dominated for most of this period; reinforcing the current account surplus. This imbalance manifested because China was reluctant to allow money to leave whilst foreign investors were keen to take advantage of the rapid growth by investing in the country.

An appreciation of the Yuan should have balanced the Financial and Current Account surplus as Chinese goods would become more expensive internationally whilst giving Chinese households more purchasing power; decreasing more costly exports and increasing cheaper imports. China relied on exports, however, and to keep Chinese goods internationally competitive; the Government pegged the Yuan to the dollar from 1996-2006 whilst the US economy was growing far slower.

They then rapidly increased their Forex reserves which devalued the Yuan to make Chinese exports cheaper and more competitive internationally. Fixing the exchange rate and growing forex reserves reinforced the transfer of wealth as it made Chinese households poorer on the international stage, whilst increasing business for exporting companies.

Whilst Chinese households have a smaller share of total income, living conditions have vastly improved as a result of the undoubtedly successful investment-led growth model with China’s Human Development Index increasing to 0.75.

The result is that China’s GDP, Investment levels, and exports have skyrocketed, whilst domestic consumption (demand) remains suppressed.

China’s growth model: from powerful to unsustainable

After the 2008 financial crash, global demand for Chinese exports plummeted. China’s response was to ramp up domestic investment even further. In the short run, this was undoubtedly powerful as the economy recovered quickly. The long-term viability of these investments, however, have been called into question by Chinese officials. Estimates suggest that $6.9 trillion was wasted due to unproductive investments from 2009-2014.

The reason why investment is unproductive is that China’s growth model constitutes suppressing consumption to allow investment, as outlined above. This model worked for a while as there were seemingly infinite investment opportunities after years of war and communist suppression in the 20^th century.

The model may have reached its limit, however, as investment needs consumption to be productive. Building a shoe factory is unproductive if there is no one to buy shoes. The Feldstein-Horioka puzzle outlines that in the globalized economy savings need not be invested domestically but can be invested in more profitable ventures abroad. This, however, is not the case as they find a correlation of investment across countries.

One symptom of China’s overinvestment is under-occupied developments dubbed ‘ghost cities’. In addition to this, China is still building subways in desolate marshlands with no one to use them. Whilst writing this article, the Economist reports that China’s Covid-19 recovery is unbalanced in favour of supply over demand; whether this is due to underlying forces or COVID secure restrictions only time will tell. A result of this unproductive investment is that China’s debt burden continues to rise as the investments do not pay for themselves; it now stands officially at 250% of national income (and could be as high as 300%).

In ‘Trade Wars are Class Wars’, Klein and Petits outline three pathways China may go down; an increasing debt burden, rising unemployment and a transfer of wealth back to households. The first is detrimental because it will lead to China reaching its debt capacity. As a result, it will either default, making it almost impossible to borrow again, print money causing massive inflation, or force the Government to cut investment leading to unemployment which is, without doubt, a loss of welfare. The second will result from either the rising debt burden as mentioned or China immediately reducing investment which is again undoubtedly harmful. Both will lead to reduced or even negative GDP growth. The third option, therefore, is the most desirable.

How a transfer of wealth could rebalance China’s economy in a sustainable way

A transfer of wealth from the investing classes back to consuming households could work to rebalance China in a way that avoids much of the adverse effects mentioned above. Investment opportunities in China would be productive again; there would be people to buy the shoes from the new shoe factory.

This transfer could manifest itself in multiple ways. One way, for example, could be more robust labour rights, increasing worker bargaining power. A rise in wages and thus, a transfer of money from businesses to households would most likely follow. A further mechanism could involve making the taxation system more progressive by raising more taxes from income, profit and capital gains and less from consumption.

The Chinese Communist Party has begun to address these issues by reducing taxes on consumption, for example. However, problems with overinvestment persist with no real transfer of wealth back to consumers. The barriers to these reforms, using premier Li Keqiangs words, stem from ‘vested interests’ from influential people who benefit from the current system.

If China continues on its current path, it will have huge ramifications domestically and internationally; one needs only refer to the great depression to find a strikingly similar case. On the other hand, if it can rebalance less destructively as outlined above, then historically it will be the exception, not the norm.

Bibliography

• Barsby, S., 1969. Economic Backwardness and the Characteristics of Development. The Journal of Economic History, 29(3), pp.449-472.
• The Economist. 2017. China’S Labour Law Is No Use To Those Who Need It Most. [online] Available at: <https://www.economist.com/china/2017/08/17/chinas-labour-law-is-no-use-tothose-who-need-it-most> [Accessed 9 September 2020].
• People.umass.edu. 2011. [online] Available at: <https://people.umass.edu/dmkotz/China_Growth_Model_%2010_09.pdf> [Accessed 21 September 2020].
• Financial Sense. 2018. Beijing’S Three Options: Unemployment, Debt, Or Wealth Transfers. [online] Available at: <https://www.financialsense.com/michael-pettis/beijings-three-options-unemployment-debt-or-wealth-transfers> [Accessed 21 September 2020].
• Ahuja, A. and Nabar, M., 2012. Investment-Led Growth in China: Global Spillovers. IMF Working Papers, 12(267), p.1.
• Klein, M. and Pettis, M., 2020. Trade Wars Are Class Wars.
• The Economist. 2020. What Is Fuelling China’S Economic Recovery?. [online] Available at: <https://www.economist.com/finance-and-economics/2020/09/19/what-is-fuelling-chinas-economic-recovery> [Accessed 21 September 2020].