Rebalancing Act, Part Two – On the Extremity of China’s Investment-led Development Model

DANIEL ROARTY

The recently released data on China’s 3rd quarter growth seems optimistic on the surface – while many analysts have been predicting a gradual slowdown in the Chinese economy, 3rd quarter figures show it accelerating from 7.5% growth in the previous quarter to 7.8% this quarter. However, rapidly expanded credit enacted earlier this year is mainly responsible for this acceleration – industrial output, energy output, and exports all slumped in the same period. Conversely, investments in transportation infrastructure and sewage systems skyrocketed. These figures lead to the conclusion that China is still heavily dependent on investment for economic growth and that it has yet to begin a long-awaited rebalance away from investment-led growth to consumption-led growth.

This post will investigate China’s rebalancing from a historical perspective, comparing China’s consumption to GDP ratio to that of other countries using data from the World Bank, and will end with some conclusions that can be derived from this comparative historical analysis.

China and major economies/regional parallels

In a previous post, I looked at Yukon Huang’s arguments in favor of China’s unbalanced growth strategy and his argument that China is simply following the same investment-led model that Japan and South Korea used in their development.

In 2009, China’s consumption ratio (Final Household Consumption Expenditure (% of GDP) in the World Bank Database) stood at 33.94 percent, among the lowest ever recorded by a major economy. Recent data from the World Bank now puts it at 35.7 percent, a modest improvement but also an improvement lacking forward momentum. This compares with 71.57 for the United States, over double China’s figure. All other major economies stand in the range between 50-65 percent. Analysts such as Huang see this as natural, as China and is using heavily investment-led growth to develop infrastructure and increase productivity for future growth. While Japan and South Korea followed a similar model, neither ever reached the same level of investment as China.

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World Bank data gives Japan’s lowest recorded consumption ration as 49.26 percent, which is the lowest level recorded in its post-war development, according to IMF statistics. Additionally, South Korea’s lowest consumption ratio was 49.33 percent, recorded in 1998. Both of these were relatively short dips below 50 percent and both have hovered between 50 to 60 percent since the eighties. China, on the other hand, has seen its consumption ratio remain around 50 percent in the eighties and plummet since the year 2000.

Two things to note about this graph: First, most of the developed economies present here exhibit very weak, gradual upward trends in their consumption ratios. South Korea, being the newest developed country represented, would exhibit a similar trend if one started from the late 1980s. Second, the ratios of more developed countries move very slowly, which raises the question of whether rapid growth in China’s consumption ratio is a possibility or even desired. More on this later.

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Converse to consumption, neither South Korea nor Japan’s investment ratio (Gross Capital Formation (% of GDP)) ever approached the levels seen in modern day China: Japan’s ratio topped out at 38.84 percent, and South Korea’s reached a high of 39.74 percent. Neither rivals China’s 2011 ratio of 48.42 percent. Therefore, while China may be following a similar investment-heavy model that worked in East Asia, it is a far more extreme version than those utilized by Japan and Korea.

(Note: Hong Kong and Singapore were purposefully left out of this analysis since their roles as regional financial centers, as well as their small size, make them poor comparisons for China’s model.)

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But what about developing countries? Even among China’s peers in the BRIC bloc, its low level of consumption is abnormal. China consistently spends more of its GDP than its BRIC counterparts, with India and Brazil’s ratios at levels more common in developed nations. Russia’s more erratic levels during the 1990s display another attribute of consumption ratios: their erratic reaction to crises. The collapse of the Soviet Union in 1991 and the 1998 financial crisis are both visible in the graph as wild swings in the consumption ratio – while Russia’s consumption ratio did grow by nearly 25 points from 1992 to 1998, this was unsustainable and quickly collapsed. Brazil’s attempt to rein in inflation in the mid-to-late 1980s is also apparent.

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Other countries have also experienced wild swings in their consumption ratios during crises, and few have seen rebounds after a crisis. Indonesia’s ratio swung up during the Asian Financial Crisis, only to return to previous levels before moderately trending downward. Argentina’s ratio swung wildly as the country grappled with massive inflation in the late 1980s and early 1990s, and then collapsed in 2002 as the Argentine economy collapsed.

Conclusions

There are a few overriding conclusions from the analysis above. First, China’s version of the investment-heavy development model is far more extreme than its East Asian counterparts. There are many possible reasons for this: the effects of corruption, the much larger land mass of China as a country, China’s late emergence and the costs associated with such a rapid game of technological catch-up, etc. However, one thing that many analysts agree on is that such continued dependence on investment heightens the risks for crises, and many think that the time for such a crisis has arrived. Chinese firms will have to pay $1 trillion in interest this year on their debt, and by some measure, China is using 39% of its GDP to service its debt.  A country with such a huge but unbalanced economy is historically unprecedented.

Second, expecting China to become the engine of global economic growth is premature. With 35 percent of it $8.227 trillion economy (2012 GDP) being consumption, we come up with a back-of-the-envelope figure of $2.8 trillion in consumption. The United States, on the other hand, contributes roughly $11.13 trillion in consumption. In the next decade, should China’s GDP more than double to $20 million but with consumption making up 45 percent of GDP (an optimistic figure in this time frame), China would only contribute $9 trillion in consumption. Therefore, China’s GDP might overtake the US, yet the US would remain the main driver of global consumption.

Additionally, although China’s GDP has been rising rapidly, it remains a developing country and will require more investment. Therefore, it is unlikely for consumption to spike in the near to medium term. Furthermore, the consumption ratios of developing countries are historically more vulnerable to economic shocks compared with developed countries. An economic shock (which China seems ready for) could further hamper efforts to rebalance the Chinese economy, unless that “rebalancing” was more like a severe reaction to such a shock and a resulting recession. There is still a possibility that China’s extreme-investment method of development will result in successful development – indeed, some might say that countries with more balanced consumption ratios are hitting the middle income trap due to their comparative lack of investment. However, the great concerns of China’s method are the externalities associated with its extreme development model and the ramifications for the global economy of the effects of these externalities.

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