China’s vi­cious growth cir­cle

Financial Mirror (Cyprus) - - FRONT PAGE -

Most econ­o­mists have a rea­son to be wor­ried about China’s econ­omy – whether it be low con­sump­tion and large ex­ter­nal sur­pluses, in­dus­trial over­ca­pac­ity, en­vi­ron­men­tal degra­da­tion, or gov­ern­ment in­ter­ven­tions like cap­i­tal con­trols or fi­nan­cial re­pres­sion. What many fail to recog­nise is that th­ese are merely the symp­toms of a sin­gle un­der­ly­ing prob­lem: China’s skewed growth model.

That model is, to some ex­tent, a pol­i­cyin­duced con­struct, the re­sult of a deep-rooted bias to­ward con­struc­tion and man­u­fac­tur­ing as the lead­ing driv­ers of eco­nomic de­vel­op­ment. This predilec­tion harkens back to the Great Leap For­ward of the 1950s, when scrap metal was melted to meet wildly op­ti­mistic steel­pro­duc­tion tar­gets, thereby ad­vanc­ing Mao’s dream of rapid in­dus­tri­al­i­sa­tion.

To­day, China’s pro­cliv­ity for in­dus­trial pro­duc­tion is man­i­fested in large-scale man­u­fac­tur­ing and in­fra­struc­ture projects, en­cour­aged by di­rect and in­di­rect gov­ern­ment sub­si­dies. By boost­ing in­vest­ment and gen­er­at­ing tax rev­enue for lo­cal gov­ern­ments, this ap­proach has a more im­me­di­ate pos­i­tive im­pact on GDP than ef­forts to de­velop the ser­vice sec­tor.

But the model also car­ries con­sid­er­able costs. In­deed, China is now locked in a vi­cious eco­nomic cir­cle, sus­tained by seem­ingly un­re­lated dis­tor­tionary poli­cies that are, in fact, deeply in­ter­con­nected, even sym­bi­otic.

One of the most glar­ing fea­tures of this pat­tern is the dis­par­ity be­tween China’s GDP growth, which has av­er­aged nearly 10% an­nu­ally over the last few decades, and its em­ploy­ment growth, which has amounted to just 1-2% an­nu­ally. Clearly, in­dus­tri­al­i­sa­tion and ex­port ex­pan­sion alone can­not ab­sorb China’s mas­sive labour force.

The prob­lem is that rapid labour­pro­duc­tiv­ity growth in the in­dus­trial sec­tor – more than 10% per year over the last two decades – is re­duc­ing the need to hire more work­ers. The ser­vice sec­tor, by con­trast, ex­pe­ri­enced much slower la­bor-pro­duc­tiv­ity growth (about 5% an­nu­ally over the same pe­riod), mean­ing that it could be far more ef­fec­tive in gen­er­at­ing em­ploy­ment growth. In the United States, about 80% of the to­tal labour force was de­ployed in the ser­vices sec­tor in 2012.

Another con­se­quence of China’s skewed growth model has been a de­cline in house­hold in­come as a share of GDP, from 70% in 1990 to 60% in 2009, whereas in the US, for ex­am­ple, the ra­tio has re­mained sta­ble, at around 80% of GDP. In other words, Chi­nese house­holds are miss­ing out on the ben­e­fits of eco­nomic growth.

This phe­nom­e­non, too, can be blamed largely on dis­tor­tionary poli­cies. In or­der to cap the rise in la­bor costs, wages were sup­pressed, grow­ing by only 5% an­nu­ally over the last 20 years, even as pro­duc­tiv­ity grew at an an­nual rate of 8.5%. Mean­while, fi­nan­cial re­pres­sion low­ered the cost of cap­i­tal. In the last decade, the av­er­age real (in­fla­tion­ad­justed) re­turn on de­posits has been near zero.

With about 80% of Chi­nese house­hold sav­ings de­posited in banks, this im­plicit tax on sav­ings has had a ma­jor eco­nomic im­pact, re­in­forc­ing Chi­nese house­holds’ ten­dency to save and thus un­der­min­ing con­sump­tion growth and ex­ac­er­bat­ing global im­bal­ances.

In this way, China’s dis­tor­tionary poli­cies have helped to per­pet­u­ate a dys­func­tional growth model. Wage sup­pres­sion, fi­nan­cial re­pres­sion, and an un­der­val­ued ex­change rate sub­sidise ex­ports and pro­duc­tion, at the ex­pense of house­holds, which are thus com­pelled to save, weak­en­ing do­mes­tic de­mand. In or­der to achieve growth tar­gets, the gov­ern­ment thus must de­pend on ex­ports and in­vest­ment – an ap­proach that leads to the ac­cu­mu­la­tion of mas­sive re­serves, which sub­se­quently need to be ster­ilised. Low in­ter­est rates help to con­tain the cost of ster­il­i­sa­tion at the na­tional level and re­duce costs at the firm level – again at the ex­pense of house­holds.

Break­ing the cy­cle will not be easy, but there is no other way to ad­dress many of the most press­ing prob­lems con­fronting China’s econ­omy. In­deed, the cur­rent growth model is also tak­ing a heavy toll on the en­vi­ron­ment, with pol­lu­tion threat­en­ing the pop­u­la­tion’s health, es­pe­cially in ur­ban ar­eas.

More­over, the bias to­ward man­u­fac­tur­ing and ex­port in­dus­tries leads to a se­vere mis­al­lo­ca­tion of cap­i­tal. Less ef­fi­cient in­dus­trial sec­tors have ac­cu­mu­lated sig­nif­i­cant ex­cess ca­pac­ity, desta­bil­is­ing the en­tire econ­omy, while more pro­duc­tive, ef­fi­cient sec­tors lack ac­cess to the re­sources they need.

Re­struc­tur­ing the econ­omy is per­haps the most ur­gent – and most dif­fi­cult – chal­lenge fac­ing China’s lead­ers to­day. Given that the cur­rent dis­tor­tions are in­ter­linked, they may need to be ad­dressed simultaneously. China’s grad­u­al­ist ap­proach may no longer work.

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