1) The fundamental imbalance in China is the very low GDP share of consumption. This low GDP share of consumption, I have always argued, reflects a growth model that systematically forces up the savings rate largely by repressing consumption, which it does by effectively transferring wealth from the household sector (in the form, among others, of very low interest rates, an undervalued currency, and relatively slow wage growth) in order to subsidize and generate rapid GDP growth.
2) China must and will rebalance in the coming years – its imbalances, in other words, cannot get much greater and we will soon see a reversal. There are two reasons for saying this, neither of which has to do with the claims being made by Beijing that they are indeed determined to rebalance the economy.
Michael Pettis believes that Beijing will begin rebalancing well before we reach the debt capacity limit. I will discuss later how Beijing can engineer the rebalancing process, but the point here is just that either Beijing forces rebalancing, or rebalancing will be forced upon China in the form of a debt crisis. One way or the other, in other words, debt will force China to rebalance.
The second reason for assuming that China will rebalance is because of external constraints. Globally, savings and investment must balance. This means that for any set of countries whose savings exceed investment, like China, there must be countries whose investment exceeds savings, like the US. To put it another way, the world can function with a group of underconsuming countries only if they are balanced by a group of overconsuming countries.
For the past decade the underconsuming countries of central Europe and Asia, of which China was by far the most important, were balanced by overconsuming countries in peripheral Europe and North America. But conditions are changing. The overconsuming countries are being forced to reduce (in the former case) or are working towards reducing (in the latter case) their overconsumption.
To the extent they succeed, by definition unless there is a surge in global investment – which given the weak state of the world is very unlikely – underconsuming countries must increase their total consumption rates, or else the world economy cannot balance savings and investment. This global rebalancing must involve China. As the biggest source of global underconsumption by far, it is very hard to imagine a world that adjusts without a significant adjustment in China.
Where some analysts might disagree with my second assumption is in the issue of timing. China bulls continue to argue that there isn’t yet a significant overinvestment problem in China, which implies that debt is not rising at an unsustainable pace, or if it is, that it can continue rising for many more years before the debt burden itself becomes unsustainable. This, for example, is the view of the folks at Dragonomics, and it is a view often expressed sympathetically in The Economist.
This disagreement with my assumption also implies that the consumption imbalance is temporary and can resolve itself gradually and over time as the benefits of earlier investment begin to emerge and eventually overwhelm the total costs of those investments. Of course if this is true China does not need a surging current account surplus because if investment isn’t being wasted it can keep investment rising faster than savings for many more years. The current account surplus, remember, is just the excess of savings over investment.
The key vulnerability of my argument, then, is whether or not you think investment in the aggregate is being misallocated in China and has been for many years. If you agree that it has, and that it has reached unsustainable levels, then you must also agree that consumption must become a greater share of GDP over the next five to ten years. What’s more, you should also agree that the only way to increase the consumption share of GDP is to increase the household income (or wealth) share of GDP.*
China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption.
Ways to Rebalance
the various ways in which this transfer can take place can all be accounted for by one or more of the five following options:
1. Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, the foreign exchange value of the currency, and wages, or by lowering income and consumption taxes.
2. Beijing can quickly reverse the transfers in the same way.
3. Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.
4. Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt.
5. Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
Notice that all of these options effectively have China doing the same thing: In each case the state share of GDP is reduced and the household share is increased. There are however very big differences in how the changes are distributed among various parts of the household sector and the state sector.
Notice also that the changing share of GDP tells us little or nothing about the actual GDP growth rate, or about the growth rate either of household wealth or of state wealth. It just tells us something very important about the relative growth rates. For example we can posit a case in which GDP grows by 9% annually while household income grows by 12-13% annually. In that case the rest of the economy would grow by roughly 5-6% annually (household income is approximately half of GDP), and the distribution of this growth would be shared between the sate sector and the business sector. This might be considered the “good case” scenario of rebalancing.
Alternatively, we can posit that annual GDP growth is 0%. In that case the annual growth in household income might be 3-4% while the state and business sectors contract at roughly 3-4%. This would be the “bad case” scenario.