The Ways China Can Rebalance

No matter how sincere its intentions, what Beijing says it will do over the next few years is meaningful only if its policies are both internally consistent and do not violate external constraints. As I proposed two weeks ago, in this post I will try to lay out as logically as possible the economic options available to Beijing, with some discussion of their limitations. Any decision made by Beijing that is not consistent with these options, I will argue, is not worth taking seriously as a prediction of the future.

To try to work out what these options might be I will begin with two key assumptions. The first is that 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.

As a consequence of this consumption-repressing growth model, Chinese growth is driven largely by the need to keep investment levels extraordinarily high. What’s more, the very high growth rate in investment, combined with significant pricing distortions, especially in the cost of capital, has resulted in massive overinvestment and an unsustainable increase in debt. China cannot slow the growth in debt and resolve its internal economic problems without raising the consumption share of GDP.

My second major assumption is that 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.

The first reason is the debt dynamics. Every country that has followed a consumption-repressing investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led either to a debt crisis or to a “lost decade” of very low growth.

At some point the debt burden itself poses a limit to the continuation of the growth model and forces rebalancing towards a higher consumption share of GDP.How?When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. When this happens China will automatically rebalance, but it will rebalance through a collapse in GDP growth, which might even go negative, resulting in a rising share of consumption only because consumption does not drop as quickly as GDP.

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Before any journalist reading this decides to write an article with the headline “Peking University Professor Predicts China Collapse,” I must stress that I am not saying that a collapse in growth must happen, or even that it is likely to happen. My argument here is only that if the unsustainable rise in debt isn’t addressed and reversed, China must eventually reach its debt capacity limit, and this will force a catastrophic rebalancing.

I expect however 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.

This adjustment won’t be easy, especially if Japan, as I argued two weeks ago, is attempting to resolve its excess debt problems by forcing up its savings rate. One way or the other, however, it must happen, either with a surge in consumption in the underconsuming countries or with a fall in production – both of which accomplish the same thing, albeit in very different ways.

How can China rebalance?

How plausible are my two assumptions? I think the first one may have been controversial in some quarters as recently as three years ago, and there still are a few who disagree, but it is pretty much accepted among most economists, and it has certainly been a formal part of Beijing’s discourse.Everyone from Premier Wen and Vice Premier Li on down has insisted that Beijing’s consumption imbalance has reached danger levels, and that China must and will rebalance.

Written By: Michael Pettis