China must reform to maintain high levels of economic growth
by Nicholas Lardy
03 February 2012
The country's next generation of leaders face a considerable challenge in pushing through the reforms needed to sustain China's economic growth
The argument that China must significantly alter its growth model may seem a little strange given how successfully it weathered the global financial crisis. China's growth ticked down only slightly in 2009 to 9.2 per cent, while the rest of the world suffered its sharpest decline in 60 years. Yet the success of the past several years should not obscure the fact that, in the words of Premier Wen Jiabao, the country's growth remains "unsteady, imbalanced, uncoordinated, and unsustainable".
The signs of imbalanced economic growth in China's are manifold: low levels of private consumption, super-elevated share of investment in gross domestic product, an outsized manufacturing sector, a diminutive service sector, an unprecedentedly large hoard of official holdings of foreign exchange, and an unsustainable rate of investment in residential property. To borrow Herbert Stein's famous phrase "if something cannot go on forever, it will stop". China should reform its unsustainable growth model now, while in a position of relative strength, before it is forced to by an economic slowdown. Addressing these imbalances will require fundamental market-oriented reforms; continuing the modest, incremental reforms of recent years will not be sufficient to propel it onto a new growth path.
One of the most important sources of economic imbalances in China is financial repression, reflected in the low or negative rates on savings deposits since 2003. In the six years prior to 2003, a Chinese household earned an average real rate of 3 per cent on a one-year deposit, while for the subsequent nine years households only earned -0.5 per cent. Negative real deposit rates depress the growth of household income, leading to lower consumption. Lower interest rates also lead to a change in household behavior, causing them to save more money and further reduce their consumption. Households appear to be target savers- trying to save a set amount of money to meet unforeseen medical treatments or for retirement. The increase in the household saving rate has depressed the share of private consumption in China's GDP.
Negative deposit rates have also led households to put an increasing share of their savings into housing. Since 2003, the return to owning property has far exceeded the interest rate on bank deposits. As a result, housing investment exploded from 5 per cent of GDP in 2003, to 10 per cent by the end of last year. To put this in perspective, housing investment in Taiwan peaked at 4 per cent when it was growing and urbanising rapidly and had a level of per capita income roughly comparable to China today. The sharp rise in investment in residential housing accounts for much of the increase in investment since 2004, and has become the single most important driver of China's economic growth.
This level of residential property investment cannot continue at the same rapid pace as the last decade. Housing as a share of household wealth doubled over the last decade and is unlikely to do so again. Moreover, banks have become increasingly exposed to the property market and may become wary of extending new loans. Finally, Chinese household have become much more leveraged over the past few years. Household debt - largely in the form of mortgages - has doubled as a share of income and household will become increasingly unwilling or unable to take on additional debt to invest in housing. All of these developments suggest that a slowdown in the pace of property investment is inevitable and that it will have a potentially large negative impact on China's economic growth.
Beyond reforming interest rates – the state needs to reduce the direct and indirect subsidies provided to the manufacturing sector, allow greater flexibility of the exchange rate and continue the rapid build out of the social safety net. None of these policies are new and all have been acknowledged by various leaders as important goals. Yet many of these reforms have been on the agenda for a decade, with little to no progress. The reason for such little progress is that he beneficiaries of imbalanced growth - including the export and manufacturing sectors, the trade-oriented coastal provinces, the real estate and construction industries and banks - have fought reform to a standstill. The country's next generation of leaders face a considerable challenge in pushing through the reforms needed to sustain China's economic growth.
Nicholas Lardy works for the Peterson Institute for International Economics think-tank, in the United States, and is the author of Sustaining China's economic growth after the global financial crisis
The argument that China must significantly alter its growth model may seem a little strange given how successfully it weathered the global financial crisis. China's growth ticked down only slightly in 2009 to 9.2 per cent, while the rest of the world suffered its sharpest decline in 60 years. Yet the success of the past several years should not obscure the fact that, in the words of Premier Wen Jiabao, the country's growth remains "unsteady, imbalanced, uncoordinated, and unsustainable".
The signs of imbalanced economic growth in China's are manifold: low levels of private consumption, super-elevated share of investment in gross domestic product, an outsized manufacturing sector, a diminutive service sector, an unprecedentedly large hoard of official holdings of foreign exchange, and an unsustainable rate of investment in residential property. To borrow Herbert Stein's famous phrase "if something cannot go on forever, it will stop". China should reform its unsustainable growth model now, while in a position of relative strength, before it is forced to by an economic slowdown. Addressing these imbalances will require fundamental market-oriented reforms; continuing the modest, incremental reforms of recent years will not be sufficient to propel it onto a new growth path.
One of the most important sources of economic imbalances in China is financial repression, reflected in the low or negative rates on savings deposits since 2003. In the six years prior to 2003, a Chinese household earned an average real rate of 3 per cent on a one-year deposit, while for the subsequent nine years households only earned -0.5 per cent. Negative real deposit rates depress the growth of household income, leading to lower consumption. Lower interest rates also lead to a change in household behavior, causing them to save more money and further reduce their consumption. Households appear to be target savers- trying to save a set amount of money to meet unforeseen medical treatments or for retirement. The increase in the household saving rate has depressed the share of private consumption in China's GDP.
Negative deposit rates have also led households to put an increasing share of their savings into housing. Since 2003, the return to owning property has far exceeded the interest rate on bank deposits. As a result, housing investment exploded from 5 per cent of GDP in 2003, to 10 per cent by the end of last year. To put this in perspective, housing investment in Taiwan peaked at 4 per cent when it was growing and urbanising rapidly and had a level of per capita income roughly comparable to China today. The sharp rise in investment in residential housing accounts for much of the increase in investment since 2004, and has become the single most important driver of China's economic growth.
This level of residential property investment cannot continue at the same rapid pace as the last decade. Housing as a share of household wealth doubled over the last decade and is unlikely to do so again. Moreover, banks have become increasingly exposed to the property market and may become wary of extending new loans. Finally, Chinese household have become much more leveraged over the past few years. Household debt - largely in the form of mortgages - has doubled as a share of income and household will become increasingly unwilling or unable to take on additional debt to invest in housing. All of these developments suggest that a slowdown in the pace of property investment is inevitable and that it will have a potentially large negative impact on China's economic growth.
Beyond reforming interest rates – the state needs to reduce the direct and indirect subsidies provided to the manufacturing sector, allow greater flexibility of the exchange rate and continue the rapid build out of the social safety net. None of these policies are new and all have been acknowledged by various leaders as important goals. Yet many of these reforms have been on the agenda for a decade, with little to no progress. The reason for such little progress is that he beneficiaries of imbalanced growth - including the export and manufacturing sectors, the trade-oriented coastal provinces, the real estate and construction industries and banks - have fought reform to a standstill. The country's next generation of leaders face a considerable challenge in pushing through the reforms needed to sustain China's economic growth.
Nicholas Lardy works for the Peterson Institute for International Economics think-tank, in the United States, and is the author of Sustaining China's economic growth after the global financial crisis
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COMMENTS
All it will need for China's growth to be decimated is for the people - both consumers and those in power - of the western nations to realise that 1."Made in China" may momentarily give you relief from the higher prices of indigenous products, but in the long run, it means that the money that was supposed to be circulating in your country and sustaining the economy has gone into China and is sustaining their economy. 2.The US and the EU aren't known for being places where 10 men succeed enormously and the rest follow their lead. On the contrary, they are known for being the places where anyone and anything can succeed. They should remember this in making their choices in life, especially with respect to careers.
Aritra
I would advise this news outlet not to publish articles from Americans. Narrow technical educations underpinned by a strong ideological bias means that these people churn out articles that may be summarised as "China should reform to be more like America". Having little knowledge of the subject matter is no excuse for low quality articles. Please use European or Asian sources.
pmcdonald
