Most people have something to be disgruntled about China’s economic situation – whether it is its low consumption demand and large external surpluses, industrial overcapacity, environmental degradation, or the range of government intervention spanning from capital controls to financial repression. Pessimists have long called for the demise of the Chinese model, each focusing on a different subset of these issues.
But it is a fallacy to think that these issues are disparate problems. They are, in fact, mere symptoms of a more fundamental problem, the problem of a skewed development model. The model is to some extent a policy-induced construct, the result of a nascent bias for production and manufacturing as the main pillar for economic development, and a penchant for speed – the `Chinese impatience’. That bias earned China the title of ‘factory of the world.’
China’s predilection for production harks back to the days of the Great Leap Forward, where scrap metal was melted to meet the wildly optimistic targets of steel production and Mao’s dream of rapid industrialisation. In today’s China, this proclivity has manifested itself again in the form of vehement fervour for project-based GDP boosters. These industrial and infrastructure projects invite investment and generate tax revenue for the local government. They can push up GDP in a short period of time and meet targets quickly – as opposed to the time it takes to develop service sectors. Direct and indirect government subsidies from the center occasion huge incentives to take on more and more projects in the periphery.
The bias for industrial production is further reinforced by a notion that expanding exporting sectors can somehow help absorb China’s vast labour force. But this belief is misconceived. Exporting sectors experience some of the fastest growth in labour productivity, and for that reason, do little to generate actual employment. The bias has lead to a deeply intricate, self-propelling economic cycle, kept alive by a web of seemingly unrelated distortionary policies that are in fact interwoven, interlinked, and symbiotic. Growing like China has thus produced five main perils.
1. Where is the Employment?
One of the most glaring problems of China’s growth model is that its remarkably high GDP growth has not transpired into rapid employment growth. While China’s annual GDP growth has averaged near double digits in the last few decades, its employment growth has been averaging only 1-2% per annum. Absorbing China’s vast labour force may require more than industrialisation and exports; it will need to turn to service industries.
In advanced economies, the service sector absorbs the lion’s share of employment. In the U.S. in 2012, according to the Bureau of Labor Statistics, about 80% of the total labour force was deployed in services sectors. Service sectors are more labour -intensive, and can provide more employment growth relative to manufacturing industries due to their slower pace of labour productivity. Rapid labour productivity growth reduces the need to hire more labour. Compared to industrial sectors, which has seen an annual labour productivity growth of above 10% in the last two decades, service sectors have only registered about 5% annual labour productivity growth. At the end of the day, China needs to shift gears to tackle its deeply-rooted employment problems.
2. Suppression of Households
Between 1990-2009, the share of household income in GDP in China fell from 70 to 60%, while the share of household income in the U.S. remained stable at around 80% of GDP.
So households are losing out, relatively, in the process of growth. The blame can again be placed on the lopsided macro-structure. Wages were suppressed to cap the rise in labour costs, and financial repression lowered the cost of capital; the beneficiaries were corporates, whose production was subsidised. But these costs were ultimately borne by the household.
Indeed, households were not able to fully reap the full gains of their rapid productivity improvements in the last few decades: the 8.5% average annual labour productivity growth has not been commensurate with an average 5% average wage growth over the same period. At the same time, where the households have missed out on wage growth, they have not been able to compensate it with lucrative returns to savings either. In the last decade, the average real return on deposits has been hovering around 0 percent, negative in many of the years. Since about 80% of Chinese household savings is placed into bank deposits, this implicit tax on savings has been large.
What are the consequences of household suppression? Low wages and interest income have ultimately fed into China’s high investment and low consumption tendencies. And `global imbalances’ ensued.
3. A vicious loop and interwoven policies
China’s economic structure is regarded as ‘unbalanced’. But a more accurate description is that it is a vicious loop. Distortionary policies propel the loop and keep it going. As succinctly synthesized by Kai Guo, the loop goes as follows: financial repression and wage suppression and undervalued exchange rates subsidize exports and production, at a cost ultimately borne by households. The ensuing weak demand and low consumption compel the government to turn to exports and investment to maintain GDP growth. Reliance on exports leads to a massive accumulation of reserves, which subsequently needs to be sterilised. Low interest rates, in turn, help contain the cost of sterilisation on the national level and reduce costs at the firm level. And the cycle repeats itself.
4&5. Misallocation of Resources and the Cost of Environment
The upshot of a structure bent on manufacturing is invariably a toll on the environment. If China can shift gears to move to a service-based economy, the burden on the environment would also be eased. Equally important, however, is that policies skewed towards manufacturing industries and exporting firms can cause a severe misallocation of capital. Productive and efficient firms and industries may not obtain the resources they deserve, and implicit subsidies may help unproductive firms/sectors be apportioned an unmerited amount of resources. This lowers aggregate productivity and the efficiency of the economy. It has also caused an `industrial over-capacity’ that the government is in the course of trying to resolve.
Thus, many of the problems that beset the Chinese economy stem from one single problem of structure – and thus fixing the structure can to a large extent mitigate a host of troubles. In some ways, reforms, however are difficult precisely because one has to operate on the entire system rather than zero in locally – correcting one policy distortion requires correcting another. Because distortions are all interlinked, fixing the problem requires an absolute resolve to once and for all change the orient and the nature of the economy – in its entirety. A gradualist approach may no longer work.
