China must boost domestic demand to absorb new productive capacity.China’s economy has achieved stunning growth since it entered the World Trade Organization (WTO) in 2001. Annual growth has averaged 10 percent in real terms over the last decade, and gross domestic product (GDP) was 162 percent higher in 2009 than in 1999 in constant prices. This growth has largely stemmed from two developments: the lifting of the lid that had been placed on Chinese growth for decades, particularly the freeing up of international trade flows; and capital deepening, or an increase in the stock of fixed capital per person. Capital deepening increases the average productivity of each Chinese employee (and thus total output) and is exactly what emerging market economies need to “catch up” with developed economies.
Capital deepening—and the resulting increase in production—could continue for many more years. But because external markets cannot absorb rapidly rising amounts of Chinese goods forever and may already be nearing saturation, growth in Chinese production will have to be absorbed by increases in Chinese demand. The transition to relying on domestic demand carries risks—risks that will show up first in government finances.
Gambling on growth
The proportion of China’s GDP devoted to investment has jumped over the last decade. In 2000, fixed-asset investment was 35 percent of GDP (in current prices)—high, but not unprecedentedly so. By 2009, it had risen to about 44 percent, but this number significantly understates the real increase in investment, since the prices of investment goods have fallen globally relative to other goods and services. Expressed in constant prices, the increase in the investment-to-GDP ratio over the period would probably be twice as large as it is in current prices.
Since no official data on the size of the capital stock in China are publicly available, it is difficult to know by how much it has increased over the last decade. GDP has risen 162 percent in that period, and it looks as though capital accumulation can explain most if not all of that increase. The question is how much of that growth can be attributed to capital deepening. Of the 162 percent increase in GDP, Fathom Consulting estimates that about 135 percent was likely due to capital deepening, 6 percent to the modest increase in labor supply, and the remaining 20 percent to growth in total factor productivity (TFP). That equates to 1.8 percent TFP growth per year, which is about average for a developing, rapidly industrializing economy. That apportioning suggests that the capital stock has increased three to four fold over the decade.
Such a high rate of capital accumulation implies an increasing capital-to-GDP ratio across the economy as a whole, and an increasing capital-to-labor ratio, as the Chinese population rose by barely 0.6 percent per year over the last decade.
Despite the dramatic growth in the Chinese capital stock, however, the overall capital-to-labor ratio across the whole economy remains low by international standards. (Much of the rural population is engaged in labor-intensive agriculture, which keeps the average capital per head and average GDP per head low.) Capital accumulation per head in China would need to quadruple again to bring China’s capital-to-labor ratio into line with that of South Korea, for example. That could happen—but only if China were to find a market for the extra output such an increase would imply.
China’s impact on the global economy
Major structural shifts within China, such as capital deepening, matter at the global level. China has already had a dramatic impact on global growth and has achieved a significant market share by maintaining low export prices, keeping its currency low, and holding down manufacturing wage costs through rural-to-urban migration. The country has been a net saver abroad, recycling its export earnings into purchases of foreign financial assets, particularly US government bonds. China’s growth strategy has meant that global goods prices have been kept low, and government bond prices have been held up, depressing real interest rates globally. Developed economy demand for manufactured products cannot increase without limit, no matter how cheap those products become. When developed economies—particularly the United States and the United Kingdom, which have essentially been borrowing from China to buy Chinese products—enter a deleveraging cycle, as is happening now, the process breaks down. Developed economies have borrowed too much already, and those high levels of debt are acting as a brake on further consumption. In the next decade, developed economies are far more likely to become net lenders to the rest of the world than to borrow more.
The search for new markets
China urgently needs to find other sources of demand for its products if its productive capacity is to increase at anything like recent rates. The alternatives are either much weaker growth or an excessive investment cycle, which would result in bad loans, low or negative rates of return on investment, falling prices, and recession.
The last decade has seen a cumulative $10 trillion (in constant, 2009 prices) spent on fixed capital in China. Over the same period, Chinese GDP has increased by $3.3 trillion (in constant, 2009 prices). If China were to follow the path of South Korea over the coming decade in terms of fixed investment per person, cumulative investment would top $40 trillion, according to Fathom Consulting estimates. The result would be an annual GDP increase of about 12 percent—in other words, at the top of the range that China has achieved over the last decade. A more modest scenario would see investment per person rise to half the peak reached in South Korea, with cumulative investment of around $25 trillion over the decade. In that scenario, GDP would grow about 8 percent per year, toward the bottom of the range that China has achieved over the last decade.
In either case, China must find a huge new market. In the high-investment scenario, Chinese supply capacity would increase massively, but Chinese demand for investment goods would absorb a large proportion of that supply. In the modest investment scenario, Chinese supply capacity would increase by much less, but investment would absorb a smaller proportion of that increase. The bottom line is that between $5 and $7 trillion worth of extra Chinese-produced goods and services will need to find a home—every year—by the end of the coming decade (in constant, 2009 prices). The world economy as it stands cannot readily absorb so much new capacity. Global GDP, excluding China, is in the region of $55 trillion. But global growth in aggregate demand outside China over the coming decade will at best equal (and will probably be less than) global growth in productive capacity outside China. Therefore, China must be able to absorb not only growth in its own capacity but also some of the growth in global capacity.
Enter the Chinese consumer
China therefore cannot rely on external global demand to absorb its new output. With developed economies deleveraging, and developing economies already net exporters to China, most of this growth will have to come from private and government consumption in China. The most feasible new market to absorb the extra Chinese capacity is China’s own domestic market. Tapping that market means unlocking the Chinese consumer.
Chinese consumers spend an average of about $1,200 to $1,400 per year. If they were to absorb two-thirds of the lower estimate of additional Chinese output by the end of the coming decade, they would have to spend around $4,000 to $6,000 per year (in constant, 2009 prices). For Chinese consumers to have that kind of spending power, the average standard of living will need to increase by a factor of between three and five in a decade—a rather ambitious goal.
The alternative is a huge overhang of spare capacity in China, which would depress prices, interest rates, and growth for decades to come in China and in the rest of the world. PRC authorities are keenly aware of these issues and have instituted policies to reduce capacity in certain industries. But the size of the challenge is daunting. If China can boost domestic incomes and demand to the point where the domestic market can absorb China’s extra production, the coming decade will see strong growth in China and the rest of the world. If not, the world risks entering a deflationary spiral driven by debt and excess capacity.
Government finances will provide an early warning
One of the first problems PRC authorities will likely encounter relates to the fiscal position. The PRC government ran a budget deficit during 2009 for the first time in over a decade. The collapse in export markets during the global recession meant that China had to fall back on domestic demand to support growth and, in the short term, the only option was government spending. The government chose to focus that spending on capacity-building infrastructure projects, largely in inland regions—aggravating the problem of finding a market large enough to absorb that new extra capacity in the longer term.
China’s budget deficit was worth about 2.8 percent of GDP during 2009 and is expected to be about the same in 2010. Although this level is not considered dangerous, it could rise quickly if the world economy turns down again and Chinese domestic demand does not pick up the slack. If the Chinese consumer steps up, and demand for Chinese goods recovers and starts to grow again at the sort of rates seen before the recession, the deficit will shrink and return to surplus. This scenario would require Chinese private consumption to increase by around 12 percent to 15 percent in real terms every year for the next decade—significantly more than the average real growth rate of 8 percent over the past decade.
That kind of consumption growth would presumably be fueled by wealthier consumers who could afford to pay more tax, giving the PRC authorities a tax base that, in a decade’s time, should allow them to balance the books comfortably. But the transition to that situation could be delicate, in part because China would have to change its tax structure. Until now, Chinese taxes have largely fallen (directly or indirectly) on export-oriented industry. With export markets now much weaker, that source of tax revenue has shrunk, resulting in last year’s budget deficit. China now faces a conundrum: It must replace that lost revenue, but not by raising taxes quickly, which would dampen the consumption growth needed to absorb new productive capacity. If it holds back on raising taxes, and global growth remains as weak as expected, the deficit could widen further, potentially reaching double digits as a proportion of GDP. That could create a funding problem.
How would the PRC government finance its deficit in such a case? It has three options: issue new debt, print money, or draw down its reserves of foreign currency.
The first two options would lead to higher inflation, which worries the PRC government for political reasons. The third implies either increasing government imports of foreign goods and services, which would cause the trade balance to deteriorate, or selling foreign currency to buy renminbi, which would drive up the value of the currency.
Whichever option China chooses, the current account of the balance of payments will deteriorate sharply, and China would no longer be able to add to—and may even have to reduce—its foreign-exchange reserves. Of course, that is exactly what the global economy needs.
A fundamental shift to ensure global growth
The best-case scenario for global growth will see China shift from being a net lender to the rest of the world to being a net borrower from the rest of the world over the coming decade. The Chinese consumer will flourish, the renminbi will appreciate in real terms, and the PRC government will draw down its foreign currency reserves. Such a mix would deliver an extremely positive outcome for the world economy, correcting many of the imbalances that led to the recent crisis in financial markets and the global recession. Moreover, this also presents the best option for the Chinese economy to maintain the kind of growth rates it has achieved over the past decade.
But there are many pitfalls along the way. If PRC authorities raise taxes too early—before consumers become wealthy enough to spend significantly—or try to prevent the deterioration in net trade that this scenario demands, the consequences could be dire, and not just for China. The world could face a prolonged, investment-led recession on a scale not seen for decades.
Foreign companies exporting to or investing in China face important consequences. Under the best-case scenario, the Chinese domestic market for consumer goods and services would quadruple in the next decade—effectively creating a new consumer market worth $5 to $7 trillion by the end of the decade. This new market will provide foreign companies with a much-needed source of demand. Another layer of this transformation is even more beneficial for firms in developed economies: Growth in Chinese demand for foreign financial and business services will likely outstrip growth in demand for manufactured goods. Financial and business services are industries in which developed economies have a comparative advantage. The blossoming of the Chinese consumer market for goods and services over the coming decade could provide developed economies with their best route for future growth.
[author] Erik Britton ([email protected]) is director, Fathom Financial Consulting. [/author]