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Rebalancing China and Bracing for the Trade War

The only thing more ambitious than Beijing’s goals is its time frame.

Deep Dive

Phillip Orchard |August 9, 2018

Summary

It has been 40 years since Deng Xiaoping launched China’s “reform and opening up” policy. By most metrics, China’s economic “miracle” has indeed been nothing short of preternatural, with some 800 million people rising out of poverty over the span of just a few generations and the country becoming an indispensable part of the global economy. But this growth happened neither evenly nor sustainably, and it’s running out of the sort of low-hanging fruits that fueled China’s rise.

As a result, like most developing countries, China has a fundamental problem: It wants to transition to a consumption-based economy (which is more stable than relying on exports and investment), but its domestic consumer base is not yet wealthy enough to support the level of economic productivity needed to allow for that transition. With a trade war looming, a shift to domestic consumption is becoming all the more urgent. Beijing is scrambling to conjure up yet another economic miracle.

This Deep Dive will explain why the economic model that made much of China rich is nearing its expiry date, with continued, even if slowly declining, dependence on cheap exports and investment now creating as many problems as it solves. We’ll check in on China’s efforts to make the leap many of its neighbors did long ago, to a more stable model based on consumption, services and high-tech industry. Ultimately, we conclude that China’s progress has been mixed, at best, with new risks emerging on the road ahead.

Why China Needs to Rebalance

More than anything else, China’s growth has been fueled by three things: cheap exports, investment and the one-time gains of land and resource privatization. This is the standard blueprint for developing economies (cheap exports, in particular), taking advantage of low wages to piggyback off growth in wealthier countries by both undercutting their industries and making a pretty penny on their voracious appetites for consumption.

There are two overriding problems with a dependence on cheap exports. First, China’s ability to sustain its economy hinged too much on economic conditions outside the country. China has been overly beholden to its customers, most of them located in distant markets, none of them immune to their own periodic downturns in consumption or protectionist social pressures. If the U.S. or European economies crashed, so too would China’s. Following the crash of the U.S. economy in 2008, for example, Chinese exports fell off a cliff – including by a record 26 percent year-over-year in February 2009. That January, the Chinese government estimated that 20 million migrant workers had lost their jobs in 2008 because of the global economic slowdown.

Second, the wealthier China becomes, the more difficult it becomes to sustain this export-heavy model. Rising standards of living push wages up, making Chinese exports less competitive and giving foreign firms in the country cause to look to lower-cost alternatives. China wants to accommodate this shift by moving into high-tech, higher-value exports, but here it is facing stiff competition from countries that climbed the value ladder decades ago. This is known as the middle-income trap – something China is desperate to avoid. The challenge for China has only been intensifying as its neighbors in South and Southeast Asia, in particular, began investing heavily in manufacturing and export infrastructure since putting the regionwide chaos wrought by the Cold War largely behind them.

Reliance on investment, the bulk of it government-driven, has enabled Beijing to keep the economy humming somewhat amid global downturns in consumption and (most important, considering China’s outsize socio-economic risks) keep employment generally steady. The 4 trillion yuan ($586 billion) firehose of stimulus Beijing opened up in late 2009 enabled China to bounce back from the crisis much quicker than most of the West. But this created its own problems. In China, among other unintended consequences, it has resulted in a system that’s awash in cheap credit and not enough productive places to put it. This can lead to industrial inefficiency and unprofitability; wildly inflated real estate and land bubbles; and firms, banks and local governments saddled with unsustainable debt loads, among other side effects. The Chinese economy is littered with ticking time bombs.

Thus, China is in a race against the clock – before Western economies crash again, before its internal debt loads and asset bubbles start a crisis at home – to rebalance the economy away from low-cost exports and investment and toward domestic consumption, high-value manufacturing and services. China’s aging, shrinking workforce will only make this endeavor more difficult. And now, China has yet another pressing reason to rebalance: the growth of protectionist political forces in Western economies. China’s progress will affect its ability to ride out a trade war with the U.S. In theory, at least, the calculus is fairly straightforward: The less the Chinese economy relies on exports to the U.S., the less measures by the U.S. to limit China’s access to the world’s largest consumer market will sting. And the more U.S. businesses rely on China’s own growing consumer base, the harder China can punch back.

Mixed Results

On the whole, China’s rebalancing process has proceeded in fits and starts. This is, in part, because different measures can work against each other. For example, reforms to rein in excessive lending to oversized exporting sectors can hurt domestic consumption by, say, lowering employment. More so, it reflects the reality that the Communist Party of China’s paralyzing fear of social unrest and power struggle has compelled Beijing to continually try to thread the needle between structural reforms and the status quo.

On external rebalancing, at least, China has indeed been gradually easing its dependence on exports for quite some time.

As a percent of China’s gross domestic product, Chinese exports have declined from as high as 38 percent in 2006 to around 20 percent in 2017. Of course, this trend wasn’t solely the result of structural reforms aimed at easing dependence on exports. The 2008 crisis and subsequent decline in global consumption played a major role. Over this same period, China’s GDP growth was nearly cut in half, from 12.7 percent to 6.9 percent last year. (As we’ve noted several times, official Chinese data should always be taken with more than a pinch of salt.)

It’s true that China’s slowdown wasn’t nearly as steep as in Western countries. But for about a decade, this, like its “success” on the external balancing front, came primarily from investment – not, as Beijing would hope, from its burgeoning consumer class. From the early 2000s until around 2011, investment as a share of GDP jumped from roughly 37 percent to 47 percent. By comparison, in developed countries, investment generally accounts for around 20 percent of GDP. Meanwhile, the contribution of Chinese consumption to GDP declined from around 63 percent in 2000 to just 48 percent a decade later, before beginning to tick back upward, according to the World Bank and Organization for Economic Cooperation and Development.

Initially, the outsize role of investment wasn’t necessarily a problem. China’s entry into the World Trade Organization in 2001 had accelerated an investment boom that, for about a decade, effectively commiserated with a boom in exports. The growth in dependence on exports may have made Beijing uneasy in the big picture, but at least the investment was generally being put to productive and profitable uses. This began to change once demand for exports crashed in 2008, forcing Beijing to start shoveling stimulus money into whatever domestic projects would keep its people and businesses busy. According to International Monetary Fund figures, credit intensity in China – the ratio of credit needed to generate 1 trillion yuan of nominal GDP – soared from around 1.3-to-1 to around 4.8-to-1 in a year after the crisis hit. In other words, investment in China stopped getting the same bang for the buck. Exports rebounded sharply beginning in 2010, and investment as a share of GDP leveled off in 2012. But China’s addiction to credit hadn’t really receded, and the amount of liquidity sloshing around in the system began dragging down efficiency. In 2016, in fact, credit intensity reached 5.3-to-1, surpassing even the stimulus-soaked levels reached in 2009. The reality is that breakneck growth in China was always going to be difficult to perpetuate; as economies grow larger, high growth rates naturally get harder to sustain. The problem in China has been that the government, until recently at least, feared that any major slowdown would lead to social unrest, so it kept its foot on the gas.


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Though relying less on exports and more on investment would theoretically help blunt the direct effects of the trade war in the short term, if it doesn’t make China’s economy more resilient as a whole – or if it actively raises the risk of a financial crisis – it magnifies the risks that any hit to exports from the trade war would destabilize the economy. Investment, in other words, transformed quickly from a palliative to an anabolic steroid, intensifying all sorts of other problems, from unprofitability to credit and land bubbles to local government debt loads to pollution. According to the Institute of International Finance, for example, gross debt rose from 170 percent of GDP to nearly 300 percent between 2008 and 2017. The systemic risks these pose to China is a core reason China has re-embraced the rise of a dictator in the form of President Xi Jinping.

Still, since the beginning of this decade, China has found some reason to be optimistic – in particular, the greater role domestic consumption has played as a growth driver. Gross consumption (combined public and private) as a share of GDP growth has gradually ticked upward, from less than 50 percent in 2010 to nearly 65 percent in 2016, according to official figures. As a result, over this same period, investment as a share of GDP growth fell by around 3 percent without dealing a major blow to the economy. Meanwhile, China’s current account surplus has declined from its peak of about 10 percent of GDP in 2007 to 1.3 percent in 2017. Notably, the current account actually registered a rare deficit in the first quarter of this year. Meanwhile, services’ share of GDP is approaching 50 percent – which is important because the sector is less capital-intensive than the industrial sector, less tied to exports and often reflects growing consumer spending.

China took a modest step back last year by some metrics, with exports taking a slightly larger share and consumption declining to 59 percent – its first drop in five years. The increased share held by exports can be credited in part to strong global demand, so the increase wasn’t necessarily bad news. Importantly, moreover, investment growth remained in check at 44 percent of GDP growth, roughly in line with recent years. According to the IMF, the credit intensity ratio improved to 3.9-to-1, suggesting credit is being put to better use in at least some sectors as Beijing’s ambitious structural reform agenda has kicked in.

On the flip side, return on assets held by China’s 150,000 state-owned enterprises has bottomed out over the past two years to just above 2 percent, a level not hit since the 2000s. Private firms are faring better than SOEs, though even their returns have nonetheless been dropping steadily, from more than 14 percent in 2011 to around 10 percent last year. Notably, SOEs are also playing a more dominant role in the economy, their share of assets growing steadily over the past decade to more than 200 percent of GDP in 2016 and their share of investment nearing a post-2008 high of 150 percent. This matters to the rebalancing effort because SOEs account for around 20 percent of employment and play an outsize role in metabolizing state-directed investment. Considering just how much bloated SOEs are used by Beijing to absorb excess labor, nonperforming loans and toxic assets, their weakness can be viewed as a reflection of the underlying fault lines waiting to rock the economy as a whole.

Whither Chinese Consumers?

This relates to another reality complicating China’s rebalancing picture: The growth in consumption has relied heavily on public spending. Since the turn of the century, the composition of China’s consumption picture has remained strikingly consistent, with government expenditures accounting for between 25 and 27 percent of total consumption and household spending making up the rest. As a share of GDP, however, private consumption steadily dropped for the first few decades of China’s reform period, from upward of 50 percent in the 1980s to just 35 percent in 2010. If China were truly rebalancing, we’d expect to see Chinese consumers pick up even more of the slack. There are some signs of optimism here, but also ample reason for concern. Since 2010, private consumption as a share of GDP has grown from around 35 percent to just more than 39 percent the past two years. Still, by comparison, private consumption in the U.S. has accounted for upward of 65 percent of GDP since 2000. In Japan, this figure has remained in the mid-50s.

Part of the reason Chinese consumers don’t spend as much is the heavy cultural emphasis on savings. This is good to the extent that it buffers consumption during downturns and makes up for the country’s weak social safety nets. (Similarly, China’s homebuyers are typically required to make down payments exceeding 50 percent, limiting discretionary spending elsewhere, but also making the housing markets somewhat less vulnerable to a cascading crisis akin to what sank the U.S. in 2008 since Chinese homeowners have so much equity sunk into their homes.) High savings rates have also enabled China to fuel its investment boom without heavy borrowing from abroad, unlike most developing economies, many of which routinely face default. On the other hand, high savings prevents private consumption from becoming the dominant driver of the economy and easing dependence on foreign buyers. (In this regard, China is similar to Japan and South Korea, both of which had high savings rates early on in their development before establishing robust consumer bases.)

The relatively low share of private consumption also stems from core aspects of the economic model that fueled China’s rise. A weak currency, measures that have suppressed wages and deposit rates capped below inflation may all be good for keeping exports competitive, sustaining heavily indebted SOEs and fueling investment, but they also encourage savings at the expense of consumption. (Or, worse, they encourage risky investments in high-yield wealth management products.) The lack of social safety nets has had a similar effect. Of course, this model is what Beijing is now trying to change.

Thus, to gauge whether Chinese consumers are both earning and spending more, the indicators to watch going forward will be metrics like household disposable income, retail sales and so forth, as well as household savings and debt. Household disposable income has been rising by around 9 percent per year, ticking slowly upward as a share of GDP, from 59.8 percent in 2013 to 60.6 percent last year. Considering how much GDP has grown, this means that aggregate incomes have surpassed $5 trillion a year. Recent studies by Credit Suisse and McKinsey show that discretionary spending on things like travel and recreation has been surging. Overseas travel, in fact, may be the single biggest contributor to China’s shrinking current account surplus. Meanwhile, household savings as a share of disposable incomes have started to come down, from 38.5 percent in 2013 to 35.5 percent last year.

With respect to the trade war, this matters because as Chinese consumer power has grown, so too have U.S. exports to the Middle Kingdom – some 115 percent over the past decade to nearly $120 billion today. General Motors sold nearly a million more cars in China last year than in the United States. Beijing can’t match U.S. tariffs dollar for dollar, because it doesn’t buy enough goods from the U.S. to do so. But it can at least try to make it politically unpalatable for the U.S. to continue the trade war by targeting sectors that look at China’s burgeoning consumer market with yuan signs in their eyes.

There are, of course, trade-offs to this shift. For one, household debt in China is surging, from 33 percent of GDP in 2013 to 49.2 percent last year, according to the IMF, putting the debt-to-income ratio in China at 120 percent and growing. This is manageable but rising beyond levels considered safe. Chinese credit card debt has expanded at three times the rate of balances in the U.S., while bank lending to households has surged an estimated 73 percent over the past three years, according to the central bank, most of it going to real estate. Moreover, a vast amount of this debt is held outside the formal banking system. Lending from small online peer-to-peer lenders tripled in volume to 2.3 trillion yuan from 2015 to 2017. Last month, dozens of such lenders went belly up, leading to small-scale protests in Beijing.


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Moreover, while average household incomes have been rising (by 9.1 percent through the first three quarters of 2017), the median income hasn’t kept pace (up 7.4 percent over the same period). This indicates that income growth has been largely concentrated among high earners.

This reflects a dominant underlying reality both driving and constraining the rebalancing effort. In effect, there are two Chinas. One, coastal China, already has an advanced economy climbing the value chain – one that looks quite a bit like its competitors in Japan, South Korea and Taiwan. The other, interior China, hasn’t yet reaped the fruits of the country’s reform and opening period to nearly the same degree; its economy looks quite a bit like a house of cards.

Of course, the two Chinas are tied at the hip. Beijing is trying to find a way to make the success of either dependent on the other, to have coastal capital and technology modernize the interior, and to have the interior’s mass reduce the coast’s dependency on foreign buyers and keep the Chinese labor pool competitive. China isn’t all that unique in this regard; the economies of the American West Coast, Texas and the Northeast have long both sustained and benefited from a similar relationship with less prosperous U.S. states. What’s different in China is the whirlwind time frame in which Beijing is trying to complete this process – and the stakes if it fails. Reconciling the gaps between the coasts and the interior is an age-old challenge in China, after all, and one where failure has sunk many a dynasty.