China’s miraculous growth era is over. The financial crisis has dealt a major blow to its export-led growth model by ushering in a prolonged period of weak global growth. Even if China is successful at igniting domestic consumption, GDP growth could well halve to 5 percent a year on average in this decade.
After Mao, the Chinese people had nothing but brawn, brains and sheer determination to succeed. The first two decades of reform saw substantial productivity gains from disbanding agricultural communes and shifting capital and labor from agriculture to low-end manufacturing and processing, mostly for export.
China’s growth model has relied on a relentless increase of its global market share. Strong export income and a high domestic savings rate allowed the economy to industrialize at breakneck speed.
Savings are vital for an economy as they provide the financial resources needed for investment in homes, factories, machines, roads, schools and hospitals. The more savings are used for investment, the faster incomes grow and the easier it becomes to save more. This was the virtuous cycle that the thrifty Chinese enjoyed.
But savings can turn from benign into malign. Investment is derived demand. It depends on consumption and export growth. The more people want to save, the less they spend on clothes, phones, televisions and cars. Saving more to invest more is a dead end when there is no increase in the desire and ability to consume more or export more.
Such investment becomes unprofitable, at the end of the day hurting company profits and people’s income. Investment in social infrastructure is different, but it also has limits. Building “roads to nowhere” or “vegetable” airports can continue for a long time.
But if the cost of building infrastructure exceeds the implied productivity gain ultimately financing such investment becomes unbearable. Either the taxes people have to pay become too high or public debt begins to spiral out of control.
But the usual limits to investment have not applied to China and its investment rate has jumped to an exorbitant 48 percent of GDP in 2009. In China private and state-owned firms alike are not driven by profitability.
Private entrepreneurs are focused entirely on the short term, exploiting arbitrage opportunities with little regard for strategic planning. No wonder the production of fake goods is so widespread. State-owned “national champions” appear profitable but enjoy a raft of subsidies or monopoly positions.
China's Mispriced Cheap Loans
The most important subsidy is access to mispriced cheap loans. The bulk of China’s savings are held in the state-owned banks, which lend primarily to state-owned firms or investment vehicles, set up by local governments to avoid a ban on direct bank borrowing.
China’s policymakers control the direction, amount and cost of loans, keeping borrowing interest rates low. If state firms cannot pay their debts, new loans are dished out to keep them going. Thus the financial sustainability of past investment binges is not undermined during economic downturns.
Banks accumulate bad loans. But the expectation is that strong output growth will shrink them away over time. Banks may be insolvent, but as long as the closed exchange controls prevent capital outflows, domestic savings must stay at home, mostly deposited with state banks. Steadily rising bank deposits supply new loans for old and state companies never default. Banks can’t go bust.
China’s economic model has seen an exorbitant investment rate being sustained and increased for years because the state uses the banking sector like an ATM to finance its massive expansion plans.
The ability to industrialize fast has driven supply, while the final demand for China’s surplus products has come from abroad. At home, a rising savings rate has meant that the share of household consumption has declined to an ultra low 35 percent of GDP.
The financial crisis changed the rules of the game. China can no longer rely on good fortune abroad. The rest of the world will struggle to achieve strong growth. The workout of the debt excesses of the past decade will take years.
This export shock is likely to be compounded when the rest of the world can no longer tolerate China’s continual market share grab, backed by its refusal to allow its currency to rise fast or allow free capital outflows. Slower export growth will undermine the sustainability of its excessive investment.
Beijing has realized the need to rebalance growth away from wasteful investment towards domestic consumption. But even if successful this will entail much slower growth than the 10 percent of the past.
The authorities will have to contend with the social and political consequences that go with slower growth. The pressure to fall back onto the safety net of what seemed to have worked best in the past – state-directed, credit-fuelled investment binges – will be strong. But it won’t work in the future.
Diana Choyleva is director at Lombard Street Research (www.lombardstreetresearch.com). She has also co-authored a book "The Bill from the China Shop" and is a regular guest on CNBC TV.