What the U.S. Gets Wrong About China—and Why That Spells Trouble

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What the U.S. Gets Wrong About China—and Why That Spells Trouble
By: Michael Pettis / Barron's - April 4, 2019 8:31 a.m. ET
RE: https://www.barrons.com/articles/wha...=past_editions

China’s ferocious economic growth in recent years has transformed U.S.-China relations—largely for the worse.

The very difficult economic adjustment that China now faces will again change that relationship. Unfortunately, if history is a useful guide, it will take many years before policy makers in Washington recognize the changed circumstances and formulate an appropriate policy response.

Just a few years ago, it was almost impossible to find anyone who doubted the inexorable rise of China’s economy, eventually to become the world’s largest and most powerful. Today, however, more analysts, both inside and outside China, recognize that its relative rise economically may have already peaked, or soon will, and that its real economic performance has been seriously overstated by the gross-domestic-product data.

This won’t be the first time we got it so wrong, and as in every previous case—most obviously that of the Soviet Union in the 1960s and Japan in the 1980s—it will probably take many years for American perceptions to change. But in whatever way events actually unfold, the China of the near future will no longer be the aggressively rising China of American fears, and the sooner we recognize this change, the less likely we are to engage in useless and costly confrontation.

The historical precedents for China tell a consistent story. Every country that enjoyed many years of an investment-driven economic “miracle” has faced the same difficult challenges that China now faces: how to resolve the deep demand imbalances and the ballooning debt that drove growth in its final stages. None have managed the transition without a significant, and probably inevitable, downgrading of longer-term economic, technological, and geopolitical prospects.

What can be certain is the China that emerges from this adjustment will be a very different country from the one we know today.

To understand the challenges that Beijing faces, it is helpful to understand the process that led to China’s current state. One of the biggest mistakes in understanding the nation’s development is to conflate the four decades since Deng Xiaoping began his historic reforms into a single, consistent growth model. It is much more useful to think about this period as consisting of four very different economic growth stages, the last of which, with great difficulty, we are only just entering.

The first stage began in political and economic crisis following the Cultural Revolution. By the end of the 1970s, China had lived through more than 40 years of Japanese conflict, civil war, and Maoist policies that had distorted its economy and left it underinvested. To prevent collapse, the economy had to be transformed in a way that eliminated the many constraints on Chinese economic productivity.

Deng’s reforms did just that, and they were immediately successful. In 1977, the last year of the old regime, China’s GDP shrank 1.7%, but over the next decade, it soared, with China experiencing only one year of growth below 7%. In that decade, Beijing relaxed laws preventing unplanned economic activity, freed workers and farmers from their work units, and reduced the role of central planning in favor of localized planning. These reforms unleashed an explosion of economic activity that generated tremendous wealth creation.

But it is really not until the next stage, beginning in the early 1990s, that we can speak about the Chinese growth model, itself a version of the investment-driven growth model practiced by Japan and others. Rather than just eliminate growth constraints, Beijing put into effect new policies that set off rapid growth and development, and, as they always do, these policies began to generate the imbalances that the current administration must resolve.

Among the most important of these imbalances is the extraordinarily low share of GDP retained by ordinary Chinese households. At 50%, this low share was not an accident. As in every other investment-driven growth “miracle” of the past century, the Chinese government forced up domestic savings and directed these savings into urgently needed investment. The most effective way of forcing up savings, i.e., forcing down consumption, is to repress the growth of household income relative to GDP by directly or indirectly taxing household wealth to subsidize government-directed investment.

This Beijing did, adopting a number of mechanisms pioneered by Japan. As the total value of Chinese goods and services soared, household income grew by still-enviable, but much lower, rates. The household share of total GDP consequently dropped every year to become, in the past decade, among the lowest ever.

There are two important consequences of this model. First, because consumption accounted for such a low share of demand for the goods and services China produced, investment had to make up a disproportionately large share of total Chinese demand. In fact, at nearly 50%, the investment share of China’s GDP exceeds that of any of the other countries that had followed this growth model.

Second, the relationship between Beijing and the country’s elite was transformed. Deng’s original reforms had been strongly opposed by the Communist Party elite during the first stage, mainly because the reforms undermined their control of economic behavior. It is part of his genius that he nonetheless managed to force through his vision of a transformed China.

During this second stage of growth, however, Beijing’s development policies created a powerful new group, heavily overlapping with the old elite, that strongly supported government policies and competed to accomplish the objectives set out by Beijing. The more successful they were, the more they were rewarded in the form of subsidies, with access to extraordinarily cheap credit quickly becoming the most profitable resource in China.

The third stage of Chinese growth, which probably began early in the last decade, was characterized by continued rapid GDP growth driven by investment. This was, however, underpinned by even more rapid growth in debt.

This, too, is typical of countries that have followed this growth model. Undeveloped economies are usually poor not because they are underinvested, but because their social, legal, financial, and economic institutions constrain their ability to absorb high levels of investment productively. Typically, they encourage or require individuals and businesses to behave in ways that are not socially or economically beneficial.

In the early 1990s, these constraints did not seem to matter. The country so badly lacked infrastructure and manufacturing capacity that the only important constraint on productive investment was the pace at which savings could grow. An unsophisticated financial system that chose investment projects for political or other noneconomic reasons was not a serious problem: The best financial system was simply the one that expanded most rapidly.

But with its still-undeveloped social, legal, financial, and economic institutions, the amount of capital stock that businesses and workers in China could absorb productively was much lower than in advanced economies. Without substantial institutional reform, additional investment was unlikely to be economically justified, but these reforms were far too politically disruptive for Beijing to consider implementing them.

Still, China’s very low consumption share meant that rapid GDP growth required rapid investment growth, and because China’s financial system was designed to expand credit as rapidly as possible, this is what it got. What is more, because the costs of investing in infrastructure or manufacturing capacity were heavily subsidized by hidden transfers from households, it was easy to miss the problem. Without mechanisms to constrain, or even to identify, wasted investment, China, like all of its predecessors, began allocating investment increasingly into unproductive projects, much like Japan’s famous “bridges to nowhere” two decades earlier.

When this happens, the debt supporting the investment rises faster than the country’s debt-servicing capacity. With very high GDP growth rates needed to sustain employment and political stability, the gap between reported economic growth (i.e., GDP) and real economic growth widened, and, more worryingly, debt soared. Every country that has followed this model has suffered eventually from this unsustainable rise in debt, but in China debt rose faster than it ever has in history, leaving the country with an enormous burden of debt, equal by most estimates to more 300% of GDP.

Today, China urgently needs institutional reforms that both rechannel bank lending and change its legal and other institutions in ways that raise the productivity of Chinese businesses and workers. China must, in other words, begin the fourth stage of its growth period. It must rein in credit growth and, with it, investment growth, but if it is to prevent growth from collapsing, consumption must take up the slack. This requires redistributing large amounts of wealth from local elites and local governments to ordinary Chinese households.

The historical precedents for such a transformation are grim. The only countries that have succeeded in redistributing wealth and power and rechanneling the financial system to such an extent without suffering political chaos have either been robust democracies, like the U.S. in the 1930s, or highly centralized autocracies, like China itself in the 1980s, and in both cases it took a crisis to force the change.

Will China pull it off? There are broadly three ways that China can manage its adjustment. The best way is if President Xi Jinping has been able temporarily to consolidate enough power to force through the necessary wealth transfers that raise household wealth quickly enough so that consumption can power growth as nonproductive investment is forced down. In this case, China’s share of global GDP—currently around 15% to 16%—will probably continue to rise, albeit more slowly than in the past, and the Chinese economy will end up with a much larger and more powerful household sector, more stable growth, and eventually a weaker government sector.

The sheer extent of the needed reforms make this an unlikely outcome. Still, it is not impossible: China managed an equally difficult transformation with Deng’s reforms in the 1980s.

The second way is if Beijing is able to stabilize the debt burden with smaller but more-manageable wealth transfers to Chinese households. In that case, Chinese GDP growth will drop to well below half of current levels, although household income growth by a lot less. China’s share of global GDP would probably drop, even if not as precipitously as its predecessors, but it runs the risk, like Japan, of failing to resolve its debt burden and so suffering many years of stagnation.

The third way is if Beijing is unable to gain control of credit growth in time and the economy runs up against debt-capacity limits, either in the form of a financial crisis, or by effectively monetizing new debt as it comes due. A crisis is very unlikely as long as the Chinese banking system remains closed and the regulators powerful, but either way Chinese GDP growth would drop sharply, to zero or even negative.

Each of these broadly different outcomes can occur in different ways, and clearly the evolution of the U.S.-China relationship will depend on how China manages its economic adjustment and how the U.S. manages its own high debt levels and income inequality. It will also depend on the outcome of the trade conflict, which will drag on for many years, far beyond President Donald Trump’s time in office.

The point, however, is that Washington is managing the relationship with an obsolete idea of China. To the extent that U.S. foreign policy concerning China is built around the need to contain a dangerously rising China, this policy will also soon become obsolete. China’s ferocious economic growth has ended, and very few serious economists, in or out of China, still think its high GDP growth rates accurately represent the performance of the underlying economy.

The U.S. has always had a good relationship with China, and that relationship will eventually return, but probably not for many years.

One thing is certain. The adjustment period that has followed every growth miracle in history has always overturned expectations, especially the most seemingly obvious and widely accepted ones. It is safe to assume that it will happen again.

About this writer: Michael Pettis is a senior associate at the Carnegie Endowment for International Peace.