There is little arguing against the fact that China’s economic growth is unprecedented, with the possible historical exceptions of postwar Japan, South Korea, and Taiwan. However, Michael Pettis, a leading economist on China at Peking University, argues in Avoiding the Fall: China’s Economic Restructuring that China’s days of furious economic development are in the past. Its accumulating debt will eventually force it to rebalance, if it does not do so on its own.
To understand China’s unstable growth model and its burgeoning debt, Pettis analyzes its approach to increasing economic production, particularly on the domestic level. Much of what Beijing has achieved in the recent past has been made possible precisely because it had substantial debt. China was able to raise debt quickly and spawn investment that permitted it to circumvent the complications of its development model. Politics in China hindered the types of changes required to allow the country to keep growing in a positive manner. Some of these issues include large alterations in interest rates, wages, currency, and legal structure, with, of course, political gain of the reimbursements of growth.
Pettis asserts that China’s investment-driven growth model relies not so much on high taxation to confiscate household wealth, but rather uses three much more couched mechanisms of capital generation: lagging wage growth, an undervalued exchange rate, and a “repression” tax. A “repression” tax reduces a government’s interest expenses for any kind of debt, or, in the case of negative interest rates, it transfers capital from the lender to the borrower. Essentially, all these Chinese economic apparatuses transfer wealth from the household sector to virtually any lender with access to a bank and a basis of production. Investment is important to the extent that the capital invested engineers growth, but it is not reasonable to assume that every single dollar that China spends on infrastructure or some arbitrary project will do so. Additionally, the cost of investment in one sector of the Chinese economy may bounce back to a completely unrelated sector. In this sense, the burden of cost can be disproportionately spread across different facets of the economy.
Logically speaking, China’s biggest comparative advantage is its labor supply. However, the mechanisms above suggest China’s relative edge lies in its capital. It may be true that labor is cheap in China, but capital is cheaper, and can even be free or have a negative cost (as a result of a negative interest rate). However China’s reliance on capital, and, more ominously, its misallocation of it, has made China’s economic future bleak and somewhat unpredictable.
In the future, the availability of capital, or lack thereof, may force China to reconsider what it believes to be its most valuable economic asset. China’s investments in infrastructure and foreign enterprises do not yield high returns. Though China may benefit by making profits, in the end it will still be a producer economy; it will not be an inventor economy.
The Asian Tigers, Western Europe, and North America may all be experiencing slower economic growth than China in the present, but they also have more sustainable growth models, especially because they invent, patent, and sell their own products. This leads into another key point: the world is buying Chinese products as it is producing them, but there may come a point where world consumption cannot keep up with Chinese production. What then? Will China start selling to its own people? If it does that, then it will need to return money to the household sector, which will decrease capital available for investment. This closed-loop system may end up being extremely harmful to China in just a few years.
In light of these issues, Pettis brilliantly lays out the routes China can take while bearing in mind their limitations. If China is to rebalance, it must experience a surge in household wealth, whether that is at the expense of its GDP growth or high investment rates.
Some important routes include increasing interest rates to force up foreign exchange values of the currency, transferring wealth from the state to the private sector by absorbing private-sector debt, or privatizing assets to increase household sector wealth. Of course, China’s communist leadership makes the latter two of these options highly unlikely. Yet selling state assets to pay for loans instead of taking new loans in order to pay off old ones is a more feasible idea and would ease China’s rebalancing process.
A few years ago, it would have been hard to believe that China could see economic stagnation, but now it is obvious. Those who refuse to accept the reality of China’s unsustainable growth model may see their beliefs shattered, especially if China does not change its course of action.