China urgently needs to rebalance its economy, but how it chooses to do so should not be constrained by undue focus on the value of the renminbi. In an edited excerpt from his book Avoiding the Fall, Michael Pettis looks at various rebalancing strategies China may choose to pursue, and the potential impact of this process on China’s long-term growth and competitiveness.
There are very strong conceptual reasons for assuming a powerful tendency within China to misallocate investment. This was always likely to be a consequence of China’s repressed financial system, which after so many years of delivering robust growth had shifted toward delivering growth driven by capital misallocation. When the state has unrestricted access to national savings and few constraints on how they are allocated, no economic system in history has failed to experience capital misallocation.
Of course, capital misallocation can never be proven until well after the fact, especially when capital is spent on large-scale infrastructure projects, whose ultimate value is very sensitive to assumptions about future growth. But if capital had been allocated on a significant scale in China during the past several years, we would expect to see certain kinds of circumstantial evidence:
• If capital is being misallocated because interest rates are too low, then we could assume that this would occur both in areas where we can measure misallocation and areas where we cannot. We can measure misallocation in state-owned enterprises, which have benefited from artificially low interest rates, and it is easy to prove that over the past decade they have been value destroyers on a significant scale.
Studies done by Unirule Institute of Economics suggest that well over 100 percent, and perhaps much closer to 200 percent, of the aggregate profitability of state-owned enterprises in China over the past decade can be explained by monopoly pricing and direct subsidies. Without these subsidies, according to the study, state-owned enterprises earned a negative return on equity equal to 6 to 7 percent.1
• If debt-funded capital is being misallocated, debt must be rising faster than debt-servicing capacity. If this is the case, at least two consequences are apparent. Firstly, we should see evidence that debt is rising too quickly and at some point is causing strain in the banking system. Secondly, if debt has been rising faster than debt-servicing capacity, either the borrowing entity must have defaulted at some point or there must have been a transfer of resources from another part of the economy in order to service the debt.
To address the first, there is no way of measuring precisely the relation between growth in debt and growth in debt-servicing capacity. But following the debate about the banking system gives a sense of how rapidly debt has been rising. It is pretty clear that there are grounds to worry that debt has emerged as a substantial problem in China. Statements and actions from a wide range of policymakers and business leaders suggest that they are concerned about rising debt.
Private-sector estimates about the true level of government debt reinforce this concern. They place total debt at anywhere from 80 to 120 percent of GDP.
• The second consequence is the more revealing. Because there have been few major defaults in China, clearly if capital were being misallocated there must have been a transfer of resources from another part of the economy in order to service the difference between debt and debt-servicing capacity. Identifying the sector of the economy that has paid for the transfer of resources would provide strong circumstantial evidence that capital has indeed been misallocated.
It turns out this is relatively easy. The sector is, as it nearly always is in any economy, the household sector. China’s household sector has paid for the bad debt in two ways. First, and most obviously, the spread between the deposit and lending rates mandated by the central bank had the effect of guaranteeing substantial profits to the banking sector. These profits allowed the banks to absorb nonperforming loans, but this came at the expense of the household sector.
We know that the household sector paid for all these bad loans because despite twenty years of rapidly rising GDP and rapidly rising household income, China began the last decade with a very low household income share of GDP. At 46 percent of GDP in 2000, this level of consumption was not unprecedented, but it was likely to occur only in the case of large economies that had suffered crises. And normally, after such low household consumption amid such rapid growth for so many years, we would have expected some catching up of the household income share.
But from 2000 to 2010, household consumption dropped from 46 percent of GDP, already a low share, to an astonishing 34 percent of GDP. The collapse in the household share of China’s GDP, in other words, occurred because households had been forced to pay for the difference between the real debt-servicing cost of a decade of misallocated investment and the debt-servicing capacity created by that investment.
The Rebalance Scenarios
Once we accept that investment is being significantly misallocated and that the current system cannot resolve the problem, we must agree that consumption will become a greater share of GDP over the next five to ten years. What’s more, we must agree that the only way to increase the consumption share of GDP is to increase the household income (or wealth) share of GDP.2
China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption. The key is that after three decades during which household income declined as a share of the economic pie (and the state sector, which many think of as a proxy for the wealth of the political elite, increased its share), China must now engineer a development model in which household income rises as a share of the economic pie.
Although difficult, transferring wealth from the state to the household sector is not impossible. As I see it, the various ways in which this transfer can take place can be accounted for by one or more of the six following scenarios:
1. Beijing can continue with its existing growth model, maintaining its high investment growth rates, until it reaches its debt capacity limits, after which a sudden stop in investment will force up the household share (albeit under conditions of negative growth).
2. Beijing can quickly reverse the transfers that created the imbalances by, for example, raising real interest rates sharply, forcing up the foreign exchange value of the currency by 10 to 20 percent overnight, pushing up wages, or lowering income and consumption taxes.
3. Beijing can slowly reverse the transfers in the same way.
4. Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.
5. Beijing can indirectly transfer wealth from the state sector to the private sector by absorbing private-sector debt.
6. Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
Notice that all of these options effectively have China doing the same thing: in each case, the state share of GDP is reduced and the household share is increased. There are, however, very big differences in how the changes are distributed among various parts of the household and state sectors.
Can China Increase Export Competitiveness?
It may help in understanding the process to consider what rebalancing means to such widely discussed issues as China’s currency regime.
From July 2005 to February 2012, the renminbi rose by just over 30 percent in nominal U.S. dollars. The increase in the value of the renminbi has nonetheless been seen, correctly, as a part of China’s rebalancing process.
But these worries may have been unfounded. If China is serious about rebalancing its economy, devaluing the renminbi will not result in a net improvement in export competitiveness. China’s export competitiveness will deteriorate no matter what Beijing does to the currency.
China must sharply reduce investment, or at least reduce the growth rate of investment. In principle the adverse impact of slower growth in investment should be offset by faster growth in consumption, but it has proven very difficult for China to raise the GDP share of consumption, largely because consumption-constraining policies are at the heart of China’s growth model and indeed at the heart of investment growth models more generally. It will take many years of adjustment before consumption is large enough and can grow into its proper role.
This means that during the adjustment process, it is a virtual certainty that growth in China will slow significantly for many years. That’s because if Beijing brings investment growth down more quickly than can be counterbalanced by an increase in consumption growth, its overall growth rate must slow sharply. This is true almost by definition.
I say “almost” because there is a third source of demand that affects domestic growth — the trade surplus — and this is why there is now so much focus on the value of the renminbi. If China’s trade surplus rises sharply during the adjustment process, overall economic growth rates could be much better than expected. If the trade surplus contracts, however, growth will be worse.
As China rebalances, by definition Chinese household income must rise as a share of total GDP. This is the important point that is often forgotten in the debate about Chinese competitiveness. In the aggregate, as China rebalances, the net impact of changes must result in reduced subsidies to Chinese manufacturers and so, at least initially, in reduced Chinese competiveness abroad.
If Beijing wants to rebalance, and it decides to devalue the renminbi anyway, that just means that Beijing must raise wages or interest rates all the more in order to force a real increase in the growth rate of household income. Any improvement in Chinese export competitiveness achieved by devaluing the renminbi, in other words, would be fully made up for by a deterioration in Chinese export competitiveness caused by rising wages or rising interest rates.
How China rebalances, then, will mainly reflect domestic priorities and political maneuvering. Revaluing the currency would disproportionately help middle- and working-class urban households — for whom import costs tend to be important — and disproportionately hurt manufacturers whose production costs are primarily local, that is, most manufacturers that are not in the processing trade.
These three strategies, in other words, broadly have the same impact on trade competitiveness, although in each case the winners and losers within China would be different. This is why we should not be overly concerned with what happens just to the exchange value of the renminbi. As long as China genuinely rebalances its economy — a painful process no matter how Beijing chooses to manage it — Chinese export costs will rise and in the short term Chinese goods will be less competitive in the global markets.
The path China chooses to follow should be seen by the world primarily as something that affects the way the costs and benefits of rebalancing are distributed domestically. For the sake of more sustainable and equitable long-term growth, and in the interests of economic efficiency, it is almost certainly much better for China and the world if Beijing raises interest rates than if it revalues the renminbi. Because raising interest rates is likely to be opposed by the very powerful groups that benefit from excessively cheap capital, however, Beijing may instead put more focus on raising wages, which comes mainly at the detriment of economically efficient but politically weak small and medium-size enterprises and service industries.
China urgently needs to rebalance its economy, but how it chooses to do so should not be constrained by too much focus on the value of the renminbi. The exchange rate is only one of the mechanisms — and not even the most important mechanism — that will determine the price of Chinese goods abroad. It is domestic politics that will determine the form in which the rebalancing takes place, and as long as rebalancing occurs, the world should not overly emphasize the role of the currency.
Do not expect, in other words, that China will steal export share from the rest of the world while rebalancing its economy by depreciating the renminbi. Increasing competiveness in export markets is not compatible with rebalancing. As China rebalances, it has no choice but to reduce its export competitiveness. Even devaluing the renminbi would not improve Chinese competitiveness abroad, because Beijing would have to raise wages or interest rates all the more. Doing so would simply shift the brunt of the export adjustment from one group within the country to another.
Excerpted from Avoiding the Fall: China’s Economic Restructuring (Washington DC: Carnegie Endowment for International Peace, 2013). By Michael Pettis, © Carnegie Endowment for International Peace.
About the Author
Michael Pettis is a finance professor at Peking University and a senior associate at the Carnegie Endowment. He has previously taught at Tsinghua University and at Columbia University’s Graduate School of Business. Before and during this time he spent fifteen years on Wall Street running trading and capital market desks, and has published several books on international finance.
1. “The Nature, Performance and Reform of State-Owned Enterprises,” Unirule Institute of Economics, June 2011.
2. Technically there is another way, and that is for household debt to surge as households borrow to fund consumption. But most evidence suggests that consumer financing is correlated with household wealth, and anyway China will require many years to develop a robust consumer-financing infrastructure.