Subject: Wen is right to worry about China’s growth - Wolf -FT
From: "Michael Andrews" <[email-masked]>
To: "Hunter Biden" <[email-masked]>, "Devon Archer" <[email-masked]>, "Curt Hastings" <[email-masked]>, "Eric Schwerin" <[email-masked]>, "Neil Callahan" <[email-masked]>
Date: Wed, 22 Sep 2010 10:50:36 -0400

Why don't we all talk about this in the next few days?

Michael

Wen is right to worry about China’s growth
By Martin Wolf
Published: September 21 2010 20:40 | Last updated: September 21 2010  
20:40

“In the case of China, there is a lack of balance, co-ordination and  
sustainability in economic development.”

EDITOR’S CHOICE
Opinion: China must have the courage to save less - Sep-20

Opinion: Beijing is right to ignore the currency pleas - Sep-19

China dispatches buying mission to US - Sep-16

Small steps to help reshape renminbi - Sep-19

Missed opportunities in China - Sep-21

More from Martin Wolf - Sep-02

Who dares to make such a downbeat assessment of the world’s most  
dynamic economy before a gathering of influential foreigners in the  
heart of China itself? The answer is Premier Wen Jiabao at last  
week’s“summer Davos” in Tianjin. He is right. When almost everybody  
believes China is invulnerable, what might go wrong? As Andy Grove of  
Intel said: “Only the paranoid survive.” Mr Wen is wise to be  
similarly cautious.

Yet, as Mr Wen also noted, “the past two years have seen China emerge  
as one of the first countries to achieve an economic rebound, and  
maintain steady and relatively fast economic development under  
extremely difficult and complex circumstances.” Mr Wen added: “We owe  
our achievements to the ... implementation of the stimulus package.”  
As a result, the economy grew by 9.1 per cent in 2009 and 11.1 per  
cent in the first half of 2010.

This success has followed three decades of very fast growth. At  
purchasing power parity, gross domestic product per head has risen  
almost tenfold since the “reform and opening up” began, under Deng  
Xiaoping, in 1978. It is a remarkable record, but not quite  
unprecedented. China’s rate of “catch-up” on the US is not so very  
different from that of Japan prior to the mid-1970s and South Korea’s  
between the early 1960s and the financial crisis in 1997.

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What is different, however, is the scale of the country and its  
initial poverty. China’s GDP per head (at purchasing power parity) was  
a mere 4 per cent of US levels in 1978. Even now, it is less than a  
fifth. The latter was in the position of Japan in 1950 and of South  
Korea as long ago as 1978. If China were to achieve Japan’s relative  
GDP per head before growth slowed sharply, it would enjoy another 25  
years of fast economic expansion, to emerge with much the world’s  
biggest economy.

What could stop the juggernaut? Some point to rapid monetary growth,  
credit bubbles, asset price overshoots and bad debts (see chart). But  
I agree with Jonathan Anderson of UBS, a respected analyst of the  
Chinese economy, that this concern is exaggerated. Credit growth is  
normalising already. Mr Wen argues that the capital adequacy ratio and  
non-performing loans ratio now stand at 11.1 per cent and 2.8 per  
cent, respectively, both in safe territory. More fundamentally, so  
long as the government remains solvent and growth is sustained, the  
financial sector should be unable to create an unmanageable crisis. A  
rapidly urbanising country with an economy expanding at 8-10 per cent  
a year will grow out of shocks, not least by absorbing excess capacity.

The most interestingly pessimistic view comes from Michael Pettis of  
Peking University’s Guanghua School of Management.* The characteristic  
of Chinese growth is that it is “unbalanced”, as Mr Wen notes: it is  
highly dependent on investment as a source of demand and driver of  
supply (see charts). It is, in a sense, the most “capitalist” economy  
ever.

Thus, between 1997 and 2009, gross investment rose from 32 per cent to  
46 per cent of GDP, while household consumption fell from 45 per cent  
of GDP to a mere 36 per cent. This must be the lowest share of  
consumption in any significant economy ever. In a country with  
hundreds of millions of poor people, it is even shocking. Meanwhile,  
the rising investment rate has been the main driver of growth. In the  
early 2000s, “total factor productivity” – increases in output per  
unit of input – were also important. But the contribution of higher  
efficiency has been waning.

This, Prof Pettis argues, is a “souped-up version” of the Asian  
development model we saw in Japan and South Korea in earlier decades.  
The characteristics of this production-oriented approach are:  
transfers from households to manufacturing, via low interest rates on  
savings, repressed wages and a depressed exchange rate; very high  
investment; rapid growth of exports; and high external surpluses.  
China is “Japan plus”: its investment rate is higher, trade surpluses  
larger, rate of consumption lower and exchange rate intervention bigger.

This has been an extraordinarily successful development model, but,  
notes Prof Pettis, it eventually runs into the constraints of “massive  
over-investment and misallocated capital”. He continues: “In every  
case I can think of it has been very difficult to change the growth  
model because too much of the economy depends on hidden subsidies.”  
Moreover, China’s scale will shift the price of imports, particularly  
raw materials, against it, so accelerating the decline in profits.

In China, a rising rate of investment is needed to maintain a given  
rate of economic growth. At some point, investment will stop rising  
and growth will slow. China will then face the Japanese challenge: how  
to sustain demand as the required rate of investment collapses. If,  
for example, the gross investment needed to sustain a 10 per cent rate  
of growth is 50 per cent of GDP, then the rate of investment required  
to sustain 6 per cent growth might be just 30 per cent of GDP. With  
its massive dependence on investment as a source of demand, any  
decline in expected growth threatens a huge recession.

One answer would be another government-driven investment surge,  
however low the returns. The more attractive answer is faster growth  
of consumption. There is evidence of that during the past two years.  
But, as Prof Pettis notes, for consumption to grow consistently faster  
than GDP, household disposable income must also do so. Yet if this is  
to happen, income must be shifted from the corporate sector. That  
implies a squeeze on profits, through higher interest rates, higher  
real wages or a higher exchange rate. But that increases the risk of  
an investment collapse, with dire consequences for demand. As Prof  
Pettis argues, in China “growth is high ... because consumption is  
low”. Rebalancing the economy towards household consumption could  
undermine the ability to sustain growth itself. If so, China is on an  
investment treadmill.

China’s is the most impressive “catch-up” economy in history. That is  
partly because it is so unbalanced. The longer rebalancing is  
postponed, the more painful the adjustment will be. The Chinese  
economy of two decades from now will have to be vastly less investment- 
driven than the one of today. How smoothly and how soon will it get  
there? These are huge questions.

* “Chinese consumption and the Japanese ‘sorpasso’”, mpettis.com.