The Investment-Driven Growth Model and its Weaknesses
Over the past year, the Chinese economy has continued to struggle, with real estate sales down 25% and GDP growth slowing to 4.7% in the second quarter. Professor Michael Pettis, a finance professor at Peking University, has long expressed concerns about China's investment-driven growth model.
The problem with this model is that it works well when an economy is seriously underinvested, as China was in the 1980s and 1990s. However, as investment becomes increasingly unproductive, including in the property sector, it needs to be reined in. This poses a challenge, as investment has been the primary driver of China's growth, accounting for 43% of GDP, compared to a global average of around 25%.
Shifting from Real Estate to Manufacturing
In 2021, Beijing finally took steps to constrain the growth in the real estate sector, which accounted for about one-third of total investment in the Chinese economy. However, this created a new problem - if investment is reduced, either consumption growth must surge or GDP growth will drop.
China's solution has been to shift investment from the property sector into manufacturing. This has led to a growing trade surplus, as China's share of global manufacturing is increasing relative to its share of global GDP and consumption. The rest of the world must accommodate this shift, but in a hostile global environment, this is unlikely to happen.
The Difficulty of Boosting Consumption
Increasing the consumption share of GDP is incredibly difficult for China. This requires increasing the household income share, which involves a redistribution of resources from businesses, local governments, or the central government. This creates conflicts within China, as different sectors resist losing their share.
Japan faced similar challenges in the 1980s, and 38 years later, it is still an open question whether they have successfully rebalanced their economy. The competitiveness of Chinese manufacturing is not due to efficiency, but rather a series of subsidies and transfers from the household sector to the manufacturing sector. Reversing these transfers would undermine the manufacturing sector's competitiveness.
The Impact on the United States and the Global Economy
China's investment-driven growth model and its resulting trade surpluses have had a significant impact on the United States and the global economy. The US has absorbed roughly half of the world's trade surpluses through its own large trade deficits.
The US is now trying to reduce its role as the "consumer of last resort" and the "absorber of last resort" for global excess savings. This puts pressure on other surplus countries, such as China, Germany, and Japan, to either redirect their surpluses or face the consequences of a decline in their manufacturing sectors.
Potential Paths Forward for China
Professor Pettis outlines three potential paths for China:
Do nothing and accept that the Chinese economy will be distorted by policies not designed in China, leading to a continued decline in the manufacturing share of the economy.
Pursue selective industrial policies to support strategically important sectors, but resign to a gradual decline in the overall manufacturing sector.
Refuse to play the accommodating role in global imbalances, regain control of the capital account and trade account, and rebalance the economy through measures like taxing capital inflows.
The most likely scenario is a prolonged period of much slower GDP growth and a gradual rebalancing of the economy, similar to Japan's experience in the 1990s and 2000s. Achieving a more rapid rebalancing would require significant transfers from local governments to the household sector, which faces significant political and economic obstacles.
Part 1/6:
China's Struggle to Rebalance its Economy
The Investment-Driven Growth Model and its Weaknesses
Over the past year, the Chinese economy has continued to struggle, with real estate sales down 25% and GDP growth slowing to 4.7% in the second quarter. Professor Michael Pettis, a finance professor at Peking University, has long expressed concerns about China's investment-driven growth model.
Part 2/6:
The problem with this model is that it works well when an economy is seriously underinvested, as China was in the 1980s and 1990s. However, as investment becomes increasingly unproductive, including in the property sector, it needs to be reined in. This poses a challenge, as investment has been the primary driver of China's growth, accounting for 43% of GDP, compared to a global average of around 25%.
Shifting from Real Estate to Manufacturing
In 2021, Beijing finally took steps to constrain the growth in the real estate sector, which accounted for about one-third of total investment in the Chinese economy. However, this created a new problem - if investment is reduced, either consumption growth must surge or GDP growth will drop.
Part 3/6:
China's solution has been to shift investment from the property sector into manufacturing. This has led to a growing trade surplus, as China's share of global manufacturing is increasing relative to its share of global GDP and consumption. The rest of the world must accommodate this shift, but in a hostile global environment, this is unlikely to happen.
The Difficulty of Boosting Consumption
Increasing the consumption share of GDP is incredibly difficult for China. This requires increasing the household income share, which involves a redistribution of resources from businesses, local governments, or the central government. This creates conflicts within China, as different sectors resist losing their share.
Part 4/6:
Japan faced similar challenges in the 1980s, and 38 years later, it is still an open question whether they have successfully rebalanced their economy. The competitiveness of Chinese manufacturing is not due to efficiency, but rather a series of subsidies and transfers from the household sector to the manufacturing sector. Reversing these transfers would undermine the manufacturing sector's competitiveness.
The Impact on the United States and the Global Economy
China's investment-driven growth model and its resulting trade surpluses have had a significant impact on the United States and the global economy. The US has absorbed roughly half of the world's trade surpluses through its own large trade deficits.
Part 5/6:
The US is now trying to reduce its role as the "consumer of last resort" and the "absorber of last resort" for global excess savings. This puts pressure on other surplus countries, such as China, Germany, and Japan, to either redirect their surpluses or face the consequences of a decline in their manufacturing sectors.
Potential Paths Forward for China
Professor Pettis outlines three potential paths for China:
Do nothing and accept that the Chinese economy will be distorted by policies not designed in China, leading to a continued decline in the manufacturing share of the economy.
Pursue selective industrial policies to support strategically important sectors, but resign to a gradual decline in the overall manufacturing sector.
Part 6/6:
The most likely scenario is a prolonged period of much slower GDP growth and a gradual rebalancing of the economy, similar to Japan's experience in the 1990s and 2000s. Achieving a more rapid rebalancing would require significant transfers from local governments to the household sector, which faces significant political and economic obstacles.