Dec. 13 issue
Smart investors don’t like tall buildings. Too often a country has announced a plan to build the world’s highest structure in the midst of an economic boom, typically marking the heady peak of an investment cycle. Understandably, then, there was some concern recently when officials in the southern Chinese boomtown of Guang-zhou said they were aiming for the record books with plans to construct the world’s tallest tower.
The announcement underscores the point that China is experiencing the most staggering investment boom in recorded history. There have been other growth miracles over the past century, with Japan, South Korea and Taiwan all registering similar increases in GDP over a 25-year period as China has done since 1978. But the scale of investment in China is unprecedented, with fixed investments now making up nearly half of GDP. (Among the other miracle economies, the high was 39 percent in 1991 by South Korea.) It’s all there to be seen, with 40 new airport terminals coming into operation over the past three years and a quarter of the world’s cranes now working on Chinese cities.
The fixed-investment frenzy has altered many equations in the global marketplace. China has become the largest consumer of many commodities, and the oil shock of the past year can be largely attributed to a “demand shock” from that country. The unexpectedly high Chinese demand also explains why the global economy has been remarkably resilient to the surge in crude prices. Both the price of oil and global economic growth have been reacting to the same dynamic—China’s strong growth.
China has been the largest contributor to global economic growth over the past five years in terms of purchasing-power parity (that is, adjusted for China’s under—valued currency). In fact, proxies for GDP growth, such as electricity consumption, suggest GDP growth probably averaged 11 to 12 percent over the past year. All this, however, seems unsustainable when put in a historical context.
In the late 1960s, when Japan’s per capita income level crossed the $1,000 threshold, as China’s did last year, its growth rate began to shift to a lower trajectory. In the early phases of development, the most powerful driver of growth is “convergence,” when reforms have a disproportionately large effect in spurring growth due to the low starting base and a high degree of inefficiency in the system. Reforms have led to a productivity boom in China over the past two decades, but the country has consumed a lot more capital than Japan ever did. While China pessimists are an endangered species these days, the few survivors continue to warn that too much money is chasing the China story without getting a reasonable return.
The hot money lands in the People’s Bank of China, which has been accumulating foreign-exchange reserves at a frightening pace of $10 billion a month over the past two years. The question is whether China will continue to rewrite the laws of development economics, or is about to enter a more mature growth phase, as Japan did in the 1970s.
There are intriguing parallels between Japan then and China today. Starting in the late 1960s the Japanese yen faced strong pressure to appreciate, which it resisted, leading to a huge surplus of liquidity in the system and a resultant inflation problem. Eventually Japan was forced to let the yen revalue, just as the economy faced the headwinds of soaring prices and more pollution-prevention regulations. These factors, combined with a natural exhaustion of high-return investment opportunities, led to a downward shift in Japan’s growth rate, from an average of more than 9 percent from 1955 to 1973 to about 4 percent in the subsequent 15 years.
Today most observers assume that China’s economy will expand at 8 percent for the foreseeable future. With significant inefficiencies still in the system and reform efforts continuing, the growth miracle is far from over. But even Chinese policymakers admit that the quality of growth is deteriorating. In the clearest sign of an overheating economy, inflation is rising rapidly even though many of the administered prices, such as those for diesel and gasoline, haven’t even been adjusted.
One of China’s big problems is that most input prices don’t reflect market reality. The price of money in China is distorted, with interest rates below inflation and the banking system in no shape to perform its lending function. The undervalued exchange rate and the resulting capital flow have led to a liquidity explosion. At 146 percent of GDP, China has the highest credit-to-GDP ratio of all major emerging markets.
The Chinese leadership likes to repeat that its main goal is stability, which in economic terms means steady growth of 8 percent and an inflation rate well south of 5 percent. This is a utopian goal that, again, no country has been able to achieve, including China in 25 years of reform. While real GDP growth in China has averaged more than 8 percent during that period, it has oscillated between 4 and 12 percent, —with the economy almost always slowing down sharply after a year of double-digit growth. Japan’s GDP growth rate in the 1960s had swings from 4 to 13 percent.
Stability is even harder to attain in China’s microeconomic climate. The economic structure is increasingly hybrid, with the state sector now accounting for half of GDP, down from 80 percent a decade ago. As China moves rapidly to a market system while most prices remain fixed, basic economics argues for greater volatility in growth. Further, an investment boom this extreme could well end in a slowdown in trend GDP growth. After all, can China build another 40 airports in the next three years, and won’t the higher input costs of skilled labor and commodities come to matter at some point?
There remains an aura of invincibility around China, based on the belief that policymakers can achieve any equilibrium they desire. All sorts of arguments are bandied about to support the widely held assumption that the country will continue to grow at supersonic speed. One of the more silly ones is that China needs to create 20 million new jobs a year to maintain social stability. Well, what country doesn’t aspire to create more jobs? Desire alone doesn’t ease the constraints to growth, the most prominent of which in China’s case is skilled labor. A high level of wage inflation and a rising inflow of skilled workers from places like Taiwan are signs that China’s overextended economy is facing labor shortages.
China needs to undertake decisive market reforms—such as revaluing the exchange rate—to rein in growth fever before the situation gets out of control. Focused leadership has been one of China’s main economic strengths in the reform years, with leaders from Deng Xiaoping to Zhu Rongji providing clear direction and acting firmly to keep the economy on track. But now the economic structure has morphed, making it more difficult for the traditional diktats to work. Moreover, the new leadership is still establishing authority over provincial leaders, who are used to operating only on the growth-at-any-cost mantra.
All of this indicates that stability will be elusive for China. More likely, economic variables such as growth, inflation and the exchange rate are going to witness much more volatility as China transitions to a more mature growth phase. The world will need to adjust to that reality rather than lazily assuming that the Chinese economy will steadily grow at the lucky number 8 every year.