By Michael Pettis
China’s official growth rate has fallen sharply; its real growth rate may be substantially lower; the country is tipping into deflation; and Premier Wen Jiabao has warned, yet again, that the economy is under serious pressure. China seems to be heading towards a hard landing and Beijing, many Chinese and foreign experts warn, must cut interest rates drastically and expand credit, so saving itself and the world from disaster.
The process will not be easy. Debt levels have risen so quickly that unless many years of over-investment are quickly reversed, China will face serious problems, maybe even a crisis – but the sooner China starts rebalancing, the less painful it will be. With China’s consumption share of gross domestic product at barely more than half the global average, however, and with the highest investment rate in the world, rebalancing will require effort.
The key to raising the consumption share of growth is to get household income to rise from its unprecedentedly low share of GDP. This requires China to increase wages, revalue the renminbi and, most importantly, reduce the enormous tax that households implicitly pay to borrowers in the form of artificially low interest rates.
But these measures will slow growth. The implicit “financial repression” tax, especially, is both the major cause of China’s economic imbalance and the source of its spectacular growth. Forcing up the real interest rate is the most important step Beijing can take to redress the domestic imbalances and to reduce wasteful spending.
And this seems to be happening. Beijing has reduced interest rates twice this year and reluctant policy makers are under intense pressure to reduce them further, but with inflation falling much more quickly than interest rates, the real return for household depositors has soared in recent months, as has the real cost of borrowing. China is repairing one of its worst distortions.
This cannot help but reduce investment growth, and so China’s GDP growth rate must fall sharply. China bulls, late to understand the unhealthy implications of the distortions that generated so much growth, have finally recognised how urgent rebalancing is, but they still fail to understand that this cannot happen at high growth rates. China’s investment growth rate must fall for many years before the household income share of GDP is high enough for consumption to replace investment as the engine of growth.
As China rebalances we would expect slowing growth and rapidly rising real interest rates, which is exactly what we are seeing. Rather than panicking and demanding that Beijing reverse the process, we should be relieved that China is finally solving its problems.
But won’t slower growth create social dislocation in China and economic dislocation around the world? No, not if it is managed well. Remember that Chinese rebalancing requires household to income grow faster than GDP for many years, and if Chinese growth slows even to 3 per cent, as I expect it will, but household income continues growing at 5-6 per cent, this is far from being socially disruptive.
What the rest of the world needs from China is not faster growth but more demand. Rebalancing will provide that, although the trade surplus will probably rise before it begins to decline. This will result in falling prices for hard commodities, and so will hurt countries such as Australia and Brazil, but rising Chinese demand and lower commodity prices are good for global growth overall.
It is too early to say whether or not China has really begun its great rebalancing. Among other things, this would mean the rapid growth in state sector wealth – which mainly benefits China’s political elite – must slow sharply. It is likely that the elite will resist this ferociously. We should expect tremendous pressure to reverse the process. Commodity exporters and China’s economic elite may not like it, but this is a good sign for nearly everyone else.
The writer is a finance professor at Peking University and a senior associate at the Carnegie Endowment