Growth and rebalancing

China's economy is cooling, with lower growth over the medium term. At the same time, China needs to adjust its growth pattern to address major challenges and imbalances. While there is little disagreement on these two points, views differ on the extent of the slowdown and the risks of a hard landing and there is confusion over the key motivations for rebalancing and which rebalancing policies are essential. For rebalancing to be successful it is important to get the motivation right.

The medium-term trend towards slower growth is not new and quite gradual. In addition to a cyclical slowdown this year, looking at the medium-term drivers of growth, accumulation of labour and total factor productivity are likely to decelerate. Trying to offset these pressures by further hiking (physical) capital accumulation would not sit well with the government's rebalancing plans. In all, with fixed investment assumed to gradually slow down, the medium -term trends suggest an easing of GDP growth to an average of around 8 percent in 2012-20.

The government's official growth target of 7.5 percent for 2012, compared to 8 percent for previous years, caused quite a stir globally, but it should not have, as lower growth targets were already included in the 12th Five-Year Plan (2011-15) adopted last year and the targets are not binding in the sense of guiding the macro stance. Actual growth tends to exceed official targets, often by a large margin.

China needs to adjust its growth model as the current pattern has led to rising imbalances and is not sustainable. But what exactly are the key motivations? Some observers have suggested that China could soon hit a wall because of misallocated investment and escalating debt. Yet although its remarkably high investment - an estimated 48 percent of GDP in 2011 - poses risks of wastage overall China's infrastructure investment has served the real economy well and its utilization rates compare favorably internationally. In the commercial sphere rates of return on investment do not compare unfavorably. Economy-wide total factor productivity growth of 3 percent in 1995-2011 is high by international standards. The setting in which decisions on financing and investment are made in China raises risks of misallocation, which is why financial sector and corporate governance is important, however, there are so far no convincing signs of systemic over-investment or misallocation.

Is debt China's Achilles heel? Household debt remains modest. The corporate sector's gross debt in China's bank-dominated financial system is estimated at around 100 percent of GDP. The majority of investment in the commercial sphere, however, continues to be financed by retained earnings rather than debt, leaving the corporate sector's leverage manageable. Although that is not true for property developers and some of the bank lending to them may go sour. And even after the recent maturity restructuring, some loans to local governments are likely to go bad, with the burden split between the banks and the central government. However, with much of the debt held within the broader public sector and the central government fiscally healthy, and with substantial current account surpluses and low foreign debt, China's debt problems are unlikely to become systemic at the macro level.

The key motivations for changing China's growth pattern lie largely outside of the narrow financial-economic realm. But that does not make them any less important. The investment and industry-heavy pattern of growth has led to several imbalances. Since the late 1990s, in a policy setting too favorable to industry and capital, flourishing industrial firms ploughed back increasingly large profits into new capacity, while wage increases lagged behind productivity growth. With profits rising, wages and household incomes have declined as a share of GDP. This combined with low deposit rates and a rising household saving rate in no small part due to rising income inequality accentuated by this growth pattern to constrain consumption and swell external surpluses. External surpluses have come down recently, but that could be temporary in the absence of rebalancing. This growth pattern was also very damaging to the environment and led to intensive use of natural resources and energy.

China needs to rebalance the pattern of growth away from industry and investment towards services and consumption. Such a shift would mean more labor-intensive growth, with more urban employment creation. By boosting the share of wages and household income in GDP, this would increase the role of consumption in a way that is economically sustainable and would lower the external surplus. Such rebalancing would also make growth less energy and resources intensive and less harmful to the environment.

As to how to rebalance, many observers emphasise financial-sector reform and appreciation of the yuan. These are important measures, but they need to be part of a comprehensive set of reforms to channel new resources to new sectors, and to support more full migration to the cities, allowing migrant workers to behave like full-blown urban citizens in order to foster more labor-intensive, services-oriented and consumption-based growth.

The key reforms include removing the subsidies to industry by raising the prices of inputs such as land, energy, water, electricity, and the environment; increasing private-sector participation and removing entry barriers in several service industries; improving access to finance for small and medium-sized enterprises and service-sector firms; continuing State-owned enterprise dividend reform and channelling the revenues to the Ministry of Finance; liberalizing the hukou, or household registration system, and reforming the inter-governmental fiscal system to give local governments the means and incentives to fund public services and affordable housing for migrants; and pursuing land reform to increase the mobility of migrants and, by facilitating land consolidation and mechanization, boost per capita incomes and consumption in the countryside.

There is nothing dramatic about China's easing growth and, from a financial-economic perspective, China's economy is on a sounder footing than is often believed. But successfully rebalancing the growth pattern requires a major reform push in many areas, including ones where change will be difficult.

The author is a project director at the Fung Global Institute.

Fung Global Institute

(China Daily 04/17/2012 page9)