Robert Samuelson November 25, 2013

It has been only a few years since China was widely regarded as anunstoppable economic colossus. For three decades, its economy grew about 10 percent annually; China seemed to be gliding through the global economic storm. Well,maybe not. Many economists — Chinese and foreign — think China’seconomic model is unworkable. Without a new model, they say, China willsomeday face a collapse of growth or worse. The outcome has hugeimplications for China’s internal stability and its global economicfootprint. The precedent of Japan, a highflier laid low, suggests thatrapid growth can’t be taken for granted.

First, some background.

China’s economic model emphasizesinvestment and export-led growth over consumption. The idea is simple:Build an industrial base by adopting technologies and productiontechniques pioneered elsewhere; complement this with a moderninfrastructure of roads, rails, ports and airports. All this spendingcreates jobs and raises wages for millions of poor Chinese who move from rural areas to cities. Exports further bolster jobs. In 2007, China’scurrent account surplus (an expanded trade balance) was an astonishing10 percent of its economy (gross domestic product).

The formula long succeeded. Average inflation-adjusted incomes rose from $250 in 1978 to $9,000 in 2012. Now, though, there are problems.

The easiest technologies have been adopted. Increasingly, the economy needs to generate growth through innovation. Next, major export markets — the United States and Europe — have weakened. Demand is sluggish, andresistance to allegedly unfair Chinese trade practices has stiffened. In 2012, China’s current account surplus was only 2 percent of GDP. Last but not least: Much private and public investment has beendebt-financed and seems wasteful. The infrastructure (roads, bridges)may be overbuilt. The same is true of industry.

“China’s highinvestment levels have led to overcapacity in multiple industries,including steelmaking, shipbuilding and solar panel manufacturing,”reports the congressionally created U.S.-China Economic and Security Review Commission.

What dooms today’s model, argues economist Michael Pettis of Peking University in his book “Avoiding the Fall,” is the debt buildup. At some point, some borrowers — state-ownedcompanies, local governments, property developers — won’t repay, bankswould sharply curtail lending, or both. Investment spending wouldplunge. On paper, the solution is obvious: Switch to a consumption-ledeconomy. In practice, it’s not so easy.

So dominant is investment spending in China that consumption — household spending for food,clothes, cars and all personal goods — amounted to only 36 percent ofGDP in 2012. By contrast, consumption’s share in the U.S. economy was 69 percent.

Wage increases, though large, have lagged behind overall economic growth, slowed by weak unions and plentiful workers.Government interest-rate ceilings on bank deposits punish savers —reducing their incomes and causing them to save more to offset the lowrates. With deposit rates suppressed, banks then provide cheap loans toindustry, fueling more investment. Finally, China undervalues itscurrency, the renminbi, to promote exports and deter imports.

Aswith Japan in its boom years, China is too wedded to investment andexports. Distortions feed on themselves. Consider housing. Deniedadequate returns on their savings, many Chinese invest in real estate,driving prices up and prompting fears of overbuilding and a “bubble.”

China is at a crossroads. Rapid economic growth underlies the regime’slegitimacy at home and its power abroad. But rapid growth is imperiled.China’s leaders acknowledge the problem. Their latest effort to fix itoccurred at the recent “third plenum” of the 18th Communist Party conference, which, among other things, relaxed the one-child-per-couple restriction and provided farmers more freedom to dispose of their land.

“The [communique’s] most telling statement was that market forces wouldbegin to play a ‘decisive’ role in allocating resources,” says economist Nicholas Lardy of the Peterson Institute, whose earlier book “Sustaining China’s Economic Growth After the Global Financial Crisis” also found the traditional economic model outdated. Taken literally,the communique implies that China will soon deregulate interest rates,float the exchange rate, end energy subsidies and curb state-ownedenterprises. No one expects this; many policy proposals are vague.

Here’s the dilemma: The old model may not be sustainable, but getting to a new model may be painful. Higher interest rates could bankrupt some firmsdependent on cheap credit. A revalued renminbi could close some exportcompanies. Stronger consumption might not instantly fill the void.Naturally, those benefiting from the status quo will fight to preserveit.

This defines China’s predicament. In 2012, its economy grew a respectable 7.7 percent. With good policies, Lardy thinks something like this could continue. Pettis sees a harder transition. At best, growth will average 3 percent to 4 percent. That’s not much higher than the United States’. China remains a colossus, but its future is increasingly clouded.

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