China Financial Markets
quantifies various growth and investment scenarios. Pettis maintains 6%
or higher growth is not plausible and that even 3-4% growth may be
optimistic. What follows is from Pettis ...
Consumption and Investment Growth Under Rebalancing
Under specified rebalancing assumptions for China it is possible to
calculate arithmetically the annual growth rate for consumption and
investment under different GDP growth scenarios. This allows us to
decide whether these scenarios are plausible or not.
Table: GDP, consumption, and investment growth in a rebalancing China
To read the table, let us start by assuming, as an example, that we
believe the average GDP growth rate over the ten-year period will be 6%.
For China to do a minimal amount of rebalancing that gets consumption
to 50% of GDP and investment to 40% of GDP, we can quickly figure out
what the corresponding growth rates of consumption and investment must
be. Consumption must grow by 9.9% a year and investment must grow by
4.5% a year to get us there.
Notice the reason why I do it this way rather than the “normal” way most
other economists would. Instead of estimating what I expect the growth
rates in consumption and investment will be, and then calculating the
implicit GDP growth rate from those numbers, I start with an assumed GDP
growth rate and then calculate what the implicit growth rates in
consumption and investment must be in order for rebalancing to take
place. I am not making predictions, in other words. I am simply working
out logically what any GDP growth rate must imply in terms of
consumption and investment growth rates in order for China to rebalance.
This allows me to make statements like this: If you think that China’s
GDP will grow by 7% a year over the next decade, and if you expect a
minimal amount of rebalancing, then you are implicitly predicting that
consumption will grow by 10-11% a year for ten years and that investment
will grow by 4-5.5%. If you believe these two implicit predictions are
plausible, then your 7% prediction is also plausible.
I want to state again that these numbers are not predictions. They are
simply the arithmetically necessary growth rates that are consistent
with our assumptions. To return to the interpretation of the table, let
us assume again that China does the minimal amount of rebalancing so
that in ten years household consumption is 50% of GDP and investment is
40% of GDP, what are the investment and consumption growth rates
consistent with, say, 6% GDP growth, and are they plausible?
It turns out that average GDP growth rates of 6% require, as an
arithmetical necessity, that household consumption grow by 9.9% a year
over the next ten years and that investment grow by 4.5%, after many
years of high double digit growth and more recently growth in the low
double digits. Is this plausible?
I would argue that positive investment growth rates for another ten
years are highly likely to result in our reaching debt capacity
constraints well before the end of the decade, so I am skeptical about
the investment implications of this scenario. By the way some analysts
have mischievously pointed to the very poor construction quality in
China to argue that investment growth rates have to stay high just in
order to account for higher-than-estimated depreciation costs, and that
this suggests that China can grow faster than what we might otherwise
This of course is nonsense. The fact that buildings and infrastructure
are poorly constructed means that China is worse off, not better off,
and the investment projects will ultimately be required to generate
sufficient returns to pay off even more debt than originally estimated.
Because it is debt capacity constraints that constrain investment,
anything that creates debt without creating additional productivity to
service the debt cannot possibly be a solution. Higher-than-expected
depreciation increases debt relative to debt-servicing capacity.
I would also argue, more importantly, that if annual investment growth
drops to 4.5%, and GDP growth to 6%, it will be very difficult, without
significant and politically painful transfers from the state sector to
the household sector, for consumption to grow at anywhere close to 9.9% a
year for ten years. Consumption growth is, after all, positively
correlated with investment growth, especially in the internal provinces
upon which a lot of useless investment has been lavished.
In order to get Chinese households to increase their consumption by
nearly 10% every year, I would argue that household income would have to
grow at that rate, which means that wages, interest rates, and the
value of the renminbi should in the aggregate increase rapidly to get
consumption to rise fast enough, and of course since it is precisely low
wage growth, low interest rates, and an undervalued currency that goose
GDP growth, reversing them is not consistent with high GDP growth.
Can consumption grow at close to 10% for ten years while household
income grows much more slowly? Yes, of course it can, if the household
savings rate declines, but as China’s economy slows and as concerns
about debt rise, it seems to me a tad optimistic to assume that the
household savings rate will decline sharply. Rising income and rising
uncertainty both suggest that we should expect higher, not lower,
household savings rates, which in turn imply that household income must
grow faster, not slower, than household consumption.
All of this suggest to me that while 6% GDP growth for the next ten
years might not be impossible, it is extremely unlikely because it
requires what are to me implausible assumptions about the ability to
maintain and increase already-high levels of investment without
increasing the debt burden unsustainably and about the rise in the
growth rate of household income as both GDP and investment growth drop
sharply. This is why even 6% annual GDP growth rates, which are still
lower than most current growth projections for China, are implausibly
high, in my opinion.
What about if you believe that reducing investment is a much more urgent
priority than raising consumption? In that case you might argue that
China can grow at 6% while the household consumption share of GDP rises
to 50% and the investment share of GDP declines to 35%.
In that case you are implicitly assuming that household consumption will
grow on average by 9.9% a year for ten years while investment grows by
3.1% a year. Is this possible? Of course it is. Is it plausible? Again,
only if you believe that investment growth can drop sharply while the
growth in household consumption rises to nearly 10% a year for ten
So what is plausible? My working assumption, which I acknowledge is
probably still optimistic, is that somehow or the other Beijing can keep
household consumption growing at around 7-8% a year, even with a sharp
decline in the investment growth rate and with the pressing need to
clean up the banking system (and remember that traditionally, in China
and elsewhere, cleaning up the banking system always means finding ways
of getting the household sector to pay for the losses).
I know many consider assumption this to be a little optimistic, but if
Beijing is worried about the social implications of adjustment, this is
probably the target it will need to meet, and Beijing can do so even
with much slower GDP growth if the leadership implements mechanisms that
transfer wealth from the state sector to the household sector. I
discuss why this is the right growth rate for to target in more detail
in a recent piece published on the Carnegie Endowment website and in an
OpEd piece in the Financial Times.
The table above shows that if China is to do the minimal amount of
rebalancing, which requires that the world accommodate for another ten
years large Chinese trade surpluses, and that debt can continue to grow –
quickly but at a lower rate than in the past – for another ten years
without pushing China up against its debt capacity constraints, 7-8%
growth in household consumption is consistent with roughly 3-4% growth
in GDP. It is also consistent with more or less no growth in investment,
which would after ten years bring the investment level down to 35% of
These numbers are, I think, plausible if still a little optimistic. This
is something, in other words, that I think Beijing can reasonably pull
off – if it is able to manage political opposition from the domestic
elite – because they can transfer resources from the state sector to the
household sector at a pace necessary to keep the growth rate of
household income and household consumption fairly high. However GDP
growth rates significantly above 3-4%, I would argue, require
assumptions that are unlikely to be met unless Beijing is able radically
to transform its attitude to state ownership and the power of the
elite, and so embark on a major transfer of assets from the state to the
This is why I have argued since 2009 that that 3-4% average GDP growth
for a decade is likely to be the upper limit once Beijing seriously
begins to rebalance the Chinese economy, and if the administration of
President Xi and Premier Li is able to pull this off, it would be a huge
accomplishment. China would rebalance substantially, the problem of
debt would have been managed relatively well, and the income of average
Chinese households will have nearly doubled over the decade. The key
assumption, of course, is that in the face of a sharp drop in
investment, Beijing is nonetheless able to maintain current high levels
of consumption growth.
Before closing it is worth pointing out that many analysts have told me
that they do not think it is possible for household income growth to
exceed GDP growth for many years. But why not? After all state income
growth exceeded household income growth for many years, and if Beijing
reverses the mechanism that accomplished this – albeit with political
difficulty – it can reverse the relative growth rates. More importantly,
Japan did just this after 1990, when GDP grew by around 0.5% annually
but household income and household consumption grew by between 1% and
2%. The US did this too in the early 1930s when, if I remember
correctly, household income and household consumption dropped by a lot
less than GDP (around 35%) and investment (around 90%).
But notice these two examples. One occurred under conditions of no
growth and the other under conditions of negative growth. Severely
unbalanced systems always rebalance in the end, but the process of
rebalancing is rarely easy.
Michael Pettis stresses his table is not a series of predictions, but
rather a mathematical model of what is probable or not. I agree with his
model. If correct, a slow-growth China is baked in the cake, and that
is going to catch nearly every economist off guard. Every country will
be impacted, but especially the commodity exporters like Australia and
Mike "Mish" Shedlock