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China took one step forward over the past year in rebalancing its economy towards a more sustainable growth model. But, in the past few months it has also taken one step back.
Building on a trend that began last year, consumption was a bigger contributor than investment to growth in the first three quarters of this year, a crucial shift for an economy which has long been excessively reliant on investment.
Nevertheless, faced with a deepening slowdown, the Chinese government has undone some of that progress by reaching for a familiar solution: it has cranked up spending, especially on infrastructure projects.
As a result, the Chinese economy is poised to end 2012 on a relatively strong note, but data are likely to show that it was thanks to investment, not consumption.
A surge in spending on railways has been emblematic of this. Investment in rail projects increased 82 per cent year on year in October, up from a 37 per cent pace in August.
Such backsliding has been seen before. As early as 2007 Wen Jiabao, the departing premier, pronounced that China’s economy was dangerously out of kilter: growth had become “unsteady, unbalanced, uncoordinated and unsustainable”. But when the global financial crisis erupted in late 2008, China unleashed a Rmb4tn ($585bn) stimulus package to avoid falling into a recession.
That pushed investment up to nearly 50 per cent of gross domestic product in 2010, a level never seen before in any leading economy in peacetime. The other side of the coin is that personal consumption accounts for just about 35 per cent of GDP, down from 46 per cent in the 1990s and far below the norm in other fast-growing countries.
A recent working paper by the International Monetary Fund assessed the extent of China’s over-investment. Its conclusion was that investment in China had been running at a level about 10 per cent higher than would be considered optimal for an economy at its stage of development.
The deviation is “larger and [more] persistent than the implied over-nvestment in other Asian economies leading up to the Asian crisis [of 1997-98] or in Japan in 1980 before the onset of its lost decade,” the authors of the IMF paper wrote.
Based on that comparison alone, it would seem that a miserable fate awaits the Chinese economy. There are, however, two crucial distinctions between China and its previously over-invested Asian peers.
The first is that the funding for China’s investment has been almost entirely domestic in origin. This means that the country should be safe from the sort of external debt crisis that plagued South Korea and Thailand.
The second is that, despite the recent backsliding, the government appears to be acutely aware of the dangers of over-investment and has started to take a series of steps to change the underpinnings of growth.
It has made progress in building a welfare state, a necessary backstop that will allow people to spend more money. More than 430m Chinese are covered by basic health insurance, up from just 40m a decade ago.
Cautiously, the government has begun to introduce interest rate deregulation. As of June this year, commercial banks are able to set deposit rates 10 per cent above benchmark rates. This seemingly small move is helping pave the way to greater competition for funding among banks, raising the cost of capital for borrowers and hence discouraging investment.
The cause of rebalancing is being furthered by structural changes in the economy.
Most important of these is the pending decline of that part of the population that is of working age. With the labour force already growing more slowly, employers must compete for workers more than ever and wages have been rising by about 10 per cent a year – an important spur for consumption.
Li Keqiang, who is all but guaranteed to be appointed premier in March, has so far made many of the right noises about economic reform. “If we do not do it, then we will not make mistakes, but we will bear historic responsibility,” he said in a speech in late November.
Ha Jiming, vice-chairman of the investment management division of Goldman Sachs in China, believes that, among other issues, Mr Li will concentrate on making it easier for rural residents to settle in cities and will also push for service industries to be opened more widely to private investors. But these ideas have all been talked about for a while and new policies are likely to be implemented only slowly.
Mr Ha says: “Gradualism, instead of cold turkey, is still the tone of future reforms. This is manifested by the emphasis on the importance of introducing pilot programmes when carrying out major reforms.”
These are all positive omens. But, as this year has shown, the shift in China’s economic model is far from preordained.
Officials were all too willing to put the objective of rebalancing to one side when confronted with the alternative of a sharp growth slowdown.