James Ferguson illustration, China horse

Chinese policymakers have a stellar reputation for the quality of economic management but the same was true of the Japanese three decades ago. For the Japanese, the difficulty of shifting from their high-savings, high-investment, “catch-up” economic model proved very large. Indeed, this has still not been completed. While the Chinese economy has far more room to grow than Japan a quarter of a century ago, its disequilibria are even bigger. Moreover, contrary to conventional wisdom, the transition to a new pattern of growth has not really begun.

Already, the difficulty of handling this transition is damaging Chinese policymakers’ reputation. Mistakes in handling the implosion of the “bubble economy” of the 1980s did the damage in Japan. Now it is the Chinese authorities’ mishandling of the currency and the stock market. Similarly, the financial crisis of 2007 and 2008 devastated the reputation of western financiers and policymakers. Everybody seems to be a genius when credit is surging.

Understandably and rightly, observers are calling upon the Chinese authorities to be more transparent. Given their political system — “the bureaucrat knows best” — that is going to be hard to do, but this is a second-order matter. The first-order one is that it is unclear how and whether the transition to a more balanced economy is to be made.

Again, some people focus on the transition from manufacturing to services. This does seem to be going quite well: according to Chinese data, industry grew at an annual rate of just 6 per cent in the first three quarters of 2015, while services grew 8.4 per cent. However, a large part of this apparent success is due to growth of income from financial services. Just as was the case in the west, before the crisis, this is as much a symptom of credit growth as of a transition to a more balanced “new normal”.

The fundamental indicators of a change in the shape of the economy would be a fall in savings and investment and a rise in consumption. Such a shift is necessary not only because much of the investment is wasted, but because it is associated with an explosive rise in debt. China has today a far higher share of investment in gross domestic product than other high-growth east Asian economies ever had. Furthermore, according to the McKinsey Global Institute, overall indebtedness is extremely high with a concentration in non-financial corporations. It is higher than in the US, for example. (See charts.)


In response to the 2008 financial crisis, China promoted a huge rise in debt-fuelled investment to offset the weakening in external demand. But underlying growth in the economy was slowing. As a result, the “incremental capital output ratio” — the amount of capital needed to generate additional income — has roughly doubled since the early 2000s. China’s overall capital-output ratio is also very high and rising. At the margin, much of this investment is likely to be lossmaking. If so, the debt associated with it will also be unsound. But, if wasteful investment were slashed, the economy would go into recession.

What is needed is a measured adjustment in the economic structure, with credit-fuelled investment falling and consumption rising as shares of GDP. Is this happening? No, or at least it is happening far too slowly. The investment share has fallen slightly while the explosion in indebtedness continues: the ratio of debt to GDP was 157 per cent at the end of 2007, 250 per cent at the end of 2013 and 290 per cent at the end of the second quarter of 2015.


Again, household disposable incomes were just 61 per cent of GDP in 2013 (the most recent year for which data are available). This is a little above the low of 59 per cent in 2008 and 5 percentage points below where it was in 2000. Chinese households also save about a third of disposable incomes. This explains why consumption is only some 40 per cent of GDP. Again, the shift in incomes towards households, needed to raise the consumption share in GDP decisively, is happening at a glacial pace.

In brief, demand continues to depend on growth of wasteful, debt-fuelled investment. The shifts in the economic structure needed to remove this dependency are just not happening.

Are there alternatives? Yes. The first would be to let investment decline and replace it with a bigger current account surplus. A weakening currency would help this along. Given the fierce desire of the Chinese people to take their money out of the country, shown in the decline of the foreign currency reserves, this could well happen under the freely floating exchange rate the US demands. However, a Chinese surplus of, say, 10 per cent of GDP, would surely be far too large for the world to handle.


The second possibility would be to run a far larger fiscal deficit. This could be used to transfer spending power to Chinese households. That would also shift rising indebtedness towards government from the rest of the economy.

The reality is that the Chinese economy is not becoming consumption-led. Indeed, given the low share of households in GDP, it cannot be consumption-led. It continues to be heavily dependent on debt-financed investment. The authorities face a dilemma: either continue to drive wasteful growth or push through radical reforms that might be destabilising in the short term but fruitful in the long term.

Whatever the rhetoric, the path chosen so far is the former, but that is also likely to be one of disappointing growth, soaring debt and even a financial shock. Chinese policymakers are unlikely to regain their reputations soon.


Letters in response to this column:

Large fiscal deficit may already exist for China / From Rupert Foster

Reputation of Chinese policymakers lost its sheen some time ago / From Jonathan Fenby

Copyright The Financial Times Limited 2023. All rights reserved.
Reuse this content (opens in new window) CommentsJump to comments section

Follow the topics in this article