Book summary: The Great Rebalancing

The Case of Unbalanced Growth in China

China, as is well known, has in the past decade experienced the largest trade surplus in the word, and as a share of global GDP its trade surplus may be the highest—or certainly among the highest—ever generated in history.

But China also has an extraordinarily high investment rate, the highest in the world, and this is something that is in principle unlikely to be accompanied by a high trade surplus.

But China runs a huge current account surplus. This implies that China must also have an exceptionally high savings rate—one high enough fully to satisfy domestic needs and yet with enough excess to generate a very large surplus.

Before going further it is important to note that an excessively high savings rate can be just as debilitating for an economy, perhaps even more so, as an excessively low savings rate.

Rebalancing will require, as I demonstrate in the rest of this chapter, that household income grow faster than GDP, and so by definition the state sector must grow more slowly. Even if we accept what I believe are excessively optimistic average annual growth expectations of 7 percent for the next decade, for China to rebalance, the average growth rate of the state sector cannot exceed 5 percent annually

The transition from a state in which the accumulation of state assets grows by roughly 15 percent or more annually to one in which it grows by less than 5 percent will be at the heart of the distributional struggles among Chinese factions and prominent Chinese families.

What Kind of Imbalance?

Is China’s growth “unbalanced,” and if so, in what sense is it unbalanced, and how does that affect the trade account? Most commentators pretty much agree that China’s economy is indeed unbalanced, and they agree on the nature of the fundamental imbalances.

Chinese growth is unbalanced because the very rapid GDP growth generated especially in the past decade has relied too heavily on net exports and investment and too little on domestic household consumption. The most striking expression of this imbalance is the declining share of GDP represented by household consumption.

The story of Chinese consumption since the 1978 reforms is instructive. In the 1980s household consumption represented about 50 to 52 percent of GDP. This is not an unprecedented number, but it is very low. Consumption for most European countries lies in the 60 to 65 percent range.

By Asian standards, however, Chinese consumption in the 1980s was not exceptionally low. South Korean and Malaysian consumption is around 50 to 55 percent of GDP. Other major Asian economies, like India, Japan, Taiwan, and Thailand, show consumption in the 55 to 60 percent of GDP range.

Nonetheless, even though it started the decade at the low end of the range even for low-consuming Asian countries, as the country grew during the 1990s Chinese consumption declined further as a share of GDP.

By the end of the decade Chinese household consumption represented a meager 46 percent of GDP. This was not unprecedented—Malaysian consumption after all had dropped to 45 percent a year after the 1997 crisis—but the Chinese consumption level was more typical of a country in crisis than of a country in ruddy good health.

But the story doesn’t end there. By 2005 household consumption in China had declined to around 40 percent of GDP. With the exception of a few very special and unique cases, this level is unprecedented in modern economic history.

Beijing’s response to this very low number, not surprisingly, was a worried one. Policymakers pledged during 2005 to take every step necessary to raise household consumption growth and to help rebalance the economy.

Why were they worried? Because, as we pointed out in chapter 1, in any economy there are three sources of demand—domestic consumption, domestic investment, and the trade surplus—which together compose total demand, or GDP. If a country has a very low domestic consumption share, by definition it is overly reliant on domestic investment and the trade surplus to generate growth.

With the largest trade surplus ever recorded as a share of global GDP—all the more astounding given that the two previous record holders, Japan in the late 1980s and the United States in the late 1920s, were countries whose share of global GDP was two to three times China’s share—it wasn’t at all obvious that China could expect its trade surplus to increase much more.

It turned out that even the skeptics underestimated the difficulty of the adjustment China was facing. For the next five years GDP growth continued to surge ahead of household consumption growth until by 2010, the last year for which we have complete statistics as of this writing, household consumption declined to an astonishing 34 percent of GDP. This level is almost surreal.

Growth Miracles Are Not New

There is nothing especially Chinese about the Chinese development model. It is mostly a souped-up version of the Asian development model, probably first articulated by Japan in the 1960s, and shares fundamental features with a number of periods of rapid growth—for example Germany during the 1930s, Brazil during the “miracle” years of the 1960s and 1970, and the Soviet Union in the 1950s and 1960s, when most informed opinion expected the country to overtake the United States economically well before the end of the century.

At the heart of the various models are massive subsidies for manufacturing and investment aimed at generating rapid growth and the building up of infrastructure and manufacturing capacity.

The important thing to remember from the growth model perspective is that, whatever the reason, lagging wage growth in China represented a transfer of wealth from workers to employers. An increasing share of whatever workers produced, in other words, accrued to employers, and this effective subsidy allowed employers to generate transferred profit or to cover real losses.

The fact that productivity grew much faster than wages acted like a growing tax on workers’ wages, the proceeds of which went to subsidize employers. This forced up China’s savings rate.

The second mechanism common among Asian development model countries for transferring income from households to manufacturers, is an undervalued exchange rate, and most analysts acknowledged that after the massive devaluation of the renminbi in 1994, followed by soaring productivity, the renminbi was seriously undervalued for much of the past two decades.

It is not wholly meaningful to discuss by how much the renminbi was undervalued because any undervaluation of the currency must be considered in conjunction with the other transfers that had similar impacts on the trade balance. Most economists, however, have estimated the undervaluation to be anywhere from 15 percent to 30 percent, which given long-term changes in productivity and inflation is probably a reasonable if imprecise estimate.

The Trade Impact

The second constraint is that policies that force households to subsidize growth are likely to generate much faster growth in production than in consumption—growth in household consumption being largely a function of household income growth.

In that case even with high investment levels, large and growing trade surpluses are needed to absorb the balance because, as quickly as it is rising, the investment share of GDP still cannot increase quickly enough to absorb the decline in the consumption share.

As long as the rest of the world—primarily the United States and the trade deficit countries of Europe and Latin America—have been able to absorb China’s rising trade surplus, the fact that domestic households absorbed a declining share of Chinese production didn’t matter much. A surge in American and European consumer financing allowed those countries to experience consumption growth that exceeded the growth in their own manufacture of goods and services.

But by 2007 China’s trade surplus as a share of global GDP had become the highest recorded in one hundred years, perhaps ever, and the rest of the world found it increasing difficult to absorb it. To make matters worse, the global financial crisis sharply reduced the ability and willingness of other countries even to maintain current trade deficits, and as we will see this downward pressure on China’s current account surplus is likely to continue.

So China has hit both constraints—capital is wasted, perhaps on an unprecedented scale, and the world is finding it increasingly difficult to absorb excess Chinese capacity—and in fact may have hit the former constraint a decade or more ago. For all its past success China now needs urgently to abandon the development model because debt is rising furiously and at an unsustainable pace, and once China reaches its debt capacity limits, perhaps in four or five years, growth will come crashing down.

A Lost Decade?

How can China rebalance away from investment and toward domestic consumption as the main engine of growth? Only with great difficulty. Chinese households consume only about 34 percent of GDP, not much above half the global average and far less than the rate in any other country.

It bears repeating that such a large domestic imbalance has no historical precedent. Over the next ten years policymakers have said that they will try to raise consumption to 50 percent of GDP. Although this represents a substantial adjustment for China, it is worth remembering that 50 percent will still leave China with by far the lowest consumption rate of any major economy, and given the need for an equal and opposite adjustment by the low-savings economies of the rest of the world, it is not at all obvious that the world will be able to accommodate even this limited improvement in the imbalance in the Chinese economy.

The world is desperate for demand, and foreigners may be unwilling to accommodate such a large gap between what China produces and what it consumes.

But even achieving this goal will be hard because it requires that household consumption grow 4 percentage points faster than GDP. To raise consumption from 34 percent of GDP to 50 percent of GDP in ten years, in other words, consumption growth must outpace GDP growth by 4 full percentage points every single year of the decade. ?

Such consumption growth is unlikely because powerful structural factors work against it. First and most obviously, the global environment is likely to be much less accommodating over the next decade than it was in the previous decade. Second, the Chinese growth model, remember, transfers income from households to the corporate and state sector, mainly in the form of artificially low interest rates, in order to generate such rapid growth.

Low interest rates in particular sharply reduce borrowing costs for the state-owned companies that funnel this easy money into mega-investments. The easy financing also gooses banks’ profit margins and allows them to resolve bad loans with ease.

Can China Manage the Transition More Efficiently?

So what kind of GDP growth rates can we expect for China over the next decade? Even if consumption manages to keep growing at the same rate it has during the past decade, when Chinese and global conditions were buoyant and debt levels much lower, China’s growth must slow to 3–4 percent at best to achieve real rebalancing. This is the impact, in other words, of the required reduction in investment, which will have to be sudden and sharp.

In a less optimistic scenario, consumption growth will slow down to less than what it was last decade—perhaps because of slower GDP growth—making rebalancing even harder. In that case for China to achieve real rebalancing, GDP growth rates will be even lower than 3 to 4 percent.

Will slower growth be a disaster for China, and will it lead to social instability? Not necessarily. If the rebalancing is well managed, by definition household income and consumption will grow faster than GDP, and so the lost decade of growth will not be as painful for the household sector as one might imagine.

For example, one can easily posit a case in which China’s GDP grows by 3 percent annually, Chinese household income grows at 5 percent, and consumption at 5 or 6 percent. In that case Chinese households will continue to feel better off and to have improving economic prospects.

But by definition if household income grows faster that GDP, there must implicitly be a transfer of resources from the state to the household sector. For much of the past three decade we have seen the opposite, so the household share of the rapidly growing pie has contracted while the state share has expanded. This must be reversed.

There is a “good” way to manage and speed up the process, and that is through some form of direct or indirect privatization of state assets. This would involve the government’s recapitalizing and transferring resources from the state sector to the household sector in other ways. Remember that the key to raising the consumption share of GDP is to raise the household income share of GDP.

Transferring state assets to the private sector is, however, easier to say than to do, and there will be significant political constraints and resistance from vested interests that will make this transfer very difficult, as we saw at the beginning of this chapter.

Foreign Capital, Go Home!

One of the biggest worries that periodically sweep the international markets is the fear that countries like China, which buy huge amounts of U.S. Treasury bonds, will stop buying U.S. government bonds—perhaps as a way of expressing concern over U.S. creditworthiness or displeasure with U.S. foreign and trade policies.

It turns out that the fear of a foreign, or Chinese, boycott of U.S. government bond purchases, one of the most common nightmare scenarios bruited about the market, is actually a claim without any real basis and makes little sense for two reasons.

First, as we explore in chapter 8, purchases by foreign central banks of U.S. Treasury obligations do not lower U.S. interest rates and do not benefit U.S. growth. If anything, they raise U.S. interest rates by forcing the country to choose between higher debt and higher unemployment.

Second, the decision by countries like China to buy U.S. government obligations is not a discretionary decision that can be made or unmade at will. Remember that the People’s Bank of China does not purchase huge amounts of U.S. government bonds simply because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of U.S. government bonds is mainly and even exclusively a function of its trade policy.

What does the People’s Bank of China do with the dollars it purchases? Because it is such a large buyer of dollars, it must put them in a market that is large enough to absorb the money and—and this is the crucial point—whose economy is willing and able to run a large enough corresponding trade deficit.

Remember that the recipient country must see an equivalent deterioration in its trade balance. In practice, only the U.S. fulfills those two requirements. It has very large and extraordinarily flexible financial markets, and it has the ability and willingness (although perhaps the latter is declining) to run large trade deficits.

Can We Live without the Dollar?

The above question, however, as the ongoing financial crisis demonstrates, is far from being solved, and has become even more severe due to the inherent weaknesses of the current international monetary system.

Though the super-sovereign reserve currency has long since been proposed, yet no substantive progress has been achieved to date. Back in the 1940s, Keynes had already proposed to introduce an international currency unit named “Bancor,” based on the value of 30 representative commodities.

Unfortunately, the proposal was not accepted. The collapse of the Bretton Woods system, which was based on the White approach, indicates that the Keynesian approach may have been more farsighted. The IMF also created the SDR in 1969, when the defects of the Bretton Woods system initially emerged, to mitigate the inherent risks sovereign reserve currencies caused.

A super-sovereign reserve currency not only eliminates the inherent risks of credit-based sovereign currency, but also makes it possible to manage global liquidity.

A super-sovereign reserve currency managed by a global institution could be used to both create and control the global liquidity. And when a country’s currency is no longer used as the yardstick for global trade and as the benchmark for other currencies, the exchange rate policy of the country would be far more effective in adjusting economic imbalances. This will significantly reduce the risks of a future crisis and enhance crisis management capability.

Transferring the Center of the Crisis

The global balance of payments, after all, must balance. An increase in savings relative to investment in the rest of the world must either force up Chinese investment or force down Chinese savings.

If Beijing is serious about bringing down investment levels over the next few years, as it claims to be, then deleveraging abroad will force China to reduce domestic savings dramatically, something it has been unable to do for many years and in which it can succeed only with great difficulty and serious reform.

One very unwelcome way to lower the Chinese savings rate, of course, is in the form of rising unemployment, but even if China is able to keep unemployment low, deleveraging abroad will force China to grow in a very different way. To claim that China can remain unaffected by the crisis-linked rebalancing of the global imbalances, of which it was a major component, simply does not make sense.

In fact more generally any claim that certain major developing countries, like Brazil, have managed to avoid being derailed by the global crisis is likely to be based on a misunderstanding of the transmission mechanism.

Every major economy that participated in the imbalances will be affected by the crisis, but some countries can postpone the impact of a contraction in global consumption by an expansion in investment, even if that investment turns out subsequently to have been unsustainable.

Some Predictions

So how will the global crisis end, and what kinds of rebalancing will have to take place before each of the world’s major economies can be said to have put the global crisis behind it? I propose the following:

1. The United States is slowly and painfully rebalancing.

The United States entered the crisis suffering from high debt and excessively low savings driven by a number of factors. Of these I stress three. First, as the world’s most open economy with an extremely flexible financial system, the U.S. economy was the automatic counterbalance to underconsumptionist policies abroad.

Second, and possibly related to the liquidity generated by the recycling of these large trade imbalances as well as to excessively low interest rates in the United States, surging stock and real estate markets made American households feel wealthier—mistakenly as it turns out—and so they increased consumption more than was justified economically.

Third, military adventures abroad have been ruinously expensive and, perhaps like most previous unpopular American wars, were funded by borrowing and money creation rather than by taxes.

2. German growth rates will slow sharply for many years, and German banks will take significant losses.

Most of German growth in the past decade has been a direct result of growing European imbalances. As a necessary consequence of its trade surplus, the German banking system has accumulated substantial claims against the trade deficit countries of Europe.

By definition peripheral European countries, which have heretofore been running large trade deficits, cannot repay their obligations without running trade surpluses, and if they do so, these will force a sharp corresponding deterioration in Germany’s trade balance.

This leaves Germany with only two meaningful alternatives. Either Berlin must reverse Germany’s surplus by cutting taxes and boosting spending, in which case it will suffer from much slower growth, rising unemployment, and rising debt, or it must write off its claims on peripheral European economies, in which case government debt levels will surge anyway as Berlin backstops the banks.

Not everything that is happening is bad, however. Countries like Spain are putting into place real tax, labor, and business reform that will help them grow once the crisis is put behind, but these measures, unfortunately, cannot regain competitivity by themselves. Ultimately these countries will still have to leave the euro.

There is no question that abandoning the euro will be painful, but postponing devaluation and debt restructuring will be more painful because the financial distress process will itself ensure that over the next few years businesses will disinvest, workers will become radicalized, savers will flee, and the political structure will become less stable.

4. China has already taken too long to address its domestic imbalances, and it is running out of time.

Economists like to debate whether China will suffer a hard landing or a soft landing, but I expect that it will suffer from, to use Nicholas Lardy’s phrase, a long landing, and a very bumpy one at that. Growth rates will jump up and down dramatically during the long landing, but the trend will be sharply down. Beijing so far has been very reluctant to force through an adjustment and rebalancing of its extreme underconsumptionist policies, but rapidly rising debt means that within four or five years it will have no choice.

As the economy adjusts, I expect Chinese GDP growth to average 3 percent or less over the decade of adjustment. But contrary to conventional opinion this is not necessarily a disaster for China.

If much slower growth is accompanied by a real shift toward labor-intensive industries and a substantial transfer of assets from the state sector to the household sector, unemployment can remain low and household income can continue growing rapidly—perhaps at 4–5 percent a year. This will help prevent social instability and will ultimately leave the country with a much healthier economy and long-term sustainable growth.

For thirty years Chinese households have done well even while receiving a sharply declining share of a rapidly growing economic pie. The state sector, with its growing share, has done even better because its share of the growing economic pie was itself growing. For the next twenty years, as growth slows substantially, the household share must increase. The implication is not just a rapid reduction in the growth of state wealth, but perhaps even an absolute decline.

5. Japan is still struggling with the legacy of its overinvestment surge in the 1980s.

Unfortunately Japan indicates one of the ways China can mismanage the rebalancing of its economy. Rather than write down bad loans and transfer corporate and state wealth directly to households, perhaps by privatization, which might have resulted in a deeper economic contraction in the early 1990s but would have reenergized the capital allocation process and permitted Japan to grow again, Japan instead chose to do otherwise. It hid losses, kept the cost of capital low in order to prevent bankruptcies, and rebalanced the economy effectively by having the government absorb all the noncollectible debt in the economy.

Tokyo, in other words, is implicitly attempting to manage Japan’s debt burden by forcing up exports relative to imports in a world that is barely able to absorb existingproduction as it is. Will it succeed? Probably not, and if it does, it will do so only at the expense of the rest of the world.

Rather than try to return to the old days of wealth transfers from households to the state and corporate sector, which it abandoned after 1990, it must continue building household wealth to power domestic growth, perhaps by privatizing assets to pay down debt.

6. If it is managed well, China’s eventual rebalancing and much slower growth will be positive for China and the world, although the benefits to the world will not be evenly distributed.

If the transition is not mismanaged it will be positive for China because the end of valuedestroying investment and environmental degradation will actually increase Chinese wealth—as opposed to Chinese economic activity—and a much larger share will be passed on to Chinese households.

It will be positive for the world because, contrary to popular perception, China is not currently the engine of world growth. With its huge trade surplus it actually extracts from the world more than its share of what is now the most valuable economic resource in the world—demand. A rebalancing will mean a declining current account surplus and a reduction of its excess claim on world demand.

This will be positive for the world. But not positive for everybody. By shifting from investment to consumption, the demand for nonfood commodities will drop sharply, as will the price of metals and other nonfood commodities.

This will be very painful for countries that rely heavily on nonfood commodity exports, like Brazil, Australia, and Peru, but positive for commodity importers. On the other hand food exporters should continue to see rising Chinese demand for food as households increase their wealth and, with it, their consumption of food.

7. Growth in global demand will remain weak for many years.

The massive banking crisis unfolding in Europe as the euro crisis works itself out, the expected surge in Chinese nonperforming loans, the 2007–9 bailout of the U.S. banking system, and the costs associated with the still unresolved Japanese banking crisis of the 1980s all imply that households in the world’s leading economies will spend the next several years effectively paying for the cleaning up of their national banking systems, in which case it is unreasonable to expect any significant increase in consumer demand over the next few years.

The growth in their disposable income will be insufficient to spur a consumption boom. But it gets worse. Since 2009, the impact on global demand of the sharp drop in global consumption growth was partially mitigated by a surge in investment in China and other developing countries.

But the purpose of investment today is to serve consumption tomorrow, and without a revival of consumption, the current surge in investment must itself be reversed. This suggests that overall growth in private- sector demand over the next few years is likely to be minimal.

8. Trade tensions will rise.

In a world of deficient demand and excess savings, every country will try to acquire a greater share of global demand by exporting savings. ?It will be an attempt by each country to gain a greater share of global demand.The problem may be that the balance of power in trade war rests clearly with one side while the popular perception has it resting on the other side, and this can cause each side to exert more pressure on the other than can be justified.

In a world of weak demand growth, demand is the most valuable economic asset. Deficit countries have excess demand and surplus countries are deficient. This is why in most trade conflicts—think of the United States in the 1930s or Japan in the 1990s—the leading surplus countries have eventually suffered the most.

This is not to argue in favor of trade protection—there is little disagreement among economists that a world of free trade increases wealth at a faster pace than otherwise. It is only to point out that historically, during periods of global crisis and demand contraction, international trade always suffers and protectionist tensions always rise, and for the reasons that are rational among the participants in trade.

Unfortunately the historical precedents are not very comforting, and the experience of the United States in the 1930s indicates just how dangerous the arrogance of virtue can be for surplus countries.

9. The world will rebalance.

One way or the other the world must rebalance, and it will. Major imbalances are unsustainable and always eventually reverse, but there are worse ways and better ways they can do so.

Any policy that does not clearly result in a reversal of the deep debt, trade, and capital imbalances of the past decade is a policy that cannot be sustained. The goal of policymakers must be to work out what rebalancing requires and then to design and implement the least painful way of getting there. International cooperation, of course, will reduce the pain.