Will China's Economic Miracle End in Tears?

During my freshman year in college in 1976, I took a class on development of the “Third World” which highlighted Brazil’s “economic miracle” and its rise as a leading economic power. That same year, the renowned MIT economic historian Charles Kindleberger, mulling over what country might assume global leadership from a waning United States, suggested Germany, Japan “or some country of energy and wealth, like Brazil, which has yet to make its presence felt on the world scene.”

By the early 1980s, Japan was considered by many to be the most dynamic economy in the world and on the way to surpassing the U.S.?This “miracle” economy was accompanied by a huge asset bubble, with real estate prices in Tokyo peaking in 1989 at 300 times the level of equivalent space in Manhattan.

China, the latest “economic miracle,” is now expected to become the largest economy in the world by the middle of this decade. The debates of the 1970s on global leadership have resurfaced, as the U.S.?shows signs of fatigue from shouldering the burdens of a benevolent hegemon, and China aims to reshape the world economic order into something new.

However, history shows us that economic “miracles” end in excesses of debt and speculation, and are followed by long periods of stagnation.?The Brazilian and Japanese booms are distant memories, and these economies have struggled to work out the large imbalances built up during the good years.?China’s rise also came with massive debt accumulation and an enormous real estate bubble, and it too faces a difficult transition.

At least, this is the view of the Beijing-based economist Michael Pettis, a Professor at Peking University’s Guanghua School of Management, and a keen observer of China’s developmental challenges. Pettis argues that China’s economic miracle peaked many years ago, and the drivers of growth – labor growth, investment, and exports – are now all severely constrained. Given its level of development and these constraints, Pettis argues, China now should promote consumption to sustain growth, but this path is blocked by vested interests (the beneficiaries of the previous model: provincial governments, exporters, business elites). Pettis sees a clear parallel with what has happened in Brazil and Japan, where reactionary political, business, and financial elites blocked the reforms necessary to secure sustained economic expansion.

The imbalances of China are well known and long dated. Early in 2007,?Wen Jiabao (溫家寶), premier of China at the time, declared that the country’s economic growth trajectory was “unstable, unbalanced, uncoordinated and unsustainable.” Since Wen Jiabao expressed his concern, China’s debt to GDP ratio has doubled, and the real estate sector’s share of GDP grew by 50% to unprecedented heights. We can see the rise in debt levels in the chart below from the Bank for International Settlements. Given that most economist believe that China’s GDP is overstated by at least 20%, actual debt ratios may be considerably higher.

The following chart from?Rogoff and Yang (2020) ?shows the disproportionate share of China’s GDP related to real estate, surpassing greatly the levels reached in other countries affected by real estate bubbles.

The Chinese “economic miracle,” Pettis argues, petered out over a decade ago as productivity growth and returns on investment collapsed. GDP growth has slowed sharply, and the quality of that growth is dubious, as it comes increasingly from unproductive investments related to infrastructure and real estate. We can see this in the three charts below. The first shows the path of GDP growth, both based on official data and on the basis of an alternative methodology which aims to align China’s numbers with those of other countries. The second and third chart?show the composition of that growth for both GDP data sets. Over the past ten years, GDP growth has been cut by more than half, from the low teens to below 5%.?Meanwhile, the quality of the growth has deteriorated dramatically, coming now primarily from investment capital instead of labor growth and productivity. We can see this deterioration more starkly in the alternative data. This data comes from?The Conference Board?and has been developed in a partnership with the?Groningen Growth and Development Centre?(University of Groningen, The Netherlands) (Link) .

China’s over-dependence on capital investment is in line with the experience of other Asian “tiger” economies, as described by Paul Krugman in his 1994 article “The Myth of Asia’s Miracle.” Both the Brazilian “miracle” of the 1960s and 1970s and the Japanese “miracle” of the 1980s followed a similar pattern of investment-led growth hitting a wall when returns on capital declined and debt levels reached high levels.

The Brazilian Miracle

?Brazil experienced very high growth from the 1950s to the end of the 1970s. Much of the growth in the 1950s was driven by multinational firms bringing mass production manufacturing to the country, in a process very similar to what China went through in the 1990s and 2000s. Mature technologies and business models were easily assimilated and had the advantage of being highly labor intensive. In the 1960s, more FDI came to meet Brazil’s growing consumer market, and “Asian-like” public policies were introduced to promote domestic savings and investment. During the 1970s, Brazil, benefited from a commodity boom but debt levels rose sharply (especially external debt), and investment quality and returns plummeted (increasingly pharaonic projects, roads to nowhere, as in China). The boom came to an end in 1980, and since then Brazil has stagnated, achieving growth of GDP 2.1% per year and GDP per capita growth of 0.8% annually. The mass production paradigm that benefitted Brazil so much in the 1960s and 1970s was exhausted by 1980. Since then, Brazil has been unable to grow its consumer market, leading MNCs to focus on better opportunities elsewhere (Asia, Mexico). Brazil became the poster-child for the “middle-income trap” – a middle-income economy unable to build the institutions required to sustain growth.

The first chart shows the path of GDP growth, and the second shows the enormous debt accumulation and fiscal deficits towards the end of the “miracle” in the 1970s. The third chart shows the composition of growth from 1952-2023. Remarkably, total factor productivity declined from 1.6% annually between 1952 and 1979) to negative 0.9% annually from 1980 to 2023. TFP declined sharply in the second half of the 1970s as investment-led growth lost traction.?Since 1980, Brazil has deindustrialized dramatically, and today the economy has returned to the commodity-dependence levels experienced before the industrialization process took off in the early 1950s.

Japan’s “Economic Miracle”

Japan enjoyed very high GDP growth during the 1950s and 1960s. This growth was briefly interrupted by the 1973 oil crisis, but then resumed in the second half of the 1970s and into the 1980s. This later phase of growth was characterized by real estate and stock market speculative bubbles. The asset bubble popped in 1989, and since then annual GDP growth has averaged 0.9%.

The chart below shows the contribution of labor, capital, and total factor productivity to Japan’s GDP growth. We can see broad contributions from all these factors from the 1950s until 1989, with a sharp increase of reliance on capital in the 1980s. As in Brazil in the 1970s and China over the past decade, declining returns on capital during the 1980s asset speculative boom marked the end of the Japanese miracle. From 1951 to 1989 TFP contributed 2.4% to annual GDP growth, but from 1990 until 2023, this contribution has been -0.9% annually.

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Conclusion

Unfortunately, “economic miracles” are more chimerical than miraculous. This is most true in the last phase of the boom when excesses and speculation generate mainly malinvestment.

The post-boom periods tend to be painful and drawnout because the beneficiaries of the past resist the reforms necessary to achieve a rapid transition to a more sustainable growth model. The U.S came out of the Great Recession of the 1930s because radical “anti-elite” measures implemented by President Roosevelt became consensual in the post-war boom. Brazil’s political and financial elites have resisted the reforms needed to improve income distribution and create a broader consumer market. The political process in Japan also has failed to change the investment and export-focused economic model. China appears to be following Japan’s example, as it continues to focus on the exhausted drivers of past growth instead of actively pushing for policies that would build the purchasing power of households in a consumption-driven economy.