China’s Bad Growth Bet

Nouriel Roubini

China’s Bad Growth Bet

LONDON– I recently took two trips to China just as the government launchedits 12th Five-Year Plan to rebalance the country’s long-term growthmodel. My visits deepened my view that there is a potentiallydestabilizing contradiction between China’s short- and medium-termeconomic performance.

China’s economy is overheating now, but, over time, its currentoverinvestment will prove deflationary both domestically and globally.Once increasing fixed investment becomes impossible – most likely after2013 – China is poised for a sharp slowdown. Instead of focusing onsecuring a soft landing today, Chinese policymakers should be worryingabout the brick wall that economic growth may hit in the second half ofthe quinquennium.

Despite the rhetoric of the new Five-Year Plan – which, like theprevious one, aims to increase the share of consumption in GDP – thepath of least resistance is the status quo. The new plan’sdetails reveal continued reliance on investment, including publichousing, to support growth, rather than faster currency appreciation,substantial fiscal transfers to households, taxation and/orprivatization of state-owned enterprises (SOEs), liberalization of thehousehold registration (hukou) system, or an easing of financial repression.

China has grown for the last few decades on the back of export-ledindustrialization and a weak currency, which have resulted in highcorporate and household savings rates and reliance on net exports andfixed investment (infrastructure, real estate, and industrial capacityfor import-competing and export sectors). When net exports collapsed in2008-2009 from 11% of GDP to 5%, China’s leader reacted by furtherincreasing the fixed-investment share of GDP from 42% to 47%.

Thus, China did not suffer a severe recession – as occurred in Japan,Germany, and elsewhere in emerging Asia in 2009 – only because fixedinvestment exploded. And the fixed-investment share of GDP has increasedfurther in 2010-2011, to almost 50%.

The problem, of course, is that no country can be productive enoughto reinvest 50% of GDP in new capital stock without eventually facingimmense overcapacity and a staggering non-performing loan problem. Chinais rife with overinvestment in physical capital, infrastructure, andproperty. To a visitor, this is evident in sleek but empty airports andbullet trains (which will reduce the need for the 45 planned airports),highways to nowhere, thousands of colossal new central and provincialgovernment buildings, ghost towns, and brand-new aluminum smelters keptclosed to prevent global prices from plunging.

Commercial and high-end residential investment has been excessive,automobile capacity has outstripped even the recent surge in sales, andovercapacity in steel, cement, and other manufacturing sectors isincreasing further. In the short run, the investment boom will fuelinflation, owing to the highly resource-intensive character of growth.But overcapacity will lead inevitably to serious deflationary pressures,starting with the manufacturing and real-estate sectors.

Eventually, most likely after 2013, China will suffer a hard landing.All historical episodes of excessive investment – including East Asiain the 1990’s – have ended with a financial crisis and/or a long periodof slow growth. To avoid this fate, China needs to save less, reducefixed investment, cut net exports as a share of GDP, and boost the shareof consumption.

The trouble is that the reasons the Chinese save so much and consumeso little are structural. It will take two decades of reforms to changethe incentive to overinvest.

Traditional explanations for the high savings rate (lack of a socialsafety net, limited public services, aging of the population,underdevelopment of consumer finance, etc.) are only part of the puzzle.Chinese consumers do not have a greater propensity to save than Chinesein Hong Kong, Singapore, and Taiwan; they all save about 30% ofdisposable income. The big difference is that the share of China’s GDPgoing to the household sector is below 50%, leaving little forconsumption.

Several Chinese policies have led to a massive transfer of incomefrom politically weak households to politically powerful companies. Aweak currency reduces household purchasing power by making importsexpensive, thereby protecting import-competing SOEs and boostingexporters’ profits.

Low interest rates on deposits and low lending rates for firms anddevelopers mean that the household sector’s massive savings receivenegative rates of return, while the real cost of borrowing for SOEs isalso negative. This creates a powerful incentive to overinvest andimplies enormous redistribution from households to SOEs, most of whichwould be losing money if they had to borrow at market-equilibriuminterest rates. Moreover, labor repression has caused wages to grow muchmore slowly than productivity.

To ease the constraints on household income, China needs more rapidexchange-rate appreciation, liberalization of interest rates, and a muchsharper increase in wage growth. More importantly, China needs eitherto privatize its SOEs, so that their profits become income forhouseholds, or to tax their profits at a far higher rate and transferthe fiscal gains to households. Instead, on top of household savings,the savings – or retained earnings – of the corporate sector, mostlySOEs, tie up another 25% of GDP.

But boosting the share of income that goes to the household sectorcould be hugely disruptive, as it could bankrupt a large number of SOEs,export-oriented firms, and provincial governments, all of which arepolitically powerful. As a result, China will invest even more under the current Five-Year Plan.

Continuing down the investment-led growth path will exacerbate thevisible glut of capacity in manufacturing, real estate, andinfrastructure, and thus will intensify the coming economic slowdownonce further fixed-investment growth becomes impossible. Until thechange of political leadership in 2012-2013, China’s policymakers may beable to maintain high growth rates, but at a very high foreseeablecost.

Nouriel Roubini is Chairman of Roubini Global Economics (www.roubini.com), professor of Economics at the Stern School of Business at NYU and co-author of Crisis Economics, whose paperback edition is forthcoming this month.