Thursday, November 27, 2014

Long Live China’s Slowdown

NEW HAVEN – At 7.7%, China’s annual GDP growth in the first quarter of this year was slower than many expected. While the data were hardly devastating relative to a consensus forecast of 8.2%, many (including me) expected a second consecutive quarterly rebound from the slowdown that appeared to have ended in the third quarter of 2012. China doubters around the world were quick to pounce on the number, expressing fears of a stall, or even a dreaded double dip.

But slower GDP growth is actually good for China, provided that it reflects the long-awaited structural transformation of the world’s most dynamic economy. The broad outlines of this transformation are well known – a shift from export- and investment-led growth to an economic structure that draws greater support from domestic private consumption. Less well known is that a rebalanced China should have a slower growth rate – the first hints of which may now be evident.

A rebalanced China can grow more slowly for one simple reason: By drawing increased support from services-led consumer demand, China’s new model will embrace a more labor-intensive growth recipe. The numbers seem to bear that out. China’s services sector requires about 35% more jobs per unit of GDP than do manufacturing and construction – the primary drivers of the old model.

That number has potentially huge implications, because it means that China could grow at an annual rate in the 7-8% range and still achieve its objectives with respect to employment and poverty reduction. China has struggled to attain these goals with anything less than 10% growth, because the old model was not generating enough jobs per unit of output. As Chinese manufacturing moved up the value chain, firms increasingly replaced workers with machines embodying the latest technologies. As a result, its economic model spawned a labor-saving, capital-intensive growth dynamic.

On one level, that made sense. Capital-labor substitution is at the heart of modern productivity strategies for manufacturing-based economies. But it left China in a deepening hole: increasingly deficient in jobs per unit of output, it needed more units of output to absorb its surplus labor. Ultimately, that became more of a problem than a solution. The old manufacturing model, which fueled an unprecedented 20-fold increase in per capita income relative to the early 1990’s, also sowed the seeds of excessive resource consumption and environmental degradation.

Services-led growth is, in many ways, the antidote to the “unstable, unbalanced, uncoordinated, and ultimately unsustainable” growth model that former Premier Wen Jiabao’s famously criticized in 2007. Yet services offer more than just a labor-intensive growth path. Compared to manufacturing, they have much smaller resource and carbon footprints. A services-led model provides China with an alternative, environmentally friendlier, and ultimately more sustainable economic structure.

It is premature, of course, to conclude that a services-led transformation to slower growth is now at hand. The latest data hint at such a possibility, with the tertiary sector (services) expanding at an 8.3% annual rate in the first quarter of this year – the third consecutive quarter of acceleration and a half-percentage point faster than the 7.8% first-quarter gain recorded by the secondary sector (manufacturing and construction). But it will take more than a few quarters of mildly encouraging data to validate such an important shift in the Chinese economy’s underlying structure.

Not surprisingly, China skeptics are putting a different spin on the latest growth numbers. Fears of a shadow-bank-induced credit bubble now top the worry list, reinforcing longstanding concerns that China may succumb to the dreaded “middle-income trap” – a sustained growth slowdown that has ensnared most high-growth emerging economies at the juncture that China has now reached.

China is hardly immune to such a possibility. But it is unlikely to occur if China can carry out the services-led pro-consumption rebalancing that remains the core strategic initiative of its current (12th) Five-Year Plan. Invariably, the middle-income trap afflicts those emerging economies that cling to early-stage development models for too long. For China, the risk will be highest if it sticks with the timeworn recipe of unbalanced manufacturing- and construction-led growth, which has created such serious sustainability problems.

If China fails to rebalance, weak external demand from a crisis-battered developed world will continue to hobble its export machine, forcing it to up the ante on a credit- and investment-led growth model – in effect, doubling down on resource-intensive and environmentally damaging growth. But I remain hopeful that China’s new leadership team will move quickly to implement its new model. There are no viable alternatives.

Financial markets, as well as growth-starved developed economies, are not thrilled with the natural rhythm of slower growth that a rebalanced Chinese economy is likely to experience. Resource industries – indeed, resource-based economies like Australia, Canada, Brazil, and Russia – have become addicted to China’s old strain of unsustainable hyper-growth. Yet China knows that it is time to break that dangerous habit.

The United States is likely to have a different problem with consumer-led growth in China. After all, higher private consumption implies an end to China’s surplus saving – and thus to the seemingly open-ended recycling of that surplus into dollar-based assets such as US Treasury bills. Who will then fund America’s budget deficit – and on what terms?

Just as China must embrace slower growth as a natural consequence of its rebalancing imperative, the rest of the world will need to figure out how to cope when it does.

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    1. CommentedNirav Desai

      What would your opinion be of a India-China-Russia currency union that would include other Asian economies like Indonesia and Singapore, on the exact same lines as the European Union with the same model? A strong currency would help stable sustainable growth in these economies. Brazil could also be included if it is willing. Geographically it is very far though - though not that far. It is close to Americas than Asia.

    2. CommentedPaul Mathew Mathew

      Roach is WRONG. I have been speaking to the head of a major mining supply company in Canada and he says business is dire.

      The price of nickel and copper has crashed due to crashing demand FROM CHINA.

      This is turn is causing mining companies to shutter operations and cease expansions that were planned.

      He is not believing the China 7%+ growth story.

      Nor am I.

      This is absolute bs.

      If you want good info on China see Jim Chanos - he has skin in the game - Roach is simply an armchair QB sitting in his ivory tower pontificating.

    3. Portrait of Pingfan Hong

      CommentedPingfan Hong

      For those who only focus on the demand side of the economy, and only on the short term growth fluctuation, economic growth can be led by anything: consumption led growth, export led growth, service led growth, manufacture led growth, etc. But for those who studied economic growth in the long run understand well the economic growth can only be led by two things: increase in labour, and growth in labour productivity.

    4. CommentedMichael Lombardi

      Indeed, emerging economies are developing and growing. According to Bloomberg, May2, 2013 “Ethiopia Courts BRICS for Rail Projects to Spur Economic Growth”, there are negotiations going on between three BRICS nations, viz. Brazil, Russia and India
      and the country of Ethiopia for the purpose of finance for building rail links. This follows the agreement reached in 2012 with companies in China and Turkey for other routes. The proposal is stated to involve the probable funding of a 587-kilometer southern line which will be connected to Kenya at its Lamu port (proposed) as per an interview given by Ethiopian Railways Corp. General Manager Getachew Betru. There is potential for the companies in Brazil for constructing a 439-kilometer stretch to Sudan and oil business can flourish there. In addition, India is thinking of export financing for a line to a port in Djibouti. Thus, growth in BRICS countries can be expected.

      On the other hand, referring to the article by KA Badarinath, KR Sudhaman May 02 2013 in Financial Chronicle titled “BRICS bank difficult, says ADB chief,” the Asian Development Bank (ADB) felt that the proposed development bank by the BRICS nation may have to face hurdles. The bank’s president Takehiko Nakao said that there would be co-operation from their end in setting up the new development bank considering the need for funds in these economically emerging nations. The areas of development that need looking into are the airports, roads and ports and the investment for the same will be to the tune of $8 trillion investment in the next 10 years.

    5. CommentedMichael Lombardi

      Although China looks to be enveloped in a holding pattern with its economy proceeding to face its fourth consecutive under-performing year, it does seem that the country’s economy has paused in terms of growth. If we consider the situation in the year 2010, the nation’s gross domestic product grew 10.4%. The condition today is a far cry from the scenario at that time; China having been staring at stalling GDP growth in the last two years; viz. in 2011 and 2012.

      In Market Watch dated April 15, 2013, there was an article by Kumar P titled “JPMorgan cuts China 2013 GDP view to 7.8%.” So if we assume that the probable GDP growth will be 7.8%, while the previously estimated growth was 8.2%, it does look like the lackluster growth will continue in the Chinese economy. The country’s two leaders seem determined to solve the ongoing crisis by employing policies both monetary and fiscal and bring it on the path to recovery. After all, China holds foreign reserves to the tune of above $3.0 trillion and is thus in a better financial situation than many of its industrialized peers in the world.

    6. CommentedElwood Anderson

      "Who will then fund America’s budget deficit – and on what terms?"

      We don't need anyone to fund our deficit. We can print the money until our economy reaches capacity.

    7. CommentedZsolt Hermann

      Unfortunately we are all behaving like children when they break something and try to explain that it was actually not them who broke it but wind did it, or the dog, and actually that vase or plate looks even better in its broken form...
      China is slowing down because the whole world is slowing or already stopped.
      And the whole global economy is screeching to a halt because it is unsustainable, since the present socio-economic model is built on illusions, without any natural foundations.
      We try to grow quantitatively in a closed, finite, natural system.
      We try to live in bubbles and when they burst we try to solve them by building new bubbles.
      We take credit, fall under its burden and then take more credit to pay for it. If we run out of money we print more although there is no commodity, assets behind it. We pretend to unite, join forces on one hand in order to keep ruthless, exploitative competition on the other hand.
      How long can we sustain such a false, artificial system?
      This is not a Hollywood movie where the happy ending is guaranteed otherwise people would not want to watch it.
      We live in a vast natural system that has unbreakable, strict, natural laws. Here we cannot appeal, cannot try to cheat. A law is a law.
      I can ignore the law of gravity and jump off the top of a skyscraper, but then who is to blame for the inevitable accident?
      We cannot chase illusion, dream any longer as we are all in the end of the 11th hour.
      The end of the movie is guaranteed here as well, we have to adapt to the system around us, living on the foundations of natural necessities and available resources.
      But it depends on us if it is a happy ending, a happy movie or a very sad one like in a Shakespeare composition where almost everybody dies at the end...

    8. CommentedProcyon Mukherjee

      It may sound rather odd that what Stephen is prescribing has already been tested in India as the country switched to a services led growth model that took the component to assume 55% of the GDP, while manufacturing has come down to just 18%. Contrary to Stephen's prescription the country is reeling under the pressures of sustaining momentum in this growth model, while poverty reduction or at least the pace with which this was moving has seen strong headwinds.