The Chinese economy is rebalancing, at last

We are seeing a necessary change towards more reliance on consumer demand

Martin Wolf

Consumption is at last becoming the most important driver of demand in the Chinese economy.

This is a long-awaited and desirable adjustment. It promises to shift China away from its excessive reliance on inefficient, debt-fuelled investment. But it still has a long way to go. As the shift is being completed, the country will need to manage an overhang of bad debt. But the adjustment has begun.

In 2007, premier Wen Jiabao argued rightly that “the biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable”. In that year, gross national savings were 50 per cent of gross domestic product, up from 37 per cent in 2000. These huge savings financed domestic investment of 41 per cent of GDP and a current account surplus of 9 per cent.

Then came the global financial crisis. The Chinese authorities promptly realised that the current account surplus had become unsustainable. In the short run, the only way to avoid a slump was to expand investment further. In 2011, gross investment reached 48 per cent of GDP and the current account surplus fell to 2 per cent. But national savings remained at 50 per cent of GDP. (See charts.)

This solution brought new problems. The first was a declining return on investment. The simplest way of showing this is via the incremental capital-output ratio (ICOR), which measures the amount of investment needed to generate a given increase in output. This has roughly doubled since 2007. That is not surprising: the investment rate has jumped, while growth has nearly halved. Moreover, the rise in the ICOR may well understate the true decline in returns: as Michael Pettis of Peking University’s Guanghua School of Management argues, useless investment does not contribute to GDP.

The second problem is that the increased investment was driven by a huge rise in debt.

According to the Institute of International Finance, gross debt rose from 171 to 295 per cent of GDP between the fourth quarter of 2008 and the third quarter of 2017. This is very high for an emerging country. Moreover, half of the increased debt went to non-financial corporate entities, which did much of the increased investment. A substantial portion of this increased debt may prove to be bad. Starting from the dramatic rise in the credit-dependence of growth, London-based Enodo Economics argues that the needed debt write-offs might ultimately amount to 20 per cent of GDP. This might seem big. But it would be manageable for a creditor country with a largely closed financial system.

Up to 2014, then, nothing had happened to make the Chinese economy seem any less unstable, unbalanced, uncoordinated and unsustainable. On the contrary, China had merely replaced an excessive current account surplus, with still more excessive investment, soaring debt and property bubbles.

The past three years have witnessed change at last: investment has fallen by 3 per cent of GDP, while public and private consumption have risen by much the same proportion. As a result, consumption has become a more important source of additional demand than investment.

Thus, in 2017, notes a background paper to this year’s China Development Forum, final consumption contributed 59 per cent of GDP growth. As investment growth has declined at long last, the rise in indebtedness has also (apparently) stopped.

Behind this has been a willingness to substitute quality for quantity of growth. Explanations for this willingness include the shrinkage of the labour force and a slowing of the rate of rural-urban migration. The increasingly service-driven economy of today is also more employment-intensive than the heavy-industry driven economy of the past. With the labour force now shrinking and growth more employment intensive, real wages have soared, raising the share of labour in national income. Enodo Economics argues that in 2015 the share of household disposable income and labour compensation were already higher than in Japan and South Korea.

It is only because the household savings rate is still very high in China that private consumption is so low a share of GDP. As ageing takes hold, that is likely to change, possibly quite quickly. If the government were to provide an adequate safety net and better health and education services, as well, the household savings rate might fall sharply. If so, the investment rate could also shrink to a more appropriate level. After all, it is still substantially higher than it was in 2007, let alone 2000.

In brief, while the shifts are slow and the full adjustment to more reasonable levels could take until the middle of the next decade, we are seeing early signs of the necessary change in the structure of the Chinese economy towards one that is less unbalanced and, above all, one that is more reliant on the consumer demand of China’s vast population. That would, in turn, be good for China and for the rest of the world.

Good policy could also accelerate the shift, by increasing the transfer of profits to the people, via ownership, taxation or, better still, a bit of both. It is more or less inevitable that a clean up of excessive debt will also be needed, together with substantial reform of the financial sector. But that would also become far easier if the huge imbalances — above all, the excessive reliance on investment — were at an end.

The chances of achieving desperately needed rebalancing and even of managing that transformation fairly smoothly are rising. The story told by former premier Wen is far from over. But we can now at least envisage a happy ending.

How the world swapped a big idea for a bad one

It is now fashionable to dismiss the assumptions of the post-cold war order

Philip Stephens

Sad to say, Donald Trump cannot be blamed for everything. Watching the US president lavish praise on autocrats, throw up trade barriers and disdain global rules and institutions, it seems a fair conclusion that he wants to upturn the liberal international order. Much of this work, though, had been done before he reached the White House. Mr Trump is as much emblem as cause of the descent into disorder.

The west misread the collapse of Soviet communism. It was not, after all, the end of history.

Happy assumptions about the permanent hegemony of laissez-faire capitalism and the historical inevitability of liberal democracy were rooted in a hubris that invited nemesis. For all that, the end of the cold war did produce a big idea. Now, as we are daily reminded by Mr Trump’s Twitter feed, it is being swapped for a very bad idea.

Communism’s demise promised, in a favourite phrase of my Chinese friends, a world of win, win. The revolutionary thought was that the selfish interests of rich and rising states could be accommodated if everyone played by the rules. The deep interdependence woven by globalisation would square the circle between competing national interests and multilateral obligations.

In Europe, where borders had long been blurred by the EU, the idea gave impetus to further integration. Europeans embraced what the British diplomat Robert Cooper called a “postmodern” view of state relations. Elsewhere, national sovereignty was more highly prized, but the new order seemed enough to prevent a return to Hobbesian conflict among the great powers.

The rules and institutions were necessarily imperfect, not least because they had been written largely by the rich nations. There was too much triumphalism in the west and insufficient recognition of the redistribution of global power to the south and east. The goal, though, was a good one: China, India, Brazil et al would rise in a fashion that did not collide with established powers. Robert Zoellick, then a senior official at the US state department, coined the phrase “responsible stakeholders” to describe their role in the existing order.

The fashion now is to dismiss such assumptions as naive. China may have been the biggest winner from the west’s design — its entry to the World Trade Organization was the seismic geopolitical event of the early 21st century — but Beijing was never going to accept a second-fiddle place in a US-led system.

Xi Jinping, now installed as emperor-president for life, is held up as proof. Mr Xi judges the time has come for China to expunge two centuries of humiliation. The aim of the Belt and Road Initiative is to shift the centre of global gravity to Eurasia. The Middle Kingdom can then take its rightful place centre stage.

What is less clear is what Mr Zoellick and others could have sensibly proposed as an alternative to positive engagement. Should the west have sought to halt China’s rise — declared it an enemy and locked it out of the WTO and other global institutions? Would such containment have extended to a naval blockade of the South China Sea? These are not approaches likely to have safeguarded the international peace.

In the event, the US has turned out to be a bigger enemy than Beijing of its own grand design. Washington has seemed more determined to throw away the big idea faster than Beijing has been to challenge it. Wars of choice in Afghanistan and Iraq sapped America’s moral authority. The attempt to impose democracy at the point of a cruise missile undercut faith in political pluralism. The 2008 financial crash put paid to the consensus that liberal, open markets were a certain route to prosperity.

Mr Trump is picking up where others left off. If the west was careless in the defence of the rules-based system, the present occupant of the White House flatly repudiates it. Mr Trump lives in a world of winners and losers. He blames the postwar structures built by America and its allies for western weakness. He is allergic to multilateralism. “I do bilateral”, he said the other day. Everything in Trumpworld is zero sum.

So the only surprise about his decision to slap higher tariffs on imports of steel, aluminium and a range of other goods is that anyone should have been surprised. Mr Trump has few deep-rooted beliefs, but economic nationalism has always been at the centre of his worldview. He blames weak leadership in Washington for allowing others to challenge US pre-eminence.

Protectionism is his only remedy. When Mr Trump rails about unfair trade as often as not he is making a general point rather than aiming specifically at, say, China, Canada, or Mexico. His target is the system.

The problem is not simply that trade wars are a very bad idea. History tells protectionism is virulently contagious. Europe has its own populists. These mount-the-barricades nationalists hail from both extreme right and extreme left. Their demands for trade barriers could soon enough secure them a larger following. The snag with zero-sum games is that win or lose can quite quickly turn into lose, lose.

A dwindling band of optimists among my American friends tell me that Mr Trump is as bad as it gets — whoever comes next will rebalance US policy. Maybe. But Mr Trump is setting a direction that other nations feel compelled to follow. Beijing now belongs to nationalists.

Europe has its own nativists. There will not be any winners. Before long all those cynics may realise that Mr Zoellick was right after all.

What If Global Growth Falters Now?

Commodity markets—and global industry— are starting to send concerning signals

By Nathaniel Taplin

A worker walks past a mound of scrap steel at a plant in Dalian, China last month. Commodities markets began selling off at the end of last year, a potentially worrying sign amid escalating trade tensions between Washington and Beijing. Photo: China Stringer Network/Reuters

This week’s headlines have all been about trade wars—real or imagined. But the response from economists has been largely sanguine: global growth itself appears to be holding up well.

But is it really? Commodity markets—and global industry— are starting to send some worrying signals. 
While manufacturing in most big economies is still expanding, the pace of those gains has slowed noticeably in recent months. Meanwhile, key industrial commodities like copper and aluminum also started selling off in late 2017, well before trade worries started spooking markets.

Manufacturing purchasing managers' indexes

Source: Thomson Reuters,
CEIC Note: Over 50 indicates expansion on the month.

The implication: The strong global manufacturing rebound evident since late 2016 may have already—or be close to—peaking, whether or not a true trade war erupts.

Slowing momentum in China has been evident for months. A modest bounce after February’s Chinese New Year notwithstanding, China’s official manufacturing Purchasing Managers’ Index appears to have peaked in the third quarter of last year, while Caixin’s alternative index has also trended sideways since then.

What’s new is that other major indexes are now following suit.

Markit’s Eurozone PMI is down four points since December, although it still remains comfortably above the 50-point mark separating expansion from contraction. Japanese and Korean PMIs have also nudged lower. Even in the U.S., strong headline numbers have masked slowing growth in new orders since the fourth quarter of 2017, along with a rebound in inventories.

Pigs ready for market at an Iowa farm this week. China has proposed tariffs on American pork and other imports in retaliation for those on Chinese steel and aluminum. Photo: Craig Lassig/EPA/Shutterstock 

Given the numbers coming out of industry, it’s not surprising to see commodities struggling too.

Although oil has held up relatively well on the back of rising geopolitical concerns, copper and coal prices have shed over 5% since late December. Aluminum prices are down over 10%, and iron ore is off nearly 9%.

Their weakness is particularly striking given that the dollar has continued to slide over the same period—which usually helps commodities.

Commodity price indexes, 9/2008 = 100.
Source: Thomson Reuters, CEIC

Some of that weakness—particularly for aluminum, an early target of U.S. President Donald Trump’s tariff ire—is likely related to rising trade tensions and rebounding Chinese production following the end of winter output curbs.

But the fact that the sell-off is so broad-based, and started around the time global PMIs began peaking, suggests slowing industrial growth is the main culprit.

That’s not to say another manufacturing recession is near. But for the first time since early 2017, major PMIs are all pointing towards slower, rather than faster, growth ahead.

Investors hoping comforting tales of a synchronized global uptick will protect their portfolios from severe damage even if trade tensions keep rising should think again.

Crisis, Rinse, Repeat

J. Bradford DeLong

Job seekers wait in line for a job fair

BERKELEY – Later this century, when economic historians compare the “Great Recession” that started in 2007 with the Great Depression that started in 1929, they will arrive at two basic conclusions.

First, they will say the immediate response of the US Federal Reserve and the Department of the Treasury to the crisis in 2007 was first-rate, whereas the response immediately after the stock-market crash of 1929 was fifth-rate, at best. The aftermath of the 2007-2008 financial crash was painful, to be sure; but it did not become a repeat of the Great Depression, in terms of falling output and employment.

On the other hand, future historians will also say that the longer-term US response after 2007-2008 was third-rate or worse, whereas the response from President Franklin Roosevelt, Congress, and the Fed in the years following the Depression was second- or even first-rate. The forceful policies of the New Deal-era laid the foundations for the rapid and equitable growth of the long postwar boom.

Now, consider some key economic data points. US per capita national income peaked in 2006, just before the Great Recession, and was still 5% below that point in 2009. Within three years, however, it had returned to its 2007 peak; and, if we are lucky, it will end up being 8% above its 2007 peak this year.

By contrast, four years after US per capita national income peaked in 1929, it was still down 28%, and would not return to its 1929 peak for a full decade. In other words, there can be no comparison to the Great Depression, at least in terms of decreased per capita national income.

But nor can there be any comparison to the Great Recession in terms of weak productivity growth. Within 11 years of the peak of the pre-Depression business cycle in 1929, output per worker was up 11% and still growing rapidly. By contrast, output per worker this year is only 8% higher than its pre-Great Recession peak, and that figure continues to rise slowly.

So, within 11 years of the start of the Depression, Roosevelt and his team had gotten US per capita national income back to its previous peak while pushing output per worker 11% higher. Moreover, they did that having started from a position in 1933 that was incomparably worse than what US policymakers faced in late 2009. When historians look back at the two periods, they will have to conclude that the relative performance after the Great Recession was nothing short of appalling.

In assigning blame for this dismal track record, Democrats point to the fact that Republicans turned off the spigot of fiscal stimulus in 2010, and then refused to turn it back on. Republicans, for their part, have offered a range of incomprehensible and incoherent explanations for the anemic growth recorded since the financial crisis.

Some Republicans, naturally, blame Obama and his signature legislative accomplishments like the 2010 Affordable Care Act (Obamacare) and the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Others blame the unemployed, those who have dropped out of the labor market altogether, or those who want to work but supposedly have nothing of value to contribute – the so-called “zero marginal product workers.”

There is much more truth to the argument offered by the Democrats, even if Obama and his team also deserve a fair share of the blame for pursuing inappropriate fiscal austerity in the early stages of the recovery. At any rate, austerity is not the whole story. And when thinking about what comes next, the most worrisome aspect of the post-2007 response is that those who implemented it, and those who succeeded them, still do not recognize it as a failure.

For example, Fed policymakers, with a few honorable exceptions, still insist that they did the best they could, considering the fiscal headwinds at the time. Likewise, Obama administration policymakers still pat themselves on the back for preventing a second Great Depression, and say they did the best they could, given recalcitrant Republican congressional majorities after the 2010 midterm elections.

At the same time, right-leaning economists still busy themselves arguing that the Obama administration’s fiscal policies and then-Fed Chair Ben Bernanke’s monetary policies were dangerously inflationary. If we are to believe them, we should consider ourselves lucky to have escaped the fate of Greece or Zimbabwe.

But as Christina D. Romer and David H. Romer of the University of California, Berkeley, have shown, countries throughout the post-war period that lacked the monetary or fiscal space to deal with a financial crisis often suffered from output shortfalls of 10% or more even a decade after the fact.

It has now been 11 years since the start of the last crisis, and it is only a matter of time before we experience another one – as has been the rule for modern capitalist economies since at least 1825. When that happens, will we have the monetary- and fiscal-policy space to address it in such a way as to prevent long-term output shortfalls? The current political environment does not inspire much hope.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.