China’s Economic Model Is in Crisis (and Xi Knows It)
"China’s grotesquely overinflated property bubble is at perpetual risk of bursting. A youth-unemployment crisis plagues its major cities. A perennially underpaid labor force is struggling to prop up consumer demand. And the demographic collapse wrought by the one-child policy has just begun.
What happens in China does not stay there. The economic trajectory of the world’s most populous country has profound implications for its trade partners and geopolitical rivals... In his 2020 book Trade Wars Are Class Wars, co-authored with the journalist Matthew Klein, Pettis argued that China’s economic policies increase global inequality and reduce American prosperity...
In order to understand what China’s facing today, you really have to look beyond the past two years. COVID did not change the Chinese economy so much as it exacerbated its underlying problems, which are at least a decade old.
Those problems are most visible in the property sector. But they derive from China’s growth model. That model has two parts. First, through a variety of policies, you increase the share of national income that goes into savings and reduce the share that goes into consumption. In practice, this means restricting the amount of GDP that goes to households and increasing the amount that goes to businesses. Second, you channel those savings through the banking system into investment.
This model is not unique to China. Quite a number of countries have followed it. China has just followed it to a greater extent than any country in history.
Is it a good model or a bad model? Well, it depends on the underlying circumstances. When China started this, it was among the most underinvested economies in the world. After five decades of anti-Japanese war, civil war, and Maoism, it was hugely underinvested. So this model was exactly what it needed. Opportunities for productive investment were abundant.
But the trouble with a very successful development model is that, by definition, it resolves the problems it was created to address. A good development model renders itself obsolete. And yet, if such a model eliminates its animating purpose, it does not eliminate the interest groups who’ve come to benefit from it.
The economist Albert Hirschman wrote about this way back in the 1970s. A successful growth model will disproportionately benefit certain constituencies. And it will also make those constituencies disproportionately powerful. Which makes it politically difficult to shift away from the model after it’s become obsolete. So you end up following an outdated economic strategy. What happens is that you try to keep rapid, investment-driven growth going after you’ve exhausted every easy opportunity for productive investment. So you fund nonproductive investments. And then you see debt start to rise. This happened in China between 2006 and 2008.
And debt continues rising until either you decide to adjust or you’re forced by debt constraints into adjusting. And adjustment is always very, very difficult.
So the reason COVID matters is because, if you look at all of the indicators, the consumption share of GDP got even worse during the COVID period, while debt rose very rapidly. And the share of growth attributable to nonproductive investments in the property sector and infrastructure grew. So, COVID accelerated all of the problems China already had. This year, and for many years to come, what China really has to do is find a way to adjust...
In most countries, almost all income is divided between households and businesses. In China, however, a substantial share of income actually goes to local governments. So technically, the way to solve the Chinese problem is not so much by redistributing from businesses to households but rather redistributing from local governments to the household sector. But, of course, the fact that local governments currently take in a lot of income makes them very powerful. And local elites are dependent on the growth of local government spending...
If you redistribute income from local governments to the household sector, that’ll certainly make households very happy. But it will be very painful for local governments. Right now, you could argue that households retain roughly 60 percent of GDP while governments and businesses each retain roughly 20 percent. So one way of looking at it is that households retain about three times the income share that governments do. In order for China to be — not even a normal country — but a normal low-consuming country, they would need to transfer at least 10 to 15 percentage points of GDP from governments to households...
You cannot have such a massive redistribution in relative income without a massive redistribution in relative political power. And again, it is the very ability of local governments to fund enormous amounts of spending that has basically created a lot of local political, business, and financial elites.
There’s a stereotype that to be a millionaire in China, you have to write computer code. But that’s not true. The vast majority of rich Chinese are rich because they were in the property sector or in the construction sector or in other basic parts of the economy that receive lots of government spending. So adjustment requires a major transformation in all of the business, political, and financial institutions that have developed over the last 30 years...
The first thing is to understand how out of control the property sector became. The direct and indirect share of GDP attributable to the property sector is estimated to be between 25 and 30 percent, which is twice the level in other countries. Real-estate prices are equal to between 300 and 350 percent of GDP, which is two and a half to three times what it is in other countries. When you look at household savings, the real-estate component of household savings is between 60 and 70 percent, which is more than twice what it is in other countries. Real estate is always important in any economy. But in China, it is far more important. And this has happened over 20 to 30 years of rapid property expansion and rapid increases in real-estate prices.
When a boom lasts that long, it changes behavior. Whether you’re a business or a household or a bank, you learn to bet on continued expansion in the property sector. If you don’t learn that, you get put out of business. Households that borrow too much and buy too many apartments, instead of getting punished, end up becoming incredibly successful. Property developers that find every way they can to borrow money — including ways that are technically illegal — and use it to buy land outperform the more prudent property developers.
Banks that lend too much to real estate, and even cut corners to do so, are the really successful banks. And those that don’t do that lose market share. So eventually, after so many years, much of the economy is implicitly betting on continued expansion in the property sector. This is not just a Chinese problem. We saw this in Japan and in the U.S. and Spain before the financial crisis.
So when you try to bring the property sector under control, you are reversing this entire process. And that means everybody — households, banks, businesses, local governments — suffer enormously from any attempt to bring the property sector under control. And the pain is so great at some point they try to back away.
This was not the first time that they went after the property sector, although it has been the most aggressive attempt. They’ve gone after it many times before in the last five to six years. But they always pull back when they see the pain.
And the pain is really brutal this time because they really clamped down on it. And it’s particularly brutal for local governments because they’ve depended heavily on land sales for their revenues to pay for everything. And they’re being so heavily squeezed that they’re cutting their expenses, reducing salaries, doing all the things that they shouldn’t be doing, but they don’t have a choice. So now Beijing is trying to “stabilize” the property bubble without reviving it. They want to slow down the contraction.
But we’ve never really seen that happen in a highly speculative market. It keeps going up until it starts to go down, and once it goes down, it’s very hard to get it to stabilize. Speculative markets go up or they go down; they don’t do stability. So there’s a real big question as to whether or not Beijing will indeed be able to stabilize them...
The private sector, and particularly the service sector, is starved of demand. If you go out and talk to local businesses and you ask them, “What’s your problem?” they’ll tell you the problem is that no one is buying anything and they haven’t been for years. COVID just made it worse. So what you really should be doing is demand-side policies like the U.S. and Europe did in response to COVID. But for ideological and institutional reasons, China just doesn’t seem able to do demand-side policies. So they respond with supply-side ones.
If you listen to the ministries of Commerce or Industry or Transportation, they’re all saying the same thing. The way to get out of this mess — the way to regain growth — is to keep spending more, supporting manufacturers, and building more infrastructure. Which is another way of saying we need to continue subsidizing the supply side of the economy. The problem with subsidies is that they’re just transfers. If you get subsidized, then I must pay for it. And so, effectively, these supply-side policies require implicit transfers from the household sector. For example, a weak currency hurts households, who are importers, in favor of manufacturers, who are exporters. Low interest rates hurt households who are net savers in favor of, again, manufacturers who are net borrowers, et cetera. So these types of policies end up supporting the wrong part of the economy.
The flip side, of course, is that reversing the direction of subsidies would really hurt manufacturers and exporters. So what’s good for China in the medium and long term may be quite painful in the short term. And again, this isn’t a Chinese problem. The Japanese have been saying the same thing for 30 years: “We have to boost consumption, but we must boost consumption without hurting the export sector.” And that’s a problem because boosting domestic demand will hurt the export sector in the beginning. So they never end up doing it...
People are confusing the geopolitics of economic growth with economic growth. ..
What really matters for people is their income...
A falling population is a problem for China as a military power. But if you’re thinking about the Chinese economy, it’s much less of a problem. ..
If you’ve got more retired people relative to the number of workers, then that means you need to transfer more income away from workers in order to keep the retired people alive. But that’s a problem many countries have. The U.S. is sort of lucky, but almost every rich country has that problem. Japan has that problem. Spain and Italy have that problem, and we don’t think of it as a collapse in those countries. So I don’t think we should think of it as a collapse in China. It will make China less of a geopolitical power. But it’s just not a big deal from an economic point of view...
For all the talk of decoupling and tariffs on Chinese goods, the American trade deficit has widened to its greatest level since just before the 2008 crisis. And the Chinese trade surplus has also widened to its greatest amount in history as a share of GDP. So I think a lot of that is based on a real misunderstanding of trade patterns. People think that you have this discretionary ability to buy from wherever you want. But it doesn’t really work that way. Remember that Chinese exports are among the most competitive in the world. Why is that? It’s not because the Chinese are particularly hardworking or China has particular comparative advantages beyond size. The reason is that all of these transfers from the household sector to manufacturers, both implicit and explicit, to subsidize manufacturing and investment makes Chinese labor cheap relative to its productivity.
And that’s true not just of China but of Germany, the Netherlands, South Korea, and Japan. All of these countries that run persistent trade surpluses do so because of the very low household share of GDP; workers get paid less relative to their productivity than among their trading partners. So as long as that’s the case, it doesn’t matter whether you want to have operations in China or not. Whoever does have operations there will be more competitive and its market share will expand. So I’m very skeptical about this decoupling idea. I think it’s going to take a very different understanding of the way trade works in the modern environment before that can happen."
