By Alfred Wong

The Chinese government’s rebalancing of China’s economy is today seen as a fact and an inevitability. This means that the government is reducing its investment in infrastructure and capital goods, such as railroads and power plants, while encouraging growth in household consumption, such as families buying food or clothes. Economists and businesses around the world agree with the Chinese Communist Party (CCP) that this is the right way forward for China. But amidst the seeming triumph of rebalancing, the case against it is often drowned out.

The conventional case for rebalancing is based on two premises: first, China has been investing too much, as well as investing solely to boost immediate gross domestic product (GDP) growth. This ignores the massive waste that results from over and mal-investment such as the archetypal ‘bridges to nowhere’. Second, China should instead promote domestic consumption, which has for years lagged behind investment as a share of economic growth. This would lead to a more economically and environmentally sustainable growth model because consumers would allocate resources more efficiently, according to their own needs. It would also improve standards of living because people would have more money to spend.

While no one denies that China’s status quo economic model needs reform, that does not automatically mean that rebalancing is a good idea. Rather, I believe that investment should be maintained at current levels, but significantly reallocated towards more productive uses. At the same time, consumption should be allowed to grow at its own rate.

Consumption doesn’t need government aid to thrive

The World Bank recorded China’s consumption as 34% of GDP in 2013, while investment was a much higher 49%, but this does not mean that consumption needs government support. In fact, consumption growth has averaged around 8% a year over the past 20 years, even as policies like state-mandated low interest rates should have slowed it. Data from the Reserve Bank of Australia shows that Chinese domestic consumption growth is on average 3% higher than other emerging economies in Asia, and 6% higher than in the G7 advanced countries. The reason for the furore over ‘falling Chinese consumption’ is simply that investment has been growing faster than consumption.

Furthermore, some economists are questioning the very merits of increasing consumption as a share of Chinese GDP. A consumption-oriented economy would also be much more vulnerable to global business booms and busts, as well as to the caprices of financial markets. Moreover, Qu Hongbin, Chief China Economist at HSBC, and Yukon Huang, former World Bank country director for China, have both stated that there is little academic evidence suggesting a link between higher consumption and higher GDP growth. In fact, China needs more investment, albeit with reforms in usage and financing, to maintain high GDP growth in the future.

Investment continues to be needed

Gross domestic investment in China was 49% of GDP in 2013, which is high even compared to other developing countries. But this measurement of investment does not show whether investment is efficient or necessary. JP Morgan Asset Management in Hong Kong uses another measure of investment for this purpose: incremental capital-output ratio (ICOR). This measures the marginal investment capital needed to increase production by one unit; in other words, how much more investment China needs. Decision Economics, an economics research firm, measured ICOR for different countries from 1970-2010. They concluded that after removing recession years, China’s ICOR in the 2000s is lower than the developed economies and roughly equal to that of Taiwan and Singapore. The 2013 OECD Economic Survey of China found that capital stock per worker is also “well below levels in advanced economies.” Moreover, the OECD also argues that “[n]otwithstanding a very high investment rate, profitability outside agriculture and housing has remained elevated by international standards.” While China’s ICOR has increased sharply since 2008, this does not necessarily indicate over-investment. As The Economist argues, ICOR has risen everywhere since the global financial crisis because it is measured against GDP growth, which fell sharply due to the crisis and the consequent decrease in demand. At the very least, Chinese over-investment is not a foregone conclusion, and I believe that there remain many efficient and profitable areas of investment.

The serious and worsening problems of regional inequality and a rapidly ageing population also means that China needs more government investment, and sooner rather than later. China is a highly unequal country, with a Gini coefficient of 0.55 out of a maximum of 1 in 2012. A large component of total inequality is due to regional inequality between eastern provinces and the other ones, in both GDP per capita and foreign direct investment (FDI). As Zhang Xiaobo and Fan Shenggen of the International Food Policy Research Institute argue in a 2000 paper, government investment in rural education and agricultural R&D is crucial to correcting this disparity. China’s demographics has further shrunk the timeframe in which China can easily invest. The government’s ability to invest is based on China’s high savings rate, which is currently over 50% of GDP. This is due to the large workforce relative to total population. But this will fall rapidly in the future, as the share of dependents to workers in the populace will rise to 64.7% by 2050. The result is that investing will cost more in the future, which is why China should do it now.

What reforms are needed

The fact remains, however, that there has been rampant waste of investment in the past. But reducing total investment amounts because of some unprofitable investments would be a mistake. So what should China invest in? Jamil Anderlini, the Financial Times’ Beijing bureau chief, suggests better public transportation, cleaner cheap energy, industrial upgrading and anti-pollution technology. In fact, the conversion to smarter investment has already begun: the CCP’s 2011-15 12th Five-Year Plan proposes seven priority industries in the ‘sustainable growth’ and ‘higher-value-added’ sectors, whose GDP contributions should be increased from 2% to 15% by 2020. The Chinese government should therefore continue its current level of investment, but also redirect where it’s spent.

Finally, the Chinese government also needs to reform how it finances investments. Currently, provincial government investment in long-term, capital-intensive projects is funded through short-term lending and often via shadow banking networks. This creates a ‘duration gap’ between short-term debt and long-term returns on investment. This financing model threatens local governments’ ability to honour their debts, which according to China’s National Audit Office has risen by 70% between 2010-2013. Moreover, local governments are repaying their loans with the sale of land lease rights, which is heavily reliant on high land prices, and also necessitates highly unpopular appropriations of rural properties. Chinese investment financing should therefore be reformed, such as through local government infrastructure bonds, as Mr Qu at HSBC recommends.

It is important to note that there is a non-economic argument for rebalancing the Chinese economy. Low interest rates combined with the high savings rate have prevented the population’s wealth and standard of living from being as high as possible. Rebalancing would improve people’s satisfaction with the Chinese government’s economic management, even during slowing growth. This is particularly important to the CCP, as its primary source of legitimacy today is its record of economic success since the late 1970s. While this is a legitimate political justification of rebalancing, the fact remains that reducing investment is likely to reduce long-run growth and consumption. If the CCP accepts the arguments put forward in this article, then the public interest requires it to refrain from reducing investment or making policy decisions that would restrain investment.

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