Pedalling prosperity
S P E C I A L R E P O R T
C H I N A ’ S E C O N O M YMay 26th 2012
CHINA.indd 1 15/05/2012 16:11
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IN 1886 THOMAS STEVENS, a British adventurer (pictured above), set o�on an unusual bicycle trip. He pedalled from the �ower boats of Guangzhou in China’s south to the pagodas of Jiujiang about 1,000km (620miles) to the north. He was disarmed by the scenery (the countryside outside Guangzhou was a �marvellous �eldgarden�) and disgusted by thesqualor (the inhabitants of one town were �scrofulous, soreeyed, andmangy�). His passage aroused equally strong reactions from the locals:fascination, fear and occasional fury. In one spot a �soulharrowing�mob pelted him with stones, bruising his body and breaking a couple ofhis bicycle’s spokes.
A century later the bike was no longer alien to China; it had becomesymbolic of it. The �bicycle kingdom� had more twowheelers than anyother country on Earth. Many of those bikes have since been replaced bycars�one obvious sign of China’s rapid development. But even today thebicycle looms large in the battle for China’s soul.
For China’s fastdiminishing population of poor people, bikes remain an important beast of burden, piled high with recycled junk. ForChina’s fastexpanding population of city slickers, the bicycle representseverything they want to leave behind. �I’d rather cry in the back of yourBMW than laugh on the back of your bicycle,� as China’s material girlssay. Some dreamers in government see a return to the bike as an answerto China’s growing problems of prosperity�pollution, tra�c and �ab.The country’s National Development and Reform Commission wantsgovernment o�cials to cycle to work one day a week, though only if thedistance is less than 3km.
Even if it is a fading symbol of Chinese society, the bicycle remains atempting metaphor for its economy. Bikes�especially when heavily lad
Pedalling prosperity
China’s economy is not as precarious as it looks, says Simon Cox.But it still needs to change
A C K N O W L E D G M E N T S
CONTENT S
In addition to those quoted in the
text, the author would like to thank
the following for their help in
preparing this special report: Vivek
Arora, Kent Calder, Stephen Green,
Han Gaofeng, Louis Kuijs, Edwin Lim,
Koji Nomura, Jack Rodman, Andrew
Sheng, Michael Spence, Murtaza
Syed, Mark Williams, Xiao Geng and
Wenlang Zhang
A list of sources is at
Economist.com/specialreports
An audio interview with
the author is at
Economist.com/audiovideo/specialreports
3 ExportsThe retreat of the monstersurplus
5 InvestmentPrudence without a purpose
6 Local governmentThe ballad of Mr Guo
8 FinanceBending not breaking
8 Crossborder �owsHomeric wisdom
10 Shadow bankingShades of grey
11 ConsumersDipping into the kitty
13 The next chapterBeyond growth
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Years since take-off
30
40
50
60
70
80
90
0 5 10 15 20 25 30 35 40
Private consumption
1The alchemy of China’s growth
Source: CEIC
Contributions to growth, percentage points:
3
0
3
6
9
12
15
18
+
–
1980 85 90 95 2000 05 11
Consumption Investment Net exports
China’s GDP growth% increase on year ago
Years since take-off
0
10
20
30
40
50
0 5 10 15 20 25 30 35 40
Investment
% of GDP: China South Korea Japan
Sanya (Phoenix Island)
Ordos(Kangbashi)
WenzhouYingtan
Shanghai
Dongsheng
Yingxiu
Jiujiang
GuangzhouShenzhen
Gushi
Beijing
Macau Hong Kong
X I N J I A N G
T I B E T
HEILONGJIANG
J I L I N
LIAONING
SHANDONG
JIANGSU
SHANGHAI
GUANGDONG
Q I N G H A I
HAINAN
GANSU
GUANGXI
NINGXIA
CHONGQING
GUIZHOU
SHAANXI
SHANXIHEBEI
BEIJING
TIANJIN
HENAN
H U B E I
SICHUAN
YUNNAN
ZHEJIANG
FUJIAN
I N N E R MO
N
GO
LI
A
G o b i De
se
rt
JIAN
GXI
AN
HU
I
HUNAN
Pearl RiverDelta
mand to China’s growth has always been exaggerated, and it isnow shrinking.
It is investment, not exports, that leads China’s economy.Spending on plant, machinery, buildings and infrastructure accounted for about 48% of China’s GDP in 2011. Household consumption, supposedly the sole end and purpose of economic activity, accounts for only about a third of GDP (see chart 1). It is likethe small farthing wheel bringing up the rear.
A disproportionate share of China’s investment is made bystateowned enterprises and, in recent years, by infrastructureventures under the control of provincial or municipal authorities but not on their balance sheets. This investment has oftenbeen clumsy. In the 1880s, according to Stevens, China showed a�scrupulous respect for individual rights and the economy of thesoil�. The road he pedalled took many wearisome twists andturns to avoid impinging on any private property or fertile plot.These days China’s roads run straight. Between 2006 and 2010local authorities opened up 22,000sq km of rural land, an area the sizeof New Jersey, to new development.
China’s cities have grown faster in area than in popula
en�are stable only as long as they keep moving. The same issometimes said about China’s economy. If it loses momentum, itwill crash. And since growth is the only source of legitimacy forthe ruling party, the economy would not be the only thing towobble. From 1990 to 2008 China’s workforce swelled by about145m people, many of them making the long journey from its rural backwaters to its coastal workshops. Over the same periodthe productivity of the workforce increased by over 9% a year, according to the Asian Productivity Organisation (APO). Outputthat used to take 100 people in 1990 required fewer than 20 in2008. All this meant that growth of 810% a year was not a luxurybut a necessity.
But the pressure is easing. Last year the ranks of workingage Chinese fell as a percentage of the population. Soon theirnumber will begin to shrink. The minority who remain in China’s villages are older and less mobile. Because of this loss of demographic momentum, China no longer needs to grow quite soquickly to keep up. Even the government no longer sees 8% annual growth as an imperative. In March it set a target of 7.5% forthis year, consistent with an average of 7% over the course of the�veyear plan that ends in 2015. China has been in thehabit of surpassing these �targets�, which represent a�oor not a ceiling to its aspirations. Nonethelessthe lower �gure was a sign that the central leadership now sees heedless doubledigit growthas a threat to stability, not a guarantee of it.
The pennyfarthing theory
Stevens’s 1886 journey across southeast China was remarkable not only for theroute he took but also for the bike he rode: a�highwheeler� or �pennyfarthing�, withan oversized wheel at the front and a diminutive one at the rear. The contraption is notwidely known in China. That is a pity, because it provides the most apt metaphor forChina’s highwheeling economy.
The large circumference of the pennyfarthing’sfront wheel carried it farther and faster than anything that preceded it, much as China’s economy has grown faster for longerthan its predecessors. Asked to name the big wheel that keepsChina’s economy moving, many foreign commentators wouldsay exports. Outside China, people see only the Chinese goodsthat appear on their shelves and the factory jobs that disappearfrom their shores; they do not see the cities China builds or theshopping aisles it �lls at home. But the contribution of foreign de
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tion. This rapid urbanisation is a big part of the country’s economic success. But it has come at a heavy price in depleted natural resources, a damaged environment and scrupulouslydisrespected property rights.
The imbalance between investment and consumptionmakes China’s economy look precarious. A cartoon from the1880s unearthed by Amir Moghaddass Esfehani, a Sinologist,shows a Chinese rider losing control of a pennyfarthing andfalling �at on his face. A vocal minority of commentators believethat China’s economy is heading for a crash. In April industrialoutput grew at its slowest pace since 2009. Homebuilding wasonly 4% up on a year earlier. Things are looking wobbly.
But China’s economy will not crash. Like the highwheeledpennyfarthing, which rolled serenely over bumps in the road, itis good at absorbing the jolts in the path of any developing country. The state’s in�uence over the allocation of capital is thesource of much waste, but it helps keep investment up whenprivate con�dence is down. And although China’s repressedbanking system is ine�cient, it is also resilient because most ofits vast pool of depositors have nowhere else to go.
Not so fast
The pennyfarthing eventually became obsolete, superseded by the more familiar kind of bicycle. The leap was madepossible by the invention of the chaindrive, which generatedmore oomph for every pedal push. China’s highwheelinggrowth model will also become obsolete in due course. As thecountry’s workforce shrinks and capital accumulates, its savingrate will fall and new investment opportunities will becomemore elusive. China will have to get more oomph out of its inputs, raising the productivity of capital in particular. That will require a more sophisticated �nancial system, based on a morecomplex set of links between savers and investors.
Other innovations will also be needed. China’s stateowned enterprises emerged stronger�too strong�from thedownsizing of the 1990s, but the country’s social safety net neverrecovered. Thus even as the state invests less in industrial capacity, it will need to spend more on social security, including healthcare, pensions, housing and poverty relief. That will help boostconsumer spending by o�ering rainyday protection.
The chaindrive was not the only invention required tomove beyond the pennyfarthing. The new smaller wheels alsoneeded pneumatic tyres to give cyclists a smoother ride. In theabsence of strong investment to keep employment up and socialunrest down, China’s state will also need a new way to protect itscitizens from bumps in the road ahead. 7
Keep those wheels turning
THREE DINOSAURS LURK in a former factory district ofBeijing. Bright red, with �Made in China� embossed on
their bellies, they look like the cheap plastic toys China exportsto the rest of the world. But these model dinosaurs are lifesized,towering over passersby. And they look hungry.
The three beasts are one of the imposing installations at the798 Art District in Beijing. Sculpted by Sui Jianguo, a former factory worker, they are imprisoned in three cages, stacked on topof each other, like the 20foot containers that carry the country’smanufactures to the world. In resin, bronze and steel, the sculpture embodies the widespread fear that China’s exporters willgobble up foreign markets and manufacturers. When it wasmade in 1999, the country’s exports were less than a third ofAmerica’s. Ten years later China was the world’s largest exporter. Of the toys shipped to America and the European Union,8590% were made in China.
The country’s roaring exports contributed to a growing currentaccount surplus, which exceeded 10% of its GDP in 2007 (seechart 3, next page). China’s surpluses�its failure to import asmuch as it exported, spend as much as it earned, or invest asmuch as it saved�became an economic cause célèbre, generatingan equally impressive surplus of commentary and explanation.
Ben Bernanke, now chairman of America’s Federal Reserve, argued that China’s surplus was adding to a �global savings glut�. It was the subject of much debate and diplomacy atG20 summits, and the object of much blame and many bills inAmerica’s Congress. The latest of those, which passed the Senate in October, calls for retaliation against any country that engineers an oversized surplus with an undervalued currency. MittRomney, the presumptive Republican nominee for president,has threatened to brand China as a currency manipulator on his�rst day in the White House.
China’s trade surplus with America remains large and controversial, but its currentaccount surplus with the rest of theworld is dying out. Last year it narrowed to $201billion, less than
Exports
The retreat of themonster surplus
China’s currentaccount surplus is on the verge of
extinction
Safely caged
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2 2.8% of the country’s GDP, the smallest percentage since 2002. Inmoney terms it was smaller than Germany’s.
Is that small enough? The Senate bill relies on IMF methodsto calculate a currentaccount �norm� for a country like China.Such calculations are more art than science: one exercise by theEuropean Central Bank estimated China’s norm 16,384 di�erentways. But an uno�cial study using the IMF’s methods calculateda benchmark of about 2.9% of GDP over the medium term,which suggests China’s surplus is about where it should be.Whether it remains there depends partly on why it narrowed inthe �rst place. In its latest World Economic Outlook, the IMF iden
ti�es four reasons: China’s exchange rate, its terms of trade, global spending and China’s own investment expenditure.
China’s exchange rate has risen, if not as far or as fast asmany Americans had hoped. This appreciation can be measuredin various ways. The measure most economists watch is the reale�ective exchange rate (REER) adjusted for consumerprice in�ation and weighted by trade. This has gone up by 27% since July2005. An alternative gauge is the internal real exchange rate(IRER), which measures the price of Chinese goods that cannotbe traded across borders relative to the price of things that can.According to a study by the Hong Kong Institute for Monetary Research, China’s internal real exchange rate rose by over 35% between July 2005 and December 2011 (see chart 2). This appreciation encourages the Chinese to make more nontradable goodsand to buy more tradable ones. Both help narrow its surplus.
The size of China’s surplus also depends on some volatileprices, such as the cost of crude oil and other commodities thatChina imports. The price of China’s imports has risen relative tothe price of its exports in recent years. According to the IMF, thisdeterioration in China’s terms of trade could explain up to halfthe drop in its surplus between 2007 and 2011. Those terms areunlikely to improve. As long as China remains the dominantforce in the market for its main imports and exports, it will continue to in�uence the price of both.
This pincer movement shows up in surprising ways. OneBritish scholar argues that cheap Chinese exports have deterredburglaries in his country because a £19.99 DVD player is hardlyworth stealing. But others say that China’s imports of copperhave contributed to a rise in metal theft because China’s appetitefor such commodities has made them a more tempting target.
Domestic demand in China’s big trading partners has beenslow to recover from the crisis. China’s own spending, on theother hand, has surpassed all expectations. Investment as ashare of GDP rose by over six points between 2007 and 2010 asbanks lent liberally to help stimulate the economy. The IMF reckons that this rise in investment in itself accounted for between aquarter and a third of the narrowing of China’s surplus. But itmay also have been a contributory cause of some of the otherfactors, such as the rise in commodity prices and the increase inChinese wages and prices.
Will it return?
The surplus could widen again, for one of two reasons.First, China’s high investment could set the stage for a renewedexport boom. Second, China’s investment rate could falter without consumption rising to make up for it, forcing China to rely onforeign demand to keep the economy moving.
To imagine the �rst scenario, you only have to examine therecent past. Pieter Bottelier of the Conference Board, a thinktank, argues that China’s big surpluses before 2008 owed something to an investment boom around the time China joined theWorld Trade Organisation in 2001. This investment created excess capacity in industries such as cars, construction materialsand especially steel. At �rst these new factories displaced imports; then, when the domestic market proved too small, they�ogged their surplus wares on foreign markets instead. Chinawent from being a net importer of steel in 2004 to being theworld’s largest net exporter, note Brett Berger and Robert Martin
of the Federal Reserve. But a repeat is unlikely. It would re
quire China’s low consumption rate tomove still lower to make room for somuch investing and exporting. It wouldalso require China to make further rapidgains in global market share.
The postcrisis investment boom was also di�erent fromthe postWTO one. It was weighted towards inland provinces,far from the seaports that ship China’s goods to the rest of theworld. Inland China’s share of �xedasset investment matchedthat of the coastal provinces for the �rst time in 2009, then exceeded it in 2010. The investment boom in 200910 was also concentrated in infrastructure and property. Neither can be tradedacross borders.
But some economists believe that the latest investmentboom will prove unsustainable. If construction collapses, someof the industries that fed China’s building rush will turn their attentions overseas, as they did in 2006.
The future of China’s export monster thus depends onwhether China’s high investment rate is sustainable. Manythink it is not. Economists likePaul Krugman, a professor atPrinceton University and acommentator for the New York
Times, have gone from bashingChina for its underpriced currency to fretting about its overpriced property. Its spectacularbuilding boom has divertedChina’s energies inwards, sucking in imports and displacingexports. It has thus eased theworld’s fear of China. But it hasraised fears for China. 7
2Less cheap
Sources: Hong Kong Institute for Monetary Research Working Paper; BIS
China’s exchange rate, March 2005=100
2005 06 07 08 09 10 11 12
90
100
110
120
130
140
Internal real exchange rate
Real effective exchange rate
02 04 06 08 10
3Back where it belongs
Source: CEIC
China’s current-account surplusAs % of GDP
0
2
4
6
8
10
2001 03 05 07 09 11
The future of China’s export monster depends onwhether China’s high investment rate is sustainable.Many think it is not
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GENGHIS KHAN SQUARE in Kangbashi, a new city in thenorthern province of Inner Mongolia, is as big as Tianan
men Square in Beijing. But unlike Tiananmen Square, it has onlyone woman to sweep it. It takes her six hours, she says, thoughlonger after the sandstorms that sweep in from the Gobi desert.Kangbashi, or �new Ordos�, as it is known, is easy to clean because it is all but empty. China’s most famous �ghost city�, it hasattracted a lot of journalists eager to illustrate China’s overinvestment, but not many residents.
Ordos was one of the prime exhibits in an infamous presentation by Jim Chanos, a wellknown shortseller, at the London School of Economics in January 2010. Mr Chanos arguedthat China’s growth was predicated on an unsustainable mobilisation of capital�investment that provides only for further investment. China, he quipped, was �Dubai times 1,000�.
His tongueincheek reference to the blingswept, debtdrenched emirate caused a stir. But not everywhere in Chinashrinks from the comparison. One property development thatactively courts it is Phoenix Island, o� the coast of tropical Sanya,China’s southernmost city. It is a largely manmade islet, muchlike Dubai’s Palm Jumeirah. Its centrepiece will be a curvaceoussevenstar hotel, rather like Dubai’s Burj Al Arab, only shapedlike a wishbone not a sail. The �ve podlike buildings already upresemble the unopened buds of some strange �ower. Coated inlightemitting diodes, they erupt into a lightshow at night, featuring adverts for Chanel and Louis Vuitton.
After a visit to Ordos or Sanya, it istempting to agree with Mr Chanos thatChina has overinvested from its northernsteppe to its southern shores. But what exactly does it mean for a country to �overinvest�? One clear sign would be investment that was running well ahead ofsaving, requiring heavy foreign borrowing and buying. The result could be a currency crisis, like the Asian �nancial crisisof 199798. Some veterans of that episodeworry about China’s reckless investmentin tasteless property. But although Chinainvests more of its GDP than those crisisstruck economies ever did, it also saves farmore. It is a net exporter of capital, as itscontroversial currentaccount surplus attests. Indeed, for every critic bashing China for reckless investment spending thereis another accusing it of depressing worlddemand through excessive thrift. China isin the odd position of being cast as bothmiser and wanton.
Even an extravagance like Kangbashiis best understood as an attempt to soakup saving. The Ordos prefecture, to whichit belongs, is home to a sixth of China’scoal reserves and a third of its natural gas
(not to mention its rare earths and soft goat’s wool). According toTing Lu of Bank of America Merrill Lynch, Kangbashi is an attempt to prevent Ordos’s commodity earnings from disappearing to other parts of the country.
China as a whole saved an extraordinary 51% of its GDP lastyear. Until China’s investment rate exceeds that share, there is nocause for concern, says Qu Hongbin of HSBC. Anything Chinafails to invest at home must be invested overseas. �The mostwasteful investment China now has is US Treasuries,� he adds.
When talking about thrift, economists sometimes draw ona parable of prudence written three centuries ago by Daniel Defoe. In that novel the resourceful Robinson Crusoe, shipwreckedon a remote island, saves and replants four quarts of barley. Thereward for his thrift is a harvest of 80 quarts, a return of 1,900%.
Castaway capital
Investment is made out of saving, which requires consumption to be deferred. The returns to investment must be setagainst the disadvantage of having to wait. In Robinson Crusoe,the saving and the investing are both done by the same Englishman, alone on his island. In a more complicated economy,households must save so that entrepreneurs can invest. In mosteconomies their saving is voluntary, but China has found waysof imposing the patience its high investment rate requires.
Michael Pettis of Guanghua School of Management at Peking University argues that the Chinese government suppressesconsumption in favour of producers, many of them stateowned. It keeps the currency undervalued, which makes imports expensive and exports cheap, thereby discouraging theconsumption of foreign goods and encouraging production forforeign customers. It caps interest rates on bank deposits, depriving households of interest income and transferring it to corporate borrowers. And because some of China’s markets remainlargely sheltered from competition, a few incumbent �rms canextract high prices and reinvest the pro�ts. The government has,in e�ect, con�scated quarts of barley from the people who mightwant to eat them, making them available as seedcorn instead.
Investment
Prudence without apurpose
Misinvestment is a bigger problem than
overinvestment
China’s answer to Dubai
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What has China got in return? Investment, unlike consumption, is cumulative;it leaves behind a stock of machinery,buildings and infrastructure. If China’scapital stock were already too big for itsneeds, further thrift would indeed bepointless. In fact, though, the country’soverall capital stock is still small relative toits population and mediumsized relativeto its economy. In 2010, its capital stock perperson was only 7% of America’s (converted at market exchange rates), according to Andrew Batson and Janet Zhang of GK Dragonomics, aconsultancy in Beijing. Even measured at purchasingpower parity, China has only about a �fth of America’s capital stock perperson, depending on how its PPP rate is calculated.
China needs to �produce lots more of almost everything�,argues Scott Sumner of Bentley University, even if it does notproduce �everything in the right order�. Its furious homebuilding, for example, has unnerved the government and cast a shadow over its banks, which worry about defaults on property
loans. But it still needs more places for people to live. In 2010 ithad 140m150m urban homes, according to Rosealea Yao of GK
Dragonomics, 85m short of the number of urban households.About threequarters of China’s migrant workers are squeezedinto rented housing or dormitories provided by their employer.
Nor is China’s capital stock conspicuously large relative tothe size of its economy. It amounted to about 2.5 times China’sGDP in 2008, according to the APO. That was the same as America’s �gure and much lower than Japan’s. Thanks to China’s stim
ulusdriven investment spree, the ratio increased to 2.9 in 2010, but that still does notlook wildly out of line.
Malinvestors of great wealth
In Defoe’s tale, Robinson Crusoespends �ve months making a canoe forhimself, felling a cedartree, paring awayits branches and chiselling out its innards.Only after this �inexpressible labour�does he �nd that the canoe is too heavy tobe pushed the 100 yards to the shore. Thatis not an example of overinvestment(Crusoe did need a canoe), but �malinvestment�. Crusoe devoted his energy tothe wrong enterprise in the wrong place.
It is surprisingly hard to show thatChina has overinvested, but easier toshow that it has invested unwisely. OfChina’s misguided canoebuilders, twoare worth singling out: its local governments (see box) and its stateowned enterprises (SOEs).
China’s SOEs endured a dramaticdownsizing and restructuring in the1990s. Thousands of them were allowedto go bankrupt, yet those that survivedthis cull remain a prominent feature ofChinese capitalism. Even in the retail,wholesale and restaurant businessesthere are over 20,000 of them, accordingto Zhang Wenkui of China’s Development Research Centre.
SOEs are responsible for about 35%of the �xedasset investments made byChinese �rms. They can invest so muchbecause they have become immenselypro�table. The 120 or so big enterprisesowned by the central government lastyear earned net pro�ts of 917 billion yuan($142 billion), according to their supervisor, the Stateowned Assets Supervisionand Administration Commission (SA
SAC). It cites their pro�tability as evidence
SINGING KARAOKE WITH Taiwanese investors, smearing birthday cake on thecheeks of an American factory owner,knocking back baijiu, a Chinese spirit, withproperty developers: Guo Yongchangwould do anything to attract investment toGushi, a county of 1.6m people in Henanprovince, where he served as party secretary. His antics are recorded in �The Transition Period�, a remarkable �yonthewalldocumentary about his last months ino�ce, �lmed by Zhou Hao.
Mr Guo persuades one developer toraise the price of his �ats because Gushipeople are interested only in the priciestproperties. After a boozy dinner he drapeshimself over the developer’s shoulder andextracts a promise from him to add morestoreys to his tower to outdo the one in theneighbouring city.
The oneupmanship exempli�ed byMr Guo has generated great economicdynamism, but also great ine�ciency.When the central government tries to stopeconomic overheating, local governmentsresist. Conversely, when the governmenturged the banks to support its 2008 stimulus e�ort, local governments scrambled toclaim an outsized share of the lending. Theresult is a localgovernment debt burdenworth over a �fth of China’s 2011GDP.
The worst abuses, however, involveland. Local o�cials can convert collectively owned rural plots into land for privatedevelopment. Since farmers cannot selltheir land directly to developers, they have
to accept what the government is willing topay. Often that is not very much.
Such perverse incentives have causedChina’s towns and cities to grow faster inarea than they have grown in population.Their outward ripple has engulfed somerural communities without quite erasingthem. The perimeter of Wenzhou city inZhejiang province, to take one example,now encompasses clutches of farmhouses,complete with vegetable plots, quackingducks and freerange children. This resultsin some incongruous sights. Parked outsideone farmhouse are an Audi, a Mercedes anda Porsche. Alas, they do not belong to thelocals but to city slickers who want their hubcaps repainted.
Oddly, where electoral reforms havegiven Chinese villagers a bigger say in localgovernment, growth tends to slow, according to Monica MartinezBravo of JohnsHopkins University and her colleagues. Thisis partly because elected local o�cials shifttheir e�orts from expanding the economyto providing public goods, such as safewater. But it is also because a scatteredelectorate cannot monitor them as closelyas their party superiors can.
Fear of their bosses and hunger forrevenues keep local o�cials on their toes.Mr Guo, star of �The Transition Period�, waseventually convicted of bribery. He was notentirely honest in the performance of hisduties, and not always sober either. Butwith all the parties, banquets and karaoke,no one could accuse him of being lazy.
The ballad of Mr Guo
What makes localgovernment o�cials tick
Boom, boom
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2 of their e�ciency. But even now, returns on equity among SOEsare substantially lower than among private �rms. Nor do SOEsreally �earn� their returns. The markets they occupy tend to beuncompetitive, as the OECD has shown, and their inputs of land,energy and credit are arti�cially cheap. Researchers at Unirule, aBeijing thinktank, have shown that the SOEs’ pro�ts from 2001to 2008 would have turned into big losses had they paid the market rate for their loans and land.
Even if the SOEs deserved their large pro�ts, they wouldnot be able to reinvest them if they paid proper dividends to theirshareholders, principally the state. Since a 2007 reform, dividends have increased to 515% of pro�ts, depending on the industry. But in other countries state enterprises typically pay out half,according to the World Bank. Moreover, SOE dividends are nothanded over to the �nance ministry to spend as it sees �t butpaid into a special budget reserved for �nancing state enterprises. SOE dividends, in other words, are divided among SOEs.
The wrong sort of investment
Loren Brandt and Zhu Xiaodong of the University of Toronto argue that China’s worst imbalance is not between investment and consumption but between SOE investment and private investment. According to their calculations, if state capitalistshad not enjoyed privileged access to capital, China could haveachieved the same growth between 1978 and 2007 with an investment rate of only 21% of GDP, about half its actual rate. Asimilar conclusion was reached by David Dollar, now at America’s Treasury, and ShangJin Wei of Columbia Business School.They reckon that twothirds of the capital employed by the SOEsshould have been invested by private �rms instead. Karl Marxmade his case for collective ownership of the means of production in �Das Kapital�. Messrs Dollar and Wei called their riposte�Das (Wasted) Kapital�.
Perhaps the best that can be said of China’s SOEs is thatthey give the country’s ruling party a direct stake in the economy’s prosperity. LiWen Lin and Curtis Milhaupt of ColumbiaUniversity argue that the networks linking the party to the SOEs,and the SOEs to each other, help to forge an �encompassing� coalition, a concept they draw from Mancur Olson, a political scientist. The members of such a coalition �own so much of thesociety that they have an important incentive to be actively concerned about how productive it is�. China’s rulers not only ownlarge swathes of industry, they have also installed their sons anddaughters in senior positions at the big �rms.
The SOEs provide some reassurance that the governmentwill remain committed to economic growth, according to MrMilhaupt and another coauthor, Ronald Gilson. The party o�cials embedded in them are like �hostages� to economic fortune,�the children of the monarch placed in the hands of those whoneed to rely upon the monarch�. That gives private entrepreneurs con�dence, because the growth thus guaranteed willeventually bene�t them as well�although they will have towork harder for their rewards.
What are the implications of China’s malinvestment for itseconomic progress? At its worst, China’s growth model adds insult to injury. It suppresses consumption and forces saving, thenmisinvests the proceeds in speculative assets or excess capacity.It is as if Crusoe were forced to scatter more than half his barleyon the soil, then leave part of the harvest to rot.
The rot may not become apparent at once. Goods for whichthere is no demand at home can be sold abroad. And surplusplant and machinery can be kept busy making capital goods foranother round of investment that will only add to the problem.But when the building dust settles, a number of consequencesbecome clear. First, consumption is lower than it could be, be
cause of the extra saving. GDP, properly measured, is also lowerthan it appears, because so much of it is investment, and some ofthat investment is ultimately valueless. It follows that the capitalstock, properly measured, is also smaller than it seems, because alot of it is rotten. That would make for a very di�erent kind of island parable, a tale of needless austerity and squandered e�ort.
Fortunately there is another side to China’s story. It has notonly accumulated physical capital but also acquired more knowhow, better technology and cleverer techniques. That is why foreign multinationals in the country rely on local suppliers�andalso why they fear local rivals. A Chinese motorbikemaker studied by John Strauss of the University of Southern California andhis coauthors started out producing the metal casings for exhaust pipes. Then it learnt how to make the whole pipe. Next itmastered the pistons. Eventually it made the entire bike.
China �bears� like Mr Chanos sometimes neglect this sideof the country’s progress. In his 2010 presentation he comparedChina to the Soviet Union, another empire in the east that enjoyed a stretch of beguiling economic growth. Like the Sovietcommand economy, China is good at marshalling inputs of capital and labour, he pointed out, but China has failed to generategrowth in output per input, just as the Soviet Union failed beforeit. Yet this analogy with the Soviet Union is preposterous.
Economists refer to a rise in output per input of capital andlabour as a gain in �total factor productivity�. Such gains havemany sources. One textile boss got 20% more out of his seamstresses by playing background music in his factory, recalls Arnold Harberger of the University of California at Los Angeles.The striking thing about the growth in China’s total factor productivity is not its absence but its speed: the fastest in the worldover the past decade. Between 2000 and 2008 it contributed 43%of the country’s economic growth, according to the APO. That isjust as big a contribution as the brute accumulation of capital,which accounted for 44% (excluding information technology).Thus even if some of China’s recent investment has in fact beenwasted, China’s progress cannot be written o�.
And even if some of China’s past investment has been futile, adding nothing worthwhile to the capital stock, there is aconsolation: it will leave more scope to invest later, suggestingthat the country’s potential for growth is even larger than the optimists think. The right kind of investment can still generate highreturns. But what if the mistaken investments of the past disruptthe �nancial system, preventing resources from being deployedmore e�ectively in the future? 7
4Plenty of upside
Sources: Asian Productivity Organisation; IMF
Net capital stock and GDP per person, constant 2010 $’000
GDP per person
Cap
ita
l sto
ck p
er p
erso
n
0
50
100
150
200
0 10 20 30 40 50 60
China South Korea Japan United States
1980 19902000
2010
1980
1990
20002010
1990
2000
2010
20102000
19801990
SPEECHMAKERS LIKE TO claim that theChinese word for crisis (weiji) contains thecharacters for both danger and opportunity. Most linguists dispute this. Either way,China’s economic policymakers don’t seemto believe it. For them, a crisis is a reason tobatten down the hatches.
In 1996 China’s government told theIMF that it intended to remove its controlson international capital �ows within �ve toten years. But when the Asian �nancialcrisis struck a year later, China’s government retreated into its shell.
Sixteen years later the timing looksbetter. Fear of capital out�ows has beenassuaged by China’s vast foreignexchangereserves. The opposite danger�excessivecapital in�ows�has also eased. Indeed, theyuan has come under downward pressure atseveral points in the past year.
Reformers in the government are
testing the waters. In April regulatorsraised the amount that �quali�ed� foreigninvestors can venture in the country’ssecurities markets to $80 billion, and easedthe limit that similarly quali�ed Chineseinvestors can whisk out of the country. Thecentral bank also loosened its grip on thecurrency a little, widening the yuan’s dailyband from 0.5% either way to 1%.
China has no obvious need for foreigncapital: its own saving is more than enoughto meet its investment needs. So liberalisers may have ulterior motives in mind,calculating that external liberalisation willforce the pace of domestic �nancial reform.If capital could move more freely acrossborders, the authorities would struggle tokeep interest rates arti�cially low�unlessthey were prepared to let capital �ee andthe currency fall.
By opening the capital account soon,
China could claim several prizes, reformersargue. Its investors could acquire foreign �rmsat low prices, thanks to European turmoil andAmerican caution. The country could also takeadvantage of the world’s disillusion with thedollar to promote the yuan as an internationalstore of value and medium of exchange.
Eswar Prasad of the Brookings Institution calls this a �Trojan horse� strategy, afterthe gift horse described by Homer that trickedthe Trojans into opening their gates. Thereformers’ ploy poses some risks. If Chinaopens the capital account before it reforms itsSOEs, foreign lending may help feed theirinvestment hunger. An open border would alsomake it harder to contain a domestic bankingcrisis. A di�erent Homer put it best. Told thatChinese uses the same word for crisis andopportunity, Homer Simpson exclaimed: �Yes!Crisatunity!� A premature opening of thecapital account would be just that.
Homeric wisdom
Easier crossborder capital �ows may help liberalise interest rates
8 The Economist May 26th 2012
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VISITORS TO SICHUAN’S atmospheric mountains, hometo both Tibetan and Qiang minorities, used to skip Yingxiu
village on their way to more scenic spots higher up. But the devastating earthquake that struck the area in May 2008 has turnedthe village into an unlikely tourist attraction. The earthquakekilled 6,566 people in the village, over 40% of its population. Its�vestorey middle school collapsed, killing 55 people. Nineteenstudents and two teachers remain buried in the rubble.
Four years on, the crumpled school remains. It has beenpreserved as a memorial to the disaster, but almost every othersign of the quake has been erased. The village is full of newhomes with friezes painted in strong Tibetan colours. Otherbuildings are topped with �at roof terraces, a white concrete triangle in each corner, echoing the white stones that adorn traditional Qiang architecture. The new homes look a little like Qiangstone houses on the outside, one villager concedes. �But insidethey are all Han.�
Yingxiu is an example of �outstanding reconstruction�, according to a billboard en route. Outside this showcase village,people have rebuilt their lives with less government help. Butthere is no denying that China set about reconstructing the earthquake zone with a speed and determination few other countrieswould be able to match. A propaganda poster shows Hu Jintao,China’s president, bullhorn in hand, declaring that �NothingCan Stop the Chinese�.
The earthquake did great damage to the region’s property
and infrastructure. But although it left the local economy worseo�, the pace of economic activity picked up in the wake of the disaster. There was much to do precisely because so much hadbeen lost. Even today the mountain road is lined with lorries.
Some economists worry that China may soon su�er a different kind of economic disaster: a �nancial tremor of unknownmagnitude. Pivot Capital Management, a hedge fund in Monaco,argues that China’s recent investment spree was driven by a�credit frenzy� which will turn into a painful �credit bust�.
Lending jumped from 122% of GDP in 2008 to 171% just twoyears later, according to Charlene Chu of Fitch, a ratings agency,who counts some items (such as credit from lightly regulated�trust� companies) that do not show up in the o�cial �gures.This surge in credit is reminiscent of the runup to America’s �nancial crisis in 2008, Japan’s in 1991 and South Korea’s a few
Finance
Bending not breaking
China’s �nancial system looks quakeproof, but for
how long?
The school that became a shrine
The Economist May 26th 2012 9
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years later (see chart 5), Ms Chu argues.When Fitch plugged China’s �gures intoits disaster warning system (the �macroprudential risk indicator�), the model suggested a 60% chance of a banking crisis bythe middle of next year.
China’s frenzied loanmaking hastraditionally been matched by equallyimpressive deposittaking. Even now,most households have few alternative havens for their money. This captive sourceof cheap deposits leaves China’s bankslargely shockproof. They make a lot ofmistakes, but they also have a big marginfor error. That will help them withstandany impending tremors.
But this traditional source ofstrength will not last for ever. China’s richest depositors are becoming restless, demanding better returns and seeking waysaround China’s regulated interest rates.
The government will eventually have to liberalise rates. Thatwill make China’s banks more e�cient but also less resilient.
There remains great uncertainty about China’s �nancial exposure. Not all of the country’s �malinvestment� will result inbad loans. Some of its outlandish property developments, including the empty �ats of Ordos, were bought by debtfree investors with money to burn. By the same token, not all of China’s�bad� loans represent malinvestment. Rural infrastructure projects, to take one example, are often �unbankable�, failing to generate enough income from fees, charges and tolls to service their�nancial obligations. But the infrastructure may still contributemore to the wider economy than it cost to provide. That is especially likely for stimulus projects, which employed labour andmaterials that would otherwise have gone to waste.
But suppose a �nancial quake does strike China: how willits economy respond? Financial disasters, like natural ones, destroy wealth, sometimes on a colossal scale. But as China’s earthquake showed, a oneo� loss of wealth need not necessarilycause prolonged disruption to economic activity as measured byGDP. Yingxiu su�ered a calamitous loss of people and property,but this was followed by a conspicuous upswing in output (especially construction) and employment.
If this seems counterintuitive, that is because GDP is easilymisunderstood. It is not a measure of wealth or wellbeing, bothof which are directly damaged by disasters. Rather, it measuresthe pace of economic activity, which in turn determines employment and income. Financial distress will damage China’s wealthand welfare, almost by de�nition. The interesting question iswhether it will also lead to a pronounced slowdown in activityand employment�the muchpredicted �hard landing�. To put itin Mr Hu’s terms, can a �nancial quake stop the Chinese?
If the banking system as a whole had to write o� more than16% of its loans, its equity would be wiped out. But the statewould intervene long before that happened. Despite the excesses of China’s local authorities, its central government stillhas the �scal �repower to prevent loans going bad, or to recapitalise the banks if they do. Its o�cial debt is about 26% of GDP
(including bonds issued by the Ministry of Railways and otherbits and pieces). If it took on all localgovernment liabilities, thatratio would remain below 60%. Alternatively, it could recapitalise a wipedout banking system at a cost of less than 20% of GDP.
Even if many loans do eventually sour, banks do not haveto recognise these losses all at once. No loan is bad until someone demands repayment, as the saying goes. In March the gov
ernment released details of a longrumoured plan to roll overloans to local governments. Many of these loans were due to mature before the project they �nanced was meant to be completed.If the project is worth �nishing, this kind of evergreening is an ef�cient use of resources. And some projects, once under way, areworth �nishing even if they were not worth starting.
Loan rollovers give banks time to earn their way out oftrouble, setting aside pro�ts from good loans before they recognise losses on bad ones. This task is easier in China than in othercountries because its �nancial system remains �repressed�.Banks can force their depositors to bear some of their losses bypaying them less than the market rate of interest. Indeed, depositrates are often below the rate of in�ation, making them negativein real terms. A bank’s depositors, in e�ect, pay the bank to borrow their money from them.
Chinese banks can get away with this because deposit ratesare capped by the government, preventing rival banks from offering higher rates. China’s capital controls also make it hard fordepositors to escape this implicit tax by taking their moneyabroad. As a consequence, Chinese banks luxuriate in a vastpool of cheap deposits, worth 42% more than their loans at theend of 2011.
This cash �oat gives Chinese banks a lot of room for error.In 2011 new deposits amounted to 9.3 trillion yuan, according too�cial �gures, more than enough to cover fresh loans of 7.3 trillion yuan. Although deposit growth is slowing, these in�owsgive banks a cash bu�er, allowing them to keep lending, even iftheir maturing loans are not always repaid in full and on time.
A chronic complaint
So China’s �nancial strains will not result in the sort ofacute disaster su�ered so recently by the West. Instead, they willremain a chronic a�iction which the state and its banks will tryto ameliorate over time with a combination of governmentorchestrated rollovers, repression and repayment.
Such a combination is unfair to taxpayers and depositors,but it is also stable. According to Guonan Ma of the Bank for International Settlements, bank depositors and borrowers endedup paying roughly 270 billion yuan ($33 billion) towards the costof China’s most recent round of bank restructuring, whichstretched over a decade from 1998. However, some commentators think that China will �nd it harder to repeat the trick in thefuture. Depositors are not as docile as they were. In �ts and starts,resistance to China’s �nancial repression seems to be growing.
�Let’s be frank. Our banks earn pro�ts too easily,� Wen Jiabao, China’s prime minister, admitted on national radio in April.He is right. The ceiling on deposit rates and the �oor under lend
5
*Fitch-adjusted credit †Estimate
Bubbles in the makingCredit as % of GDP
Source: FitchRatings
United States Japan China*South Korea
100
125
150
175
200
225
2002 04 0607 1994 96 98 1985 87 8990 2007 09 11 12†
2
10 The Economist May 26th 2012
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ing rates guarantee banks a fat margin, preventing competitionfor deposits and allowing big banks to maintain vast pools ofmoney cheaply.
If the deposit ceiling were lifted, small banks would o�erjuicier rates to take market share from incumbents. Conversely,the big banks would trim their deposit bases as they becamemore expensive. Households would be better rewarded for theirsaving, and China’s banking �monopoly� would be broken, asMr Wen professes to want. In fact, though, the government is stilldragging its feet on rate liberalisation. Itshesitancy may re�ect the political clout ofthe stateowned banks. It may also re�ectthe government’s own fears.
Most developing countries (andsome developed ones too) that freed uptheir �nancial systems su�ered some kindof crisis afterwards. Upstart �rms canpoach the incumbents’ best customers,threatening their viability but at the sametime overextending themselves. Even inAmerica, rate liberalisation in the early1980s allowed hundreds of Savings andLoan Associations to throw their balancesheets out of joint, o�ering higher returnsto depositors even though their assetswere producing low �xed returns. In a2009 paper, Tarhan Feyzioglu of the IMF
and his colleagues strongly endorsed Chinese rate liberalisation. But they also acknowledged that it can be mishandled, citing America’s S&L crisis as well as evenworse debacles in South Korea, Turkey,Finland, Norway and Sweden. The mostfamous study of these risks was writtenmore than 25 years ago. Its sobering titlewas �Goodbye Financial Repression, Hello Financial Crash�.
The risks of repression
These are good reasons for caution,but not for procrastination. Repressedrates have their own dangers. To avoidthem, savers have overpaid for alternativeassets such as property, contributing toChina’s worrying speculative bubble. Inplaces like Wenzhou, a city in Zhejiangprovince, rate ceilings have encouraged�rms and rich individuals to make informal loans to each other, bypassing the regulated banking system in favour of unsafe,unprotected intermediation in the shadows (see box). The patience of the publicat large is also wearing thin. At a centralbank press conference in April, a journalist (from Xinhua, the o�cial mouthpiece,no less) refused to let go of the microphone until her complaint about negativedeposit rates was heard.
A growing number of depositors are
looking for ways to circumvent the ceiling. Those with lots of money to park aredriving the demand for �wealthmanagement products�, shortterm savings instruments backed by a mix of assets thato�er better returns than deposit accounts.
By the end of the �rst quarter of 2012 these productsamounted to 10.4 trillion yuan, according to Ms Chu of Fitch.That is equivalent to over 12% of deposits. Most had short maturities, leaving buyers free to shop around from month to month.Banks accustomed to sitting on docile deposits may struggle tomatch the timing of cash payouts and in�ows, Ms Chu frets. Thebanking regulator may also be worried. It has now banned maturities of less than a month.
The recent proliferation of wealthmanagement products
THE SMALLBUSINESS association of Wenzhou, a city in Zhejiang province renownedfor its scrappy entrepreneurialism, used toinhabit spartan premises in the city centre,but in March it graduated to plusher o�ces15 �oors up on the fringes of the city. It is asign that Wenzhou’s brand of wheelerdealer capitalism is being spruced up.
The desk of Zhou Dewen, the association’s head, must be ten feet long. But hestill does most of his talking on the couchor in a nearby restaurant where he entertains visiting businessmen. In his o�ce, MrZhou hears a pitch from Mao Shuhui, whoruns the province’s �rst and only etiquettecompany. Her clients include the local taxo�ce and a number of mostly stateownedbanks. Their sta� sometimes need a fewpointers, she says. Their hair can be messyand their gestures impolite. Placing a�nger on each corner of her mouth, sheteaches them how to smile as though theymean it.
However wide their grins, China’sbanks have not been much help to mostWenzhou entrepreneurs. Longestablished�rms like Ritai, the shoemanufacturingout�t run by Mr Zhou’s deputy, Jin Zhexin,can get a loan if it is guaranteed by a morecreditworthy enterprise. But most Wenzhou entrepreneurs have turned elsewhere. Businessmen with money to sparelend it directly to �rms in need, without abank as middleman. Wenzhou’s shadow�nancial system amounted to 110 billionyuan in 2010, according to one estimate,equivalent to 38% of the city’s GDP.
In escaping China’s �nancial repression, however, the city’s informal lendingsystem also ducked out of its �nancialsafety system, including its prudentialsafeguards and its lender of last resort. As
the central bank tightened credit in 2010and 2011, desperate borrowers drew tooheavily on grey �nance, taking loans theycould not repay. Some simply �ed. Unnerved, informal lenders began calling intheir loans and refusing new ones. The crisisfed on itself. Eventually the governmentcracked down on borrowers and lendersalike, so the money dried up completely.
In Wenzhou’s Fortune Centre, wherethe most successful lenders once congregated, all that is left of one shadow �nancier are the indentations on a plaquewhere its name used to be. In anothero�ce, an erstwhile private lender has gonefor a completely di�erent sort of business,investing 10m yuan in a TV spy caper setduring the Japanese occupation. He wears aDennis Hopper Tshirt and keeps cans ofBudweiser in the o�ce fridge. In the pasthe could arrange a loan with a single telephone call. Now �the trust is destroyed.�
In the absence of trust, lenders demand more tangible collateral. The manager of Dongkai Pawnshop says his businesshas bene�ted from the crisis. People whocould previously borrow on the strength oftheir relationships must now o�er something solid, like the 100g gold bar commemorating the Beijing Olympics that is for salein the lobby.
In March the central governmentunveiled a number of sensible reforms totame the Wenzhou system without crushingit. Informal lenders will henceforth need tobe registered, more private capital will beencouraged and the issuance of highyieldbonds approved. Yet the government stillresists the more elegant solution to theproblem proposed by Mr Zhou: allowingborrowers and lenders the freedom to setwhatever interest rate they like.
Shades of grey
Wenzhou’s shadow banking system has taken a knock
To avoid repressed interest rates, savers have overpaidfor alternative assets such as property, contributing toChina’s worrying speculative bubble
2
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ZHANG GUIDONG GREW up on a farm in Anhui, a poorinland province, where China’s economic reforms made a
humble beginning. He left home for Beijing in 1995 with only afew years’ schooling. First he sold belts and lighters in Tiananmen Square. When that was banned, he joined some friendsfrom back home in Beijing’s Silk Market, where he sold vegetables and silk items to the sta� of the embassies nearby.
The Silk Market is famous for selling brandname goods atsuspiciously low prices, often to tourists who seem to enjoy thecombination of ripo�s and knocko�s. Fined many times forselling fakes, Mr Zhang eventually decided to change his strategy. He sought a licence to sell genuine goods under the brand
�Hello Kitty�. A white bobtailed cat that �rst appeared on a pursein the 1970s, Kitty now counts as Asia’s answer to Mickey Mouse.
The brand’s guardians were initially worried by all thefakes on sale in the market, but in the end they were persuadedthat the place was trying to clean itself up. Mr Zhang’s business isnow doing well. In March he was set to move from his old tensquaremetre stall on the ground �oor to a 15squaremetre spoton the third �oor, where the market is grouping its more reputable outlets. Most of the other stallholders are also from the countryside, Mr Zhang notes. �I never dreamt that I could one dayhave a life like this.�
Most people think of China as an industrial powerhouse,not a consumer’s paradise. Household consumption as a percentage of GDP fell for ten years in a row from 2001. By the end ofthat decade it amounted to only 34% of GDP, about 19 points below Japan’s lowest postwar ratio and 15 points below South Korea’s. America’s consumption did not dip far below 50% of GDP
even during the second world war, as Mr Lardy of the PetersonInstitute for International Economics points out in his book,�Sustaining China’s Economic Growth�. But this declining ratiois deceptive. Consumption in China has actually been growingfaster than in any other big country. It is just that China’s GDP hasbeen growing even more rapidly.
Consumption always lags income, both on the way up andon the way down, argue Carl Bonham of the University of Hawaii at Manoa and Calla Wiemer of the University of SouthernCalifornia. This is partly because people choose to �smooth�their consumption over time, but also because people generallyhesitate to abandon a lifestyle to which they have grown accustomed. Although China’s output and income surged after 2000,its consumption habits have yet to catch up.
Bootstrap businessmen from the boondocks do not alwaysknow what to do with their newfound wealth, according to research by Jacqueline El�ck, a cultural anthropologist. One couple, newly arrived in Shenzhen, lined their entire �at with bathroom tiles. Another complained that their bathroom windowslacked the blue translucent glass found in rural toilet blocks. Ahomebuyer who had never previously lived in anything biggerthan a tworoom �at took a residence with six rooms, �lling fourof them with dining suites.
But consumer habits are evolving. In Shenzhen, notes MsEl�ck, the constant churn of the population and relative absenceof established hierarchies means �you are what you buy.� Thenew rich announce themselves by spending profusely. They favour �heavy ornate furniture in faux Baroque�. In Sanya, an advert for one luxury residence shows a painting of Napoleoncrossing the Alps hanging on the wall as a woman in a low
Consumers
Dipping into the kitty
Chinese consumption is about much more than
shopping
6Squeezed
Sources: Barclays Capital; The Economist *To include undermeasured consumer spending
China’s consumption as % of GDP
45
50
55
40
35
30
1997 98 99 2000 01 02 03 04 05 06 07 08 09 10
Official share
Adjusted share*
amounts to a defacto liberalisation of interest rates, Ms Chu argues. The growing competition for deposits is showing up in other ways too. When the �nance ministry auctions its own sixmonth deposits, banks are now willing to o�er rates as high as6.8%, more than twice the maximum they are able to o�er to ordinary depositors.
The government may seek to formalise this de facto liberalisation, gradually allowing banks more freedom to set rates onlarge longterm deposits�the kind that will otherwise disappearfrom banks’ books. Net corporate deposits, for example, did notgrow at all in 2011. Higher rates would help attract them back.
That would also raise banks’ costs of funding, forcing China to become more e�cient in its allocation of capital. At the moment the system is segregated between big enterprises, whichenjoy relatively low borrowing costs, and creditstarved private�rms that could potentially earn much higher returns on investment. In a freer �nancial system, competition would begin toclose this gap. If interest rates went up to match the return on capital, Chinese investment would fall by 3% of GDP, according to astudy by Nan Geng and Papa N’Diaye of the IMF.
More �exible interest rates would also raise Chinese consumption, says Nick Lardy of the Peterson Institute for International Economics. He calculates that if banks paid something resembling a market interest rate on their vast deposits, householdincome would increase by 2% of GDP. Higher incomes, he argues, would cause their spending to rise and their saving rate tofall. The idea that higher rates will make people save less is unorthodox, but Mr Lardy argues that the higher income from savingwill have a bigger e�ect than the higher reward o�ered for it. Chinese households save towards a goal, he suggests, such as thedownpayment on a house or the cost of a potential medicalemergency. Lower the return to saving, and they will just saveeven harder to achieve their goal.
Research by Malhar Nabar of the IMF suggests that higherinterest rates would indeed bring down saving rates, but the effects would be modest. If the real rate on oneyear deposits rosefrom roughly 0% today to a more reasonable 3%, it would lowerhousehold saving by only about 0.5% of GDP, he calculates. Butif higher interest rates alone will not liberate Chinese consumption, what will? 7
12 The Economist May 26th 2012
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backed evening dress lingers by the window. But there is also a growing class of discerning customers
who look down on ostentation. They pride themselves on theirappreciation of wine, tea and co�ee. In Beijing the TV screensthat now pop up in taxis teach passengers how to judge a wine’sintensity and why they should not over�ll their glass. �Knowledge of how to consume has in itself become a commodity,� MsEl�ck writes.
Just as consumption failed to grow as quickly as incomesover the past decade, it will fail to slow as quickly over the decade to come. As China’s growth eases from 10% a year to something closer to 7% during this decade, consumption will rise naturally as a share of GDP.
Some economists think it has already begun to do so. Yiping Huang of Barclays Capital says the o�cial statistics failto re�ect a surge in consumer spendingsince 2008. They are particularly bad atcapturing extra spending on accommodation, such as rent payments by tenants orthe bene�ts enjoyed by owneroccupiers.
One proxy for consumer spending isretail sales, which have grown much fasterthan GDP in recent years. Unfortunately,these statistics are no better at capturingexpenditure on accommodation. And inChina they include many things otherthan household consumption, such asgovernment purchases and trade in industrial products like basic chemicals. Buteven when those items are stripped out,Mr Huang shows, sales are rising fast.
He thinks that the level of expenditure as well as its growth may be understated. Despite the conspicuous consumption, a lot of income and spending ishidden from the prying eyes of taxmenand statisticians. The best e�ort to throwlight on this shadow income is a study byWang Xialou of the National EconomicResearch Institute at the China ReformFoundation. His team asked about 4,000of their friends how much they earnedand spent. The answers they got weremore candid, though also less representative, than o�cial surveys. After doingsome statistical tricks to eliminate the bias,Mr Wang calculated that the disposableincome of China’s households was 9.3 trillion yuan ($1.4 trillion) higher than the of�cial 2008 �gure of 14 trillion yuan. Drawing on this work, MrHuang thinks that private consumption may have accounted for41% of GDP in 2010, about seven points higher than the o�cial�gure (see chart 6, previous page).
Mr Huang’s calculations do not convince everybody, andeven if they are right, they have disturbing implications. Hiddenincome disproportionately bene�ts the bettero�: the richest 10%of urban households take home over 60% of it. That might helpexplain why China is now the world’s largest market for luxurygoods, according to one estimate. If that hidden income is counted, the top tenth of urban families are about 26 times better o�than the bottom tenth, not just nine times, as the o�cial �guressuggest. These �gures make China’s economic imbalances lookbetter but its social inequities far worse.
However, there is another important source of �nal de
mand that is often neglected: the government. Its consumptionspending (on health care, education, subsidised rent and so on)as a share of GDP has been growing since 2009, but it remains inadequate and uneven.
The patchwork state
China has greatly broadened its rural pension scheme,which collected contributions from 140m people in 2011, compared with under 80m a year before. But even now it reachesonly about 30% of the eligible population. The government hasalso expanded the coverage of health insurance, bringing 95% ofthe population into the net, according to the OECD. Patients nowpay directly for only 35% of China’s total health spending, com
pared with well over 60% ten years ago. But progress has notbeen uniform. China has one scheme for urban workers, another for nonworkers and a third for rural folk, each administeredby separate city or county governments. The contributions required and bene�ts provided di�er a lot between the threeschemes. According to the OECD, the rural scheme pays out anaverage of only $16 per person per year and covers only 41% ofthe cost of inpatient care.
In social as in economic policy, the government prefers local experimentation and piecemeal expansion. That works wellfor economic reforms, but in social policy it fails to pool risk e�ciently. And the safety net is thin as well as patchy. This keepsdown its cost to the exchequer but leaves the population exposed to dangers such as debilitating illness or job loss. Healthbene�ts, for example, are capped, leaving patients uncovered for
An important source of demand
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the worst crises. And China’s hospitalcentric healthcare systemprovides only one general practitioner for every 22,000 people.
Older Chinese grew up in a society where many of theirconsumption choices were dictated by the state or by their workplace. They ate in state canteens and slept in stateprovided dormitories or �ats. It was a grinding, tedious existence. But in discarding the �iron rice bowl�, the Chinese state failed to providealternatives, including health care and minimum pensions. According to the World Bank, China spends only 5.7% of its GDP onthese items and other forms of social protection, such as payments to support the very poor. Other countries in the same income category as China spend more than twice as much, an average of 12.3%.
More social spending of the rightkind would not crowd out private consumption. On the contrary, it would encourage it. The patchiness of China’s safety net is one reason why households saveso much of their incomes. According toEmanuele Baldacci and other economistsat the IMF, a sustained rise in publicspending by 1% of GDP, spread evenlyacross health, education and pensions,would increase the ratio of householdconsumption to GDP by 1.25 percentagepoints. The IMF’s Steven Barnett and RayBrooks calculate that in urban areas everyextra yuan the government spends onhealth prompts an extra two yuan of consumer spending.
Can China a�ord to spend so freely?In one sense, it cannot a�ord not to. If investment were to falter and private consumption failed to compensate, Chinawould be left with a big hole in demand,jeopardising employment and growth. Ifthe investment rate were to drop back toits 2007 level, for example, the demandshortfall would run to over 6% of GDP. Tomake up for that, the government wouldhave to spend about 3.4 trillion yuan thisyear, or face widespread joblessness. Thatis a substantial amount. With only a sixthof that sum, the government could raisethe incomes of all of China’s poor to theequivalent of $2 a day, according to calculations by Dwight Perkins of Harvard. Thepoint of such a thought experiment is todemonstrate that China has enormousproductive powers to mobilise, and has to
spend a lot to mobilise them fully. There is another obvious measure, peculiar to China, that
would lift consumer spending. That is the earliest possible repealof the country’s household registration system, or hukou, whichlimits the access of rural migrants to public services in the citieswhere they work and live. This keeps migrants unsettled andtherefore unwilling to spend. Migrants without an urban hukou
spend 30% less than otherwise similar urban residents, according to research by Binkai Chen of the Central University of Finance and Economics, Ming Lu of Fudan University and Ninghua Zhong of Hong Kong University of Science and Technology.
Mr Zhang, the Silk Market trader, is a good example of thesystem’s iniquity. He arrived in Beijing 17 years ago. He has ahouse, a son, a business and even a licence from Hello Kitty. Buthe still does not have a Beijing hukou. 7
THE POLICYMAKERS WHO will determine China’s futureare trained at the Central Party School, a spacious oasis of
scholarly tranquillity in northwest Beijing. The campus lookslike an Ivy League school with Chinese characteristics. Thegrounds are dotted with sti� bamboo as well as pendulous willows, pagodas as well as ducks. The school remains largelyclosed to outsiders. In the past it did not even appear on maps.But it is opening up. The campus signpost, for example, is sponsored by Peugeot Citroën.
The school has over 1,500 students and almost as manyprofessors, many of whom are much younger than their students. It teaches economics, public �nance and humanresourcemanagement as well as communist doctrine, such as Marx’s labour theory of value. It takes only three or four classes to teachDeng Xiaoping Theory, the party dogma that legitimised China’seconomic reforms and still guides its Politburo. But if even that istoo much, three famous clauses may su�ce: �Our country mustdevelop. If we do not develop then we will be bullied. Development is the only hard truth.�
Deng said these words 20 years ago, not at a portentousparty conference in Beijing but on his �southern tour� of theworkshops of the Pearl River Delta. He was inspired by practice,not theory, having just visited a refrigerator factory in the deltathat had expanded 16fold in seven years. Even the word he usedfor truth (daoli, which is often translated as reason or rule) ismore colloquial than the loftier term, zhenli, reserved for hightruths like MarxismLeninism.
Giants playing catchup
Thanks to a sevenfold rise in its output since then, China iswell past the point of being bullied. Its dollar GDP, measured atpurchasingpower parity, may have already overtaken America’s, according to economists such as Hu Angang of TsinghuaUniversity or Arvind Subramanian of the Peterson Institute forInternational Economics. Converted at market exchange rates, itis still much smaller than America’s. But even by that measure,China may catch up sooner than many people currently expect.To draw level with America by 2020, China’s dollar GDP would
have to grow at only about threequartersof the average rate it recorded over thepast decade.
Now that China has become too important to be bullied, development maybe less of an imperative. Indeed, in somequarters of society there is an increasingdistaste for the unwelcome sidee�ects ofChina’s growth model, which depletesthe country’s natural assets at the sametime as it expands its physical ones, andwhich builds lots of property but oftenbulldozes property rights.
Some party elites and vested interests may also have grown complacent,worrying more about how to divide theeconomic spoils than how to enlarge
The next chapter
Beyond growth
China will have to learn to use its resources more
judiciously
�Our countrymustdevelop.If we do notdevelopthen we willbe bullied.Developmentis the onlyhard truth�
of investment, but there is nothing else to replace this as asource of demand. Much of thecredit extended by banks andshadow banks to keep growthgoing will sour. A governmentthat owes its legitimacy entirelyto growth will �nd it hard tocontain the disappointmentthat a slowdown will entail.
This special report subscribes to a third school ofthought. It argues that Chinadoes face signi�cant problems,but nothing it cannot handle. Ithas not obviously overinvested,but it has often invested unwisely. That is imposing reallosses on Chinese developers,depositors and taxpayers. However, China’s �nancial system isbetter equipped than many others to ride out these losses. Itmay be ine�cient in its allocation of capital, but it is quite stable. Indeed, it is resilient forsome of the same reasons that itis ine�cient.
Until recently most economists believed that China washeavily dependent on exports.But it has carried on growing even as its currentaccount surplushas shrunk, and trade has subtracted from growth, not added toit. The country is undoubtedly investmentdependent, but itsbiggest problem is malinvestment not overinvestment. Mostpeople believe that its past malinvestment will impede future
growth. This special report has raiseddoubts about that. Clearly China wouldbe better o� had it not wasted so muchcapital. But if the capital stock is not asgood as it should be, that gives the country all the more room for improvement.
If the investment rate does fall, China will need another source of demand.The obvious place to look is householdconsumption, but consumers may notrise to the challenge. This special reporthas argued that a much higher rate of government consumption would be equallydesirable�and perhaps more feasible.
As China’s capital accumulates, itspopulation ages and its villages empty,saving will grow less abundant and goodinvestment opportunities will becomescarcer. China will then need to use its resources more judiciously. That will require it to free up its �nancial system, introducing more e�ciency even at somecost to stability.
China is a vastly more prosperousand expansive country than it was 20years ago. It has broader horizons and cana�ord a wider range of concerns. Development is no longer China’s only truth.But it is still hard. 7
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SPECIAL REPORT
14 The Economist May 26th 2012
2
CHINA’S ECONOMY
them. But at least in their rhetoric, leaders do not appear to beresting on their laurels. Asked about China’s prospects of becoming the world’s number one economy, Li Wei, head of the Development Research Centre, which advises China’s cabinet, saw noreason to celebrate. The country’s income per person still ranksaround number 90 in the world. And even if its GDP overtakesAmerica’s by the end of the decade, China will remain as poor asBrazil or Poland are today, by one estimate.
Hubris may be less of a danger than its opposite, a kind ofeconomic di�dence. If China is still poor in the minds of policymakers, they may conclude that the economy is not yet ready forreforms that are in fact overdue. They may feel that a poor developing country does not need a more sophisticated �nancial system, cannot cope with a more �exible exchange rate and cannota�ord to let its rural masses settle in the cities with their families.
As long as the demand for investment remains strong andthe supply of saving captive, China’s policymakers can feel con�dent that their country’s economy will continue to enjoy rapidgrowth and stability. But the faster that China expands, thesooner it will outgrow the development model that has served itso well for so long. Japan began to change its growth model backin the mid1970s. By some measures China has already reached asimilar stage of development, and yet its reforms remain tardyand timid.
School rules
There are at least three schools of thought on China’s economic prospects over the next few years. The �rst sees few dangers ahead. China has expanded quickly, always beating forecasts, and will continue to do so for the time being. It is a huge,fastdeveloping country with plenty of room yet to grow. It invests a lot�and so it should. These investments might not alwaysgenerate good returns for the bankers that lent the money. Butthey will contribute more to the economy than they cost.
The second school of thought argues that China’s imbalances could overwhelm it. It cannot sustain its current high rate
Still plenty of room to grow