With the European economy deeply mired and America facing both the 'fiscal cliff' and the need to correct its budget deficit, the world has come to depend on China continuing to grow at a reasonable pace.
China's own forecasts are for 7.5% growth, and the IMF agrees. Overshadowing these forecasts, however, is the widespread belief that China's growth depends on running an export surplus and spending hugely on investment. How can China go on supporting domestic production by exporting when the rest of the world is growing slowly and is in any case unwilling to see its own feeble demand spill over into imports from China? And how can China go on putting half its GDP into investment without creating surplus productive capacity and fast-trains-to-nowhere?
Leading the growth pessimists is Michael Pettis, who has a bet with The Economist that growth will average no more than 3.5% for the decade. China's most recent annual growth is twice this pace, close to forecast. How feasible is a continuation of this expansion?
It doesn't require any extra demand from a higher export surplus. China's surplus has already fallen to a sustainable 3% of GDP and China's current rate of growth has been achieved with imports growing faster than exports. What about the seemingly outlandish proportion of GDP going into investment? In fact by international comparisons of countries going through the 'growth spurt', China's 50% investment ratio doesn't look that unusual. It matches Singapore in 1978-88 and is not much higher than Japan, South Korea and Thailand in their high-growth periods.
That said, this ratio wasn't sustained in those countries and at least in the case of Thailand, the slowdown was very bumpy. Can China pull off the transition from high growth to medium growth without the painful sudden stop experienced by Thailand in 1997?
To answer this, look at the nature of the growth spurt. When China was growing at over 10%, an investment/GDP ratio of around 50% was needed just to keep the capital/output ratio around its usual level and allow for the capital deepening ('more and more expensive equipment with a lesser corresponding rise in wage expenses') that is part-and-parcel of the development process.
China's capital per worker is still only 8% of America's and 17% of South Korea's. If growth has now slowed to around 7.5%, this still requires investment to be almost 30% of GDP just to maintain a steady capital/output ratio, and quite a bit more to allow for capital deepening.
Of course, at some time in the not-too-distant future, China needs to shift consumption up from its current 35% of GDP to a more conventional number, at least half of GDP. Compared with the task faced by most of Europe and by America (cutting consumption and raising taxes to fix the budget, while maintaining growth), China's task is the easier one, but it does require a major change in thinking. So far China is fumbling the job.
Pettis' growth pessimism goes beyond simply arguing that the current high levels of investment will inevitably contain some white elephants. He thinks the policy instruments available to the authorities won't work because they're caught in a Catch-22: it is hard to alter the long-standing policies which restrain consumption, so the authorities maintain growth by retarding the rebalancing: artificially boosting investment, with the risk of bad debts from excessive credit expansion and unproductive investment projects.
This seems to under-rate the policies available to a hands-on interventionist government which gives high priority to employment. It may also seriously underestimate the growth potential of an economy which still has many useful investment opportunities, achieving the necessary rebalancing over a longer period.
If Pettis wins his bet with The Economist, the world economy will indeed be a dismal place for the medium term. But so far he has had to tweak his forecasts to keep them consistent with the unfolding actual record of higher growth ('forecast early and forecast often'). Earlier this year Pettis said 'average growth in this decade will barely break three per cent'. Given the growth already achieved in the first few years of the decade, this would have implied almost no growth at all for the rest of the decade. In a more recent blog post he talks about China's growth slowing 'even to 3%, as I expect it will within the next few years...'. So he's no longer talking about the whole decade.
Even when Pettis talks more positively about the prospects of China rebalancing, he sees this being bad news for Australia, as the rebalancing will hurt commodity prices. The 'glass half-full' interpretation of that problem was offered by the Reserve Bank Governor:
That presents some challenges of economic analysis and management. But even so, it may be better to be exposed to a Chinese economy with a high average, even if variable, growth rate, than, say, to a Europe with a very low average growth rate that is apparently also still rather variable.
Photo by Flickr user Major Clanger.