You worked with Campbell R. Harvey and Christian Lundblad to apply a wide range of standard growth models to China to try to explain its growth experience with standard growth determinants, such as trade openness, financial development and so forth. You found — not so surprisingly, you say — that the standard models cannot explain China’s growth miracle.
We do say that it’s not surprising that China doesn’t fit the standard models, but our study still yielded some surprising results. For example, usually when there is such strong growth, there’s also a lot of volatility — the growth rate moves up and down a lot from one year to another. China has had a lot of growth and very steady growth, without much volatility.
It’s also been assumed that trade plays a big role and that China is more open to trade than other countries. A lot of big countries — like the U.S. — do not have large trade sectors relative to the size of their economies, and compared to the U.S., China is actually quite open. However, China’s ratio of trade to GDP is actually smaller on average than that of other emerging markets, and in our analysis contributed surprisingly little to economic growth.
What does play an important role in China’s growth experience is its enormous investment-to-GDP ratio. Some 40 percent of total resources available are being used for investments; in other countries that number is typically 20 to 25 percent.
In all, even accounting for exceptional investment levels and for some of the measurement problems associated with Chinese statistics, China’s growth potential remains a real outlier.
How does all this investment get financed?
It turns out that most of the investments are really financed by a huge pool of local domestic savings. It all gets plunked into investing for growth. If you think about welfare, you want people to consume, you want people to get richer. But individuals are saving a lot of money — because they have to. There’s no social security to speak of, so people have to really plan for old age; and they have to save to fund educational expenses, etc. China should figure out how to keep growing fast but at the same time use more of its resources to build a welfare system with pensions and healthcare to care for its people, deal with pollution and other problems. It can do so if it manages to allocate capital more efficiently than it currently does.
The state sector remains huge, but capital allocation by state-owned enterprises is notoriously inefficient. So in some sense what is kind of amazing is that as fast as it is already growing, China could actually grow even faster if it employed capital more efficiently.
The flip side of the huge savings and investment rates is that a smaller proportion of the total resources available is being consumed than is typical in most countries. But if you think about general welfare, it’s consumption that should grow, not necessarily investment and GDP. You want the people to benefit from all these investments, and right now China is totally focusing on growth. They will have to make some sort of shift there, I think.
China has also taken a different path when it comes to financial openness. Can you explain the dynamics there?
Typically, when countries open their capital markets for foreign investment, it’s a two-way street. Foreigners can invest in the country either through the capital markets or through foreign direct investment [FDI], which most people believe is the most valuable form of capital. FDI involves buying or starting up real companies, as opposed to buying stocks on the stock market. And people in that country can also invest abroad. Whereas I firmly believe that financial openness promotes economic growth, a number of countries that have opened up their markets in the past also went on borrowing binges. While the subject of much debate, some see too much or too fast financial openness as the root cause of the crises Mexico and Southeast Asian countries faced in the mid- to late ’90s.
China has avoided such crises perhaps because it has opened up in an asymmetric and controlled fashion. First, Chinese citizens cannot invest abroad. Second, China has very purposely avoided borrowing from abroad; foreign capital mostly comes in the form of FDI. Now, we shouldn’t assume FDI is enormous, either. Shang-Jin Wei, who also contributed to the book and is a true China expert, has already pointed this out. While there is much hype about FDI in China, the UK gets proportionally more FDI than China. Foreigners can also invest in the Chinese stock market, but that’s still being opened up and is still pretty limited as an option for foreign investors.
How does that affect the local investment climate for the Chinese?
At home, investors have few interesting investment options: they can put their savings under their mattress, they can try to invest in private enterprises — but that can be difficult — or they can go to the local stock market, which last year did really well but over the 10 years before performed terribly. They can also deposit their savings in a state bank, but the real interest rate in China is negative. I suspect those individuals would prefer to put their money somewhere else, probably in Europe or the U.S., but they cannot.
The upshot is that the government is sitting on this massive pool of local savings it uses to invest in the economy, but the return on savings for those individual Chinese is very low. Ironically, the Chinese central bank itself is investing massively abroad, especially in U.S. Treasury bonds, which the Chinese people themselves cannot buy.
So that’s another asymmetry: on the one hand, the savings allows the government to invest, which drives overall growth, but the state doesn’t leave the people with many good options for increasing their own consumption or welfare through a better return on their individual savings. Yet, our analysis does reveal that the avoidance of foreign debt has played a role in promoting growth, and without a massive pool of domestic savings, China could not have sustained such high investment levels.
That’s certainly the question, isn’t it? It’s really hard to predict what will happen. I’m not an expert on China, by the way, but I can offer some perspective building on what I learned doing this project.
China features prominently in the current debate about global trade imbalances. Many believe China’s restrictive exchange-rate system has led to an undervalued exchange rate that gives it an unfair advantage in international trade. The U.S. has pressured China to make its exchange rate more flexible, thinking that market forces would make the exchange rate in China appreciate.
I’m not so convinced. Over the long term, probably yes. But if China opens its capital markets further, those with domestic capital might search for better investment opportunities and diversification abroad. This market force may cause the exchange rate to depreciate. Some of the more well-off are already trying to park capital abroad, and the central bank in China is trying to slow this illegal capital outflow down.
However, the current growth model with an emphasis on high GDP growth, without regard to the resources used, is unsustainable. The state has to get out of the way. China needs to focus more on the overall welfare of its aging population. To sustain high growth, it must find a way to grow more efficiently. Using efficient capital allocation through developing its local financial markets and through financial openness is the best way forward.
It’s not really an issue of growing faster, it’s an issue of growing more efficiently.
Geert Bekaert is the Leon G. Cooperman Professor of Finance and Economics at Columbia Business School.
Bekaert, Geert, Campbell R. Harvey and Christian Lundblad, “Financial Openness and the Chinese Growth Experience.” In China’s Financial Transition at the Crossroads, edited by Charles W. Calomiris. New York: Columbia University Press, Columbia Business School Publishing, 2007.
Professor Bekaert teaches courses on international finance, empirical asset pricing and investments. His research focus is international finance, with a particular interest in foreign exchange market efficiency, exchange rate determination and international and emerging equity markets. He is also interested in portfolio management. He is an associate editor of the Journal of Financial and Quantitative Analysis, the Journal of Finance