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February 22, 2011

A Contrarian View of China's Growth

David Beim argues that China's golden age of hyper-growth is likely nearing an end.


For 30 years, China’s mix of entrepreneurial energy, heavy investment, and low-wage exports has proven such a potent formula that many, both inside and outside China, cannot imagine it slowing down. But sustained high growth is being undermined by inflation, declining returns on investment, and rising bad loans in the banks.

Perhaps China realizes that a series of unique, transformative events coincided to its benefit during the past 30 years: the carefully-managed but decisive policy shift away from Maoism and toward market economy in the 1980s, which released the remarkable entrepreneurial spirit of the Chinese people. Then, globalization and a massive push for exports in the 1990s culminated in the reunification of Hong Kong with China and the growing connection between offshore China with the mainland. Finally, the burst of financial and consumer excesses in the United States and Europe in the 2000s fueled a consumption boom in both regions and created a rapidly expanding market for Chinese goods.

China’s fundamental growth strategy has been massive investment in physical capital by loans from state-owned banks, aided by high household savings rates. Government-controlled banks effectively insulated China from the warning signs of impending financial turmoil experienced by other economies. This is why China did not appear to suffer in the East Asia crisis of 1997-98 or the current global financial crisis. But, in a sense, China was affected. From 1981 to 2003, the expansion of credit outpaced the growth of the larger economy, averaging 15 percent per year. This long credit expansion left a hangover of nonperforming loans that was only gradually acknowledged by the Chinese government. The explosion of new bank lending since 2008 has almost surely generated another burden of nonperforming loans while fueling a bubble in real estate and stock prices. Banks are notorious for concealing value destruction.

Furthermore, China’s export-driven growth model has caused strains within the country. Workers are unhappy with very low wages, working conditions, and inflation, and have begun demanding — and are increasingly receiving — much higher wages. This has created a fundamental problem for China: rising wages will undermine its export model, which is based on being the lowest-cost supplier.

And already, China is starting to lose competitiveness. In April 2010, China had its first monthly trade deficit in six years, and the country ended 2010 with a 6 percent decline in its trade surplus. At the same time, China already has such a large share of the export market that further domination would be challenging, if not impossible.

The natural answer lies in changing the export-based economic model in favor of a new model based on local consumption. As outside competition increases and the export market reaches saturation, China needs to shift its prodigious production toward domestic consumers. But this is easier said than done. Up to now institutions — the state and large producers — have been the beneficiaries of the country’s growth, leaving behind individual consumers. The fact is, most Chinese people are poor: they are paid very, very little and have negative real returns on their savings.

If domestic consumption is to be China’s saving grace, wages need to increase substantially and the famously high savings rates of individual Chinese will have to come down. That requires better state healthcare and more affordable education, so that the Chinese people do not have to save money to shoulder these costs on their own. The entire development philosophy needs to shift away from producers and toward consumers, with businesses raising wages and banks raising deposit rates and increasing consumer loans. However, there is a timing problem: raising wages will impact export competitiveness immediately, but the benefits of wealthier consumers buying more will take many years to evolve.

So what does the future hold? A sudden stop of growth as happened in Japan in the 1990s seems unlikely; a more probable role model is Korea, whose annual growth crested at 10 to 11 percent in the mid-1980s before gradually settling down to a more normal 4 to 5 percent after 2002.

Chinese leadership has a well-established pattern of gradualism, so any change in favor of workers and consumers is likely to move slowly, though it must come in due time. In the meantime, it seems more than likely that the golden age of Chinese expansion is coming to an end. The old growth model has run its course, and a new one is needed. In order to ensure a strong future, China’s stratospheric economic success must find a new foundation.

David Beim is Professor of Professional Practice in the Finance and Economics Division and a Bernstein Faculty Leader in the Sanford C. Bernstein & Co. Center for Leadership and Ethics at Columbia Business School.

This piece is adapted from Beim’s paper, “The Future of Chinese Growth.”

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