Decisions taken in 2011 will set China's growth path for next few years
This year, Beijing will face the task of keeping gross domestic product growth rates high - probably about 9 per cent - while trying to reduce the economy's dependence on increasing investment. This will not be easy.
To see why, consider the engines of economic growth. China, like nearly every other country, relies on three sources of economic growth - domestic household consumption, the trade surplus and domestic investment. Of the three, household consumption constitutes a lower share of GDP in China than in any other country. This low share is at the heart of China's economic imbalance. It is now widely recognised that raising it sharply is key to the long-term sustainability of Chinese growth.
To compensate for low consumption, China is heavily reliant on the other two sources of growth: a rising trade surplus and rising investment.
The level of investment is the highest ever and is increasingly viewed as a serious problem because of the risk that misallocated investment will lead to growth today that will be more than fully reversed in the future. China's trade surplus is already the highest ever recorded as a share of global GDP and is much too high as a share of domestic GDP for such a large economy.
In an ideal world, for the next five to 10 years, Chinese household consumption would grow annually by 10-11 per cent or more (it has grown 6 to 9 per cent a year over the past decade) as part of a rebalancing of the economy. In fact, Beijing has said many times over the past few years, including in its latest five-year plan, that accelerating household consumption growth is a priority.
But China's growth model is heavily dependent on the factors that automatically repress growth in household income and, with it, household consumption. Reversing these factors - by raising wages, interest rates and the value of the yuan - can only be done slowly if Beijing wants to avoid a short-term rise in financial distress and joblessness.
If there cannot be a surge in consumption this year, then what about a surge in the country's trade surplus?
Most of the world's trade deficits in the past two decades were associated with either the United States or the peripheral countries of Europe. The US is unwilling to see a surge in its trade deficit, and peripheral Europe is experiencing a financial crisis that will cause its deficits to collapse. Without rising deficits elsewhere, it will be very difficult for China to force up its trade surplus without triggering devastating trade wars.
So unfortunately that leaves investment as the main generator of economic growth in 2011. Beijing is rightfully worried that investment has become its biggest problem.
Investment always generates growth today, but unless the economic value of that investment is greater than the true economic cost, the growth it creates is a mirage.
So what will Beijing do? This is the year when policymakers must come to terms with the sustainability of the growth model. Depending on how they deal with key issues such as excess investment and excessively low interest rates, the adjustment will be more or less painful in the long run.
A real attempt to raise the household income share of GDP may hurt many constituencies that benefited from the growth model, especially as Beijing raises interest rates, probably the single most important step in the adjustment process. But it will make the transition easier and less socially disruptive than many expect.
The year 2011 may end up being the most important year for China's policymakers. It will set the stage for the next several years, during which China can either veer dangerously close to an investment crisis or begin rebalancing its economy.
Michael Pettis is the senior associate of the Carnegie Endowment for International Peace and finance professor of the Guanghua School of Management at Peking University