Tyranny of arithmetic will defeat Beijing's grand plan

Hong Kong officials have made a great song and dance over the past month about how their assiduous lobbying won the city a mention in Beijing's latest five-year plan.

They seem so pleased with themselves, it feels slightly churlish to wonder why anyone with a choice in the matter would want to be associated with a plan that looks so certain to fail in its central objective.

The main aim of the plan is to re-engineer the country's growth engine. Over the next five years, Beijing hopes to wean the mainland economy off its long-standing addiction to high levels of investment, instead promoting private consumption as the principal driver of growth.

It's a worthwhile policy objective. Last year investment made up almost half of mainland gross domestic product, a proportion everyone from Premier Wen Jiabao downwards acknowledges is unsustainable. Meanwhile, private consumption contributed just 34 per cent of GDP, the lowest level ever recorded for a major economy.

To restore some balance between investment and consumption, Beijing recognises that the growth rate will have to fall. Over the next five years it is targeting annual growth (adjusted for inflation) of just 7 per cent. That compares with an average annual rate of 11 per cent over the past five years.

To see whether these objectives are feasible or not, we can borrow a technique from physics and invert the problem. Let's assume that at the end of the five-year plan in 2015, Beijing has indeed met its policy goals, and then work what trajectory it would have to have followed to do so.

First let's assume that the mainland economy really does grow at a 7 per cent annual rate over the next five years. That will push gross domestic product up to 56 trillion yuan (HK$66.5 trillion) (in 2010 money), 40 per cent greater than last year.

Then let's assume the mainland achieves only a modest rebalancing. Let's assume the economy reverts to the situation that prevailed in 2005 - just before Wen warned that things were getting dangerously out of kilter - when investment and private consumption each made up around 40 per cent of GDP.

Now, for the share of private consumption in GDP to climb from 34 per cent to 40 per cent over five years in an economy growing at 7 per cent a year, simple maths tells us that consumption would have to grow at an annual rate (adjusted for inflation) of 10.5 per cent.

That might not sound too demanding, but it is over a percentage point faster than consumption growth last year, when Beijing was already doing everything it could to spur consumer demand.

Meanwhile, for the share of investment in GDP to decline from 49 per cent to 40 per cent over the same five year period would mean that investment growth would have to fall to just 2.75 per cent a year.

That's not going to happen. In an economy where fixed asset investment grew by close to 20 per cent last year (adjusted for inflation), such a brutal deceleration would cause severe economic whiplash, with widespread job losses.

In reality, no one seriously believes that average growth rates are likely to slow to 7 per cent over the next five years (at least in an orderly fashion) or that Beijing will be able to achieve a meaningful economic rebalancing in such a short timescale.

For example, in its economic outlook published yesterday, the Asian Development Bank forecast that the mainland economy would grow by 9.6 per cent this year and by 9.2 per cent in 2012. Investment growth will moderate but continue to be the main engine of China's expansion, says the ADB, with fixed asset investment growing at close to 20 per cent a year.

Meanwhile, private consumption growth is expected to pick up slightly in nominal terms. But with inflation rising, in real terms the increase is likely to be minimal.

In other words, the mainland's rapid growth is set to continue over the next two years, with investment growth far outstripping the growth of private consumption. The result will be that its domestic economy will become even more skewed towards investment at the expense of consumer demand.

That will make achieving the rebalancing outlined in the latest five-year plan impossible in the absence of an abrupt and painful slump in growth and investment in a couple of years time.

It's hardly a desirable outcome, which makes you wonder why it is that Hong Kong's officials have been so eager to sign up to the plan. It can't work.