China must sacrifice GDP growth to rebalance its economy

China has little choice: it needs to transition from an investment to consumption-driven economy, even if doing so will be painful
Since boosting consumption until it surpasses investment growth is practically impossible, China will need to slow down GDP growth altogether

Michael Pettis

Published: 4:30pm, 6 Oct 2022

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China was once blessed, and now is cursed, with an extraordinarily high investment share of GDP. According to the World Bank, investment comprises around 25 per cent of global GDP, ranging from the high teens and low 20s for more mature economies to the high 20s and low 30s for developing economies during their high-growth stages.

China is different. For decades it has invested an amount equal to 40-50 per cent of its annual GDP. This is an astonishingly high level, but whether it is a good thing or a bad thing depends, like much in economics, on underlying circumstances.

When China began its reform and opening up four decades ago, its economy was so severely underinvested for its level of social development that it benefited enormously from the high investment that propelled growth forward and accommodated the rising needs of Chinese businesses and workers.

By definition a good growth model is one that resolves the imbalances that have repressed development. The very success of China’s growth model, in other words, rapidly closed the gap between China’s actual level of investment and the level of investment its businesses and workers could productively absorb.

As the productivity benefits of additional investment declined, China’s high investment level would necessarily lead to a rising debt burden. This is what eventually happened to every country that has followed this growth model: a period of rapid, sustainable growth was followed by a period of still-rapid but unsustainable growth, driven by surging debt. This started to happen to China at least a decade ago.

That is why one way or another, even if it is possible to move some non-productive investment into more productive sectors, the investment share of China’s GDP must decline sharply in the next few years. Historical precedents suggest that the sooner this happens, the better for the long-term health and stability of the economy.

Workers at a construction site for the World Expo Culture Park in Shanghai on September 27. For decades China has invested an amount equal to 40-50 per cent of its annual GDP. But as the productivity benefits of additional investment declined, the debt burden has risen. Photo: Bloomberg

But this adjustment, which in every previous case in history has been very difficult, is much more difficult when a country starts from such a high investment base. This is probably because of the relationship between high investment levels and the financial, business and political institutions that drive the economy, with each reinforcing the other.

Because large economies cannot depend on an ever-expanding trade surplus to generate growth, the only meaningful alternative to investment is consumption. Reducing the investment share of GDP, as Beijing has long recognised, is simply the obverse of increasing the consumption share. This is what is meant by “rebalancing” in a Chinese context.

There are in principle three ways China can rebalance. One way – although this has never happened before – is for a surge in consumption growth to replace investment growth as the driver of GDP. If China can transfer roughly 2 percentage points of GDP every year from local governments and the rich to ordinary households, it is possible in theory to grow consumption by 6-7 per cent a year.

If investment grew roughly by 1 per cent annually, after 20 years of around 4 per cent growth, China would become a more “normal” economy, with investment representing a still-high 30 per cent of GDP.

The problem is that such large income transfers from local governments and the rich to ordinary households are politically difficult to manage without major changes in the country’s economic, financial and political institutions. This is probably why no high-investment country in history has ever managed such a transition.

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The second way China can rebalance requires a sharp slowdown in GDP growth. In this case, like Japan in the early 1990s, Beijing would implement policies that maintain consumption growth at roughly 3-4 per cent annually, even as GDP growth drops. With investment still growing annually by 1 per cent, average annual GDP growth would drop to roughly 2 per cent and, after 30-40 years, China would become a more “normal” high-investment economy.

The third way involves a very sharp, short-term contraction in GDP in which investment contracts far more sharply than household income and consumption. This, for example, is how the US rebalanced its economy in the early 1930s but while this form of adjustment tends to be more economically efficient over the longer term, it is usually a chaotic and politically disruptive process. Beijing will naturally do all it can to avoid this path.

The point is that it will be impossible for China to maintain such investment levels for much longer and there are arithmetically a limited number of ways China can rebalance its economy. They all require that after three decades in which consumption sharply lagged GDP growth, it must now drive GDP growth.

While this inevitably involves a difficult transition to a very different set of business, financial and political institutions, the choice is not whether China rebalances from investment to consumption, but rather how it manages the rebalancing.

This means that China’s overall GDP growth rate will depend crucially on the pace of future consumption growth. While it is possible in principle to engineer an acceleration in consumption growth, China’s experience over the past 15 years (not to mention Japan’s over the past 30 years) shows just how difficult this is.

But it is impossible to keep such a high investment share indefinitely. China must rebalance to get debt under control, and without much, much faster consumption growth, driven by substantial and politically contentious income transfers, the arithmetic is unassailable: the only way to rebalance involves much slower GDP growth.

Michael Pettis is a senior fellow at the Carnegie Endowment. His most recent book, co-authored with Matthew Klein, is Trade Wars Are Class Wars (Yale University Press)