A sharp drop in mainland car sales would reveal the big flaw in its economic strategy

What is happening to car sales on the mainland? Amid the excited press commentary about China overtaking Japan as the world's second-largest economy, there was some worrying news. Mainland car sales might contract by as much as 20 per cent in the second half of this year.

Why does this matter?

Because after growing 48 per cent in the first half of 2010, and 45 per cent last year, the sharp contraction will intensify the debate over mainland consumption growth.

In order to rebalance, the mainland must raise the consumption share of gross domestic product. Are policies aimed at boosting domestic consumption working?

On the positive side, car sales surged last year. Some analysts credit this increased demand to a shift in the consuming and saving behaviour of mainland households.

Sceptics disagree. They argue that the surge in demand for cars was caused mainly by government subsidies, and that these were not sustainable. More importantly, any current increase in car sales would be reversed in the future as households absorbed the cost of the subsidies.

The sceptics seem right. If car and other consumption is indeed weaker in the following months, as evidence seems to suggest, it should become increasingly clear that low consumption on the mainland is not a discrete problem that can be resolved with administrative measures.

It suggests instead that the consumption problem is fundamental to the mainland's economic growth model. It cannot be resolved without a big change in the model.

As is widely acknowledged, Beijing must create higher levels of consumption so as to reduce the mainland's reliance on increasingly unwilling foreign customers and increasingly toxic investment.

So what must it do? The key, it turns out, is household income.

Contrary to conventional thinking, mainlanders have no aversion to consuming. They are eager consumers, as the most cursory visit to a shopping mall will indicate.

So why do they consume such a low share of national GDP - perhaps the lowest share ever recorded? The answer has to do with the level of household income as a share of GDP, also one of the lowest ever.

Mainland households are happy to consume, but they own such a small share of total national income that their consumption is necessarily also a small share of national income. And just as the household share of national income has declined dramatically in the past decade, so has household consumption.

The key, then, is not to create additional incentives for consumption, to tinker with subsidies and taxes, or to change cultural habits. What is needed is a substantial increase in the share of national income that ordinary households take home. Give them money, and they will spend.

So how can their share rise? Here, the problem gets very difficult.

It turns out that fundamental to growth has been a system that channels wealth away from the household sector and uses it to subsidise growth, by restraining wages, undervaluing the currency, and keeping the cost of capital extremely low.

This model, which some refer to as the Japanese model and which many countries have followed before, has been extraordinarily successful in generating eye-popping growth, but it always runs into the same constraints: massive overinvestment and misallocated capital. In every case it has been very difficult to change the growth model because too much of the economy depends on hidden subsidies to survive.

Unfortunately the longer we wait to make the transition, the more difficult the transition will be.

Japan itself provides the most worrying example. It kept boosting investment to generate high growth well into the early 1990s, long after the true economic value of its investment had turned negative.

But, for a long time, the problem of misallocated investment, which was whispered about in Japan but not taken seriously, didn't seem to matter. By the early 1990s Japan had generated so much investment-driven growth that it had grown from 7 per cent of global GDP in 1970 to 10 per cent in 1980 and nearly 18 per cent at its peak in the early 1990s.

Less than 20 years later, after a terribly long struggle to adjust to high debt levels and massive overinvestment, Japan is about to be overtaken by China with only 8 per cent of global GDP. Japan has paid a terrible price for years of wasted investment, and this is why switching China's economic dependence from investment to consumption is so important.

Michael Pettis is professor of finance at the Guanghua School of management at Peking University and senior associate at Carnegie Endowment for International Peace

Screeching to a halt

Car sales might contract by as much as 20 per cent in the second half

That would come after car-sales growth on the mainland last year of 45 per cent and in the first half of this year of: 48%