China’s economic rebalancing act is finally starting to pay off
With household consumption on the rise and the services sector expanding, a sustainable growth model is within China’s reach
The Chinese economy ended the first half of 2017 on a solid note, comfortably beating what is required to achieve the government’s full-year target of 6.5 per cent.
Data for second-quarter gross domestic product, released early this week, showed the economy expanded at a respectable clip of 6.9 per cent, well ahead of market expectations. While annual growth was level with the first quarter, sequential growth accelerated on a quarter-on-quarter basis, suggesting the economy has, if anything, gained further momentum following the usual seasonal pattern.
Besides the solid headline print, the details of the data also revealed some encouraging signs. Most noticeably, the structure of the economy has continued to improve, with growth rebalancing towards more sustainable sources.
According to the official data breakdown, household consumption accounted for close to 70 per cent of GDP expansion in the second quarter. Its share has risen by 13.5 percentage points over the past two years. At the same time, the investment share in the economy has fallen from 35.8 per cent to 32.6 per cent, suggesting a clear rebalancing from investment to consumption has taken hold. Even though this process has been accompanied by a slowdown in headline growth, the rebalancing – away from credit-intensive investment – is needed to take the economy off its debt binge.
Progressing hand-in-hand with rising consumption, the economy has also become more services-oriented. Second-quarter GDP data showed that the services sector had made up the largest part of the Chinese economy, commanding a 52 per cent share, and its growth had continued to outpace that of the manufacturing and agricultural sectors. Compared to a typical developed economy, where the services sector usually accounts for two-thirds of growth, China still has plenty of room to grow its tertiary sector, meeting the demand of its burgeoning middle class.
Promoting growth in the services sector is also positive for improving the structure of the economy.
Not only is services-sector growth more self-sustaining as it tailors itself to domestic consumption, it also tends to be capital-light (compared with manufacturing) and hence requires less investment and debt. Finally, the services sector tends to be dominated by private-sector businesses, which are generally more productive and less indebted than state-owned companies.
These arguments for more consumption and services-driven growth are not meant to downplay the importance of investment and the manufacturing sector. For a large and developing country like China, it is in fact more important that it invests in its manufacturing base and leverages international trade to develop its economy. This strategy has in fact proven successful in generating economic prosperity for Japan and the Asian Tigers (Hong Kong, Singapore, Taiwan and South Korea) and helped China lift hundreds of millions of people out of poverty.
China, in other words, has benefited tremendously from this investment/manufacturing/export-driven growth model in the past 30 years.
However, two problems have emerged since the 2008 financial crisis that have made this growth model unsustainable. First, so much investment was made in a short period after the financial crisis as Beijing tried to offset the negative impact from vanishing external demand. In retrospect, a sizable portion of this investment was not justified by economics and was made based on unrealistic future expectations.
As domestic growth slowed and external demand failed to rebound, the new production capacity became idle, investment returns plummeted and industrial prices declined precipitously. The persistent producer price index deflation (until last year) and industrial overcapacity were clear indications that China was approaching the end road of relying on its old growth model.
The second problem is debt. An investment-powered growth model typically requires adequate financing to sustain. While China’s high domestic savings can ensure a constant flow to credit without external borrowing, it cannot guarantee that these investments will generate sufficient returns to pay off the debt.
In fact, as business conditions deteriorated shortly after these investments were made, non-performing loans at banks started to rise and credit events accelerated. In recent years, more and more credit has been used to keep borrowers afloat instead of generating output, resulting in a general deterioration in credit utilisation. This has sent China’s debt-GDP ratio on an accelerated climb, fuelling talks that an imminent financial crisis is just around the corner.
Recognising these two problems, the Chinese government has been trying to engineer a rebalancing in the economy. Some successes have been achieved in recent years, as indicated by the official data and plenty of anecdotal evidence. However, given the still-severe imbalances, most noticeably in debt, further progress is clearly needed to avoid the doomsday scenario and set the economy onto a more sustainable path.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers