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The China Growth Fantasy

Yasheng Huang of MIT writes on WSJ: China’s economic growth has largely been driven by government-heavy-handed investments. Chinese economy lacks a real consumption base. So in hindsight, the “decoupling” theme now sounds almost ludicrous.

I see the key to solve the problem is to shift investment/consumption decision-making from government to individuals. But in order to nurture a good investment/consumption environment for individual investors, it requires establishing a social security system and an affordable healthcare system. Without them, individuals will still resort to precautionary savings and deposit their their money into the banks. And of course, since all large banks are controlled by the state, government thus replaces individuals in their decision making. So in this sense, privatization of state banks and simultaneous introducing foreign competition into the financial system will also help.

Remember the hype about “decoupling”? Not so long ago, Western analysts — in particular investment-bank economists — were peddling the idea that China had become a powerful economic center of its own, able not only to drive its own growth independent of the United States but also to power the global economy forward.

To the extent that these Wall Street economists are still employed, few would make that argument now. The economic numbers emerging out of China are sobering. Exports, still the backbone of the economy, are contracting for the first time in seven years, according to the latest data. They’re being driven down by slackening demand overseas. Even worse is the sharp decline of imports, a sure sign of falling domestic demand. These two developments taken together signal monumental economic challenges ahead. Clearly China is not bucking global trends.

So how did all the decoupling theorists get it so wrong? This isn’t an idle question. The decoupling theory itself was the product of faulty economic analyses that persist today, even as the decoupling theory falls out of favor. Debunking these claims carries important policy implications.

The fundamental problem, and a mortal bias of economists, is a fixation with simple measurements — especially GDP data. Ask a professional economist how many provinces China has and you are likely to draw a blank stare. But ask him what the GDP growth of China has been and he’ll quickly be able to tell you that China has grown at a double-digit rate for 30 years and that at this rate China will overtake the U.S. by 2035 (or some other date). GDP-centrism is endemic, and often comes at the expense of deeper analysis. Just look at the enthusiasm with which economists and analysts greeted Goldman Sachs’s famed “BRIC” report forecasting dramatic booms in Brazil, Russia, India and China — a report based on little more than fifth-grade mathematics.

This obsession with China’s impressive GDP growth often ignores discussion of what’s causing that growth and whether it’s self-sustained. This is where the decoupling enthusiasts stumbled, and where policy makers can still go seriously wrong. Consider, for example, data about the very slow growth of household incomes in China. This is particularly apparent in rural households. For the past 20 years or so, rural household income has grown at a rate half that of GDP growth. The slow household income growth, combined with rapid GDP growth, means that China has created a huge production capacity but it has done so at the expense of its own consumption base. This fact alone should have disproved the decoupling hypothesis. All the new “excess” production had to go somewhere, i.e., to the U.S. What’s more, the persistence of this gap suggests that over time, China’s growth has become more, not less, a derivative of America’s consumption appetite.

This raises the important policy question of why and how Chinese growth systematically undermined its own consumption potential. To answer this, one has get a grip on how China’s rapid GDP growth happened in the first place. Part of that growth is a result of economic liberalization, but the market-driven part is small and has been diminishing. Fixed asset investment, heavily controlled by the government, has risen to nearly 45% today, from a level of 30-35% during the 1980s. Much of the GDP growth since the mid-1990s has been a result of government-organized massive investment drives — in infrastructure, urban construction and urbanization. This government-heavy growth has done the most damage to China’s consumption potential, pushing the country further to a dependency on the markets of the rich nations.

Let me illustrate this point by an example. The following proposition will sound familiar to many foreign investors who have done business with Chinese local officials eager to get their investment capital: “Do you want 10 acres of densely populated land for your new factory? No problem. We will clear the land for you in three weeks.” Many foreign investors marvel at the “business friendly” attitude of local governments in China, especially in sharp contrast to the seeming incompetence of the Indian government to get things done.

But this “business friendliness” is the heart of the problem: The Chinese households often reap almost no financial benefits from the conversion of their residential land into industrial or commercial development. The Chinese government, thanks to its formal ownership of all land assets, can relocate households on a scale unthinkable in a market economy, often with compensation far below the fair market value of the land. This is why factory owners incur far lower costs in setting up operations in China as compared with other countries, and also is why thousands of skyscrapers can mushroom seemingly out of nowhere overnight in Chinese cities.

But China is not exempt from a basic economic principle: A cost to one person is an income to another. The fact that factory owners and developers in China incur lower costs means that the income to some other economic participant is low. Those who derive low income in China happen to be the majority of the population, especially the rural Chinese who have little political power to protect themselves. Thus one sure mechanism of private wealth creation — urbanization achieved when small landholders sell out to developers at market prices — is almost completely missing in China despite the fact that the country is urbanizing at a dizzying rate on the surface.

All this is significant beyond the esoteric confines of the decoupling debate. To truly rebalance the Chinese economy requires the Chinese government to focus on income growth of the Chinese people rather than being fixated with GDP growth. One straightforward way to do this is to adopt market pricing of land by permitting and encouraging competition when acquiring land from Chinese peasants as a part of its current stimulus package. In the past two years, the Chinese leadership has done a good job reducing the expenditures — such as taxes, education and health fees — of the Chinese peasants. It is time now to raise their income.

China is one of the few countries in the world endowed with the land mass, the energetic and talented population, and the entrepreneurship to become a true global economic powerhouse. But that potential has been squandered by a misguided development strategy that privileges production at the expense of consumption and uses political power to suppress costs rather than relying on market mechanisms to boost income. In the midst of a global recession, China, along with its 1.3 billion people, is paying a dear price for that mistake now.

Mr. Huang is a professor of international management at the MIT Sloan School of Management and the author of “Capitalism with Chinese Characteristics” (Cambridge University Press, 2008).

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