China’s never-ending story

Michael Pettis is a finance professor at Peking University and a senior associate at the Carnegie China Center.

China’s recently released economic data illustrate just how difficult it has been for the authorities in China to implement economic policies to expand sustainable domestic demand.

While first-quarter GDP grew nominally by 8.4 per cent year on year (4.8 per cent in real terms), household disposable income rose by much less — 6.3 per cent — suggesting that the share of GDP retained by Chinese households declined by at least one percentage point over the past year.

Consumption put in an even more worrying performance. First-quarter retail sales — a widely-used proxy for consumption — grew year on year by just 3.3 per cent. This suggests that the consumption share of GDP declined by at least two percentage points over the year, partly because of higher, Covid-related savings and partly because of lagging wage growth.

On the other hand, growth in fixed asset investment, industrial output and exports soared. The trade numbers were especially instructive. In the first quarter of 2022, China’s total foreign trade grew a little faster than GDP, but this growth wasn’t evenly distributed. Exports grew year on year by 13.4 per cent, more than one and a half times the growth rate of the economy overall. Over that same period, imports grew by 7.5 per cent, more slowly than GDP and much more slowly than exports.

This really isn’t the way trade is supposed to work.

If the revenues generated by rising exports are properly distributed domestically, as they normally are in a well-functioning economy, imports should rise just as quickly as exports.

Instead, China had the highest first-quarter trade surplus in its history, the latest in a line of record-breaking trade surpluses. These surpluses are symptoms neither of manufacturing prowess nor of a culture of thrift, but are instead a consequence of the great difficulty China has had in rebalancing its domestic economy.

And yet for years Beijing has stressed the need to boost domestic demand, so what has gone wrong?

The problem seems to be that Beijing is only able to implement various forms of supply-side policies, including business subsidies, export subsidies, “window guidance” for bank lending, investment in infrastructure and logistics, business tax rebates and so on.

After three very successful decades of relying on supply-side measures to boost growth, Chinese authorities in the past decade have found it very difficult — almost certainly for both political and institutional reasons — to switch to demand-side measures to support growth.

Even when they specifically try to address consumption, they still end up proposing mainly supply-side policies. Last week, for example, the State Council, recognising explicitly the need “to boost consumption as part of the effort to keep economic fundamentals stable”, proposed a series of policy measures to increase consumption.

These consisted of tax rebates, better logistics and warehousing, improved policing of counterfeit goods, easier online shopping, a reduction of restrictions on automobile purchases, relief policies for hard-hit producers of consumer goods, and so on.

There were few if any demand-side proposals, however, that could boost consumption directly by increasing the share that households receive of their total production. All of the declared policies to support consumption do so by subsidising the production and distribution of consumption and export goods.

The problem is that while these various measures may affect the ways in which Chinese households spend on consumption, and may direct consumption into favoured sectors, they cannot actually boost the role of consumption in driving growth.

There are only two ways policymakers can increase the consumption share of GDP. One way is to force banks to increase consumer lending, which China did for many years but is now trying to rein in. The other way is to increase the household share of GDP — either directly, for example though higher wages, or indirectly, through currency appreciation, stronger social safety nets, or more state services.

These are literally the only two ways to raise consumption’s share of economic output. That is why China’s “consumption-enhancing” policies have not and cannot rebalance overall demand.

This isn’t because of any inherent superiority of demand-side policies over supply-side policies in supporting economic growth. Either set of policies can work, but under different circumstances. When business investment is constrained by scarce capital, poor infrastructure, or supply-side bottlenecks, as they were for the first three decade of China’s reform period, supply-side measures are likely to be most effective in boosting sustainable growth.

But when business investment is constrained by weak demand, as it clearly has been in China for over a decade, supply-side measures can only boost savings and excess capacity. In that case policymakers must implement policies that boost sustainable demand directly.

The good news is that an increasing number of prominent economic policy advisers recognise the problem, and have called for direct demand-side support.

Earlier this month, for example, Yao Yang, dean of Peking University’s National School of Development wrote in an essay that “promoting consumption remains a pressing priority”, to which end he recommended converting a portion of supply-side subsidies into demand-side support, specifically suggesting “giving the people cash to promote consumption.”

This won’t be easy to manage. After three-four decades of supply-side policies, many of them taken to extremes never before seen, it isn’t surprising that China’s political, financial, and legal institutions are powerfully structured around a continuation of such policies.

But until Beijing is able to shift towards implementing demand-side policies that boost the consumption share of demand — and with it, business investment — by directly or indirectly increasing the share ordinary Chinese households retain of China’s total production, we are likely to see the same sort of data throughout the rest of the year.

Economic growth will be powered by unwanted infrastructure investment, manufacturing subsidies, surging exports and rising debt, while household disposable income continues to lag, along with consumption and imports. For now, this remains the seemingly never-ending story of China’s economy.

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