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Four Theses on Chinese Growth

Jonathan Anderson
UBS Global Economics Team, Hong Kong

Background Paper for the National Committee on US-China Relations conference “China, the United
States and the Emerging Global Agenda,” July 13-15, 2008 at the Wye River Conference Center

Perhaps the biggest shock to the global economy since the end of the 1990s has been the
dramatic rise of the Chinese economy, which quadrupled in US dollar terms in the past ten years
alone. And one of the most pressing questions facing the world today is the ability of the
mainland to continue its rapid expansion going forward. In this short summary we review the
following four theses: The first is that China’s recent double-digit growth rates are unsustainable,
and that the economy will necessarily slow in the coming few years; indeed, the trends of the
past 12 months suggest we are already in the beginning stages of this process. Second, despite
this cyclical retrenchment the mainland economy should continue to expand at a trend rate of 9%
or even 9.5% in real terms for the next decade. Third, many of the commonly perceived risks to
the Chinese growth outlook – the banking system, fiscal performance, demographic changes –
turn out not to be significant threats at all. And fourth, this doesn’t mean that there are no
looming dangers on the horizon; in particular, volatility associated with ongoing external
liberalization and the question of raw material availability could potentially put a sharper brake
on growth down the line.

1. China’s recent growth rates are unsustainable. Over the past half-decade the Chinese
economy has seen four extraordinary changes: To begin with, since 2004 the trade and current
account surpluses rose to record highs as a share of the economy, exceeding 10% by the
beginning of last year. This sharp increase in net exports, in turn, pushed China’s economy into a
double-digit expansion with nearly 12% growth in 2007 – far in excess of what most economists
assume to be a sustainable pace. At the same time, household consumption expenditure shares
fell to record lows, well below the average for the past 30 years and significantly below regional
Asian experience as well. Finally, China’s gross domestic savings rate jumped to an
unprecedented 50% of GDP, again far higher than regional or global comparators.

These trends are extraordinary not only because China itself has never seen such extreme
levels in any of these macro indicators; they also represent a macro conundrum on an
international scale. Very few countries have seen such rapid swings in the internal and external
balance, especially in a non-crisis environment, and for an economy the size and scale of China
they are virtually unparalleled. Even more important, in comparator cases with a sharply rising
trade surplus the initial shock has always come from a similar fall in domestic investment
demand, whereas the current mainland swings were driven by a dramatic increase in domestic
savings while the investment/GDP ratio remained near historic highs.

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A full analysis of the recent imbalances is beyond the scope of this report, but suffice it to
say that the heart of the problem has been the truly massive expansion in Chinese heavy
industrial capacity since 2003, particularly in sectors like steel, cement, autos, shipbuilding and
machinery. This industrial buildout pushed down import needs and raised exports at the same
time, increasing GDP growth and corporate earnings while lowering the apparent consumption
share of the economy.

Some of this capacity expansion was likely driven by domestic overinvestment and
excessively loose credit policies; exchange rate undervaluation may also have been an important
factor. The key point here, however, is that for the most part this has been a cyclical rather than
structural phenomenon – and many of the above imbalances are beginning to reverse themselves.
China’s headline investment ratio has been falling steadily since the authorities first tightened
macro policies in 2004, industrial capacity growth has slowed, manufacturing utilization rates are
rising once again, the renminbi exchange rate is on a steady appreciation path and (most
important) the mainland trade surplus is no longer increasing. All of this suggests that the worst
of China’s unusual macro swings is already behind us.

As a result, there’s little doubt that headline growth will slow. Keeping in mind that
anywhere from 2pp to 3pp of the recent 12% real growth performance has come from net exports
(or the rising trade surplus), the reversal of China’s external position automatically means that
growth will slow to 10%, then 9% and perhaps as low as 8% as the net export contribution turns
negative. This is an unavoidable consequence of unwinding the imbalances of the past five years,
and should be the most important trend of the next few years to come. So the world should be
prepared for a slowing China.

2. However, 9% real GDP growth is a perfectly reasonable prospect over the next decade.
On the other hand, just as China’s recent growth upswing was cyclical in nature, the downturn
should prove to be short-lived as well. If we strip out the fluctuations in net export behavior we
find that domestic demand – i.e., consumption and investment spending in the economy – have
been far more stable, growing at 9% to 9.5% since 2004 with no sign of excessive volatility or
downward pressure. And as long as these two “core” components of growth continue to expand
at an unchanged pace, the Chinese economy will inevitably return to 9%-plus growth over the
medium term.

Why such a sanguine view of China’s medium-term prospects? We would highlight the
following elements:

First, to a very important degree the “China growth model” is none other than the well-
trodden Asian growth model. In strict macro terms, East Asia grew by generating high structural
saving rates, recycling those savings into equally strong levels of investment, opening their
economies to international trade and generating consistent factor productivity gains over time.
And on every point China looks just like its regional neighbors, with record-high saving and

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investment ratios and a very strong track record in external competition. Moreover, the areas
where China clearly has been different – i.e., its historical starting point of state enterprises,
communal agriculture, strict price controls and a closed economy – have actually allowed the
mainland to grow even faster, as market reforms and opening helped the economy record record-
high productivity gains as well. Going forward, just as Japan, the Asian “tigers” and parts of
ASEAN were able to maintain average real growth rates of 8% or more over many decades,
China should also have little problem sustaining continued high growth over the next 20 years (at
9% or more through 2015 and then around 7.5% through 2025).

Second, by any reasonable definition the Chinese is not an “export-led” economy, and thus
has relatively little to fear from a slowdown in developed countries. For outsiders looking at the
flood of goods “Made in China” rushing into US and European shops, it’s easy to conclude that
this must be the bulk of what the mainland produces, with the authorities essentially propping up
growth through the export sector. However, the macro numbers tell a very different story.
China’s export sector is by no means tiny, but it is still a very moderate share of the overall
economy, accounting for perhaps 14% of final expenditure demand, 9% of total value-added, 7%
of mainland employment and 5% of fixed capital spending; each of these numbers is far smaller
than in neighboring Asian countries. And despite the rapid growth of headline export turnover,
the actual contribution to GDP is rising much more slowly over time.

This helps explain China’s buoyant performance during the 2001 global IT downturn. The
events of 2001 constituted a nearly perfect laboratory case for the impact of an export slowdown
on Asia; not only was this the single largest negative trade shock that Asia had experienced in
the past 30 years, it was also spread more or less equally across the entire region, as every
country saw peak-to-trough export growth swings of 40 to 50 percentage points (and China was
no exception). As you might expect, small export economies like Hong Kong, Malaysia,
Singapore and Taiwan careened into sharp recession, while larger domestically-driven countries
like China, India and Indonesia escaped with only minor damage.

Third, mainland household consumption is stronger than commonly believed. As noted

above, the key problem in China is not that consumption slowed per se, but rather that industrial
output expanded so rapidly around it. For most of the past decade household income and
expenditure have been increasing steadily at 8% to 9% in real terms – not fast enough to prevent
a fall in the consumption/GDP ratio when the overall economy is growing at nearly 12%, but
certainly sufficient to support 9% structural growth over the medium term.

In fact, consumption growth may well accelerate going forward. One of the most striking
trends of the current decade is the pickup in farm incomes, as the favorable combination of (i)
rising food prices, (ii) higher migrant wage receipts, and (iii) increased fiscal support pushed
rural household real income growth from only 1% y/y in 2000 to over 10% y/y in the past three
years. As a result, the rural sector is finally catching up (in growth terms) with their urban
counterparts after a long period of malaise in the 1990s. And the driving factors behind this

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“rural renaissance” are should persist for the next decade: falling land supply, rising caloric
consumption and changing dietary patterns point to higher food prices over the medium term;
relative unskilled labor shortages as a result of demographic changes and the effects of the “one
child” policy will continue to push up low-end migrant wages; and the ongoing sharp increase in
tax revenues as a share of GDP is steadily increasing the government’s ability to redirect social
expenditure and production support back to the rural economy.

Finally, the current investment environment appears sustainable. Perhaps the most
controversial issue surrounding Chinese growth is the investment/GDP ratio, which is a good bit
higher than the already strong East Asian average. However, while the ratio should show a
continued decline from the 2003 cyclical peak over the next few years, there is surprisingly little
evidence of structural overinvestment pressures. Most of the trend increase in the mainland
investment share has come from housing construction; the corporate fixed capital spending share
of GDP has been stable, and the current housing boom looks well supported by ongoing
urbanization and middle-class demand. Every available measure of corporate returns has risen
steadily over the past decade – and most important of all, the best estimates of productivity
growth still show rapid efficiency gains.

Nor is China “running out of areas to invest”. The main drivers of growth so far this decade
– urbanization, the rise of the middle class, housing construction, transport and communication
infrastructure, stronger rural incomes and spending, etc. – have yet to show signs of strain, and
most analysis suggests that these should carry the mainland economy for at least another decade
to come.

3. There are few obvious pitfalls along the way. A discussion on China’s medium-term
growth would not be complete without a discussion of the possible pitfalls along the way. After
all, while high saving rates, strong investment and buoyant consumption are a good guarantee of
rapid future growth, emerging market experience is replete with unforeseen events like financial
or political crises can bring momentum to a halt. As it turns out, however, even seven years into
its current expansion cycle the mainland economy looks relatively robust; this section reviews
some of the most popular downturn scenarios (and why we believe they are generally

The first is China’s historical “boom-bust” cyclicality. Although the mainland has had high
average growth and productivity gains over the past few decades, the state’s role in the economy
and the banking system have made China the most volatile country in Asia. To date this
tendency has not derailed long-term growth prospects – but it nearly did during the 1996-98
downturn, when the government was forced to close or downsize tens of thousands of insolvent
firms and fire nearly 30 million state workers. Could it happen again?

In practice, we don’t expect a repeat of the dramatic 1980s or 1990s cycles going forward.
The early 1990s bubble, in particular, reflected a very specific set of circumstances: a sudden

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liberalization of the economy at a time when the government had virtually no tools to regulate
the economy. Today, the most crucial elements of the “boom-bust” economy (such as state
ownership and the lack of control of the banking system) have been considerably dismantled,
with much improved macroeconomic controls and regulation. This helps explain why the recent
2001-03 overheating period was more muted, and points to even lower economic volatility in the

The next common “disaster” scenario is a mainland banking crisis. Here, the most
significant factor is the unprecedented recent clean-up of the state commercial banking system,
which has reached hundreds of billions of US dollars in writedown and recapitalization costs,
and the considerable ongoing privatization efforts. As a result, bank balance sheets are now
cleaner than at any point in the past and the chances of economy-wide financial instability have
fallen dramatically. Barring a sudden, large-scale opening of the external capital account or an
overly hasty liberalization of deposit interest rates (discussed further below), it’s difficult to see
any near-term catalyst for systemic banking system problems.

Another popular concern in the past was fiscal instability – and indeed, if we were writing
on this topic ten years earlier, one of the main macro crisis scenarios would have involved the
threat of fiscal insolvency, as the sharp economic downturn and tentative taxation reforms had
pushed official budgetary revenue to less than 10% of GDP; at this level the government could
barely afford to pay civil service workers, much less fund health, education or other social
welfare functions, and was beginning to issue debt at a rapid pace. Since then, however, revenues
have rebounded sharply, allowing the government to expand social expenditure significantly; the
consolidated budget is running a growing surplus and gross debt outstanding has fallen to
negligible levels. Indeed, China’s fiscal position is now a source of significant comfort to macro
policymakers, as it allows the government to buttress adverse shocks with fiscal expenditure
stimulus if need be.

Demographics are also worth mentioning here. It is well understood that the Chinese labor
force will peak over the next 15 years, and that the overall population should stabilize by 2030 or
so; as this happens, the rising numbers of elderly retirees will push up the per-worker
“dependency ratio” significantly. Many observers worry that these trends could constitute a
serious challenge to the traditional mainland growth pattern, in the form of burgeoning labor
shortages and a rising pension burden.

Neither of these appears very likely, however. It’s certainly true that the rural labor market
has tightened significantly with visible acceleration in unskilled wage growth, but to date
Chinese producers have taken increased wage costs in stride and passed them on to overseas
buyers. Over time higher domestic costs should reduce competitiveness and bring an end to
China’s virtual monopoly on low-end manufactured goods, but this is nothing more than a
natural by-product of successful growth, as evidenced by similar transitions in Japan, Taiwan,
Korea and the other Asian “tigers”. Best estimates suggest that slower labor force growth will

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simply reduce the sustainable pace of real GDP growth to 7% or 7.5% by 2020, without further
complications. Pension concerns are generally overstated as well; as discussed above, the current
fiscal position is still improving in leaps and bounds; extremely low debt levels and one of the
world’s largest pools of available liquidity make it very easy to finance any additional
government liabilities; and perhaps most important, the lack of a well-developed defined benefit
pension system at present means that China has the luxury of determining future support levels
in a very flexible manner.

Finally, there is the common view that China has artificially propped up growth through
pervasive mispricing of resources, i.e., “cheap capital, cheap energy and a cheap currency”. This
mantra is a favorite among investors as well, and raises concerns that ongoing market
liberalization will entail painful adjustment in one or more of these areas. Regarding interest
rates, there’s no question that mainland real interest rates are low according to developed country
and other emerging market experience – but they are not low by high-growth Asian standards; in
anything, Chinese real rates are on the high side when compared with historical levels in Japan,
the four Asian tigers and the faster growing parts of ASEAN. The key here is saving rates; one of
the best-performing correlations in the emerging world is that between high structural savings
and low cost of capital, and once we account for this relationship there is little role left for
artificial government policy actions in explaining mainland interest rates today (and thus no
reason to expect real capital costs to rise aggressively going forward).

Turning to the currency, the renminbi certainly appears undervalued today given China’s
large external surpluses, but this is a very recent phenomenon; for most of the past 25 years
economists concluded that the currency was overvalued as a result of high inflation and net
capital outflows, and the main fear was a sudden renminbi devaluation. Even the more recent
experience is hardly a classic example of growth fueled by an artificially cheap exchange rate;
the rising mainland surplus was not caused by excessive export competitiveness but rather a
sharp drop in import spending concentrated in a few goods areas, i.e., it’s not completely clear
that the level of the renminbi had much to do with trade surpluses at all.

And the claim that China has propped up growth by chronically underpricing energy
resources is simply untrue. The mainland never subsidized fuel or electricity prices to any
significant degree in the post-reform era until the past year or two; it’s true that the sharp recent
spike in oil and coal prices has now left the economy with sizeable implicit subsidies – and as
argued below, rising commodity prices may well constitute a threat to growth – but this cannot
serve as an explanation for the high growth of the past few decades.

4. That begin said, some of the more serious potential threats includes external
liberalization, geopolitics and resource availability. What then do we see as the real potential
concerns for the next decade or two? As China continues to open its markets and increase its
level of engagement with the rest of the world, there are a couple of looming question marks.
The first concerns financial markets; one of the reasons the mainland never faced an outright

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crisis is that monetary and banking policies have always been carried out against a relatively
closed external capital and financial account. Emerging market economies have a very poor track
record of managing capital account liberalization (this played a major role in the 1997-98 Asian
financial crisis, for example), and China may well prove no exception. So far the authorities have
been very cautious in opening capital flows, but the process is already underway and is likely to
pick up speed in the next five years; this trend bears close watching.

The second and broader issue has to do with political relationships; anyone who has
followed mainland development in the past five years should be aware of the rapid expansion in
overseas investment, acquisitions and development assistance. As China’s involvement in
foreign affairs grows to match its economic might, there is a heightened risk of tensions and
“backlash” that could threaten growth prospects as well.

Last but certainly not least, in our view one of the biggest challenges to growth over the
medium term could easily come from outright resource availability and rising raw material costs.
Over the past ten years mainland began the process of moving from self-sufficiency to external
dependency in virtually every primary resource area (first oil, then minerals, now coal, and
agriculture will likely follow over the next few years), with visible impact on global commodity
prices. Already analysts are talking about potential shortages of coal this year given the lack of
transport infrastructure – and wondering how long it will be before resource-related strains put a
sharper brake on growth.

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