Why China can keep on going

September 2011 Arthur Kroeber

Managing director, GK Dragonomics Research Editor, China Economic Quarterly

What, me worry?

Six crises: the bear case

1. Chinas economy is an unsustainable investment bubble 2. Chinas housing market is an unsustainable investment bubbleghost cities prove it 3. Chinas investment is financed by an unsustainable and rapidly rising public sector debt 4. Chinas growth is dangerously unbalanced and there is not enough consumption 5. China is running out of surplus agricultural labor 6. Chinas growth is about to slow sharply because of the middle income trap

An answer for everything

1. Investment bubble?
Fact: Chinas capital stock is very low

2. Housing bubble?
Fact: China has a severe urban housing shortage

3. Too much debt?

Fact: Sovereign debt load is manageable and finances productive investments

4. Not enough consumption?

Fact: China has the fastest growth in per capita consumer spending in world history

5. No more workers?
Fact: Rural-urban labor transfer has a decade to run

6. Middle income trap?

Fact: There is no middle income trap
3

More investment needed (1)

Capital stock per capita in China and the US US$ at constant 2005 prices
$140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 2010 China 2010 China at PPP 1930 US 2009

Chinas per capita capital stock is far below developed country levels.

Chinas physical capital per head is about the same as Japans in 1970.
It is less than half that achieved by the US at the beginning of the Great Depression. It is less than one-fifth that of Japan at the beginning of its bust in 1990.

Capital stock per capita in China and Japan US$ at constant 1990 prices
$70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 2010 China at PPP 1971 at PPP Japan 1990 at PPP

China needs to invest a lot more before it achieves developed-country status.

There is no evidence that China is over built.

4
4

More investment needed (2)

China's capital-output ratio Net capital stock relative to annual GDP, at current prices
3.0 2.5 2.0 1.5 1.0 0.5 0.0

Chinas investment efficiency is well within the normal range.

There is no evidence to support claims that Chinas investment is in aggregate wasteful and inefficient.
For most countries, the ratio of capital stock to annual GDP (capital-output ratio or COR) is between 2 and 3.
Capital-output ratios in Asia Net capital stock relative to annual GDP, at current prices

4.0 3.5 3.0 2.5 1980 2007

Chinas is now at 2.4, boringly middle-of-the road, and substantially lower than that of the US, which is around 3. The increase in Chinas capital-output ratio since 1980 is also a normal sign of capital deepening, and much smaller than the increases in other Asian countries. 5
5

2.0
1.5 1.0 0.5 0.0 China Philippines Taiwan Indonesia Thailand South Korea Japan

Housing shortage (1)

Housing stock vs urban households, in m units
300 250 200 150 100 50 0 1998 2005 2009 2015f 300 250 200 150 100 50 0

Chinas housing market is in shortage, not bubble. Of Chinas 225m urban households only 150m are adequately housed.
Urban households: migrants Urban households: natives Units of independent housing

China still must house 1/3 of existing urban households (75m), plus 100m new urban households to be created over the next 20 years. After accounting for depreciation, this implies annual housing completions must average about 10m a year for the next 20 years vs 6m/yr in 2000-08. Many cities are building ahead of this demand creating ghost cities. But these are just Chinas equivalent of 1950s suburban Levittowns. 6
6

Housing shortage (2)

Migrant worker accommodation by type share of total
0.9% 3.9% 18.8%
Employer-supplied housing Shared rental Self rental

Few migrants own homes. The vast majority of the unhoused are recent migrants from rural areas, who account for about one quarter of urban households. Only 1% of migrant households own their home. Most migrants live in employer-supplied housing in factories or on work sites. Meeting migrant demand for housing will require a large increase in the supply of both purchase and rental units.

57.1% 19.3%

Other Own home

7
7

Public debt burden

China's public debt as share of GDP
100%

Public debt burden is manageable, even after 2009-10 stimulus.

90%
80% 70% 60% 50% NPLs on bank balance sheets Financial sector

Pre-stimulus, public debt was stable at 80% of GDP.

Explicit liabilities of the central government were just 26% of GDP in 2010.

40%
30% 20% 10% 0%

Local gov't
Central gov't

Local government debt jumped from 17% of GDP in 2008 to 36% in 2010.
But the contingent liability from bank NPLs has shrunk dramatically. 90% of other financial sector debt is PBC sterilization bills and policybank bonds; neither will likely cause a direct liability to the central government. Unlike US/Europe Chinas debt finances economically productive infrastructure. 8
8

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Strong consumption (1)

China's consumption paradox
50% 45% 40% 35% 30% 25% 20% 1996 1998 2000 2002 2004 2006 2008 2010 5% 10% 15% 20%

Consumption growth is very robust. Critics focus on the private consumption share of GDP, which fell from 46% in 2000 to 33% in 2010. Yet during the same period, real per capita consumption growth accelerated from 7% p.a. to 10%. Chinas per capita consumption growth over the past decade is almost certainly the fastest ever recorded by any nation. The falling consumption share of GDP is a natural phenomenon during a successful industrialization.

Private consumption share of GDP (lhs) Real growth in per capita private consumption, 3yma (rhs)

9
9

Strong consumption (2)

Decline in consumption share of GDP after take off percentage points
0

The fall in Chinas consumption ratio is similar to that of other Asian success stories. The fall in Chinas consumption ratio since 1990 is about the same as that experienced by Japan in 1995-70, and much less than that of South Korea in 1975-90. Consumption ratios normally when countries transition from agriculture to industry, because capital earns a greater share of national income. Even the US saw a 25pp fall in its consumption ratio from 1900-1950. The only thing unusual about China is how low its consumption ratio was when it started industrialization in 1980. This is a legacy of the communist system, which suppressed consumption, and may also reflect measurement problems. 10
10

-5

-10

Japan (T=1955) China (T=1990)

-15

South Korea (T=1975) India (T=2001)

-20

-25 T T+10 T+20 T+30 T+40 T+50

Consumption ratios in major Asian economies Private consumption share of GDP

100% 90% 80% India 70% 60% 50% 40% 30% 1955 1965 1975 1985 1995 2005 Taiwan Japan South Korea China

Lots more workers

Share of workforce in agriculture
70% 60% 50% 40% 30% 20% 10% 0% At $2,000 per capita GDP At $7,500 per capita GDP China South Korea Taiwan Japan

China still has plenty of agricultural labor waiting to move to the modern economy. By our estimate (lower than official figures), about 34% of the current Chinese workforce (268m people) is employed in agriculture. China has achieved faster growth, with less rural-urban labor transfer, than S. Korea or Taiwan. China has a higher share of workers in agriculture than did Japan, S. Korea and Taiwan at a comparable stage of development.

Agriculture and development in Asia

Share of workforce in agriculture
80% 70%

60%
50% 40%

Growth in those countries did not slow until the agricultural share of employment fell to about 20%.
Based on NE Asian precedents China can still plausibly enjoy another decade of high-speed growth based on transfer of workers from traditional agriculture to the modern urban economy. 11
11

30%
20% 10%

0%
0 5 10 15 20 25 30

Per-capita GDP, 000 US$ PPP

China 1980-2009
Taiwan 1963-2005

South Korea 1963-2005

Japan 1953-1990

Middle income trap (1)

Two types of successful catch-up growth Percentage of US per capita GDP at PPP
100 90 80 70 60 50 40 30 20 10 0 Pre-1970 low Recent average

Actually, there is no evidence for a middleincome trap. Our survey of 96 economies since 1970 shows that 80% of countries that started poor (<15% of US p/c GDP) are still poor today.

By contrast, one-third of middle-income countries in 1970 (15-50% of US p/c GDP) became rich by 2010.
So there is much more of a poverty trap than a middle income trap.

European integrators

Asian exporters

Two kinds of countries have achieved sustained catch-up to US living standards: countries on the European periphery, and Asian export champions. China fits comfortably in the second group. 12
12

Middle income trap (2)

Asia's partial catch up: Percentage of US per capita GDP at PPP
100 90 80 70 Japan Taiwan

Will China be more like Japan/Korea, or more like Thailand/Malaysia? In Japan, catch-up growth slowed at 75% of US p/c GDP and stopped at 90%. In Korea/Taiwan slowdown started at 5560% of US GDP.

60
50 40

South Korea
Malaysia Thailand China India

30
20 10

China is only at 20% of US GDP, suggesting another decade or two of fast catch-up growth is possible.
But there is some risk that it will follow Thailand/Malaysia, whose convergence slowed at 30% of US p/c GDP. However Chinas industrial structure and policy system much more closely resemble NE Asian models than SE Asian. 13
13

0
1950 1955 1965 1970 1980 1990 1995 2005
1960 1975 1985 2000

Middle income trap (3)

Which threshold will China hit? Levels of per capita GDP (% of US) where catch-up slowed
100

There is no pattern to when catch-up growth stops. Historically, the slowdown in catch-up growth starts anywhere from 20% of US p/c GDP (Thailand) to 80% (Finland). China has just begun to enter the very broad range where slowdown becomes more likely. The average slowdown threshold is 55% of US p/c GDP, suggesting China could have a continued long run of catch-up growth.

90
80 70 60 50 40 30 20 10

0
1952 1960 1968 1976 1984 1992 2000 2008 2016 2024 2032 2040 2048

14
14

Nothing to worry about? Well

Our exhaustive review of the evidence suggests that, with sensible policies, China can reasonably expect at least another decade of high-speed growth. But high-speed means average real GDP growth of 8% in 2011-2020, vs 11% in 2003-2010. Meanwhile, structural CPI inflation is rising because of an inexorably tighter labor market. In 1997-06 CPI inflation averaged 1%; in 07-11 (excluding 09), it averaged 5%. Slower growth and higher inflation mean that capital must be allocated more efficiently. This is especially true in light of the stimulus hangover of increased debt.
15

Credit over-easy
China bank loans and total credit
170% % of GDP

Deleveraging needed. Between 2008 and 2011 total credit soared from 117% of GDP to 160%. Much of the increase came from off-balance sheet shadow banking, which rose from a stable 18-20% of GDP in 19972008 to 42% in 2011. China shadow banking is mainly dressed-up bank lending, rather than the risky leveraged derivative products in pre-2008 US shadow finance. China successfully deleveraged in 03-08, thanks to nominal GDP growth of 18% p.a. With slower GDP growth, the next deleveraging will require greater capital efficiency. 16
16

160%
150%

140%
130% 120% 110% 100% 90% 80%

Total credit (incl 'shadow finance') Bank loans

1997 1999 2001 2003 2005 2007 2009 2011e

Concluding thoughts
Structurally, there is no reason why China cannot achieve average 7-8% growth, with average 5% CPI inflation, over the next decade. This performance would be about the same as Japans in the 1960s and South Koreas in the 80s. Financial sector reform to improve the efficiency of capital is essential to long-run (post 2020) growth. But financial reform would also attack one of the key pillars of Communist Party rule. If China grows without financial reform and deleveraging in the next decade, the 2020s could be a replay of Japans 1990s. But if it does deleverage, then the 2020s could see a solid average growth rate of 5-6%.
17

GK Dragonomics, a GaveKal company, is an independent research and advisory firm specializing in Chinas economy and its influence on Asia and the world.
www.gavekal.com www.dragonomics.net