Ruchir Sharma: China’s Illusory Growth Numbers; Huge new flows of credit and public investment are delaying needed reforms and inflating a real estate bubble

Ruchir Sharma: China’s Illusory Growth Numbers

Huge new flows of credit and public investment are delaying needed reforms and inflating a real estate bubble.

RUCHIR SHARMA

Oct. 30, 2013 7:09 p.m. ET

Beijing appears to be on track, yet again, to hit its official growth target. According to China’s National Bureau of Statistics, gross domestic product rose 7.8% in the third quarter of 2013, well on its way toward hitting the official target of 7.5% GDP growth for the year. But can these numbers be trusted? Beijing has a long tradition of setting and then claiming to exceed high growth targets, which makes growth appear both rapid and stable. For years, China reported much less volatile economic growth than other developing nations, but lately volatility has all but disappeared. Since the start of 2012, China has reported a GDP growth rate within a few decimal points of the official target—every quarter.Another reason to question these numbers is that China’s second most powerful official has. In a 2007 cable revealed by WikiLeaks in late 2010, Chinese Premier Li Keqiang was quoted acknowledging that official GDP numbers are “man-made.” Mr. Li, who was head of the Communist Party in northeastern Liaoning province at the time, told then-U.S. Ambassador to China Clark Randt that he looked to more reliable numbers—on bank loans, rail cargo and electricity consumption—to get a fix on the actual growth rate.

Some economists now call these economic indicators the “LKQ Index.” That index shows that China’s economic growth was a lot weaker than officially claimed in the first half of 2013 and picked up in the third quarter only on a new round of stimulus to meet the annual GDP target of 7.5%.

Pressure to hit the official target has reached new highs as China’s Communist Party leaders prepare for a critical Central Committee meeting next month. With a per capita income of about $7,000, China has reached the stage of development when even the previous “miracle economies” of East Asia—Japan, Korea and Taiwan—began to slow, from a GDP growth rate near double digits to around 5% to 6%.

The Central Committee is expected to address key issues facing China in this middle-income phase, including the need to reduce the role of state-owned enterprises, promote fiscal reform and reorient the economy away from an overreliance on exports toward a stronger consumer sector. Though widely praised for the market reforms that got China this far, the Communist leadership seems fixated on a growth target that is no longer realistic for a middle-income country. This obsession will make the next stage of reforms difficult, if not impossible, to achieve.

At the start of this year, there had been signs that Beijing was ready to dial back on the huge new flows of credit and public investment that it unleashed to keep China growing at its target rate after the 2008 global downturn. But that course correction was short-lived. By July, the leadership was ordering up a fresh wave of credit and investment to reach its inflated target.

This approach is not going to produce genuinely sustainable growth. In recent years, China has pumped out new credit faster than any other country, and much of it is going to increasingly shaky investments, not new manufacturing muscle. Five years ago, it took just over a dollar of debt to generate a dollar of economic growth in China, but now it takes four dollars of debt to generate the same growth.

Much of today’s lending is going to real-estate speculation and local government vanity projects. Investment is growing at a 20% annual pace this year, much faster than consumption. This is the opposite of what China needs to create a stronger consumer sector and to reform other excesses—including property-market speculation, corruption and pollution—now threatening its old industrial model.

Why did Beijing return to this outdated path? China’s leaders may believe they need a GDP growth rate of at least 7% to avoid joblessness and social unrest, but this concern is misplaced. Every percentage point of growth in China’s maturing economy now produces 1.6 million to 1.7 million new jobs, up from 1.2 million 10 years ago. So even at a GDP growth rate of 5% to 6%, China would generate enough new jobs for its aging population and maturing economy, which has fewer young people entering the workforce.

China’s leaders may also believe they need high growth to ensure that the recent credit binge does not lead to a wave of bankruptcies. But a new wave of low-quality loans only puts millions more borrowers at risk. Loosening credit conditions have pushed up home prices by 17% this year in major cities, raising fears that this latest real-estate boom will end in a burst bubble.

China grew rapidly for three decades by relying on a huge base of low-income workers that no longer exists, and by building the manufacturing export industries that are essential to high productivity growth. This model has reached its limits. Japan and Germany followed a similar path in the postwar years, and their share of global exports eventually hit a peak of 12%—exactly the level at which China has flatlined in the past two years.

The manufacturing share of China’s economy is now 30%—the same as Japan at its 1970 peak. Consumption in China is already growing at 7% to 8%, the maximum rate any miracle economy has achieved. If consumption cannot grow faster, and the current rate of investment is dangerously high, then slower GDP growth is unavoidable.

Beijing’s devotion to hitting a 7.5% growth target is at the heart of China’s problems. That target comes from a rough estimate of the growth rate China needs to double its GDP by the end of this decade. This is a purely political ambition with no basis in economics, reminiscent of the man-made targets that guided the Soviet Union’s effort to catch up to the West. The lesson of that failed Communist experiment is that it would have been better to arrive late than never.

Mr. Sharma is head of emerging markets at Morgan Stanley Investment Management and author of “Breakout Nations: In Pursuit of the Next Economic Miracles” (Norton, 2012).