China faces crucial choice over future growth; Growth can be robust or consumption-led but not both

June 2, 2014 6:08 am

China faces crucial choice over future growth

By Manoj Pradhan

Growth can be robust or consumption-led but not both

China has always divided investor opinion. The biggest debate now is about the future path China’s growth will take. Bulls say the transition to sustainable growth will be smooth; bears argue it will be volatile. Yet both agree consumption will rise to offset weaker investment. The result? Economic growth of 6 per cent, give or take, led by consumption.

This may turn out to be wishful thinking. Growth in China can either be robust, or consumption-led, but not both. If China chooses consumption-led growth, it could also be choosing much lower growth than the 6 per cent or so most have in mind.

There are three reasons for this. First, high investment growth in the past few years has added capital and supported labour income and hence consumption. Lower investment growth would weaken that support.

Second, consumption-led growth needs a well-allocated stock of capital that can generate consistent returns and income growth. We are not there for China yet.

Finally, the historical precedent. Japan and Korea are the oft-cited examples of rebalancing. In both, consumption as a share of gross domestic product rose while that of investment fell. However, that “rebalancing” turns out to be more a mathematical tautology than an economic transformation.

Rebalancing trick

In both countries, investment growth and consumption growth fell, but the former fell faster, which mathematically attributed an increasing share of the pie to consumption. Japan never really transformed into an economy with even modest growth led by consumption, and Korea became more of an export story than one guided by consumption.

But why worry about this issue now, when the rebalancing could be a long way away? Because China may be at the crossroads sooner than we think. Which path China takes hinges critically on how quickly the People’s Bank of China continues the process of interest rate liberalisation.

The connection between China’s economic choice and financial liberalisation has a lot to do with China’s closed capital account. If investment has been implicitly “subsidised” because firms were paying low real interest rates, then the closed capital account means the subsidy had to be financed by “taxing” others – the households that earned a low real interest rate on savings.

If financial liberalisation leads to higher interest rates (which the PBoC governor expects will happen, according to a recent speech), then households will receive a higher interest rate and pay a lower “tax”. As a consequence, the “subsidy” to investment will also be lower.

We have already seen a preview of the movie. The second half of 2013 saw the removal of all restrictions on the lending rate and a de facto but partial liberalisation of the deposit rate through the advent of internet-based depositary institutions that offer households much higher rates than traditional banks.

With traditional banks encumbered by restrictions on the deposit rate, online depositary institutions offering higher interest rates were successful in attracting household sector savings. One way or another, the cost of attracting deposits went up. Coupled with no restrictions on the lending rate, it is no surprise that lending rates went up too. The result was a sharp slowdown in economic activity as real lending rates moved higher than trend GDP growth.

Liberalisation question

But do policy makers really want to pursue liberalisation from here? Haven’t they backed off and also injected liquidity into the economy?

The prospects for financial liberalisation are uncertain. Interest rate liberalisation preceded November’s reforms announcements. In March, the PBoC governor indicated that full interest rate liberalisation could happen within “one to two years”, which implies that incremental changes will have to be made over the next few months and quarters. Yet the International Monetary Fund/World Bank spring meetings in Washington DC in April introduced a more cautious line from China’s policy makers.

What will finally transpire is anybody’s guess, but the experience of the past 12 months certainly weighs in favour of a PBoC determined to liberalise, delever and transform China’s interest rate market.

If financial liberalisation continues, investors will probably see a shift towards consumption-led but much lower growth. On the other hand, if policy makers want to protect growth, we will need to see an increasing reluctance to liberalise further.

Whichever path China takes, investors will have to let go of either the robust growth or the consumption-led growth aspects of their long-term vision for China. To expect both appears to be too good to be true.

Manoj Pradhan is global emerging markets economist at Morgan Stanley