China and the consumption transition
Consumption is increasingly driving China’s economy, perhaps marking the country’s much-needed transition to a more sustainable model.
But even if China is moving away, slowly, from its old model based on saving, investing, building and exporting, it is important to realize that the change brings with it new uncertainty, risks and the potential for disappointing growth.
China’s economy grew 7.4% in the third quarter, down from 7.6% in the preceding three months and marking the seventh consecutive quarterly slowing in growth. Underlying figures, however, gave some cause for optimism, particularly a 14.2% rise in September retail sales, a rise of a full point from the month before.
In the first nine months of the year consumption contributed 55% of Chinese GDP growth, outpacing the share of investment, which accounted for 50.5% (net exports subtracted 5.5%).
That’s welcome news: economists have long fretted about China’s growth model, which relied on capital investment at home and, supported by an artificially cheap yuan, exports abroad. While that helped to underwrite a stunning run of growth, it also kept savings rates high and consumption at home relatively low. It also helped to facilitate a build-up of debt which leaves China structurally vulnerable and subject to asset and investment bubbles.
The very idea of transition, even if inevitable, brings up the possibility of totally unpredictable step changes in the way in which China’s economy operates. These changes, again even if needed, might well be smooth but also might be sudden and unsettling.
That’s sparked much comparison with Japan, which enjoyed its own debt and investment-fueled period of growth, only to fall into a morass of deflation and continued poor allocation of capital.
With the rest of the world less willing and able to absorb China’s exports, and with real signs, such as in real estate, that debt was financing less and less viable projects, any sign of a transition to consumption at home is good news.
Like so much change for the good, however, it brings with it real problems and risks during the transition period.
First off, it is probably wise not to get too excited, even though 2012 would make the second straight year of consumption providing the lion’s share of growth. Chinese data is notoriously unreliable, and consumption includes government consumption as well as households, growth of which is both less sustainable and valuable.
Secondly, the very idea of transition, even if inevitable, brings up the possibility of totally unpredictable step changes in the way in which China’s economy operates. These changes, again even if needed, might well be smooth but also might be sudden and unsettling.
As Michael Pettis, a professor at Peking University’s Guanghua School of Management, argues, most of the economic forecasting on China takes as its underlying assumption that change will be fairly smooth and evolutionary, looking to predict changes in inputs and outputs. If something, however, is unsustainable – and much in China looks just that – then this approach fails, rarely but spectacularly.
“If we are on the verge of a shift in the development model – perhaps, and usually, because the existing model is unsustainable and must be reversed, the analysis has no value at all,” Pettis wrote in a note to clients this month, before the GDP data.
For a comparison, think about the relationship in the U.S. during the middle part of the last decade between interest rates, housing prices, construction employment and economic growth. Those relationships didn’t change little by little, but all of a sudden, and when they did all sorts of other relationships economists used to predict the future died with them.
Therefore, at the very least, signs of a change towards a domestic- and consumption-oriented economy in China means that there may be quite a bit more uncertainty over the future. As financial markets don’t like uncertainty, to the extent that they realize this, they will impose a larger discount on what they are willing to pay for Chinese financial assets.
This also makes forecasting demand for the many things China consumes much more difficult, at least in the short term. Over the medium and long term the trend is more clear: export-oriented investment for its own sake will diminish, though probably not before more capital is expended, making things even more difficult for industries abroad which must compete with China.
To be sure, long term, China’s transition away from an export-at-all-costs model is both good news and inevitable.
Expecting the US, much less Europe, to continue to eat as much as China cooks over the coming five or 10 years is simply unrealistic. Both have their own transitional problems to wrangle.
As with the US after its own model change, still ongoing, China’s transition period will be both fraught and extremely interesting.
(You can email Jim at email@example.com)