Challenges to China’s Growth: Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Nottingham University Ningbo, China November 9 th 2010

2 Challenges to China’s Growth “In the case of China, there is a lack of balance, co- ordination and sustainability in economic development.” Wen Jiabao, Premier of the State Council of the People’s Republic of China, September 2010

3 Challenges to China’s growth Potential Model Challenges Policies

4 1. China’s potential The simplest measure of the growth potential of an economy is its distance from the global productivity frontier. This can be called its “catch-up potential”. Despite more than 30 years of very fast growth, China is still far behind the frontier, with output per head, at common international prices (or “purchasing power parity), at a fifth of US levels.

5 1. China’s potential PATTERNS OF CATCH-UP GROWTH

6 1. China’s potential China is still so far behind the frontier, because it was extremely poor when rapid growth began after the shift to “reform and opening up”. GDP per head, at PPP, was only 3 per cent of US levels in the later 1970s. Today it is about the same ratio to US levels as that of Japan in 1950, before more than two decades of very fast growth. So China may have up to another two decades of very fast growth in front of it.

7 2. Model China is following what professor Michael Pettis of Peking University’s Guanghua School of Management calls a “souped-up” version of the “Asian model” pioneered by Japan and South Korea. The characteristics of this production-oriented model are: high investment, transfers from households to industry (via low interest rates, suppressed wages and a depressed exchange rate), rapid growth of exports and high external surpluses. China is “Japan plus”: with a higher investment rate, larger trade surpluses, lower consumption and much more currency intervention.

8 2. Model: fast growth

9 2. Model: investment INVESTMENT AS THE DRIVER OF DEMAND

10 2. Model: investment HOW INVESTMENT SOARED

11 2. Model: financial repression FINANCIAL REPRESSION

12 2. Model: exchange rate THE MANAGED EXCHANGE RATE

13 2. Model: exchange intervention CHINA’S FOREIGN CURRENCY INTERVENTION

14 2. Model: trade CHINA’S OPEN ECONOMY

15 2. Model: trade CHINA’S OPEN ECONOMY

16 3. Challenges So what might prevent China from sustaining the high growth model for two or more decades? Answers lie in: –Productivity; –Investment; –Finance; –Resources; –External demand; and –Geo-politics.

17 3. Challenges: productivity First challenge – raising productivity: –Further increases in the investment rate seem implausible. –That will make economic growth relatively more dependent on rising productivity. –There is some evidence that the rate of growth of whole economy productivity is slowing. –The lowering of the rate at which labour is transferred from rural activities to the modern sector will lower productivity growth. –So raising productivity growth will become ever more important.

18 3. Challenges: productivity INVESTMENT AS DRIVER OF SUPPLY

19 3. Challenges: investment Second challenge – managing investment: –China’s economic growth has been pushed by an extraordinary savings and investment effort. –Astonishingly, the country has emerged as both the largest investor, relative to gross domestic product, in the world and the largest exporter of capital, in absolute terms. –While a source of very rapid growth, this growth pattern also creates significant vulnerabilities.

20 3. Challenges: investment –Assume the incremental capital output ratio is close to 4. –Then a decline in the growth rate from 10 per cent to 5 per cent would reduce China’s warranted investment rate by 20 per cent of GDP. –If abrupt, that would generate a collapse in demand. –This does not seem to be imminent. But such a sharp adjustment is likely in the next 25 years. –When this happens, China must either shrink savings dramatically or increase its current account surplus enormously, if it is to balance its economy. –Otherwise, it would risk prolonged Japan-style recession.

21 3. Challenges: finance Third challenge – containing finance: –China’s growth has been driven by rising ratios of credit and money to GDP and heavy taxation of savers. –As the marginal returns on capital fall and bubbles become frequent, large banking sector losses become plausible. –Higher interest rates, to support household incomes and improve efficiency in the use of capital, would further squeeze the margins of the banking sector. – A move to open up the capital account, perhaps to support the internationalisation of the renminbi, would make the financial sector vulnerable to a severe crisis.

22 3. Challenges: finance MONETISATION OF CHINA

23 3. Challenges: resources Fifth challenge – managing resources: –China’s size means that, at any given level of development, it needs vastly more resources than other countries, except India. –This means that it shifts the terms of trade against itself, as it grows. –It also means that it has to secure vast quantities of resources. –If, for example, China were to have as many vehicles per head as Japan, its fleet would increase fifty-fold and world consumption of oil would almost have to double.

24 3. Challenges: resources IMPORTS OF THE “WORKSHOP OF THE WORLD”

25 3. Challenges: resources IMPORTS OF THE “WORKSHOP OF THE WORLD”

26 3. Challenges: resources COMMODITY BOOM

27 3. Challenges: resources ENERGY INTENSITY OF THE CHINESE ECONOMY

28 3. Challenges: world demand Sixth challenge – managing external demand: –China is already the world’s largest exporter and has the world’s largest current account surplus. –It also has had unsustainably rapid growth of exports. –Natural forces will tend to drive the economy into current account deficit, since export growth will be constrained by the growth of world trade, while import growth will be linked to the growth of the domestic economy. –This shift needs to be welcomed, since it will defuse tension and enhance the level of welfare at home.

29 3. Challenges: world demand EXPORTS OF THE “WORKSHOP OF THE WORLD”

30 3. Challenges: world demand CHINA’S SOARING TRADE

31 3. Challenges: world demand CHINA RISES TO THE TOP OF THE SURPLUS LIST

32 3. Challenges: geopolitics Seventh challenge – a premature superpower –China is a developing country and is also likely to remain a relatively poor country for decades, in terms of incomes per head. –But, by virtue of its size, it has a gigantic impact. Indeed, it is on its way to becoming a superpower. –As a result, it is one of the few countries – arguably one of two or three (if the European Union is viewed as one) – that must take account of the impact of its actions on the world economy. –China cannot just “import order”. It must “export order”, too.

33 3. Challenges: geopolitics CHINA’S LEAP TO THE TOP

34 4. Policies China has the potential to develop rapidly for another two decades, or more. But if it is to succeed it will have to: –Shift towards growth driven by domestic consumption. –Manage a decline in the investment rate. –Accelerate innovation. –Rebalance the economy away from growth of exports. –Further reduce the current account surplus. –Sustain an open world economy. –Increase resource efficiency. –Secure resources at manageable prices. –Help maintain a peaceful world.

35 4. Policies As the economy becomes bigger and more complex and its impact on the world grows, all this will become much harder. The premier has correctly defined the challenges. We all wait to see how the next generation rises to meet them.