Popular views abroad about imbalances in China's economic growth may be built on false premises

Why does China's economy generate such varied and heated views? Optimists see a rapidly emerging power that will soon overtake the United States. Pessimists see a house of cards that will soon collapse in a major financial crisis.

These alternative perspectives stem partly from the fact that China's growth model does not fit the Western stereotype. China's economic institutions are fragile yet the implementation of policies is strong. The costs of key inputs for production are distorted, yet what is being manufactured is exceptionally competitive in global markets. The income gap between the haves and the have-nots has grown rapidly yet about 500 million people have been pulled out of poverty. These paradoxes are shaped in part by differing ideological views but they also reflect a misinterpretation about the nature of China's growth process.

China's rapid economic rise over the past three decades has shown that strong implementation capacity at the local levels guided by centralized but collective decision-making processes can substitute, at least temporarily, for the market-based financial and regulatory institutions that characterize developed economies.

No one disputes that wages are too low, capital too cheap, and that land is misused in China. But since the country's products must compete in global and national markets, competitive regional pressures discourage the costly inefficiencies that led to economic collapse in other countries with extensive government interventions. And although increasing urban-rural disparities in having access to social services and opportunities have exacerbated inequalities, the rising living standards of the poorest segments of society compare quite favorably with other middle-income countries. This is the consequence of sustained double-digit growth rates.

But these accomplishments were achieved when global and national conditions were quite different to what present circumstances portend. This is that policies that served China well in the past need to be reconsidered.

Foremost in the minds of almost everyone, including China's senior leaders, is how to deal with what is widely perceived as an exceptionally unbalanced growth process. These imbalances are also seen as driving the trade surpluses with the United States. Compared with other countries, China's consumption to GDP ratio is exceptionally low, suggesting that consumers are being repressed. China's investment to GDP ratio is exceptionally high, suggesting a bias toward exports and low efficiency. This leads most observers to a standard solution: China must increase domestic consumption and dampen investment. In the process China's trade surplus should moderate, making it easier for the US to reduce its trade deficits with the rest of the world.

But this view about China's unbalanced growth may be misleading. Few pause to ask why these GDP numbers are so inconsistent with the prevailing impression that households have been indulging in a spending spree for years. There are countless reports of double-digit growth rates in retail sales. The property boom is driving demand for home furnishings and related services. How can one reconcile growth of about 20 percent a year in key consumption items with GDP numbers that show household consumption growing at less than 10 percent? Something is wrong.

Simple logic tells us that China's domestic consumption is seriously understated. This is due in part to the difficulties in moving to an accounting system used in market economies from what was used during China's central planning period. As noted by China's National Bureau of Statistics, more work is still needed to incorporate informal activities, non-cash transactions, and the rising costs of housing services into the official GDP figures. Adjusting for these statistical discrepancies may account for about half of the unusually low consumption to GDP ratio for China compared with other countries at a similar stage in their development. The rest can be explained by the declining share of household income as a share of GDP.

While much attention has been given to how the exceptionally low interest rates paid to savers have reduced household incomes and thus consumption, studies have shown that this has accounted for only a fifth of the decline in the share of income to GDP over the past decade.

Far more important has been the structural shift of workers from rural to urban activities and within the urban areas. As more workers move out of agriculture and into industry, which is obviously a good thing, labor's share of national income falls. This is because labor's share of income in agriculture is nearly 90 percent, but in industry it is only 50 percent. So even though workers enjoy higher earnings, and productivity increases when they move from rural to urban activities, the percentage of income that goes directly to workers declines.

And contrary to expectations, labor's share of income within industry is also declining. This is because of the expanding role of the private sector relative to the State. Labor's share of income in State-owned enterprises is higher than that of private companies, because State enterprises pay higher salaries and are more generously staffed. This partially explains why the private sector is more efficient. Thus, despite the numbers showing labor's decreasing share of income, the expanding role of private enterprises should be warmly welcomed.

But even as household incomes expand, consumption has not increased at the same rate because savings rates are rising. This stems in part from "precautionary savings" as households do not have total confidence in the newly created pension schemes. But it also stems from the very high savings rates of migrant workers in urban areas who lack formal residency rights (hukou) and thus are reluctant to spend as freely as established residents.

Things will change, but this will take time. Eventually as urbanization peaks, labor's share of income will begin to rise just as it has in other countries. As migrant families are given urban residency rights and the relative shares of State and private enterprises stabilize, the ratio of consumption to GDP will begin to increase - again, just as we have seen in other higher income countries. But China is still several years away from this turning point.

The other factor influencing the lower share of household consumption is the role of non-wage income. What differentiates China from other countries is that income from investments and government transfers accounts for a much smaller share of disposable income. In a socialist economy with all land and major enterprises owned by the State, the returns from these assets accrue largely to the State and not to private households in the form of dividends, profit sharing, and interest payments.

Under these conditions, the State needs to provide a much larger share of public social expenditure to supplement household consumption. But the reality is that China's social expenditure as a share of GDP is below, rather than above, the norm. Unless the government's budget provides more money for such benefits, it is almost impossible for China's share of consumption to GDP to rise to the same level seen in other countries.

Disagreements over China's economic trajectory will continue, because these changes will not happen overnight. And since trade balances are determined by the difference between what is produced and consumed domestically, without major budgetary reform China will continue to generate significant trade surpluses that will prolong its trade tensions with the West.

The author is a senior associate at the Carnegie Endowment and former country director for the World Bank in China. The opinions expressed in this article do not necessarily reflect those of China Daily.

(China Daily 09/09/2011 page9)