Is Chinese urbanisation really the answer?

Cross-posted from Kate Mackenzie at FTAlphaville.

Last week we ran a guest post from Yukon Huang of the Carnegie Foundation, which argued that China’s high rate of investment to GDP (which exceeds levels ever reached by obvious comparisons such as Japan and South Korea) is a consequence of China’s economic rise, not a problem in itself.

The imbalance, says Huang, merely reflects the urbanisation-industrialisation process — income rises and output grows as newly-urbanised workers earn more, but the proportion of their income spent on consumption falls for a time.

Adam Wolfe at Roubini Global Economics is not convinced, arguing that this is at best “an incomplete explanation for the shift in China’s growth model”.

The logic behind Huang’s argument is an extension of Arthur Lewis’s model, in which surplus labor migrates from the agricultural sector to manufacturing as an economy modernizes. Initially, labor is plentiful and capital is scarce, and capital earns higher returns than labor until the surplus is exhausted. Huang’s argument is that China is near this tipping point and that economic rebalancing will be a natural consequence of the demographic trend. Therefore, policy makers are likely to make a mistake if they target rebalancing. Instead, China should simply focus on “improve[ing] the efficiency of its urbanization process and develop more appropriate financing sources.”

To test the idea that savings rates and consumption are driven by urbanisation, he compares both relationships in the years 2000 to 2010 in 32 emerging economies:

The relationship is there but it is weak and, in both cases, China is the outlier. In fact, Wolfe says removing China leaves no correlation in the scatter plot, and the coefficient sign changes in the consumption comparison.

Wolfe argues that rather than an evolutionary process of urbanisation and development, China’s extremely high investment levels relative to consumption are the result of policies that transferred wealth from households to state-backed companies (emphasis ours):

Instead, specific policy decisions that transferred wealth from households to government-linked corporates appear to be the more likely culprit. As we’ve argued previously, negative real deposit rates, RMB undervaluation, changes in fiscal policy and weak land rights have all effectively taxed household incomes since the early 2000s. These policies better explain the decline in wages as a share of GDP than the increase urbanization. After all, consumption as a share of GDP was largely stable until 2001, even though the pace of urbanization was roughly the same in the 1990s as it was in the 2000s. These policy distortions, as well as the sharp decline in the dependency ratio that began around 1998, largely explain the increase in China’s savings rate as well.

Apart from specific repressive policies as the possible culprit, urbanisation itself may not be the growth-driving force that is sometimes assumed.

First, there’s the Chinese approach to urbanisation. It has to be remembered that the hukou or household registration system (which Huang mentions as a possible cause for an increase in the savings rate, and hence investment) is in itself a reason forwariness about China’s urbanisation actually driving the kind of growth that is generally assumed.

Then there’s the question of whether China’s top-down urbanisation strategy is simply building cities that are either empty or populated by indebted, underemployed citizens who were forced there on unfavourable terms.

The counter-argument that China’s rapid push to urbanise, even if it’s a little too rapid, will reap economic benefits in the end.

Is that a safe assumption? An Asian Development Bank working paper by Anett Hofmann and Guanghua Wan which looks at determinants of urbanisation argues that growth drives urbanisation, instead of the reverse.

Previous research, they say, has tended to ignore the question of what drives urbanisation, in favour of making assumptions about rural-urban productivity gaps, and going on to focus on the effect of government policies.

Hofmann and Wan had a different finding:

Taking advantage of the latest UN World Urban-ization Prospects, we use an instrumental variables approach to identify and analyze key urbanization determinants. We estimate the impact of gross domestic product (GDP) growth on urbanization to be large and positive. In answer to Henderson’s (2003) finding that urbanization does not seem to cause growth, we argue that the direction of causality runs from growth to urbanization. We also find positive and significant effects of industrialization and education on urbanization, consistent with the existence of localization economies and labor market pooling.