Michael Pettis on China’s new down is up economic model

Via FTAlphaville comes Michael Pettis,  finance professor at Peking University and a senior fellow at the Carnegie-Tsinghua Center.

Ever since May, when President Xi Jinping first introduced the concept of a “dual circulation” economic model, analysts who follow the Chinese economy have been struggling to understand exactly what the Chinese leadership has committed to. From the many subsequent formal references that have followed, it seems that Beijing’s new economic strategy calls for the country to continue to expand domestic production for exports (“international circulation”) while shifting the economy towards a greater relative emphasis on production for domestic consumption (“internal circulation”).

In principle this makes sense. Once it had closed the underlying gap between desired investment and actual investment — which it probably did in the early 2000s — China needed to base growth on domestic demand driven by rising wages, rather than depending on exports or on increasingly non-productive investment. Because China has relied so much on the latter, its debt burden has soared to one of the highest in the world.

But while “dual circulation” is presented as a new strategy, it really isn’t. Beijing has been proposing something similar since at least 2007, when a speech by then-premier Wen Jiabao promised that Beijing would make it a priority to rebalance domestic demand towards consumption.

This didn’t happen. The consumption share of Chinese GDP remains extraordinarily low, just two percentage points higher in 2019 than it was in 2007. Meanwhile, and not coincidentally, during this period China’s debt-to-GDP ratio doubled.

It will get worse this year. With the sharp decline of consumption relative to GDP — partly because of Covid-19 and partly because of Beijing’s production focused response to the pandemic — the consumption share of GDP will decline in 2020 to erase most of the gains it made since its low point a decade ago. Meanwhile China’s debt-to-GDP ratio, which rose by six percentage points in 2019, will rise an astonishing 16-20 percentage points in 2020. Little has changed since 2007, in other words, except for the country’s debt burden: demand in the Chinese economy is otherwise as unbalanced as ever.

Dual circulation by name, rebalancing by nature

This is clearly unsustainable and it is why it is so urgent for China to boost sustainable domestic demand. There are two major problems that Beijing faces with dual circulation, however. The first problem is that reorienting the economy toward domestic demand, whether you call it “rebalancing” or “dual circulation”, requires an economic, social and political transformation that is likely to be much greater than Beijing — and most Chinese and foreign economists, for that matter — seem to realise.

China’s low domestic consumption rates — among the lowest in history — is mainly the consequence of households retaining one of the lowest shares of GDP of any country in history. To rebalance demand towards consumption means nothing less than a major rebalancing of income towards ordinary households. For Chinese consumption to be broadly in line with that of other developing countries, ordinary households must recover at least 10-15 percentage points of GDP at the expense of businesses, the wealthy, or the government. This means rebalancing involves a massive shift of wealth — and with it, political power — to ordinary people. This will not be easy.

The second major problem is the internal contradiction at the heart of China’s new “dual circulation” model. China’s export “competitiveness”, as former Alphaville writer Matt Klein and I explain in our recent bookTrade Wars are Class Wars, depends on ensuring that workers are allocated, whether by wages or the social safety net, a very low share of what they produce. China’s export strength, in other words, depends, at least in part, on the low share workers retain of what they produce.

Here’s the problem. China can only rely on domestic consumption to drive a much greater share of growth if workers begin to receive a much higher share of what they produce, so the very process of rebalancing must undermine China’s export competitiveness.

This means that for “internal circulation” to succeed, “international circulation” must be undermined. One cannot boost the other, as Beijing proposes: the shift itself will require a difficult adjustment period.

Although the vocabulary has changed, the sustainable growth Chinese policymakers want still requires a major transformation in the way income is distributed to different sectors. Not only is the political challenge as great as ever, but because past Chinese growth has depended so heavily on the current distortions in income distribution, the transformation to a new model will almost certainly require a very difficult adjustment period. For dual circulation to work, internal circulation can only come at the expense of international circulation, and as this happens, wealth – and with it power – must be shifted from today’s elites to ordinary Chinese households.

Nothing new there whatsoever. In practice, it will no doubt continue the lurching of policy between slowing down and dropping more stimulus within the larger declining flight path into the middle-income and low growth trap forever.

David Llewellyn-Smith

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