China’s “dual circulation” drivel

Via News:

It doesn’t sound all that riveting: the fifth plenum of the 19th Communist Party of China’s central committee.

Nor does the 14th five-year-plan that sprung from the rubberstamping event, held in Beijing at the end of last month.

But buried beneath the bureaucratic bumpf is a radical new plan that China hopes will catapult it into an unassailable economic position, dominating markets and being able to shrug off US trade disputes. It also reveals an uncomfortable truth for Beijing.

It all revolves around two, seemingly benign words: “dual circulation”. Like “belt and road”, it’s a phrase from China that could soon become very common knowledge indeed.

…“It’s Xi’s solution to the US and bilateral tensions,” Professor Jane Golley of ANU’s Centre on China in the World told news.com.au.

At its core, dual circulation would look to overcome this weakness. It would split China’s economy into two spheres that would mean it was less dependent on goods and trade from overseas.

The first “circulation” is the domestic economy. Growing this will mean the nation is less prone to global economic shocks. In addition, making more stuff at home – from semiconductors to soy beans – will mean China won’t be stuck when the US or other nations choke off supply chains of vital products, which is happening now.

The second circulation is the international economy that China still intends to engage in.

Prof Golley said while the two circles may be close, they are also separate and the degree to which they interact could wax and wane depending on international tensions.

“China has never been more global that it is now. So, this is not about completely cutting off both circles but most fundamentally a push for technological self-sufficiency particularly in those sectors where there are tensions with US.

“There might be normal integration in times of non-crisis but more careful and different forms of integration in times of crisis,” she said.

It’s not a wholly new theory – but it’s the first time it has been so explicitly enshrined as the nation’s policy.

This is not a growth strategy it is rebranding. China has been trying to wean itself off investment in tradeables and boost domestic demand for a decade with no success. Michael Pettis at the FT describes the truth of it:

Will China double the size of its economy by 2035, as President Xi Jinping proposed at a Communist party conference three weeks ago? To do so, the Chinese economy must grow annually by just over 4.7 per cent on average for the next 15 years. It grew by 6.1 per cent last year, and by 6.7 per cent annually over the previous five years.

In that context, 4.7 per cent a year seems quite manageable. But while the calculations may seem straightforward, there are economic and demographic constraints that are not.

Every country that followed the high-savings, investment-led growth model that China adopted in the early 1990s — such as Japan in the 1970s and 1980s, or Brazil in the decade before — has gone through three distinct stages. The first stage, characterised by heavy investment in badly-needed infrastructure, delivered many years of rapid but unbalanced growth. In that stage, debt grew in line with the economy because when debt mostly funds productive investment, gross domestic product grows faster than debt.

In the second stage, as each country sought to rebalance demand away from investment, typically with little success, growth remained fairly high, although now driven increasingly by non-productive investment. When this happens, total debt in the economy must grow faster than GDP. So the debt burden rose.

Finally in the third stage, the country either reached its debt capacity limits or a worried government took steps to prevent debt from rising further. Either way, the economy was forced finally to rebalance away from investment and towards consumption amid far slower, sometimes even negative, growth.

China today is clearly in the second stage. Between 1980 and 2010, Chinese GDP doubled four times, but debt levels were low and rose slowly. However, between 2010 and 2020 when GDP doubled again, China did so by tripling its total debt burden to $43tn, so that it now stands, officially, at over 280 per cent of GDP.

Assume conservatively that the relationship between debt and growth doesn’t change, and China’s debt-to-GDP ratio will have to rise to over 400 per cent by 2035 if it is to double GDP again. This is a level that would be unprecedented in history. Everywhere else, growth collapsed long before debts reached levels close to this.

China can in principle reduce its dependence on debt by shifting domestic demand from investment to consumption, as Beijing has long proposed. Yet this requires that the household income share of GDP rise from roughly 50 per cent today to at least 70 per cent.

Beijing has long wanted to do this but with limited success, despite a decade of trying. There is still little to suggest the party is willing to tackle the institutional implications of the large wealth transfer from local governments and elites to households this entails.

There is also a demographic problem. From the late 1970s, China benefited from a rapidly rising working-age population, but this reversed around a decade ago. In fact, over the next 15 years, while China’s population will grow by an estimated 1.5 per cent, its working population will decline by an astonishing 6.8 per cent, and will continue to decline for the rest of the century. To put it in context, while today there are 4.7 Chinese of working age for every equivalent American, by the end of the century there will be only 2.4.

This has economic implications. Achieving GDP growth of 4.7 per cent with a declining working population requires as much productivity growth per worker as 5.2 per cent GDP growth with a stable working population. Growth in Chinese labour productivity has in fact fallen steadily since 2010. Looking ahead, a declining working population requires that the pace of this decline in productivity drops by nearly two-thirds if China is to double GDP by 2035.

None of this means that Mr Xi’s goal is impossible, but we must recognise the constraints. Absent China discovering an entirely new engine of economic growth to absorb the huge amount of debt-financed spending that now goes into non-productive investments, China can double GDP by 2035 only under one of two conditions.

Either there is in effect no limit to China’s debt capacity, or Beijing boosts consumption by managing a massive redistribution of income to ordinary households. History suggests that the former is very unlikely, and that the latter will set off substantial and unpredictable political and social change. Either way, it is an unlikely bet.

In short, “dual circulation” is a complete contradiction. In the absence of high productivity, to shift growth towards domestic demand one needs to allow wages and the real exchange rate to rise which, in turn, diminishes exports. Conversely, to lift exports one must cap wages which demands over-investment and debt-saturation for the high growth needed to keep the CCP in power.

I have no doubt that “dual circulation” will target areas of particular economic vulnerability especially relating to CCP security. China needs to remain engaged in the global economy so it can steal the IP it needs to offset weaknesses such as semi-conductors:

But that’s not a growth strategy. And by doing so it means China must also sustain the debt-addiction in the absence of domestic demand growth which only ensures that growth steadily bogs down into Japanification and secular stagnation.

The CCP will hide it, of course. It already does that by calculating GDP in ways that do not account for its bad investments and debt. We need to subtract 1-2% from growth to measure real output today.

The one number that is certain to keep growing strongly under “dual circulation” is fake growth!

David Llewellyn-Smith
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