(This post originally appeared on Stratfor, and can be found here.)
At the root of the East Asian model of economic growth is the need to maintain employment for massive populations. East Asian states in general have high population densities and histories of labour-intensive agriculture. Governments that do not provide stable employment conditions inevitably end up with large and unhappy populations on their hands — frequently the cause of revolutions. In the modern context, East Asian governments have focused on harnessing the savings of the population and controlling the country’s financial system to ensure credit is directed to expanding infrastructure and industrial capacity. Cheap credit enables businesses — especially export-oriented manufacturers — to maximise employment and output and seize greater international market share, bringing in more cash to perpetuate the cycle.
Following from the East Asian model of growth, China’s economic “miracle” relies on the channeling of massive household and corporate savings into fixed capital investment to build the roads, factories, trains and buildings necessary to modernize and expand economic activity. But a serious defect of the East Asian model is that it discourages the development of household consumption as a third source of growth to complement exports and investment. Families are encouraged to save (which helps the government finance national policies) rather than spend (which would assist the local economy), depressing household consumption. Increasing government investment in recessionary periods means building more production capacity despite weak demand (domestically or abroad). This practice cannot be maintained indefinitely, and East Asian states have tended to undergo transitions (sometimes very rocky ones) during which policies are adjusted to stabilise or boost domestic consumption while allowing fixed investment to taper off. The result — if the restructuring is successful — is a more balanced economy sustained by consumption while varying degrees of exports and investment contribute to its growth.
Both Taiwan and South Korea have gone through this process. In Taiwan, rapid growth in exports, savings and investment between 1962 and 1985 was accompanied by the decreasing importance of consumption to the overall economy. Taiwan’s exchange-rate deprecation in the late 1970s facilitated a rapid rise in exports, which outstripped domestic consumption as a share of gross domestic product (GDP). However, since Taiwan is a small island with limited room for heavy industry, capital formation never rose above 30 per cent of GDP, meaning the economy never became so reliant on investment as to detract from consumption. After 1983, Taiwan implemented financial liberalization to allow for more efficient, market-oriented allocation of capital and to help make the transition into a high-tech economy. This transition facilitated a rise in private consumption from 47 per cent of GDP in 1968 to 60 per cent of GDP in 2008. Today, Taiwan maintains a balance of consumption (60 per cent of GDP), exports (73 per cent of GDP) and investment (21 per cent of GDP).
Similarly, beginning in the 1970s, South Korea saw rapid growth in exports, savings and fixed investment, reaching the peak of fixed investment in the years leading up to and immediately following the Seoul Olympics of 1988. While geographically small, South Korea required large fixed investment to support the expansion of heavy industry by cheobol, or state-supported corporate conglomerates. Naturally, consumption fell as a portion of GDP until 1988, when it reached a low of 49 per cent. After this period, currency appreciation (which increased domestic purchasing power) enabled consumption to remain stable, while the resulting drop in exports was offset by an increase in investment. Even after the 1997 Asian financial crisis, when consumption dropped to its lowest point amid domestic financial troubles and recession, South Korea was able to recover rapidly on the back of a policy-supported domestic consumption boom from 1998 to 2002. Today, Korea balances consumption (55 per cent of GDP) with exports (53 per cent of GDP) and investment (about 30 per cent of GDP).
China, however, has not yet undergone this transition to consumer-led growth and remains heavily dependent on exports and investment. While consumption in Taiwan and Korea fell below half of GDP only once (and quickly recovered), in China consumption fell below half of GDP in 1990 and, especially since 2000, has continued to fall, hitting a low point of 35 per cent of GDP in 2008. Of course, household consumption grew in absolute terms during this period as family incomes improved and consumer markets expanded. But as a portion of the overall economy, household consumption fell while savings, fixed investment and especially exports grew. In other words, unlike other East Asian states, China has not succeeded in shoring up the consumption share of its economy. A major danger of this economic structure is that it makes China extremely vulnerable to global slowdowns that affect trade. In fact, when exports plummeted during the 2009 global recession, a surge in investment from government stimulus accounted for more than 90 per cent of growth while consumption contributed less than 10 per cent.
A variety of historical factors account for the metamorphosis of the South Korean and Taiwanese economies, in contrast to China, beginning with the obvious fact that their development process began earlier. It is not a coincidence that in both South Korea and Taiwan, the shift from state-guided investment to consumption-driven economies occurred in tandem with democratization. More private control over wealth generated more popular demand for control over other things, like political representation and governance. Moreover, these states set out on the path of modernization sooner and were supported every step of the way by the United States, which provided them with security, capital investment and expertise and granted them access to the world’s biggest consumer market. In China, the Communist Party remains resolutely opposed to popular-style governments that could challenge its regime and does not have the strategic option of opening its doors fully to the United States — though since its opening up in 1978 it has enjoyed the enormous advantage of exporting to the U.S. consumer market. Nevertheless, allowing greater domestic freedoms and more extensive foreign presence poses a threat to the Chinese regime’s unity and stability. These factors have contributed to the government’s reluctance to unleash the consumptive power of Chinese households.
Despite China’s inherent handicaps, the trend of falling consumption as a share of China’s economy was not inevitable. In the first decade of economic reforms, China experienced relatively balanced growth. Economic liberalization in 1979 unleashed 30 years of pent-up consumption as households, entrepreneurs and farmers gained the freedom to buy and sell. Consumption stayed at 50 per cent of GDP throughout the 1980s, while exports and fixed investment expanded at a gradual rate averaging 25 per cent and 18 per cent per year respectively. However, by the late 1980s consumption growth became unstable, as rapid inflation and political unrest forced the government to re-centralize control, including control over economic policy in order to cool down the overheating economy.
Consumption has never contributed as much to the Chinese economy as it did in the 1980s, though it enjoyed a period of relative stability from 1994 to 2000. In 1992, then-leader Deng Xiaoping launched a growth strategy focused on promoting the coastal cities as manufacturing and export powerhouses. Initially, the booming export economy and investment led to a rapid rise in private employment in the export sector, stabilizing the decline in consumption, but this proved unsustainable. By the late 1990s, coastal cities and state-owned enterprises were flooded with subsidized capital, much of it misallocated by government-controlled banks, and the domestic banking system was at risk because of an increasing number of non-performing loans and an overheating real-estate sector. Blaming the inefficient management of state-owned enterprises (SOEs) for the economic problems, the government launched major reforms that caused rising unemployment and a breakdown of the “iron rice bowl” — the welfare system for the masses of state employees. After Premier Zhu Rongji initiated the process of downsizing the state sector in 1995, 48 million jobs were lost and the state sector contracted by 3 per cent per year for the following decade. This downsizing, in addition to pro-export policies, resulted in China’s consumption as a share of GDP falling more than it ever had. It was not that Chinese consumers were not earning more and spending more — rather, it was that their overall contribution to the economy was smaller relative to exports and investment.
In the last decade, the Chinese economy has been driven primarily by fixed investment (44 per cent of GDP in 2008) and exports (32 per cent of GDP) at the expense of domestic consumption (35 per cent of GDP). Employment and wage growth have lagged behind rising costs for education, housing, health care and basic goods, leading to the rise in savings. And with few investment opportunities, most families deposit their savings in the state-run banking system, which converts the funds into government-planned investments. Meanwhile, consumers and small- and medium-sized businesses have trouble obtaining credit and must rely on their earnings for self-financing or on underground lending, thus perpetuating the high savings rate.
Limited capital for entrepreneurs and small and medium-sized enterprises has made China dependent on the export sector for employment. Over the last two decades, state-sector downsizing and a shrinking agricultural sector has put pressure on the Chinese government to create jobs. The relaxation of agricultural trade barriers leading up to China’s World Trade organisation accession, in addition to greater job opportunities in the booming cities, caused rural jobs to fall as a proportion of China’s labour force from 73 per cent in 1990 to 61 per cent in 2007. This created a contingent of at least 150 million migrant workers who move between rural and urban areas providing low-wage labour, which was soaked up — especially before the recent global recession — by export-oriented private and foreign enterprises. For most of the early 2000s, China’s economy increasingly achieved growth through foreign consumer demand rather than its own.
Emerging from the global economic crisis, China’s economy is in a period of flux, with exports diminishing in importance and government investment taking up the slack. There is much official rhetoric about economic “restructuring” to create sustainable household demand to drive growth in the future. Nevertheless, the economy at present retains the structure — and structural liabilities — of the patterns of development over the past two decades. The transition away from export dependency has only just begun, and stimulus policies targeting domestic-driven growth are necessarily temporary.
China’s increasing economic dependency on exports and investment — and the accompanying decline of consumption — has contributed to regional disparities. Looking at China’s provinces through the lens of economic structure, four major classes can be identified: those provinces that are the most heavily dependent on exports, those that are most heavily dependent on investment, those that show a relative balance and those with limited exports and investment.
The first category (orange on the accompanying map) consists of export-dependent regions, where exports generally take a greater share of regional GDP than consumption. These are the wealthy, cosmopolitan coastal provinces and municipalities, including Beijing, Tianjin, the Greater Shanghai region and Guangdong province. When Western countries speak of “China,” they refer to these vibrant manufacturing hubs. Xinjiang, the autonomous region in the far northwest and the single non-coastal province in this category, is a newcomer to the category due to a recent push by Beijing to deepen economic links to Kazakhstan and Central Asia. But the wealth of these export centres is deceptive, and they are really China’s most vulnerable regions. Not only are their economies extremely dependent upon international markets, but investment has surpassed what local consumption there is, making them uniquely vulnerable to factors well beyond their control.
Second (yellow on the map) come the investment-heavy regions, where fixed investment is vastly more important than consumption. Northeast China, previously known as Manchuria, the “Rust Belt” or old industrial heartland, lies in this category — a region kept alive by government subsidies and transfers. Sparsely populated regions such as Inner Mongolia in the north and Tibet in the west serve as geopolitical buffers that give China strategic depth and provide natural resources but otherwise have no economies to speak of. High fixed investment goes into the capital-intensive industries that exploit resources in these regions, including coal (China’s number one source of energy by far). Beijing also needs to maintain sovereignty over these buffer regions for them to serve a strategic purpose effectively. This category also includes landlocked, poor, populous and resource-rich provinces that lie next to wealthier coastal areas, such as Shaanxi and Shanxi in the north and Anhui and Jiangxi in the south. These regions are — and probably always will be — dependent upon monies from Beijing to subsidise their social stability. It is not a coincidence that Mao Zedong’s famous Long March began and ended in such regions (Jiangxi and Shaanxi, respectively).
Two neighbouring provinces on the eastern coast, Jiangsu and Shandong, as well as Hebei in the north and Heilongjiang in the northeast, fall into their own category (white on the map). These four provinces present as close a semblance of “balanced” economic structure as China can provide. Exports are beneficial but not essential, and though investment is more important than consumption, the discrepancy between these sources of growth is not as warped as it is in the investment-dependent regions. Both these provinces are wealthy and have large populations, diversified natural resources and vibrant light manufacturing sectors, and benefit from foreign trade and investment. Many leading Chinese politicians come from this area, and if China has a region that could ever achieve the “success” of Taiwan or Korea it would be comprised of some combination of these provinces.
Finally, there are the interior provinces (green on the map) that cannot develop export industries and where the investment share of the economy is not outrageously high (though often more than half of GDP). These range from the heavily populated central provinces known for providing migrant labour to other provinces (Henan, Hubei, Hunan) to the sparsely populated western provinces (Gansu, Qinghai) as well as the poor, relatively isolated and self-contained Sichuan and Chongqing provinces in the southwest. These areas are exceedingly poor in absolute and relative terms, but they are not dependent on the outside world or subject to the most rapid or volatile forces of change.
Despite the massive amount of public funds spent in 2009 and 2010 to boost domestic consumption, no amount of incentives or subsidies will enable Beijing to turn domestic household consumption into the engine of China’s growth in the near term. The past two decades of export-orientated growth have taken money out of the pockets of consumers to finance infrastructure and industrial capacity to the detriment of growth in consumer credit, wages and social services. The result is an economy with overcapacity, over-reliance on the outside world and anemic domestic consumption. A transition to a consumer-driven economy will take a long time and will come at the cost of rising unemployment for low-wage laborers from rural areas unable to find jobs in an economy that increasingly demands skilled labour. Rising unemployment in the export sector and falling government investment likely will create sociopolitical instability. Adding a sense of urgency to the dilemma, the Communist Party is preparing for a leadership transition in just two and a half years, and the outgoing administration must weigh the need for timely economic restructuring against the bleak realities of inertia in the system.
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