Pedalling prosperity

S P E C I A L R E P O R T

C H I N A ’ S E C O N O M YMay 26th 2012

CHINA.indd 1 15/05/2012 16:11

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IN 1886 THOMAS STEVENS, a British adventurer (pictured above), set o�on an unusual bicycle trip. He pedalled from the �ower boats of Guang­zhou in China’s south to the pagodas of Jiujiang about 1,000km (620miles) to the north. He was disarmed by the scenery (the countryside out­side Guangzhou was a �marvellous �eld­garden�) and disgusted by thesqualor (the inhabitants of one town were �scrofulous, sore­eyed, andmangy�). His passage aroused equally strong reactions from the locals:fascination, fear and occasional fury. In one spot a �soul­harrowing�mob pelted him with stones, bruising his body and breaking a couple ofhis bicycle’s spokes.

A century later the bike was no longer alien to China; it had becomesymbolic of it. The �bicycle kingdom� had more two­wheelers than anyother country on Earth. Many of those bikes have since been replaced bycars�one obvious sign of China’s rapid development. But even today thebicycle looms large in the battle for China’s soul.

For China’s fast­diminishing population of poor people, bikes re­main an important beast of burden, piled high with recycled junk. ForChina’s fast­expanding population of city slickers, the bicycle representseverything they want to leave behind. �I’d rather cry in the back of yourBMW than laugh on the back of your bicycle,� as China’s material girlssay. Some dreamers in government see a return to the bike as an answerto China’s growing problems of prosperity�pollution, tra�c and �ab.The country’s National Development and Reform Commission wantsgovernment o�cials to cycle to work one day a week, though only if thedistance is less than 3km.

Even if it is a fading symbol of Chinese society, the bicycle remains atempting metaphor for its economy. Bikes�especially when heavily lad­

Pedalling prosperity

China’s economy is not as precarious as it looks, says Simon Cox.

But it still needs to change

A C K N O W L E D G M E N T S

CONTENT S

In addition to those quoted in the

text, the author would like to thank

the following for their help in

preparing this special report: Vivek

Arora, Kent Calder, Stephen Green,

Han Gaofeng, Louis Kuijs, Edwin Lim,

Koji Nomura, Jack Rodman, Andrew

Sheng, Michael Spence, Murtaza

Syed, Mark Williams, Xiao Geng and

Wenlang Zhang

A list of sources is at

Economist.com/specialreports

An audio interview with

the author is at

Economist.com/audiovideo/specialreports

3 ExportsThe retreat of the monstersurplus

5 InvestmentPrudence without a purpose

6 Local governmentThe ballad of Mr Guo

8 FinanceBending not breaking

8 Cross­border �owsHomeric wisdom

10 Shadow bankingShades of grey

11 ConsumersDipping into the kitty

13 The next chapterBeyond growth

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Years since take-off

30

40

50

60

70

80

90

0 5 10 15 20 25 30 35 40

Private consumption

1The alchemy of China’s growth

Source: CEIC

Contributions to growth, percentage points:

3

0

3

6

9

12

15

18

+

–

1980 85 90 95 2000 05 11

Consumption Investment Net exports

China’s GDP growth% increase on year ago

Years since take-off

0

10

20

30

40

50

0 5 10 15 20 25 30 35 40

Investment

% of GDP: China South Korea Japan

Sanya (Phoenix Island)

Ordos(Kangbashi)

WenzhouYingtan

Shanghai

Dongsheng

Yingxiu

Jiujiang

GuangzhouShenzhen

Gushi

Beijing

Macau Hong Kong

X I N J I A N G

T I B E T

HEILONGJIANG

J I L I N

LIAONING

SHANDONG

JIANGSU

SHANGHAI

GUANGDONG

Q I N G H A I

HAINAN

GANSU

GUANGXI

NINGXIA

CHONGQING

GUIZHOU

SHAANXI

SHANXIHEBEI

BEIJING

TIANJIN

HENAN

H U B E I

SICHUAN

YUNNAN

ZHEJIANG

FUJIAN

I N N E R MO

N

GO

LI

A

G o b i De

se

rt

JIAN

GXI

AN

HU

I

HUNAN

Pearl RiverDelta

mand to China’s growth has always been exaggerated, and it isnow shrinking.

It is investment, not exports, that leads China’s economy.Spending on plant, machinery, buildings and infrastructure ac­counted for about 48% of China’s GDP in 2011. Household con­sumption, supposedly the sole end and purpose of economic ac­tivity, accounts for only about a third of GDP (see chart 1). It is likethe small farthing wheel bringing up the rear.

A disproportionate share of China’s investment is made bystate­owned enterprises and, in recent years, by infrastructureventures under the control of provincial or municipal authori­ties but not on their balance sheets. This investment has oftenbeen clumsy. In the 1880s, according to Stevens, China showed a�scrupulous respect for individual rights and the economy of thesoil�. The road he pedalled took many wearisome twists andturns to avoid impinging on any private property or fertile plot.These days China’s roads run straight. Between 2006 and 2010local authorities opened up 22,000sq km of rural land, an area the sizeof New Jersey, to new development.

China’s cities have grown fast­er in area than in popula­

en�are stable only as long as they keep moving. The same issometimes said about China’s economy. If it loses momentum, itwill crash. And since growth is the only source of legitimacy forthe ruling party, the economy would not be the only thing towobble. From 1990 to 2008 China’s workforce swelled by about145m people, many of them making the long journey from its ru­ral backwaters to its coastal workshops. Over the same periodthe productivity of the workforce increased by over 9% a year, ac­cording to the Asian Productivity Organisation (APO). Outputthat used to take 100 people in 1990 required fewer than 20 in2008. All this meant that growth of 8­10% a year was not a luxurybut a necessity.

But the pressure is easing. Last year the ranks of working­age Chinese fell as a percentage of the population. Soon theirnumber will begin to shrink. The minority who remain in Chi­na’s villages are older and less mobile. Because of this loss of de­mographic momentum, China no longer needs to grow quite soquickly to keep up. Even the government no longer sees 8% an­nual growth as an imperative. In March it set a target of 7.5% forthis year, consistent with an average of 7% over the course of the�ve­year plan that ends in 2015. China has been in thehabit of surpassing these �targets�, which represent a�oor not a ceiling to its aspirations. Nonethelessthe lower �gure was a sign that the central lead­ership now sees heedless double­digit growthas a threat to stability, not a guarantee of it.

The penny­farthing theory

Stevens’s 1886 journey across south­east China was remarkable not only for theroute he took but also for the bike he rode: a�high­wheeler� or �penny­farthing�, withan oversized wheel at the front and a dimin­utive one at the rear. The contraption is notwidely known in China. That is a pity, be­cause it provides the most apt metaphor forChina’s high­wheeling economy.

The large circumference of the penny­farthing’sfront wheel carried it farther and faster than anything that pre­ceded it, much as China’s economy has grown faster for longerthan its predecessors. Asked to name the big wheel that keepsChina’s economy moving, many foreign commentators wouldsay exports. Outside China, people see only the Chinese goodsthat appear on their shelves and the factory jobs that disappearfrom their shores; they do not see the cities China builds or theshopping aisles it �lls at home. But the contribution of foreign de­

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tion. This rapid urbanisation is a big part of the country’s eco­nomic success. But it has come at a heavy price in depleted natu­ral resources, a damaged environment and scrupulouslydisrespected property rights.

The imbalance between investment and consumptionmakes China’s economy look precarious. A cartoon from the1880s unearthed by Amir Moghaddass Esfehani, a Sinologist,shows a Chinese rider losing control of a penny­farthing andfalling �at on his face. A vocal minority of commentators believethat China’s economy is heading for a crash. In April industrialoutput grew at its slowest pace since 2009. Homebuilding wasonly 4% up on a year earlier. Things are looking wobbly.

But China’s economy will not crash. Like the high­wheeledpenny­farthing, which rolled serenely over bumps in the road, itis good at absorbing the jolts in the path of any developing coun­try. The state’s in�uence over the allocation of capital is thesource of much waste, but it helps keep investment up whenprivate con�dence is down. And although China’s repressedbanking system is ine�cient, it is also resilient because most ofits vast pool of depositors have nowhere else to go.

Not so fast

The penny­farthing eventually became obsolete, super­seded by the more familiar kind of bicycle. The leap was madepossible by the invention of the chain­drive, which generatedmore oomph for every pedal push. China’s high­wheelinggrowth model will also become obsolete in due course. As thecountry’s workforce shrinks and capital accumulates, its savingrate will fall and new investment opportunities will becomemore elusive. China will have to get more oomph out of its in­puts, raising the productivity of capital in particular. That will re­quire a more sophisticated �nancial system, based on a morecomplex set of links between savers and investors.

Other innovations will also be needed. China’s state­owned enterprises emerged stronger�too strong�from thedownsizing of the 1990s, but the country’s social safety net neverrecovered. Thus even as the state invests less in industrial capaci­ty, it will need to spend more on social security, including healthcare, pensions, housing and poverty relief. That will help boostconsumer spending by o�ering rainy­day protection.

The chain­drive was not the only invention required tomove beyond the penny­farthing. The new smaller wheels alsoneeded pneumatic tyres to give cyclists a smoother ride. In theabsence of strong investment to keep employment up and socialunrest down, China’s state will also need a new way to protect itscitizens from bumps in the road ahead. 7

Keep those wheels turning

THREE DINOSAURS LURK in a former factory district ofBeijing. Bright red, with �Made in China� embossed on

their bellies, they look like the cheap plastic toys China exportsto the rest of the world. But these model dinosaurs are life­sized,towering over passers­by. And they look hungry.

The three beasts are one of the imposing installations at the798 Art District in Beijing. Sculpted by Sui Jianguo, a former fac­tory worker, they are imprisoned in three cages, stacked on topof each other, like the 20­foot containers that carry the country’smanufactures to the world. In resin, bronze and steel, the sculp­ture embodies the widespread fear that China’s exporters willgobble up foreign markets and manufacturers. When it wasmade in 1999, the country’s exports were less than a third ofAmerica’s. Ten years later China was the world’s largest export­er. Of the toys shipped to America and the European Union,85­90% were made in China.

The country’s roaring exports contributed to a growing cur­rent­account surplus, which exceeded 10% of its GDP in 2007 (seechart 3, next page). China’s surpluses�its failure to import asmuch as it exported, spend as much as it earned, or invest asmuch as it saved�became an economic cause célèbre, generatingan equally impressive surplus of commentary and explanation.

Ben Bernanke, now chairman of America’s Federal Re­serve, argued that China’s surplus was adding to a �global sav­ings glut�. It was the subject of much debate and diplomacy atG20 summits, and the object of much blame and many bills inAmerica’s Congress. The latest of those, which passed the Sen­ate in October, calls for retaliation against any country that engi­neers an oversized surplus with an undervalued currency. MittRomney, the presumptive Republican nominee for president,has threatened to brand China as a currency manipulator on his�rst day in the White House.

China’s trade surplus with America remains large and con­troversial, but its current­account surplus with the rest of theworld is dying out. Last year it narrowed to $201billion, less than

Exports

The retreat of themonster surplus

China’s current­account surplus is on the verge ofextinction

Safely caged

weibo.com/pdfmags

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2 2.8% of the country’s GDP, the smallest percentage since 2002. Inmoney terms it was smaller than Germany’s.

Is that small enough? The Senate bill relies on IMF methodsto calculate a current­account �norm� for a country like China.Such calculations are more art than science: one exercise by theEuropean Central Bank estimated China’s norm 16,384 di�erentways. But an uno�cial study using the IMF’s methods calculateda benchmark of about 2.9% of GDP over the medium term,which suggests China’s surplus is about where it should be.Whether it remains there depends partly on why it narrowed inthe �rst place. In its latest World Economic Outlook, the IMF iden­

ti�es four reasons: China’s exchange rate, its terms of trade, glo­bal spending and China’s own investment expenditure.

China’s exchange rate has risen, if not as far or as fast asmany Americans had hoped. This appreciation can be measuredin various ways. The measure most economists watch is the reale�ective exchange rate (REER) adjusted for consumer­price in�a­tion and weighted by trade. This has gone up by 27% since July2005. An alternative gauge is the internal real exchange rate(IRER), which measures the price of Chinese goods that cannotbe traded across borders relative to the price of things that can.According to a study by the Hong Kong Institute for Monetary Re­search, China’s internal real exchange rate rose by over 35% be­tween July 2005 and December 2011 (see chart 2). This apprecia­tion encourages the Chinese to make more non­tradable goodsand to buy more tradable ones. Both help narrow its surplus.

The size of China’s surplus also depends on some volatileprices, such as the cost of crude oil and other commodities thatChina imports. The price of China’s imports has risen relative tothe price of its exports in recent years. According to the IMF, thisdeterioration in China’s terms of trade could explain up to halfthe drop in its surplus between 2007 and 2011. Those terms areunlikely to improve. As long as China remains the dominantforce in the market for its main imports and exports, it will con­tinue to in�uence the price of both.

This pincer movement shows up in surprising ways. OneBritish scholar argues that cheap Chinese exports have deterredburglaries in his country because a £19.99 DVD player is hardlyworth stealing. But others say that China’s imports of copperhave contributed to a rise in metal theft because China’s appetitefor such commodities has made them a more tempting target.

Domestic demand in China’s big trading partners has beenslow to recover from the crisis. China’s own spending, on theother hand, has surpassed all expectations. Investment as ashare of GDP rose by over six points between 2007 and 2010 asbanks lent liberally to help stimulate the economy. The IMF reck­ons that this rise in investment in itself accounted for between aquarter and a third of the narrowing of China’s surplus. But itmay also have been a contributory cause of some of the otherfactors, such as the rise in commodity prices and the increase inChinese wages and prices.

Will it return?

The surplus could widen again, for one of two reasons.First, China’s high investment could set the stage for a renewedexport boom. Second, China’s investment rate could falter with­out consumption rising to make up for it, forcing China to rely onforeign demand to keep the economy moving.

To imagine the �rst scenario, you only have to examine therecent past. Pieter Bottelier of the Conference Board, a think­tank, argues that China’s big surpluses before 2008 owed some­thing to an investment boom around the time China joined theWorld Trade Organisation in 2001. This investment created ex­cess capacity in industries such as cars, construction materialsand especially steel. At �rst these new factories displaced im­ports; then, when the domestic market proved too small, they�ogged their surplus wares on foreign markets instead. Chinawent from being a net importer of steel in 2004 to being theworld’s largest net exporter, note Brett Berger and Robert Martin

of the Federal Reserve. But a repeat is unlikely. It would re­

quire China’s low consumption rate tomove still lower to make room for somuch investing and exporting. It wouldalso require China to make further rapidgains in global market share.

The post­crisis investment boom was also di�erent fromthe post­WTO one. It was weighted towards inland provinces,far from the seaports that ship China’s goods to the rest of theworld. Inland China’s share of �xed­asset investment matchedthat of the coastal provinces for the �rst time in 2009, then ex­ceeded it in 2010. The investment boom in 2009­10 was also con­centrated in infrastructure and property. Neither can be tradedacross borders.

But some economists believe that the latest investmentboom will prove unsustainable. If construction collapses, someof the industries that fed China’s building rush will turn their at­tentions overseas, as they did in 2006.

The future of China’s ex­port monster thus depends onwhether China’s high invest­ment rate is sustainable. Manythink it is not. Economists likePaul Krugman, a professor atPrinceton University and acommentator for the New York

Times, have gone from bashingChina for its underpriced cur­rency to fretting about its over­priced property. Its spectacularbuilding boom has divertedChina’s energies inwards, suck­ing in imports and displacingexports. It has thus eased theworld’s fear of China. But it hasraised fears for China. 7

2Less cheap

Sources: Hong Kong Institute for Monetary Research Working Paper; BIS

China’s exchange rate, March 2005=100

2005 06 07 08 09 10 11 12

90

100

110

120

130

140

Internal real exchange rate

Real effective exchange rate

02 04 06 08 10

3Back where it belongs

Source: CEIC

China’s current-account surplusAs % of GDP

0

2

4

6

8

10

2001 03 05 07 09 11

The future of China’s export monster depends onwhether China’s high investment rate is sustainable.Many think it is not

1

GENGHIS KHAN SQUARE in Kangbashi, a new city in thenorthern province of Inner Mongolia, is as big as Tianan­

men Square in Beijing. But unlike Tiananmen Square, it has onlyone woman to sweep it. It takes her six hours, she says, thoughlonger after the sandstorms that sweep in from the Gobi desert.Kangbashi, or �new Ordos�, as it is known, is easy to clean be­cause it is all but empty. China’s most famous �ghost city�, it hasattracted a lot of journalists eager to illustrate China’s overin­vestment, but not many residents.

Ordos was one of the prime exhibits in an infamous pre­sentation by Jim Chanos, a well­known short­seller, at the Lon­don School of Economics in January 2010. Mr Chanos arguedthat China’s growth was predicated on an unsustainable mobil­isation of capital�investment that provides only for further in­vestment. China, he quipped, was �Dubai times 1,000�.

His tongue­in­cheek reference to the bling­swept, debt­drenched emirate caused a stir. But not everywhere in Chinashrinks from the comparison. One property development thatactively courts it is Phoenix Island, o� the coast of tropical Sanya,China’s southernmost city. It is a largely man­made islet, muchlike Dubai’s Palm Jumeirah. Its centrepiece will be a curvaceousseven­star hotel, rather like Dubai’s Burj Al Arab, only shapedlike a wishbone not a sail. The �ve pod­like buildings already upresemble the unopened buds of some strange �ower. Coated inlight­emitting diodes, they erupt into a lightshow at night, featur­ing adverts for Chanel and Louis Vuitton.

After a visit to Ordos or Sanya, it istempting to agree with Mr Chanos thatChina has overinvested from its northernsteppe to its southern shores. But what ex­actly does it mean for a country to �overin­vest�? One clear sign would be invest­ment that was running well ahead ofsaving, requiring heavy foreign borrow­ing and buying. The result could be a cur­rency crisis, like the Asian �nancial crisisof 1997­98. Some veterans of that episodeworry about China’s reckless investmentin tasteless property. But although Chinainvests more of its GDP than those crisis­struck economies ever did, it also saves farmore. It is a net exporter of capital, as itscontroversial current­account surplus at­tests. Indeed, for every critic bashing Chi­na for reckless investment spending thereis another accusing it of depressing worlddemand through excessive thrift. China isin the odd position of being cast as bothmiser and wanton.

Even an extravagance like Kangbashiis best understood as an attempt to soakup saving. The Ordos prefecture, to whichit belongs, is home to a sixth of China’scoal reserves and a third of its natural gas

(not to mention its rare earths and soft goat’s wool). According toTing Lu of Bank of America Merrill Lynch, Kangbashi is an at­tempt to prevent Ordos’s commodity earnings from disappear­ing to other parts of the country.

China as a whole saved an extraordinary 51% of its GDP lastyear. Until China’s investment rate exceeds that share, there is nocause for concern, says Qu Hongbin of HSBC. Anything Chinafails to invest at home must be invested overseas. �The mostwasteful investment China now has is US Treasuries,� he adds.

When talking about thrift, economists sometimes draw ona parable of prudence written three centuries ago by Daniel De­foe. In that novel the resourceful Robinson Crusoe, shipwreckedon a remote island, saves and replants four quarts of barley. Thereward for his thrift is a harvest of 80 quarts, a return of 1,900%.

Castaway capital

Investment is made out of saving, which requires con­sumption to be deferred. The returns to investment must be setagainst the disadvantage of having to wait. In Robinson Crusoe,the saving and the investing are both done by the same English­man, alone on his island. In a more complicated economy,households must save so that entrepreneurs can invest. In mosteconomies their saving is voluntary, but China has found waysof imposing the patience its high investment rate requires.

Michael Pettis of Guanghua School of Management at Pe­king University argues that the Chinese government suppressesconsumption in favour of producers, many of them state­owned. It keeps the currency undervalued, which makes im­ports expensive and exports cheap, thereby discouraging theconsumption of foreign goods and encouraging production forforeign customers. It caps interest rates on bank deposits, depriv­ing households of interest income and transferring it to cor­porate borrowers. And because some of China’s markets remainlargely sheltered from competition, a few incumbent �rms canextract high prices and reinvest the pro�ts. The government has,in e�ect, con�scated quarts of barley from the people who mightwant to eat them, making them available as seedcorn instead.

Investment

Prudence without apurpose

Misinvestment is a bigger problem thanoverinvestment

China’s answer to Dubai

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What has China got in return? Invest­ment, unlike consumption, is cumulative;it leaves behind a stock of machinery,buildings and infrastructure. If China’scapital stock were already too big for itsneeds, further thrift would indeed bepointless. In fact, though, the country’soverall capital stock is still small relative toits population and medium­sized relativeto its economy. In 2010, its capital stock perperson was only 7% of America’s (con­verted at market exchange rates), accord­ing to Andrew Batson and Janet Zhang of GK Dragonomics, aconsultancy in Beijing. Even measured at purchasing­power par­ity, China has only about a �fth of America’s capital stock perperson, depending on how its PPP rate is calculated.

China needs to �produce lots more of almost everything�,argues Scott Sumner of Bentley University, even if it does notproduce �everything in the right order�. Its furious homebuild­ing, for example, has unnerved the government and cast a shad­ow over its banks, which worry about defaults on property

loans. But it still needs more places for people to live. In 2010 ithad 140m­150m urban homes, according to Rosealea Yao of GK

Dragonomics, 85m short of the number of urban households.About three­quarters of China’s migrant workers are squeezedinto rented housing or dormitories provided by their employer.

Nor is China’s capital stock conspicuously large relative tothe size of its economy. It amounted to about 2.5 times China’sGDP in 2008, according to the APO. That was the same as Ameri­ca’s �gure and much lower than Japan’s. Thanks to China’s stim­

ulus­driven investment spree, the ratio in­creased to 2.9 in 2010, but that still does notlook wildly out of line.

Malinvestors of great wealth

In Defoe’s tale, Robinson Crusoespends �ve months making a canoe forhimself, felling a cedar­tree, paring awayits branches and chiselling out its innards.Only after this �inexpressible labour�does he �nd that the canoe is too heavy tobe pushed the 100 yards to the shore. Thatis not an example of overinvestment(Crusoe did need a canoe), but �malin­vestment�. Crusoe devoted his energy tothe wrong enterprise in the wrong place.

It is surprisingly hard to show thatChina has overinvested, but easier toshow that it has invested unwisely. OfChina’s misguided canoe­builders, twoare worth singling out: its local govern­ments (see box) and its state­owned enter­prises (SOEs).

China’s SOEs endured a dramaticdownsizing and restructuring in the1990s. Thousands of them were allowedto go bankrupt, yet those that survivedthis cull remain a prominent feature ofChinese capitalism. Even in the retail,wholesale and restaurant businessesthere are over 20,000 of them, accordingto Zhang Wenkui of China’s Develop­ment Research Centre.

SOEs are responsible for about 35%of the �xed­asset investments made byChinese �rms. They can invest so muchbecause they have become immenselypro�table. The 120 or so big enterprisesowned by the central government lastyear earned net pro�ts of 917 billion yuan($142 billion), according to their supervi­sor, the State­owned Assets Supervisionand Administration Commission (SA­

SAC). It cites their pro�tability as evidence

SINGING KARAOKE WITH Taiwanese in­vestors, smearing birthday cake on thecheeks of an American factory owner,knocking back baijiu, a Chinese spirit, withproperty developers: Guo Yongchangwould do anything to attract investment toGushi, a county of 1.6m people in Henanprovince, where he served as party secre­tary. His antics are recorded in �The Transi­tion Period�, a remarkable �y­on­the­walldocumentary about his last months ino�ce, �lmed by Zhou Hao.

Mr Guo persuades one developer toraise the price of his �ats because Gushipeople are interested only in the priciestproperties. After a boozy dinner he drapeshimself over the developer’s shoulder andextracts a promise from him to add morestoreys to his tower to outdo the one in theneighbouring city.

The one­upmanship exempli�ed byMr Guo has generated great economicdynamism, but also great ine�ciency.When the central government tries to stopeconomic overheating, local governmentsresist. Conversely, when the governmenturged the banks to support its 2008 stimu­lus e�ort, local governments scrambled toclaim an outsized share of the lending. Theresult is a local­government debt burdenworth over a �fth of China’s 2011GDP.

The worst abuses, however, involveland. Local o�cials can convert collective­ly owned rural plots into land for privatedevelopment. Since farmers cannot selltheir land directly to developers, they have

to accept what the government is willing topay. Often that is not very much.

Such perverse incentives have causedChina’s towns and cities to grow faster inarea than they have grown in population.Their outward ripple has engulfed somerural communities without quite erasingthem. The perimeter of Wenzhou city inZhejiang province, to take one example,now encompasses clutches of farmhouses,complete with vegetable plots, quackingducks and free­range children. This resultsin some incongruous sights. Parked outsideone farmhouse are an Audi, a Mercedes anda Porsche. Alas, they do not belong to thelocals but to city slickers who want their hubcaps repainted.

Oddly, where electoral reforms havegiven Chinese villagers a bigger say in localgovernment, growth tends to slow, accord­ing to Monica Martinez­Bravo of JohnsHopkins University and her colleagues. Thisis partly because elected local o�cials shifttheir e�orts from expanding the economyto providing public goods, such as safewater. But it is also because a scatteredelectorate cannot monitor them as closelyas their party superiors can.

Fear of their bosses and hunger forrevenues keep local o�cials on their toes.Mr Guo, star of �The Transition Period�, waseventually convicted of bribery. He was notentirely honest in the performance of hisduties, and not always sober either. Butwith all the parties, banquets and karaoke,no one could accuse him of being lazy.

The ballad of Mr Guo

What makes local­government o�cials tick

Boom, boom

The Economist May 26th 2012 7

SPECIAL REPORTCHINA’S ECONOMY

2 of their e�ciency. But even now, returns on equity among SOEsare substantially lower than among private �rms. Nor do SOEsreally �earn� their returns. The markets they occupy tend to beuncompetitive, as the OECD has shown, and their inputs of land,energy and credit are arti�cially cheap. Researchers at Unirule, aBeijing think­tank, have shown that the SOEs’ pro�ts from 2001to 2008 would have turned into big losses had they paid the mar­ket rate for their loans and land.

Even if the SOEs deserved their large pro�ts, they wouldnot be able to reinvest them if they paid proper dividends to theirshareholders, principally the state. Since a 2007 reform, divi­dends have increased to 5­15% of pro�ts, depending on the indus­try. But in other countries state enterprises typically pay out half,according to the World Bank. Moreover, SOE dividends are nothanded over to the �nance ministry to spend as it sees �t butpaid into a special budget reserved for �nancing state enter­prises. SOE dividends, in other words, are divided among SOEs.

The wrong sort of investment

Loren Brandt and Zhu Xiaodong of the University of To­ronto argue that China’s worst imbalance is not between invest­ment and consumption but between SOE investment and priv­ate investment. According to their calculations, if state capitalistshad not enjoyed privileged access to capital, China could haveachieved the same growth between 1978 and 2007 with an in­vestment rate of only 21% of GDP, about half its actual rate. Asimilar conclusion was reached by David Dollar, now at Ameri­ca’s Treasury, and Shang­Jin Wei of Columbia Business School.They reckon that two­thirds of the capital employed by the SOEsshould have been invested by private �rms instead. Karl Marxmade his case for collective ownership of the means of produc­tion in �Das Kapital�. Messrs Dollar and Wei called their riposte�Das (Wasted) Kapital�.

Perhaps the best that can be said of China’s SOEs is thatthey give the country’s ruling party a direct stake in the econ­omy’s prosperity. Li­Wen Lin and Curtis Milhaupt of ColumbiaUniversity argue that the networks linking the party to the SOEs,and the SOEs to each other, help to forge an �encompassing� co­alition, a concept they draw from Mancur Olson, a political sci­entist. The members of such a coalition �own so much of thesociety that they have an important incentive to be actively con­cerned about how productive it is�. China’s rulers not only ownlarge swathes of industry, they have also installed their sons anddaughters in senior positions at the big �rms.

The SOEs provide some reassurance that the governmentwill remain committed to economic growth, according to MrMilhaupt and another co­author, Ronald Gilson. The party o�­cials embedded in them are like �hostages� to economic fortune,�the children of the monarch placed in the hands of those whoneed to rely upon the monarch�. That gives private entrepre­neurs con�dence, because the growth thus guaranteed willeventually bene�t them as well�although they will have towork harder for their rewards.

What are the implications of China’s malinvestment for itseconomic progress? At its worst, China’s growth model adds in­sult to injury. It suppresses consumption and forces saving, thenmisinvests the proceeds in speculative assets or excess capacity.It is as if Crusoe were forced to scatter more than half his barleyon the soil, then leave part of the harvest to rot.

The rot may not become apparent at once. Goods for whichthere is no demand at home can be sold abroad. And surplusplant and machinery can be kept busy making capital goods foranother round of investment that will only add to the problem.But when the building dust settles, a number of consequencesbecome clear. First, consumption is lower than it could be, be­

cause of the extra saving. GDP, properly measured, is also lowerthan it appears, because so much of it is investment, and some ofthat investment is ultimately valueless. It follows that the capitalstock, properly measured, is also smaller than it seems, because alot of it is rotten. That would make for a very di�erent kind of is­land parable, a tale of needless austerity and squandered e�ort.

Fortunately there is another side to China’s story. It has notonly accumulated physical capital but also acquired more know­how, better technology and cleverer techniques. That is why for­eign multinationals in the country rely on local suppliers�andalso why they fear local rivals. A Chinese motorbike­maker stud­ied by John Strauss of the University of Southern California andhis co­authors started out producing the metal casings for ex­haust pipes. Then it learnt how to make the whole pipe. Next itmastered the pistons. Eventually it made the entire bike.

China �bears� like Mr Chanos sometimes neglect this sideof the country’s progress. In his 2010 presentation he comparedChina to the Soviet Union, another empire in the east that en­joyed a stretch of beguiling economic growth. Like the Sovietcommand economy, China is good at marshalling inputs of capi­tal and labour, he pointed out, but China has failed to generategrowth in output per input, just as the Soviet Union failed beforeit. Yet this analogy with the Soviet Union is preposterous.

Economists refer to a rise in output per input of capital andlabour as a gain in �total factor productivity�. Such gains havemany sources. One textile boss got 20% more out of his seam­stresses by playing background music in his factory, recalls Ar­nold Harberger of the University of California at Los Angeles.The striking thing about the growth in China’s total factor pro­ductivity is not its absence but its speed: the fastest in the worldover the past decade. Between 2000 and 2008 it contributed 43%of the country’s economic growth, according to the APO. That isjust as big a contribution as the brute accumulation of capital,which accounted for 44% (excluding information technology).Thus even if some of China’s recent investment has in fact beenwasted, China’s progress cannot be written o�.

And even if some of China’s past investment has been fu­tile, adding nothing worthwhile to the capital stock, there is aconsolation: it will leave more scope to invest later, suggestingthat the country’s potential for growth is even larger than the op­timists think. The right kind of investment can still generate highreturns. But what if the mistaken investments of the past disruptthe �nancial system, preventing resources from being deployedmore e�ectively in the future? 7

4Plenty of upside

Sources: Asian Productivity Organisation; IMF

Net capital stock and GDP per person, constant 2010 $’000

GDP per person

Cap

ita

l sto

ck p

er p

erso

n

0

50

100

150

200

0 10 20 30 40 50 60

China South Korea Japan United States

1980 19902000

2010

1980

1990

20002010

1990

2000

2010

20102000

19801990

SPEECHMAKERS LIKE TO claim that theChinese word for crisis (weiji) contains thecharacters for both danger and opportuni­ty. Most linguists dispute this. Either way,China’s economic policymakers don’t seemto believe it. For them, a crisis is a reason tobatten down the hatches.

In 1996 China’s government told theIMF that it intended to remove its controlson international capital �ows within �ve toten years. But when the Asian �nancialcrisis struck a year later, China’s govern­ment retreated into its shell.

Sixteen years later the timing looksbetter. Fear of capital out�ows has beenassuaged by China’s vast foreign­exchangereserves. The opposite danger�excessivecapital in�ows�has also eased. Indeed, theyuan has come under downward pressure atseveral points in the past year.

Reformers in the government are

testing the waters. In April regulatorsraised the amount that �quali�ed� foreigninvestors can venture in the country’ssecurities markets to $80 billion, and easedthe limit that similarly quali�ed Chineseinvestors can whisk out of the country. Thecentral bank also loosened its grip on thecurrency a little, widening the yuan’s dailyband from 0.5% either way to 1%.

China has no obvious need for foreigncapital: its own saving is more than enoughto meet its investment needs. So liber­alisers may have ulterior motives in mind,calculating that external liberalisation willforce the pace of domestic �nancial reform.If capital could move more freely acrossborders, the authorities would struggle tokeep interest rates arti�cially low�unlessthey were prepared to let capital �ee andthe currency fall.

By opening the capital account soon,

China could claim several prizes, reformersargue. Its investors could acquire foreign �rmsat low prices, thanks to European turmoil andAmerican caution. The country could also takeadvantage of the world’s disillusion with thedollar to promote the yuan as an internationalstore of value and medium of exchange.

Eswar Prasad of the Brookings Institu­tion calls this a �Trojan horse� strategy, afterthe gift horse described by Homer that trickedthe Trojans into opening their gates. Thereformers’ ploy poses some risks. If Chinaopens the capital account before it reforms itsSOEs, foreign lending may help feed theirinvestment hunger. An open border would alsomake it harder to contain a domestic bankingcrisis. A di�erent Homer put it best. Told thatChinese uses the same word for crisis andopportunity, Homer Simpson exclaimed: �Yes!Crisa­tunity!� A premature opening of thecapital account would be just that.

Homeric wisdom

Easier cross­border capital �ows may help liberalise interest rates

8 The Economist May 26th 2012

CHINA’S ECONOMY

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1

VISITORS TO SICHUAN’S atmospheric mountains, hometo both Tibetan and Qiang minorities, used to skip Yingxiu

village on their way to more scenic spots higher up. But the dev­astating earthquake that struck the area in May 2008 has turnedthe village into an unlikely tourist attraction. The earthquakekilled 6,566 people in the village, over 40% of its population. Its�ve­storey middle school collapsed, killing 55 people. Nineteenstudents and two teachers remain buried in the rubble.

Four years on, the crumpled school remains. It has beenpreserved as a memorial to the disaster, but almost every othersign of the quake has been erased. The village is full of newhomes with friezes painted in strong Tibetan colours. Otherbuildings are topped with �at roof terraces, a white concrete tri­angle in each corner, echoing the white stones that adorn tradi­tional Qiang architecture. The new homes look a little like Qiangstone houses on the outside, one villager concedes. �But insidethey are all Han.�

Yingxiu is an example of �outstanding reconstruction�, ac­cording to a billboard en route. Outside this showcase village,people have rebuilt their lives with less government help. Butthere is no denying that China set about reconstructing the earth­quake zone with a speed and determination few other countrieswould be able to match. A propaganda poster shows Hu Jintao,China’s president, bullhorn in hand, declaring that �NothingCan Stop the Chinese�.

The earthquake did great damage to the region’s property

and infrastructure. But although it left the local economy worseo�, the pace of economic activity picked up in the wake of the di­saster. There was much to do precisely because so much hadbeen lost. Even today the mountain road is lined with lorries.

Some economists worry that China may soon su�er a dif­ferent kind of economic disaster: a �nancial tremor of unknownmagnitude. Pivot Capital Management, a hedge fund in Monaco,argues that China’s recent investment spree was driven by a�credit frenzy� which will turn into a painful �credit bust�.

Lending jumped from 122% of GDP in 2008 to 171% just twoyears later, according to Charlene Chu of Fitch, a ratings agency,who counts some items (such as credit from lightly regulated�trust� companies) that do not show up in the o�cial �gures.This surge in credit is reminiscent of the run­up to America’s �­nancial crisis in 2008, Japan’s in 1991 and South Korea’s a few

Finance

Bending not breaking

China’s �nancial system looks quake­proof, but for

how long?

The school that became a shrine

The Economist May 26th 2012 9

SPECIAL REPORTCHINA’S ECONOMY

1

years later (see chart 5), Ms Chu argues.When Fitch plugged China’s �gures intoits disaster warning system (the �macro­prudential risk indicator�), the model sug­gested a 60% chance of a banking crisis bythe middle of next year.

China’s frenzied loan­making hastraditionally been matched by equallyimpressive deposit­taking. Even now,most households have few alternative ha­vens for their money. This captive sourceof cheap deposits leaves China’s bankslargely shock­proof. They make a lot ofmistakes, but they also have a big marginfor error. That will help them withstandany impending tremors.

But this traditional source ofstrength will not last for ever. China’s rich­est depositors are becoming restless, de­manding better returns and seeking waysaround China’s regulated interest rates.

The government will eventually have to liberalise rates. Thatwill make China’s banks more e�cient but also less resilient.

There remains great uncertainty about China’s �nancial ex­posure. Not all of the country’s �malinvestment� will result inbad loans. Some of its outlandish property developments, in­cluding the empty �ats of Ordos, were bought by debt­free inves­tors with money to burn. By the same token, not all of China’s�bad� loans represent malinvestment. Rural infrastructure pro­jects, to take one example, are often �unbankable�, failing to gen­erate enough income from fees, charges and tolls to service their�nancial obligations. But the infrastructure may still contributemore to the wider economy than it cost to provide. That is espe­cially likely for stimulus projects, which employed labour andmaterials that would otherwise have gone to waste.

But suppose a �nancial quake does strike China: how willits economy respond? Financial disasters, like natural ones, de­stroy wealth, sometimes on a colossal scale. But as China’s earth­quake showed, a one­o� loss of wealth need not necessarilycause prolonged disruption to economic activity as measured byGDP. Yingxiu su�ered a calamitous loss of people and property,but this was followed by a conspicuous upswing in output (espe­cially construction) and employment.

If this seems counterintuitive, that is because GDP is easilymisunderstood. It is not a measure of wealth or well­being, bothof which are directly damaged by disasters. Rather, it measuresthe pace of economic activity, which in turn determines employ­ment and income. Financial distress will damage China’s wealthand welfare, almost by de�nition. The interesting question iswhether it will also lead to a pronounced slowdown in activityand employment�the much­predicted �hard landing�. To put itin Mr Hu’s terms, can a �nancial quake stop the Chinese?

If the banking system as a whole had to write o� more than16% of its loans, its equity would be wiped out. But the statewould intervene long before that happened. Despite the ex­cesses of China’s local authorities, its central government stillhas the �scal �repower to prevent loans going bad, or to recapi­talise the banks if they do. Its o�cial debt is about 26% of GDP

(including bonds issued by the Ministry of Railways and otherbits and pieces). If it took on all local­government liabilities, thatratio would remain below 60%. Alternatively, it could recapital­ise a wiped­out banking system at a cost of less than 20% of GDP.

Even if many loans do eventually sour, banks do not haveto recognise these losses all at once. No loan is bad until some­one demands repayment, as the saying goes. In March the gov­

ernment released details of a long­rumoured plan to roll overloans to local governments. Many of these loans were due to ma­ture before the project they �nanced was meant to be completed.If the project is worth �nishing, this kind of evergreening is an ef­�cient use of resources. And some projects, once under way, areworth �nishing even if they were not worth starting.

Loan rollovers give banks time to earn their way out oftrouble, setting aside pro�ts from good loans before they recog­nise losses on bad ones. This task is easier in China than in othercountries because its �nancial system remains �repressed�.Banks can force their depositors to bear some of their losses bypaying them less than the market rate of interest. Indeed, depositrates are often below the rate of in�ation, making them negativein real terms. A bank’s depositors, in e�ect, pay the bank to bor­row their money from them.

Chinese banks can get away with this because deposit ratesare capped by the government, preventing rival banks from of­fering higher rates. China’s capital controls also make it hard fordepositors to escape this implicit tax by taking their moneyabroad. As a consequence, Chinese banks luxuriate in a vastpool of cheap deposits, worth 42% more than their loans at theend of 2011.

This cash �oat gives Chinese banks a lot of room for error.In 2011 new deposits amounted to 9.3 trillion yuan, according too�cial �gures, more than enough to cover fresh loans of 7.3 tril­lion yuan. Although deposit growth is slowing, these in�owsgive banks a cash bu�er, allowing them to keep lending, even iftheir maturing loans are not always repaid in full and on time.

A chronic complaint

So China’s �nancial strains will not result in the sort ofacute disaster su�ered so recently by the West. Instead, they willremain a chronic a�iction which the state and its banks will tryto ameliorate over time with a combination of government­or­chestrated rollovers, repression and repayment.

Such a combination is unfair to taxpayers and depositors,but it is also stable. According to Guonan Ma of the Bank for In­ternational Settlements, bank depositors and borrowers endedup paying roughly 270 billion yuan ($33 billion) towards the costof China’s most recent round of bank restructuring, whichstretched over a decade from 1998. However, some commenta­tors think that China will �nd it harder to repeat the trick in thefuture. Depositors are not as docile as they were. In �ts and starts,resistance to China’s �nancial repression seems to be growing.

�Let’s be frank. Our banks earn pro�ts too easily,� Wen Jia­bao, China’s prime minister, admitted on national radio in April.He is right. The ceiling on deposit rates and the �oor under lend­

5

*Fitch-adjusted credit †Estimate

Bubbles in the makingCredit as % of GDP

Source: FitchRatings

United States Japan China*South Korea

100

125

150

175

200

225

2002 04 0607 1994 96 98 1985 87 8990 2007 09 11 12†

2

10 The Economist May 26th 2012

CHINA’S ECONOMY

SPECIAL REPORT

1

ing rates guarantee banks a fat margin, preventing competitionfor deposits and allowing big banks to maintain vast pools ofmoney cheaply.

If the deposit ceiling were lifted, small banks would o�erjuicier rates to take market share from incumbents. Conversely,the big banks would trim their deposit bases as they becamemore expensive. Households would be better rewarded for theirsaving, and China’s banking �monopoly� would be broken, asMr Wen professes to want. In fact, though, the government is stilldragging its feet on rate liberalisation. Itshesitancy may re�ect the political clout ofthe state­owned banks. It may also re�ectthe government’s own fears.

Most developing countries (andsome developed ones too) that freed uptheir �nancial systems su�ered some kindof crisis afterwards. Upstart �rms canpoach the incumbents’ best customers,threatening their viability but at the sametime overextending themselves. Even inAmerica, rate liberalisation in the early1980s allowed hundreds of Savings andLoan Associations to throw their balancesheets out of joint, o�ering higher returnsto depositors even though their assetswere producing low �xed returns. In a2009 paper, Tarhan Feyzioglu of the IMF

and his colleagues strongly endorsed Chi­nese rate liberalisation. But they also ac­knowledged that it can be mishandled, cit­ing America’s S&L crisis as well as evenworse debacles in South Korea, Turkey,Finland, Norway and Sweden. The mostfamous study of these risks was writtenmore than 25 years ago. Its sobering titlewas �Goodbye Financial Repression, Hel­lo Financial Crash�.

The risks of repression

These are good reasons for caution,but not for procrastination. Repressedrates have their own dangers. To avoidthem, savers have overpaid for alternativeassets such as property, contributing toChina’s worrying speculative bubble. Inplaces like Wenzhou, a city in Zhejiangprovince, rate ceilings have encouraged�rms and rich individuals to make infor­mal loans to each other, bypassing the reg­ulated banking system in favour of unsafe,unprotected intermediation in the shad­ows (see box). The patience of the publicat large is also wearing thin. At a central­bank press conference in April, a journal­ist (from Xinhua, the o�cial mouthpiece,no less) refused to let go of the micro­phone until her complaint about negativedeposit rates was heard.

A growing number of depositors are

looking for ways to circumvent the ceil­ing. Those with lots of money to park aredriving the demand for �wealth­manage­ment products�, short­term savings in­struments backed by a mix of assets thato�er better returns than deposit accounts.

By the end of the �rst quarter of 2012 these productsamounted to 10.4 trillion yuan, according to Ms Chu of Fitch.That is equivalent to over 12% of deposits. Most had short maturi­ties, leaving buyers free to shop around from month to month.Banks accustomed to sitting on docile deposits may struggle tomatch the timing of cash pay­outs and in�ows, Ms Chu frets. Thebanking regulator may also be worried. It has now banned ma­turities of less than a month.

The recent proliferation of wealth­management products

THE SMALL­BUSINESS association of Wen­zhou, a city in Zhejiang province renownedfor its scrappy entrepreneurialism, used toinhabit spartan premises in the city centre,but in March it graduated to plusher o�ces15 �oors up on the fringes of the city. It is asign that Wenzhou’s brand of wheeler­dealer capitalism is being spruced up.

The desk of Zhou Dewen, the associa­tion’s head, must be ten feet long. But hestill does most of his talking on the couchor in a nearby restaurant where he enter­tains visiting businessmen. In his o�ce, MrZhou hears a pitch from Mao Shuhui, whoruns the province’s �rst and only etiquettecompany. Her clients include the local taxo�ce and a number of mostly state­ownedbanks. Their sta� sometimes need a fewpointers, she says. Their hair can be messyand their gestures impolite. Placing a�nger on each corner of her mouth, sheteaches them how to smile as though theymean it.

However wide their grins, China’sbanks have not been much help to mostWenzhou entrepreneurs. Long­established�rms like Ritai, the shoe­manufacturingout�t run by Mr Zhou’s deputy, Jin Zhexin,can get a loan if it is guaranteed by a morecreditworthy enterprise. But most Wen­zhou entrepreneurs have turned else­where. Businessmen with money to sparelend it directly to �rms in need, without abank as middleman. Wenzhou’s shadow�nancial system amounted to 110 billionyuan in 2010, according to one estimate,equivalent to 38% of the city’s GDP.

In escaping China’s �nancial repres­sion, however, the city’s informal lendingsystem also ducked out of its �nancialsafety system, including its prudentialsafeguards and its lender of last resort. As

the central bank tightened credit in 2010and 2011, desperate borrowers drew tooheavily on grey �nance, taking loans theycould not repay. Some simply �ed. Un­nerved, informal lenders began calling intheir loans and refusing new ones. The crisisfed on itself. Eventually the governmentcracked down on borrowers and lendersalike, so the money dried up completely.

In Wenzhou’s Fortune Centre, wherethe most successful lenders once congre­gated, all that is left of one shadow �­nancier are the indentations on a plaquewhere its name used to be. In anothero�ce, an erstwhile private lender has gonefor a completely di�erent sort of business,investing 10m yuan in a TV spy caper setduring the Japanese occupation. He wears aDennis Hopper T­shirt and keeps cans ofBudweiser in the o�ce fridge. In the pasthe could arrange a loan with a single tele­phone call. Now �the trust is destroyed.�

In the absence of trust, lenders de­mand more tangible collateral. The manag­er of Dongkai Pawnshop says his businesshas bene�ted from the crisis. People whocould previously borrow on the strength oftheir relationships must now o�er some­thing solid, like the 100g gold bar commem­orating the Beijing Olympics that is for salein the lobby.

In March the central governmentunveiled a number of sensible reforms totame the Wenzhou system without crushingit. Informal lenders will henceforth need tobe registered, more private capital will beencouraged and the issuance of high­yieldbonds approved. Yet the government stillresists the more elegant solution to theproblem proposed by Mr Zhou: allowingborrowers and lenders the freedom to setwhatever interest rate they like.

Shades of grey

Wenzhou’s shadow banking system has taken a knock

To avoid repressed interest rates, savers have overpaidfor alternative assets such as property, contributing toChina’s worrying speculative bubble

2

The Economist May 26th 2012 11

SPECIAL REPORTCHINA’S ECONOMY

2

1

ZHANG GUIDONG GREW up on a farm in Anhui, a poorinland province, where China’s economic reforms made a

humble beginning. He left home for Beijing in 1995 with only afew years’ schooling. First he sold belts and lighters in Tianan­men Square. When that was banned, he joined some friendsfrom back home in Beijing’s Silk Market, where he sold vegeta­bles and silk items to the sta� of the embassies nearby.

The Silk Market is famous for selling brand­name goods atsuspiciously low prices, often to tourists who seem to enjoy thecombination of rip­o�s and knock­o�s. Fined many times forselling fakes, Mr Zhang eventually decided to change his strat­egy. He sought a licence to sell genuine goods under the brand

�Hello Kitty�. A white bobtailed cat that �rst appeared on a pursein the 1970s, Kitty now counts as Asia’s answer to Mickey Mouse.

The brand’s guardians were initially worried by all thefakes on sale in the market, but in the end they were persuadedthat the place was trying to clean itself up. Mr Zhang’s business isnow doing well. In March he was set to move from his old ten­square­metre stall on the ground �oor to a 15­square­metre spoton the third �oor, where the market is grouping its more reputa­ble outlets. Most of the other stallholders are also from the coun­tryside, Mr Zhang notes. �I never dreamt that I could one dayhave a life like this.�

Most people think of China as an industrial powerhouse,not a consumer’s paradise. Household consumption as a per­centage of GDP fell for ten years in a row from 2001. By the end ofthat decade it amounted to only 34% of GDP, about 19 points be­low Japan’s lowest post­war ratio and 15 points below South Ko­rea’s. America’s consumption did not dip far below 50% of GDP

even during the second world war, as Mr Lardy of the PetersonInstitute for International Economics points out in his book,�Sustaining China’s Economic Growth�. But this declining ratiois deceptive. Consumption in China has actually been growingfaster than in any other big country. It is just that China’s GDP hasbeen growing even more rapidly.

Consumption always lags income, both on the way up andon the way down, argue Carl Bonham of the University of Ha­waii at Manoa and Calla Wiemer of the University of SouthernCalifornia. This is partly because people choose to �smooth�their consumption over time, but also because people generallyhesitate to abandon a lifestyle to which they have grown accus­tomed. Although China’s output and income surged after 2000,its consumption habits have yet to catch up.

Bootstrap businessmen from the boondocks do not alwaysknow what to do with their newfound wealth, according to re­search by Jacqueline El�ck, a cultural anthropologist. One cou­ple, newly arrived in Shenzhen, lined their entire �at with bath­room tiles. Another complained that their bathroom windowslacked the blue translucent glass found in rural toilet blocks. Ahomebuyer who had never previously lived in anything biggerthan a two­room �at took a residence with six rooms, �lling fourof them with dining suites.

But consumer habits are evolving. In Shenzhen, notes MsEl�ck, the constant churn of the population and relative absenceof established hierarchies means �you are what you buy.� Thenew rich announce themselves by spending profusely. They fa­vour �heavy ornate furniture in faux Baroque�. In Sanya, an ad­vert for one luxury residence shows a painting of Napoleoncrossing the Alps hanging on the wall as a woman in a low­

Consumers

Dipping into the kitty

Chinese consumption is about much more than

shopping

6Squeezed

Sources: Barclays Capital; The Economist *To include undermeasured consumer spending

China’s consumption as % of GDP

45

50

55

40

35

30

1997 98 99 2000 01 02 03 04 05 06 07 08 09 10

Official share

Adjusted share*

amounts to a de­facto liberalisation of interest rates, Ms Chu ar­gues. The growing competition for deposits is showing up in oth­er ways too. When the �nance ministry auctions its own six­month deposits, banks are now willing to o�er rates as high as6.8%, more than twice the maximum they are able to o�er to or­dinary depositors.

The government may seek to formalise this de facto liberal­isation, gradually allowing banks more freedom to set rates onlarge long­term deposits�the kind that will otherwise disappearfrom banks’ books. Net corporate deposits, for example, did notgrow at all in 2011. Higher rates would help attract them back.

That would also raise banks’ costs of funding, forcing Chi­na to become more e�cient in its allocation of capital. At the mo­ment the system is segregated between big enterprises, whichenjoy relatively low borrowing costs, and credit­starved private�rms that could potentially earn much higher returns on invest­ment. In a freer �nancial system, competition would begin toclose this gap. If interest rates went up to match the return on cap­ital, Chinese investment would fall by 3% of GDP, according to astudy by Nan Geng and Papa N’Diaye of the IMF.

More �exible interest rates would also raise Chinese con­sumption, says Nick Lardy of the Peterson Institute for Interna­tional Economics. He calculates that if banks paid something re­sembling a market interest rate on their vast deposits, householdincome would increase by 2% of GDP. Higher incomes, he ar­gues, would cause their spending to rise and their saving rate tofall. The idea that higher rates will make people save less is unor­thodox, but Mr Lardy argues that the higher income from savingwill have a bigger e�ect than the higher reward o�ered for it. Chi­nese households save towards a goal, he suggests, such as thedown­payment on a house or the cost of a potential medicalemergency. Lower the return to saving, and they will just saveeven harder to achieve their goal.

Research by Malhar Nabar of the IMF suggests that higherinterest rates would indeed bring down saving rates, but the ef­fects would be modest. If the real rate on one­year deposits rosefrom roughly 0% today to a more reasonable 3%, it would lowerhousehold saving by only about 0.5% of GDP, he calculates. Butif higher interest rates alone will not liberate Chinese consump­tion, what will? 7

12 The Economist May 26th 2012

CHINA’S ECONOMY

SPECIAL REPORT

2

1

backed evening dress lingers by the window. But there is also a growing class of discerning customers

who look down on ostentation. They pride themselves on theirappreciation of wine, tea and co�ee. In Beijing the TV screensthat now pop up in taxis teach passengers how to judge a wine’sintensity and why they should not over�ll their glass. �Knowl­edge of how to consume has in itself become a commodity,� MsEl�ck writes.

Just as consumption failed to grow as quickly as incomesover the past decade, it will fail to slow as quickly over the de­cade to come. As China’s growth eases from 10% a year to some­thing closer to 7% during this decade, consumption will rise nat­urally as a share of GDP.

Some economists think it has al­ready begun to do so. Yiping Huang of Bar­clays Capital says the o�cial statistics failto re�ect a surge in consumer spendingsince 2008. They are particularly bad atcapturing extra spending on accommoda­tion, such as rent payments by tenants orthe bene�ts enjoyed by owner­occupiers.

One proxy for consumer spending isretail sales, which have grown much fasterthan GDP in recent years. Unfortunately,these statistics are no better at capturingexpenditure on accommodation. And inChina they include many things otherthan household consumption, such asgovernment purchases and trade in indus­trial products like basic chemicals. Buteven when those items are stripped out,Mr Huang shows, sales are rising fast.

He thinks that the level of expendi­ture as well as its growth may be under­stated. Despite the conspicuous consump­tion, a lot of income and spending ishidden from the prying eyes of taxmenand statisticians. The best e�ort to throwlight on this shadow income is a study byWang Xialou of the National EconomicResearch Institute at the China ReformFoundation. His team asked about 4,000of their friends how much they earnedand spent. The answers they got weremore candid, though also less representa­tive, than o�cial surveys. After doingsome statistical tricks to eliminate the bias,Mr Wang calculated that the disposableincome of China’s households was 9.3 tril­lion yuan ($1.4 trillion) higher than the of­�cial 2008 �gure of 14 trillion yuan. Drawing on this work, MrHuang thinks that private consumption may have accounted for41% of GDP in 2010, about seven points higher than the o�cial�gure (see chart 6, previous page).

Mr Huang’s calculations do not convince everybody, andeven if they are right, they have disturbing implications. Hiddenincome disproportionately bene�ts the better­o�: the richest 10%of urban households take home over 60% of it. That might helpexplain why China is now the world’s largest market for luxurygoods, according to one estimate. If that hidden income is count­ed, the top tenth of urban families are about 26 times better o�than the bottom tenth, not just nine times, as the o�cial �guressuggest. These �gures make China’s economic imbalances lookbetter but its social inequities far worse.

However, there is another important source of �nal de­

mand that is often neglected: the government. Its consumptionspending (on health care, education, subsidised rent and so on)as a share of GDP has been growing since 2009, but it remains in­adequate and uneven.

The patchwork state

China has greatly broadened its rural pension scheme,which collected contributions from 140m people in 2011, com­pared with under 80m a year before. But even now it reachesonly about 30% of the eligible population. The government hasalso expanded the coverage of health insurance, bringing 95% ofthe population into the net, according to the OECD. Patients nowpay directly for only 35% of China’s total health spending, com­

pared with well over 60% ten years ago. But progress has notbeen uniform. China has one scheme for urban workers, anoth­er for non­workers and a third for rural folk, each administeredby separate city or county governments. The contributions re­quired and bene�ts provided di�er a lot between the threeschemes. According to the OECD, the rural scheme pays out anaverage of only $16 per person per year and covers only 41% ofthe cost of in­patient care.

In social as in economic policy, the government prefers lo­cal experimentation and piecemeal expansion. That works wellfor economic reforms, but in social policy it fails to pool risk e�­ciently. And the safety net is thin as well as patchy. This keepsdown its cost to the exchequer but leaves the population ex­posed to dangers such as debilitating illness or job loss. Healthbene�ts, for example, are capped, leaving patients uncovered for

An important source of demand

The Economist May 26th 2012 13

SPECIAL REPORTCHINA’S ECONOMY

2

1

the worst crises. And China’s hospital­centric health­care systemprovides only one general practitioner for every 22,000 people.

Older Chinese grew up in a society where many of theirconsumption choices were dictated by the state or by their work­place. They ate in state canteens and slept in state­provided dor­mitories or �ats. It was a grinding, tedious existence. But in dis­carding the �iron rice bowl�, the Chinese state failed to providealternatives, including health care and minimum pensions. Ac­cording to the World Bank, China spends only 5.7% of its GDP onthese items and other forms of social protection, such as pay­ments to support the very poor. Other countries in the same in­come category as China spend more than twice as much, an av­erage of 12.3%.

More social spending of the rightkind would not crowd out private con­sumption. On the contrary, it would en­courage it. The patchiness of China’s safe­ty net is one reason why households saveso much of their incomes. According toEmanuele Baldacci and other economistsat the IMF, a sustained rise in publicspending by 1% of GDP, spread evenlyacross health, education and pensions,would increase the ratio of householdconsumption to GDP by 1.25 percentagepoints. The IMF’s Steven Barnett and RayBrooks calculate that in urban areas everyextra yuan the government spends onhealth prompts an extra two yuan of con­sumer spending.

Can China a�ord to spend so freely?In one sense, it cannot a�ord not to. If in­vestment were to falter and private con­sumption failed to compensate, Chinawould be left with a big hole in demand,jeopardising employment and growth. Ifthe investment rate were to drop back toits 2007 level, for example, the demandshortfall would run to over 6% of GDP. Tomake up for that, the government wouldhave to spend about 3.4 trillion yuan thisyear, or face widespread joblessness. Thatis a substantial amount. With only a sixthof that sum, the government could raisethe incomes of all of China’s poor to theequivalent of $2 a day, according to calcu­lations by Dwight Perkins of Harvard. Thepoint of such a thought experiment is todemonstrate that China has enormousproductive powers to mobilise, and has to

spend a lot to mobilise them fully. There is another obvious measure, peculiar to China, that

would lift consumer spending. That is the earliest possible repealof the country’s household registration system, or hukou, whichlimits the access of rural migrants to public services in the citieswhere they work and live. This keeps migrants unsettled andtherefore unwilling to spend. Migrants without an urban hukou

spend 30% less than otherwise similar urban residents, accord­ing to research by Binkai Chen of the Central University of Fi­nance and Economics, Ming Lu of Fudan University and Ning­hua Zhong of Hong Kong University of Science and Technology.

Mr Zhang, the Silk Market trader, is a good example of thesystem’s iniquity. He arrived in Beijing 17 years ago. He has ahouse, a son, a business and even a licence from Hello Kitty. Buthe still does not have a Beijing hukou. 7

THE POLICYMAKERS WHO will determine China’s futureare trained at the Central Party School, a spacious oasis of

scholarly tranquillity in north­west Beijing. The campus lookslike an Ivy League school with Chinese characteristics. Thegrounds are dotted with sti� bamboo as well as pendulous wil­lows, pagodas as well as ducks. The school remains largelyclosed to outsiders. In the past it did not even appear on maps.But it is opening up. The campus signpost, for example, is spon­sored by Peugeot Citroën.

The school has over 1,500 students and almost as manyprofessors, many of whom are much younger than their stu­dents. It teaches economics, public �nance and human­resourcemanagement as well as communist doctrine, such as Marx’s la­bour theory of value. It takes only three or four classes to teachDeng Xiaoping Theory, the party dogma that legitimised China’seconomic reforms and still guides its Politburo. But if even that istoo much, three famous clauses may su�ce: �Our country mustdevelop. If we do not develop then we will be bullied. Develop­ment is the only hard truth.�

Deng said these words 20 years ago, not at a portentousparty conference in Beijing but on his �southern tour� of theworkshops of the Pearl River Delta. He was inspired by practice,not theory, having just visited a refrigerator factory in the deltathat had expanded 16­fold in seven years. Even the word he usedfor truth (daoli, which is often translated as reason or rule) ismore colloquial than the loftier term, zhenli, reserved for hightruths like Marxism­Leninism.

Giants playing catch­up

Thanks to a sevenfold rise in its output since then, China iswell past the point of being bullied. Its dollar GDP, measured atpurchasing­power parity, may have already overtaken Ameri­ca’s, according to economists such as Hu Angang of TsinghuaUniversity or Arvind Subramanian of the Peterson Institute forInternational Economics. Converted at market exchange rates, itis still much smaller than America’s. But even by that measure,China may catch up sooner than many people currently expect.To draw level with America by 2020, China’s dollar GDP would

have to grow at only about three­quartersof the average rate it recorded over thepast decade.

Now that China has become too im­portant to be bullied, development maybe less of an imperative. Indeed, in somequarters of society there is an increasingdistaste for the unwelcome side­e�ects ofChina’s growth model, which depletesthe country’s natural assets at the sametime as it expands its physical ones, andwhich builds lots of property but oftenbulldozes property rights.

Some party elites and vested inter­ests may also have grown complacent,worrying more about how to divide theeconomic spoils than how to enlarge

The next chapter

Beyond growth

China will have to learn to use its resources more

judiciously

�Our countrymustdevelop.If we do notdevelopthen we willbe bullied.Developmentis the onlyhard truth�

of investment, but there is noth­ing else to replace this as asource of demand. Much of thecredit extended by banks andshadow banks to keep growthgoing will sour. A governmentthat owes its legitimacy entirelyto growth will �nd it hard tocontain the disappointmentthat a slowdown will entail.

This special report sub­scribes to a third school ofthought. It argues that Chinadoes face signi�cant problems,but nothing it cannot handle. Ithas not obviously overinvested,but it has often invested un­wisely. That is imposing reallosses on Chinese developers,depositors and taxpayers. How­ever, China’s �nancial system isbetter equipped than many oth­ers to ride out these losses. Itmay be ine�cient in its alloca­tion of capital, but it is quite sta­ble. Indeed, it is resilient forsome of the same reasons that itis ine�cient.

Until recently most econo­mists believed that China washeavily dependent on exports.But it has carried on growing even as its current­account surplushas shrunk, and trade has subtracted from growth, not added toit. The country is undoubtedly investment­dependent, but itsbiggest problem is malinvestment not overinvestment. Mostpeople believe that its past malinvestment will impede future

growth. This special report has raiseddoubts about that. Clearly China wouldbe better o� had it not wasted so muchcapital. But if the capital stock is not asgood as it should be, that gives the coun­try all the more room for improvement.

If the investment rate does fall, Chi­na will need another source of demand.The obvious place to look is householdconsumption, but consumers may notrise to the challenge. This special reporthas argued that a much higher rate of gov­ernment consumption would be equallydesirable�and perhaps more feasible.

As China’s capital accumulates, itspopulation ages and its villages empty,saving will grow less abundant and goodinvestment opportunities will becomescarcer. China will then need to use its re­sources more judiciously. That will re­quire it to free up its �nancial system, in­troducing more e�ciency even at somecost to stability.

China is a vastly more prosperousand expansive country than it was 20years ago. It has broader horizons and cana�ord a wider range of concerns. Devel­opment is no longer China’s only truth.But it is still hard. 7

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The Arctic June 16thLondon June 30thNatural gas July 14thJudaism and the Jews July 28th

SPECIAL REPORT

14 The Economist May 26th 2012

2

CHINA’S ECONOMY

them. But at least in their rhetoric, leaders do not appear to beresting on their laurels. Asked about China’s prospects of becom­ing the world’s number one economy, Li Wei, head of the Devel­opment Research Centre, which advises China’s cabinet, saw noreason to celebrate. The country’s income per person still ranksaround number 90 in the world. And even if its GDP overtakesAmerica’s by the end of the decade, China will remain as poor asBrazil or Poland are today, by one estimate.

Hubris may be less of a danger than its opposite, a kind ofeconomic di�dence. If China is still poor in the minds of policy­makers, they may conclude that the economy is not yet ready forreforms that are in fact overdue. They may feel that a poor devel­oping country does not need a more sophisticated �nancial sys­tem, cannot cope with a more �exible exchange rate and cannota�ord to let its rural masses settle in the cities with their families.

As long as the demand for investment remains strong andthe supply of saving captive, China’s policymakers can feel con­�dent that their country’s economy will continue to enjoy rapidgrowth and stability. But the faster that China expands, thesooner it will outgrow the development model that has served itso well for so long. Japan began to change its growth model backin the mid­1970s. By some measures China has already reached asimilar stage of development, and yet its reforms remain tardyand timid.

School rules

There are at least three schools of thought on China’s eco­nomic prospects over the next few years. The �rst sees few dan­gers ahead. China has expanded quickly, always beating fore­casts, and will continue to do so for the time being. It is a huge,fast­developing country with plenty of room yet to grow. It in­vests a lot�and so it should. These investments might not alwaysgenerate good returns for the bankers that lent the money. Butthey will contribute more to the economy than they cost.

The second school of thought argues that China’s imbal­ances could overwhelm it. It cannot sustain its current high rate

Still plenty of room to grow