August 22, 2010


Is China Turning Japanese?: China is now the world's second largest economy. Here's why Beijing, not Washington, should be worried. (MICHAEL PETTIS, AUGUST 19, 2010, Foreign Policy)

China has formally overtaken Japan as the world's second largest economy. Yet, for all the recent excited commentary, there's less cause for baijiu toasts in Beijing than they might think. That's because China's economic growth has followed what's sometimes called "the Japanese model." In Japan and other Asian countries, this model has proved extraordinarily successful in the short term in generating eye-popping rates of growth -- but it always eventually runs into the same fatal constraints: massive overinvestment and misallocated capital. And then a period of painful economic adjustment. In short: Beijing, beware.




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Japan's "lost decade" of the 1990s -- from which it still has not emerged -- followed a period of high growth, at the heart of which were massive subsidies for manufacturing and investment. The Japanese model channels wealth away from the household sector to subsidize growth by restraining wages, undervaluing the currency, and, most powerfully, forcing down the cost of capital. In every prior case, once the train gets rolling, it has been very difficult to correct course. That's because too much of the economy depends on hidden subsidies to survive.

Nor is Japan the only country to rise quickly and then suffer in this fashion. Brazil, which experienced "miracle" growth years during the 1960s and 1970s, had its own lost decade in the 1980s, for similar reasons. Beijing would do well to heed these tales of caution. [...]

hy do Chinese consume such a low share of what they produce -- in spite of determined efforts by Beijing to get them to increase consumption? Contrary to conventional thinking, the Chinese have no aversion to consuming. They are eager shoppers, as even the most cursory visit to a Chinese mall will indicate. The problem is that Chinese households own such a small share of total national income that their consumption is necessarily also a small share. And just as the household share of national income has declined dramatically in the past decade, so too has household consumption.

This isn't to say households are getting poorer. On the contrary, they are getting richer quite rapidly, but they are getting richer more slowly than the country overall, which means their share of total income is declining.

If Beijing wants to increase the consumption share of GDP, it shouldn't waste effort and money trying to create additional incentives for consumption, tinkering with subsidies and taxes, improving the social safety net, attempting to change cultural habits. What is needed is to increase the share of national income that households take home. Give them more money, and they will spend it.

So how can their share rise? Here, the problem gets very difficult.

One option might be for Beijing to engineer a huge shift of state wealth to the household sector through, say, a massive privatization program. This could drive up consumption significantly by boosting household wealth, but the likelihood of mass privatization is slim, given the political realities in China.

Another option, and ultimately the only sustainable path forward, would involve reversing the subsidies that generated such furious growth. Wage growth must at least keep pace with productivity growth; interest rates must rise substantially; and the currency must be revalued. But if any of these happen too quickly, we could expect a surge in bankruptcies -- as old businesses struggle to survive without familiar subsidies.

Unfortunately, the longer China waits to make the transition from this model of growth, the more difficult the transition will be. Forcing banks to fund projects at artificially low interest rates inevitably raises non-performing loans, and these eventually become government debt. The longer China waits, the more debt there will be and the more dependent growth will be on the subsidies.

For a worrying case study, one need only look to Japan, which grew very rapidly thanks largely to very high rates of investment forced through the banking system. For a long time the problem of misallocated investment -- which was whispered about in Tokyo but not taken too seriously -- didn't seem to matter. Everyone "knew" that Japan's leaders could manage a transition easily. After all, they were extremely smart, with a deep knowledge of the very special circumstances that made Japan unique, with real control over the economy, with a strong grasp of history and penchant for long-term thinking, and most of all with a clear understanding of what was needed to fix Japan's problems. Sound familiar?

In the end, they were seduced by their own success. Look what a great job they had already done: by the early 1990s Japan had generated so much investment-driven growth that it had grown from 7 percent of global GDP in 1970 to 10 percent in 1980, and then surged to nearly 18 percent at its peak in the early 1990s. In about twenty years, Japan's share of global GDP was two-and-a-half times its initial share. And yet it kept boosting investment to generate high growth well into the early 1990s, long after the economic value of its investment had turned negative.

Less than 20years later, after a terribly long struggle to adjust to high debt and massive overinvestment, Japan is about to be overtaken by China with only 8 percent of global GDP. Japan, in other words, has given back in less than two decades almost the entire share of global GDP it had taken in the two astonishing decades that preceded it (during the same period the United States has roughly maintained its share).

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Posted by Orrin Judd at August 22, 2010 8:17 AM
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