Yale historian Jonathan Spence once famously posited that since the times of Marco Polo, the West has invariably seen China through the same lens that it sees itself. As global equity markets swoon in response to the recent meltdown in Chinese stocks, these deep-rooted biases are in play once again. The Western version of China has darkened out of fear of asset bubbles, excess investment, and debt overhangs—precisely the same imbalances that have afflicted the major economies of the developed world over the past two decades. The truth is far less bleak.
China’s plunging stock market is the most obvious case in point. Yes, a big bubble has burst—as of July 8, the domestic Chinese equity market has fallen by 31 percent from its June 12 peak after surging by nearly 150 percent over the preceding year. Notwithstanding massive government support actions now being unleashed, there’s no telling how much further the sell-off has to go. The question for China is precisely the same as that which was raised by the bursting of earlier stock bubbles—especially those in Japan and the United States: Will the carnage in asset markets do lasting damage to China’s real economy?
The answer is no. The linkage between asset markets and economic activity is captured through what economists call “wealth effects”—basically the capital gains (both realized and psychological) that consumers accrue from the ups and downs of asset prices. An unbalanced Chinese economy has a built-in insulation from the downside of these wealth effects. Consumption is only 36 percent of its GDP—literally half that in the U.S., where consumer demand growth has been more than halved over the post-bubble period of the past seven years. While speculators who were borrowing on margin to buy stocks will undoubtedly feel pain as the Chinese bubble bursts, these impacts are likely to be limited. China, with its still-embryonic consumption sector, and without an American-style overhang of household debt, is unlikely to suffer from the wrenching balance-sheet recessions that afflicted the United States and Japan.
What about China’s notorious investment bubble—the “ghost cities” you see on 60 Minutes, the excess capacity in steel, cement, plate glass, and other basic industries, or an investment share that approaches an unheard-of 50 percent of GDP? From a Western perspective, these are all telltale signs of imbalance and impending collapse. But that’s not the case for China.
There are two main reasons for that. First, China is going through unprecedented urbanization. Since 2000, its urban population has increased by approximately 20 million citizens per year. In terms of shelter and its associated infrastructure requirements, China is adding the equivalent of 2½ New York Citys a year. With urbanization likely to continue at this rate through at least 2030, that spells high investment for years to come.
Second, there is the critical difference between stocks and flows—something that is drilled into college undergraduates in their first economics course. The investment share of GDP, a flow, is high in China in large part because the stock of productive capital is so low. That largely reflects the sad state of the Chinese economy in the late 1970s in the aftermath of the Cultural Revolution. In fact, China’s stock of capital per worker—long recognized as a key driver of productivity—is currently less than 15 percent of that of the United States and Japan. China’s economic development will depend critically on its ability to raise its capital-to-labor ratio—an outcome that requires it to maintain a high investment share of its GDP for the foreseeable future.
But surely China’s debt load—estimated at close to 250 percent of its GDP—is cause for concern. This is a Japanese-style problem that on the surface appears likely to end in tears. But here, as well, the Western lens that Spence warns of clouds the analysis.
China’s financial system is, at best, only partially developed. Most of the credit flows through the banking sector. The bond market is tiny when compared with most modern economies. The bubble-prone stock market is hardly a secure source of financing for its companies. That biases financing toward debt-intensive bank credit—a bias that has been compounded in recent years as China moved aggressively to shield itself from the recent financial crisis and Great Recession.
Mindful of the perils of debt-intensive growth, Beijing is now attempting to wean local governments and state-owned enterprises from their recent credit binges. That, in fact, is a key source of the current slowdown that is now playing out in the real economy. To the extent that Chinese authorities are successful in this so-called deleveraging—and recent indications are encouraging in that respect—China’s still rapid growth in nominal GDP should bring its overall debt ratio down sharply over the next few years. In contrast with sentiment in the Western press, China is not the next Japan or the next Greece.
While the warning signs noted above are in the danger zone as seen from a Western perspective, they don’t capture the essence of the biggest story in China—a major shift in the focus of its growth model. For 30 years, the Chinese development boom drew its sustenance from manufacturing-led exports and investment—a combination that produced a 30-fold increase in per capita incomes that elevated China to the world’s second-largest economy.
But this strain of growth was not sustainable. It left the economy unbalanced and unstable, to borrow the prophetic 2007 words of former Premier Wen Jiabao. Shifting to a services- and consumer-led model was the only recipe for sustainable development, and China’s leadership has embraced that strategy in the past five years through its 12th five-year plan adopted in early 2011 and in a series of major reforms enacted in late 2013.
Structural change is a glacial process and a Herculean task for any economy. China’s challenge—shifting the engine of growth from manufacturing-led exports and investment to services-led consumption—is no less daunting. But as has been the case throughout China’s extraordinary development since the late 1970s, it is making surprisingly quick progress in transforming its growth model.
Encouraging evidence shows up on three fronts: First, the development of the services sector—the foundation of consumer demand—is well ahead of schedule. Services rose to 48 percent of Chinese GDP in 2014, eclipsing the combined 43 percent share of manufacturing and construction. With services requiring about 30 percent more jobs per unit of output than China’s other nonagricultural sectors, slower GDP growth raises little risk of rising unemployment and social instability.
Second, explosive growth in e-commerce has become a powerful shortcut to Chinese consumption growth. Unlike emerging consumers of yesteryear who relied on the bricks and mortar of physical shopping malls to exercise their buying preferences, China’s new generation of consumers has turned to virtual malls offered by companies such as Taobao and Tmall. E-commerce has been growing by more than 70 percent annually since 2009, according to Bain & Co., and in 2013 China surpassed the United States as the world’s largest digital marketplace. The West, by fixating on cyberhacking and Internet censorship, has missed China’s newfound potential for networked tastes, brand awareness, and nationwide buying patterns as catalytic developments on the road to Chinese consumerism.
Third, urbanization is proceeding at breakneck speed. In 2014, the urban share of the Chinese population hit 55 percent—up from less than 20 percent in 1980 and on its way to an estimated 69 percent by 2030, according to OECD projections. Urbanization is the glue that cements the emergence of the Chinese consumer. Not only does it boost real incomes—urban workers earn approximately three times their counterparts in rural communities—but urbanization also underpins the development of new services like local transportation, communications, utilities, as well as wholesale and retail trade.
And by fixating on China’s so-called ghost cities, the West misses yet another key milestone in the emergence of the next China. One district in Zhengzhou that was portrayed as ghost-like by 60 Minutes is now fully occupied. In China, proactive urban development anticipates migration. This stands in sharp contrast to India’s urban squalor, where urbanization is always struggling to catch up with migration from the countryside.
So think again before you ponder the perils that China supposedly faces. While China has many of the symptoms that have and are still afflicting more prosperous economies in the West, it is at a very different state in its development journey. The lens through which we see ourselves overstates China’s downside risks and misses the strategic building blocks of its nascent structural transformation. While hardly problem-free, the Chinese economy continues to offer a growth potential unmatched by any other nation in the world today.