Solving China's Rebalancing Puzzle

• Author: Jonathan Anderson
• Position: Head of Asia-Pacific Economics at UBS
• Pages: 32-35

Page 32

Market forces will do the trick "naturally"

OVER the past year, observers of the global economic scene have been treated to a rare spectacle, as a host of U.S. cabinet-level officials and their Chinese counterparts sat down in a much-touted series of meetings under the banner of the "U.S.-China economic Dialogue." the official program covers a long list of topics, including market access, intellectual property rights, U.S. export controls, and investment guarantees; however, it is safe to say that the real agenda is the ever-present U.S. bilateral trade deficit with China and the mainland's burgeoning trade surplus with the world at large. In other words, the delegation is focused on the rebalancing of the Chinese economy, a topic that many China-watchers have latched onto in recent months.

But what does "rebalancing" really mean, and how can it be achieved? this is by no means a simple question because China is one of the most unique and puzzling economies in the world-and, as it turns out, conventional wisdom on the topic may be misguided.

What is going on?

Here is the fundamental problem. On the one hand, over the past three years, China has seen a rapidly rising trade and current account surplus-about 10 percent of GDP in the first half of 2007, up from 3 percent in 2004 and about 2 percent in 2000-03. On the other hand, the gross investment share of the economy has also increased over the same period, to a record high of 43 percent of GDP, from about 35 percent at the beginning of the decade. this is arguably the first time in 50 years that economists have seen anything like it. normally, a sharply rising investment ratio drives the current account into deficit: think, for example, of Southeast Asia in the run-up to the Asian financial crisis. vice versa, Japan's and taiwan's massive trade surpluses in the mid-1980s were due mostly to falling investment shares at home. this regularity has played itself out again and again in emerging markets across the globe, except in China, where a rising investment rate and a rocketing current account surplus have gone hand in hand.

What is going on? By definition, if both ratios are increasing, then it must be that the domestic saving rate is rising even faster, which in turn implies that the domestic consumption share of GDP must be falling-and falling precipitously at that. Sure enough, the official data show that overall Chinese consumption spending has fallen from more than 60 percent of GDP at the beginning of the decade to about 50 percent today, with household consumption at a record low of 37 percent of GDP. this is the smallest ratio in all of Asia, and perhaps in emerging market countries as well.

Clearly, something is more than a little bit "out of whack" in the vibrant, rapidly growing mainland economy, and the obvious conclusion from the above scenario is that weak consumption is the culprit. By implication, the solution to China's domestic and external imbalances is urgent action to boost consumer spending, the only driver that can restore balanced growth.

Page 33

That, in a nutshell, is the consensus version of events. however, as it turns out, there are also very good reasons to question that consensus, and a closer look at the macroeconomic data does in fact suggest that the real story lies elsewhere. I will argue in this article that household consumption is not the main problem; instead, the bulk of excess savings has come from Chinese firms as they "expropriate" market share and profits from the rest of the world. Moreover, this imbalance is a temporary rather than a structural phenomenon, and the economy is already in the process of self-adjusting. Of course China still needs longer-term structural reforms in the areas of consumer finance and the social safety net-but these are not the solutions to the current cyclical disparity.

Three additional puzzles

How do we get there? Start by considering the...