Wall Street Journal

Beijing's Steady Progress Toward Rebalancing

While the world's attention has been focused on the political and economic dramas in Europe, Japan and the U.S., one country has been quietly chipping away at some of its own economic problems. Recent data suggest a gradual but remarkable transformation in China's growth model. It is far too early to declare victory, however, and the new leadership has its work cut out for itself.

New data suggest that it is time to revise the view that China's growth is driven largely by exports and investment. Private and government consumption together accounted for more than half of China's output growth in 2011-12, signaling a big shift in the composition of domestic demand. Physical capital investment, the main driver of growth over the previous decade, is no longer the dominant contributor to growth. As for exports, a shrinking trade balance has in fact dragged down growth these past two years.

China has made substantial progress in reducing its external imbalances. Its trade and current account surpluses have shrunk steadily and markedly relative to their peaks in 2007, when they hit 7.6% and 10.1% of gross domestic product, respectively. In 2012, both of these surpluses were below 3% of GDP.

One reason for this shift is that China's strong growth, combined with economic weaknesses in its key export markets, has brought down the trade deficit. Another is that the government has eased restrictions on capital inflows and outflows, allowing Chinese investors and corporations to look to foreign investments for diversification purposes.

Capital outflows exceeded inflows in 2012, something not seen for over a decade. This has raised concerns about capital flight. But the reversal might simply reflect a maturing, richer economy with more open financial markets that allow investors to take advantage of diversification opportunities.

There are other signs of progress on domestic rebalancing as well. The decline in the share of private consumption in GDP has been halted. The share even went up slightly in the last two years, although it still remains well below that of every other major economy, advanced or emerging. Consistent with the government's objective of promoting the services sector, employment in this sector grew faster in 2012 than in the industrial sector. The shares of these two sectors in GDP are now equal.

This is not to say that all is well with the Chinese economy. There are problems lurking on the books of the big state-owned banks which have continued lending mainly to state enterprises. The shift away from state-owned to private enterprises has ground to a halt. Provincial governments have large levels of debt. Overall employment growth remains meager, and the environmental consequences of the growth model are painfully obvious. For all of these and other problems, however, the fact that the government has been able to gently steer the large and fast-moving economic ship in the right direction is a notable achievement.

Growth is the magic tonic that has helped China cope with the myriad of economic problems it faces. A declining labor force and limits to investment growth suggest that China will have to rely on faster productivity growth to keep up its GDP growth.

The big challenge now is to speed up reforms needed to improve the quality and efficiency of growth, continue the shift away from capital-intensive production, generate more employment and allow more of the benefits of growth to filter down to the average household. This will require more disciplined banks, broader financial markets, a stronger social safety net and other reforms that were clearly laid out in China's 12th five-year plan two years ago.

Earlier this month the government announced a plan to reduce inequality that incorporates some of these reforms. Trying to reduce inequality through government intervention is usually not a good idea, as it puts the focus on redistributive policies rather than ones that promote growth.

But this plan seems to use the goal of reducing inequality more as a framework for a broad set of reforms that will secure growth and improve income distribution. The proposed reforms include liberalization of interest rates to boost competition in the banking system, removal of restrictions on labor mobility to promote urbanization, and increased spending on social programs to reduce household savings and raise private consumption. Beijing has hit upon a clever strategy, as it will be a lot harder for vested interests to block reforms that are sold as being for the benefit of the masses.

China has a golden opportunity—with growth recovering and inflation low—to look beyond short-term demand management and focus instead on improving the balance, quality and sustainability of growth. While its new leaders have sung the appropriate paeans to reforms, now is the time to pick up the playbook from two years ago and act on it.