Cheer up, Wall Street—China’s correction is welcome news

Wall Street and fellow markets around the world have started 2016 on an abysmal note, and fears of a China slowdown are a central reason. What is puzzling is that the economic news so far is largely positive. China needed to adjust away from an investment-heavy growth model to more sustainable growth-based one, focused more on innovation on the supply side and consumption on the demand side.

That this adjustment is now occurring gradually is welcome news. With luck, such a slowing could have a calming effect on strategic tensions in the western Pacific as well.

Number crunching

First for the economics. The old growth model vastly overemphasized investment. That approach propels rapid growth in the short run, but excess capacity eventually grows. At recent investment rates, the capital stock is doubled in six to seven years; but there is simply not enough demand to make those investments profitable. Hence the current situation of empty apartments, excess capacity in manufacturing (especially steel and cement), and literally “bridges to nowhere.” 

The old growth model vastly overemphasized investment.

Investment is now slowing down, a natural response to excess capacity, pulling down the reported GDP growth rate to 6.8 percent year-on-year in the fourth quarter of 2015. But the good news is that the growth of consumption has held up well—at more than 8 percent in real terms—so that consumption’s share of GDP, which has been very low in China, has started to rise. 

As GDP slows, it is reasonable to wonder if China will create enough jobs. An old canard says that China must grow at 8 percent in order to create the number of jobs it needs and avoid social and political unrest. But there are three problems with the canard: 

  1. First, there is no simple relationship between GDP growth and employment growth. 
  2. Second, China’s demographics have changed such that the working-age population has now peaked and started to decline. There is still under-employed rural labor, but not a need to create as many jobs as in the past. 
  3. Third, consumption growth primarily drives the expansion of the service sectors, which are more labor-intensive than industry. 

So, while GDP growth has been cut nearly in half in real terms, employment growth remains robust and the labor market tight. The growth of household income has been very consistent at about 8 percent in real terms, so people’s lives have continued to improve, and poverty has continued to decline.

The old growth model also had serious negative spillovers for the local and global environment. The life-shortening air pollution prevalent in China is tied to the heavy role of industry in the economy. The service sectors in 2015 for the first time made up more than half the economy, and their continued rise will help China manage its environmental problems. 

China’s break-neck investment also created a lot of demand for metals and energy, driving up prices that benefited primary exporters around the world. Some of these countries now face difficult adjustments as metals prices have fallen 60 percent from their peak. (What is happening to energy prices has more to do with new supply than China, however.) In the long run, it is surely a good thing that China is transitioning to a less resource-intensive growth path.

The spillover effects of bullishness

Another likely implication of a less stratospheric level of Chinese economic growth is less Chinese assertiveness in the region. For an Asia-Pacific that experienced serious China-Taiwan tensions in the 1990s and 2000s, and more recently serious problems between China and neighbors like Japan, the Philippines, and Vietnam over maritime issues in the East China Sea and South China Sea, this is likely to be good news. 

There is no obvious correlation between economic growth and foreign policy chutzpah in international affairs. But internal Chinese voices in favor of greater bullishness and assertiveness—over Taiwan, or over overlapping claims to islands and seabeds and waters in the South China Sea, or over the Senkaku (also called Diaoyu) islands—will be emboldened if Chinese are collectively feeling their oats. Narratives that talk about a Chinese century, or China as the new hegemon, or China as the world’s top economic power, will likely be more influential in internal debates if growth rates remain inexorably robust. 

In the long run, it is surely a good thing that China is transitioning to a less resource-intensive growth path.

It could be irresistible for a country and people that already see themselves as the Middle Kingdom to keep their nationalistic sentiments in check if they continue to sustain 8 to 10 percent growth. The notion of “hide and bide”—Deng Xiaoping’s argument that China should be humble and restrained internationally until it reached a more advanced level of development—will be harder and harder to sustain if China continues to achieve things that no other country (at least no other large country) in the history of the human race has done before. And the expectation that, in a crisis, other countries will choose to kowtow to Beijing rather than push back against it will strengthen as does China’s economic clout.

Defense budgets at bay

There is another related reason, tied more concretely to military budgets, why we should welcome a modest slowdown in China’s economic growth. Historically and bureaucratically, China has tended to couple its defense spending levels closely to GDP. For several decades, the military budget has averaged 1.5 to 2 percent of national economic output, depending on different estimates. The linkage does not seem quite as strong or precise as in Japan, where the military virtually always receives 1 percent of GDP. But there has been far less variation in the military spending of the People’s Liberation Army relative to overall economic output than, say, in the United States.

[I]nternal Chinese voices in favor of greater bullishness and assertiveness…will be emboldened if Chinese are collectively feeling their oats.

As such, a slowdown in the economic growth rate of China implies a likely slowdown in increases to the defense budget. China’s military resources are somewhere between $150 billion and $200 billion a year—far less than America’s $600 billion, but far more than any other country. When Chinese GDP growth rates approach 10 percent, so typically have military budget increases.

With a base of a $200 billion military budget, 10 percent GDP growth translates into an annual real increment in military resources of $20 billion each year. By contrast, at 5 percent growth, China might be expected to grow its defense budget from, say, $200 billion to $210 billion this year, and wind up around $250 billion by decade’s end. That would leave the United States the unquestioned dominant world military power well into the 2020s (and probably far beyond).

Even if China ultimately does approach American defense budget levels, the pace at which it does so is important. A slow convergence gives time—for Chinese political systems to mature, for Beijing to adjust to the responsibilities of global leadership, and for America and its allies to respond and increase their own defense levels if needed. Thus, annual growth rates closer to 5 percent are far less disruptive strategically than the recent norms closer to 10 percent.

We wish China well, and believe its continued economic growth is beneficial not only for its own people but for the global economy too. Handled right by all key parties, it can also be consistent with continued regional strategic stability. But the superhuman leaps that China and its military have been taking needed to decelerate, for lots of reasons. Investors around the world might be taking a short-term hit as the Chinese slowdown comes into clearer focus. But whether they yet realize it or not, they will benefit in the end from a moderate slowing of the Chinese behemoth that puts it on a more sustainable and stabilizing path.