China has been growing extremely rapidly for a long time, but an important shift in its growth pattern occurred at the time of the global financial crisis. During the six years up to 2007, China’s gross domestic product (GDP) grew at an average rate of 11 percent, with investment equaling 41.5 percent of GDP. The current account surplus was rising in this period, reaching over 10 percent of GDP. In the six years since the global crisis, the external surplus has fallen sharply into the range of two to three percent of GDP, but the shortfall in demand was made up almost completely by an increase in investment, which has reached more than 50 percent of GDP in recent years.
China’s growth has been impressive compared to the rest of the world, but lost in the admiration is the fact that the growth rate has slowed down to around 7 percent—down more than four percentage points from the pre-crisis period. So, in the recent period, China has been using a lot more investment in order to grow significantly more slowly than in the past.
This pattern of growth manifests three problems. First, technological advance, as measured by Total Factor Productivity (TFP) growth, has slowed down. Second, and closely related, the marginal product of capital is dropping (it takes more and more investment to produce less and less growth). The real world indicators of this falling capital productivity are empty apartment buildings, unused airports, and serious excess capacity in important manufacturing sectors. The third manifestation of China’s growth pattern is that consumption is very low, especially household consumption, which is at only one-third of GDP.
Big initiatives, at home and abroad
China’s response to this changing growth dynamic is partly external and partly internal. On the external side, it’s no coincidence that this period of excess capacity at home is the moment when China launched expensive new initiatives, such as the Asian Infrastructure Investment Bank (AIIB), the BRICS Bank, and the “One Belt, One Road” initiative. The AIIB was born largely out of frustration with the slow pace of governance reforms at the existing international financial institutions. The “One Belt” initiative—larger than the AIIB—seeks to strengthen infrastructure both on the westward land route from China through Central Asia and on the southerly maritime routes from China through Southeast Asia and on to South Asia, Africa, and Europe.
China’s Asian neighbors largely welcome these measures, and they can contribute to Asian integration. However, the thinking in China that these initiatives can be a major solution to China’s excess capacity problems is largely misguided. The overall contributions that these initiatives make to China’s demand are likely to be too small to be macroeconomically meaningful.
The domestic response to China’s over-capacity problem is a set of reforms that emerged from the Third Party Plenum in November 2013. The ones that are likely to have the greatest effect on rebalancing China’s economy fall into four areas: the household registration system (hukou); inter-governmental fiscal reform; financial liberalization; and opening up China’s service sectors to competition. Together, these form a coherent set of measures that would rein in wasteful investment, increase innovation and productivity growth, and enhance consumption. Success in these areas will enable China to continue to grow well for another decade or more.
The yin to trade’s yang
China’s initiatives in Asia are seen in many quarters as a setback for the United States. The U.S. government contributed to this narrative through its efforts to discourage allies from joining the new AIIB. In the end, major American allies—such as the United Kingdom, Australia, and South Korea—did join the Chinese initiative, and Japan is seriously considering becoming a member.
However, this is likely to be only a temporary diplomatic setback for the United States.
America’s own main economic initiative in the Asia-Pacific—the Trans-Pacific Partnership (TPP)—now seems likely to be completed by the end of 2015. Many major economies in Asia, such as Australia, Singapore, South Korea, and Vietnam want to be part of both Chinese initiatives (the AIIB and the “One Belt, One Road”) and the American-led effort to reduce trade barriers.
These different efforts are in fact complementary. The kind of infrastructure financed by the Chinese initiatives is the “hardware” of trade and investment—necessary but not sufficient to deepen integration. TPP, on the other hand, represents the “software“ of integration, reducing trade barriers, opening up services for trade and investment, and harmonizing various regulatory barriers to trade.
There is a risk that the competing initiatives of China and the United States will lead to regional blocs and a disintegration of trade, but it is more likely that Sino-American competition will lead to strengthened institutions and deeper integration throughout Asia-Pacific.
This post is adapted from the recent paper “China’s rise as a regional and global power: The AIIB and the ‘one belt, one road.'”
The U.S. still has some leverage over China, because China clearly wants a deal. ... U.S. financial markets also seem to have been boosted by the prospects of a U.S.-China trade deal, so I think it could have a negative effect on both financial markets and economic activity in both countries if a deal is not struck