Why China's Fast Growth May Not Last

The subprime-mortgage crisis laid bare America's decadence. The world's largest economy is rife with overconsumption of everything from McMansions to tchotchkes from Target, cursed by negative real savings rates and weighed down by debt that has spilled from Wall Street to Main Street. Yet China's role in the binge is less understood. As America's primary enabler, the world's fastest-growing major economy furnishes massive capital infusions that keep the U.S. financial system afloat, and its factories make most of the stuff Americans buy. The relationship is symbiotic and mutually intoxicating, argues Tom Holland, a Hong Kong-based financial columnist. He calls the two giants "drunkards reeling crazily down the pavement in a tight embrace."

As such, one of them can't do a face plant in the gutter without the other toppling too. That, at least, is the risk Beijing policymakers run today unless they sober up and execute a delicate industrial pirouette economists call "rebalancing." It entails consuming much more of national output at home, relying less on exports and slowly weaning the American financial system off cheap Chinese credit. The problem: China's economy is as thoroughly hard-wired against consumption-led growth as America's is for it. And all the money in the world—even the $1.8 trillion in China's foreign reserves—can't buy a quick fix. Here's why:

China's domestic consumption was an anorexic 38 percent of its GDP (a third less than India's) in 2007. The other 62 percent came from investment, much of it spent on export-oriented infrastructure, plus net exports. Consumption as weak as China's is unprecedented even for a developing industrial economy, and it makes the shift to a domestic demand-led growth model following the 20th-century pattern set elsewhere in East Asia extremely tricky. The idea that China can make this transition smoothly from such a "skewed position … is rather naive," says Hugh Young, managing director of Aberdeen Asset Management Asia.

The problems begin with China's national savings, which are as hard to trace as America's subprime debts. China has accumulated huge cash hordes of indeterminate size and ownership. World Bank economists Bert Hofman and Louis Kuss estimate that China's gross savings reached a staggering 50.6 percent of GDP in 2006, up from 40.7 percent a decade earlier. Yet they calculate that household savings dropped from 20.1 to 15.3 percent of GDP during the same period, while savings by enterprises nearly doubled to 28.3 percent of GDP. Behind this growth chart is a deeply troubling truth: China Inc., not the Chinese people, has prospered most from the boom.

Nevertheless, some analysts still wrongly assume that rebalancing China's economy is as simple as convincing households to draw down their bank accounts and spend, spend, spend. In fact, China's households saving rate, estimated at 25 percent of disposable income, "is actually fairly normal in Asia," wrote Harvard economist Kenneth Rogoff last year. The figure is not excessive, given the country's utter lack of a social safety net and resultant need for households to plan for rainy days. At the same time, "we've seen a sharp increase in nonhousehold savings in China since 2000," says Charles Adams, visiting professor at the National University of Singapore and a former economist for the International Monetary Fund in Asia. "And this is a black hole because the ownership structure of the state-owned enterprises that control this money is not well-defined."

Many of these companies are linked to provincial or local governments, and they prefer to spend their wealth expanding old businesses or branching into new areas (the perennial favorite: property development). Such behavior merely reinforces the export-led structure and drives down consumption as a percentage of GDP. According to new data from JPMorgan Chase, investment contributed 4.9 percent of China's 11.9 percent growth in 2007, compared to 4.3 and 2.7 percent for consumption and net exports, respectively. While many Asian countries need to reduce their reliance on investment and exports for growth, says Adams, "quantitatively, the transition in China matters most because it's just so big."

The IMF and other development agencies say Beijing could boost consumer spending power by transferring wealth held by state-linked enterprises to households by taxing businesses and either reducing taxes on households or expanding free social services. That strategy would address China's underlying imbalance, but only after a tough interim. "The fact that over the next five years China may be able to move in the right direction is great," says Michael Pettis, a professor of finance at Peking University's Guanghua School of Management. "But crises don't require five-year solutions, they require five-week solutions."

Whenever the solution comes, Chinese industry faces a painful retooling process during which the country's vast nonfarm workforce will experience a sensation largely absent since the days of Chairman Mao: systemic uncertainty. Only then will China's immoderations, like those of its favorite drinking buddy, be visible for all to see.