Key Trends in the World Economy

Why China will grow rich before it grows old

The announcement of the relaxation of China's one child policy created great discussion in China and internationally. But its significance was widely misunderstood. Contrary to myth, the increase in China's labor supply plays little role in China's rapid economic growth. In reality, 96 percent of China's economic growth comes from factors other than a rising labour supply. Therefore, there is no reason why China's economy should slow significantly because China's working age population stopped growing in 2012. The mistaken view, sometimes expressed, that China will grow old before it becomes rich is therefore the reverse of the reality: China will grow rich before it grows old. To demonstrate clearly why, first the facts will be stated and then their implications analysed.

A worker of a company processes galvanized products in Qingdao, east China's Shandong Province,[Xinhua/Yu Fangping]

Even an elementary back of an envelope calculation shows why increases in China's working age population have made only a relatively small contribution to China's economic growth. Indeed, this is so immediately clear it is somewhat of a puzzle that the myth ever existed in some quarters that China's growth depended essentially on increases in labor and therefore China's economic growth faces a serious "demographic challenge" due to the end of the increase in the working age population.

From the beginning of reform in 1978 up to 2012, the average annual increase in China's population aged 15-64, the international definition of working age, was 1.7 percent. Over the same period the annual average increase in China's GDP was 10.2 percent -- almost six times as fast. The increase in China's working age population was therefore only 17 percent of the rate of increase of China's GDP -- showing clearly that the rate of growth of population could not possibly explain, or be the main reason for, China's rapid economic growth.

Looking at the trends in more detail shows still more clearly that population trends did not determine China's economic trajectory. Taking five year moving averages for changes in working age population and GDP, to remove the effects of short term fluctuations, China's average annual growth rate of working age population was 2.8 percent in 1983, five years after the beginning of reform. By 2000 this had fallen to 1.6 percent, and by 2012 it was only 0.6 percent. The growth rate of China's working age population was therefore consistently falling.

But China's GDP growth showed the exact opposite trend. Annual average GDP growth rate was 8.1 percent in 1983, 8.6 percent by 2000, and 9.3 percent by 2012. Therefore while the growth rate of China's population was falling its economy was accelerating! This shows clearly changes in China's labor supply were not the prime cause of its economic growth.

Making exact calculations shows the situation even more graphically. It might be naively imagined that as China's working age population grew at 17 percent of the rate of its GDP increase therefore increases in labour accounted for 17 percent, which is under one fifth, of the increase in China's economic growth. This contribution would already seem surprisingly small for those who believe increases in working age population was a major factor in China's economic development, that China's growth rate must therefore now necessarily fall sharply, and China will "grow old before it grows rich." But in reality even 17 percent is a great exaggeration of how much increase in the labor supply contributed to China's growth.

The reason for this is that the increase in the amount of time actually worked grows more slowly than the increase in the working age population. This is because the period of time spent in education rather than work tends to increase, vacations tend to get longer reducing the number of days worked, and other factors.

To show the effect of this, the chart shows the sources of China's GDP growth in 1990-2010 -- the latter being to the latest date for which international comparisons are available. As can be seen, 64 percent of China's growth was due to investment increases, 30 percent to increases in productivity, and only 6 percent to increases in labor. China's rapid economic growth was therefore overwhelmingly driven by increases in investment and increases in productivity with increases in the labour supply playing only an extremely small role. Given its growth rate, eliminating the entire increase in labor into China's economy would have taken only half a percent from China's GDP growth.

 

But even that 6 percent number slightly exaggerates the role of increases in labor supply in China's economic growth! Increase in labor contribution to economic growth take place due to two processes. The first is a rise in the number of hours worked as the workforce gets bigger (the increase in labor quantity). The second is the improvement in skills and education -- a skilled worker creates more value than an unskilled one (the increase in labor quality).

The increase in China's labor quality is 2 percent per year, in line with the average for developing countries. This has a modest scope to increase with higher expenditure on education and skills -- the average increase in labor quality in a developed economy is 3 percent a year. Only 4 percent of China's GDP growth comes from increases in the quantity of labor, which are affected by demographics.

In short, increases in China's labor supply, due to expansion of the working age population, accounted for only 4 percent of China's total GDP growth -- less than half a percentage point of annual GDP growth!

Claims by those such as that by Financial Times writer David Pilling that "the song of China's miracle has a three-word refrain: Just add people" are therefore absolute nonsense. Only 4 percent of China's growth came from "adding people" and 96 percent came from factors other than "adding people!"

This does not mean no economic problems are created by China's aging population. But these come from a completely different route than shortage of labor. The real economic difficulty China faces with regard to population is that people in work can save, while those not working, because they are too young or too old, generally do not save. The decline of the percentage of China's population in work therefore tends to lower China's household savings rate. As investment necessarily has to be financed by savings, this puts downward pressure on China's investment rate, and as investment is the main source of economic growth not only in China but in most economies this could lower China's economic growth. While the decline in China's working age population does not pose a risk of significant economic slowdown due to lack of labor, it could cause a problem due to fall in savings.

But fortunately households are only one of three sources of savings. Of the other two, government savings are small in almost all countries, and usually negative. But company profits are the biggest source of saving in China. If savings via company profits were to increase, this can compensate for any decline in household savings due to the fall in the percentage of the population which is working.

Maintaining high growth in China therefore depends more on maintaining company profitability than it does on population. A decline in company profitability is a much more serious threat to China's growth than any demographic factor. A rise in company profitability, through its effect in raising company savings, would be a far more powerful factor in maintaining China's economic growth than relaxing the one child policy.

In summary, the claim that China faces a significant slowing of its economy due to population factors, and therefore China will "grow old before it grows rich," is a typical example of myths created by engaging in woolly rhetoric without using numbers. Increases in labor supply play such a small role in China's economic growth that the end of the rise in the working age population will have only a very small effect in reducing China's growth rate. It is what happens to China's productivity, and above all its investment, that overwhelmingly will determine its economic growth and therefore its prosperity. Provided the correct policies are pursued, China will certainly become rich before it becomes old.

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This article was originally published in English at China.org.cn and in Chinese at Sina Finance. 

 

China accounts for 100% of the reduction in the number of the world's people living in poverty

In 2010 Professor Danny Quah, of the London School of Economics, noted: 'In the last 3 decades, China alone has lifted more people out of extreme poverty than the rest of the world combined. Indeed, China’s ($1/day) poverty reduction of 627 million from 1981 to 2005 exceeds the total global economy’s decline in its extremely poor from 1.9 billion to 1.4 billion over the same period.' The aim of this article is to analyse the situation taking data published three years after Quah's analysis; look at the trends not only of extreme poverty, which the World Bank calculates using expenditure of $1.25 a day or less; examine a slightly wider poverty definition ($2 a day expenditure), and compare the trends in other regions of the world economy.

The conclusion is simple. Quah's conclusion still holds. China is responsible for 100% of the reduction in the number of people living in poverty in the world. This finding is the necessary backdrop to any serious and informed discussion of the role of China in the world economy and its contribution to human rights.

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There are many remarkable economic statistics about China.

• China contained 22% of the world’s population when its reforms began in 1978, so the percentage of the world’s population directly benefitting from China’s rapid economic growth is seven times that of the 3% of the world’s population in the US or Japan when they began rapid growth, or the 2% of the world's population in the UK at the time of the Industrial Revolution.
• China’s 9.9% average increase in GDP per capita during the two last five year plans is the fastest economic growth per capita ever achieved by a major country in human history.
• In the same period China’s annual average 8.1% increase in household consumption, and 8.3% annual increase in total consumption, including state expenditure on items vital for quality of life such as education and health, was the fastest of any major economy. Coupled with a life expectancy above that which would be expected from China’s GDP per capita it is evident China experienced the most rapid increase in living standards of any country.
• Measured in Parity Purchasing Powers (PPPs) – that is the real increase in output in steel, cars, transport, services etc. - the greatest absolute increase in output ever recorded in single year by the US was in 1999 when it added $567 billion in output. But in 2010 China added $1,126 billion – more than twice the increase in output in a single year ever achieved by any other country in human history.

Nevertheless, impressive as such statistics are, from the point of view of human welfare it is another number which dwarfs all others: the contribution of China to the reduction of human poverty not only within its own borders but in its impact on the world. The astonishing fact remains that China has been responsible for the entire reduction in the number of people living in absolute poverty in the world!

To show this the table below gives the number of those in China and the world living on expenditure less than the two standard measures used by the World Bank to measure poverty. These are the criteria for extreme poverty, expenditure of less than $1.25 a day ($37.5 a month) and those living in poverty – expenditure of $2 day ($60 a month). Charts showing the trends are at the end of the article.

In 1981, on World Bank data 972 million people in China were living on an expenditure of less than $37.50 a month. By 2008 this had been reduced to 173 million, by 2009 it fell to 157 million. Consequently 662 million people were lifted out of extreme poverty in China in the twenty seven years up to 2008 and 678 million by 2009.

In contrast the number of people living in such extreme poverty outside China increased by 50 million between 1981 and 2008 – the number of people emerging from poverty was less than the population increase. This was due to the rise in the numbe of people living in extreme poverty in sub-Saharan Africa. China was consequently responsible for 100% of the world’s reduction of the number of people living in extreme poverty.

Analysing those living on $2 a day ($60 a month), still a very low figure, the trend was even more striking. The number of people in China living on an expenditure of this figure or less fell from 972 million in 1981, to 395 million in 2008, to 362 million in 2009. The number living on expenditure of $60 a month or less in China fell by 577 million by 2008, and by 610 million by 2009.

In contrast the number of those living at this level of poverty in the world outside China rose from 1,548 million in 1981 to 2,057 million in 2008 – an increase of 509 million. Again, China accounted for the entire reduction in the number of people in the world living at this level of poverty.

It is therefore almost impossible to exaggerate what a contribution not only to its own people but to the welfare of the whole of humanity China’s economic progress has made. Without China there would have been literally no reduction in the number of world’s people living in poverty.

The gigantic impact of this on human well-being is not only in its direct effect on personal income and expenditures. It is also in its indirect consequences for human welfare. To take simple examples

• Life expectancy in China is nine years longer than in India – a country which at the end of the 1940s had a higher GDP per capita than China.
• Measured per thousand people China has 66% more nurses and midwives and 160% more doctors than India.
• In China the literacy rate for women aged 15-24 is 99%, on the latest World Bank data, while for India it is 74%.
• The infant mortality rate per 1,000 live births is 12 in China compared to 44 in India.

The direct and indirect effect of bringing people out of poverty is also the greatest contribution that can be made to human rights, The reality is that China’s bringing over 600 million out of poverty means no other country in the world remotely matches China’s contribution to human wellbeing and real human rights.

Notes

Quah, D. (2010, May). 'The Shifting Distribution of Global Economic Activity'.Retrieved January 2, 2012, from London School of Economics: econ.lse.ac.uk/~dquah/p/2010.05-Shifting_Distribution_GEA-DQ.pdf

China has the world's fastest growth in living standards

Summary

China has the world’s fastest growth of consumption while its population lives significantly longer than would be expected from China’s level of economic development. These facts clearly establish China has easily the world’s fastest rise in living standards.

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One of the strangest claims about China that sometimes appears in the media is that it has a slow growth of consumption and living standards. In reality China has the fastest growth of consumption of any country in the world – whether this is measured only by household consumption or includes government consumption on areas vital for quality of life such as education and health. Furthermore, indicators show that compared to other countries, China's quality of life is better than would be expected from its present stage of economic development.

First the facts regarding these issues will be established and then they will be analyzed.

Table 1 shows the growth rates of consumption, both total and household, for the G7 and BRIC economies. These economies are selected for comparison as, given China's size, the appropriate comparison is with major economies – not Caribbean islands or African states. Nevertheless including small economies would make no difference – China would still be seen to have the world's fastest consumption growth rate.

The fundamental period of comparison used is from 1978, the beginning of China's economic reform, to 2011 – the latest date for which figures are available for all countries. However, as data is not available for Russia before 1990, a comparison for 1990-2011 is also given.

The pattern is clear. China's average annual increase in total consumption was 7.9 percent in 1978-2011 and 8.5 percent in 1990-2011. The increase in household consumption in the same periods was 7.7 percent and 8.1 percent. China's are easily the world's highest rates of growth of both household and total consumption.

By comparison, India, ranking second after China, has an annual rate of total consumption increase in the same periods of 5.4 percent and 5.9 percent and its rates of increase of household consumption are 5.2 percent and 5.9 percent.

The U.S., by comparison, had an annual growth rate of total consumption of 2.7 percent in 1978-2011 and 2.5 percent in 1990-2011. U.S. growth rates of household consumption are 2.9 percent and 2.8 percent in the same periods. China's consumption growth rate was therefore almost three times as fast as the U.S.

It is obvious that such a rise in consumption – an increase in quantity and quality of food, housing, holidays, phones, cars, furniture, health care etc. – is a decisive factor in determining any country's living standards. China's rapidly growing numbers of smartphones, cars, internet users, those taking foreign holidays etc. reflect its rising living standards. However some people attempt to claim, entirely falsely, that China's dramatic increases in consumption may be offset by other factors – for example weaknesses in health care, deterioration in the environment etc.

Fortunately, this can be tested objectively. Life expectancy, as is well known, is a very sensitive indicator of overall living conditions. As well as most people having a direct goal of living longer, length of life also summarizes the combined impact of health, environment, consumption and other factors on human well-being.

As people in China live significantly longer than would be expected given its economic development level any claim China’s rapid rise in consumption is more than offset in terms of rising living standards by health, environmental or other considerations is false. The evidence is clear that environmental, health and other factors affecting health quality are superior in China than would be expected for its level of economic development.

None of this is grounds for complacency. What have been analyzed here are growth rates, not absolute levels. China’s life expectancy (73.5 years) is still significantly behind the US (78.6 years) let alone Italy (82.1 years) or Japan (82.6 years). China must still undergo a prolonged period of economic growth before it achieves the highest levels of developed economies.

Nevertheless China is developing from a situation where in 1949 it was one of the world’s least developed countries. It is therefore ridiculous utopianism, which in practice would lead to the wrong policies, to believe China can in one step achieve the highest levels of the most advanced economies. The relevant question is whether China is developing living standards and consumption more rapidly than other economies, in which case it is catching up with them, or whether it is developing more slowly than other countries – in which case it is falling behind.

But given that China has the world’s fastest growth of consumption, why is the totally erroneous statement made that China underdevelops consumption? Such claims commit the elementary mistake of confusing China’s growth rate of consumption, the world’s highest, with the percentage of consumption in GDP – which is low in China. But for change in the population’s living standards what counts is how fast their consumption is growing, not the percentage of consumption in GDP – for example the percentage of consumption in GDP of the Democratic Republic of the Congo is an extremely high 89% but it is the world’s poorest country for which data exists!

The conclusion is therefore absolutely clear. China has by far the fastest growth rate of consumption in the world, together with life expectancy significantly above that which would be expected given its level of economic development. China, in short, has easily the world’s fastest rise of living standards.

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An earlier version of this article originally appeared in Chinese on Sina Finance. This article was originally published in English by China.org.cn.

Comparison of relative performance of China and the West since the financial crisis began

I greatly admire and avidly read Gavyn Davies blog, but his latest comments on China, unusually, lack precise numbers which therefore creates some ambiguities which can give unnecessary credibility to wrong analysis. Putting in precise numbers should bring clarity.

China's government has spelt out officially its precise growth target. That is to increase GDP by 100% in 2010-2020 – about four times the prospective growth rate of the US in the same period.

Given China’s cumulative growth in 2010-2012 (17.8%) this means China has to hit a 6.9% average growth rate for the rest of the decade to achieve its target. As all this is unambiguously spelt out the relevant yardstick is whether China will achieve this.

It is a wholly spurious method, not used by Gavyn but used by others, to invent some target China never set and then claim there is a ‘crisis’ because China has ‘failed’ to achieve a target it never put forward! There is no indication China is falling below its projected growth target - China’s growth this year will clearly be above the target rate.

If Gavyn, or anyone else, wants to say argue there is a serious crisis in China, they have to claim growth will fall below the average 6.9% rate – some people do of course, so we will examine that below.

As for the efficacy of the 2008 stimulus programme it can be seen in two sets of figures. In the five years between the 1^st quarter of 2008 and the 1st quarter of 2013 China’s GDP grew by 51.8% and the US by 3.5% - the EU and Japan contracted. This is shown in Figure 1.

Figure 1

 

To remove any claim of possible distortion caused by the depth of the US recession in 2007-2009, in the year to the 1^st quarter of 2013 China’s economy grew by 7.7% and the US economy by 1.6% - that is China’s economy grew 6.1% faster than the US economy, or at 480% of the US growth rate. This is shown in Figure 2.

Figure 2

 

The argument that China is suffering from economic ‘crisis’ on anything like the scale of the US, Europe or Japan, for example because of its recent liquidity problems, is rather like the spurious argument that really the flu is the same as polio because they are both illnesses!

As for the suggestion that Michael Pettis has been proved right I am afraid that although he edits his blog very fairly his predictions on China are extremely inaccurate. In 2009 he insisted: ‘'I continue to stand by my comment last year... that the US would be the first major economy out of the crisis and China one of the last.' This statement is entirely inaccurate – as the more than 50% growth in China and less than 4% in the US since the beginning of the financial crisis shows. His new thesis  is that: ‘'I still maintain that average growth in this decade will barely break 3%.' The projection of 3% growth is itself entirely inaccurate but given China’s existing growth this means that for the rest of the decade it would have to grow at 1.6%!!! The reason for such inaccurate predictions is that Michael Pettis makes, as shown in his book The Great Rebalancing, one of the oldest errors in economics – underconsumptionism, that is the confusion of demand (consumption plus investment) with consumption. He himself lists in the opening pages a whole series of underconsumptionist authors.

Coming back to Gavyn’s blog, China’s growth rate continues to be above the target it has set itself of 100% GDP growth in a 10 year period. That will be about 4 times US GDP growth in the same period. China will overtake the US to become the largest economy in the world in approximately 5 years. The rest of the world would be highly delighted to have such a ‘crisis'’.

I actually sort of assume Gavyn doesn’t disagree with those numbers? If I am wrong, and he does then of course it would clarify the debate, if he gave his own. But indicating numbers is the best way to clarify the discussion. My projection is simple – China will hit its 100% GDP growth target over a 10 year period.

Behind China's liquidity crisis

In June, China suffered its worst liquidity crisis in over a decade. Some sections of the U.K. and U.S. media exploded with wild comparisons to the US financial crisis in 2008.

Such comparisons were nonsense, however, based on an elementary economic mistake. The U.S. did not suffer a liquidity crisis in 2008. It faced an insolvency crisis. The former is a shortage of means to meet immediate payments; the latter occurs when banks' liabilities exceed their capital. In 2013, Chinese financial institutions faced liquidity problems, but not a single major institution failed. Numerous U.S. financial institutions collapsed in 2008. Comparing the two events is rather like claiming that the flu and the bubonic plague are equally serious, since both are illnesses!

But not being the bubonic plague doesn't mean that in its own terms flu is not unpleasant, or that it doesn't have side effects that last for some time. Therefore, it is important to analyze the crisis' causes in order to determine whether similar events will recur. While the exact form of crisis was not predictable - it never is - both Chinese economists and the present author predicted why there would be problems for the Chinese economy. Now that June's symptoms have been somewhat ameliorated, whether a similar crisis emerges in the future depends on whether the key mistake that led to the present one is resolved.

The key symptom of June's crisis was a spike in interbank lending rates to a 13 percent peak. Willingness to pay this indicated that financial institutions urgently needed cash. Analyzing the links between the underlying disease and the symptoms shows why.

The core problem that led to the liquidity crisis was advocacy that China abandon the policies which for 35 years have made it the world's most rapidly growing economy, in favor of something termed "consumer led growth," a theory that boosting consumer demand will lead companies to a more rapid increase in production of consumer goods and a more rapid rise in living standards. Unfortunately, this theory factually doesn't take into account that investment is the main source of economic growth, and conceptually it doesn't understand what a market economy actually is.

A market economy necessarily can only be "profit led growth." Output does not increase due to "demand," but only because of profit. Failure to understand this pushed the economy towards the liquidity crisis via its key policy proposal that the percentage of consumption in China's GDP be increased, and to pay for these purchases the percentage of wages in GDP should increase.

Increasing the percentage of wages in the GDP necessarily means reducing the percentage of profits. Therefore the theory of "consumer led growth" in reality advocated that a profits squeeze should be applied to companies via wages growing more rapidly than GDP. Regrettably, in the first part of 2013, this policy was pursued, with China's consumption rising significantly more rapidly than its investment, an indication wages were rising more rapidly than GDP. This produced the only possible consequence in a market economy: a chain reaction leading to crisis, which duly broke out in June in credit markets

Wages rising more rapidly than GDP squeezed company profits. By May 2013, the overall profit increase by companies listed on China's A-share market was zero percent - they were falling in inflation-adjusted terms. Consequently, both private and state-owned companies starting reining in investments. In the first five months of 2013, growth in fixed assets investment was 0.2 percent lower than growth in the first four months, and private investment growth was 0.1 percent less than it had been a year before.

This, in turn, led to economic slowdown. GDP growth fell from 7.9 percent in the last quarter of 2012 to 7.7 percent in the first quarter of 2013, placing greater pressure on profits. Profits were then squeezed further by the rise in the RMB exchange rate, which created difficulties for China's exporters.

This inevitably affected credit markets. With profit growth slowing, and in some cases, becoming negative, companies needed credits to plug holes in cash flows. Simultaneously, as companies were using cash to plug payment holes and not to invest, credit became less effective at stimulating growth. Given that profits were squeezed in most sectors, companies diverted what resources they could into markets which were more profitable - most notably, real estate, fuelling price increases in this sector. The pressure on company profitability therefore expressed itself via ballooning demand for credit, ineffectualness of credit in accelerating growth and excess upward pressure on real estate prices.

To attempt to stop ballooning credit, the Central Bank tightened liquidity. But this tackled symptoms, not the disease - rather like treating chicken pox by pressing on the spots. The disease was therefore not cured. Indeed the situation worsened as companies' cash flows were now squeezed from two directions - from the fundamental processes described above and by the Central Bank's liquidity tightening. If this dual pressure had continued, there would have been a financial collapse. Therefore, the Central Bank had to alter course and inject credits.

By supplying liquidity, the Central Bank took pressure off companies from one side, thereby overcoming the immediate crisis. But the underlying cause of the problem will not be overcome until the company profits squeeze is fully reversed.

Finally, while a crisis would have occurred anyway, it was worsened by the incomplete structure of China's banking system. China, like every country, must possess a core of system making banks that are "too big to fail." Such huge banks will never be adequately responsive to small companies' needs, however. In the U.K., which has a private dominated banking system, there are endless complaints by smaller companies about large banks! China has not yet created an adequate system of "small enough to fail" banks, which are responsive to smaller companies, around its large core lenders. Instead, an insufficiently regulated shadow banking system developed.

But the same fundamental factors that made it possible to accurately predict rapid growth of China's economy for 35 years show it is relatively easy for China to overcome these problems, as they are self-inflicted policy problems, not objective constraints.

In 2012, under the influence of the World Bank report on China, similar policies were pursued in the first half of the year. They also led to a growth slowdown. When this policy was reversed in mid-2012, with an investment stimulus, growth accelerated from 7.4 percent to 7.9 percent. In 2013, unfortunately, the wrong policy was pursued for longer and therefore led to June's crisis.

Lin Yifu, former senior vice president of the World Bank, recently stated: "Those who advocate that China's economy should rely on consumption are, in fact, pushing the country into a crisis." Regrettably, June's events confirmed these words.

Large forces in China are working against the errors that led to the June crisis. Companies do not want profits pressured. Slower economic growth will lead to less rapid increase in living standards, creating dissatisfaction among consumers. As June's events in China's financial market were a liquidity crisis, not one of solvency, and China's banks remain highly profitable with assets far outweighing liabilities, no systemic damage has been done to China's banking system. June's events simply demonstrated that even in a country with China's very strong macroeconomic fundamentals, an incoherent theory can wreak havoc. A non-sequitur like "consumer led growth," which necessarily applies a profit squeeze to companies, inevitably leads to economic crisis.

June's credit market explosions were simply the market economy reminding everyone that, within it, there can never be "consumer led growth." Only "profit led growth" is possible.

Hopefully the appropriate lessons have been drawn.

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An earlier version of this article appeared at China.org.cn.

Why China can maintain 8% growth

China’s National People’s Congress (NPC) has set a 7.5% official GDP growth target for this year. Lin Yifu, former Senior Vice-President and Chief Economist of the World Bank, and one of China’s most important economists, predicts that China can maintain 8% annual growth for 20 years. A key question is evidently whether such targets are realistic. Can China maintain this type of growth rate?

The immediate negative factors are evident. The international context for China’s economy this year is bad. The Eurozone economy is shrinking, Japan is stagnant and US growth is anemic. A 16% fall in world commodity prices since their peak has led to slower growth in major developing economies such as Brazil.

China’s policy makers initially underestimated the problems in the advanced economies. Adjusted for inflation, imports by developed economies have not regained pre-financial crisis levels. China therefore did not achieve its 2012 target of a 10% trade increase – the ctual rise was 6.2%. The lower 8% trade growth target set for 2013 is more realistic if still challenging. All major motors for growth will therefore have to come from China’s domestic economy.

In terms of strengthening China’s relative international economic position, and maintaining its ranking as the world’s most rapidly growing market, all this makes no difference. China is the world’s most open major economy, so it cannot cut itself off from international trends. China’s growth rate inevitably goes up or down with global economic fluctuations – the constant is that China strongly outperforms these trends.

To give more precise numbers, a rule of thumb of over 20 years, which successfully passed the test of events, is that China grows on average at whatever the advanced economies expand at plus 6% - the greater outperformance during the financial crisis was untypical. Developed economies this year will probably grow at around 1.5-2.0%, implying China will grow at 7.5-8.0% - in line with official forecasts. This is consistent with the official target of doubling the size of China’s economy between 2010 and 2020.

But for estimating expansion of China’s market, and growth of living standards, the absolute rate at which China’s economy develops is obviously key. It is therefore worth looking beyond short term ups and downs to the fundamental factors determining how fast an economy grows. This makes clear why China will achieve its 7.5-8% growth target. It also eliminates ‘manic-depressive’ analyses of China’s economy – periodic oscillating predictions of ‘hard landing’ and ‘rampant growth’ which appear in some parts of the media.

The current infatuation with examining consumption in China’s GDP is misleading in terms of analysing its economic performance. A country’s consumption growth is overwhelmingly determined by its GDP growth – internationally 87% of consumption increase is determined by the latter. If China’s GDP grows rapidly consumption will grow rapidly. If China’s GDP growth slows its consumption, over anything other than the very short term, will be lower than its potential with high GDP growth.

Every economy’s growth, including China’s, is necessarily determined by two key parameters: how much it invests and how efficiently that investment creates growth. Taking the five year average for 2006-2011, the latest internationally comparable data, China’s fixed investment was 43.1% of GDP, and it invested 4.1% of GDP for its economy to grow by a percentage point. Consequently, as a matter of simple arithmetic, China’s economy grew at an annual average 10.5%.

The lower the percentage of GDP invested for any given economic growth the more efficient that investment is. Furthermore, contrary to some myths, China’s investment is extremely efficient by international standards as the Table shows. For example in 2006-2011 China needed to invest 4.1% of GDP to grow by 1% whereas the US invested 24.3% - China’s investment was six times as efficient in generating GDP growth as the US. Even before the international financial crisis the US invested 7.0% of GDP to grow by 1% compared to China’s 3.4%. These key numbers determine how fast China’s economy grows.

Table 1

 

If China’s economy is to slow, as some critics argue, then it is necessary one or both of these key parameters changes. Either China’s percentage of investment in GDP must fall or the efficiency of its investment in generating GDP growth must decline – there are no other choices.

Taking first investment efficiency, the Table shows that almost all economies were negatively affected by the international financial crisis. China was no exception – the percentage of GDP which had to be invested for its economy to grow by a percentage point rising from 3.4% to 4.1%. But this deterioration was less than for most countries – the US figure rose from 7.0% to 24.3%, Germany’s from 8.2% to 18.4%.

China’s investment efficiency would have to fall greatly not to achieve its 7.5% growth target. If China’s recent investment level was maintained then the percentage of GDP it needs to invest to grow by a percentage point would have to rise to over 5.7% before China failed to hit its growth rate target. Maintaining China’s efficiency of investment is therefore a constant challenge for the government, but China has a considerable safety margin in setting its target growth. The government’s entire focus is on maintaining the efficiency of investment, not reducing it.

The other possibility for slowing China’s economy would be a sharp reduction in the percentage of investment in GDP. There are certainly some in China advocating reducing the level of investment in GDP, but not by nearly enough to prevent China hitting its growth targets. At its present level of investment efficiency China’s GDP growth rate falls by 1% for each 4.1% reduction in the percentage of fixed investment in GDP. But in the last 5 years China’s annual GDP growth averaged 10.5%. To reduce China’s GDP growth below 7.5% requires a fall in the percentage of investment of GDP of 10%. No serious figure in China, as opposed to a few Western analysts, advocates this. A fall in investment share of 2-4% of GDP, the type of figure sometimes advocated, would only slow China’s economic growth by 0.5-1.0%.

Therefore international economic headwinds are negative. But in both the efficiency of its investment and the percentage of investment in GDP China has considerable safety margins for achieving its growth targets - unless the administration makes very large errors the growth targets will therefore be met. Indeed, looking at these margins of manoeuvre, Lin Yifu’s 8% is perhaps more realistic that the government’s 7.5% - administrations always like to announce they have exceeded targets.

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This article is slightly edited for an international audience from one which originally appeared in Shanghai Daily.

China's economy speeds up

China's economy in 2012 was "a tale of two halves": In the first six months slowdown, even a feeling of developing crisis; in the second half recovery and accelerating growth. The story therefore had a happy ending. But it is worth noting what went wrong in the first half, and how it was corrected in the second, as this contains lessons for the future.

The initial problem in early 2012 was simple. China's economic policy makers underestimated the problems in the developed economies. China's official prediction of 10 percent export increase in 2012 could not be achieved without significant growth in developed markets. This did not materialize – the US economy grew slowly while Japan and the EU's fell into a new decline. Consequently, as is now officially stated, 2012's export target will not be achieved.

This itself was not an extremely serious error. It is impossible in economics, due to the enormous number of variables involved, to make precisely accurate predictions, only orders of magnitude can be accurately predicted. The undershoot in export growth in 2012 will not be enormous. To compensate for international demand being weaker than predicted China required a domestic economic stimulus. It was here that a much more serious problem initially arose.

Early in 2012 the World Bank produced a report arguing that China's state should "get out" of the economy – something clearly going against a new state stimulus program. Supporters of such neo-liberal policies in China, for example Lang Xianping, launched a campaign arguing that a stimulus program was futile and that China faced terrible economic depression. Western authors such as Nouriel Roubini advanced less extreme versions of the same analysis.

Such "the state must get out of the economy" neo-liberal policies have produced economic disaster where they have been pursued in countries as diverse as Europe, Latin America and Russia. I warned in this column in March that such policies would damage China's economy.

By summer 2012 the damaging consequences of state failure to intervene were clear. In May annual fixed asset investment growth fell to 20.1 percent, the lowest level for a decade. In August the yearly increase in industrial production declined to 8.9 percent, from 11.4 percent in January. In the same month industrial company profit fell 6.2 percent year on year. A sense of malaise, even elements of crisis, was evident during the first half of the year under the impact of policies which reflected neo-liberal opposition to state intervention.

Fortunately from mid-year policy changed, creating the happy economic ending to the year. In late May Premier Wen Jiabao announced growth must receive more support. An infrastructure investment program that grew to US$157 billion was launched. Theoretical support to the new stimulus was given by former World Bank Chief Economist and Vice President Lin Yifu – who specifically stressed an investment based stimulus package was preferable to a consumer based one.

These policies meant the state "getting back" into the economy – not in the sense of trying to administer it, but in that of setting the overall investment level. Such policies are familiar in either Chinese economic analysis stemming from Deng Xiaoping or Western ones coming from accurate reading of Keynes. Premier Wen Jiabao also turned the economic tables, explicitly justifying not only the 2012 stimulus but the earlier one in response to the 2008 financial crisis.

The stimulus package launched in mid-2012 was rightly of a much smaller scale than 2008's. In 2008 the world economy plunged downwards in the greatest economic decline since 1929. A huge stimulus was necessary to guard against downturn on such a scale – particularly under conditions where not only was there severe existing global recession but also further downside risks. The 2008 scale of stimulus, US$586 billion, was to guarantee China's economy was not dragged into global downturn.

But in 2012 there was stagnation, not sharp decline, in the advanced economies. China's required stimulus was therefore much smaller – a program on 2008's scale would have been highly undesirable in overheating the economy in these different circumstances. The announced infrastructure stimulus in 2012 was approximately one third of 2008's. But the state was "stepping into" the economy on an appropriate scale.

The correctness of these policies was shown rapidly. By November the investment decline had reversed – the annual increase in fixed asset investment rising to 20.7 percent. The same month year on year industrial production accelerated to 10.1 percent. Industrial company profits began to grow – rising to a 20.5 percent yearly increase in October and 22.8 percent in November. Profits growth in October and November was so strong that it turned the 1.8 percent yearly decline in January-September into a 3.0 percent increase in January-November. While GDP growth for the 4th quarter 2012 will not be available until later it would be highly astonishing, given these trends, if it were not higher than the 3rd quarter of 2012's 7.4 percent.

What are the conclusions, and what are 2013's perspectives? It showed, as always, the disastrous consequences of neo-liberal opposition to appropriate state intervention in the economy. A moderate problem facing China, lower than anticipated growth in developed economies, and consequently somewhat slower than anticipated export growth, became a significant crisis due to opposition to appropriate state intervention. However once policies were corrected, and appropriate investment stimulus policy measures adopted, all the advantages of China's economic structure came into play. Within a few months China's economy was recovering with an impetus that is strong enough that it will clearly continue into 2013.

China's difference to Western economies is that once the appropriate economic policy response is decided it has structures to deliver it. The Chinese state has sufficient levers that it can set an overall investment level in the way that Deng Xiaoping or Keynes considered necessary. This created rapid economic recovery in the second half of 2012. In contrast the Western economies have no structures to set the overall investment level. The latter remains purely in private hands – something Keynes explicitly warned would create crisis.

In the Western economies, to attempt to reverse the decline in fixed investment which is the core of the Great Recession, governments are reduced to running huge, ultimately unsustainable, budget deficits or flooding the economy with money – symbolized by the various quantitative easing programs in the US and hyperexpansionary monetary policies now followed by the European Central Bank and Japan's central bank. These have failed both to reverse the investment decline in developed economies while threatening other states in the global economy with inflation and currency fluctuations due to this excessive monetary expansion. China's policies ensure its own investment does not decline, thereby generating economic growth, while not pumping excessive monetary stimulus into the global economy.

Provided the policies which brought China's economy success in the second half of 2012 are continued, its economy's prospects for 2013 are clear. China's economy in the 2nd half of 2012 was on an upward trajectory shown clearly by upward shifts in profitability. As this was still growing it will clearly continue into the first half of 2013. Projections of accelerated growth for the first half of 2013, compared to 2012, therefore appear well founded.

During the course of 2013 external conditions will have to be reviewed to see if the existing domestic stimulus is sufficient – theoretically the domestic stimulus could be reduced if export conditions significantly improve, or it could be accelerated further if external conditions deteriorate. But 2013's basic dynamic is that China will grow much more rapidly than other major economies, due to its structural strength and its much superior mechanisms for dealing with economic downturns which 2012 again demonstrated.

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This article originally appeared on China.org.cn.

Note to neo-liberals: Earth orbits the sun

The following article originally appeared in China Daily Europe.

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In the next 15 years one of the greatest turning points in world history can occur. In five to seven years China will become the world's largest economy. In about 15 years China will achieve the annual $12,000 GDP per capita qualifying it as a developed economy by World Bank criteria. China is so large that these events will change the world. For example, China's 1.3 billion population is larger than the combined 1.1 billion of all existing developed economies.

But these successes are not inevitable. China has enjoyed tremendous economic achievements since 1978, experiencing in the last decade the fastest per capita GDP growth in any major economy in history, and the fastest growth of consumption in a large country. It achieved this because it followed economic policies laid out by Deng Xiaoping from 1978. But now an attempt is being made by some to divert China onto an economic path, neo-liberalism, which has failed wherever it has been carried out. Examining the factual record of neo-liberal policy shows the scale of what is at stake both for China and internationally.

Neo-Liberal policies were applied in Latin America in the 1980s. The result was that Latin America's per capita GDP fell by an average 0.5 percent a year for 10 years.

In the former Soviet Union neo-liberal shock therapy, based on full privatization, was carried out after 1991. Russia's GDP fell 36 percent, the greatest decline of a major economy in peacetime in modern world history. Russia's male life expectancy fell by four years, to only 58, by 1998 and Russia's population today is 7 million less than it was in 1991.

Neo-liberal policies in the US instigated under Ronald Reagan led to the colossal accumulation of debt that culminated in the international financial crisis of 2008. During the earlier Keynesian period of US economic policy, lasting from the end of the Korean War (1950-53) until 1980, US state debt fell from 70 percent to 37 percent of GDP. During the succeeding neo-liberal period US state debt rose to 88 percent of GDP by last year. Over the same period the 10-year moving average of annual US GDP growth fell from 3.3 percent to 1.6 percent. Under neo-liberal policies US state debt more than doubled, and US economic growth halved.

Given neo-liberalism's disastrous record, which is even starker when compared with China's growth, how can anyone advocate that China adopt such a failed policy? The answer is that intellectually this can be done only by making no reference to economic facts or by falsifying them. An example of the latter is the assertion that China's investment is less efficient than that of economies such as the US when the facts show the opposite. Even before the international financial crisis China had to invest only 4.1 percent of GDP to produce each percentage point of economic growth, compared with the 8.8 percent in the US. Since the financial crisis the US position has worsened.

Neo-liberalism fails as economic policy because it refuses to follow science's first rule of starting with the facts, or, in the famous Chinese phrase, it refuses to "seek truth from facts". Rather in the style of pre-Copernican astronomers who insisted that the sun orbited the Earth, because they failed to make measurements showing the Earth circles the sun, neo-liberals construct models of an economy that does not exist. They imagine an economy made up of millions of competitive firms (technically "perfect competition"), in which prices are flexible downward as well as upward, and in which investment is a low percentage of the economy. The real economy is nothing like this.

The scale of investment has been rising for 300 years to levels of 20 percent, or even more than 40 percent, of GDP. Huge financial structures were necessarily created to centralize the resources for this. Banks now agreed to be "too big to fail", and which therefore cannot be allowed to operate in a free market without incentivizing uncontrollable risk taking. Due to this high investment the world's most important industries - automobiles, aviation, computers, finance, pharmaceuticals - do not operate according to "perfect competition" but are monopolies or oligopolies. As neo-liberalism does not correspond to economic reality its policies are necessarily damaging.

For this reason, even when not fully adopted, neo-liberalism's influence damages China's economy. For example, early this year severe negative pressure on China's economy occurred due to a downturn in the global economy driven by a fall in private investment. However, due to the influence of neo-liberal views, that the State should "get out" of the economy, the necessary stimulus to counter this was not launched early enough. Fortunately, in the second half of the year, China's government launched a required medium-scale State-led investment stimulus that stabilized the economy during the third quarter and should now lead to accelerated growth.

The consequences for the popularity of those implementing neo-liberal policies, and for social stability, are also clear. For example in Britain David Cameron launched the Big Society, the concept that the state should be small and be replaced in social protection by the market and voluntary organizations. But factual evidence shows that pure operation of the market increases, not decreases, social inequality and fails to provide social protection. The result under Cameron was sharply rising social inequality, ridiculing of his policies even by those not associated with the political opposition, and a collapse in the government's popularity.

In China, where there is a widespread consensus that in the recent period social inequality has gone too far, and which due to size is more difficult to govern than any European state, to embark on neo-liberal policies, which would inevitably increase inequality, would not only be economically damaging but socially and politically destabilizing.

However, neo-liberalism is not just an intellectual theory. Many people profit from it. In the US most of those in the finance sector who led its economy to disaster in 2008 retain the private wealth gained from neo-liberal policies.

Two groups of people would gain from neo-liberalism in China, and therefore support it. The first are some financial layers in the country. The second are US neo-con circles that aim to maintain the US as the world's largest economy despite remorseless arithmetic showing this is impossible.

The population of the US is only 23 percent of China's. The only way the US could remain the world's largest economy is if China's per capita GDP, and by implication its living standards, never reaches 23 percent of US levels. Quite rightly China's population will never accept they can only have less than one quarter of the US living standard; nor in the future will India. As China's GDP per capita moves toward that of the US China's economy will become first the largest and later the strongest in the world. The only way to stop this is to sharply slow China's economic growth, neo-liberalism's disastrous consequences being the way to achieve that.

China's economic rise immensely benefits not only itself but humanity. When, in about 15 years, China achieves advanced economy status, 35 percent of the world's population, for the first time in modern history, will enjoy the benefits of this. When China has come so close not only to full national revival but to decent living standards for its people it would be one of the greatest tragedies in world history for neo-liberalism to block this.

Investment will boost China’s economy

The underlying weakness in the US, European and Japanese economies was underestimated in China’s forecasts for 2012. The US is currently consuming more capital than it creates, while its percentage of investment in GDP is near post-World War II lows. Japan’s investment levels have declined for two decades while its savings rate has fallen. EU investment is the lowest percentage of GDP since World War II and declining. These economies cannot achieve rapid recovery under such conditions.

These structural features dictated the poor short term performance of Western economies during 2012. The EU entered a new recession with GDP still 2.1% below 2008’s peak levels. Japan’s latest GDP data shows tortoise like 0.8% annualized growth with output still 1.9% below its peak. US GDP growth decelerated from 4.1% at the end of 2011 to 1.7% in the last quarter. The US PMI fell for three months to 49.6 in August. US industrial production in the same month only rose 2.8% compared to a year previously – less than a third of China’s growth.

The problems in developed economies directly affected China. China’s 10% projected export increase in 2012 will not be achieved, helping explain why China's economy significantly decelerated in the first part of the year. GDP growth fell to 7.8 percent in the first half of the year, while August’s industrial growth declined to 8.9 percent and the official manufacturing Purchasing Managers Index fell to 49.2.

Weakness in Western economies can to a certain degree be compensated for by China’s export growth to developing countries as the latter now constitute 53% of China’s exports. But as Western economies still account for almost half China’s current global market the growth prospects for China’s exports are structurally limited. Consequently, as the great majority of analysts conclude, China’s economic expansion in the next few years must be based primarily on domestic demand. It is therefore good news for China’s economy later this year that lessons drawn by China’s economic policy makers have begun to overcome some confusions which existed earlier regarding the dynamics of China’s domestic demand. This process has been aided by policy recommendations by Lin Yifu - China’s former World Bank Senior Vice President and Chief Economist.

Problems had earlier been created in discussion of China’s economic policy by confusing ‘domestic demand’ with ‘domestic consumption’. The two are not the same. Domestic demand consists not only of domestic consumption but also domestic investment. Formulas such as the following, which were regularly used, were therefore erroneous: ‘China will not be able to rely on exports for its economic growth. Therefore, China will have to adopt a consumption-driven growth strategy.’

From the viewpoint of increasing domestic demand, China’s exports can just as much be replaced by raising China’s domestic investment as by increasing consumption. Indeed whether, and in what proportion, to expand China’s domestic demand by expanding investment or consumption is a crucial economic policy choice.

The clarity necessary on this has been highlighted by Lin Yifu and confirmed by trends in China’s economy in the first part of 2012. Lin argued that, compared with boosting consumption, encouraging investment is a more sustainable and successful path. This analysis, which is justified by factors set out in Lin’s writings on long term economic growth, was also clearly confirmed by trends in China’s economy during 2012.

Some deceleration in China’s economy was inevitable in 2012 due to negative international trends. Nevertheless this was magnified earlier in the year by errors in China’s normally surefooted economic policy which are now being overcome.

China’s economic policy during the last period took as a key aim raising consumption – i.e. living standards. This indeed should be economic policy’s aim – the target should be maximizing the sustainable rate of increase of consumption. But unfortunately this became confused with a different idea of sharply increasing the percentage of consumption in China's GDP. These two goals are actually contradictory as GDP growth, which is largely fueled by investment, underpins sustainable consumption. Sharply increasing consumption’s percentage in GDP cuts investment levels, thereby inadvertently leading to lower GDP and consequently lower consumption growth.

The practical consequences of this confusion were clear in 2012. To attempt to raise the share of consumption in China's GDP, wage increases far above the economy's growth rate were pushed through. In the most striking examples, Sichuan raised the 2012 minimum wage by 23 percent, and Shenzhen announced a 16 percent increase to the 2012 minimum wage following a 20 percent increase in 2011.

Such measures increased inflationary pressures in China’s economy and squeezed private and state company profits, helping create in the first half of 2012 a trend accurately termed ‘profitless growth’. Falling profits in turn led to investment reductions, with fixed asset growth declining from 25.0% in August 2011 to 20.2% in August 2012. Falling economic growth also reduced government tax receipts, pressuring the state budget.

This process illustrates why the phrase ‘consumer-led growth’, sometimes used in China, is fatally confused. In a market economy production does not take place because there is a demand for consumption. It only occurs if production is profitable. As profits declined in 2012 investment fell, the economy slowed, and consumption's growth rate therefore declined. The growth rate of retail sales, before adjusting for inflation, fell by 4.9 percent between December 2011 and August 2012 while the CPI fell by 2.2 percent. Real retail sales growth, the main factor in consumption, therefore fell. Predictably, attempting to sharply increase consumption's percentage in GDP led to the population’s consumption rising more slowly!

But while consumption was boosted the government initially did not use available policy tools to halt the decline in fixed investment – as shown by the fall in fixed asset formation. These policies are now being corrected. Instead of the confused formula of ‘consumer-led growth,’ Premier Wen Jiabao has rightly emphasized ‘a pattern in which economic growth is jointly driven by consumption, investment and exports.‘ A $154 billion state-stimulated investment program has been announced. These practical steps by the government are clearly broadly in line with the economic policy arguments advanced by Lin Yifu.

If China's government continues these corrections, China’s growth will stabilize and then accelerate towards the end of 2012.

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This article originally appeared in China Daily.

Quantitative easing - US and non-US markets

An important article by Gavyn Davies on his Financial Times blog analyses the effects of US quantitative easing (QE) on bond, share and commodity markets and the relation of these to trends in the productive economy.

Gavyn Davies charts the graph in Figure 1.

Figure 1

 

His commentary is self-explanatory:

‘A quick glance at the graph suggests that equities, bonds and commodities have all been in bull market trends ever since the successive rounds of quantitative easing started. However, a closer inspection reveals that this is not in fact the case. Only bonds have been in a continuous uptrend. The behaviour of global equities and commodities can more meaningfully be split into two separate phases.

‘From the start of the recovery to the end of April 2011, both equities and commodities recorded extremely strong bull markets, with both asset classes rising by some 90 per cent.

‘Since then, however, the bull market in risk assets has fizzled out. In the second phase (shaded blue), equities have been volatile around a broadly flat trend, and commodities have actually fallen by 16 per cent from the peak, despite their recent rally. Quantitative easing has not been powerful enough, at least up to now, to restore the 2009-11 bull market.’

As regards bond markets the essentially continuous upward trend of prices noted by Gavyn Davies naturally indicates that the intended goal of QE of depressing interest rates has been achieved. As regards commodity prices he is accurate that these have not yet regained their post-financial crisis peaks reached in April 2011 – as is clear from Figure 2.

Figure 2

 

World share prices have also not significantly risen above their April 2011 post-international financial crisis highs – see Figure 3. However this graph also illustrates the sharp difference between US and non-US share price performance.

US shares have continued to advance since April 2011, more than overcoming their decline in the second half of 2011. Non-US shares have, however, fallen back from April 2011 levels.

Whereas up to April 2011 US and non-US share markets moved in the same direction, both showing recovery, since April 2011 US and non-US share markets have moved in opposite directions with the former having risen and the latter fallen.

Figure 3

 

In order to illustrate this more clearly Figure 4 shows the changes in world, US and non-US share prices since 31 March 2011. By 21 September US share prices were 9.9% above their 31 March 2011 levels whereas non-US share prices were 9.2% below them.

Figure 4

 

These contrary trends in US and non-US share prices naturally don't contradict Gavyn Davies’s fundamental argument. But they highlight an important trend within its overall framework.

US QE policies have been accompanied by, almost certainly caused, a significant and continuing rise in US share prices which continued after April 2011. But US QE policies have been accompanied since April 2011 by a fall in non-US share prices. Any analysis of trends in world markets must take into account and explain these divergent trends.

It is also unlikely that the explanation can simply be more rapid economic growth in the US compared to other economies . Despite some recent slowdowns emerging economies have grown significantly more rapidly than the US, but emerging economy share prices have performed significantly worse than the US – Figure 5. Whereas emerging economy share prices have fallen by 14.2% since 31 March 2011 US shares have risen by 9.9%.

Figure 5

 

The Federal Reserve could, therefore, argue that it has created a ‘wealth effect’ within the US through QE – US house prices have also stabilised and then risen slightly this year. However the data from commodity markets and non-US share markets indicates no such effect has been created by QE outside the US.

Whether US QE has contributed to the negative trends in non-US economies, as countries such as Brazil have argued, would of course requires a separate article. The distinction between US and non-US markets is however relatively clear.