China's economy is changing. Indeed, it has to change, as I argued two weeks ago. The good news is the scale of the external rebalancing. The bad news is that this is at the cost of larger internal imbalances.
China's balance of payments has been a roller coaster. Thus, between 2003 and 2007, the current account surplus rose from 2.8 per cent to 10.1 per cent of gross domestic product. The surplus then fell sharply, to 2.9 per cent, by 2011. Over the same period, the share of exports and imports in GDP exploded upwards and then fell once again.
In orthodox theory the level of current account surpluses and deficits reflect voluntary decisions to save and invest: countries with surplus savings, such as China, export capital while countries with a deficit import it. Surplus countries enjoy a higher return on savings; deficit countries enjoy a lower cost of investment. Everything is for the best in the best of all possible worlds. It seems peculiar that a poor country exports capital to rich ones, as China has done, but there is no reason, in this view, to question the wisdom of the underlying choices.
Unfortunately, this Panglossian view is hardly plausible after the repeated shocks in international finance over the past three decades, which culminated with the crisis in high-income countries that broke out in 2007. The U.S., in particular, proved incapable of using its capital inflows wisely: they financed fiscal deficits and the construction of unneeded houses. Of course, the U.S. is largely to blame for this sad outcome, as are other capital-importers. But large external deficits also have a contractionary impact on demand. This did not seem to matter when the latter was strong. it matters a great deal now when it is weak.
Beyond these general points, specific issues arose over the past explosion in China's surpluses. These were partly the consequence of interventions in foreign currency markets and consequent accumulation of foreign currency reserves. The latter rose from $170-billion in January 2001 to $3.2-trillion at the end of last year. One tool in the policy box was to sterilize the monetary consequences of these interventions. All these are mercantilist policies.
Moreover, if a country is to have a huge investment boom and a strong external position, consumption normally has to be repressed and savings encouraged. This is what happened: private consumption fell from 46 per cent of GDP in 2000 to just 36 per cent in 2007. Public and private consumption together fell from 62 to 49 per cent of GDP, while gross saving jumped from 38 to 51 per cent of GDP. A substantial part of these savings were invested abroad, in low-yielding assets, at great cost: China's external reserves are $2,300 for every man, woman and child, or as much as 40 per cent of GDP.
Thus, a reduction in the external surpluses has been in the interests of both the rest of the world and China. So how happy should the results make us? The answer is: not ecstatic.
First, even a decline in the current account surplus, as a share of GDP, might mean a rising surplus, relative to the rest of the world's output. In 2008, China's surplus was $412-billion, or 9.1 per cent of GDP. By 2011, it was just under half of the 2008 level, at $201-billion. But the share of China's GDP fell to 2.9 per cent. Suppose the share remained at 2.9 per cent: the surplus would be over $400-billion by 2016 if China's dollar GDP grew at 15 per cent a year. That is a plausible rate, since China's real exchange rate is likely to appreciate. If one wants to assess the adjustment imposed on others, one has to look at surpluses in relation to their GDP, not China's.
Second, the domestic counterpart of the external adjustment consisted of ever higher investment as a share of GDP: between 2007 and 2010, the share of investment in GDP rose by close to 7 percentage points. In every year since 2007, real fixed investment has grown faster than GDP. The Organization for Economic Co-operation and Development made the point in China in Focus:"thus far, the adjustment towards domestic demand has almost entirely reflected strong public infrastructure investment that has been financed off-budget". Wen Jiabao, the premier, has himself frequently described China's development as "unbalanced, unsustainable, and uncoordinated." Unfortunately, the process of eliminating one important imbalance - the external surplus - has exacerbated the most striking of the internal imbalances - the extraordinarily high investment.
Suppose that China were to grow over the next decade at the still high rate of 7 per cent a year. Suppose, too, that investment (including investment in inventories) fell from 50 per cent of GDP to a still very high 40 per cent, because a smaller rate of investment is needed to support lower growth. Suppose, too, that the external surplus remained 3 per cent of GDP. To achieve the expected 7 per cent GDP rate of growth, consumption (public and private) needs to grow at a real rate of 9 per cent while investment grows at 4.6 per cent. This would be an astonishing reversal. It would be impossible, without a big shift in the distribution of income towards households. That, in turn, would requite comprehensive reforms in the financial system, in corporate governance and even in the power structure of the country. Moreover, there is a risk that such reform lowers investment far more than it adds to consumption. The result could be a very hard landing.
China has done a far better job of eliminating its huge current account and trade surpluses than I expected. The principal domestic cause of this shift has, however, been a surge in investment to still dizzier heights, assisted by appreciations in the real exchange rate. But that makes the domestic adjustment now required even bigger than before the crisis. If the external surplus is to remain a constant share of GDP, while the rate of economic growth slows, an extraordinary turnaround in relative rates of growth of consumption and investment is essential. To put it bluntly, the growth dynamic of the past 15 years must be reversed. Is that feasible? Perhaps. But it requires a huge expansion in consumption relative to investment. Will that happen, while the economy continues to grow? Nobody knows.