The Confusion Over Chinese Rebalancing

The popular economic wisdom in China holds that only by boosting consumption can China unleash a secondary wave of growth. There are a variety of reasons China cannot rebalance but a primary problem stems from failing to understand what exactly “rebalancing” means.

Two terms are regularly almost interchangeably but in reality have, for the purposes of economic policy insight, very different meanings. Economists and journalists regularly use terms like “boosting consumption” and “rebalancing” almost interchangeably and while these terms have similar meanings they do in practice and reality mean and imply very different things.

The Chinese economy is defined by low levels of consumption and specifically household and private consumption. This number typically hovers around 40% of total GDP. This is very low especially when compared to developed countries but even when compared to countries at similar income levels like Mexico, Russia, and Malaysia which have consumption levels around 65-70% of GDP.

Given the low levels of productivity for new investment and flagging economic activity, economists inside and outside of China argue that to revive growth, China needs to boost consumption from the very low 40%. However, this is where the confusion sets in: though often used interchangeably boost consumption and rebalancing are similar but fundamentally different.

Boosting consumption is taken to mean increasing the amount of consumption or in short hand convincing Chinese consumers to buy more. Rebalancing though sounding inoccuous is a more radical understanding saying China needs to derive less economic growth from investment and more economic growth from consumption. Put another way, China needs to not just boost consumption but boost consumption so that it grows faster than investment.

To help you understand the size of the differences we are talking about here, let us use a simple model and assume that private Chinese consumption is 40% of GDP. To keep things simple, we will assume that private consumption grows at 6% annually and everything else grows at 5% annually. In 20 years, private Chinese consumption will account for 44% of GDP. Only if private Chinese consumption grows at 7.5% annually and everything else grows at 5% annually will private Chinese consumption equal non-consumption economic activity.

For private Chinese consumption to equalize all other activity as a share of GDP, it will have to grow nearly 50% faster than all other activity for 20 years. That means consumption does not just have to grow but it has to grow a lot faster than every other part of the economy just to equalize.

Boosting consumption does not change the problem if consumption only grows at the same rate as for instance investment. To address the underlying imbalance, consumption has to grow not just a little faster but a lot faster than other activity and it has to do it for a long time.

This confusion about what the actual problem is has real world consequences that show up is malformed policy solving the wrong problem.

This confusion is more than mere academic hair splitting but proscribes different policy solutions. Beijing has been rolling a variety of policies to try and boost consumption. In a manner of speaking they succeed. They boost consumption but they boost consumption only in the short term by relying on government subsidies funded by additional government debt.

However, if the objective is to boost consumption then it is entirely fair to say short term government subsidies to consumers for specific goods and services will boost consumption above its previous status quo level. However, if the objective is to rebalance with a higher percentage of economic activity coming from consumption by definition it cannot succeed. By mathematical definition, the government cannot increase debt to rebalance away from government and investment. Government borrowing to fund subsidies to consumer will simply require offsetting tax increases now or in the future that effectively negate any “rebalancing”.

The truth that Chinese and global economists refuse to face is that rebalancing means reducing the role of the direct and quasi state entities in the Chinese economy. Between state directed investment, official state owned enterprises, unofficial state owned enterprises, and the government share of the economy the Chinese state through all its tentacles dominates the economy. The state wants to direct that investment and those funds but also relies on that activity for a variety of reasons. Even if the state wanted to move away from dominating such a large portion of the economy, unlikely at best, it would face a secondary constraint on the difficulty of extracting itself from such a large swathe of the economy.

This returns us full circle to the original point of confusion: if the objective is simply to boost consumption over a status quo stagnancy then providing subsidies to purchase refrigerators or washing machines while not economically efficient at least provides an incentive to boost consumption; however if the objective is to rebalance away from government and investment share of the economy increasing the share of household and private consumption then increased government spending to boost private consumption simply will not rebalance the economy.

Whether Beijing wants to rebalance is a separate and equally discouraging question but to arrive at the correct answer, we must ask the correct question. Boosting consumption is not the same as rebalancing and present very different policy recommendations. While Beijing might be interested in boosting consumption, there is no evidence they are interested in rebalancing.