Chinese Growth Set for Lower Lows

Jul 19 2013 | 11:07am ET

By Mark A. DeWeaver
Principal, Quantrarian Capital Management

China is slowing fast. Since hitting a post-financial crisis high of 11.9% in the first quarter of 2010, Chinese quarterly GDP growth has risen in just two of the subsequent 13 quarters. The latest figure of 7.5%, for the second quarter of this year, is down from 7.7% in the first quarter and 7.9% in the last quarter of 2012.

This downtrend is set to continue into the second-half. Beijing has just launched a new campaign to rid the Party of “formalism, bureaucratism, hedonism and extravagance.” This will stifle both consumption and investment for at least the next two quarters.

Beijing’s economic planners are in a bind. High levels of excess capacity have reduced the return on investment to the point where China’s traditional investment-led growth model is no longer viable. Yet this is the only model that the country’s economic institutions can support.

The obvious way forward would be to dismantle these institutions by privatizing state-owned assets and radically reducing the role of the state in the economy. But this is a solution that Secretary General Xi Jinping has explicitly ruled out. He is instead relying on stricter discipline of Party members to make the existing system more efficient. Genuine reform is not really on the table.

This approach will do little to incentivize better economic decision making. In the short term, officials will take cover as they wait for the storm to blow over. Few will dare to promote obvious white elephants or to indulge in public displays of conspicuous consumption. Sales of cement, steel, Rolex watches, and shark’s-fin soup will be poor.

But there will be no long-term gain for this short-term pain. China’s economic problems are not primarily the result of immorality on the part of individual Party members or an imperfect understanding of national priorities at the local level. They are an unavoidable consequence of state ownership and bureaucratic management. The current rectification drive, with its focus on prosecuting corrupt officials and studying Marxist classics, might temporarily treat some of the symptoms but will not cure the disease.

The campaign will certainly do nothing to weaken the state’s economic power. This means that competition among government officials will continue to be more important than market forces.  Even if new performance evaluation criteria are introduced—as Secretary General Xi has recently suggested—hitting targets will still take precedence over economic rationality. Transitioning to productivity-led growth will be impossible under these circumstances.

Continued state sector dominance will also stifle consumer demand. The low share of consumption in Chinese GDP is not primarily the result of household over-saving. It is due instead to the fact that ordinary citizens have no real claim to the income of state-owned entities.  In fact, state-sector profits derive largely from subsidies, the burden of which ultimately falls on households. As long as this is the case, the consumer can hardly be expected to step up to the plate.

China’s economic system, like the Soviet system on which it is based, is designed to channel national income into state-promoted investment. In the initial phases of economic development, this strategy can work because it is relatively easy for planning authorities to identify investment projects that make sense on a cost-benefit basis. Productivity growth is relatively unimportant and a case can be made for postponing consumption for the sake of rapid industrialization.

In China, this big push phase could be said to have ended in the late 1990’s, when excess-capacity problems emerged in many sectors that had previously experienced excess demand.  The country had reached a point at which, as then-premier Zhu Rongji told the National People’s Congress in 2001, “further development would be impossible without structural adjustment.”

Yet structural adjustment has proved elusive. As the Soviets discovered in the 1980s, a productivity renaissance cannot be brought about by fiat. Nor are government and state enterprise elites going to allow a significant reduction in the state’s share of the national income pie. As long as the economy is dominated by the state, switching to a new mode of growth is not a real possibility.

China is now facing a sustained deceleration. In the absence of any other driver, GDP growth is not going to pick up until investment recovers. But with the return on investment continuing to decline, such a recovery will prove to be short-lived. Before long, Beijing will once again have to take up the battle against corruption and inefficiency, pushing growth rates even lower in the process.

Dr. Mark A. DeWeaver manages the emerging markets fund Quantrarian Asia Hedge and is the author of Animal Spirits with Chinese Characteristics: Booms and Busts in the World’s Emerging Economic Giant.

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