Is China Turning Japanese?

China is now the world's second largest economy. Here's why Beijing, not Washington, should be worried.

China has formally overtaken Japan as the world's second largest economy. Yet, for all the recent excited commentary, there's less cause for baijiu toasts in Beijing than they might think. That's because China's economic growth has followed what's sometimes called "the Japanese model."  In Japan and other Asian countries, this model has proved extraordinarily successful in the short term in generating eye-popping rates of growth -- but it always eventually runs into the same fatal constraints: massive overinvestment and misallocated capital. And then a period of painful economic adjustment. In short: Beijing, beware.

Japan's "lost decade" of the 1990s -- from which it still has not emerged -- followed a period of high growth, at the heart of which were massive subsidies for manufacturing and investment. The Japanese model channels wealth away from the household sector to subsidize growth by restraining wages, undervaluing the currency, and, most powerfully, forcing down the cost of capital. In every prior case, once the train gets rolling, it has been very difficult to correct course. That's because too much of the economy depends on hidden subsidies to survive. 

Nor is Japan the only country to rise quickly and then suffer in this fashion.  Brazil, which experienced "miracle" growth years during the 1960s and 1970s, had its own lost decade in the 1980s, for similar reasons. Beijing would do well to heed these tales of caution.

From a distance, China's boom times seem unstoppable. It's worth looking closer. In early June, the head of China's official carmakers' association forecast that 2010 sales will exceed 15 million units, surpassing the United States this year as the largest market for new cars in the world. But there was bad news buried in this seemingly good number. After growing 48 percent in the first half of 2010, and 45 percent last year, this forecast suggests a 20 percent contraction in car sales in the second half of 2010.

These numbers will likely intensify the already-fierce debate over Chinese consumption growth. In order to rebalance China's economy, which still depends heavily on exports, Beijing must raise its very low consumption share of GDP. That share declined from 46 percent of GDP in 2000 to an unprecedented low of 41 percent in 2003 -- and then shrank further to an astonishing 38 percent in 2006, finally falling below 36 percent in 2009. (In August, Credit Suisse released a study by the China Reform Foundation's  Wang Xiaolu, which suggested that if we include China's unrecorded economy -- market activity that isn't reflected in official data -- the consumption share is even lower.)

Chinese policymakers aren't blind to the urgency of reversing this decline. A low consumption share is the obverse of China's excessive reliance on export surpluses and investment. Unless domestic consumption expands dramatically, China can continue growing rapidly only by increasing investment well beyond what is economically useful or by forcing larger trade surpluses onto a reluctant world.  To raise consumption, Beijing has implemented a number of policies in the past five years, and especially since 2008, aimed at boosting Chinese consumption.  But are they working?

On the positive side, automobile sales surged last year. For most analysts, this was immensely good news, signaling a major shift in the consuming behavior of Chinese households. But skeptics disagreed. They claimed that the surge in demand for automobiles was caused mainly by unsustainable government subsidies and tax rebates.  Last year also saw a surge in durable goods, but they were also backed by subsidies.

More importantly, the skeptics argued, any current increase in automobile and durable goods sales would be reversed in the future as households absorbed the cost of the subsidies. Subsidies must be paid for, ultimately by the household sector -- and as they are paid out of future income, consumption will rise today, but inevitably decline tomorrow.

It seems the skeptics may have been right. If the growth in automobile and other consumption is indeed substantially weaker in the following months, as evidence seems to suggest, it would suggest that low consumption in China is not a discrete problem that can be resolved with administrative measures. It would argue instead that the consumption problem is fundamental to China's economic growth model and therefore cannot be resolved without a substantive change to the status quo.

Most economists continue to argue nonetheless that surging retail-sales figures and rising wages show China's shift to greater consumer spending is on track and that, within ten years, consumption is likely to be anywhere from 47 to 50 percent of GDP -- but this is still too low by most measures. Even if the rest of the world were willing to run the large trade deficits needed to support China's low relative consumption for so long, the math that gets us there is tricky at best.

Here's why.

In order to get consumption to generate 47 to 50 percent of GDP in ten years, every year consumption needs to grow faster than GDP by 3 to 4 percentage points, something it has never been able to do. If China continues growing at 7 to 9 percent for the next decade, as many analysts are projecting, consumption must grow by 10 to 14 percent, much faster than it ever has in post-reform Chinese history. Yet all projections show China growing more slowly than it ever has during these next ten years.

It's arithmetically possible, of course, but there are two schools of thought about how to proceed. One school argues that relatively low-consumption growth can be reversed without changing the fundamental growth model.  Many reasons have been given for low Chinese consumption -- demographics, Confucian culture, skewed tax incentives, amateurish marketing, the sex imbalance, the tattered social safety net, etc. If Beijing takes administrative steps to address the correct cause of low consumption, so goes the theory, it will automatically rise.

If they are right, then presumably Beijing can goose consumption while keeping GDP growth rates high. But if that's all it takes, one wonders why they just haven't gotten on with it. Since 2005 the government has wanted to drive up the consumption share of GDP, and yet it has plummeted.

The other, smaller (but rapidly growing) school of thought argues the model itself prohibits high consumption: growth is high because consumption is low. China cannot enjoy the double-digit GDP growth generated by low wages, cheap capital, and an undervalued currency and still have strong domestic consumer demand.  This school has been arguing for five years that the measures Beijing has taken to boost consumption growth will fail because they do not address the underlying cause.

We will just have to wait and see who is right, but the arithmetic seems to suggest that current rates of GDP growth won't allow for the surge in consumer spending necessary for China to rebalance away from its excess reliance on exports and investment.  Unless China's GDP growth plummets to below 5 percent annually on average, and probably even then, it is very unlikely that consumption can represent 47 to 50 percent of GDP in ten years.

So why do Chinese consume such a low share of what they produce -- in spite of determined efforts by Beijing to get them to increase consumption?  Contrary to conventional thinking, the Chinese have no aversion to consuming. They are eager shoppers, as even the most cursory visit to a Chinese mall will indicate. The problem is that Chinese households own such a small share of total national income that their consumption is necessarily also a small share. And just as the household share of national income has declined dramatically in the past decade, so too has household consumption.  

This isn't to say households are getting poorer. On the contrary, they are getting richer quite rapidly, but they are getting richer more slowly than the country overall, which means their share of total income is declining.

If Beijing wants to increase the consumption share of GDP, it shouldn't waste effort and money trying to create additional incentives for consumption, tinkering with subsidies and taxes, improving the social safety net, attempting to change cultural habits. What is needed is to increase the share of national income that households take home. Give them more money, and they will spend it.

So how can their share rise? Here, the problem gets very difficult.

One option might be for Beijing to engineer a huge shift of state wealth to the household sector through, say, a massive privatization program. This could drive up consumption significantly by boosting household wealth, but the likelihood of mass privatization is slim, given the political realities in China.

Another option, and ultimately the only sustainable path forward, would involve reversing the subsidies that generated such furious growth. Wage growth must at least keep pace with productivity growth; interest rates must rise substantially; and the currency must be revalued. But if any of these happen too quickly, we could expect a surge in bankruptcies -- as old businesses struggle to survive without familiar subsidies.

Unfortunately, the longer China waits to make the transition from this model of growth, the more difficult the transition will be. Forcing banks to fund projects at artificially low interest rates inevitably raises non-performing loans, and these eventually become government debt. The longer China waits, the more debt there will be and the more dependent growth will be on the subsidies.

For a worrying case study, one need only look to Japan, which grew very rapidly thanks largely to very high rates of investment forced through the banking system.  For a long time the problem of misallocated investment -- which was whispered about in Tokyo but not taken too seriously -- didn't seem to matter.  Everyone "knew" that Japan's leaders could manage a transition easily. After all, they were extremely smart, with a deep knowledge of the very special circumstances that made Japan unique, with real control over the economy, with a strong grasp of history and penchant for long-term thinking, and most of all with a clear understanding of what was needed to fix Japan's problems. Sound familiar?

In the end, they were seduced by their own success. Look what a great job they had already done: by the early 1990s Japan had generated so much investment-driven growth that it had grown from 7 percent of global GDP in 1970 to 10 percent in 1980, and then surged to nearly 18 percent at its peak in the early 1990s. In about twenty years, Japan's share of global GDP was two-and-a-half times its initial share. And yet it kept boosting investment to generate high growth well into the early 1990s, long after the economic value of its investment had turned negative.

Less than 20years later, after a terribly long struggle to adjust to high debt and massive overinvestment, Japan is about to be overtaken by China with only 8 percent of global GDP. Japan, in other words, has given back in less than two decades almost the entire share of global GDP it had taken in the two astonishing decades that preceded it (during the same period the United States has roughly maintained its share). 

The sooner China begins the difficult transition, the less costly it will be, but in no circumstance is it likely to be easy. They key will be to get consumption to grow quickly relative to GDP, and China might simply not have the time to do it by reversing the wage, currency, and interest-rate subsidies paid by the household sector. Among other unlikely things, it will require the rest of the world continue to absorb its soaring trade surplus. In the end, the only "easy" solution (economically, not politically) might be a massive transfer of wealth from the public sector to households, perhaps via privatization. China will probably reluctantly play this card -- but only after a painful period of sluggish growth forces Beijing's hand.



Why Doesn't the World Care About Pakistanis?

Because they live in Pakistan.

The United Nations has characterized the destruction caused by the floods in Pakistan as greater than the damage from the 2004 Asian tsunami, the 2005 Pakistan earthquake, and the 2010 Haiti earthquake combined. Yet nearly three weeks since the floods began, aid is trickling in slowly and reluctantly to the United Nations, NGOs, and the Pakistani government.

After the Haiti earthquake, about 3.1 million Americans using mobile phones donated $10 each to the Red Cross, raising about $31 million. A similar campaign to raise contributions for Pakistan produced only about $10,000. The amount of funding donated per person affected by the 2004 tsunami was $1249.80, and for the 2010 Haiti earthquake, $1087.33. Even for the Pakistan earthquake of 2005, funding per affected person was $388.33. Thus far, for those affected by the 2010 floods, it is $16.36 per person.

Why has the most devastating natural disaster in recent memory generated such a tepid response from the international community? Something of a cottage industry is emerging to try to answer this latest and most sober of international mysteries.

There is no shortage of theories. It's donor fatigue. It's Pakistan fatigue. It's because the Pakistani government is corrupt and can't be trusted. It's because the victims are Muslim. It's because people think a nuclear power should be able to fend for itself. It's because floods -- particularly these floods -- spread their destruction slowly, over a period of time, rather than instantaneously. It's because of the tighter budgets of Western governments. It's because of the lingering effects of the financial crisis.

There's a degree of truth to all these explanations. But the main reason that Pakistan isn't receiving attention or aid proportionate to the devastation caused by these floods is because, well, it's Pakistan. Given a catastrophe of such epic proportions in any normal country, the world would look first through a humanitarian lens. But Pakistan, of course, is not a normal country. When the victims are Haitian or Sri Lankan -- hardly citizens of stable, well-governed countries, themselves -- Americans and Europeans are quick to open their hearts and wallets. But in this case, the humanity of Pakistan's victims takes a backseat to the preconceived image that Westerners have of Pakistan as a country.

Pakistan is a country that no one quite gets completely, but apparently everybody knows enough about to be an expert. If you're a nuclear proliferation expert, suddenly you're an expert on Pakistan. If you're terrorism expert, ditto: expert on Pakistan. India expert? Pakistan, too, then. Of South Asian origin of any kind at a think-tank, university, or newspaper? Expert on Pakistan. Angry that your parents sent you to the wrong madrassa when you were young? Expert on Pakistan.

This unique stock of global expertise on Pakistan naturally generates a scary picture. Between our fear of terrorism, nervousness about a Muslim country with a nuclear weapon, and global discomfort with an intelligence service that seems to do whatever it wants (rather than what we want it to do), Pakistan makes the world, and Americans in particular, extremely uncomfortable. In a 2008 Gallup poll of Americans, only Afghanistan, Iraq, the Palestinian Authority, North Korea, and Iran were less popular than Pakistan.

The net result of Pakistan's own sins, and a global media that is gaga over India, is that Pakistan is always the bad guy. You'd be hard pressed to find a news story anywhere that celebrates the country's incredible scenery, diversity, food, unique brand of Islam, evolving and exciting musical tradition, or even its arresting array of sporting talent, though all those things are present in abundance.

How bad is it? Well, in 2007, when the Pakistani cricket team's national coach, an Englishman named Bob Woolmer, was found dead in his hotel room, the first instinct of the international press was that a Pakistani team member must have killed him. This is the story of modern day Pakistan.

Contrary to what many Pakistani conspiracy theorists believe, the suspicion and contempt with which the country is seen is not deliberate or carefully calculated. It's just how things pan out when you are the perennial bad boy in a neighborhood that everyone wishes could be transformed into Scandinavia -- because after 9/11, the world cannot afford a dysfunctional ghetto in South and Central Asia anymore. Or so goes the paternalist doctrine.

It is bad enough that the Pakistani elite don't seem eager to cooperate with this agenda of transformation; now, nature also seems to be set against it. The floods in Pakistan are the third major humanitarian crisis to afflict the country in recent years. The 2005 earthquake and the massive internal displacement of Pakistanis from Swat and the FATA region in 2009 were well-managed disasters, according to many international aid workers. While international support was valuable in mitigating the effects of those disasters, most experts agree that it was Pakistanis, both in government and civil society, that did the heavy lifting.

The 2010 floods, however, are a game-changer. The country will not and cannot ever be the same. The loss of life, disease, poverty, and human misery themselves are going to take years to overcome. But the costs of desilting, cleaning up, and reconstructing Pakistan's most fertile and potent highways, canals, and waterworks will be exhausting just to calculate. The actual task of building back this critical infrastructure is a challenge of unprecedented proportions.

Last week, I visited a relatively well-to-do village called Pashtun Ghari in Khyber Pakhtunkhwa province. Pashtun Ghari is right off the historic Grand Trunk Road, and less than two miles from the river. Flood victims there did not feel abandoned by authorities; indeed they were quite satisfied with how they had been taken care of. Still, there was inconsolable despair among residents. Why? The town's entire livestock population, some 2,300 cows, had perished beneath waters that stood more than 10 feet high in the first wave of flooding. Those cattle are both assets and income generators for Pakistani villagers along the Indus River. There is no recovering from losing that quantum of livestock.

The fact that people in other countries don't like Pakistan very much doesn't change the humanity of those affected by the floods or their suffering. It is right and proper to take a critical view of Pakistani politicians, of their myopia and greed. It is understandable to be worried about the far-reaching capabilities of the Pakistani intelligence community and reports that they continue to support the Taliban in Afghanistan. It is even excusable that some indulge in the fantasy that a few hundred al Qaeda and Taliban terrorists are capable of taking over a country guarded by more than 750,000 men and women of the Pakistani military, and the 180 million folks that pay their salaries.

But are the farmers of Pashtun Ghari, of Muzaffargarh and Dera Ghazi Khan, of Shikarpur and Sukkur, really obligated to allay these fears before they can get help in replacing their lost livelihoods? Twenty million people are now struggling to find a dry place to sleep, a morsel of food to eat, a sip of clean water to drink -- and the questions we are asking have to do with politics and international security. The problem is not in Pakistan. It is where those questions are coming from.

Pakistan has suffered from desperately poor moral leadership, but punishing the helpless and homeless millions of the 2010 floods is the worst possible way to express our rejection of the Pakistani elite and their duplicity and corruption. The poor, hungry, and homeless are not an ISI conspiracy to bilk you of your cash. They are a test of your humanity. Do not follow in the footsteps of the Pakistani elite by failing them. That would be immoral and inhumane. This is a time to ask only one question. And that question is: "How can I help?"