[Ｇｅｔｔｉｎｇ　ｔｈｅ　Ｂａｌａｎｃｅ　Ｒｉｇｈｔ] the Right path

　　“The tilt away from exports and investment toward consumption, along with the moderation of aggregate GDP growth could well challenge many of the world’s perceptions about the ‘China factor.’” --Stephen S. Roach
　　Stephen S. Roach, Managing Director and Chief Economist of Morgan Stanley, is widely recognized as one of Wall Street’s most influential economists. At the 2006 Annual Conference of the Boao Forum for Asia, held April 21-23 in China’s Hainan Province, he delivered a speech on the significance of China’s adjustment of its growth model--a shift away from export- and investment-led growth to more of a consumer-driven dynamic. Excerpts follow:
　　China’s accomplishments on the economic development front are unrivalled over the past quarter of a century. But there is no guarantee that any nation can stay the course.
　　There are now signs that the growth model that has worked so brilliantly since 1979 is in need of a major overhaul. I am confident that China will rise to the occasion. A failure to do so could well lead to a serious setback on the road to reform.
　　China is now sending the world a very important message: A critical mid-course correction in its development model is in the offing-a shift away from export-- and investment-led growth to more of a consumer-driven dynamic. This change will not be abrupt, but it will likely be an increasingly dominant characteristic of the Chinese growth outcome for years to come.
　　It is aimed, first and foremost, at providing greater stability to the Chinese economy. It could also have profound implications for the global economy and world financial markets.
　　The essence of the coming adjustment is actually very simple: For the past 27 years, China’s remarkable growth story has been built largely on a foundation of resource mobilization, powered by the recycling of a huge reservoir of domestic saving into export- and investment-led growth. That strategy has now outlived its usefulness. Senior Chinese officials believe the time is right to shift to more of a self-sustaining internal demand model, driven increasingly by private consumption.
　　I concur with that key conclusion. Rebalancing will not only enable China to deal more effectively with both internal and external imbalances, but it takes the reform process to an entirely different level--providing China with the opportunity to turn its attention to the critically important quality dimension of the growth experience.
　　
　　Consequences of inaction
　　
　　China’s rebalancing imperatives are obvious. The economy has become far too reliant on exports and fixed investment. These two sectors now account for between 70 percent and 80 percent of overall Chinese GDP. And they are still expanding collectively at around a 25 percent annual rate. If those trends were to continue, the sustainability of the Chinese growth model would be at risk. Years of rapid export growth have already led to serious trade frictions and heightened risks of protectionism. Those pressures would only intensify if China’s exports remained on an open-ended growth path.
　　A continuation of soaring investment growth could result in excess capacity and deflation. China is intrinsically a high-investment economy. Given its extraordinary development over the last 27 years and the recent westward push of its growth model, investment should remain well supported by the confluence of infrastructure imperatives, urbanization and continued industrialization. But on the basis of continued rapid growth in the 25 percent range per annum, the investment share of Chinese GDP, which hit 45 percent in 2005, is in danger of crossing the 50 percent threshold. In their earlier heydays of economic development, this ratio never got much above 40 percent in either Japan or South Korea.
　　Sustainability of China’s export- and investment-led model can also be drawn into question from a different, yet equally important, point of view. The externalities of an industrial production-led growth dynamic have become increasingly worrisome, especially over the past four years, as industrial output growth has powered ahead at close to a 16 percent average annual rate. Open-ended growth in manufacturing activity has led to serious environmental degradation, worker safety problems and periodic bottlenecks in China’s supply chain of strategic materials-especially oil and industrial metals. China’s share of global demand in many commodity markets has risen dramatically in recent years, pushing material prices sharply higher and triggering serious cost pressures for many businesses. These mounting externalities are very visible signs that China is now starting to labor under the stresses and strains of its own success.
　　Similarly, the mix between capital-intensive manufacturing (47.3 percent of GDP in 2005) and services (40.3 percent) reflects yet another layer of distortions in China’s economy. Services are, by definition, highly labor-intensive activities. As such, they hold great opportunity for China’s job creation challenge. But a manufacturing-led growth dynamic takes China down the other road, in effect, biasing its growth away from job creation. This is precisely the opposite of what a reform-oriented system requires--especially for China, where state-owned enterprise reforms continue to spur unrelenting headcount reductions. China needs labor--intensive--not laborsaving-growth. Services are a much better prescription for achieving that end than manufacturing.
　　
　　Rebalancing strategy
　　
　　The good news is that China’s senior leadership gets it. The just enacted 11th Five-Year Plan (2006-10) is all about the coming rebalancing of the Chinese economy. Three important aspects of rebalancing are stressed--the first being a moderation of the overall growth objective. The plan calls for 7.5 percent average real GDP growth through 2010, a marked downshift from the 9.5 percent average pace of the preceding 25 years. This should not be viewed as a worrisome shortfall but instead as more of an effort to raise the quality of Chinese growth.
　　The second leg of the stool is the government’s intent to rebalance the mix of GDP growth over the next five years. Ma Kai, Chairman of the National Development and Reform Commission, has taken the lead in stressing the need to boost both the consumption and services shares of Chinese GDP. He has also underscored the imperatives of an enhanced safety net-not just social security but also rural healthcare and education. This was viewed as necessary to improve income security, thereby reducing the excesses of precautionary saving that continue to inhibit the expansion of private consumption. The math and time lags of the likely shift in the mix of Chinese economic activity are consistent with the more moderate GDP growth target over the next five years.
　　Financial reforms are a third key aspect of China’s rebalancing strategy. The focus, so far, has largely been on banking reforms. But there are equally strong needs for capital markets reforms, especially the development of a corporate bond market. Currency reforms have also been given considerable attention recently, reflecting, in part, the mounting bilateral trade tensions with the United States. China’s shift to a new foreign exchange regime in July 2005 was an encouraging first step in that regard. Related to that, senior Chinese financial authorities have expressed concerns over the excessive accumulation of foreign exchange reserves. The rebalancing of the real economy toward increased domestic consumption should lead to more rapid gains in Chinese imports, a related narrowing of its trade surplus, and a reduction in the pace of reserve accumulation.
　　The bad news is that many outside of China do not get it. Most foreign politicians--especially those in the United States--believe that a large and swift currency revaluation should be central to any Chinese rebalancing strategy. Some academics have come to the same conclusion. With financial sector reforms still in the early stages, China has stressed that large currency adjustments could potentially be quite destabilizing. I think those concerns are well founded. Others have noted that globalization has diminished the macro impacts of currency adjustments over the past decade, suggesting that China and the world would actually gain little by taking on big risks. Success on the rebalancing front will come as long as China makes progress in tilting the mix of economic growth away from external toward internal demand. The choice of tactics is up to China.
　　
　　Implications
　　
　　The implications of Chinese rebalancing are likely to be profound, both for China and the rest of the world. The tilt away from exports and investment toward consumption, along with the moderation of aggregate GDP growth as a rebalancing implies, could well challenge many of the world’s perceptions about the “China factor.” Three potential impacts strike me as most important:
　　Commodity markets. A reduction of investment growth is likely to temper China’s impact on the demand side of many industrial commodity markets. In 2005, China, which made up only about 4 percent of world GDP, accounted for around 25 percent of worldwide demand for aluminum and about 30-35 percent of global consumption in copper, iron, steel and coal. As the pace of Chinese industrial activity slows in the years ahead in accordance with the 11th Five-Year Plan, pressures on the demand side of industrial materials markets should ease, underscoring the downside risks to commodity inflation. China’s efforts at energy conservation as spelled out in the new five-year plan--a targeted 20 percent reduction in energy content per unit of GDP over the next five years--could push prices of oil and refined products lower, as well.
　　Currency and trade tensions. Courtesy of rebalancing, China may be more inclined toward renminbi appreciation as a means to promote a shift away from the excesses of export-led growth and provide a stimulus for internal demand. The extent and pace of this appreciation will remain very much dependent on the stability of its financial system. Pro-consumption initiatives should also boost Chinese import demand, reducing China’s net-export surplus and thereby providing support for its major Asian trading partners such as Japan and South Korea.
　　The Chinese consumer. The Chinese consumer will not spring to life overnight. Minister Ma of the National Development and Reform Commission stressed that the emphasis will initially be placed on building the infrastructure of consumer markets. This implies a focus on China’s labor-intensive tertiary industries involved in distribution and delivery--underscoring not only the opportunities for wholesale, retail and transnational shipping but also for e-based trade retail systems. Conditional on the improvement of income security and safety-net support, growth in the Chinese consumer products industry should move rapidly up the value chain from soft to hard goods over the next several years. Significantly, under the terms of WTO accession, foreign multinationals will be allowed increased access to China’s domestic retail trade opportunities within three years.
　　
　　Risks and hopes
　　
　　The Chinese growth model has been pushed to its limit, and a rebalancing is now in order. Such a mid-course correction is not without peril. As always, risks to stability qualify as the No. 1 peril, and with the dismantling of state-owned enterprises continuing apace, the risks of rising unemployment remain the biggest threat in that regard. In that vein, a shift away from export- and investment-led support can hardly be taken lightly-especially if it leads to a reduction in economic growth. Rapid economic growth has long been viewed as China’s most powerful antidote to reform-induced job loss. For an economy that needs about 8 million new jobs each year to keep its urban unemployment rate constant, any growth slowdown is a big deal.
　　The good news is that China does not need 9.5 percent growth to underwrite its commitment to reforms--7.5 percent will do just fine. There are two reasons why I believe China will be able to cope with the employment implications of slower growth: First, state-owned enterprise reform is now well-advanced and the annualized layoff pace has moderated recently to around 2 million workers, down sharply from earlier losses that were running closer to 7 million per annum. Second, the focus on services in the new plan is especially encouraging in that it directs stimulus to the most labor-intensive segment of economic activity. The ownership structure of the economy is in the midst of the most dramatic transition in modern history. The rebalancing envisioned in the 11th Five-Year Plan should make the next stage of this transition more manageable.
　　

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