How Is Chinese Growth Imbalanced?

One of the most important external threats to the Australian economy over the next 5 years is the re-balancing of Chinese growth. The reason it is important being that: China does not need to collapse in to a pile of rubble for re-balancing to affect our country greatly. China probably won't collapse, but equally it is improbable for China to re-balance without slowing growth, and impossible for China to re-balance without changing its composition of growth - a composition of growth that the Australian economy is currently quite dependent on.

The problem is best illustrated graphically, with China's household consumption share of GDP falling from over 60% down to around 35% over the last few decades, with investment (Capital Formation) taking up the position as the dominant source of growth, rising from under 30% to almost 50% of GDP:

This has occurred because the government has pursued an investment driven growth model - that is, creating policies that favour investment in infrastructure, manufacturing capacity and real estate at the expense of household consumption. This has been driven through a number of policies (Read Michael Pettis' Books or blog for more detail), but to name a couple of the major ones:

1. An undervalued Yuan: The PBoC has offset a natural appreciation of China's currency in order to maintain a competitive advantage as an exporter, simultaneously suppressing imports and consumption (Pettis would probably say it alters the savings balance or something to that effect). As I outlined in this post, this involves purchasing a basket of foreign assets such as US treasuries in order to offset the country's twin surpluses (Current an Capital account) entirely, to hold the exchange rate to a target or crawling peg.
2. Interest rates kept too low: Particularly deposit rates, which have been kept far below the nominal growth rate and often below inflation. Because there are very few options to save in China, and because deposit rates are often negative real or growing at a pace far below national output, households are either forced in to saving through real estate - which drives investment - or saving in deposits which lose relative value over time - driving more saving to offset this and also reducing their potential consumption power. More recently the rise of Wealth Management Products has given a new outlet and higher interest rates for savers, however it is yet to be seen how beneficial these financial innovations will be. Murky securitized lending and shaky underlying assets have been famously awful for those that bought in, however with most things in finance, the extent to which they are detrimental or beneficial will be seen when monetary policy tightens, and probably not before, though this should include the end of QE in the US. As US policy tightens, liquidity will be withdrawn from riskier investments and emerging markets as systemic risk rises. In addition to this, because investment in capital is often funded by debt, excessively low interest rates favour investment in capital over labour. When interest rates are 5-15% below nominal growth in the economy, it makes a lot of sense to invest in more capital - as national output grows at a faster pace than the interest rate on debt and the real value of the debt diminishes with time.

Note below the average 1 year term deposit rate for Chinese savers - savings accounts yield even less, currently about 0.35% p/a, and the lending rate is a little higher (5-8% during the last decade), currently 6%:

Luckily for Chinese savers, this excessive over-investment and under-consumption has the effect of keeping inflation relatively contained, so it could be worse for real deposit rates. For China's economy falling inflation might be a bit more of a problem, with nominal GDP growth dropping to GFC levels recently on very low inflation levels. However as a comparison, here is how interest rates and nominal GDP track in countries like Australia and the US - consider that these are discount rates, not term deposit rates, so I am understating the difference here as term deposits are typically higher yielding:

This should hopefully give some scale to the financial repression in China compared to our own experience. For instance the US has been criticized for keeping interest rates at zero and several percent below growth and inflation, however there is no comparison to China holding rates 10-20% below nominal growth.

Imbalanced Chinese growth has become more and more dependent on investment, and less related to consumption of goods and services by households. Next I will discuss why this is an issue.