1. What, me worry?
Why China can keep on going
September 2011
Arthur Kroeber
Managing director, GK Dragonomics Research
Editor, China Economic Quarterly

2. Six crises: the bear case
1. China’s economy is an unsustainable investment
bubble
2. China’s housing market is an unsustainable
investment bubble—”ghost cities” prove it
3. China’s investment is financed by an unsustainable
and rapidly rising public sector debt
4. China’s growth is dangerously unbalanced and
there is not enough consumption
5. China is running out of surplus agricultural labor
6. China’s growth is about to slow sharply because of
the “middle income trap”
2

3. An answer for everything
1. Investment bubble?
 Fact: China’s capital stock is very low
2. Housing bubble?
 Fact: China has a severe urban housing shortage
3. Too much debt?
 Fact: Sovereign debt load is manageable and
finances productive investments
4. Not enough consumption?
 Fact: China has the fastest growth in per capita
consumer spending in world history
5. No more workers?
 Fact: Rural-urban labor transfer has a decade to run
6. Middle income trap?
 Fact: There is no “middle income trap”
3

4. More investment needed (1)
Capital stock per capita in China and the US China’s per capita capital
US$ at constant 2005 prices stock is far below
$140,000
developed country levels.
$120,000
• China’s physical capital
$100,000
per head is about the same
as Japan’s in 1970.
$80,000
$60,000
$40,000
• It is less than half that
$20,000
achieved by the US at the
beginning of the Great
$0
2010 2010 1930 2009
Depression.
China China at PPP US • It is less than one-fifth
that of Japan at the
Capital stock per capita in China and Japan beginning of its bust in
US$ at constant 1990 prices 1990.
$70,000
• China needs to invest a lot
$60,000
more before it achieves
developed-country status.
$50,000
$40,000
$30,000
• There is no evidence that
China is “over built.”
$20,000
$10,000
$0
2010 at PPP 1971 at PPP 1990 at PPP
China Japan
4
4

5. More investment needed (2)
China's capital-output ratio China’s investment
Net capital stock relative to annual GDP, at current prices efficiency is well within
3.0
the normal range.
2.5
• There is no evidence to
2.0 support claims that China’s
1.5
investment is in aggregate
“wasteful and inefficient.”
1.0
• For most countries, the
0.5
ratio of capital stock to
0.0 annual GDP (capital-output
ratio or COR) is between 2
and 3.
Capital-output ratios in Asia • China’s is now at 2.4,
Net capital stock relative to annual GDP, at current prices boringly middle-of-the road,
4.0 and substantially lower than
3.5 that of the US, which is
3.0 1980 around 3.
2007
2.5
• The increase in China’s
2.0
capital-output ratio since
1.5 1980 is also a normal sign
1.0 of capital deepening, and
0.5 much smaller than the
0.0 increases in other Asian
China Philippines Taiwan Indonesia Thailand South Japan countries.
Korea 5
5

6. Housing shortage (1)
China’s housing market
Housing stock vs urban households, in m units is in shortage, not bubble.
• Of China’s 225m urban
300 300
households only 150m are
adequately housed.
250 250 Urban
households: • China still must house 1/3
200 200 migrants of existing urban
households (75m), plus
150 150 Urban 100m new urban
households: households to be created
natives
100 100 over the next 20 years.
Units of • After accounting for
50 50 independent depreciation, this implies
housing annual housing completions
0 0 must average about 10m a
1998 2005 2009 2015f year for the next 20 years
vs 6m/yr in 2000-08.
• Many cities are building
ahead of this demand -
creating “ghost cities.” But
these are just China’s
equivalent of 1950s
suburban Levittowns.
6
6

7. Housing shortage (2)
Few migrants own
Migrant worker accommodation by type
homes.
share of total
• The vast majority of the
0.9%
unhoused are recent
3.9% migrants from rural areas,
who account for about one
18.8% Employer-supplied housing quarter of urban households.
Shared rental • Only 1% of migrant
Self rental households own their home.
Most migrants live in
Other
57.1% employer-supplied housing
Own home in factories or on work sites.
19.3%
• Meeting migrant demand
for housing will require a
large increase in the supply
of both purchase and rental
units.
7
7

8. Public debt burden
Public debt burden is
China's public debt as share of GDP manageable, even after
100% 2009-10 stimulus.
90% • Pre-stimulus, public debt
80% was stable at 80% of GDP.
70% Financial sector • Explicit liabilities of the
60%
central government were
NPLs on bank balance just 26% of GDP in 2010.
50%
sheets • Local government debt
40%
Local gov't jumped from 17% of GDP in
30% 2008 to 36% in 2010.
20% • But the contingent liability
Central gov't
10% from bank NPLs has shrunk
0% dramatically.
• 90% of other financial
1998
1999
2000
2001
2003
2005
2006
2007
2008
2009
2010
2002
2004
sector debt is PBC
sterilization bills and policy-
bank bonds; neither will
likely cause a direct liability
to the central government.
• Unlike US/Europe China’s
debt finances economically
productive infrastructure.
8
8

9. Strong consumption (1)
Consumption growth is
China's consumption paradox very robust.
50% 20%
• Critics focus on the private
45% consumption share of GDP,
which fell from 46% in 2000
40% 15% to 33% in 2010.
• Yet during the same
35%
period, real per capita
consumption growth
30% 10%
accelerated from 7% p.a.
25%
to 10%.
• China’s per capita
20% 5% consumption growth over
1996 1998 2000 2002 2004 2006 2008 2010 the past decade is almost
Private consumption share of GDP (lhs)
certainly the fastest ever
recorded by any nation.
Real growth in per capita private consumption, 3yma (rhs)
• The falling consumption
share of GDP is a natural
phenomenon during a
successful industrialization.
9
9

10. Strong consumption (2)
Decline in consumption share of GDP after take off The fall in China’s consumption
percentage points ratio is similar to that of other
0 Asian success stories.
-5 • The fall in China’s consumption
ratio since 1990 is about the same
-10 Japan (T=1955)
as that experienced by Japan in
China (T=1990) 1995-70, and much less than that
-15
South Korea (T=1975) of South Korea in 1975-90.
-20
India (T=2001)
• Consumption ratios normally
when countries transition from
-25 agriculture to industry, because
T T+10 T+20 T+30 T+40 T+50 capital earns a greater share of
national income.
Consumption ratios in major Asian economies
Private consumption share of GDP • Even the US saw a 25pp fall in its
100% consumption ratio from 1900-1950.
90% • The only thing unusual about
80% China is how low its consumption
70%
India ratio was when it started
Taiwan industrialization in 1980.
60% Japan
South Korea • This is a legacy of the communist
50%
China system, which suppressed
40%
consumption, and may also reflect
30% measurement problems.
1955 1965 1975 1985 1995 2005
10
10

11. Lots more workers
Share of workforce in agriculture China still has plenty of
70%
agricultural labor waiting to
move to the modern economy.
60%
• By our estimate (lower than
official figures), about 34% of the
50%
40% China current Chinese workforce (268m
30%
South Korea people) is employed in agriculture.
Taiwan
20% Japan • China has achieved faster growth,
with less rural-urban labor transfer,
10%
than S. Korea or Taiwan.
• China has a higher share of
0%
At $2,000 per capita GDP At $7,500 per capita GDP
workers in agriculture than did
Agriculture and development in Asia
Japan, S. Korea and Taiwan at a
comparable stage of development.
Share of workforce in agriculture
80%
70%
• Growth in those countries did not
60%
50%
slow until the agricultural share of
40% employment fell to about 20%.
30%
20% • Based on NE Asian precedents
10% China can still plausibly enjoy
0% another decade of high-speed
0 5 10 15 20 25 30
growth based on transfer of
Per-capita GDP, 000 US$ PPP
workers from traditional
China 1980-2009 South Korea 1963-2005 agriculture to the modern urban
Taiwan 1963-2005 Japan 1953-1990 economy. 11
11

12. Middle income trap (1)
Actually, there is no
Two types of successful catch-up growth evidence for a middle-
Percentage of US per capita GDP at PPP income trap.
100
90 • Our survey of 96
80 economies since 1970
70
shows that 80% of
countries that started poor
60
(<15% of US p/c GDP) are
50
still poor today.
40
Pre-1970 low
30 • By contrast, one-third of
20 Recent average middle-income countries in
10 1970 (15-50% of US p/c
0 GDP) became rich by 2010.
• So there is much more of
a “poverty trap” than a
“middle income trap.”
European integrators Asian exporters
• Two kinds of countries
have achieved sustained
catch-up to US living
standards: countries on the
European periphery, and
Asian export champions.
China fits comfortably in
the second group.
12
12

13. Middle income trap (2)
Will China be more like
Asia's partial catch up: Japan/Korea, or more
Percentage of US per capita GDP at PPP like Thailand/Malaysia?
100 • In Japan, catch-up
90 Japan growth slowed at 75% of
80 US p/c GDP and stopped at
Taiwan
70 90%. In Korea/Taiwan
60 South Korea slowdown started at 55-
60% of US GDP.
50 Malaysia
40 • China is only at 20% of
30
Thailand US GDP, suggesting
China
another decade or two of
20
fast catch-up growth is
10 India possible.
0
• But there is some risk
1950
1955
1965
1970
1980
1990
1995
2005
1960
1975
1985
2000
that it will follow
Thailand/Malaysia, whose
convergence slowed at
30% of US p/c GDP.
• However China’s
industrial structure and
policy system much more
closely resemble NE Asian
models than SE Asian.
13
13

14. Middle income trap (3)
There is no pattern to
Which threshold will China hit? when catch-up growth
Levels of per capita GDP (% of US) where catch-up slowed stops.
100 • Historically, the slowdown
90 in catch-up growth starts
80 anywhere from 20% of US
p/c GDP (Thailand) to 80%
70
(Finland).
60
• China has just begun to
50
enter the very broad range
40 where slowdown becomes
30 more likely.
20 • The average slowdown
10 threshold is 55% of US p/c
0 GDP, suggesting China
could have a continued
1952 1960 1968 1976 1984 1992 2000 2008 2016 2024 2032 2040 2048
long run of catch-up
growth.
14
14

15. Nothing to worry about? Well…
• Our exhaustive review of the evidence suggests
that, with sensible policies, China can reasonably
expect at least another decade of high-speed
growth.
• But “high-speed” means average real GDP growth
of 8% in 2011-2020, vs 11% in 2003-2010.
• Meanwhile, structural CPI inflation is rising because
of an inexorably tighter labor market. In 1997-06
CPI inflation averaged 1%; in 07-11 (excluding 09),
it averaged 5%.
• Slower growth and higher inflation mean that
capital must be allocated more efficiently. This is
especially true in light of the “stimulus hangover”
of increased debt.
15

16. Credit over-easy
Deleveraging needed.
China bank loans and total credit
% of GDP • Between 2008 and 2011
170% total credit soared from
160% 117% of GDP to 160%.
150% • Much of the increase
came from off-balance
140% Total credit sheet “shadow banking,”
(incl 'shadow which rose from a stable
130% finance')
18-20% of GDP in 1997-
120% 2008 to 42% in 2011.
Bank loans
110% • China “shadow banking”
100% is mainly dressed-up bank
lending, rather than the
90% risky leveraged derivative
80% products in pre-2008 US
“shadow finance.”
1997 1999 2001 2003 2005 2007 2009 2011e
• China successfully
deleveraged in 03-08,
thanks to nominal GDP
growth of 18% p.a.
• With slower GDP growth,
the next deleveraging will
require greater capital
efficiency. 16
16

17. Concluding thoughts
• Structurally, there is no reason why China cannot
achieve average 7-8% growth, with average 5%
CPI inflation, over the next decade.
• This performance would be about the same as
Japan’s in the 1960s and South Korea’s in the 80s.
• Financial sector reform to improve the efficiency of
capital is essential to long-run (post 2020) growth.
• But financial reform would also attack one of the
key pillars of Communist Party rule.
• If China grows without financial reform and
deleveraging in the next decade, the 2020s could
be a replay of Japan’s 1990s.
• But if it does deleverage, then the 2020s could see
a solid average growth rate of 5-6%.
17

18. GK Dragonomics, a GaveKal company, is an independent research and advisory
firm specializing in China’s economy and its influence on Asia and the world.
www.gavekal.com
www.dragonomics.net