The Strategist

Why Chinese GDP growth is a bubble

11/29/2017 - 11:13

The 19th Congress of the Communist Party of China, which ended last month, showed that the new administration of Xi Jinping will restrain growth of debts by abandoning the country's long-term economic goals, and by reducing the growth rates of its gross domestic product.

Anna Frodesiak
Anna Frodesiak
As a rule, analysts proceed from the fact that the presented changes in GDP parameters reflect the movement in the sphere of living standards and productivity level. However, the situation is different in China. Local governments are expected to increase spending on any necessary amount to ensure fulfillment of the tasks assigned to the country, and this is done regardless of whether this path is effective or not.

GDP growth is not the same as economic growth. As an example, consider two plants that have the same cost of their construction and production activities. Suppose that the first produces useful goods, and the second makes unnecessary goods just to fill its warehouse premises. Only the first will contribute to the growth of the corresponding economy. However, both plants will ensure GDP growth and will do so in the same way.

At the same time, most of the economies in the world have at their disposal two mechanisms, aimed at ensuring that the GDP data correspond to the overall economic indicators. First, they are strict measures of budgetary restraint, setting limits for the budget and pushing companies out of the economy, which are wasting investments, even before they are able to seriously distort the economy.

Secondly, it is a factor of market pricing in calculating GDP, which consists in the following: if bad debts are written off due to wasted investment, then the component of GDP based on value added and overall growth indicators are reduced.

Yet, none of these mechanisms work in China. Bad debts are not written off, and the government does not receive tight budget constraints. It is the government sector that is responsible for the erroneous direction of investment, which is so characteristic of the recent growth of the Chinese economy.

The consequences are obvious, even if most economists wonderfully refuse to recognize them. Anyone who believes in existence of a significant amount of wasted investment in China should recognize that the reported GDP growth figures overstate the data on the real increase in wealth due to the refusal to recognize the existing bad debts. If they were correctly written off, then, according to some estimates, China's GDP growth would be below 3%.

Historical precedents give an idea of the possible magnitude of such overstatement. So, for example, the Japanese economy in the 1980s had distortions, similar to the current Chinese. They were not even nearly as extreme, yet Japan suffered from a very low share of consumption in GDP, as well as from excessive dependence on investments, which by the 1980s were largely misused.

In the early 1990s, Japan's GDP represented 17% of the global total, and then few doubted that the country's rapidly developing economy would become the largest in the world by the end of the century. But when credit growth stabilized, Japan's share in global GDP began to decline rapidly, and from that moment it has declined by almost 60%.

The same thing happened to the former USSR. Its economy grew at such a rapid pace after the war, that at the end of the 1960s it amounted to 14% of global GDP, which is comparable to today's Chinese indicators. Then, many expected the Soviet Union to overtake the United States. However, the share of the USSR in global GDP fell by more than 70% after two decades.

The above examples may seem shocking, yet Japan in the 1980s, the USSR in the 1960s did not have the mechanisms to account for wasted investments in GDP data – just like modern China. At peak times, the growth rates of these countries were heavily overstated, as bad costs were not written off, and inflated figures were given when the debt level stabilized. The consequences are obvious. The miracle of Chinese growth has exhausted its possibilities. And now only due to the growth of debts this country can fulfill its goals in the field of GDP. Perhaps that is why the chairman sought to emphasize more meaningful goals such as increasing household incomes. Whatever the reasons, analysts should not perceive GDP growth as an indicator of the main economic results. Accumulation of unsold and unclaimed goods or construction of unused airports can increase GDP performance in a system that does not recognize bad debts, but this does not affect the overall economic results.