Why China must waste no time in pivoting to a consumption-based economy

China’s investments make up a big proportion of its GDP, at an estimated 42.5 per cent last year, from 33.7 per cent in 2000, and 35 per cent in 1980. For too long, infrastructure and manufacturing have been two of the biggest pots for that investment.

But while expanding public investment can help ease infrastructure bottlenecks, scaling up too fast can be inefficient. It is difficult for infrastructure investments to be absorbed as they are costs of growth more than sources of growth.

Infrastructure investments make local government officials look good but there are significant diminishing returns as provinces become saturated with it. The overflowing public debt in high-growth Guizhou is a good example.

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On the other hand, China’s overt focus on manufacturing comes with two costs. First, it means a greater dependence on exports, which requires a weaker yuan. This raises the cost of imports and thus reduces the purchasing power of households, shifting wealth from consumers into manufacturing.

Second, the model is unsustainable as the rest of the world struggles to absorb the enormous trade surplus China generates.

To make up for the lack of consumption, China must rely increasingly on investment, which it props up with extensive subsidies. Though official comments on the 2023 data claim there was no massive economic stimulus, that China’s debt-to-GDP ratio has risen to a record high suggests otherwise.

Subsidies are problematic because they obscure the costs (and therefore value) of investment, and in effect transfer wealth from households into investment and manufacturing. Worse, many of these investments are failing, hence the official clampdown on local government financing vehicles (LGFVs).

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Designed to subsidise and generate investments for states, LGFVs have been hit by poor returns and caught in the property slowdown. LGFVs now have massive debt obligations linked to infrastructure investments. The net result is a destruction of wealth.

There are parallels with Japan in the 1980s and Brazil in the 1950s and 1960s, when both countries ran economies based on heavy subsidies for investment.

Japan drove growth through low interest rates and a devalued currency, which improved exports but hurt imports, and therefore consumption. Brazil drove growth with investment and subsidised it with high income taxes, which also hurt consumption. Very quickly, both ran out of investment opportunities and their economies, with minimal consumption to keep them up, collapsed.

China is edging close to these cautionary tales.

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Maintaining China’s high GDP growth under the current model would require more investment growth and manufacturing, which requires more transfers of wealth from households and higher debt. In this vicious circle, already hurting households will have to hurt some more just to keep the ship afloat.

There are mixed signals in the government’s comments on its willingness to fix the issue. For one, China wants to strengthen the renminbi, as President Xi Jinping noted in a recent speech on financial reforms. This is productive, because a weak currency is an implicit tax on households to subsidise manufacturing growth.

Yet China also intends to introduce more subsidies, even if gradually. This is part of the problem, not the solution. Barring a miraculous new field of investment opportunities, more subsidies for investment will do nothing to improve consumption. Much is at stake, as we saw from Japan’s and Brazil’s “ lost decades”.

At the risk of oversimplifying a complex subject, China has an array of tools to fix its economic woes, some of which require major shifts in its policy mindset.

To reboot China’s economy, Beijing must have the confidence to let go

First, abandon its subsidy-based investment growth model by pivoting to boosting consumption’s share of GDP. This also means embracing lower GDP growth as a difficult but necessary medicine towards a more sustainable model of growth based on consumption.

Second, it will allow China to cut subsidies and misallocated investments, reversing transfers to contribute to consumption, rather than drain it.

Third, strengthen the yuan to lower the cost of imports and improve consumption. Pumping more subsidies into manufacturing will help exports but hurt consumption.

Finally, urgently improve household wealth and income. As many economists have pointed out, one way is to increase market efficiency and increase household participation in markets. This captures a range of long-term solutions already proposed, such as improving trust and transparency in markets.

But there are also some unorthodox ones, such as transferring ownership of companies to households. While many might decry this as extreme, given China’s economic woes, extreme might just be the new rational.

Anson Au, PhD, is an assistant professor of sociology in the Department of Applied Social Sciences at the Hong Kong Polytechnic University

South China Morning Post