What happens if Chinese growth slows?
Last week I suggested that slowly the consensus is shifting towards a recognition that Chinese growth may slow sharply in the next few years. When I discuss this prospect with analysts and investors, however, they almost always worry about two things. First, since China represents the largest component of global growth, it seems reasonable to expect that a sharp slowdown in China will also mean a sharp slowdown in global growth. Slowing Chinese growth, in other words, should be terrible for the world. Secondly, if growth does slow sharply, this should cause an equally sharp rise in social instability and, with it, rising political instability.
I disagree with both claims — not that they are necessarily wrong but rather that they are not obviously true, and depend heavily on the way China rebalances. To see why it is worth considering what happened to Japan in the past two decades.
In 1990, Japan was 17 percent of the global economy and was easily the second largest economy in the world. It also accounted for the largest share by far of global growth, having completed two ferocious decades during which time it’s economy had grown annually by eight to ten percent. Only the most skeptical doubted that within a decade or two Japan would overtake the US as the world’s largest economy.
Imagine at the time that you had been smart enough, and foolhardy enough, to predict that over the next two decades Japan’s growth rate would collapse to substantially less than one percent annually, and that by 2010 it would be less than one-third the size of the US. Had anyone believed you (and of course no one would have believed you), they would have almost certainly made two very obvious predictions.
First, a collapse of that magnitude in the Japanese growth rate would create an enormous drag for the rest of the world. Without Japan to power it, global growth would be anemic at best.
Second, the Japanese people would have been unwilling to accept with equanimity such a disaster. At the very least there would be a surge in social instability and Japanese voters would have revolted against their leaders.
Although the first prediction, about a dramatic slowdown in Japanese growth, would have turned out to be completely accurate, the two subsequent predictions would have been completely wrong. First, in spite of the virtual collapse of the Japanese growth machine, the world experienced robust growth in the 1990s. Second, the Japanese people turned out to be remarkably docile about the terrible turn the Japanese economy took.
Contributing to growth
It is worth considering why Japan did not fulfill what seems like such obvious predictions. The answer, it turns out, may depend crucially on the way the Japanese adjustment took place. Take Japan’s impact on global growth. Analysts too easily confuse a country’s share of global growth with its contribution to global growth, but they are very different.
Although Japan comprised a disproportionate share of global growth before 1990, this doesn’t mean that it contributed disproportionately to growth outside its borders. On the contrary, Japan had at the time the largest trade surplus ever recorded as a share of global GDP. This meant that it absorbed far more global demand than it provided.
Since I believe that it is largely demand that powers growth, Japan may well have been absorbing more growth from the rest of the world than it contributed. In that case the impact of Japan’s declining GDP growth would come about largely as a consequence of the change in net demand it provided to the rest of the world – would its trade surplus grow or shrink?
On that score it is pretty clear that Japan’s contribution in the past two decades to the rest of the world was positive. The combination of the small decline in Japan’s surplus as a share of GDP and the large decline in Japan’s GDP as a share of the world (Japan dropped from roughly 17% of the world in 1990 to 8% today) meant that from the late 1980s to the present, as a share of global GDP, the Japanese trade surplus dropped by more than half.
This means that Japan’s net demand more than doubled during this period as a share of global GDP, or more accurately, that its deficiency in net demand dropped by more than half. This would have provided an expansionary boost to the global economy. Perhaps this is why the world was so easily able to shrug off the almost unprecedented collapse in Japanese growth rates even though Japan was seemingly the great growth engine of the world.
It wasn’t so bad
But what about social instability – why were the Japanese so accepting of such a shocking contraction in growth? The answer here has probably to do with the fact that during this difficult adjustment Japan rebalanced its economy away from one that penalized household income and consumption growth to one that supported it.
If the Japanese measured well-being in terms of GDP per capita, the last twenty years would have come as a brutal shock. But if they measured it in terms of consumption per capita, the last twenty years were not so bad. Before 1990, Japanese consumption grew much more slowly than Japanese GDP as households were forced to subsidize growth via large transfers of wealth from households to businesses – mainly in the form of very low deposit rates and a seriously undervalued currency. This, of course, is the same process that is occurring in China.
After 1990, Japanese consumption grew substantially faster than GDP as the country painfully rebalanced its growth model. One of the forms of rebalancing, interestingly enough, may have been Japanese deflation, which automatically pushed real deposit and lending rates into positive territory and so reversed one of the main mechanisms by which wealth was transferred from Japanese households to Japanese businesses – artificially low interest rates on deposits and loans.
Japanese per capital household consumption, in other words, did not decline nearly as dramatically as Japanese per capital GDP. In fact it may have grown in real terms (once you adjust for inflation in the period before 1990 and deflation after, and after you adjust for the decline in population) only a little more slowly after 1990 than it did before 1990. As Japan rebalanced, wealth was transferred from the state and corporate sector back to the household sector. Most of the slowdown was consequently borne by businesses and governments.
I think the Japanese story has important implications for our analysis of China. If China indeed experiences a rapid slowdown in GDP growth, the impact on the rest of the world may be far less than we expect. The real key is the evolution of the Chinese trade surplus. If it contracts, it will provide an expansionary boost to the rest of the world, not a contractionary one.
Of course that doesn’t mean that the world will grow quickly. My expectation is that global demand growth over the next several years is likely to be anemic with or without China. But it does man that a slowdown in Chinese growth might not be the disaster for the world that many believe.
Also a rapid slowdown in Chinese growth does not mean a social or political disaster domestically It depends on how serious China is about rebalancing its economy. If policymakers are willing to force up interest rates and wages, most of the adjustment pain will be borne by SOEs and the state sector, not by the household sector. In that case we might see a slowdown in Chinese consumption growth, but one not nearly as severe as the slowdown in Chinese GDP growth. Since the Chinese, like everyone else, probably measures their well-being in terms of purchasing power per capita, rather than GDP per capita, a sharp slowdown might not be nearly as painful as we assume.
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