Questioning Rudd’s version of ‘China 2.0’

China can easily rouse its banks, but awakening its consumers will be tougher. AAP

West Australian Premier Colin Barnett’s bold claim on Friday that his state was looking “over the horizon” past Canberra to forge stronger links with China capped off a few weeks of strong rhetoric from our politicians on relations with our biggest trading partner.

Barnett’s comments should be viewed in the context of his state’s running battle with the Federal Government over mining tax royalties, but they nonetheless highlighted the complex and multi-tiered way that Australian governments and businesses engage with China.

Barnett’s comments came a week after our ambassador to China, Geoff Raby, delivered a speech to Australian business leaders in Beijing on the importance of being “China literate”.

“To speak Chinese is not to know China,” he noted. Some considered this a dig at his Mandarin-speaking boss, Foreign Affairs Minister Kevin Rudd. While this is a stretch, the thrust of a speech delivered by Rudd just several days later does raise concerns.

Speaking in Guangdong, the economic powerhouse of southern China, Rudd asserted that the country’s latest five-year plan showed the government had embarked upon a new growth model, which he dubbed “China 2.0”.

This new model sees domestic consumption replacing the traditional drivers of growth, investment and exports.

The upshot for Australian companies is that while Chinese demand for our natural resources will continue, new opportunities will also open up in sectors as diverse as architectural and financial services.

The two countries are embarking on a new relationship, “Australia-China 2.0”.

The problem with “China 2.0” is that it assumes the Chinese government is able to switch its growth model.

Commentators have become accustomed to China’s government being able to pull a rabbit out of a hat. When the global financial crisis began cutting into growth at the end of 2008, in addition to launching a fiscal stimulus program of the type used by many governments around the world, China’s government told the banking system to open the credit taps.

While nearly every other banking system around the world was cutting lending, or at least slowing the rate of lending growth, in the first half of 2009 China’s banking system increased lending by more than 200% over the same period in the previous year.

The end result was that the Chinese economy hardly skipped a beat and by year-end was again growing at the long-term average of 9.1%.

The government was able to do this because the banking system remains majority state-owned and the chief recipients of credit were state-owned enterprises, which had been charged with embarking upon infrastructure projects and the like.

However, what is important to note is that 95.2% of China’s growth in 2009 came as a result of gross capital formation (investment). This was more than double the contribution of consumption, while net exports were actually a drain.

The lesson is that the Chinese government retains an ability to exert a strong influence over investment, but the same is not true of consumption.

In 2005, Chinese Premier Wen Jiabao delivered a speech in which he observed that a problem with China’s economy was that “the investment rate is too high, and consumption remains weak”.

Increasing the prominence of consumption has been part of Chinese government rhetoric at least since this time. Yet the private consumption share of GDP has continued to fall.

In short, “the great economic transformation now underway” to which Rudd referred in actual fact stalled at the starting line, at least with respect to rebalancing the drivers of growth.

There are good reasons why the consumption share in China remains low. In part it is explained by the preference of China’s households to save rather than consume in the absence of an effective social security system and faced with rising health and education expenses.

It also reflects a declining household income share of GDP, which reflects, amongst other things, a financial system that fixes interest rates on savings deposits at artificially low levels and fails to return corporate profits to households via dividend payments.

The government cannot simply tell households to spend more in the same way it can tell banks to lend more.

Much needed reforms in areas such as social security have moved at a snail’s pace. This is not because the central government does not want reform, but rather because it is extremely difficult to execute politically.

For example, China’s fiscal system is highly decentralised on the expenditure side with lower levels of government responsible for providing all manner of services, including social security.

Yet on the revenue side, the fiscal system is more centralised and lower levels of government, particularly in poorer provinces, lack stable income streams to fund such expenditures. In the case of financial system reform, the central government is fundamentally conflicted.

For example, to liberalise interest rates might act to boost the household income share of GDP, but it would also put pressure on the margins of state-owned banks and firms.

At the same time the Chinese government lacks powerful levers over private consumption, its legitimacy remains tied to continued, rapid economic growth. This means that the temptation is always to revert to the traditional growth model in which investment does the heavy lifting.

Rudd is certainly correct that a large and growing Chinese economy means that Australian exports to China will continue to increase. But “China 2.0” won’t be happening any time soon.