Over the past year, there has been a lot of buzz in China around the vague notion of “high-quality” economic growth.
But what exactly does “high quality” growth mean, and why is China emphasizing it now?
Before attempting to define “high quality” growth, it’s helpful to take stock of what GDP—a measure of economic production and growth—means in China.
Michael Pettis, finance professor at Peking University’s school of management, has long argued that China’s GDP numbers do not give an accurate picture of the underlying economy and are not comparable with those of other major economies, like the US. It’s a belief many economists studying China share.
According to Pettis, this is because much of the Chinese economy operates under soft budget constraints. A hard budget constraint means “you’ve got to have the money to spend it,” whereas a soft budget constraint means there’s no limit to one’s spending and losses can in principle be rolled over indefinitely. Local governments in China operate under soft budget constraints, in contrast to the hard budget constraints of other major Western economies, and because they comprise a significant share of economic activity, China’s GDP numbers are fundamentally different in nature and as such, incomparable.
He illustrates this point by two hypothetical, identical Chinas—with the only difference being one has hard budget constraints and the other has soft budget constraints.
In the first China, a construction firm spends $100 digging a hole, then $100 filling it up. “In a hard budget constraint economy or in a normal accounting, you have an expense of $200 and nothing to show for it,” said Pettis.
In the second China, a construction firm similarly spends $100 digging a hole, then $100 filling it up. “But in [this] China, you don’t expense it,” he explained. “You call it an asset. You say, I have now built an asset worth $200.” This, Pettis noted, is how GDP accounting works in the China that we all know. What this means is that China’s official GDP figures as currently reported are significantly inflated relative to actual economic conditions, and are also impossible to compare with the GDP figures of other nations.
China’s 14th Five Year Plan, which was issued last year and maps out the country’s major economic and political priorities through 2025, made clear that “high quality” growth under a “new development pattern” was a key priority.
That signalled a key “pivot” by Chinese officials, Travis Lundy, a Hong Kong-based independent analyst, said on a recent episode of Bloomberg’s Odd Lots podcast. “That means that they were telling you very clearly, the stuff that we did before to get a very high growth rate, we’re not going to that it anymore. That’s a policy decision.”
The activities that have historically boosted China’s GDP growth rates include high investment spending, primarily in infrastructure and real estate. Those two sectors make up about 25% to 30% of China’s GDP. But there are only so many apartment buildings and bridges that need to be built before those investments become unproductive. And in recent years, as “ghost towns” proliferated and real estate developers accumulated debt, Beijing came to the realization that the breakneck speed of GDP growth in decades past is no longer possible nor sustainable. China’s Evergrande, the world’s most indebted developer, is the errant poster child for what Xi has criticized as “inflated” or “fictional” growth, as opposed to “genuine.”
“The good stuff is high quality growth, and that seems to mean consumption, exports and business investment,” said Pettis.
For an authoritarian government whose legitimacy is heavily dependent on delivering sustained economic growth and improving the livelihoods of its populace, the shift in focus towards quality of growth is also a way of managing expectations and also diverting attention away from the many structural headwinds that China’s economy is facing, including an aging population and lagging productivity, said Alicia García-Herrero, chief economist for Asia Pacific at Natixis.
“I have a feeling that the official wording is evolving for a crucial reason because [China is] in the midst of both structural deceleration and also cyclical deceleration,” said Alicia García-Herrero, chief economist for Asia Pacific at Natixis. “So it’s very hard to find the right words to tell the world, ‘We’re decelerating.’”
By differentiating between “high quality” growth and everything else, Beijing is implicitly acknowledging that spending on infrastructure and real estate is of inferior value. “And I would argue that they’re right, because a lot of that is non-productive. It creates no wealth,” said Pettis.
The World Bank has a similar interpretation. As it noted in a December 2021 paper, in order for China to achieve “high quality” growth, the country will need to rebalance “from external to domestic demand, from traditional investment and industry to consumption and services, from the state to markets and the private sector, and from a high to a low-carbon economy.”
Whether China can pull off this rebalancing act towards “high quality” growth is another question.
Pettis believes there are five paths—one of which China is currently on—that Beijing can take:
- China continues what it’s doing now, with heavy emphasis on investment in infrastructure and property, and debt continues to rise faster than GDP. However, this is unsustainable, and Beijing has signalled that it doesn’t want to continue this model indefinitely.
- China reduces non-productive investment and replaces it with productive investment, such as in the high tech industry. However, it’s difficult to shift such a large part of Chinese investment into an as yet relatively small sector, and Beijing has been trying unsuccessfully to do this for years.
- China reduces non-productive investment and replaces it with consumption. However, this requires that the household share of GDP rise by at least 10-15 percentage points, mainly at the expense of local governments—a politically challenging thing to do.
- China reduces non productive investment and replaces it with a trade surplus. However, China already has a giant trade surplus and it’s difficult to increase it substantially.
- China reduces non-productive investment and doesn’t replace it, leading to a substantial drop in GDP growth rates.
“And that’s it. There is no other path China can follow. So the question is, which one will they follow?” said Pettis. “My guess is that [China] will continue on the first path for a bit longer and ultimately will go to the fifth path.”
In that case, China would slump into a long period of economic weakness, much like Japan did for decades beginning in the 1990s.