China's Economy: All GDP Is Not Created Equal

Last week was full of good news for the Chinese economy, at least according to official statistics. On Thursday, the government reported that China’s GDP grew at an annualized rate of 8.9% in the 3rd Quarter, putting it on track to top the “magic” 8% figure for the year as a whole. Another report, that same day, said that industrial production had expanded 13.9% in September, compared to the year before, while retail sales had grown 15.5% — both on an upward track from previous months. Profits at State-Owned Enterprises (SOEs) jumped 13% in September from a year earlier, the first increase in 13 months. Prominent articles in the New York Times and Wall Street Journal trumpeted the strength of China’s recovery.

So am I convinced? Not entirely. I’m not really a pessimist by nature, and I’d be only too happy to learn that things are looking up. But my main concern lies in a concept I’d like to introduce called “quality of GDP.”

If you Google the phrase “quality of GDP” on the Internet, you’ll find a variety of articles relating to the reliability of the way GDP statistics are gathered in different countries. Several insightful commentators have raised concerns in recent months about how reliable and accurate China’s official GDP numbers actually are, but that’s not the argument I’m making here. My concern is how even true-blue GDP figures can sometimes paint a misleading picture of the real health of an economy.

When smart analysts look at companies, they don’t just look at the announced profit figure and accept it at face value. Even if they have no reason to doubt the accounting, they try to apply a concept called “quality of earnings” to get a better sense of how the company is really doing.

Frequently, reported earnings include gains or losses on one-time events like the sale of business unit or a change in accounting methods. Other times, the value of a company’s foreign-denominated assets may rise or fall with a temporary fluctuation in exchange rates.

These factors may obscure the company’s underlying performance, and give a misleading impression of how it may continue to perform in the future. In some instances, a company may even adopt policies – such as special rebates on durables goods — that boost revenue today at the cost of future sales. A good analyst will figure out how to separate the wheat from the chaff, and produce an adjusted earnings figure that better captures how the business is performing on an ongoing basis. There’s no tried-and-true method, however; for arriving at the right answer; it’s all a question of applying experience and judgment to evaluate what’s really going on.

Back in March, I was asked on Chinese TV whether I thought China could achieve its target of 8% GDP growth for 2008. I said I didn’t see any reason why it couldn’t. All the government had to do was take all the laid off migrant workers and hire them to dig a hole in the ground one day and fill it up the next. Since the total would be added to National Income, the government could simply pay them enough to hit whatever GDP target it had in mind. The more important question, I said, is whether China is preparing itself for the next phase of economic growth. Focusing exclusively on GDP, as a number, is a distraction.

The example I gave may have been a little bit extreme, but it gets at an interesting and important point. GDP tells you how much the economy is producing; it doesn’t tell you whether that production is actually creating real value or not. In a free market, where people are making voluntary exchanges based on supply and demand, presumably it is, otherwise they would behave differently (unless, of course, there are major externalities that market prices aren’t taking into account, see Stiglitz, below). But when the State is either directing economic activity without regard to prices, or when it is artificially influencing the conditions of supply and demand in a way that distorts prices, the conclusion doesn’t necessarily follow. Production may actually consume more value than it creates, destroying wealth, or divert resources from more productive pursuits, yet in the short term, still count positively towards GDP.

This notion actually struck me back in high school, when we were studying Keynes. We learned, as every economics student does, that GDP = Consumption (C) + Investment (I) + Government Spending (G) + Net Exports. Keynes noted that, in times of economic recession, the government could spend, and if it taxed or borrowed from people with a higher propensity to save than consume, the increase in G would outweigh the decrease in C.

But what, I asked, if the government simply went out and bought 10 trillion paper clips that nobody needed at $10 a piece? The funds would have to come from people who otherwise would have bought products they actually wanted and/or saved to invest in businesses that produce goods that meet real needs. True, the increase in G might exceed the decrease in C, raising GDP. In fact, the more the government paid for each paper clip, the better. But we’d all be left with a ton of useful paper clips instead of the things we really wanted to improve our lives. GDP would rise, but our quality of life would fall.

The same reasoning can be applied to a war economy that produces tanks, planes, and ships that blow each other up. U.S. GDP surged during World War II, but don’t kid yourself: real wealth was being destroyed and/or supplanted.

Nobel Prize-winning economist Joseph Stiglitz recently published an article called “GDP Fetishism” which also discussed the shortcomings of GDP, although he approaches the issue from the opposite point of view that I do. Stiglitz emphasizes that in cases like environmental pollution, where the true costs are not reflected by the market, GDP understates the benefits of government action.

Curbing production, he argues, in pursuit of some less tangible benefit (like cleaner air, or greater social equality) might actually improve quality of life. What I’m more concerned about — particularly in regards to China — is something Stiglitz mentions only in passing, the fact that GDP may overstate the real benefit of government spending or policies designed to artificially stimulate economic growth.

The “resilience” of the Chinese economy right now is based, at least in part, on several factors that I find cause for concern:

• acceleration of a 20-year pipeline of infrastructure projects into a 5-year time horizon, including many seemingly redundant projects or vanity projects, or ones where the returns are far from clear (such as the construction of entirely new cities to replace perfectly good old ones);
• reconstruction in the aftermath of the Sichuan earthquake (which needs to be done, but is actually the replacement of destroyed value, not — as growth figures imply — a form of genuine economic expansion; otherwise you could tear down the whole country just to rebuilt it and call it “growth”);
• construction of large-scale luxury condo developments that go entirely unoccupied and serve merely as investment vehicles, on the expectation of future appreciation;
• easy state-provided credit that has kept businesses — many of them poorly run and financed — from exiting sectors (such as steel) that have chronic excess capacity;
• misdirection of business loans into stock market and real estate speculation, fueling bubbles in both markets
• direct investment by government ministries in order to speculate in — and thereby prop up – the real estate market, on the misconception that a rising real estate market is a “driver” of growth (rather than a result of real demand for more and better usable space driven by business expansion and rising living standards);
• the possibility of “channel stuffing,” where wholesalers and retailers are forced to build up unsold inventories to keep factories (particularly state-owned factories) running. Ironically, this shows up in China’s official statistics as “retail sales” because in China, retail sales are counted when the manufacturer ships, not when the products is sold to a consumer.

I’m not saying everything about the Chinese economy is bad, although it might sound like that. There’s actually plenty that’s good.

My main concern is that by pretending everything is wonderful, and brushing the real problems under the rug, China is missing a critical opportunity. Unlike India, which is struggling to revitalize its infrastructure, China already has the whole “building for the future” thing down pat. Bigger airports, taller skyscrapers, and more highways might be good, but they’re not the challenge China faces.

Developing a vibrant service sector, improving quality and safety in manufacturing, building recognized and well-respected brands, developing more efficient and transparent capital markets, providing a social safety net that lubricates labor markets and liberates savings, moving towards full convertibility of the Renminbi, learning how to manage and grow businesses in political and social environments beyond China’s borders — these are the challenges China must master to take its economy to the next level. But I don’t see anything in the “8% growth” story that is moving China in that direction. It’s more (a lot more) of the same, and more of the same just won’t do. Count me as someone who still needs to be convinced on the “quality” of China’s current GDP figures.

The point here isn’t to pick apart China. It would be silly to say that all construction or infrastructure development in China is wasteful; it’s not. And the same (or similar) criticisms could just as easily apply to the U.S., Europe, or any other country. The real point is that — whatever economy we’re talking about — all GDP is not created equal, and we need to be asking deeper questions about whether an economy is creating wealth, not just maximizing output. To speak of “quality of earnings” (for a company) or “quality of GDP” (for an economy) is simply a reminder that numbers never speak for themselves. We need to understand the reality behind the numbers.

Comments

[odin:]

China faces difficult challenges - while rebalancing is desired, it MUST grow. The short term incentives are heavily skewed towards providing continued employment -- even if it is on digging or filling holes. Just as the US is kicking the can down the road regarding inevitable slowdown in consumption, China is delaying the bitter medicine of shifts in employment patterns.

Continued structural imbalances and nascent signs of conflict within the governing structure (Xi Jinping failure to make it to the Central Military Commission) do not bode well for the well-being of the world.

Oct 26 11:56 AM

[tripleblack:]

Personally, I question ALL GDP numbers, but most of all those from opaque nation-states who might well just be masquerading as both sides of the equation in many cases.

I would agree, the US numbers would almost HAVE to be leavened with nonsense and multiple-counting right now, given the size of government's involvement.

Until things settle down, I would assume that ANY investment decision based upon government-supplied statistics (and that would include ANY government) be cautious and the statistics viewed with a healthy dose of skepticism.

Oct 26 12:29 PM

[Leftfield:]

Washington "stimulus" is of no better quality than China's anymore. Plus, it's all debt piled onto debt which is worse than China's. The nearer you get to the top in the US, the closer your decisions resemble China's. From where I sit, anyway. Far from the favored crony list.

Oct 26 12:57 PM

[bluesky123:]

China is the biggest car market in the world. It passed the US this year. There are 130 billionaires in China, up from 101 last year. Asia will have more millionaires than the US before 2013. Asia is already the top market for US and European auto brands. GM's sales in China are up 74% in the last 12 months. Rolls Royces are flying out the show room as are very expensive wines and art. Conspicuous consumption is booming in China. Asia is growing very, very fast.

nytimes.com/2009/1......

Oct 26 01:23 PM

[cyclingscholar:]

It is funny how so many luddites in the USA, who gabble and rant and rave about every US statistic, be it inflation, unemployment, poverty, output, yadda yadda, swallow the chinuese figures hook, line, and sinker.

If installing a flush toilet is a 30% increase in quality of life, I can goose my economic statistics pretty easily, as well.

Oct 26 02:07 PM

[Ben Gee:]

Whether the 8.9% figure is accurate or not is not that important to me. I would be just impressed if the figure was 7.2%. We in Canada would be elated if our growth figure was 2%. All I know is in China, most people are confident about their future and the people are working very, very hard to make their future better. If the governmennt gave the people rose colored glasses to wear to get this result. I do not think that is a bad thing. I believe in positive thinking. If we believe the sky is falling, we may not go to work and stay home. So good or bad thinking will reenforce itself.

Oct 26 07:26 PM

[doubleshortetf:]

How can a country where 83% or little over a billion people live with income less than $2,000 be heading to middle class?

Some sober data on China for investor (speculators) fascinated with China - 3rd world country ruled by 1 party - communist. Similar to the adoration US had for Japan 20 yrs ago right before the mother of all Japanese bear markets starting in 1989.

China would have to triple the size of its economy - and the US would have to stand still - if China were to pull even with the US in GDP.

Consider the following numbers, culled from official Chinese statistics:

1. About 65 million or 5% Chinese people live in households with more than $20,000 a year in income.
2. Around 165 million or 13% make between $2,000 and $20,000 a year.
3. About 400 million or 31% Chinese have household ­incomes between $1,000 and $2,000 a year.
4. About 670 or 52% million have household incomes of less than $1,000 a year.

As you see China is a land of extra­ordinary poverty.

And some dreamers to think that China can pull US and the world out of financial rut...

Oct 26 11:11 PM

[Options Tra...:]

Even though the Chinese people are poor, the Chinese government is RICH. That is why the US has been begging China to buy more of its bonds. That's just another way of begging to borrow some money. China's HUGE trade surplus and foreign reserves is why it has the power to help other countries, including the US, get out of the financial rut.

I have doubts about the quality of all GDP numbers of all countries in the world because I know how manipulable that number can be coming from my economics background and over a decade of economic analysis. However, no matter how manipulable GDP number is, it always follows a trend and the trend on a longer time frame tells a much clearer picture than trying to digest individual numbers.

Oct 27 01:27 AM

[Moon Kil Woong:]

The author touches upon what really counts and what people should be much more concerned about. That is quality of living. It should be the meauring stick not GDP if somehow we could enumerate the base values and measure it. No matter how you define it, we can pretty much agree that deflating your currency by 15% to get a slightly positive GDP number like the US is doing is not really increasing anyone's quality of life.

Thus quality of GDP in the US is at least if not more suspect than in China. Even if they stuff their channel with excess inventory, at least they made something. We are stuffing our economy with excess bureaucrats and financiers. I'd even take the digging holes and filling them in over that. At least that type of work doesn't create a systemic waste.

Oct 27 02:58 AM

[Patrick Cho...:]

China is my home, I live in Beijing. I

Oct 27 03:03 AM

[TradingHelp...:]

I disagree, it's because there are still 1 billion in poverty in China that makes its growth story compelling.

They could grow at 8% per annum every year for 50 years and there will still be another 500m new consumers to tap.


On Oct 26 11:11 PM doubleshortetf wrote:

> How can a country where 83% or little over a billion people live
> with income less than $2,000 be heading to middle class?
>
> Some sober data on China for investor (speculators) fascinated with
> China - 3rd world country ruled by 1 party - communist. Similar to
> the adoration US had for Japan 20 yrs ago right before the mother
> of all Japanese bear markets starting in 1989.
>
> China would have to triple the size of its economy - and the US would
> have to stand still - if China were to pull even with the US in GDP.
>
>
> Consider the following numbers, culled from official Chinese statistics:
>
>
> 1. About 65 million or 5% Chinese people live in households with
> more than $20,000 a year in income.
> 2. Around 165 million or 13% make between $2,000 and $20,000 a year.
>
> 3. About 400 million or 31% Chinese have household ­incomes between
> $1,000 and $2,000 a year.
> 4. About 670 or 52% million have household incomes of less than $1,000
> a year.
>
> As you see China is a land of extra­ordinary poverty.
>
> And some dreamers to think that China can pull US and the world out
> of financial rut...

Oct 27 04:20 AM

[chinastakes:]

This is perhaps inevitable as the People's Republic looks back on its development from the vantage point of its 60th anniversary. The financial crisis has revealed China's strength, which has earned it increasing prestige. With the establishment of the G20 China has taken its place among the world's nations as a leader and shaper of the future of the world's economy.

www.chinastakes.com/20...

Oct 27 04:41 AM

[userbob:]

The Chinese GDP growth are of good quality. They are building the world's largest highspeed railway network which the people will use and will reduce the reliance on cars.

I don't see why they need to dig a hole in the ground to fudge up GDP growth, when all they need to do is to build more new schools in the rural areas and train more teachers. Education is something they need and this service can generate more GDP.

Oct 27 06:06 AM

[H.J. Huneycutt:]

Fantastic article. A very good critique of GDP as a measure of "real added economic value" --- of course, the thing about it is that any measure we come up with, people will eventually try to game the measure rather than improve the underlying conditions. All the same, I agree that there are strong reasons to doubt the "quality" of China's GDP growth.

Oct 27 07:37 AM

[Sol Palha:]

The fact that so many Chinese are poor means that they have that much more room to expand. When your back is pressed to the wall and you have nowhere to go, you usually try your very best to advance forward, even though it might just be a few Centimeters at a time. The Chinese are very patient and think in terms of decades and not days and months like most westerners do. Given their propensity to work hard, their desperate desire to improve their lives and those of their children, the long term picture is extremely bright for this country.

Oct 27 10:52 AM

[chennian:]

Your data might be true, but they might be ten years old. This year to date, almost 10 million automobiles have been sold in China. Most of them are more than 50% more expensive than those sold in U.S. And most importantly more than 90% of them were sold on full payment of cash.


On Oct 26 11:11 PM doubleshortetf wrote:

> How can a country where 83% or little over a billion people live
> with income less than $2,000 be heading to middle class?
>
> Some sober data on China for investor (speculators) fascinated with
> China - 3rd world country ruled by 1 party - communist. Similar to
> the adoration US had for Japan 20 yrs ago right before the mother
> of all Japanese bear markets starting in 1989.
>
> China would have to triple the size of its economy - and the US would
> have to stand still - if China were to pull even with the US in GDP.
>
>
> Consider the following numbers, culled from official Chinese statistics:
>
>
> 1. About 65 million or 5% Chinese people live in households with
> more than $20,000 a year in income.
> 2. Around 165 million or 13% make between $2,000 and $20,000 a year.
>
> 3. About 400 million or 31% Chinese have household ­incomes between
> $1,000 and $2,000 a year.
> 4. About 670 or 52% million have household incomes of less than $1,000
> a year.
>
> As you see China is a land of extra­ordinary poverty.
>
> And some dreamers to think that China can pull US and the world out
> of financial rut...

Oct 27 11:07 AM

[Tony Daltorio:]

I do not doubt that many of China's economic numbers are "fudged", but their rapid economic growth of the past three decades is fact.

And why do people like the author constantly bash China and other nations for their economic numbers? They don't have to look across the oceans when it comes to rigged numbers and manipulated markets. Just look right here in the USA, the epicenter of the global financial earthquake!

Oct 27 03:49 PM

[Tony Daltorio:]

Ignore this biased China basher....he is living in the past.

Besides the auto stats mentioned by some other commenters, here are some other stats showing China's growth:

It is the 3rd largest market for luxury goods, behind the US & Japan with more than 55% of Chinese consumers who buy luxury goods having done so in just the past 4 years.

And when you look at the demographics of consumers in cities throughout the country - in the United States less than 30% of people in the 18-to-44 age bracket make more than $70,000 per year. In China, the percentage of people in the 18-to-44 age bracket making more than $70,000 is about 80%.


On Oct 26 11:11 PM doubleshortetf wrote:

> How can a country where 83% or little over a billion people live
> with income less than $2,000 be heading to middle class?
>
> Some sober data on China for investor (speculators) fascinated with
> China - 3rd world country ruled by 1 party - communist. Similar to
> the adoration US had for Japan 20 yrs ago right before the mother
> of all Japanese bear markets starting in 1989.
>
> China would have to triple the size of its economy - and the US would
> have to stand still - if China were to pull even with the US in GDP.
>
>
> Consider the following numbers, culled from official Chinese statistics:
>
>
> 1. About 65 million or 5% Chinese people live in households with
> more than $20,000 a year in income.
> 2. Around 165 million or 13% make between $2,000 and $20,000 a year.
>
> 3. About 400 million or 31% Chinese have household ­incomes between
> $1,000 and $2,000 a year.
> 4. About 670 or 52% million have household incomes of less than $1,000
> a year.
>
> As you see China is a land of extra­ordinary poverty.
>
> And some dreamers to think that China can pull US and the world out
> of financial rut...

Oct 27 04:06 PM

[doubleshortetf:]

Any of you fond of China been to China? You really think China with 1/3 US GDP will save the world?

I've been to China over 30 times since 1998 while working for 3 multinationals. It's amusing to see "experts" who has not been to China or spent few days in the big Chinese cities recommending Chinese stocks... Wonder if they ever spent weeks at a time in gritty factory towns or poor interior areas...

And Xie is right - Chinese market is indeed a ponzi scheme and gambling den where the "house" is CCP (Chinese Communist Party).

Some sober FACTS:

1. China is a communist country ruled by 1 party with iron grip. CCP party bosses appoint the national/regional/local politicians and many private company managements since many private companies are ex-SOE (state owned enterprises).

2. Corruption in China is prevalent, rampant and one of the worst even down to lower ranking employees. For example, factory canteen worker receives an "envelopes" in scheme where he claims he received 10 bags of rice when only 8 bags are delivered.

3. There is almost no "law" since laws are written to support the communist party or corrupt local communist bosses. Judges are appointed by the local communist boss and few if any understand law. Many judges got job thru "guanxi" or connection and of course bribes.

4. The Chinese banks in are BIG TROUBLE. E&Y got in heaps of trouble for discussing hidden bad and noncollectable debts. Local communist cadres dictate banks to lend to their pet projects and of course friends who bribe them not to mention COMPLETE lack of transparency.

5. No one except pea size brains trusts the communist government's statistics which are MANIPULATED.

6. Many of the listed companies numbers are COOKED. Auditors and their management can be bribed and extorted. It's beyond me how anyone would trust Chinese companies' financials unless audited by Big 4. And even Big 4s audited numbers are suspect since most Chinese companies carry multiple books including one for taxation and another with slush funds and hidden losses.

7. Latest Chinese share and commodity appreciation have lot to do with communists pumping money to the economy by directing the banks to lend. This kind of stimulus cannot go on.

Now is good time to buy FXP when all the investment gurus in unison are recommending Chinese stocks and even "taxi drivers" and clueless herd investors believe China with 1/3 US GDP will save the world.

Oct 27 09:31 PM

[Michael Clark:]

Patrick: Excellent article. You raise a lot of questions I have about economic reporting (American AND Asian). Some people on this site are actively rooting for China to topple America. Maybe China will. But there is a lot of lying going on to try to save face, much of it coming from Asia, much coming from America.

I'm living in Hanoi; and I can tell you from my experience that 'face' is driving almost every impulse in Vietnam. The truth is one thing; but how you 'appear' to the world is the most important thing. If you appear to be negotiating this economic problem successfully, then that is what matters.

If the American government lies to try to save itself, even when thousands of bloggers and newsmen are trying to prove them wrong, then why wouldn't the Chinese government lie, when it is illegal locally to try to prove them wrong. Some westerners naively seem to think if America is evil then China is good. Sorry, the world is more complicated than that.

I enjoyed your article, Patrick. I'm following you from now on.

Oct 28 11:05 AM