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.