Prepare for an Attack of the China Bears

MAY 25, 2011   THE WALL STREET JOURNAL

By TOM ORLIK

The latest data from the National Bureau of Statistics show that China's investment-led economy tilted further out of whack in 2010.

Investment as a share of gross domestic product came in at a record 46.2% in 2010, up from 45.2% in 2009. Household consumption fell to 33.8%, down from 35% the previous year.

High levels of investment and low domestic consumption are a reminder of all the things wrong with China's economy: excess industrial capacity, real-estate bubbles and a population that is still happier stuffing cash under the mattress than spending it. Pessimists say such unbalanced growth can't be sustained.

European Pressphoto Agency

A farmer works in a field nearby an windmill in Qingdao, Shandong province. Infrastructure investment has enabled China to sustain real growth in household consumption at an average of about 8.1% a year for the past decade

But investors should remember that in developing economies it is investment, not consumption, that drives growth. China may be the world's second-largest economy, but it is still developing. Building moresemiconductor foundries and steel furnaces, as well as the energy infrastructure to fuel them and the roads and ports to get the goods to market, increases output and raises income.

This is what has enabled China to sustain real growth in household consumption at an average of about 8.1% a year for the past decade. That is quite strong, even if consumption hasn't grown quite as fast as GDP.

China's economy isn't about to fall off a cliff. High levels of investment are justified given that millions of Chinese are moving to cities every year, while central and western provinces are still in dire need of infrastructure such as roads, railways and airports.

Wei Li, China economist at Standard Chartered, says such investment-heavy growth—which has continued for some 30 years now—can be sustained for another three to five years.

But not forever. Ghost towns with no residents, and excess capacity in some sectors of the economy, show wasteful investment is a growing problem. The return generated per unit of capital in the past decade is half the level it was in the 1990s, according to Harry Wu, a professor at Japan's Hitotsubashi University.

The government is in transition: President Hu Jintao and Premier Wen Jiabao are both entering their final year in top spots.

And Beijing faces some difficult policy choices. Rising wages will help boost consumption, but higher interest rates, a stronger yuan and better public services—all of which transfer funds from enterprises to households—are also needed if China is to fend off the bears.

—Tom Orlik

Write to Tom Orlik at tom.orlik@wsj.com