China's Growth Model Has No Endgame

The European debate about China is obsessed with production. It spends remarkably little time thinking about demand.

Europe is currently obsessed with Chinese industrial domination. Every week brings a fresh warning about Chinese electric vehicles hollowing out Europe’s manufacturing base, and Chinese firms racing ahead in high-tech manufacturing. The spectre of European deindustrialization and mass unemployment haunts policymaking circles, with Wolfsburg cast as the next Detroit. These are serious concerns, and Europe’s efforts to catch up in strategic industries are justified for a host of reasons. What I find striking, however, is how rarely China-watchers ask what happens next. Suppose the nightmare scenario materializes. Suppose European factories close, industrial regions collapse like dominoes, and incomes plummet. Then what?

Photo: narvikk/Getty Images

A growth model that depends on selling goods abroad should not be indifferent to the purchasing power of its customers. Europe is China’s most important export destination after the United States. European consumers and firms absorb a significant share of Chinese production. If European purchasing power collapses, so does demand for Chinese exports.

Yet the whole debate remains trapped inside a profoundly supply-side way of thinking. We have become accustomed to discussing economic success in terms of production. Exports are better than imports, and saving is better than spending — never mind that one cannot export unless somebody imports, or save unless somebody spends. The implicit assumption is that if a country can produce high-quality goods at competitive prices, demand will somehow follow automatically.

These fallacies are so deeply embedded that even critics of China often accept their premises. They may worry about the consequences, but they still tend to treat China’s trade surpluses as evidence that the country is winning.

But winning at what, exactly?

I keep revisiting this 2017 Alphaville post by Matthew C. Klein:

“Surpluses are a sign that consumers are working to produce things they can’t actually use themselves. One could therefore be forgiven for thinking big trade deficits are the sign a country is ‘winning’ relative to the rest of the world. After all, the ‘losers’ with their surpluses are ‘giving away’ goods and services in exchange for paper promises that any good dealmaker could renegotiate in the future.”

The remark gets at a fundamental insight that is often missing from discussions about China. The ultimate source of welfare is not production but consumption. A country that persistently produces more than it consumes is not winning; it is failing to enjoy the fruits of its own labor. Saving is useful because it helps sustain future consumption, but it makes little sense as an end in itself. This basic Keynesian point is still lost on many policymakers and commentators, even though Klein and Pettis’ Trade Wars Are Class Wars book did a stellar job to popularize it.

Viewed through this lens, China’s growth model looks far less coherent than either its admirers or critics suggest.

Three possible scenarios

If China continues generating large surpluses, there are only a handful of possible endgames.

The first possibility is the scenario currently terrifying Europe. Chinese firms outcompete European producers, factories close, industrial employment shrinks and Europe becomes increasingly dependent on imports. Yet if this process genuinely succeeds, incomes in Europe will fall. Workers without jobs do not buy the latest BYD. A deindustrialized Europe is not a strategic triumph for China; it is the erosion of one of its most important customer bases. China would find itself sitting on idle capacities.

This does not make the European threat any less real. Brad Setser and Sander Tordoir have persuasively argued that Europe is already experiencing the second China shock (with Germany at its epicenter), as Chinese firms increasingly displace European producers in key manufacturing sectors. But the more convincing their diagnosis becomes, the more puzzling China’s position appears. If Europe takes a hit, so too does the purchasing power of one of China’s largest markets.

The second possibility is that Europe continues absorbing Chinese surpluses through debt, much as the United States did in the wake of the first China shock. Chinese exports continue flowing, while China accumulates financial claims on Europeans. In this scenario, Europe does not necessarily suffer an unemployment shock (neither did the US, where growth and employment remained robust), but the sectoral composition of employment can shift in a way it did in the US: China manufactures, Europe turns towards a more service-based economy, with potential spatial inequalities emerging, akin to left-behind regions in the US.

This may be something China is banking on, given the experience of the first China shock. In practice, this is extremely difficult to imagine as a durable arrangement. Europe is not the US. The EU lacks both the political appetite and the institutional architecture that allowed the US to serve as the world’s credit-fueled consumer market of last resort. European governments remain deeply attached to irrational levels of fiscal restraint and debt aversion. They continue to struggle to create EU-level safe assets.

When I quiz China-admirers on this contradiction, they often point to emerging markets as viable captive markets beyond a diminished Europe. But I struggle to see how that works. Countries such as Indonesia or Brazil may be growing, but also face much starker current account constraints, and cannot indefinitely absorb Chinese surpluses by running persistent deficits. Absent some major restructuring of global financial markets, the math simply does not math. There are only so many economies with the durable ability to consume more than they produce, and even fewer who are willing to do so.

But even if one assumes that the willingness and ability can somehow be conjured into existence, one eventually arrives at a more basic question. What exactly is the rationale for continually accumulating claims on foreigners if those claims are never translated into higher domestic consumption? And at what point does this setup actually improve the living standards of ordinary Chinese households?

There is also a third possibility. If too much productive capacity is built globally, prices fall. Goods are eventually sold, but less profitably. Chinese factories continue producing, but much of the economic reward simply melts away through lower prices. Again, it does not leave China better off in real income terms.

None of these endgames is particularly attractive for China.

One could interpret the massive overseas expansion of Chinese firms as an implicit recognition of the problem. If Chinese companies manufacture in Europe, creating jobs and incomes there, they preserve part of the customer base needed to purchase their products. Instead of eliminating European industry outright, they absorb it into Chinese-led value chains, retaining the highest-value segments while leaving some activity behind to sustain local demand (the low value added assembly line jobs Eastern Europeans know quite well). Yet this is only a partial fix. A customer whose income falls by 40 percent is better than a customer whose income falls by 100 percent. But the remaining gap still has to be bridged somehow. If a growing share of profits, intellectual property and value added accrues to China while the products are sold elsewhere, somebody still needs to finance the difference.

The rebalancing that wasn’t

The reason these contradictions keep resurfacing is a central, unresolved problem at heart of the Chinese growth model: its persistent, and politically anchored weakness of household consumpion.

This became visible during the Global Financial Crisis. Prior to 2008, China relied heavily on external demand, particularly from the United States. When the crisis exposed the vulnerability of that model, Chinese policymakers quite rightly concluded that dependence on foreign consumers had become dangerous. What followed is often described as a successful rebalancing. In reality, it was a giant exercise in kicking the can down the road, one that ultimately sowed the seeds of the much larger China shock we are grappling with today.

Figure: China's current account surplus collapsed after the Global Financial Crisis—and surpluses started edging up after 2017. Data: World Bank. Brad Setser argues that CA statistics artifically deflate Chinese imbalances, and goods surpluses are actually around 5% of Chinese GDP.

China did reduce its enormous current account surplus from 10% of its GDP to nearly zero, but it did not rebalance toward household consumption. Instead, it rebalanced toward investment. Investment surged toward roughly 45 percent of GDP as local governments, state-owned enterprises and financial institutions poured resources into infrastructure and industrial expansion. The resulting boom absorbed goods that had previously flowed abroad and dramatically reduced the external imbalance.

The difficulty is that investment does not solve a demand problem, but creates an even bigger problem down the line. Every new railway, industrial park, or factory boosts demand temporarily, but also creates additional productive capacity. If household consumption remains weak, the economy emerges from each investment cycle with an even larger demand gap. Income rises, but consumption does not rise proportionately. Additional capacity therefore requires either additional investment or additional exports. Investment begins chasing itself.

This is why discussions of Chinese overcapacity often miss the point. The issue is not that China suddenly became too productive; that part is admirable and indeed something to learn from. The issue is that Chinese households still consume too little relative to what the economy produces. They do not enjoy the fruits of their impressive (while harshly exploited) labor. Weak social protection, precautionary saving, and an investment-oriented fiscal machinery all contribute to this outcome. When growth slows, policymakers know how to build more infrastructure or support another industrial project. They are far less willing to address the institutional causes of weak household demand.

Part of the difficulty may also be political. Rebalancing toward consumption is a redistribution of power and resources: strengthening household demand requires shifting income away from local governments, state-owned enterprises and investment-heavy sectors toward ordinary households. That is easier said than done. There may also be an ideological barrier: Xi Jinping has repeatedly contrasted China's developmental model with what he portrays as the welfare-dependent complacency of the West. In theory, there are many ways to raise consumption without relinquishing political control—one can easily imagine a state-led expansion of healthcare, education or social services. Yet when growth slows, Beijing continues to reach first for the familiar tools of infrastructure investment and industrial expansion.

It is telling that this spring’s policy debates increasingly converged on precisely this diagnosis. From IMF discussions to the G7 economists’ memo on global imbalances, a number of economist luminaries argued that China ultimately needs to raise household consumption. The logic is straightforward: China would become less dependent on foreign demand and less reliant on ever-expanding investment to sustain growth.

Yet this recommendation is politically awkward for reasons that go beyond China itself.

Everyone loves a surplus

China is now criticized for growing trade surpluses while failing to strengthen household consumption. Its critics, however, don’t really have a leg to stand on. For over fifteen years, Europe has pursued its own version of demand suppression. Following the euro crisis, policymakers embraced internal devaluation through wage restraint and fiscal austerity. Growth was expected to come from exports: while domestic demand was scolded as profligate, trade surpluses were celebrated as evidence of virtue.

The irony is that much of today’s European anxiety reflects the breakdown of precisely that model. European policymakers increasingly describe China’s rise as a competitiveness problem, and spend much more time on supply-side fixes than sensible demand-side ones. From Beijing’s perspective, Europe spent a decade playing the same game. The difference is that China invested more aggressively, and expanded productive capacity more successfully than Europe’s purely internal devaluation based strategy.

This may well be one reason why calls for Chinese rebalancing have gained so little traction in Beijing. Rebalancing toward consumption would require abandoning a development strategy that many Chinese policymakers still regard as successful, and doing so in a world where both Europe and the United States continue to treat trade surpluses as markers of economic achievement. Trump has elevated this fallacy to near-caricature, reducing international trade to a scoreboard where exports are points scored and imports are points conceded. European arguments sound more sophisticated, but the underlying mercantilist logic remains just as crude. The most honest articulation of the current European predicament may simply be that China has become better at Europe’s own game than Europe itself.

Yet policymakers’ continued misreading of global imbalances does not alter the underlying contradiction: running ever-expanding surpluses is a strategy that harms a country’s own citizens, harms its trading partners and has no credible endgame.

Of course, Beijing may not view the issue purely through the lens of economic welfare. Xi Jinping has been remarkably explicit about the desire to create strategic dependencies, calling in 2020 for China to "tighten international production chains' dependence on China" and build coercive leverage through supply chains. But even that strategy presupposes thriving commercial relationships. You cannot weaponize supply chains that no longer exist. If Europe's role in those value chains diminishes because its purchasing power collapses, China's leverage diminishes alongside it.