118285 chinas challen
TRANSCRIPT
November 2010
www.lombardstreetresearch.com
Monthly Review 262 November 2010
China’s challenge: letting the ‘invisible hand’ boost consumption
Summary: China has reached the end of the road for its export-led growth. Its miraculous
growth machine has produced outstanding results, but they were only made possible by
good fortune abroad. The financial crisis has ushered in a prolonged period of low global
growth. The rest of the world will no longer tolerate China’s continual grabbing of market
share when the global trade pie is hardly growing. The external demand shock has
undermined the sustainability of China’s exorbitant investment rate, which is set to fall to
35% of GDP by the end of the decade from 48% of GDP in 2009. China’s potential growth rate
could well halve to 5% in this decade. The greatest problem policymakers have to contend
with is coming to terms with much slower growth and the social and political consequences
that go with it. The Chinese growth machine is likely to continue to function in the minds of
people long after it has no visible means of support. Beijing will attempt to achieve the
growth rates of the past, but monetary and fiscal ease will do more to accelerate inflation than
to boost growth. The likely fall in the propensity to invest means that each time loans become
plentiful and cheap, there will be a rush to borrow in order to speculate on property or the
stock market. This has already happened with the massive monetary stimulus in response to
the 2008 recession causing the economy to overheat fast. Beijing needs to slam on the
brakes and rebalance growth towards domestic consumption. But if the Chinese consumer is
to emerge the Party has to release control, allowing free capital movement and letting the
market determine interest and exchange rates.
Diana Choyleva
Monthly Review 262
China’s challenge: letting the ‘invisible hand’ boost consumption Diana Choyleva
16 November 2010
Introduction 1
The savings story 2
The international dimension 9
China’s export-led growth model 11
China’s investment constraint to kick in 13
China’s growth to become more inflationary 18
China’s labour constraint 21
Consumption can be a growth driver, but will not sustain 10% growth 23
Investment implications 26
Conclusion 27
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Monthly Review – November 2010 1
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
Chart 1 China's nominal GDP per capita growth at purchasing power parity, % pa
China has enjoyed fast
catch-up growth
But its huge size
means the potential for
further catch-up is
limited
China’s growth model
has relied on gaining
export market share
China’s challenge: letting the
‘invisible hand’ boost consumption
Introduction
Since 1978, China has gone down the export-led, catch-up growth path pioneered
by Japan and Korea, with similar 10% growth rates. The growth of GDP per capita
is huge. After adjusting to purchasing power parity it comes at 12% a year,
meaning the standard of living doubles every six years. The starting point was low,
however. China’s average standard of living is still only 14% of America’s, up 10
percentage points in seventeen years. By contrast, after its comparable near-10%
growth phase ending in the mid-1970s, Japan’s was over 70% of America’s. So in
principle China’s scope for catch-up growth at high rates remains huge.
One snag arises from China’s sheer size. This has produced a meteoric rise to
over 13% of world GDP (purchasing-power parity ‘PPP’ basis) – reflecting the
compound of nearly one-seventh of the US standard of living with over four times
its population. It is the world’s second largest economy. Growth has been export-
led and concentrated in manufacturing, which accounts for a modest share of
world output. China both dominates and has saturated global output and capacity
in many industries. Although in relative terms it has catch-up potential, in absolute
terms it is already over 60% of the US in PPP GDP, twice Japan’s 1970s ratio.
China’s growth model has so far relied on the relentless increase of its global
market share, industrialising at breakneck speed while the share of its domestic
consumption in output has declined. Its huge size means that to maintain the high
trend growth rates of the past the economy needs to move up the value added
chain fast. But China’s integration into the global economy has already shaken the
2 Monthly Review – November 2010
-10
-5
0
5
10
15
1957 1963 1969 1975 1981 1987 1993 1999 2005
1990-2009 1971-89 1957-70 GDP % Linear (GDP %)
Trend
Average 1957-1970
Average 1971-1990
Average 1991-2009
Chart 2 Japan's real GDP growth, % pa
But it is has run its
course, suggesting
China’s trend growth
could well halve in this
decade
This MR will examine
the challenges of
China’s transition
There are a lot of
similarities between
China and Japan
world. The clash between China’s huge semi-command saver economy and the
market economies of the West culminated in the global financial crisis. The result
is a low-growth hostile global environment that is set to persist for years. The rest
of the world will not tolerate China’s continued grabbing of market share when the
global trade pie is hardly growing, especially if it encroaches into high value added
manufacturing.
Re-balancing growth towards consumer spending is China’s most viable route, but
even if Beijing succeeds in engineering this, China’s potential growth rate in this
decade could well halve to 5% from the 10% growth rates of the past. The
authorities are unlikely to come to terms with such a slowdown easily. They are
likely to pursue achieving the growth rates of the past, implying that China’s
cyclical expansions are set to become much more inflationary than before.
This Monthly Review will analyse the challenges that China faces in its next
transition phase and its likely success. In doing so a natural parallel exists with
Japan’s experience, which is illuminating as much in its differences in comparison
to China’s as it is in its similarities. The Review will conclude by drawing out key
investment implications for the medium term.
The savings story
“China is different” is a mantra often repeated to justify the expectation of its
unabated fast future expansion. Indeed China’s economic model is unique, but
unravelling how its economy works will be much more instructive in trying to
anticipate the future than blind belief in a miraculous growth machine. After all the
same epithet was used for Japan, whose success in rebuilding its economy and
raising the living standard of its population is undeniable. Yet its growth machine
progressively lost its impetus after years of heady near-10% growth rates to go
through a turbulent couple of decades in the 70s and 80s which saw the
Monthly Review – November 2010 3
0%
10%
20%
30%
40%
50%
60%
1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
Chart 3 China's national savings rate, % of GDP
The crucial one is their
high savings rate
Domestic savings
provide the resources
for investment
In the first twenty five
years of its catch-up
growth Japan was in a
benign savings phase
economy’s growth rate halve. Japan’s growth machine eventually spluttered after
its massive property and equity market bubble burst in the late-1980s to remain
depressed in the next two decades with no sign of revival on the horizon.
China and Japan share one similarity which has been crucial in underpinning their
respective growth machines. Whether shared Confucian values are responsible
for it or not, but the moment incomes started to rise in both Japan in the 1950s
and China in the 1980s, savings also rose. Between the early 1950s and 1970
Japanese gross national savings rose to a peak of 40% of gross national incomes
(roughly equal to GDP). In China between the early 1980s and 2009 the
comparable savings rate climbed to a peak of 54%.
Savings are vital for an economy. They provide the financial resources needed for
investment in homes, factories, machines, roads, schools and hospitals. An
underdeveloped economy needs to increase its industrial capital stock to boost
productivity and output growth. Its often fast growing population also requires a
fast expansion in its infrastructure. People demand better roads, trains, airports,
hospitals, schools and homes. On the face of it, the more a developing economy
saves out of income the more investment it can afford. But savings can turn from
benign into malign if the desired amount of income to be saved exceeds the
amount needed for profitable business investment or the amount which the
government can usefully invest in social infrastructure.
Japan saw the benign savings phase last from the early 1950s to the mid-1960s.
After the 1965 recession, savings persistently exceeded the amount required to
finance investment. The current account was in a perpetual surplus, apart from
during the two oil shocks of the 1970s, though initially the surplus was small. The
economy was continuously characterised by structural excess savings until the
inability of policymakers to implement the necessary changes to lower the savings
rate that went beyond the palliative of cyclical reflation resulted in a gigantic asset
price bubble whose bursting was to hamper Japan’s development for decades.
4 Monthly Review – November 2010
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
Chart 4 China's current account, % of GDP
China’s benign savings
phase lasted until 1994
WTO-entry in 2001
marked China’s
decisive move into
excess savings
But there are crucial
differences which
explain China’s higher
savings, investment
and excess savings
rate
In the first stage of its development China saw a gradual increase in its savings
rate which reached a high of 42% of income in 1994. The savings rate then went
down until China’s entry into the World Trade Organisation in 2001, after which
point it shot up by 16 % points in eight years. China’s recession in 1994 marked a
turning point for the economy. The currency was devalued by 45% and pegged to
the dollar thereafter. Before that point China’s high savings were benign. The
national savings rate was high, but so was domestic investment, which often ran
ahead of domestic savings to produce balance of payments deficits.
Between 1994 and 2000 China’s savings rate declined, but the investment rate fell
at a faster clip to produce a sizable balance of payments surplus, compared with
past performance. People started to save less because they saw the real return
on their assets mostly held in bank deposits rise sharply after it fell deep into
negative territory during the high inflation period of 1993-1995. After the Asian
financial crisis, the pace of investment perked up in response to the authorities’
monetary stimulus, lowering the balance of payments surplus, although never
quite pushing it into deficit. But it was entry in the World Trade Organisation
(WTO) that marked China’s decisive move into excess savings, with the current
account surplus reaching 11% of GDP in 2007.
Both Japan and China’s industrialisation were helped enormously by the ability to
finance the expansion with domestic savings, thus avoiding the vicious circle of
balance of payments and public debt crises that plagued the Latin American
economies whose inadequate savings pushed them into heavy foreign borrowing.
But there are crucial differences between how Japan and China financed
investment which explain China’s much higher savings and investment rate. In the
first stage of Japan’s expansion until 1965, under the Dodge plan the government
had to balance the budget. In fact initially, far from being allowed to borrow, it had
to save as it needed to repay maturing bonds. The Japanese saved every extra
yen which was then devoted to financing corporate expansion. The direct
Monthly Review – November 2010 5
borrowing ban was circumvented to some extent in the Japanese shadow public
sector, with the postal savings system used to finance public expenditure. After
1965 the policy of balancing the budget was abandoned and running budget
deficits became fashionable. In fact it became a necessity as the easiest route to
battle the problem of excess private sector savings was to move to reduced
government savings by means of budget deficits. Instead of the surpluses
covering all the public sector investment, the government borrowed from the
public to cover part of the cost.
One of the key elements of China’s reforms was to open up its economy to foreign
direct investment in contrast to Japan which did not rely on direct external finance.
This sped up the build up of China’s modern capital base, providing not just the
necessary finance but also transferring much needed knowhow. The Chinese like
the Japanese were still saving every penny in the initial years, but domestic
savings were ploughed back into the state sector of the economy. Until China’s
private sector was able to stand on its two legs, FDI was vital in providing finance
to a nascent but rapidly growing part of the economy which was deprived of
access to the domestic banking system, which held the bulk of the domestic
savings but lent primarily to the government and state-owned firms.
Another key difference between China and Japan is that China’s government
borrowed explicitly to finance public investment and investment by state-owned
firms, resorting to substantial fiscal stimulus whenever growth faltered. Direct bank
lending to the government was the order of the day until it was banned in 1994
after rapid monetisation of the budget deficit led to another bout of high inflation.
But to this day up to two thirds of bank lending goes to state owned firms or firms
set up by local governments in order to avoid the direct bank borrowing ban. As
such this lending is a liability of the government, even if a hidden one. So in
contrast to Japan after 1965, China’s government not only borrowed explicitly but
also borrowed very little directly from the private sector. Public sector debt is
estimated at around 30% of output, a sizable chunk of it held by banks.
China has made huge strides to turn its economy from a command economy into
a market economy. But the job is far from finished. At the heart of how the
Chinese semi-command system operates lies its banking sector. Banks do the
bulk of the intermediation of domestic savings, but the sector is dominated by the
big four state-owned banks, who hold over half the deposits. Their lending is not
done according to market principles, in other words in search of higher return after
a proper credit risk assessment. Actually China has made a lot of progress
improving banks’ ability to assess credit risk and implementing proper lending
practices. The problem is that the authorities are all too ready to override these
practices to provide cheap credit when it suits their objectives.
During each boom banks build up bad debts. In 1999 state banks dumped
Rmb1.4trn of bad loans into special asset management companies and in 2005 it
was another Rmb1.2trn batch of bad loans. Given the lack of transparency it is
difficult to judge how big the current banks’ bad loan problem is. It is fair to say
that the massive explosion in Chinese credit during 2009 and the first half of 2010
in the context of deficient global demand is likely to have burdened state banks
with a substantial bad debt problem. Chinese banks may be insolvent, but the
government can always sweep the bad loans under the carpet. If it does not take
them on directly, it could move them to the asset management companies whose
China opened up to
foreign direct
investment
China’s government
uses the banking
system to finance its
expansionary
programmes
The banks are at the
heart of China’s
economic system
They are insolvent, but
as long as they are
liquid the show can go
on
6 Monthly Review – November 2010
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2001 2002 2003 2004 2005 2006 2007 2008 2009 H1 2010
Chart 5 China's monetary and credit expansion as a % of GDP
M2 Domestic loans
funding it rolled over for another ten years last year. The main point is that as long
as banks are liquid the show can go on.
Losses on bad bank loans did not exist in the fully command economy. State
companies were not run to make profits. Servicing and replaying old loans could
be done indefinitely by extending new ones. Since the majority of household
savings flowed into bank deposits, the banks had to find ways of wasting them –
generally in value-subtracting production. The transition towards a market
economy created the recognition of bad loans without eliminating the state
sector’s need for them.
Beijing’s strategy so far has been not to realise the losses on the bad loans that
have been accumulated while the economy industrialised fast. The expectation
has been that over time strong growth will shrink the bad debts away. The
problem is that bad debts continue to mount every time growth slows, while there
is understandably little political resolve to release state control of the banking
system and allow it to function according to market principles. This would impose
an intolerable squeeze on the state sector, which is shrinking by not growing in a
high growth economy, but as yet has not withered away. The longer the economy
operates in this manner, the higher is policymakers’ incentive to keep interest
rates down. Without such life support some zombie firms will seize to exist. But
importantly all investment decisions are taken on the basis of state mandated
cheap finance, inflating both total savings and total (wasteful) investment..
The grossly inefficient intermediation of savings is a crucial reason behind China’s
abnormally high savings and investment rate when compared with Japan’s and
Korea’s catch-up growth periods. Private firms have been starved of bank capital,
so they hoard cash to use for expansion or to hedge against future uncertainties
rather than distribute it. While there is no culture of distributing dividends in the
private sector, in the state sector it was government policy that firms are not
China’s transition
created the recognition
of bad loans but didn’t
remove the need for
them
Beijing hopes bad
loans will shrink away
with growth, but they
keep accumulating
The inefficient
intermediation of
savings is a key reason
behind the savings
excess
Monthly Review – November 2010 7
-5%
0%
5%
10%
15%
20%
25%
1992 1994 1996 1998 2000 2002 2004 2006 2008
Household sector Business sector Government
Chart 6 China's savings rate by sector, % of GDP
required to pay dividends. Artificially low interest rates mean corporate savings are
artificially boosted. But also investment in the non-financial corporate sector in
China has run well ahead of corporate savings for years, which is in contrast to
Japan’s experience.
Banks lend very little to households. They were allowed to lend for home
purchases in 1997. Mortgage borrowing surged from zero to 10% of GDP in 2004.
But little expertise to assess credit risk and the difficulty to enforce foreclosures on
delinquent loans meant that the bulk of these mortgage loans quickly turned sour
and banks halted their expansion. Mortgage borrowing languished for five years
afterwards despite expectations of China moving towards consumer-driven
growth. The underdeveloped financial system means the young cannot borrow
from the old, so they have to save a lot. Moreover, as China’s economy was
booming and incomes growing, instead of consuming more, households were
actually saving an increasing proportion of the higher income they were earning.
This seems counterintuitive, but it makes sense in the context of the
underdeveloped banking sector. As people’s incomes rose, they started to covet
the big ticket items such as cars and houses. They could not borrow to buy them,
so they had to save more.
Looking at the historical development of gross national savings by sector reveals
two important features. The government sector is the smallest saver in China, but
it has been a major contributor to the rise in national saving in the last decade. Its
savings rate was over 10% in 2008, up from 3% in 2000. The business sector
savings rate rose during the 1990s to reach 20% of GDP in 2001, but it has since
then been fairly stable. The household savings rate was stable for most of the
1990s, then fell after the Asian financial crisis, but resumed its mild upward march
after 2001 to reach 23% of GDP in 2008 as consumers’ propensity to save rose.
The first interesting observation is that the household savings rate as a share of
household disposable income as opposed to output rose much faster since 2000
The underdeveloped
financial system
encourages household
savings
Government saving has
been a major
contributor to the rise
in savings
8 Monthly Review – November 2010
0%
5%
10%
15%
20%
25%
30%
35%
1993 1995 1997 1999 2001 2003 2005 2007 2009
Chart 7 China's household savings rate
% of GDP % of Household disposable income
as household disposable income fell as a share of GDP. The fall in household
investment income played a role. With two thirds of household financial assets in
interest bearing deposits ring-fenced by the closed capital account, keeping
interest rates low continues to favour the corporate sector over the household
sector in the domestic distribution of income. But the main reason was the
declining share of labour income in the economy.
In the first part of the noughties the economy was still going through massive
corporate restructuring with the size of the state sector shrinking. This led to large
scale labour retrenchment, while the influx of rural migrants continued. By the
middle of the decade the pace of state sector shrinkage abated, but by then
China’s corporate sector actually ran into its cyclical buffers, experiencing
significant energy and transport shortages which pared back its investment binge.
It was the turn of the private sector to get its act together and restructure
aggressively, improving profits and profitability. There was a sustained drive to
improve the performance of the big state-owned companies that were intended to
stay in government hands as well.
But better corporate performance did not translate into improved household
incomes. Excess labour supply amid the massive corporate restructuring and
continued rural-urban migration not only led to the declining share of labour
income, but also contributed to households’ higher propensity to save. Working in
the state sector in China used to resemble Japan’s life-time employment system.
China’s state employees not only enjoyed life-long job security, but also benefited
from generous pension provisions. The progressive loss of that job security and
less generous pension provisions for a large part of the workforce during 1997-
2005, together with the rapidly diminishing role of the family as a result of the one-
child policy, the lack of proper medical care and urbanization, were major factors
behind pushing up the household propensity to save. While Japan did see
massive urbanization, it did not have the one-child policy, had better medical
Corporate restructuring
has fuelled the rise in
household savings as
well
Urbanisation, lack of
proper medical and
pension provision, the
one-child policy are
also important reasons
Monthly Review – November 2010 9
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Chart 8 Japan's current account, % of GDP
provision and the role of the life-time employment system did not start to diminish
until after the economy lost most of its growth momentum.
The second interesting observation relates to the role of the government as the
major contributor to the rise in savings during China’s decade of excess savings.
The marked increase in government saving largely reflects higher government
income. True, high economic growth, corporate restructuring and the 1994 tax
reforms played a role in boosting government income. But the key force at play is
the fact that the government borrows very little from the Chinese people or
abroad, instead using the state-banking system to finance its large investment in
social infrastructure. This fuels strong growth and strong government revenues,
while the government has to pay little interest to finance its gigantic infrastructure
investment plans.
The international dimension
Both China’s investment and savings rate have hit higher peaks than Japan’s, but
importantly the excess of its domestic savings over domestic investment has also
reached much bigger proportions than Japan’s ever did. The impact of China
exporting its excess savings and excess production while devouring raw materials
has already been much more profound. China’s current account surplus spiked to
11% of GDP in 2007, compared with Japan’s 2.5% of GDP in 1971 and 4.2% of
GDP in 1986. But China’s impact on the US under the yuan-dollar peg and the
rest of the world for that matter was bigger than Japan’s impact during the Bretton
Woods system of fixed exchange rates. China’s current account surplus was 2.6%
of US output in 2007 compared with Japan’s current account surplus of 0.7% of
US output in 1971.
Moreover, China’s desire to save excessively coincided with the same dynamic in
Japan, Germany and North-central Europe to produce the Eurasian savings glut.
Government use of the
banks as an ATM is
reflected in their high
saving
China’s excess savings
exceeded Japan’s…
…and coincided with
Japan’s and Germany’s
10 Monthly Review – November 2010
Excess savings are by definition demand deflationary. When the desire to save
out of income exceeds the economy’s need for productive investment, income has
to fall in order to equate savings and investment. Luckily for the saver economies,
there were willing borrowers and spenders in the rest of the world – America being
the chief source of global private demand. If it was not for the borrower economies
being willing to rack up debt the global economy would have been depressed
much earlier.
China’s supersonic expansion turned it into the manufacturing hub of the world,
especially for low-value added manufacturing goods. But final demand for
manufacturing goods came from the developed borrower countries. China
provided the world with an endless supply of low-cost labour and mispriced, cheap
capital. Developed countries provided most of the supply of real and financial
assets. The interaction between supply and demand for goods, services, factors of
production and assets was polarised on a global scale.
The initial impact of China’s excess savings came through China’s excess
investment. The world was flooded with made-in-China manufacturing goods,
whose prices kept falling fast. Overinvestment in China led to manufacturing
goods price deflation, but the economy eventually hit its cyclical buffers in 2004
when widespread energy and transport shortages put a physical stop to China’s
headstrong expansion. Chinese industrial production was not only much more
energy inefficient, gobbling up natural resources, pushing up their price on
international markets, but also Beijing administered the price of energy, which
together with the yuan-dollar peg, did not allow China’s overheating to translate
into higher global manufacturing goods price inflation.
Central banks in the borrower economies felt vindicated in their policy choices by
focusing narrowly on keeping consumer price inflation contained, failing to grasp
the profound global changes at play. They paid little attention to money and credit
developments and ignored asset price inflation, partly the result of China’s
voracious appetite for assets. Once China’s manufacturing investment boom was
restrained in 2004-05, the economy had to find another outlet for its excessive
savings. This time it was lending to Americans as China’s current account surplus
exploded. China poured its excess savings into risk-free US dollar assets, stoking
America’s consumer boom which itself fuelled China’s export-led growth machine.
But the Goldilocks relationship was broken once the private sector in the US
exhausted its ability to build up debt and the excesses in its housing and financial
sectors became visible, triggering the seize-up of global liquidity and the near-
collapse of the global financial system.
Three-years on from the start of the working out of the global financial imbalances,
the global status quo is little changed in terms of the fundamental drivers. The
borrower economies are still borrowing excessively, but this time it is public sector
borrowing. Overall growth, however, is depressed as there is huge deleveraging in
the private sector. The saver economies continue to save excessively and rely on
exports or investment to pull their economies through. The dollar-euro rate has
seen large swings as the relative prospects of the two regions get assessed. But
there has been little change in the yuan-dollar peg or China’s closed capital
account, which has been the linchpin of the global financial imbalances.
The problems of our globalised world needed a global solution. But this appears
beyond the powers of policymakers on either side of the saver-borrower divide,
The interaction
between supply and
demand has been on a
global scale
China’s excess savings
first impacted the world
via its excess domestic
investment
Policymakers in the
rest of the world failed
to see the profound
global changes at play
Despite the global
financial crisis, the
global financial
imbalances remain
Monthly Review – November 2010 11
-12.0%
-9.0%
-6.0%
-3.0%
0.0%
3.0%
6.0%
9.0%
12.0%
-4,000
-3,000
-2,000
-1,000
0
1,000
2,000
3,000
4,000
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Chart 9 Global balances, advanced countries plus China and Tigers
Advanced country private financial surpluses plus China/Tigers current account surpluses
Advanced country government deficitsHard line = % of GDP, rhsDotted line = $ billion, lhs
suggesting that it will be each country fending for itself. Everyone was happy to
party together, but each economy is recovering from the hangover alone. Much
like Japan in the 1960s, China since 1994, but even more so since 2001 was
operating in a benign world trade environment. Its miraculous growth years have
been the result of unusually favourable domestic and international circumstances.
The achievements of those years should not be belittled, but they were the
product of a unique set of circumstances which are no longer there. The global
financial crisis has condemned the US and Europe to a prolonged period of sub-
par growth. Neither region will be tolerant of China’s current expansionary mode of
grabbing market share.
China’s export-led growth model
China’s high savings rate provided the necessary finance for the economy to
industrialise fast. But the flipside is the low share of consumer spending in output.
In fact, the share of consumer spending in output has declined consistently since
the start of the last decade to reach just 35% of GDP in 2009. The growth in
consumption has been fairly rapid, but it has lagged far behind the growth in
national income. China’s high and rising savings rate negates the possibility of a
mass consumer market. In the same way that foreign direct investment was
crucial in kick-starting the development of China’s private sector, the trade
integration of its economy into the rest of the world, fortified with the entry in WTO,
was crucial in providing the foreign markets for China’s surplus products.
The share of exports in output in China reached a peak of 35% in 2007. But this is
not the relevant measure to look at in order to determine the importance of exports
to growth. The share of exports tells you about the composition of output but not
about the cause of growth. To determine the cause of growth one has to look at
the change in the shares of output of the various components. In other words, the
changes in the marginal propensities to save, invest, import, tax, etc.
Consumer spending
has never been a
growth driver
Exports have provided
the main source of
genuine demand
12 Monthly Review – November 2010
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Marginal propensity to save Marginal propensity to consume Marginal propensity to invest
Chart 10 China's growth drivers
Between 2000 and 2003 China saw its marginal propensity to consume fall
sharply, while its propensity to save shot up. The marginal propensity to export fell
between 2000 and 2001 in response to the bursting of the US high-tech bubble.
But in the 2001-2003 period China’s propensity to export surged. It was this
external source of final demand that kick-started China’s investment boom.
Admittedly, the easing of monetary conditions and a large fiscal stimulus were
also behind the surge in investment, in particular as an offset to the global
weakness in 2001. Indeed, China’s marginal propensity to invest increased rapidly
in 2000-2003. The marginal propensity to import shot up alongside the propensity
to export, given the high import content of China’s exports.
The story changed in 2004. Net exports started to contribute a much larger and
increasing share to output growth. The marginal propensity to export started to
decrease, but the main impetus has come from a sharp fall in the marginal
propensity to import. Part of the explanation lies in rising import substitution as the
domestic economy has moved up the value added chain. But importantly,
investment growth had slowed sharply as the economy ran into severe energy
shortages. China’s import content is heavily skewed towards imports of raw
materials and capital equipment, which are three quarters of total imports.
Between 2003 and 2005 the propensity to invest halved.
External demand stayed strong, supporting robust export growth, although the
share of exports actually fell. But buoyant export income growth fuelled a
consumer spending boom with the share of consumption rising gently. By 2006
China had unblocked its energy bottlenecks because, while manufacturing
investment collapsed, investment in energy infrastructure was boosted. Between
2006 and 2008 the marginal propensity to consume and save stayed relatively flat,
but the marginal propensity to invest started to rise, almost doubling. Then in 2008
came the collapse of world trade, followed by China’s massive monetary stimulus
in 2009, which resulted in the marginal propensity to invest spiking up to reach an
all-time staggering high of 0.9.
Export booms are
followed by investment
booms
The economy hit its
cyclical barriers in 2004
But by 2006 investment
had picked up again
Monthly Review – November 2010 13
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Marginal propensity to import Marginal propensity to export
Chart 11 China's growth drivers
True to previous form, once external demand faltered Beijing went for a state-
sector driven expansion, ordering the banks to lend and boosting public
investment. In fact Beijing panicked in the face of the global financial crisis which
plunged China in recession at the end of 2008 and engineered the most
spectacular monetary stimulus in China’s history and when compared with the rest
of the world after WWII.
So far China has enjoyed exceptionally rapid growth, but this growth has been far
from stable. Booms and busts have been the order of the day in China. Waves of
consumer spending reinforced the boom, but they did not cause it. Exports have
provided China with the main genuine private demand impetus. Investment
spending has been an important growth driver as the economy industrialised fast,
ramped up every time the economy was battling against external headwinds.
China’s investment rate has reached exorbitant levels, but so far it has been
sustained because the economy was operating in a supportive international and
domestic banking environment. This is no longer the case.
China’s investment constraint to kick in
There are limits to investment. Fundamentally, we produce more in order to
consume more and we invest more in order to produce more. Producing more for
the sake of investing more when there is no increase in the propensity to consume
or the propensity to export is a dead end. Producers need markets for the
additional output which investment makes possible. But the more people save, the
smaller those markets, making such investment unprofitable. The limits to
spending on social infrastructure are different to those that constrain business
investment. Much of the spending for it is paid out of taxation or government
borrowing. But people object to paying high taxes, particularly where the tax
system is inefficient or unfair. Borrowing builds up public debts on which interest
has to be paid. These debts grow exponentially, if interest rate charges get so
high that the government has to borrow to pay them.
Beijing responded to
2008 with a massive
stimulus
China’s growth is far
from stable
The natural limits to
investment are
profitability and the
government’s ability to
finance investment in
social infrastructure
14 Monthly Review – November 2010
20%
25%
30%
35%
40%
45%
50%
1979 1985 1991 1997 2003 2009
Chart 12 China's investment rate, % of GDP
However, the usual limits do not apply to China. The share of total investment in
output rose to 47.5% in 2009 from 35.3% in 2000. This is clearly unprofitable. If
China’s trend growth rate is assumed to be 10% and the profit share in income to
be around the 40% norm, then gross return on capital comes up to 8.4%, which
after depreciation leaves nothing for net return on capital. China does not produce
timely GDP by income and sector data, but it provides balance sheet data for the
industrial sector. According to our estimates, the net return on total assets is
paltry, falling to 1.2% in 2009 from its peak of 4.2% in 2007.
In China’s industrial sector, whether private or state-owned, profitability is not the
driving force. In a capitalist economy companies exist for the benefit of their
owners, the shareholders. In China shareholders, whether foreign or domestic,
matter very little. In the private sector, entrepreneurial managers are focused
entirely on the short term. Where there is a shortage of some kind or an
opportunity to explore, factories are built fast, usually creating a glut of them.
Chinese firms seem to exploit arbitrage opportunities with no regard for strategic
planning. Hence, China, unlike Japan and Korea, has never created international
champions in any industry. On the contrary, domestic export firms seem to
relinquish a high share of the profits to be made to foreign firms with established
brands and distribution networks. This is also the reason why entrepreneurs once
exhausting the shot-term opportunities in one sector would move fast to another,
sometimes totally unrelated, sector.
The big state-owned firms in the protected sectors, such as oil, petrochemicals,
shipbuilding, aerospace, telecoms and so on, may appear to be profitable but
these companies often enjoy a raft of subsidies or a state-protected monopoly
position. The most important factor benefiting them is that the authorities by
rationing credit, while keeping borrowing costs low, ensure that the bust phases of
China’s cycle do not undermine the financial sustainability of past expansions,
inhibit firms from future expansion, or indeed sieve the profitable firms from the
The usual limits have
not applied to China
Profitability is not a key
driver in most of
China’s industry
Rationing credit but
keeping borrowing
costs low has not
undermined the
sustainability of past
expansions
Monthly Review – November 2010 15
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Chart 13 China's net return on assets in industry, %
unproductive behemoths. The big state-owned firms also tend to branch out into
industries that have little to do with their core business. In the property boom of
2009, many got a real estate arm.
Profits in a capitalist system are the buffer that keeps hostile takeovers at bay,
leaving firms keen on passing cost-increases onto the consumer even if that
means loss of market share. In China companies have large fixed costs
accumulated during years of overinvestment which mean that low profits on large
sales or even keeping production going when firms are loss-making are more
important than high profits on low sales. Meanwhile, the seemingly limitless supply
of labour has kept variable costs down. Wage growth not only did not match
productivity growth, but it is likely to have undershot it. This is also why there has
been little relative price inflation in China, which is the means by which the
benefits from rising productivity in manufacturing are shared with workers in other
industries and services.
Operating in this environment for years, China’s industrial sector has optimized its
finances and operations to depend crucially on maintaining and increasing its
global market share. The fear of losing market share and the fear of the unknown
explain the authorities’ reluctance to liberalise the determination of China’s
exchange and interest rates or allow faster yuan appreciation and higher interest
rates. It is striking that even after engineering the most spectacular domestic-
demand driven growth revival in the face of a severe global downturn, China only
managed to halve its current account surplus in 2009.
But the hostile international environment of poor growth, together with the
environmental and social constraints created by growth at-all-cost, have now
started to usher in a fundamental change in China’s growth model. If Beijing does
not budge on the currency front, it is entirely possible that the US will impose a
surcharge on China’s imports. The situation today resembles very much that of
Japan in the early 1970s when President Nixon applied a 10% import surcharge to
Profits are less
important to firms in
China than in a market
economy
Operating in this
environment has made
China dependent on
gaining global market
share
But the hostile global
environment of today
questions the
sustainability of the
model
16 Monthly Review – November 2010
be followed by the yen rising as the Japanese failed to peg in their panic. The
early 1970s marked the end of Japan’s years of miraculous expansion, resulting in
output growth halving to 5% a year on average in the 1970s and 1980s.
A much higher yuan (or an import surcharge) will represent a major blow to
China’s exports at a time when global demand is set to relapse. If the Chinese
resist the adjustment through the nominal exchange rate, America’s attempt to
reflate its economy with “quantitative easing” will result in a de facto devaluation of
the US dollar vis-à-vis the yuan and the adjustment will come through higher
Chinese inflation and the need to hammer domestic demand. The export and
demand shock that started in 2008 is likely to represent a defining moment for
China with its economy entering a turbulent period where trend growth could also
halve to 5% on average over this decade from the 10% trend growth achieved in
the noughties. Much like Japan in the 1970s, it is the decrease in capital
investment as a share of output that is likely to lead to slower growth.
For an economy there is an optimal capital stock. The best data on an economy’s
capital stock is to be found in the US where we have nine decades of figures. On
average throughout this period the capital stock was worth three years’ GDP,
ranging from as low as 2.3 to as high as 4.25. But 4.25 was the multiple during the
Depression in 1933. If the Depression years are excluded the peak was 3.4 times.
But let us err on the high side and assume China’s capital stock should be three
years’ of output. Depreciation in the US averaged 4% a year, but in China
industrial data suggests it is as high 7% a year. But given the already paltry return
on capital suggesting overinvestment, not all of the worn out capital needs to be
replaced. Let us assume the middle ground, a 5½% depreciation rate, so in total
16.5% of GDP a year has to be devoted to repairing wear and tear.
About 40% of the capital stock is industrial buildings, plant and equipment.
Employment growth in China has averaged 1% a year in the past twenty years.
But urban employment growth has been higher at 3.2% a year given the continued
migration of rural workers into industry. Employment growth of 3% a year requires
further investment of 3.6% a year to equip additional workers with plant and
equipment. Existing workers can also be supplied with more and better
equipment, so let us assume the capital to labour ratio rises by 4% a year, which
will require a further 4.8% of output to be devoted to investment. About 30% of the
capital stock is residential buildings. Household creation has grown by an average
of 2% a year over the past twenty years, suggesting an additional 1.8% of output
is needed to supply the new households with homes. Hence, the total of business
and residential investment needed is 26.7% of GDP. Let us then assume that a
generous 8.3% of GDP is devoted to public investment in social capital.
In all, the most China needs to devote to investment is 35% of GDP. If China’s
investment rate needs to fall by twelve and a half percentage points over ten
years, the hit to its actual and trend growth rate will be substantial. Let’s assume
that output growth stays at 10% a year and that in 2020, the investment rate is
35%. This means that investment has to grow by about 6.5% a year, compared
with the average rate of 17.4% over the past ten years. The second-round impact
on income and consumption will be substantial. It is this type of arithmetic that
underlies the violence of the structural adjustment that lies ahead of China.
China’s trend growth
rate could well halve to
5% a year in this
decade
Each economy has an
optimal capital stock
It is estimated counting
the need for capital
replacement,
employment growth,
rising capital to labour,
household creation and
the need for social
capital
China needs an
investment rate of at
most 35% of GDP
Monthly Review – November 2010 17
0%
10%
20%
30%
40%
50%
60%
1979 1985 1991 1997 2003 2009
Chart 14 China's nominal gross capital formation annual growth, %
The optimal capital stock is proportional to the expected output level. The capital
to output ratio tends to be stable over the long-run. The change in investment is a
function of the change in the growth of demand. Hence, investment is based on
expectations of the future. In the private sector of China’s economy the export
shock is likely to change long-term demand expectations. The desire and need for
investment will be reassessed even if financing conditions are kept benign.
In the state-owned industrial sector and when it comes to investment in social
infrastructure, expectations will hardly play a role as the authorities, used to the
strong growth rates of the past, will aim to maintain the pace of expansion. The
cost and availability of financing for the investment expansion given the
destruction of the return on capital will become the primary constraint. Hence, the
crux of the issue is the banking sector and China’s closed capital account.
As explained above, the main point about the banking sector is that as long as it is
liquid, even if it is insolvent, the show can go on. Overall, total debt is not
particularly high in China. LSR estimates place it at 215% of GDP compared with
344% in the US. Bank credit is around 150% of GDP. If the most drastic
assumption is made that all bank loans turn bad and the government takes them
on as a one-off increase in public sector debt, this could still be manageable as
long as new bad debts are not accumulated. Official numbers show public sector
debt in China at around 30% of GDP. Hence, China’s gross public debt will jump
to 180% of GDP. Foreign exchange reserves currently stand at 50% of GDP, so
China is left with a net public debt ratio of about 130% of GDP. This is
manageable assuming the economy maintains its trend growth rate of 10% a year.
If the government keeps the level of public debt stable going forward, within five
years public debt will be brought down to 80% of GDP.
But a sustained 10% trend growth rate and a drastic decrease in the future
accumulation of bad debts as the banking system begins to operate according to
The export shock is
likely to change private
firms’ demand
expectations and
investment plans
In the state sector the
cost of finance will
become the primary
constraint
Overall China is not
over-indebted but it is
becoming increasingly
more difficult to use
banks as ATMs
Lower growth starts to
limit that role
18 Monthly Review – November 2010
0%
20%
40%
60%
80%
100%
120%
140%
160%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Domestic credit Foreign reserves
Chart 15 China's domestic credit and foreign reserves as % of GDP
market principles are big assumptions. Even so, with China’s overall indebtedness
not excessive as yet, policymakers do have some scope left to continue to use
their domestic banking system indiscriminately to bankroll future investment plans.
But to be able to do that China will need to continue to keep domestic savings at
home, with capital outflows still under direct state control. Beijing’s recent
measures to broaden renminbi use could be an important first step towards
eventual convertibility, but for now the authorities do not seem prepared to open
up the capital account fully. They do, however, realise the need to broaden out
their sources of finance for future expansion. Issuance of public sector debt is set
to become a much more important source of finance going forward as the role of
the banking sector as provider of limitless cheap finance is set to change whether
the authorities like it or not.
China’s growth to become more inflationary
China’s growth story has become more inflationary. Here the analogy with Japan
of the early 1970s is also pertinent. My colleague Brian Reading wrote two
decades ago, referring to Japan in the early 1970s, “Like the cartoon character
who walks over the edge of a cliff, but does not fall until he looks down, the
Japanese growth machine continued to function in the minds of people long after it
had no visible means of support.” The same is likely to characterise Chinese
policymakers over the next few years. The authorities are talking about the need
for growth to slow down, but they are little prepared to accept the social and
political consequences of the change that lies ahead. The greatest problem
policymakers in China will have to contend with is coming to terms with slower
growth. They are likely to attempt stimulating the economy in order to achieve the
growth rates of the past, but easy monetary and fiscal policy will do more to
accelerate inflation than to boost growth. The likely fall in the propensity to invest
means that each time loans become plentiful and cheap, there will be a rush to
borrow in order to speculate on the property or the stock market.
China’s growth story
has become more
inflationary
Monthly Review – November 2010 19
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Oct-98 Oct-01 Oct-04 Oct-07 Oct-10
12-month growth rate 3-month annualised growth rate
Chart 16 China's broad money growth, %
This is already happening. China engineered the most spectacular monetary
expansion after the economy plunged in recession at the end of 2008. It did
achieve an impressive growth rebound, but the economy overheated within a
short period of time, with inflation accelerating on all fronts. Not only did consumer
price and wage inflation pick up speed, but there was a property boom as well.
Inflation could be as damaging for China as slow growth. The threats it brings are
twofold: it increases social inequality and it undermines the banking system.
The seize-up of liquidity in interbank markets exposed the precarious overreliance
of Anglo-Saxon banking systems on non-deposit funding. China’s banking system
could boast of no such short-coming given the tiny fraction interbank funding
represents. Ironically, it is banks’ overreliance on domestic deposits that could turn
to be its system’s undoing. Playing with inflation in China is playing with fire as it
could undermine banks’ deposit funding if people’s inflation expectations become
unanchored, especially in the context of dealing with a large bad debt problem as
well. People may decide that keeping the money “under the mattress” is safer than
in the bank or they may channel them into the parallel black loan market or use
illegal channels to invest their savings abroad in search of higher real returns.
Beijing has rushed in exactly the wrong direction when trying to deal with the
current overheating of the economy. It has resorted primarily to administrative
measure in order to curb runaway growth. Hammering domestic demand has
resulted in China’s trade surplus rising, bringing the wrath of the US and the EU
upon Beijing. It seems like the early 1970s all over again, but substitute China for
Japan and President Obama for President Nixon. By the late 1960s inflation in
Japan had accelerated. But Tokyo refused to revalue the yen in 1969, instead
opting for curbing the overheating by hammering domestic demand. Japan’s
domestic demand deflation resulted in a widening current account surplus, which
brought the wrath of the US down on Japan. The Americans pursued an
inflationary policy and were not prepared to have slow growth or fiscal austerity to
The 2009 monetary
expansion led to rapid
overheating
Inflation is dangerous
as it can undermine the
banks…
…and bring on the rest
of the world’s wrath if
the response to it is to
hammer domestic
demand
20 Monthly Review – November 2010
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
1978 1982 1986 1990 1994 1998 2002 2006 2010
Chart 17 China's output gap - actual minus potential GDP as % of potential, LSR estimates
protect the value of the dollar. In 1971 the US economy was weak, just as
President Nixon faced re-election in November 1972. In August 1971 he
announced that foreign central banks could no longer sell dollars for gold at a
fixed rate and also imposed the 10% import surcharge.
The success of Beijing’s gigantic 2009 stimulus in boosting growth made the
authorities feel vindicated in their belief that China’s government controlled model
works better than the free market. Their panic in late 2008 also left a palpable
sense of caution with respect to global growth prospects, which was reinforced by
the European debt fiasco. Add to the mix policy stalemate in the run up to the
Communist Party leadership change in 2012 and it becomes clear why Beijing has
been reluctant to use the exchange rate or the interest rate as a policy tool. If the
authorities do not overcome their mercantilist attitudes and their fear of the
unknown and revalue the yuan substantially, the US may well impose a damaging
surcharge on China’s imports.
Meanwhile, the combination of higher inflation and low interest rates has hurt
households, the bulk of whose non-financial assets are earning negative real
returns sitting in bank accounts. With mortgages only at most 20% of household
disposable income and household interest-bearing deposits one and a half times
disposable income, raising deposit rates would have been beneficial in boosting
household incomes, rebalancing growth towards consumer spending, while
restraining the froth in the housing market. But the authorities worried that raising
both deposit and credit rates or squeezing bank margins if just the deposit rate
was raised would expose all the excesses of the reckless bank lending over the
years. However, as China’s growth becomes more inflationary the authorities will
not be able to keep interest rates low and continue the indiscriminate transfer of
wealth from savers to borrowers. They may not be as bold as liberalising fully the
determination of interest rates, but they will have to raise the savers’ return on
capital and hence the cost of investment finance.
Which has now
happened
Higher inflation hurts
household incomes
and wealth
Monthly Review – November 2010 21
-20
-15
-10
-5
0
5
10
Oct-92 Oct-95 Oct-98 Oct-01 Oct-04 Oct-07 Oct-10
Chart 18 China's real one-year deposit rate, %
The other aspect of the inflation threat is the potential for social unrest. The
Chinese people are addicted to strong growth as much as the authorities are.
Perversely, China’s social harmony is based less on the equality of income and
wealth than Japan’s was. But such strains have already appeared. The following
paragraph is from an article in the People Daily paper from 14th Oct, 2010, “Now, a
spilling-over of credit liquidity has caused prices surging to uncontrollable grounds
across the board, foods and public utilities, especially, eroding the buying ability of
the yuan and threatening the quality of life of the vast poor people who either live
on petty wages and pensions, or the migrant rural workers who often make less
than US$300 per month and have to support elderly parents at home.” The
property boom has made housing unaffordable for vast swathes of the urban
population, widening the wealth divide further.
China’s labour constraint
The human factor is also set to become a key obstacle to China continuing on the
10% trend growth path of the past. China has unusual demographics for an
emerging economy, largely the result of the one-child policy. The United Nations
projects that China’s labour force will grow by 2.6% in the five years to 2015, but
then fall by 0.2% in the next five years to 2020. Over the following thirty years, it
will continue to contract and in 2050 it will be 13% smaller than in 2020. Labour
force growth is one of the determinants of an economy’s long-run potential growth
rate, together with the rate of capital accumulation and productivity growth. Even
though in a low income, low productivity economy, the scope for higher
productivity growth can be the overriding force, China’s dire demographic
projections are going to have far-reaching implications for the very long term.
But over the horizon that this Review is looking at – the next five to ten years –
worsening labour force developments are going to represent a less important
constraint to trend growth. On the face of it, China still has an unlimited supply of
And has caused
increased social
tension
China’s demographics
are dire
On the face of it, China
still has limitless labour
supply
22 Monthly Review – November 2010
-5%
0%
5%
10%
15%
20%
1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Chart 19 China's labour force growth projections, 5-year % change
cheap labour, with half of its population still living in rural areas. Urbanisation has
been one of the main sources of fast productivity growth in the economy as
workers were moved from low value added agriculture to higher value added
manufacturing. But the strains on China’s infrastructure and social conditions have
been enormous. The investment binge has helped alleviate the infrastructure
strains with the high speed rail system being a crucial improvement, while the
property boom seems to actually have run ahead of occupier demand with a vast
number of properties currently unoccupied.
The unreformed hukou system of registration that deprives rural migrants of the
rights and benefits that urban dwellers enjoy, however, continues to lead to
substantial social stress. The living conditions of migrant workers remain
depressing, recently brought to the forefront by the series of suicides at the
Foxcon’s factories. The social stress that fast urbanization has entailed could start
to rock the boat. But the process of urbanization is set to continue. The hukou
system should be changed, but so far the authorities have fallen short of
expectations that such reform is on the agenda. Instead there is a clearly
discernable policy drive to move the low value added manufacturing industry
inland in an attempt by the authorities and companies, not just to lower costs, but
to alleviate the stress of dislocating low-skilled, low-paid migrant workers.
But the most important labour constraint over the next five to ten years is likely to
come from the fact that China has reached the stage where the quality of the
labour force has begun to matter more than the quantity. As discussed in the
introduction, China’s sheer size means that the economy has already become the
global manufacturing base for low value-added manufacturing. In 2008 China
accounted for 43% of the global real value added in textiles, 39% of wearing
apparel, 43% of leather and footwear, 28% of electrical machinery and apparatus.
China has the capacity to supply nearly 80% of world demand for air conditioners
and mobile phones. In order for China to continue on the road of catch-up growth,
But fast urbanisation
has created palpable
social tension
But the most important
labour constraint will
be the quality, not the
quantity of the labour
force
Monthly Review – November 2010 23
it has to move up the value added chain in manufacturing fast. But to do so it will
require skilled labour not low-skilled rural migrants. Educating and training the
labour supply is not something that can be achieved overnight.
Consumption can be a growth driver, but will not sustain 10% growth
For China to move to a sustainable growth path, the economy has to rise up the
value-added chain fast and to boost domestic consumption. Here China’s size is
actually an advantage. If the economy manages to ignite its consumption it is big
enough to provide the markets needed for its own production. The rise of the
Chinese consumer will be welcomed by the rest of the world, while a pure
advance up the value-added chain by gobbling up export market share will be
resisted. But while consumer-driven growth is now enshrined as one of China’s
leaders’ top priorities in their five year plan for 2011-2015, it is a daunting task.
The analysis of this crucial issue can be split into what should be done, what is
going to be done and what will happen. Given the nature of China’s excess
savings the crucial change that needs to happen is to redistribute income from the
corporate sector to the household sector, for household wealth to be boosted and
for the government to pool its domestic savings for its investment plans rather
than crudely put just “print the money”. Trying to disentangle the fundamental
reason behind China’s high household savings rate is hard. Clearly increased
uncertainty in the past ten years has played a role, but high levels of uncertainty
have been a feature of China’s development for years. Improving the provision of
social security and pension cover should with the passage of time act towards
lowering the household savings rate, but such reform will take years to implement
and to get entrenched in peoples’ beliefs. And yet the household savings rate
could stay persistently high as the pressures of the one child policy and
urbanization are here to stay.
The fastest way to lower the national savings rate is to lower the business sector
savings by redistributing income from companies to employees. The most efficient
way of achieving this would be to open up the capital account and to allow both
interest rates and exchange rates to be set according to market principles. China’s
current real exchange rate is clearly too low, and is fixed rather than floating,
depriving the US of needed policy flexibility. Nominal appreciation is a less
disruptive way of going through this adjustment than domestic inflation. Nominal
appreciation would bring about the necessary rise up the value-added chain and
with it the necessary increase in consumer incomes as China ceases to have a
limitless pool of cheap labour as higher skills would be required, thus boosting the
share of wages in income. If in the process China loses some of its lower-value
added manufacturing jobs to other lower cost countries so much the better.
Another set of crucial reforms necessary for consumer incomes to rise concerns
the agricultural sector. Nearly half of China’s population lives in rural areas, but
agriculture remains woefully unproductive despite its crucial importance to China’s
development. China has to feed 21% of the world’s population with just 9% of its
arable land. Technological advances, such as the discovery of hybrid rice, and
structural reform, such as the abolition of the agricultural tax, were important steps
in boosting productivity in agriculture. But despite rapid progress since China’s
opening up thirty years ago, the sector remains fragmented and starved of capital.
For example, 78% of pig farms in China are of the smallest size with less than 100
For China to move to
sustainable growth it
needs to boost
consumption
For this to happen
income has to be
redistributed to the
household sector, for
household wealth to
rise and the
government to borrow
from the non-bank
sector
To open up the capital
account and to allow
interest and exchange
rates to be determined
by the market will be
the fastest way of
achieving this
Boosting agricultural
productivity is also key
24 Monthly Review – November 2010
pigs per farm and 98% of the laying hen farms are of the smallest size with less
than 10000 hens per farm.
The key impediment to boosting productivity and incomes in agriculture is the
state ownership of land. Farmers cannot borrow to invest or acquire or merge with
other farms by pledging as collateral their land as they do not own the land. A few
years ago land reform was on policymakers’ agenda. The idea was to give long-
term leases to farmers which would allow them to trade the land and use it as
collateral. But such reform is now dead in the water and there is no talk of such
changes being on the agenda of policymakers.
While the above reforms will boost consumer incomes, the opening up of China’s
capital account will be crucial in boosting household wealth. There is plenty of
theoretical and empirical evidence that there is an inverse relationship between
household net wealth and the savings rate. The easiest way to boost household
wealth is to allow the Chinese people the flexibility to invest their savings in search
of the highest return, rather than keep them at home where the options are low-
yielding bank accounts, a state-directed stock market and an overinvested real
estate sector. Although, of course, liberalizing the capital account could well result
in pushing the yuan down and domestic interest rates up.
Reforming the banking sector in order to start distributing domestic savings
efficiently rather than keeping it as the state’s ATM machine is crucial. Interest
rate liberalization and the removal of credit directives will help strike the right price
in the intermediation of domestic savings. It will help banks move away from more
risky corporate lending to the less risky mortgage market, raising the cost of
business sector expansion and state-sector investment, but lowering the cost of
the much needed and underdeveloped mortgage borrowing. Government
borrowing will become explicit and also priced accordingly.
The reforms listed above are the policy changes that should be done, but they are
not the same as the policies that the authorities are planning to implement in order
to achieve their goal of consumer-driven growth or what the reality could turn out
to be. Despite some nascent steps towards allowing more freedom in the capital
account, Beijing is dead set on keeping the controls in place, at least in the next
five years. It is keen on trade settlement to be increasingly denominated in yuan
and to facilitate that it is prepared to allow foreign central bank and bank
investment in its government bond and interbank market. It is also increasing the
quotas on its institutional investor schemes, both domestic and foreign. But Beijing
is maintaining its control of the system. Its main worry is the health of the banking
system as discussed before. It plans to recapitalize the banks and has imposed
controls on their mortgage and securitization activities, but it has given no
indication that interest rate liberalization is on the cards. The economy has
overheated on a massive scale and needs to be cooled. This would probably
require a combination of a higher exchange rate and higher interest rates, but on
either front, Beijing, with its predilection for the gradual approach when it comes to
the hard choices, continues to resist an increase that is high enough. The risk of
China landing itself with an import surcharge or trade restrictions from the US
and/or Europe is not insignificant.
The authorities seem determined to stick to the idea of rebalancing growth this
time around. This means that they will aim to boost consumer incomes, whether
The main impediment
there is state
ownership of land
Opening up the capital
account will boost
household wealth,
though it may well
pushing the yuan down
Interest rate
liberalisation is key to
wean the government
off excessive
investment
But the above reforms
do not seem on the
agenda
Rebalancing growth is
a priority
Monthly Review – November 2010 25
by lowering taxes or direct income transfers. Instead of land reform, boosting
agricultural productivity, and exchange rate adjustment, shedding low-value added
jobs, the authorities are trying to have their cake and eat it. They are boosting
rural incomes directly but also shifting low value added manufacturing inland. The
idea is that companies will save on labour costs, the government will provide
subsidized, at least initially, housing, while being closer to home would alleviate
the social strains on the dislocated migrants. Meanwhile, the authorities have
identified few strategic industries which they will foster over the next five years,
hoping to turn the coastal areas into high-tech hubs.
The government also plans to have a rural pension scheme by the end of 2020, to
improve social security and spend more on medical care and education, not just
university education but vocational training as well. Its response to the real estate
conundrum is likely to involve the building of affordable housing, in tandem with
the move of low-value added industry inland. Energy efficiency and conservation
is also high on the agenda as there is a general shift towards “quality” as opposed
to “quantity”. Hence, the gradual rise in the price of energy is likely to continue,
though a full liberalization of energy prices is not yet to be expected.
In the course of the next ten years demographics will have an important impact on
the likelihood of consumer spending being a growth driver. It is often said that
China will grow old before it grows rich. The share of the population above 65
years is set to increase dramatically in the next forty years from 11.4% in 2010 to
38% in 2050. The jump is set to be quite pronounced during this decade. In theory
the aging population should help rebalance growth towards consumer spending.
Pensioners consume but they do not produce. Hence, the household savings rate
comes down while the household consumption rate goes up.
The problem arises from China’s low income level and the large disparity between
labour income and pension income. While in relative terms the share of
consumption is set to rise and as such be a growth driver, in absolute terms
consumer spending could fall. Pension incomes in China tend to be a fraction of
what people earn while working. Even if we assume that pensioners spend all
their pension income and decide not to leave any of their savings as inheritance,
they could end up spending less in absolute terms than the share of their income
that they devoted to consuming when they were working. Hence, while this
demographic reality may lend a helping hand to Chinese policymakers’ efforts to
rebalance growth, it is unlikely to be a panacea.
Larger parts of the population moving up the income bracket should also be
beneficial to consumer spending. The income distribution in an economy tends to
have a bell shape, with people on very high incomes and those on very low
incomes being smaller proportions of the total than people on middle incomes. In
China the low income tail is fat or the distribution could be double-humped. But
still, as average income increases, larger parts of the population pass through the
important income milestones which allow them to be able to afford the consumer
goods that they were denied in the past. People on low incomes can just about
scrape for their daily needs, such as food and clothing. But as people’s purchasing
power increases buying more goods becomes possible and buying more
expensive goods becomes possible, whether it is consumer electronics, cars or
designer wear. China is on the cusp of such change.
But it will be done by a
top-down approach of a
fiscal boost to
consumer incomes…
…while trying to
improve social security
and pension provision
Other positive
structural forces at play
come from
demographics
Population aging could
raise the share of
consumption in GDP
were it not for
disproportionately low
pension income
Moving up the income
bracket should also
unleash pent-up
consumer demand
26 Monthly Review – November 2010
0%
5%
10%
15%
20%
25%
30%
35%
40%
1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Chart 20 China's population over 65 as a share of the labour force
Moreover, it does not have one of the key constraints which prevented Japan’s
consumption to explode, especially given their higher per capita income: space.
For various structural reasons living and parking space was at a premium in
Japan’s big metropolitan areas. Hence, while consumers may have wanted more
of everything, they could not afford to get what they wanted not because it was
beyond their means, but because they did not have the space.
Investment implications
Redesigning China’s growth model is a huge challenge, which is unlikely to go
smoothly. But the transition that the economy is set to go through also has
identifiable investment implications. While China’s trend growth is likely to come
down substantially, China’s growth is still likely to outpace that of its trading
partners. The pressure for the currency to appreciate will remain substantial. The
ongoing Chinese overheating, exacerbated by the yuan-dollar link and America’s
quantitative easing, could well convince the Chinese leadership that a higher yuan
is actually in China’s interest. This is ultimately positive news for foreign
investment in renminbi assets.
While Beijing seems to welcome slower growth, with the five year plan focused on
“quality” not “quantity”, the reality of it is likely to be difficult for the authorities to
stomach. Currently, they envisage output growth slowing from 8% to 7%, which is
in stark contrast to our expectation that it is more likely to slow from 10% to 5%. In
their attempt to achieve growth rates close to those of the past, the policy stimulus
that each expansionary phase will entail is more likely to fuel consumer and asset
price inflation than it is to boost growth. China’s cycle could well provide investors
with a larger asset price upside than it has done in the past. Calling the bottom
and the top of the cycle is not easy, but given the generally poor long-term equity
returns across Asia, getting the cycle right has always been crucial to achieving
high returns in this part of the world.
Unlike Japan space is
not at a premium in
China
China’s growth is set to
slow but should still
outperform
The more inflationary
cycle provides more
opportunity for asset
price gains if the cycle
is called right
Monthly Review – November 2010 27
Meanwhile the size of the domestic fixed income market is set to grow as the
government will gradually turn much more to both the domestic non-bank and the
international market for its finance rather than use banks to bankroll its investment
plans. As the authorities become more at ease with renminbi appreciation, they
will be prepared to widen the quotas for capital inflows and outflows, although they
are likely to continue to control the process. The foreign central banks at those
countries with which China has a currency swap agreement and banks, based in
Hong Kong have already been given permission to buy Chinese government
bonds and lend in China’s interbank market. But given that the excesses of
China’s growth have been concentrated in the banking sector, investing in the
Chinese interbank market, especially at longer maturities, may not be a great idea.
A stronger currency together with a structural long-term increase in the share of
labour income in national income will enforce China’s move up the value added
chain. Low-value added exporters are going to see their profit margins squeezed,
causing part of the sector to go bust or relocate to other lower cost economies.
But the other part of the low-value added sector should improve efficiency,
keeping its export market share or even increasing it. If China does indeed finally
fundamentally change the playing field for its business sector, this should involve
higher business sector profitability for those companies that succeed.
The low value-added assembly sector should not be entirely written off. But the
firms that are set to be successful are not only those who restructure, but also
those who in this process change their products to service the needs of the
domestic market. Subsidized energy prices have also played a key role in firms’
mode of operation. The authorities have gradually increased the price of energy
and further liberalization of energy prices is on the cards. Hence, firms which do
not change to optimize their energy use are set to lose out. In terms of the rise up
the value added chain, the government outlined the following key sectors which
will get state encouragement: information technology, hi-tech services, advanced
manufacturing, aerospace, marine, energy conservation, biology and new
medicine, new materials, new energy.
The other key transition is the move to consumer-driven growth. The importance
of the service sector is set to increase, with services catering for the older
generation bound to benefit from the demographic change underway. But as
discussed earlier, the users of those services may not necessarily be those that
will be paying for them, which may turn out to be a key distinction between
success and failure. Internal distribution and domestic marketing capabilities will
begin to play a crucial role for succeeding at home. China may have dropped
import tariffs to low levels very fast and as such be classed as an open economy,
but when it comes to its internal market, bureaucracy does constrain to some
extend the free flow of goods and services.
Conclusion
The challenges that lie ahead of China are huge. The potential for a destabilising
clash between liberal economics and rigid politics has increased, which should not
be ignored. The Chinese economy has hit the excess saving barrier with incomes
per head still far off the American vanguard, unlike Japan whose economy started
to stagnate after it had caught up in relative terms. This could either make the
Chinese people more determined to succeed or it could mean increased social
The size of the
government bond
market should grow
The move up the value-
added chain could
improve profitability in
the low value added
sector
Firms that change to
cater for the domestic
market, firms that
optimise their energy
use and firms in
supported sectors
should do well
The service sector, in
particular catering for
the aging population
will increase in
importance
China faces massive
challenges and is
running out of time to
make mistakes
28 Monthly Review – November 2010
unrest if the transition is mismanaged. When economic power was being
transferred across the Atlantic, Winston Churchill said, “One can always trust the
United States to do the right thing, once every possible alternative has been
exhausted.” The same could be true of China, but it is running out of time to try out
all the wrong alternatives.
Beijing has correctly identified that the next stage of its economic development will
have to involve developing the domestic consumer market and conserving its
battered nature, providing intangible social goods such as clean air and water. It is
going to get a helping hand as average incomes rise, unlocking pent-up consumer
demand, and the population ages, driving down the household savings rate.
Consumer spending can grow fast and can be a growth driver. But these structural
changes on their own are unlikely to be enough to support a sustained move
towards consumption unless the right policies are implemented.
The problem is that Beijing continues to believe that the best way for China to
achieve these goals is the top-down, state-directed approach with the Party
retaining control over the key economic variables such as the interest rate and
exchange rate. But the conflict between policymakers cosseting exporters and
state-owned enterprises and the need to allow free capital movement and to let
the market determine exchange and interest rates, if truly independent consumers
are to emerge, is going to intensify. As the international environment deteriorates,
economic and financial turbulence increase, China’s trend growth declines sharply
and its cycle becomes much more inflationary, the hope is that the Party will see
the benefit of relaxing considerably and fast its monopoly on power. The pressure
to fall back onto the safety of what seemed to have worked best in the past –
state-directed investment binges – will be strong, but no longer attainable.
Diana Choyleva
Consumer spending
can be a growth driver,
but the right policies
need to be
implemented
Beijing needs to
release control if truly
independent
consumers are to
emerge
Back issues
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No. 239, 2009 A road-map for EMU breakup
No. 240, 2009 China, Japan & Germany in export-led slump
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No. 242, 2009 Sovereign Rescues – how the forgotten crisis of 1914 compares with 2008-2009
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No. 246, 2009 China’s reflation to end in deflation
No. 247, 2009 Deflation to hit Germany and America
No. 248, 2009 Can we borrow our way out of the credit crunch?
No. 249, 2009 Korea and Japan – reflating and deflating
No. 250, 2010 Will the Eurasian savings glut destroy free trade?
No. 251, 2010 World Economic Forum Special Report – The spectre of protectionism
No. 252, 2010 US/UK now in private savings glut => 10% government deficits for years & deflation
No. 254, 2010 Sharpening the axe – Special Report
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No. 260, 2010 How America may escape the double-dip
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