118285 chinas challen

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

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Page 1: 118285 Chinas Challen

November 2010


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

Page 2: 118285 Chinas Challen

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

Lombard Street Research Monthly Review is intended to encourage better understanding of economic policy and financial markets. It does not constitute a solicitation for the purpose of

sale of any commodities, securities or investments. Although the information compiled herein is considered reliable, its accuracy is not guaranteed. Persons using this Monthly Review do so solely at their own risk and Lombard Street Research shall be under no liability

whatsoever in respect thereof. The contents of this publication, either in whole or in part, may not be reproduced, stored in a data retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without written

permission of the Managing Director.

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Monthly Review – November 2010 1












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


China’s growth model

has relied on gaining

export market share

China’s challenge: letting the

‘invisible hand’ boost consumption


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

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2 Monthly Review – November 2010







1957 1963 1969 1975 1981 1987 1993 1999 2005

1990-2009 1971-89 1957-70 GDP % Linear (GDP %)


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


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


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

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Monthly Review – November 2010 3








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.

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4 Monthly Review – November 2010











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


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

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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


China’s government

uses the banking

system to finance its



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


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6 Monthly Review – November 2010











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


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


Page 9: 118285 Chinas Challen

Monthly Review – November 2010 7








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


Government saving has

been a major

contributor to the rise

in savings

Page 10: 118285 Chinas Challen

8 Monthly Review – November 2010









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


Urbanisation, lack of

proper medical and

pension provision, the

one-child policy are

also important reasons

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Monthly Review – November 2010 9











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


China’s excess savings

exceeded Japan’s…

…and coincided with

Japan’s and Germany’s

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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


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

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Monthly Review – November 2010 11



















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

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12 Monthly Review – November 2010












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


The economy hit its

cyclical barriers in 2004

But by 2006 investment

had picked up again

Page 15: 118285 Chinas Challen

Monthly Review – November 2010 13










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


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

Page 16: 118285 Chinas Challen

14 Monthly Review – November 2010








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


Page 17: 118285 Chinas Challen

Monthly Review – November 2010 15











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


Operating in this

environment has made

China dependent on

gaining global market


But the hostile global

environment of today

questions the

sustainability of the


Page 18: 118285 Chinas Challen

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


Each economy has an

optimal capital stock

It is estimated counting

the need for capital


employment growth,

rising capital to labour,

household creation and

the need for social


China needs an

investment rate of at

most 35% of GDP

Page 19: 118285 Chinas Challen

Monthly Review – November 2010 17








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


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

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18 Monthly Review – November 2010










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


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Monthly Review – November 2010 19












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


Inflation is dangerous

as it can undermine the


…and bring on the rest

of the world’s wrath if

the response to it is to

hammer domestic


Page 22: 118285 Chinas Challen

20 Monthly Review – November 2010











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


Higher inflation hurts

household incomes

and wealth

Page 23: 118285 Chinas Challen

Monthly Review – November 2010 21








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


China’s demographics

are dire

On the face of it, China

still has limitless labour


Page 24: 118285 Chinas Challen

22 Monthly Review – November 2010







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


Page 25: 118285 Chinas Challen

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


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


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

Page 26: 118285 Chinas Challen

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


But the above reforms

do not seem on the


Rebalancing growth is

a priority

Page 27: 118285 Chinas Challen

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


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

Page 28: 118285 Chinas Challen

26 Monthly Review – November 2010










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’s growth is set to

slow but should still


The more inflationary

cycle provides more

opportunity for asset

price gains if the cycle

is called right

Page 29: 118285 Chinas Challen

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.


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


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


China faces massive

challenges and is

running out of time to

make mistakes

Page 30: 118285 Chinas Challen

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


Beijing needs to

release control if truly


consumers are to


Page 31: 118285 Chinas Challen

Back issues

No. 222, 2007 Anatomy of a bull market’s earnings

No. 223, 2007 Five-year prospects for real asset prices: the good (stocks), the bad (commodities), the ugly

(real estate)

No. 224, 2007 Why protectionism remains stupid

No. 225, 2008 World Economic Forum Special Report -The New World Disorder

No. 226, 2008 UK & Spain – the V-shaped and the U-shaped pain

No. 227, 2008 Credit and Credulity

No. 228, 2008 Savings glut down + Fed folly => inflation

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No. 230, 2008 Brandon Davies on central bank liquidity as a public-private partnership

No. 231, 2008 Stumbling BoE to prove critics wrong

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No. 235, 2008 Credit and Credulity Redux – how likely is deflation in America?

No. 236, 2008 Paulson/Bernanke blunders put US on the spot

No. 237, 2008 The outlook for the US housing market

No. 238, 2009 World Economic Forum Special Report - Can the world step back from the brink?

No. 239, 2009 A road-map for EMU breakup

No. 240, 2009 China, Japan & Germany in export-led slump

No. 241, 2009 Sick men shackled: Germany, Italy and the euro

No. 242, 2009 Sovereign Rescues – how the forgotten crisis of 1914 compares with 2008-2009

No. 243, 2009 Ireland & Spain as Hänsel & Gretel

No. 244, 2009 Odd man out

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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

No. 255, 2010 A road-map for EMU breakup, v. 3

No. 256, 2010 The Geddes Axe – Special Report

No. 257, 2010 Beijing’s false analogy with late-1980s Japan

No. 258, 2010 Overheating China risks slump

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No. 260, 2010 How America may escape the double-dip

No. 261, 2010 EMU – fuse or split? Special Report