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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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  • November 2010

    www.lombardstreetresearch.com

    Monthly Review 262 November 2010

    Chinas 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 Chinas continual grabbing of market

    share when the global trade pie is hardly growing. The external demand shock has

    undermined the sustainability of Chinas exorbitant investment rate, which is set to fall to

    35% of GDP by the end of the decade from 48% of GDP in 2009. Chinas 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

    Chinas challenge: letting the invisible hand boost consumption Diana Choyleva

    16 November 2010

    Introduction 1

    The savings story 2

    The international dimension 9

    Chinas export-led growth model 11

    Chinas investment constraint to kick in 13

    Chinas growth to become more inflationary 18

    Chinas 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.

  • 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

    Chinas growth model

    has relied on gaining

    export market share

    Chinas 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. Chinas average standard of living is still only 14% of Americas, up 10

    percentage points in seventeen years. By contrast, after its comparable near-10%

    growth phase ending in the mid-1970s, Japans was over 70% of Americas. So in

    principle Chinas scope for catch-up growth at high rates remains huge.

    One snag arises from Chinas 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 worlds 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 Japans 1970s ratio.

    Chinas 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 Chinas 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

    Chinas trend growth

    could well halve in this

    decade

    This MR will examine

    the challenges of

    Chinas transition

    There are a lot of

    similarities between

    China and Japan

    world. The clash between Chinas 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 Chinas 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 Chinas most viable route, but

    even if Beijing succeeds in engineering this, Chinas 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 Chinas

    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

    Japans experience, which is illuminating as much in its differences in comparison

    to Chinas 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 Chinas 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

    economys growth rate halve. Japans 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 Japans 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

    Chinas benign savings

    phase lasted until 1994

    WTO-entry in 2001

    marked Chinas

    decisive move into

    excess savings

    But there are crucial

    differences which

    explain Chinas 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 Chinas entry into the World Trade Organisation in 2001, after which

    point it shot up by 16 % points in eight years. Chinas 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 Chinas 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 Chinas 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 Chinas decisive move into excess savings, with the current

    account surplus reaching 11% of GDP in 2007.

    Both Japan and Chinas 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 Chinas much higher savings and investment rate. In the

    first stage of Japans 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 Chinas 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 Chinas 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 Chinas

    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 Chinas 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, Chinas 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

    Chinas government

    uses the banking

    system to finance its

    expansionary

    programmes

    The banks are at the

    heart of Chinas

    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

    sectors need for them.

    Beijings 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 Chinas

    abnormally high savings and investment rate when compared with Japans and

    Koreas 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

    Chinas transition

    created the recognition

    of bad loans but didnt

    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

    Japans 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 Chinas 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 peoples 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

    Chinas 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 Japans life-time employment system.

    Chinas 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 Chinas 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 Chinas investment and savings rate have hit higher peaks than Japans, but

    importantly the excess of its domestic savings over domestic investment has also

    reached much bigger proportions than Japans ever did. The impact of China

    exporting its excess savings and excess production while devouring raw materials

    has already been much more profound. Chinas current account surplus spiked to

    11% of GDP in 2007, compared with Japans 2.5% of GDP in 1971 and 4.2% of

    GDP in 1986. But Chinas impact on the US under the yuan-dollar peg and the

    rest of the world for that matter was bigger than Japans impact during the Bretton

    Woods system of fixed exchange rates. Chinas current account surplus was 2.6%

    of US output in 2007 compared with Japans current account surplus of 0.7% of

    US output in 1971.

    Moreover, Chinas 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

    Chinas excess savings

    exceeded Japans

    and coincided with

    Japans and Germanys

  • 10 Monthly Review November 2010

    Excess savings are by definition demand deflationary. When the desire to save

    out of income exceeds the economys 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.

    Chinas 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 Chinas excess savings came through Chinas 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 Chinas

    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 Chinas 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 Chinas

    voracious appetite for assets. Once Chinas 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 Chinas current account surplus

    exploded. China poured its excess savings into risk-free US dollar assets, stoking

    Americas consumer boom which itself fuelled Chinas 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 Chinas 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

    Chinas 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 Chinas current expansionary mode of

    grabbing market share.

    Chinas export-led growth model

    Chinas 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. Chinas 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 Chinas 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 Chinas 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 Chinas propensity to export surged. It was this

    external source of final demand that kick-started Chinas 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, Chinas 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 Chinas 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. Chinas 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 Chinas 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 Chinas 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.

    Chinas 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.

    Chinas 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

    Chinas growth is far

    from stable

    The natural limits to

    investment are

    profitability and the

    governments 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

    Chinas 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 Chinas 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

    Chinas 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

    Chinas 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, Chinas 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 Chinas

    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 Chinas growth model. If Beijing does

    not budge on the currency front, it is entirely possible that the US will impose a

    surcharge on Chinas 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 Japans 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

    Chinas exports at a time when global demand is set to relapse. If the Chinese

    resist the adjustment through the nominal exchange rate, Americas attempt to

    reflate its economy with quantitative easing will result in a de facto devaluation of

    the US dollar vis--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 economys

    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 Chinas 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 5% 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 Chinas

    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. Lets 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.

    Chinas 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 Chinas 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 Chinas 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, Chinas 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 Chinas 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. Beijings 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.

    Chinas growth to become more inflationary

    Chinas 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.

    Chinas 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. Chinas 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 systems undoing. Playing with inflation in China is playing with fire as it

    could undermine banks deposit funding if peoples 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 Chinas 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. Japans

    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 worlds 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 Beijings gigantic 2009 stimulus in boosting growth made the

    authorities feel vindicated in their belief that Chinas 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 Chinas 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 Chinas 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, Chinas social harmony is based less on the equality of income and

    wealth than Japans 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.

    Chinas 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 Chinas 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 economys 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, Chinas 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

    Chinas 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 Chinas 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

    Foxcons 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, Chinas 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 Chinas 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 Chinas

    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 Chinas 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 Chinas 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 Chinas 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. Chinas

    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 Chinas population lives in rural areas, but

    agriculture remains woefully unproductive despite its crucial importance to Chinas

    development. China has to feed 21% of the worlds 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 Chinas

    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 Chinas

    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 states 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 Chinas 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 peoples 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 Japans

    consumption to explode, especially given their higher per capita income: space.

    For various structural reasons living and parking space was at a premium in

    Japans 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 Chinas 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 Chinas trend growth is likely to come

    down substantially, Chinas 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 Americas

    quantitative easing, could well convince the Chinese leadership that a higher yuan

    is actually in Chinas 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. Chinas 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

    Chinas 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 Chinas interbank market. But given that the excesses of

    Chinas 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 Chinas 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 potentia