118285 chinas challen

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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

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  • Monthly Review November 2010 1

    0%

    2%

    4%

    6%

    8%

    10%

    12%

    14%

    16%

    18%

    20%

    1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

    Chart 1 China's nominal GDP per capita growth at purchasing power parity, % pa

    China has enjoyed fast

    catch-up growth

    But its huge size

    means the potential for

    further catch-up is

    limited

    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 in