by Michael Collins, Investment Commentator at Fidelity
China’s incoming leaders confront a fundamental economic challenge – how to generate new wealth to maintain political stability now that the export-driven, investment-led industrialisation of China is petering out as a formula for enriching China’s masses.
Their answer is to morph the economy into one propelled by personal consumption, which only stands at about 35% of GDP compared with about 70% in developed countries such as the US and Australia.1 It’s a valid solution and one that sounds simple. But it’s not. The economic challenges are only made more difficult because the social, legal and political settings needed to accompany reforms are missing under China’s autocratic political system.
Shifting to a consumption-driven economy means correcting major mispricings on the key ingredients of economic growth; namely, land, labour and capital. The underpricing of these resources is prompting China to spend about 50% of its GDP on new capital stock,2 a level that is unsustainable as it leads to overcapacity, asset bubbles and banking troubles as dodgy loans mount. At the same time these mispricings have reduced the personal income to about 40% of GDP from 53% in 1999, compared with 57% in the US.3
Untangling the mispricing of land, labour and money (namely the exchange rate and interest rates) increases the risk of an economic slump in China – there are no guarantees people will consume more to compensate for any drop in investment. It will almost certainly set China on a path of lower sustainable economic growth because policymakers, mathematically, need to set GDP growth at a slower pace than consumption growth for consumer spending to become a bigger part of output (a process that implies low investment growth). Authorities might even bungle into fresh mispricings. Another difficulty is that, to boost consumption, policymakers will have to adopt long-term free-market reforms that counteract the short-term investment boosts they are pursuing to insulate China from Europe’s implosion. Investment-led stimulus since the start of the global financial crisis in 2007 has lifted the share of investment in GDP by 5 percentage points, while the share of consumption has dropped by 2 percentage points over that time.4
It must be said that some analysts reject, or downplay, the verdict that China’s economic growth is wobbly, even though Chinese Prime Minister Wen Jiabao has said the country’s structural problems are causing “unsteady, unbalanced, unco-ordinated and unsustainable” development.5 They say it’s normal for economies at China’s stage of maturity to have a low ratio of consumption to GDP. They predict the ratio will rise over time, without the government taking drastic action, as an improving social welfare system will promote spending over saving. They say the goal for any government is to promote healthy consumption growth (which has been a robust 8% p.a. in recent years in China), not a high ratio of consumption to GDP. While this analysis holds some truth and the government is investing more in public goods such as healthcare, education and social security, it’s clear the government is fixing prices to favour the elite and business over the masses. They are thus denying the majority of Chinese their proper return from China’s remarkable ascent.
Skewed for business
A key mispricing behind China’s economic success is the policy to keep the yuan low. Cheaper exports have helped China become the world’s biggest manufacturer and exporter and the largest hoarder of foreign exchange. For the Chinese, the biggest cost of the low-yuan policy is that it reduces their living standards. China’s leaders, in effect, are offering the world’s shoppers bargains by ripping off their own consumers. Another cost is that an undervalued yuan keeps inflation higher than otherwise because imports are more expensive than they should be and the government is adding to the money supply in China when it buys foreign exchange to cap the yuan’s gains. Higher inflation tends to hit the poor hardest because it’s more critical for them when necessities move out of their price range. Another cost of the low-yuan policy that is relevant here is that China is squandering resources. Money is spent buying low-yielding US Treasuries rather than spent on social goods such as hospitals or on welfare transfers that would boost the quality of life of the population.
But allowing market forces to set the yuan’s value presents challenges for Beijing (apart from large losses on the US$3.2 trillion worth of foreign assets). The one that concerns China’s rulers the most is the political consequences if China’s exporters lose sales, reduce production and add to the country’s unofficial jobless rate of about 10%. Another obstacle is nakedly political. A higher yuan would upset the many politically influential, state- and military-owned companies that export or compete against imports. The dilemma for Beijing’s rulers is that these state-owned enterprises are almost slush funds of the Communist Party of China as they provide cushy jobs and perks for party members while the military safeguards their power.
The second pivotal mispricing behind China’s success is cheap money for businesses and local governments. In what some analysts label as “financial repression”, China’s savers have spent the past three decades subsidising the country’s property and investment drives because the government has set interest rates on consumer bank accounts artificially low, while applying capital controls on households to ensure their savings are funnelled to banks. Real rates have often been negative for savers and borrowers. Negative or low real interest rates have resulted in poorer savers, unviable projects, flabby state companies, wasteful local governments, vulnerable banks and a shadow financial system. On the unofficial lending market, private companies that miss out on state-directed lending pay exorbitant interest rates.
Liberalising interest rates will be hard, though. Banks, companies and local governments might struggle if they have to pay market-set rates of interest and shed workers. Once again, banks and companies, especially state ones, and regional governments are powerful enough to resist reforms to interest rates that could drive some of them to bankruptcy.
Cheap land and labour
Another critical mispricing is land. While subsidised interest rates and government stimulus helped fan China’s property frenzy in recent years, the main culprit is China’s cheap land. Few issues are as politically fraught in China as the way developers, in cohorts with corrupt local officials, underpay peasants and fringe city dwellers when they remove them, often with force, to make way for new apartments, offices, factories and infrastructure. At the same time, the state, to which all land belongs, has unfettered power to profit from declaring which land is available for development. Over time, the cheap acquisition of land has garnered a massive shift in wealth from China’s masses to local governments, crooked officials and developers.
The economic consequences of tackling the corrupt gobbling of land across China could well be a faster decline in property prices, rattled banks, tottering developers and deteriorating local-government finances. Land owners might increase their consumption if they are confident of receiving fair prices for their land, though. The politics of letting market forces set land prices in China is confronting because it goes to the biggest handicap of any dictatorship; namely the absence of property rights when rule of law is lacking.
A fourth mispricing is with labour. Communist China, where independent unions are banned, is no showcase for how to treat workers. Many of China’s factory hands work long hours in sweatshops and live in basic and restricted conditions on company premises for repressed pay. Many rely on overtime to survive. The lousy pay and conditions, China’s looming labour shortage due to the demographic consequences of its one-child policy and a more assertive attitude among China’s young have led to many illegal strikes across China. Foreign firms have caved into demands for pay rises while the response of local authorities is to usher in higher minimum pay rates. Basic wages have risen by up to 20% a year over the past four years in many parts of China, though higher productivity and inflation means that real wage costs for businesses have risen less.
While higher wages is one of the quickest ways to boost consumption, the strategy poses two dangers for policymakers. The first is that higher wages will feed into faster inflation. The second is that centralised wage-fixing creates a fresh mispricing by making Chinese labour too expensive for foreign factory owners and they shift elsewhere or automate. (Local manufacturers only face the automation option.) Already companies are leaving or skipping China for Bangladesh, India, Sri Lanka, Thailand and Vietnam where labour might be up to 40% cheaper even if less efficient. Most foreign businesses will stay and pay the higher wages, of course, because they rely on suppliers based in southern China and they eye China’s huge domestic market. But the upshot is that the government’s ability to reward the masses and boost consumption through higher wages is limited.
A final mispricing in China that favours businesses is on inputs such as water and power. Consumers are subsidising business costs or seeing government resources go to business, not them. Businesses have little incentive to conserve energy or water in China and environmental damage and health-threatening pollution are the result, making this mispricing more a issue about the quality of life than consumption.
China’s leaders probably understand the economic challenges they face in correcting these five mispricings so the masses can better enjoy the fruits of the country’s development. You can be sure they see the political threat to their monopoly on power from doing so. They just have to balance that against the longer-term threat of doing nothing.
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1 IMF. Regional Economic Outlook. “Asia and Pacific. Managing spillovers and advancing economic rebalancing.” Chapter 4. “Is China rebalancing? Implications for Asia”. Page 47. April 2012. http://www.imf.org/external/pubs/ft/reo/2012/APD/eng/areo0412.pdf
2 IMF. Op cit.
3 China Daily. “China provinces to raise minimum wages.” 1 July 2010. http://www.chinadaily.com.cn/bizchina/2010-07/01/content_10046549.htm. Note that GDP can be measured on a production, income or expenditure basis.
4 OECD. “China in focus: Lessons and challenges.” Chapter 1. Page 12. http://www.oecd.org/dataoecd/13/10/50011051.pdf
5 Ministry of Foreign Affairs of the People’s Republic of China. Transcript of China’s Prime Minister Wen Jiabao responding to question of China News Service during media conference at the end of the Fifth Session of the Tenth National People’s Congress in Beijing on 17 March 2007. http://www.fmprc.gov.cn/eng/zxxx/t304313.htm