The rebalancing of any economy is never easy. Nor is there a boilerplate recipe for such a transformation. For a state-directed Chinese economy, the challenges are very different from those in a market-based economy like the United States. China is now taking an important first step on the road to rebalancing – moving to rein in the excesses of an investment boom and a stock market bubble. A key question for the National People’s Congress as it gathers this week in Beijing: What comes next?
Most believe the answer lies with the Chinese consumer. The numbers are compelling: Private consumption in the world’s most populous nation currently accounts for only about 35% of its GDP – half the elevated share in the US, well below portions elsewhere in the developing world, and quite possibly the lowest consumption share of any major economy in modern history. There’s obviously nothing but upside to the case for the Chinese consumer. It is widely billed as one of the great hopes and opportunities of global rebalancing – capable of picking up the baton of support from China’s overheated investment sector and from an equally over-extended export sector.
Chinese consumer culture still in its infancy
I wish it were that easy. Centrally-planned or not, China can’t simply push a button to bring its vast consumer sector into play. Consumer cultures, in many respects, are the DNA of market-based capitalism. China has taken only baby steps in that direction. With over 60 million layoffs traceable to the state-owned enterprise reforms of the past decade, job and income insecurity is rife amongst the Chinese workforce. The lack of a nationwide social safety net – especially social security, pensions, and unemployment insurance – only compounds that problem. As such, Chinese households are predisposed toward an inordinate amount of precautionary saving – saving motivated by fear of uncertain economic prospects. Reflecting such high levels of personal saving, China’s national saving rate is currently close to 50% – the highest for any major economy in the world and reflective of a major stumbling block on the road to the development of a vibrant Chinese consumer culture.
The results of the latest Gallup Poll of China underscore the serious obstacles that the consumer still presents to a rebalancing of the Chinese economy. We have just obtained access to the results of a tally conducted in October 2006, covering a comprehensive sample of some 3,500 Chinese households (2,500 urban families and 1,000 rural units). Three key findings emerge from this survey that are pertinent to the Chinese consumption outlook:
(1) Fully 65% of Chinese households remain dissatisfied with their ability to save – consistent with a powerful precautionary motive to increase saving further. While this is down fractionally from the 68% found by Gallup to be similarly dissatisfied in 2004, it is higher than the dissatisfaction reading of 61% evident in 1997.
(2) Widening income disparities are also inhibiting the expansion of a broader base in Chinese consumption. This shows up in both urban and rural areas, where the Gallup tally shows that the difference between the upper and lower quintiles of household incomes increased by about 40% in 2006 relative to that prevailing in 2004; these are the largest increases in income inequality in the 10-year history of Gallup’s China Poll, especially for the rural population.
(3) The lifestyle benefits of urbanization are concentrated in China’s “Top 10” cities; by contrast, citizens in “Middle China” – medium-size urban centers – remain very much on the outside looking in. The latest Gallup tally shows that income disparities in China’s 10 largest cities increased in 2006 by only half the amount evident in the entire urban population – implying that the deterioration of income gaps was much worse in medium-size urban centers.
The pro-consumer five-year plan
These findings are not lost on Chinese policymakers, who are very focused on a pro-consumption rebalancing of the Chinese economy. The 11th Five-Year Plan enacted by the National People’s Congress a year ago addressed two of these issues head-on – the need for a national safety net and the imperatives of tempering rising income inequalities. Greater priority was placed on support for the woefully under-funded National Social Security Fund, which currently holds just RMB 300 billion, or roughly US$30 per capita. Emphasis was also placed on rural income support – especially tax incentives and improved medical and educational allowances.
In addition, the latest Five-Year Plan was explicit in identifying China’s relatively undeveloped service sector as a new and important source of job creation in the future. With downsizing in manufacturing-based state-owned enterprises likely to continue for the foreseeable future, Chinese leaders recognize the need to draw increased support from labor-intensive tertiary industries – especially those involved in distribution and delivery, like wholesale, retail, and trans-national shipping. On balance, the 11th Five-Year Plan is probably the most pro-consumer effort ever put forth by the Chinese leadership. But it underscores how far China needs to go in removing the obstacles that currently inhibit the development of a flourishing nationwide consumer culture – a challenge I suspect will be actively debated at this year’s national People’s Congress. China’s consumer-led rebalancing is only just beginning. I believe it will take at least 3-5 years for these efforts to bear fruit.
China’s need for financial sector reforms
Similar constraints are evident in China’s saving and capital allocation mechanism – and in the financial-sector reforms that such breakthroughs would require. China has made major progress in the areas of banking and capital markets reforms in the past five years. But these initiatives have effectively started from “ground zero.”
The public listing of three of China’s largest banks was a very important step in the creation of a new financial system – especially in instilling the shareholder-value culture that will ultimately drive profitability and discourage lax lending practices. But, here as well, this is a long and arduous road for China – especially the transformation of legions of former government bureaucrats into discriminating bank lending officers. In the end, the integrity of a prudential lending function – and the competence of lending officers – is the essence of a market-based credit culture for any economy. Through strategic alliances with several major foreign banks, China is making progress in this area, but the heavy lifting in the personnel, systems, and risk management areas of Chinese banking reforms has only just begun.
Two other obstacles compound the capital allocation problem in China – the currency regime and a lack of progress on broader capital market reforms. I am not a believer in the notion that China’s currency policy is a threat to global trade. I feel, instead, that many in the developed world – especially the saving-short United States – are treating RMB-related issues as scapegoats for their own macro shortcomings. I worry more about China’s quasi-fixed currency regime as a source of its own domestic instability – largely in fostering massive speculative capital inflows and a build-up of foreign exchange reserves that then have to be recycled into dollar-based assets and neutralized through a massive “sterilization” exercise. To the extent that China’s undeveloped domestic debt market makes such sterilization difficult, then excess liquidity undoubtedly spills over into its banking system. The latest trends in bank lending underscore this problem: Despite a series of recent hikes in bank reserve ratios, RMB loan growth accelerated from 13% y-o-y in June 2006 to 16% in December. With China’s policymakers trying to clamp down on excessive investment, curtail an equity bubble, and limit a new wave of nonperforming bank loans, the persistent excesses of bank lending growth continue to complicate the macro control problem (see my 28 February dispatch, “China Squeeze”).
An equally glaring shortcoming is China’s lack of capital market development – especially the low level of activity in its corporate bond market. In 2006, China’s domestic capital markets – equity and bonds, combined – accounted for only about 18% of total funds raised by the business sector; equities accounted for the bulk of that total, whereas corporate bond issuance made up only about 3% of overall funding. Banks, on the other hand, accounted for fully 82% of total credit intermediation. That underscores yet another obstacle on the road to rebalancing: China’s fragmented and still largely unreformed banking system has long been focused on funding a vast network of inefficient and largely unprofitable state-owned enterprises. In the past, this has led to a massive surge of nonperforming loans – a problem that could well resurface once the dust settles on the current bank-funded investment boom. Over-reliance on still inefficient banks, in conjunction with the lack of a capital-markets-based discipline, underscores the serious risks of a misallocation of Chinese saving and resources.
China is at a critical juncture. Over the past 15 years, its powerful investment- and export-led growth model has been driven by bank-directed recycling of its massive pool of domestic saving. Coupled with aggressive and unprecedented reforms of its state-owned enterprises, China’s transition to “market-based socialism” has been nothing short of spectacular. But this model is now in danger of outliving its usefulness. The investment sector has gone to excess and the export dynamic is in danger of triggering a protectionist backlash. The lack of a vibrant consumer sector, in conjunction with the legacy effects of state- and bank-directed capital allocation, are critical obstacles that must be overcome if the Chinese economy is to move to the next level.
China’s unbalanced macro structure is also presenting its leadership with major cyclical control problems. Lacking in well-developed market-based systems, China recently upped the ante in opting for “administrative controls” to cope with its mounting imbalances (see “China Squeeze” cited above). The latest such actions – state-directed equity selling and a clampdown of short-term foreign borrowing by domestic Chinese banks – may well have played a key role in sparking a worldwide equity market correction in late February. In my view, they were not one-off developments. Based on Premier Wen Jiabao’s opening speech to the National People’s Congress, these actions may only be the first salvo in a broader tightening campaign.
Yet this approach is not without its own shortcomings. Administrative actions not only underscore the state-dominated mindset that still pervades the China model, but they also are stop-gap measures that circumvent market-driven solutions. In my view, the only viable answer is an acceleration of reforms – focusing both on the nascent consumer as well as on an embryonic financial system. A successful rebalancing of the Chinese economy is essential to avoid the boom-bust cycles that were so prevalent in the past. Yet until the obstacles to rebalancing are removed, China’s overheated investment sector and over-extended exports pose increasingly serious risks to sustainable and stable growth.
Brilliant as its success has been since the early 1990s, China can no longer afford to stay the same course. A new direction is essential – and the sooner the better. As the National People’s Congress now meets in Beijing, the obstacles to Chinese rebalancing – and the tactics to overcome these obstacles – could well be at the top of its agenda.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum