Mapi-jul 2009

Economic Report ER-681

June 2009

China’s Future Growth: Savings, Investment, and Its Rebalancing Goal By: Yingying Xu Economist [email protected]

The Alliance promotes the technological and economic progress of the United States through studies and seminars on changing economic, legal, and regulatory conditions affecting industry. Copyright © 2009 Manufacturers Alliance, All rights reserved. 1600 Wilson Boulevard, Suite 1100, Arlington, Virginia 22209-2594 Phone: 703.841.9000 Fax: 703.841.9514 mapi.net

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China’s Future Growth: Savings, Investment, and Its Rebalancing Goal Introduction

In 2008, China celebrated the 30th anniversary of its historical economic reforms. Over the past three decades, expanding at an average annual growth rate of 10 percent, China has made itself the second largest economy in the world, based on the purchasing power parity (PPP) standard. The major driver of growth has been a significant increase in the rate of capital accumulation in the industrial sector, which has been fueled by the rapid rise in the national savings rate. The contribution to growth from household consumption has been declining steadily to a low level not seen in any major economy in the world. Instead, exports have been a strong source of growth and destination for the increased production from rising fixed asset investment. Only in recent years has it become more and more obvious that China’s industry-led, capitalintensive growth model with high savings and investment rates, comes at a price. Increasingly concerned with the negative impacts of relying heavily on investment and exports, In 2004, China’s top leaders formally called for a rebalancing of the country’s sources of growth and made one of the top priorities in its eleventh fiveyear plan (2006-2010) to promote household consumption, expand the service sector, and grow at a more sustainable and equitable pattern. If this were to be accomplished, fixed asset investment and (related) exports would be a lesser factor in Chinese economic growth. However, despite the government’s efforts to stimulate consumption and constrain investment spending in recent years, the share of savings in GDP has continued to rise, although the investment share has edged down somewhat, leading to a widened saving-investment gap. China’s policy initiatives have been criticized for being too modest to change its underlying growth dynamics. China’s real economy has been hit hard by the continued global turmoil and economic crisis, mainly through the freefall in global demand and the resulting weakness in market-based investment and sentiment, notably in the manufacturing sector. Therefore, boosting domestic demand and domestic consumption is key not only for the medium-term objective of rebalancing, but also is important in helping to dampen the alarming slowdown and to prop up economic growth in the short term. International interest, especially from chronic trade deficit nations like the United States

and the United Kingdom, is high in China’s rebalancing, because one key to move sustainable growth in deficit countries is the ability to supplement domestic demand from exports to high growth countries such as China and India. Recently, there is much talk that China should use the crisis as a broad catalyst to accelerate the pace of reform, and there already have been some positive changes. However, the progress of the transition will not likely be fast and smooth, not only because of the resistance from many vested interest groups who benefit from the old growth model and thus push for the status quo, but also because of the complexity of tasks lying ahead. During this transitional period, multinational firms, which have made significant contributions in helping China to produce products for the global market, will need to cooperate with Chinese firms in more creative ways to meet China’s huge and growing domestic demand when they both are facing a tougher business environment in China. The structure of this report is as follows. The next section will explain the necessity for China to rebalance toward a more sustainable and equitable economy. Then a detailed analysis of China’s high national savings rate will be presented. The last section reviews the progress that has been made during this transition process and gives some explanations why China still has a long way to go to achieve its rebalancing goal. China’s Past Economic Growth Pattern Several studies have analyzed the sources behind China’s rapid growth and largely agree that a significant increase in the rate of capital accumulation in the industrial sector has been the major driver. As shown in Figure 1, fixed asset investment averaged 36 percent of GDP in the 1980s before trending up quickly in the 1990s, and the share has exceeded 42 percent since 2003. On the contrary, the contribution of domestic demand to economic growth has been declining steadily, with the share of household consumption in GDP dropping from more than 50 percent in the early 1980s to only 35 percent in 2007, the lowest share of any major economy in the world. Mirrored to China’s low consumption-to-GDP ratio is its high domestic savings, which outpaced investment growth and reached an unprecedented 50 percent of GDP in 2007. Economic theory proves the mutual reinforcing relationship between savings

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investment rates, comes at a price. First, with investment booming, excess capacity and overinvestment emerged in a number of important industries.2 The resulting 60 overproduction has not only driven down product prices and eroded industrial profit margins, but has also made Chinese Household Consumption producers more vulnerable to external Gross National Savings 50 shocks as they become increasingly dependent on international markets. Take the steel industry as an example. China became the world's largest steel maker in 40 1996, and at the end of 2008, its excess capacity in crude steel production reached 160 million tons, exceeding the 118 million Gross Capital Formation metric tons of annual output in Japan, the 30 second largest steel producer in the world. After the global financial crisis intensified in September 2008, however, the average Sources: United Nations and MAPI Calculations steel price contracted by more than 30 percent, and exports dropped from 20 percent of total output in August 2008 to Figure 2 only 5 percent in February 2009. As a Household Consumption Gross Capital Formation result, annual profits in 2008 for the In East Asia in East Asia industry as a whole declined by 13.7 80 80 percent, while in 2007 a 45 percent South Korea 70 70 increase had been observed. Some Hong Kong researchers believe that this excess 60 60 capacity has contributed at least partly to South Singapore the slowdown in China’s Total Factor Korea 50 50 Productivity (TFP) growth,3 a critical factor in explaining China’s fast growth. TFP 40 40 Singapore slowed from nearly 4 percent per annum Japan 30 30 during the first 15 years (1978-1993) of China’s rapid industrialization period to 20 20 only 3 percent thereafter.4 Hong Kong Taiwan Second, the industry-led growth pattern 10 10 is particularly intensive in the use of energy and raw materials, which will not only Sources: United Nations and IHS Global Insight threaten China’s energy security but also contribute to harming domestic and global environmental sustainability and public and growth, and normally argues that a rise in the health. China’s energy consumption growth rate savings rate is necessary in order to finance rising jumped from an average 3.5 percent in the 1990s domestic investment and thus support economic ER-681 June 2009

“takeoff.” What has been surprising is the extent of the increase in both the savings and investment rates in China, which even surpassed what its neighbors in East Asia had experienced at the peak of their era of rapid industrialization (Figure 2).1 Only in recent years has it become more obvious that the industry-led, capital-intensive growth model characterized by high saving and 1

Newly Industrialized Economies (NIEs) have shown a common pattern of rising saving rates during their take-off periods.

2

2007

2003

1999

1995

1991

1987

1983

1979

1975

1971

2007

2003

1999

1995

1991

1987

1983

1979

1975

1971

Percent of GDP

Percent of GDP

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Percent of GDP

Figure 1 Evolvement of China’s Domestic Savings, Investment and Household Consumption

According to the most recent estimate from China's industry ministry, about 30 percent of the nation's aluminum production capacity, 20 percent of cement and plate-glass capacity, and 70 percent of semiconductor capacity is in idle. 3 Growth in TFP represents output growth that is not accounted for by the growth in inputs, such as capital and labor. 4 Jianwu He and Louis Kuijs, “Rebalancing China’s Economy—Modeling A Policy Package,” World Bank China Research Paper No. 6, September 2007.

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Third, the capital-intensive growth model has absorbed less labor and Figure 3 generated only modest gains in Energy Efficiency/CO2 Indicators in 2007 at PPP employment in recent years, limiting the 0.4 absorption of surplus workers from the agricultural sector into the labor force and contributing to rising urban-rural 0.3 inequality. Although higher capital intensity is generally believed to help 0.2 push up labor productivity, heavy industries producing investment goods employ far fewer workers than do light 0.1 industries producing consumer goods and the service sector. Therefore, 0.0 China’s annual employment growth China India U.S. Primary Energy Intensity Energy Intensity of Manufacturing declined from 2.5 percent during early years of reform to 1 percent between CO2 Intensity of Industy (to value added) CO2 Intensity of Houshold Consumption 1993 and 2004 and to only 0.7 percent on average since 2005, although its *The ratio of energy in kilogram of oil equivalent (koe) to 2007 GDP in Purchasing Power Parity (PPP). Source: Enerdata share in world manufacturing production keeps increasing. As shown in Table 1, to almost 10 percent during 2000-2005, despite the employment elasticity of output in the industrial similar GDP growth rates during these two sector, defined as a ratio between employment periods. By 2006 energy consumption already growth rate and the output growth rate, has fallen exceeded the higher bound projection for 2010, more than 50 percent in the past three decades, which was made in the early 2000s by various meaning that the number of jobs created in China government agencies. In 2007, its primary energy for each unit of output growth is only half of what it intensity, defined as energy consumption per unit of was 30 years ago.8 GDP, even surpassed that of the United States. As The slow pace of job creation, combined with a result of the soaring petroleum use for autosluggish wage increases, caused total employee mobiles and the massive increase in the use of coal, compensation to drop from 45 percent of GDP in which accounts for two thirds of its energy 2001 to only 35 percent in 2007 (Figure 4). Some consumption, China became the largest emitter of economists believe that slower household income greenhouse gases in 2007, and its CO2 emission growth played a larger role in the declining per capita is almost four times as high as the level in household consumption share in GDP than a India (Figure 3). Its air quality is among the worst in conscious desire by households to increase their the world and has had incalculable adverse effects 5 savings rate.9 on public health. China has also become the In recent years, China’s growing trade surplus world’s largest consumer and a major net importer has received lots of attention from the public, from of most primary industrial commodities.6 The economists, and from politicians around the world, increasing dependence on the global market to and the undervalued currency is usually quoted as meet its surging material demand generated by the a key contributing factor. Exchange rate resource-intensive growth model makes China more manipulation has become a contentious political vulnerable to the commodity price volatility and issue and raises trade tensions between China and supply uncertainties intrinsic to the global market, its major trading partners, including the United and imposes serious constraints on its future States and the European Union (EU). However, development.7 most economists believe that there is no single explanation for the trade surplus, and it helps to 5 Currently China is home to 13 of the world’s 20 most look at this issue from a savings and investment Koe/GDP*

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polluted cities. Numerous Western style environmental laws passed recently have been poorly enforced. 6 Includes oil, aluminum, copper, lead, nickel, tin, and zinc. 7 It is generally believed that China’s recent efforts to lock in energy supplies by investing in Africa, Latin America, and the Middle East will contribute little to meet its huge domestic demand.

8

The negative employment elasticity in the agricultural sector is within expectations, considering the labor oversupply before 1978 and the subsequent labor migration to the industrial and service sectors. 9 Jahangir Aziz and Li Cui, “Explaining China’s Low Consumption: The Neglected Role of Household Income,” IMF Working Paper No. 07/181.

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Table 1 Growth of Output and Employment in China, 1981-2007

Employment Growth (Annual) Value Added Growth (Annual) Employment Elasticity*

19811990

Agriculture 19912000

Industry and Construction 1981199120011990 2000 2007

3.0

-0.7

-1.9

6.1

1.6

3.6

8.2

5.2

3.3

6.3

3.8

4.1

9.6

13.6

11.1

12.3

10.2

10.5

0.5

-0.2

-0.5

0.6

0.1

0.3

0.7

0.5

0.3

20012007

19811990

Service 19912000

20012007

*Measured as the ratio between employment growth rate and output growth rate. Source: China Statistical Yearbook (2008)

Figure 4 Employee Compensation

Percent of GDP

60

United States Japan China 40

Philippines 30 India

Sources: United Nations and MAPI calculation

perspective. Based on the GDP accounting identity,10 the trade balance equals the difference between domestic savings and investment, implying that savings not absorbed in investment at home will be directed abroad as a net capital outflow. The counterpart of a net capital outflow is an excess of export revenues not spent on imports.11 In China’s 10

The term “accounting identity” is used in economics to refer to equalities that are by definition. GDP by definition can be calculated by adding up all expenditures on goods and services, and the four main components are consumption expenditures by households (C), government purchases of goods and services (G), gross private investment spending principally by firms (I), and net exports (X-M). The equation to sum this up is GDP=C+G+I+X-M. 11 The expenditure approach to calculate GDP identifies GDP=C+G+I+X-M, and the term (GDP-C-G) is the output that remains after private and government expenditure and thus is called S, which is

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

20

2007

70

50

case, after entering the World Trade Organization (WTO) in 2000, its exports and imports both rose rapidly with imports growth outpacing exports growth until 2004. During this period, a rise in savings was paralleled by a rise in domestic investment, leaving a savings surplus, hence the trade surplus remained constant as a share of GDP at less than 3 percent. Increasingly concerned with the negative impacts from relying heavily on investment and exports, China’s top leaders formally called for a rebalancing of the country’s growth sources in 2004 and made it one of the top priorities in its 11th five-year plan (2006-2010) to promote household consumption, expand the service sector, and grow at a more sustainable and equitable pattern. Despite the government’s efforts to stimulate consumption and constrain investment spending in recent years, however, the share of savings in GDP has continued to rise although the investment share has edged down somewhat, leading to a widened savings-investment gap. Correspondingly, the trade surplus jumped to 5.6 percent of GDP in 2005 and continued to rise to 9.4 percent in 2007 (Figure 5). China’s rebalancing road has thus proven to be more challenging than initially expected. ER-681 June 2009

Understanding China’s High Savings and Low Consumption What causes China’s high savings rate has been a subject of controversy, but most researchers agree that frugal Chinese households, who save more than 20 percent of their disposable income, have played a key role (Figure 6). national savings. It is easy to get S-I=X-M by rewriting the above equation.

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and Junmin Wan, “The Determinants of Household Saving in China: A Dynamic Panel Analysis of Provincial Data,” January 2007, Journal of Money, Credit, and Banking, forthcoming; Aart Kraay, “Household Saving in China,” World Bank Economic Review, Vol. 14, No. 3, September 2000, pp. 545570. 14 For a detailed discussion about the impact of the demographic shifts, see Cliff Waldman, “China’s Demographic Destiny and Its Economic Implications,” Business Economics, Vol. 40, No. 4, pp. 32-45, October 2005. 15 “Pensions at a Glance: Asia/Pacific Edition,” OECD, 2008. 16 Shin-Yi, Chou, Jin-Tan Liu, and James Hammitt, “National Health Insurance and Precautionary Saving: Evidence From Taiwan,” Journal of Public Economics, No. 87, 2003; Adam Wagstaff and Menno Pradhan, “Health Insurance Impact on Health and Non Medical

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

Percent of GDP

Billions of U.S. Dollar

Empirical studies show evidence that ER-681 among a long list of factors that can affect Figure 5 June 2009 household consumption, lack of a social Exports, Imports and Trade Balance safety net and precautionary planning for 1,600 12 future uncertainties are particularly 10 relevant in China, while the impacts of 1,400 other long-run variables, such as cultural 8 1,200 factors, habit formation,12 and 6 1,000 demographic transitions triggered by 4 800 China’s one-child policy, appear to be 2 quantitatively small though not 600 0 negligible.13,14 In 2007, nearly 50 percent 400 -2 of urban and rural residents were not 200 -4 covered by any health insurance. 0 -6 China’s pension system covered less than 50 percent of employees in urban Exports Imports Trade Balance areas while the rural workforce was basically kept outside the national system. The majority of the rural people Sources: China’s Customs Statistics, United Nations age 60 and more depend on family support and less than old age insurance.15 International experience has the elimination of the risk of health expenditures already proven the effectiveness of the exceeding 20 percent of income would have comprehensive health insurance in reducing the lowered China’s median savings rate in 2005 by demand for precautionary savings and increasing 3.5 percentage points.17 current consumption.16 A recent study predicts that Although the household savings rate in China is high compared to other countries, it has varied only slightly for the past decade and cannot fully explain the 11 percentage points increase of the national 12 Habit formation theory believes that consumption savings in GDP since 2002. A breakdown of total reacts slowly to rising income so that savings rates savings by sector reveals that high savings by may still increase during a period of high income corporations contribute significantly to China’s growth. savings share increase in recent years. Based on 13 Loayza Norman, Klaus Schmidt-Hebbel, and Luis the latest available data, corporate savings Serven, “What Drives Private Saving Across the reached 19.7 percent of GDP in 2005, up from 11.6 World?” Review of Economics and Statistics, May percent in 2002 (Figure 7).18 This level is unusual 2000; Rhee Wooheon, “Habit Formation and not only by China’s own standard but also by Precautionary Saving: Evidence From the Korean international standards, even when compared to a Household Panel Studies,” Journal of Economic rapidly industrialized country like India (Table 2). A Development, Vol. 29, No. 2, pp.1-19; Yuji Horioka

Consumption in a Developing Country,” World Bank Policy Research Working Paper, No. 3563, 2005. 17 Marcos Chamon and Eswar Prasad, “Why are Saving Rates of Urban Households in China Rising?,” NBER Working Paper 14546, December 2008, http://www.nber.org/papers/w14546. 18 The data comes from flow of funds table reported by China’s National Bureau of Statistics. Release of these tables usually lags that of other macroeconomic aggregates by two years. In 2004, the method to calculate GDP was revised, resulting in a 17 percent increase in the product measure of GDP relative to the magnitude used previously. Some economists argue that the discrete leap in the share of enterprise savings since then is due largely to expanded statistical coverage of enterprise activity rather than to changes in enterprise behavior.

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Figure 6 Cross Country Comparison of Household Savings Rate

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Percent of Disposable Income

30 25 South Korea China 20 15 Japan

Germany

10 5 United States 2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

0

Sources: OECD Economic Outlook Database and China Statistical Yearbook (2008)

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Figure 7 Savings in China

Fixed Asset Investment in China

50

50 6.2

30

5.7

6.3

13.5

11.6

12.3 20

10

5.0

40 4.7

18.2

19.1

20.9 14.8

16.3

0

Percent of GDP

Percent of GDP

40

30

3.6

3.1

3.2

24.2

24.6

26.3

5.1

5.0

5.1

1998

2000

2002

28.5 20

10

9.2

0

1998 Household

2000

2002

Corporate

2005

Government

Household

Corporate

2005

reform era.20 On the other hand, stateowned and collective-owned enterprises, which still account for 40 percent of China’s total investment, have retained a bigger share of the rapidly growing earnings under very limited shareholdership and a tradition of low dividend payments.21 According to a recent study, in 2007 152 state-owned enterprises (SOEs) directly subordinate to the central government’s agency earned profits totaling more than 4 percent of GDP and, for most of them, the remittance rate to the government owners was set at just 5 percent of aftertax profits.22 The retained earnings are used to expand capacity and contribute to further investment by enterprise managers, who face little outside scrutiny and have the incentive to enlarge their own domain through investing.23 At the same time, China’s private companies tended to use internal sources to finance their future investment as well, rather than borrowing from banks, because China’s current financial system, which is dominated by state-owned banks and an equity market, give preference to big firms, most of which are large SOEs, and alternative financing mechanisms such as corporate bond markets are still far from mature. As a result, more than 50 percent of China’s total investment comes from self-generated funds, while the shares from bank lending and foreign capital have dropped significantly (Figure 8).

Government

Sources: China Statistical Yearbook and MAPI Calculation

recent report from the World Bank concludes that the high corporate savings rate is closely related to a higher share of investment in GDP and the steady rise in corporate profits.19 On the one hand, with the industry sector expanding quickly under the industry-led, capital-intensive growth strategy, a greater share of value added was generated from capital instead of labor. At the same time, Chinese corporations in general have improved their core profitability as they restructured themselves and have become more profit-oriented during the 19

Louis Kuijs, “How Will China’s Saving-Investment Balance Evolve?” World Bank Policy Research Working Paper 3958, July 2006.

20

In China, after-tax profits of the corporate sector rose by about 6 percent of GDP between 2003 and 2006. See “Corporate Saving and Investment: Recent Trends and Prospects,” OECD Economic Outlook 82, 2007. 21

In China, the state usually has a large ownership of the capital, especially for SOEs, and it did not start to collect dividends until 2007. 22 Barry Naughton, “SASAC and Rising Corporate Power in China,” China Leadership Monitor, No. 24, 2008. 23 For a detailed discussion, see Bert Hofman and Louis Kuijs, “A Note on Saving, Investment, and Profits of China's Enterprises,” Far Eastern Economic Review, October 2006.

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Table 2 Sectoral Composition of Gross Domestic Savings and Investment (percent of GDP) Household

China (2005)* Savings Investment India (2007) Savings Investment U.S. (2007) Savings Investment

Corporate

Government

Total

20.9 9.2

19.1 28.5

6.2 5.0

46.8 42.7

23.8 12.5

7.8 7.8

3.2 4.5

35.5 35.9

2.5 4.5

11.2 10.9

0.5 3.4

14.2 18.8

*The latest data available. Sources: China Statistical Yearbook (2008), Reserve Bank of India Annual Report (2007-2008), Bureau of Economic Analysis, U.S. Department of Commerce and MAPI calculations.

Percentage

on housing to the rise in savings rates among young households in China.24 ER-681 Figure 8 At the same time, Chinese June 2009 Source of Funds for Fixed Investment in China households have to put most of their savings in bank deposits as there are 100 very few alternative investment tools. 90 Their incomes from financial investment 80 are not only hurt by the lack of portfolio 70 diversification, but also by the low and 60 negative real returns on bank deposits 50 which are determined by China’s 40 exchange rate regime and the resulting 30 monetary policy impasse. China 20 adopted a fixed exchange rate regime 10 under which its currency was pegged to 0 the U.S. dollar before 2005. When 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 faced with a fast rising external surplus after 2002, the Chinese central bank Self-generated Funds Foreign Investment State Budget Bank Loans Others intervened heavily in the foreign exchange market by purchasing dollarSources: China Statistical Yearbook and MAPI Calculation denominated assets to maintain a relatively fixed nominal exchange rate China’s slow progress in financial system and prevent the RMB from appreciating too quickly. reform is another element that is widely believed to At the same time, it tried to use sterilization have impacted the behavior of households and instruments, such as issuing central bank bonds enterprises and exacerbate the imbalance between and raising reserve ratios, to control growth in the savings and investment. A direct way for China’s domestic monetary base and mop up extra liquidity financial system to stimulate household caused by the accumulation of official foreign consumption is to facilitate more consumer credit reserves, but it only achieved partial success due markets. China did not have consumer credit to the small size of the underdeveloped capital markets until 1997. By the end of 2008, household market and the ever-increasing sterilization costs. debt was only 20 percent of GDP, even lower than the 27 percent average level in emerging Asia (Figure 9). The positive and significant effect of greater credit availability on household consumption has been identified in India, and Chamon and Prasad (2008) attribute the higher prices and the stricter down payment requirements

24

Lekshmi R. Nair, “Financial Sector Liberalization and Household Savings in India,” Indian Institute of Capital Markets, 9th Capital Markets Conference Paper, 2006, and Chamon and Prasad, op. cit.

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Figure 9 International Comparison of Household Debt, 2007 100

Percent of GDP

80

60

40

20

0 U.S.

Japan

Korea

Taiwan

Thailand

Malaysia

Sources: IMF and People’s Bank of China

Figure 10 China’s Interest Rate and Inflation Rate

Percent Change (Year/Year)

8

1-Year Lending Rate

6 4

1-Year Deposit Rate

2 Consumer Price Index

0 -2

Producer Price Index

-4

Sources: IMF, International Financial Statistics, and The People’s Bank of China

The extra liquidity created high inflation pressure, but the central bank was reluctant to raise the benchmark interest rate, worrying that higher interest rates would attract more speculative capital inflows and further force official foreign exchange intervention. Therefore, although the benchmark deposit rate for savings accounts was raised steadily between 2002 and 2007, the increase was less than half of the pace for inflation over the same period, which caused decline in the real rate of return from 2.75 percent in 2002 to -0.6 percent in 2007 (Figure 10). The boom in China’s stock and housing markets during this period can be seen at least in part as a

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

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China’s Difficult Rebalancing Road Since 2005, the Chinese government has been putting more effort into ER-681 boosting domestic consumption and has June 2009 adopted a series of public policy measures to achieve the rebalancing goal. In 2007, government expenditures on social services increased from 0.9 percent of GDP in 2005 to 2.1 percent. Spending on education and health care reached 2.9 percent and 0.8 percent of GDP, respectively, up from 2.1 percent and 0.6 percent in 2005.25 By comparison, the United States spent more than 7 percent of GDP on social insurance in 2003, 5.9 percent and 6.9 percent of GDP on education and health care, respectively, in 2004.26 According to a recent evaluation report by the World Bank, China is on the right track to meet the targets laid out in the latest five-year plan (2005-2010) for expanding basic public services, and is even ahead of schedule in the areas of health protection, disease prevention, and education (Table 3).27 Other initiatives to raise household income, including elimination of agricultural taxes, reductions in the personal income tax, and increases in minimum wages, went into effect as 2008

China

response to the negative returns on bank deposits. When the stock market collapsed in late 2007 and the housing market started to correct itself due to monetary policy tightening, household savings unsurprisingly grew by 28 percent in 2008, more than three times faster than the growth rate in the previous year, despite a record low real return level (Figure 11). For Chinese enterprises, when the domestic inflation rate rises rapidly, the relative fixed corporate deposit rates they face imply low and even negative real rate of returns on their bank savings. It is, therefore, a rational choice for firms to reinvest their own retained earnings, even when the profit margin is thin.

25

China Statistical Yearbook (2006, 2008). Human Development Report 2007/2008, United Nations. 27 th “Mid-Term Evaluation of China’s 11 Five Year Plan,” World Bank, Report No. 46355-CN, December 2008. 26

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Table 3 Indicators for Improvements in China's Basic Public Services

Coverage Rate

2005

2007

Social Protection Basic Old Age Insurance (Urban, % of Urban Population) Unemployment Insurance (Urban, % of Urban Employment) Work Injury Insurance (Urban, % of Urban Employment) Minimum Living Standard Guarantee Program "Dibao" (Rural, % of Rural Population)

31.0 39.0 31.0 1.0

34.0 40.0 42.0 5.0

Health Protection Basic Medical Insurance (Urban, % of Urban Population) Medical Assistance Program (Urban, % of Urban Population) New Rural Cooperative Medical System (% of Rural Population) Medical Assistance Program (Rural, % of Rural Population)

25.0 0.3 30.0 1.5

29.0 0.9 70.0 5.0

Education Program Gross Enrollment of Senior High School* Gross Enrollment of Higher Education (College and Above)*

59.8 22.0

66.0 23.0

*Gross enrollment refers to the percentage of total number of students attending school to the population of school age students. Sources: World Bank, China Statistical Yearbook, and MAPI Calculation

Figure 11 China’s Saving Account and Equity Market 35 30 25

Billions of U.S. Dollar

Percent Change (Year/Year)

share in GDP has been kept relatively stable, households continue to hold back their consumption, and its share 4000 in GDP declined by a further 5 3500 percentage points by 2007. China thus relied more and more on external 3000 markets to support its high growth 2500 rate. Net exports accounted for 20 2000 percent of its expansion during 20052007, almost four times higher than 1500 the level in the early 2000s. The 1000 World Bank concluded that “there has 500 been little rebalancing away from industry and investment towards 0 services and consumption. This, in turn, has made it difficult to meet the objectives on energy efficiency, the environment, and reducing the external imbalances.”28 China’s policy initiatives have been criticized for being too modest to change its underlying growth dynamics. Although the absolute public expenditure on social protection and education has increased significantly in the past several years, its share of GDP is only about half of the average level in other developing countries, including countries in Southeast Asia. Nicholas Lardy, a senior fellow from the Peterson Institute for International

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20 15 10 5

Household Savings

Shanghai Stock Market Cap

Sources: IMF, People’s Bank of China, and MAPI Calculation

well in 2004. In 2007, a program was formally established to channel savings of centrally governed SOEs into public consumption spending via dividend payments to the state. Local governments are expected to use this as guidance and determine their own formulas for profit remittance from local state-owned firms. Despite all these efforts, however, China has experienced even more unbalanced growth since 2005, as shown by the widening gap between savings and investment. Although the investment

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

0

28

Ibid, p. 6.

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Economics, pointed out in a recent paper that the agricultural tax cut for rural residents was almost offset by the record increase in other taxes, and the reduction in the personal income tax would only increase household income by 0.13 percent of GDP in 2006, a trivial amount compared to the income tax cut equivalent to 3 percent of GDP that was enacted in the United States in 2001. The increase in the minimum wage, he concluded, would not likely have a significant positive effect on household consumption expenditures given the low ratio of the minimum wage to the average wage rate and the small share of the workforce earning the minimum wage.29 At the same time, the efforts to lower the retained earnings of Chinese firms were enhanced by the unification of corporate tax rates at a lower combined effective level which reduced the nominal tax rate for domestic firms from 33 percent to 15 percent. Additionally, several other tax policy changes rolled out after the global financial crisis intensified, including the deduction of capital spending from the base for the value-added tax, and the increased tax rebates for some exported products.30 The financial sector, which has witnessed drastic restructuring of the banking system and significant reduction of the non-performing loan ratios in recent years, is still waiting for further progress. In 2008, China’s financial market sophistication was ranked 109 out of 134 countries by the World Economic Forum, although its overall competitiveness was among the top 30. The low ranking was due to restrictions on capital flows, inadequate regulation of securities exchange, and concerns about the soundness of the banking sector. Related to the weakness is the need to strengthen private institutions, including protection of minority shareholders’ interests and stronger accounting and auditing standards.31 Another important area which many believe needs more rigorous policy actions is the exchange rate. In theory, a more flexible exchange rate policy will allow the central bank to raise interest rates to moderate the investment boom and, compared to other monetary policies such as credit controls, this tool is in general more direct and efficient. The appreciation of the renminbi (RMB) will increase competition from imports and 29

Nicholas Lardy, “China: Toward a ConsumptionDriven Growth Path,” Peterson Institute for International Economics, Policy Briefs, Number PR066, 2006. 30 The nominal tax rate for foreign-invested firms was 15 percent before the reform, compared to 33 percent for domestic firms. 31 World Economic Forum, “The Global Competitiveness Report 2008-2009,” 2008.

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concomitantly reduce competitiveness in export markets. In turn, this will not only reduce the growth of savings by stimulating household consumption and slowing down domestic output growth, but also help to resolve the global imbalance problem. China reformed its exchange rate regime in July 2005, switching from pegging its currency only to the U.S. dollar to referencing it to a basket of foreign currencies. The RMB had appreciated about 19 percent vis-à-vis the dollar32 and around 20 percent on a real effective basis since then (Figure 12).33 However, the share of exports in China’s GDP continued to increase during this period, and China accounted for a larger share in the U.S. trade deficit as well. Popular explanations for the relative unresponsiveness of trade to the exchange rate change include the insufficient appreciation of the RMB which could not cancel out the continuous depreciation of the U.S. dollar that happened before September 2008 and a much slower appreciation of the real effective exchange rate relative to its long-run equilibrium level.34,35 Therefore, the Chinese government is urged consistently by its trading partners to accelerate the pace of the currency appreciation and take

32

The RMB has been essentially stable since July 2008 in response to the dollar strengthening against other currencies. 33 Real effective exchange rate is usually defined as the weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country's currency, with each other country within the index. 34 Nicholas Lardy argued that the growth of productivity in China’s exporting sector was sufficiently high to absorb the effect of the rising value of the RMB. See Bergsten, C. Fred, Charles Freeman, Nicholas R. Lardy, and Derek J. Mitchell, “China's Rise: Challenges and Opportunities,” Peterson Institute for International Economics, 2008. 35 Another hypothesis is related with the triangular trade pattern formed in East Asia in the past decade, in which advanced countries in the region export capital and intermediate goods to China and ASEAN5 countries for further processing before exporting them to global markets. This trade model is more responsive to the patterns of global economic growth and less sensitive to the exchange rate changes compared with the traditional trade in final goods for domestic consumption. For a detailed discussion, see Yingying Xu, “Exchange Rate Readjustment and Expansion of Intra-Regional Trade in East Asia,” MAPI Economic Report 663, October 2008.

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130

Index, August 2005=100

125

RMB Appreciation

Real Effective Exchange Rate

120 115

Nominal Exchange Rate Versus US$ 110 105 100 95

Nominal Exchange Rate Versus Euro

Sources: Federal Reserve Bank of St. Louis and Bank for International Settlement

more significant steps in reducing its huge trade surplus. A recent study by Cline and Williamson concluded that the RMB needs to appreciate another 31 percent against the U.S. dollar and another 18 percent on a real effective basis to achieve the targeted change in the current account balance.36 Although there is no doubt about the necessity for China to appreciate its currency and eventually adopt a free floating regime, several scholars have indicated reservations as to how effective the currency appreciation is going to be in China’s current rebalancing efforts. Wing Thye Woo, a senior fellow from Brookings Institution, argued that higher interest rates linked to the currency appreciation will not necessarily reduce the investment demand in a partially reformed economy like China when SOEs can “privatize the profits from successful investments through accounting shenanigans and socialize their losses from unsuccessful investments through new bank loans.”37 In fact, the inability of using interest rates to affect investment was previously observed in China. In 2004, the central bank removed ceilings on loan rates, trying to encourage lending to smaller, more risky firms in the private sector by 36

William Cline and John Williamson, “New Estimates of Fundamental Equilibrium of Exchange Rates,” Policy Brief, PR08-7, Peterson Institute for International Economics, July 2008. 37 Wing Thye Woo, “Understanding the Sources of Friction in U.S.-China Trade Relations: The Exchange Rate Debate Diverts Attention from Optimum Adjustment,” Asian Economic Papers, Vol. 7, No. 3, Fall 2008, pp. 65-99.

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allowing banks to charge higher rates. However, banks were not very ER-681 responsive to the policy change and June 2009 remained reluctant to lend to private companies, mainly because of the slow improvement in the market mechanism to price the risk associated with those loans and the inadequate legal framework to protect banks from defaulted loans.38 Some economists even question the importance of investment reductions in affecting China’s savings-investment balance, arguing that the very success of the administrative restrains on investment39 is one critical factor behind the widened gap between savings and investment observed since 2004, Without a significant impact on consumption, exchange rate flexibility will not likely offer the desired resolution to China’s external imbalance.40 A report from the Asian Development Bank concluded that the real constraint to growth in Asia is not domestic savings per se, but the weakness in financial systems and the related legal and regulatory structure, which cannot efficiently transform savings into loans for education, housing, and private investment and pool social risks through financial instruments such as insurance covering medical care, pensions, and unemployment.41 This is consistent with Woo’s view that the growth of competitive domestic private banks should be the most important and efficient solution for China’s switch to a new growth engine.42 China’s real economy has been hard hit by the continued global turmoil and economic crisis, mainly through the freefall in global demand and the resulting weakness in market-based investment and sentiment, notably in the manufacturing sector. Apr-09

Figure 12 China’s Exchange Rate Movements

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38

In 2007, a standard rate system, Shanghai Interbank Offered Rates (SHIBOR), was introduced by the central bank, but so far it has not been widely accepted or used. 39 Including higher reserve ratio, credit quotas, and closing down of investment projects such as unauthorized development zones. 40 Calla Wiemer, “The Saving Story Behind China’s Trade Imbalance,,Working Paper, Lee Kuan Yew School of Public Policy, National University of Singapore, May 2008. 41 Shikha Jha, Eswar Prasad, and Akiko TeradaHagiwara, “Saving in Asia and Issues for Rebalancing Growth,” Asian Development Bank Working Paper No. 162, May 2009. 42 Wing Thye Woo, op. cit.

MAPI

Therefore, boosting domestic demand and domestic consumption is not only key for the medium-term objective of rebalancing, but also important in helping to dampen the alarming slowdown and prop up economic growth in the short term. Recently, there has been much talk that China should use the global economic crisis as a broad catalyst to accelerate the pace of reform, and some positive changes are already at work. China’s $586 billion stimulus package was revised earlier this year from the initial draft, and spending on technology innovation and social expenditures, including healthcare and education, will be doubled.43 In addition, more consumption-oriented measures, such as subsidies to rural household appliance purchases, are in progress, and a series of detailed plans have been announced to repair China’s ailing health care system and correct the distortions in natural resources pricing.44 The rebalancing progress, however, will not likely be fast or smooth. There is persistent resistance from many vested interest groups which benefit from the old growth model, thus pushing to preserve the status quo. The complexity of tasks lying ahead involves significant policy initiatives in many areas and necessary institutional reforms, such as removing barriers to private participation in service sectors. Multinational firms, which have made significant contributions in helping Chinese firms to produce products for the global market, will probably have to cooperate with Chinese firms in more creative ways to meet China’s huge internal growth potential. Both domestic and multinational firms will have to face a tougher business environment in China during the transitional period from an industry-led to a consumer-driven economy. In short, the transition from an investment- and export-led growth path to a more balanced one in which domestic consumption plays a more prominent role is likely to be a long one. American firms will have to be patient as the multiple initiatives outlined in this paper to achieve rebalancing in China take hold. Consequently, any hope for a near-term boost to American growth from a more robust consumer sector in China is likely to be disappointed.

43

Barry Naughton, “The Scramble to Maintain Growth,” China Leadership Monitor, No. 27, 2009. 44

A new fuel pricing mechanism was announced in May, under which prices would be adjusted if global crude prices fluctuate more than 4 percent over 22 straight working days. Benchmark prices of gasoline and diesel were raised by 7 percent to 8 percent on June 1.

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