We started this series last year with a description of the economic challenge facing China. The very process of tripling the size of such a large economy in such a short time period has created structural imbalances that, in my opinion, will significantly lower China’s ability to keep growing at such high rates. This is perplexing both because of the scale of the Chinese economy and the worldview underlying its architects’ vision. The economic growth has been primarily through two channels: first, exporting cheap labor as the production “factory” of the world, and second, government-directed investment in the buildings, factories, and land development of China itself. Conspicuously shrinking has been the Chinese consumer, whose share of China’s Gross Domestic Product (GDP) has fallen from 50 percent to closer to 30 percent (compared to 71 percent in the United States). See Figure 1.
To the extent China hopes to keep growing, it must find a way to grow the three main economic drivers — net exports, investment and consumption. Most analysts agree that it is going to be difficult for China to grow its exports if demand is shrinking in the United States and Europe. And investments in more buildings, factories and land development already comprise the lion’s share of GDP growth. Three recent headlines point to the major challenge China faces to increase its domestic investments: high-speed rail disasters, scaling back of electric car programs and falling real estate prices. That leaves the Chinese consumer as the last great hope to sustain the country’s economic growth rate.
The China-bull story focuses on consumer potential — the absolute size of the consumer market (1.3 billion people), the potential for growth based on rising wages, the potential to close the purchasing power parity gap, etc. Yet, the consumer has been shrinking as a percentage of China’s economy (meaning net exports and investment have been growing dramatically faster). To achieve consumer-led GDP growth, consumption would have to start significantly outpacing the growth rate in exports and investment.
Chinese consumers have been paying the freight
The price of hyper economic growth has been paid by Chinese consumers in three principal ways that do not appear likely to change, particularly in the medium term. Importantly, each of these reduces consumer purchasing power. First, export growth and corporate profits (translate: government profits) have come through productivity gains without proportionally increased inflation-adjusted wages. Next, government-controlled exchange rates of the Yuan create domestic inflation and reduce spending power for imports. Finally, government-mandated deposit/lending rates at the banks artificially depress the interest paid on consumer savings.
Banking system and investment GDP are a tax on consumers
For a number of reasons, the Chinese are huge savers. Saving 30 to 40 percent of income is not uncommon. Lack of a basic social safety net such as Social Security or Medicare drives much of the financial uncertainty that is addressed through savings. Demographics (taking care of aging parents, one-child policy) and job prospects even for the college-educated are dim. Limited access to consumer financing and higher mortgage down payments also force savings. So, due to capital controls, there are only three primary parking places for those savings to be invested: real estate, Chinese stocks and bank accounts. Real estate is still unattainable for most (and showing major price declines currently), the Chinese stock market is considered too risky, and that leaves the banks.
Remember the “investment” part of the equation in China’s GDP growth? The GDP gains driven by investment in manufacturing capacity, buildings, residential real estate, etc. have been funded by bank loans. In essence, Chinese consumers are massive savers but the government limits what they can earn on their savings while directing the banks to lend money at artificially low rates to create GDP growth through investment. According to Michael Pettis, a professor at Peking University, in China, “bank lending is not so much growth, as diverting wealth from households to banks.”
How would a banking collapse affect Chinese consumers?
While financial information can sometimes be unreliable, many experts believe that a significant amount of the “investment” part of Chinese GDP may have been going down an economic sinkhole the last few years. If a large amount of the investment GDP ends up as bad loans at the government-run banks, the savings of hundreds of millions of Chinese consumers could be impacted. In two previous periods, ending in 1999 and then again in 2004, bad loans at the state-controlled banks were “repackaged” and moved to special purpose vehicles. The write-downs were never taken, but the cash is gone (estimates were that more than 30 percent of loans were bad). Currently, the total debt in the system is exponentially higher. It is unclear if the government would be able to paper over another massive bad debt cycle. Even setting aside the bad debt situation, it is possible that current consumption is flat or even declining, given the decline in real estate values and no wages as some factories are idled.
The Chinese government knows the consumer is the big issue
In each of its five-year plans, the Chinese government discussed the need for growing the consumer share of GDP. Their most recent plan is no exception, as Premier Wen discussed measures aimed at liberalizing interest rates, boosting social spending on education and healthcare, and lowering income taxes. They’ve been working on this over time and it appears the only way to grow top line GDP is through mechanisms that limit the growth of China’s consumers. As Pettis writes, “In the past decade, consumption has grown annually by between 6 and 9 percent, and I very much doubt it will ever exceed that number. It is hard to see how it could until there is a recognition that household consumption cannot grow as a share of GDP until the conditions that repressed household income growth — the widening differential between wages and productivity growth, low deposit and lending rates, and an undervalued currency — are reversed, which will be very painful for businesses and governments addicted to the huge implicit subsidies to growth and investment.”
So, if consumer spending were to grow by 10 percent (which is extraordinarily high by historical measures) and the consumer share of GDP is 35 percent, that means China would get 3.5 percent GDP growth, if net exports and investment stayed constant. As discussed previously, just keeping pace in net exports and investment will be a difficult task in the global economy going forward. Additionally, the policies needed to enable their consumer spending to grow at 10 percent would likely shrink the other two components. If, as many experts believe, it takes 5 to 6 percent GDP growth to avoid potential economic upheaval and social unrest in China, the adjustment may be a long and painful process. In the final article, we will discuss several potential “roads that might be travelled” as the China growth story continues to unfold.