Beijing's facade of resilience

By John Lee

SYDNEY- Some analysts speculate that the turmoil caused by the global financial crisis presents an opportunity for the Chinese government to push ahead with fundamental economic reforms that will raise the importance of domestic consumption as a driver of economic growth.

This point of view ignores political reality. The current crisis makes it more difficult for the Chinese, not less, to pursue reforms given the political need to achieve high growth at all costs. As Premier Wen Jiabao reaffirmed at the post-National People's Congress (NPC) press briefing in March this year, "An 8% GDP [gross domestic product] expansion is the government's pledge and responsibility."

The major response to declining growth was the announcement of a 4 trillion yuan (US$586 billion) stimulus package in November 2008 to be spent over the next two years. As usual, provincial authorities will be the main entities that effectively oversee any stimulus spending. After the announcement was made, within a fortnight, provincial authorities submitted proposals worth approximately 10 trillion yuan.

For example, investment proposals worth 3 trillion yuan from Yunnan province and worth 2.3 trillion yuan from Guangdong province were received. Significantly, these proposals overwhelmingly consisted of big-ticket fixed-investment projects. The amount provincial authorities proposed to allocate to poverty alleviation and social welfare initiatives was small.

As Cao Honghui, a senior researcher at the Chinese Academy of Social Sciences (CASS) warned in commenting on the government stimulus, "Some projects are meant to serve the real needs of the regions [but] some are not based on realistic considerations, and others are merely efforts [by local governments] to angle money out of central authorities."

Beijing explained that the rationale behind the stimulus was to loosen credit and encourage state-owned banks to lend more as part of a more "proactive fiscal policy". This would, according to government officials, incite consumer spending and boost the economy. Yet, the fiscal stimulus plan relies heavily on bulking up China's state-led fixed investment strategy.

For example, massive infrastructure construction projects such as railways, roads and airports are being planned. Tax credits are to be given to businesses to buy machinery. Unfortunately, putting more and more money into a strategy that is becoming less and less effective will lead to more capital waste, which China can hardly afford. Even though 370 billion yuan was specifically allocated for rural China, most of it will be allocated to rural infrastructure building rather than direct social welfare. The stimulus plan is much more about maintaining employment and growth than it is about re-orientating China's economy towards a consumption-based one.

The beneficiaries of any stimulus will overwhelmingly be provincial governments who extend favors to state-owned and state-controlled enterprises (SOE). Indeed, official media have estimated that around 90% of any new lending will be directed towards state-controlled entities. Very little of the stimulus package will be used to create better conditions for private sector enterprises. The exception is tax rebates for export firms even though China remains far too dependent on exports for growth. The amount likely to go towards social welfare initiatives is also small. For example, housing for the poor was promoted as a major part of the stimulus when announced. In March 2009, Premier Wen confirmed that 7.5 million poor Chinese will be provided with housing over three years - a modest number.

To be fair, any stimulus package in the current environment is designed to alleviate any hard landing for the economy in the short term. But the package indicates that Beijing will continue to rely on dangerously high levels of fixed investment to achieve a softer landing, while it waits impatiently for the export market to recover. In just the first quarter of 2009, banks have extended a total of US$669 billion worth of loans, which is 93% of the government's initial target for the whole of 2009. This is 600% higher than the same time last year. Fixed investment in the first quarter of 2009 was up 28.8% compared to the same period in 2008. In urban regions, fixed investment was up 30.3% at the end of March 2009, compared to the same period in 2008. Commenting on the unprecedented increase in lending, Jiang Dingzhi, former Vice Chairman of the China Banking Regulatory Commission warned that 'the biggest dangers to China's economy and financial system come from within, not from outside,' adding that 'The biggest of these dangers is the degree of bad loans in China.'

The stubborn donkey of Chinese consumption
The belief that the current environment makes it more likely that Beijing will pursue fundamental economic reforms that will transform its economic growth model to one driven by consumption is wide off the mark.

Since the 1990s, there has been a saying that the Chinese economy has been pulled by two strong horses (fixed investment and exports) and one weak donkey (domestic consumption). Poor countries tend to devote about 60% of GDP to consumption. From 1978-89, domestic consumption as a proportion of GDP in China hovered above 50%. In the 1990s, it was at around 45% but has been declining since 2000. It is now at around 32%, by far the lowest of any major economy in the world. Even domestic consumption in India as a proportion of GDP is around 56%.

The trauma caused by the global financial crisis and the subsequent steep fall in GDP growth has brought renewed attention to the urgency of raising Chinese domestic demand. There is an overwhelming consensus among China's leaders and leading economists that China needs to increase domestic consumption in order to move towards a more balanced and sustainable economy. In particular, many are hoping that domestic consumption can take up the slack following the decline in exports.

As mentioned before, the GDP proportion share for domestic consumption is worryingly low with a downward trend. For example, it is estimated that even if just 10% of China's shoe exports were transferred to the domestic market, the whole shoe market in China would be saturated. More generally, one economist has calculated that if US savings rise and consumption decreases by a sum equal to 5% of US GDP, consumption in China would have to rise by a sum equal to 17% of Chinese GDP. Chinese leaders have been promising the creation of a demand-driven economy for a decade but with limited success so far. Nevertheless, more optimistic commentators put forward a number of reasons why the prospects for domestic consumption in China are good.

The first is the so-called "tiger in the cage" scenario: the world-beating saving habits of the Chinese. The national savings rate has reached almost 50% of total annual output. The idea is that the "tiger" (savings in banks) once released will lead to a tide of consumer spending that will take up any slack from the reduction in fiscal stimulus and also increase demand to reduce over-supply problems.

The problems with this position are threefold. First, savings are at such high levels largely because there are very few and poor provisions for social welfare, health, and old age. Only about one-seventh of the population, for example, is covered by basic health insurance, so many households save to cover medical expenses. Families save for retirement because the basic pension scheme covers only about 16% of the economically active population - and in any case provides a pension equal to just 20% of average wages. Households also save for education. Primary school fees are a large financial burden, particularly for poorer rural households. It is unlikely that rises in domestic consumption will provide a way out.

Second, the average disposable income of urban dwellers is about US$1,350 annually, growing at between 10-20% each year. In rural areas, it is about a third of that figure. It will be a long while before it is possible to reach the US$5,000 figure, the point at which discretionary spending is said to take off.

Third, the regime needs these savings in the bank because the banks need them to maintain liquidity ratios. As mentioned earlier, most of China's banks are only solvent because of the high savings rates. The government simply cannot afford massive withdrawals from the banks to fund a consumption-led growth.

Others believe that Chinese state-owned enterprises can become increasingly innovative and learn to make better use of capital. This, it is argued, would ensure a much more efficient and prosperous economy, the effects of which will eventually flow on to create the conditions for increased domestic consumption. But since moving towards a state-led development model from the 1990s onwards, total factor productivity (TFP) is diminishing in China. Various research studies, depending on sample and methodology, offer different results. But all clearly show a declining trend in TFP. For example, one report estimates that TFP grew annually by 3.26% from 1978-95, but slowed to 0.32% from 1995-2001. Another report shows that TFP grew annually by 3.83% from 1988-94 but declined to 0.52% from 1995 onwards.

Evidence shows that dramatic improvements in the use of capital are more indicative of hope than reality. As long as SOEs - which receive the lion's share of capital - are coddled and protected, they have no incentive to innovate. Moreover, too much capital is being denied to the private sector, which is much more likely to invest in innovation or invest innovatively. Even the most successful private sector firms tend to flat-line at around 30 employees because of capital restraints. In other words, capital that should be reserved for innovators in the private sector is instead increasingly wasted on inefficient state-owned businesses whose productivity is about half that of private industry both by aggregate and sector. Whereas in 1985-90, the private sector accounted for 20.7% of all fixed asset investment, in 1996-2000 it was only 13.9%.

Private firms with poor political connections need to rely on the informal lending market. A report by consultants McKinsey estimated that this was around US$100 billion in 2006. In 2009, the People's Bank of China estimated that it could be around US$300 billion. Even so, this is a relatively small proportion compared to loans by banks, and the most profitable private businesses continue to pay higher rates of interest on capital than inefficient state-owned businesses.

Clearly, the SOEs are consuming a rising proportion of the country's available capital and crowding out the private sector. During the past decade, there has been little evidence of SOEs changing their mindsets and taking the innovation route. Even the three or four of China's most profitable SOEs are far short of world class standards in terms of sustained innovation, performance and financials. Moreover, the capital denied to the private sector, which really is the cradle of innovation, is not measurable but surely significant.

In general terms, the Chinese political-economy is preventing the robust growth of domestic consumption even as GDP growth surges. As mentioned earlier, when the state supported the private sector in the 1980s, household incomes were rising across the board largely as one and with the tide. Once Beijing moved towards its current state-led model, the private sector bottom-up economy that offered the best hope for hundreds of millions to prosper suffered. Only a relatively small number of "insiders" thrived, and development as well as income growth became much more unequal. This is substantiated by the fact that between 1992 and 2003, China's household disposable income as a share of GDP fell 5%; and fell another 4% in 2004.

John Stuart Mill famously described the study of "political economy" as "the sources and conditions of wealth and material prosperity for aggregate bodies of human beings." The use of the term "aggregate" is crucial because it gets to the heart of why economic growth matters. It does so because it offers lifestyle improvements to the majority of the population. As the evidence shows, this is something better achieved through a bottom-up entrepreneurial model than a top-down statist one. The fact that domestic consumption has been dragging its feet for more than a decade is one manifestation of the limitations of the China's political-economy model.

Dr John Lee is a foreign policy fellow at the Center for Independent Studies in Sydney and a visiting fellow at the Hudson Institute in Washington. The fully revised and updated 2nd edition of his book, Will China Fail?, will be released next week by CIS.