Saturday, June 4, 2011

Rebalancing China's savings-investment imbalances

One of the biggest macroeconomic challenges for the world economy in the years ahead lies in the manner in which China's economic growth is managed as its economy moves into the next stage of growth.

Over the past decade-and-half, China's spectacular economic growth has pulled hundreds of millions of Chinese out of poverty and provided the engine for global economic growth itself. This growth was was driven by a massive export-led industrial and infrastructure investment boom, that channelized the very high domestic savings rate and huge foreign direct investments.

Whenever, economy threatened to slowdown the government further boosted its fixed investment share of the GDP. In fact, the decline in exports during the recent global recession, the government increased the fixed-investment share of GDP from 42% to 47%, and increased further in 2010-2011, to almost 50%. Nouriel Roubini who feels that such growth is unsustainable, describes the results

"No country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

Commercial and high-end residential investment has been excessive, automobile capacity has outstripped even the recent surge in sales, and overcapacity in steel, cement, and other manufacturing sectors is increasing further. In the short run, the investment boom will fuel inflation, owing to the highly resource-intensive character of growth. But overcapacity will lead inevitably to serious deflationary pressures, starting with the manufacturing and real-estate sectors."

The only way out of this is to prune down investments and increase domestic consumption, which remains the lowest among any major economy. I have blogged earlier about China's savings paradox (massive savings, when interest rates are so low) which has generally been attributed to the uncertainty Chinese feel about their income and the market-oriented nature of Chinese reforms. It has been argued that an extensive social safety net, universal medical insurance, reduced cost of higher education, and expansion of public services would lower the uncertainty and get Chinese consumers to spend more.

However Roubini feels the challenge goes beyond this, and requires more fundamental structural changes. He argues that these structural factors contribute towards a massive transfer of wealth from households (through their savings) to corporate sector. It is natural that domestic consumption was just 35% last year, since the share of GDP going to household sector is less than 50%, again among the lowest in all major economies. These structural factors and their impacts are

1. Low interest rates - means that the returns for savings are very low, and corporates enjoy negative real rate on their borrowings. This constitutes one of the biggest direct transfer of spending power from savers to borrowers or households to corporates.

2. Artificially deflated exchange rate - Works in two dimensions. One, it increases export competitiveness. It encourages businesses, already benefitting from artificially suppressed wages and lower cost of capital, to over-invest in facilities for exports. A build-up of imbalances and excesses in export-oriented manufacturing is the result. Two, it lowers import competitiveness. Therefore, domestic consumers are prevented from enjoying cheaper imports and are forced to pay higher prices to buy lower quality domestically manufactured goods. This adds an inflationary dimension to the consumers spending, thereby reducing their real effective purchasing power.

3. Low rate of corporate taxation - This too keeps the cost of production artificially low. Higher taxes would generate higher revenues, which could be used to fund a comprehensive social safety and welfare system, besides expanding the coverage of public services. This also would dis-incentivize over-investments, apart from transferring wealth from coporates to governments and then to consumers.

4. Low wage growth - Labour repression, with policies like the household registration (hukou) system and overt arm-twisting of labor groups, have kept labour wages low. Businesses benefit by way of lower cost of production, whereas workers do not get to share proportionately the gains of higher economic growth.

5. Repressed financial markets - This is one of the most under-stated and less discussed issues, and a critical determinant of how China addresses its structural challenges. Greater depth and breadth to its financial markets would provide much higher returns to savers, who could then use it to increase their purchasing power. It would also provide a more efficient channel for the Chinese government to raise resources and invest their surpluses.

Roubini has some doomsday predictions for the Chinese economy,

"But boosting the share of income that goes to the household sector could be hugely disruptive, as it could bankrupt a large number of SOEs, export-oriented firms, and provincial governments, all of which are politically powerful. As a result, China will invest even more under the current Five-Year Plan. Continuing down the investment-led growth path will exacerbate the visible glut of capacity in manufacturing, real estate, and infrastructure, and thus will intensify the coming economic slowdown once further fixed-investment growth becomes impossible."

In this context, the findings of a recent NBER working paper by Barry Eichengreen and others on economic slowdowns in fast-growing economies is instructive. They use international data since 1957 and find that

"International experience suggests that rapid-growing catch-up economies slow down significantly, in the sense that the growth rate downshifts by at least 2 percentage points, when their per capita incomes reach around $17,000 US in year-2005 constant international prices, a level that China should achieve on or soon after 2015. Our estimates suggest that high growth slows down when the share of employment in manufacturing is 23 per cent; while current data on employment shares in China are not readily available, observation and extrapolation suggest that China is nearly there. Our estimates similarly suggest that growth slows when income per capita in the late-developing country reaches 57 per cent of that in the country that defines the technological frontier, a level that China is likely to reach only somewhat later... Most provocatively, slowdowns are more likely and occur at lower per capita incomes in countries that maintain undervalued exchange rates and have low consumption shares of GDP."

They find that countries which are more open to trade are able to maintain higher growth rates for a longer period of time. However, higher old-age dependency ratios make growth slowdown more likely, and China will have a higher old-age dependency ratio in the not-too-distant future.

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