For professional investors 27 January 2016 1 Chi on China Challenges to China s Consumption-led Growth To improve is to change; to be perfect is to change often. Winston Churchill SUMMARY China has had some initial success in shifting its economic structure to services from manufacturing. However, it has made far less progress in boosting private consumption. A key reason for this macroeconomic disconnect between surging services and lagging consumption is the rise in urban savings, despite robust per capita income growth. This reflects not only a lack of consumer confidence but also a legacy of decades of lopsided growth that has favoured output growth at the expense of labour compensation. Relaxing the household budget constraint through banking reform, among other structural reforms, may be an effective medium-term policy to boost private spending. Sunrise sectors, such as consumer staples, services, healthcare and software should shape China s new consumption landscape. China s tertiary sector out-grew the secondary sector in 2013 (Chart 1), showing a clear progress on economic structural rebalancing. After bottoming at 36% of GDP in 2010, the share of consumption has risen to 38%, while that of investment has peaked (Chart 2). The gains in services, as reflected by the tertiary sector, have been particularly strong in wholesale and retail trade, finance and real estate. The shift towards services will continue, broadening out to healthcare, education, IT services, domestic tourism and leisure and transportation. China s tertiary sector is expected to grow towards 60% of GDP from about 50% now in the next decade.
Challenges to China s consumption-led growth 27 January 2016 2 The unwilling consumer However, it is unclear if this expenditure-switching process will deepen, as China s consumers have remained unwilling to spend. While the GDP share of the tertiary sector has risen by almost 6 percentage points since 2010, the share of consumption has only risen by 2 percentage points. This gap represents a yawning household savings rate. China s urban savings rate has been rising on the back of strong per-capita income growth in recent years. This reflects a preference for precautionary saving over discretionary spending (Chart 3), and is a rational response by the majority of Chinese households to their uncertain future, which is not supported by a reliable social safety net. Given China s demographic structure, under-developed financial market and weak welfare state, high precautionary saving is likely to persist in the medium-term.
Challenges to China s consumption-led growth 27 January 2016 3 Saving for retirement has become an overriding objective for most workers. In the past, the Confucian tradition of filial piety meant that children were proxy savings vehicles, as they were expected to support their ageing parents. However, after more than three decades of one-child policy, retirees now cannot expect much support from their children, many of whom subscribe less assiduously to the Confucian tradition. Meanwhile, the country lacks a strong pension system to pick up the slack. Some observers also argue that workers are increasing their savings due to longer life expectancy and surging medical costs. From a macroeconomic perspective, this does not yet seem to be a crucial factor constraining consumption, as the share of spending out of disposable income on medical costs has not risen despite the rise in the absolute amount of medical spending (Chart 4). Labour income has shrunk One crucial macroeconomic factor hurting consumption may be the fall in the share of GDP represented by labour income (Chart 5), despite years of robust economic growth (until recently). This has eroded private consumption power, and is likely the result of China s lopsided growth model and financial repression.
Challenges to China s consumption-led growth 27 January 2016 4 More than 35 years of distorted industrial policy has favoured investment over labour income growth and relied on wage suppression to subsidise output and exports. Financial repression has boosted investment and output growth at the expense of Chinese household savings by suppressing its real rate of return to almost zero. Macroeconomic policies cannot address structural woes Cheap capital and low labour cost might be good for output growth but they have hurt household consumption. Thus, the structural imbalance that China must address is really between the income share of labour and that of other factors of production in the economy. Macroeconomic policies cannot resolve this structural woe to boost consumption effectively. This is already seen in the lack of improvement in growth, inflation expectations and consumption since 2014, despite rounds of monetary and fiscal policy stimulus. Monetary easing may even backfire on consumption, as households may save more to preserve their purchasing power in the face of declining returns on their savings. This may help explain why China s CPI and PPI inflation rates have kept falling, despite monetary easing, which has boosted asset bubbles instead of consumption. However, this is not to say that China s effort to switch from investment-led to consumption-led growth will fail. The young generation today is keenly aware of their quality of life and more inclined to consume than their parents were. When they become the main agents in the Chinese economy, i.e. when they reach middle-age, their consumption should be a much stronger driver of GDP growth. A medium-term remedy Beijing could pursue a different set of consumption-boosting policies to make that transition happen. One possible measure is to relax the household budget constraint, which has kept China in a cash-based economy. China s consumption potential has been constrained by its excessive saving behaviour. The household sector is a net creditor in the economy, with net assets amounting to more than 8% of GDP. The gross household debt-to-gdp ratio was only about 7% of GDP (Chart 6), compared to a massive 95% in the US and 66% in Japan in 2015.
Challenges to China s consumption-led growth 27 January 2016 5 The personal loan industry in China is under-developed (Chart 7). In 2015, consumer loans accounted for less than 19% of total bank loans. The bulk of personal loans were in the form of mortgages, which accounted for only 14% of all loans (while it was more than 100% in the US). Only 5% of people over the age of 15 in China had mortgage debt, and 8.2% had credit cards, compared to more than 33% and 61%, respectively, in the US. It is clear that Chinese households have plenty of room for borrowing to boost consumption. By developing the personal loan business through financial liberalisation, Beijing can effectively relax the household budget constraint by enabling intertemporal choice by individuals to boost consumption. A lesson from the US In the US, Pittsburgh, Chattanooga and other so called rust-belt cities have strived to revive themselves through the structural rebalancing of their economies from sunset to sunrise industries. And they provide a useful lesson: the importance of building and empowering the middle class, which is the primary demand driver for services, from health care and education to retail and entertainment. By successfully transforming their local economies in a way that would attract middle-class consumers, they built and improved public
Challenges to China s consumption-led growth 27 January 2016 6 infrastructure, the social safety net and education provision, as well as adding amenities, reducing crime and creating job opportunities along the way. China s consumption landscape will be totally different in the future, with the country becoming a global buyer rather than the global seller it is today. But this will take years. To facilitate the transition to consumption-led growth, China needs more banking and structural reforms and needs to raise labour income s share of the economy. It should also empower the middle class and accelerate urbanisation. Consumer staples, services, telecommunications, healthcare, education and software are some of the main economic sectors that will be shaping China s future consumption. Chi Lo Senior Economist, BNPP IP
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