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Can China's new leaders modernise its economy?

Michael Collins  |  12 Nov 2012Text size  Decrease  Increase  |  

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Michael Collins is an investment commentator with Fidelity Worldwide Investment, a global investment manager.


China's incoming leaders confront a fundamental economic challenge - how to generate new wealth to maintain political stability now that the export-driven, investment-led industrialisation of China is petering out as a formula for enriching China's masses.

Their answer is to morph the economy into one propelled by personal consumption, which only stands at about 35 per cent of GDP compared with about 70 per cent in developed countries such as the US and Australia.

It's a valid solution and one that sounds simple. But it's not. The economic challenges are only made more difficult because the social, legal and political settings needed to accompany reforms are missing under China's autocratic political system.

Shifting to a consumption-driven economy means correcting major mispricings on the key ingredients of economic growth, namely land, labour and capital. The underpricing of these resources is prompting China to spend about 50 per cent of its GDP on new capital stock, a level that is unsustainable as it leads to overcapacity, asset bubbles and banking troubles as dodgy loans mount.

At the same time, these mispricings have reduced the personal income to about 40 per cent of GDP from 53 per cent in 1999, compared with 57 per cent in the United States.

Untangling the mispricing of land, labour and money (namely the exchange rate and interest rates) increases the risk of an economic slump in China - there are no guarantees people will consume more to compensate for any drop in investment.

It will almost certainly set China on a path of lower sustainable economic growth because policymakers, mathematically, need to set GDP growth at a slower pace than consumption growth for consumer spending to become a bigger part of output (a process that implies low investment growth).

Authorities might even bungle into fresh mispricings. Another difficulty is that, to boost consumption, policymakers will have to adopt long-term free-market reforms that counteract the short-term investment boosts they are pursuing to insulate China from Europe's implosion.

Investment-led stimulus since the start of the global financial crisis in 2007 has lifted the share of investment in GDP by 5 percentage points, while the share of consumption has dropped by 2 percentage points over that time.

It must be said that some analysts reject, or downplay, the verdict that China's economic growth is wobbly, even though Chinese Prime Minister Wen Jiabao has said the country's structural problems are causing "unsteady, unbalanced, un-coordinated and unsustainable" development.

They say it's normal for economies at China's stage of maturity to have a low ratio of consumption to GDP. They predict the ratio will rise over time, without the government taking drastic action, as an improving social welfare system will promote spending over saving.

They say the goal for any government is to promote healthy consumption growth (which has been a robust 8 per cent per annum in recent years in China), not a high ratio of consumption to GDP.

While this analysis holds some truth and the government is investing more in public goods such as healthcare, education and social security, it's clear the government is fixing prices to favour the elite and business over the masses. They are thus denying the majority of Chinese their proper return from China's remarkable ascent.


Skewed for business

A key mispricing behind China's economic success is the policy to keep the yuan low. Cheaper exports have helped China become the world's biggest manufacturer and exporter and the largest hoarder of foreign exchange.

For the Chinese, the biggest cost of the low-yuan policy is that it reduces their living standards. China's leaders, in effect, are offering the world's shoppers bargains by ripping off their own consumers.

Another cost is that an undervalued yuan keeps inflation higher than otherwise because imports are more expensive than they should be and the government is adding to the money supply in China when it buys foreign exchange to cap the yuan's gains. Higher inflation tends to hit the poor hardest because it's more critical for them when necessities move out of their price range.

Another cost of the low-yuan policy that is relevant here is that China is squandering resources. Money is spent buying low-yielding US Treasuries rather than spent on social goods such as hospitals or on welfare transfers that would boost the quality of life of the population.

But allowing market forces to set the yuan's value presents challenges for Beijing (apart from large losses on the US$3.2 trillion worth of foreign assets). The one that concerns China's rulers the most is the political consequences if China's exporters lose sales, reduce production and add to the country's unofficial jobless rate of about 10 per cent.

Another obstacle is nakedly political. A higher yuan would upset the many politically influential, state and military-owned companies that export or compete against imports. The dilemma for Beijing's rulers is that these state-owned enterprises are almost slush funds of the Communist Party of China, as they provide cushy jobs and perks for party members while the military safeguards their power.