Fundamental Problems in the Chinese Economy (I)

By Tianlun Jian

China's economic data has dismayed investors and economists since last year.  The HSBC Purchasing Index (PMI) posted 47.9 in September, signaling an eleven month-on-month deterioration in China's manufacturing sector. Industrial output in August rose at the slowest rate in three years, and profits in the industrial sector declined 6.2 percent in August vs. a year ago, according to China's National Bureau of Statistics.

The Asian Development Bank has lowered its 2012 GDP estimate for China to 7.7 percent from 8.5 percent projected in April. Likewise, the World Bank and IMF have also lowered their forecasts for China’s 2012 GDP growth to 7.7 percent and 7.8 percent, respectively. Now no economists seem to forecast a 10 percent growth rate – a rate that many economists would take for granted for China just two years ago.

China’s Economic Turnpike Is Ending

Is this a temporary pause or China's economy is taking a turn?  What has led such a change?

Personally, I think such a change has been set long ago.  Just like it was set off on an economic turnpike and now it comes to an end. Current economic problems are directly linked to China's macroeconomic policies, and its income distribution system.  Yet both have been set to serve the political interests of the Chinese Communist Party. Why?

China's economic reform began with Deng Xiaoping's slogan "Let some people get rich first." Later on, "Developing is of overriding importance" and "Maintaining stability is of top priority" were added. All were meant to preserve the rule of the Chinese Communist Party. And Chinese macro policies have been set accordingly.

So since the economic reforms, especially during the past two decades, the communist regime has set high growth rate as the top priority. Its economy has since grown at an average 10 percent annual rate. And the high GDP was achieved primarily through high exports and high investment. But now neither exports nor investments can support China’s growth any more.

Macro Policies Twisted Income Distribution

While high growth in exports has been associated with its trade policies and undervaluation of rmb, high investment is a direct result of extremely low real interest rates. Between 2003 and 2011, the average real interest rate on deposits was about zero. This means whoever gets loans from banks get money for free.

Yet most loans in China have been allocated to state-owned enterprises, and in the past decade, also to local governments and land developers.  Throughout the years, such low interest rates in effect enable the transfer of vast savings freely to the government and corporations, primarily the state-owned companies. The zero real interest rates automatically made Chinese depositors provide such subsidies. 

Consequently, governments, large corporations, state-owned enterprises accumulate lots of wealth in the process. Returns on capital investment have been high in the past decades. In particular, as housing prices have increased over ten percent for several years, land developers and real estate companies made a huge fortune.

Many richest Chinese are associated with real estate.  Local governments also increased their revenue by selling land. Revenue from land sales have increased to account for 30-50 percent of local fiscal revenue. Local governments are so happy to see housing prices going up for they shall be able to sell land at a higher price.

Macro Policies Widened Income Gaps

In the past decade China's housing prices have more than doubled (Graph 1). This further widens the income gap.

The rich -- corporation CEOs, senior management of state-owned enterprises and government officials, increase their wealth benefiting from the soaring housing prices, because many of them have multiple houses. According to the Survey Report on China's Family Financial Situation, the top ten percentile income group own 85 percent of China's family assets. 

The poor, on the other hand, have to put all their savings to buy their first house and still are heavily burdened by the mortgages, becoming what they call "house slave" -- spending most their income on mortgages.

Therefore, as long as the housing bubble grows, consumption for the mass -- “house slaves” and “house slaves to be” will only decline.

The macro policy chain -- currency undervaluation, low interest rates, high investment, high housing prices have driven up exports and investment at the expense of consumption.  Without changing the current macro policy, sustained growth through consumption is only empty words.

Macro Policies Drove Down Consumption Share

As housing prices are going through the roof, people in need of housing use up all their lifetime savings to purchase houses. Many end up with huge sum of mortgages such that most of their monthly income has to be used to pay mortgages, leaving little left for consumption.

This, in part, explains why the share of private consumption of GDP has spiraled down, and accelerated in the last two decades.  China's consumption share of GDP went down from 47 percent in 1990 to 34 percent in 2011.  (Graph 2)

Many people thought that China's low consumption share is due to Chinese high savings habit, on top of the three heavy burdens on individuals: education expenses, health insurance, and pension.  This, however, is only part of the picture. 

According to the most recent published Survey Report on China's Family Financial Situation, 75 percent of China's savings comes from the top ten percentile income group of the population. About half of the Chinese population have only limited or no savings.  If the vast majority does not have much savings, their income would be spent only on daily necessities. They simply do not have enough money to spend. This is probably the main reason why China’s consumption share of GDP has continued declining.