China: Beyond the Miracle (The Complete Series)

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Emerging Markets Research March 2013

China: Beyond the miracle Yiping Huang, Jian Chang, Steven Lingxiu Yang

PLEASE REFER TO THE LAST PAGE FOR ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES.

Barclays | China: Beyond the Miracle

FOREWORD China has become a key locomotive for global growth, in many ways taking over the role traditionally played by the United States in business cycles. It is now the world’s second largest economy, and has grown much faster than any other major economy over the past couple of decades. China’s role as a key driver of global growth brings with it increased scrutiny by investors and economists: a significant slowdown in China – never mind a collapse - would have significant implications for economies and financial markets around the world. This was most recently seen in 2012, when slower economic growth – fostered in large part by policy tightening to alleviate inflation pressures and structural imbalances – generated fears of a “hard landing” that served as a headwind to financial market performance for much of last year. The extremely rapid growth in China – as welcome as it has been during an otherwise disappointing recovery from the Great Recession – represents the first stage of development in the evolution of the economy from closed to open, from fully controlled to market, and from agrarian to industrial. This initial stage is already giving way to a new phase of slower, more sustainable growth, with different drivers. It is critical for the global economy and financial markets that China’s transition is managed in a way that allows the necessary adjustments to happen gradually and without de-stabilizing effects. The Beyond the Miracle series - written by Yiping Huang, Jian Chang and Steven Lingxiu Yang and launched in September 2011 - carefully analyzes the transition that China is undergoing from various perspectives, and also discusses the economic and financial market implications. It argues that China will successfully make the transition from ‘economic miracle’ to normal development in the next decade (Chapter 1). But there is an important caveat: China must embark on a multi-pronged set of reforms if the country is to move to a slower, more sustainable growth rate that deemphasizes trade, construction and investment and instead places a greater weight on consumer spending as a source of growth. Each chapter provides an in-depth analysis of the task at hand – from financial reform (Chapter 2), to housing reform (Chapter 3), to the pivotal role of consumption in rebalancing China’s economy (Chapter 4). For China to avoid becoming a source of inflation in the future, its monetary policy-making, too, will need to be reformed (Chapter 5). China’s ageing population will also mean an end to its surplus of cheap labor, heralding a new era of rapidly rising wages (Chapter 6). In turn, this could put additional pressure on the country’s fiscal outlook, as it seeks to meet growing pension liabilities (Chapter 8). March 2013

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Barclays | China: Beyond the Miracle These challenges notwithstanding, the Beyond the Miracle series is optimistic on the outlook for China. It argues that the Chinese economy is in the middle of a major and broad-based structural transformation that will lead the country to a more sustainable growth potential of 6-8%, from a double-digit pace previously. As China continues to grow and upgrade, its outward direct investment should rise quickly (Chapter 7). And by narrowing the technological gap with the advanced economies, China should be able to avoid the “middle income trap” and graduate to the global high-income group within the next decade (Chapter 9). China’s Beyond the Miracle series is ambitious, both in scope and depth. Given the critical role now played by China in the world economy and financial markets, I highly recommend it as essential reading for investors, as well as anyone interested in current and future economic and market trends.

Larry Kantor Head of Research, Barclays

March 2013

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Barclays | China: Beyond the Miracle

CONTENTS Chapter 1: China’s next transition ......................................................... 5 Emerging economic trends ............................................................................................................ 6 The making of an economic miracle .......................................................................................... 10 Distortions in factor markets ....................................................................................................... 17 Remarkable successes and growing risks ................................................................................. 25 Why the next five years might be different ............................................................................... 29 The great rebalancing .................................................................................................................... 33

Chapter 2: The coming financial revolution...................................... 36 The revolution that needs to happen ......................................................................................... 37 How has the financial system evolved? ..................................................................................... 41 Repressive policies are now retarding growth in China ......................................................... 46 Growing financial and economic risks ....................................................................................... 49 The needed financial reforms ...................................................................................................... 53 Policy and market implications ................................................................................................... 63

Chapter 3: Bubble deflation, Chinese style ........................................ 67 Policy-induced correction ............................................................................................................. 67 Making of property bubbles ......................................................................................................... 71 How serious are property bubbles in China? ............................................................................ 75 Why hasn’t the Chinese ‘bubble’ burst? .................................................................................... 78 These favourable conditions could turn negative soon ......................................................... 82 How might bubble deflation play out in China? ...................................................................... 86 Policy and market implications ................................................................................................... 99

Chapter 4: The great wave of consumption upgrading .............. 101 Weak consumption in a strong economy ...............................................................................102 Common explanations for China’s weak consumption .......................................................104 Controversies surrounding consumption statistics ..............................................................108 Recalculating China’s consumption share of GDP ................................................................112 Will consumption improvement be sustained? .....................................................................119 A strong case for consumption upgrades...............................................................................122 Policy and market implications .................................................................................................126

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Barclays | China: Beyond the Miracle

Chapter 5: Understanding Chinese inflation .................................. 130 Has inflation really peaked? ........................................................................................................132 Reliability of Chinese inflation statistics...................................................................................134 What determines Chinese inflation?.........................................................................................138 The making of monetary policy.................................................................................................150 Rising inflation risks for China and the world.........................................................................162

Chapter 6: The consequences of demographic change ............. 165 The one-child policy .....................................................................................................................166 Gender imbalance might stimulate growth? ..........................................................................170 Will China grow old before it gets rich? ...................................................................................176 The Lewis turning point – end of surplus labour? .................................................................193 Demographics pose new challenges, but unlikely to derail growth .................................205

Chapter 7: Will China buy up the world? ........................................ 210 A new giant investor on the global stage ................................................................................211 Some “stylised” facts about Chinese ODI ...............................................................................214 Economic literature on ODI motivation ...................................................................................219 Why Chinese companies invest overseas?..............................................................................223 American, Japanese and Chinese models of ODI ..................................................................230 Outlooks, challenges and policies .............................................................................................234

Chapter 8: Can China manage its fiscal risks? ............................... 240 Mixed picture for China’s fiscal outlook ..................................................................................242 Fiscal decentralisation, Chinese style .......................................................................................245 Local government debt the biggest medium-term risk .......................................................254 Pension liability the biggest long-term risk.............................................................................266 Overall assessment and investment implications .................................................................271

Chapter 9: Can China avoid the middle-income trap? ................ 278 China’s new growth challenge ..................................................................................................280 Lessons from the other countries .............................................................................................283 Underappreciated structural improvement ............................................................................286 Political and economic reforms .................................................................................................293 Early takeoff of science & technology ......................................................................................298 What could derail the growth train? .........................................................................................304 Toward a high-income economy ..............................................................................................306 March 2013

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Barclays | China: Beyond the Miracle

CHAPTER 1

China’s next transition

• This is the first in a series of reports titled China: Beyond the Miracle that will analyse the major structural issues facing the Chinese economy.

• We think China is about to experience a transition from ‘economic miracle’ to what can be considered normal development in the next five to ten years. This process will not only transform the Chinese economy, but will also have significant implications for the rest of the world.

• The key to the upcoming transition lies in the anticipated reform of factor

markets, including rapid wage growth, interest rate and exchange rate liberalisation, and market-based resource prices.

• We identify a number of important trends that will emerge during the transition

process. Growth is likely to moderate steadily, economic cycles will probably become more violent, and inflation pressures could escalate, as a result of widespread increases in factor costs.

• Industrial upgrading is likely to accelerate, with a rapid move into high value-

added manufacturing and service sectors, and faster development of inland provinces. We also expect income distribution to improve.

• The economy should see the beginning of great rebalancing, which is likely to mean an end to investment-led growth but much stronger consumption. As a result, demand for commodities could slow.

• China will likely achieve basic convertibility of the capital account over the next five years, and its capital outflows are likely to primarily take the form of direct and portfolio investment.

This article was originally published on 5 September 2011.

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Barclays | China: Beyond the Miracle

Emerging economic trends As economies show visible signs of weakening trends around the world, market participants, economists and policymakers are again looking for likely policy actions by the Chinese government. We think China probably would respond quickly if global economic conditions deteriorated sharply. However, it probably will not be able to repeat the action it took three years ago at the height of the global financial crisis, given elevated inflation, large local government borrowing, an expected deterioration in the quality of banking assets, worsened structural imbalances and the upcoming leadership transition. Beyond short-term cyclical considerations, the biggest challenge facing Chinese policymakers is how to transform the economic development pattern, as identified by the 12th Five-Year Program (FYP). Some market participants are sceptical that China can ever achieve this policy objective. Since the government failed to improve the growth model during the 11th FYP, why should it be different this time? The current economic development pattern, however, is no longer sustainable. Despite China’s great success in achieving rapid growth during the past decades, its economy has developed a number of structural problems, including a high investment ratio, large current account surplus, unequal income distribution, high resource intensity, serious environmental degradation and widespread corruption. The Politburo meeting in lateJuly 2011 also reiterated its concerns about China’s uncoordinated, unbalanced and unsustainable development pattern. Many of these structural problems have worsened sharply since the global financial crisis as a result of the aggressive fiscal and monetary expansion implemented to support economic growth. Investment’s share of GDP, for instance, rose from 41.7% in 2007 to 48.5% in 2010 (see Figure 1). Asset bubbles and excess capacity have become more serious and widespread (see Figure 2), and prompted many predictions of a hard landing. For instance, James Chanos, founder of Kynikos Associates, a New York-based investment company, has predicted a slump due to excessive property investment in China. Similarly, James Rikards, former General Counsel of hedge fund Long-Term Capital Management, warned that China was in the midst of “the greatest bubble in history”.

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Barclays | China: Beyond the Miracle FIGURE 1 GDP: Unsustainable investment-led growth

FIGURE 2 Continued build-up of a property bubble

100

25

80

20

60

15

40

10

20 0 Investment Private consumption Government consumption Net export -20 1980 1985 1990 1995 2000 2005 2010

Source: CEIC, Barclays Research

House price/household income

5 0 Mar-07

Mar-08 Shang hai

Mar-09 Beijing

Mar-10

Mar-11

Guang zhou

Note: We assume an average house size of 70 sqm. Source: CEIC, Wind, Barclays Research

While acknowledging these serious – and even worsening – structural risks, we do not see a high probability of a hard landing or a fiscal/financial crisis in the near term. In our view, the pessimists are wrong on at least two fronts. One, they often underestimate the flexibility and resilience of the policy regime. Chinese policymakers have proved their ability to respond and adjust in the face of crisis risks, as evidenced by their decision to adopt the household farming system at the beginning of the 1980s, to privatise lossmaking state-owned enterprises (SOEs) in the mid-1990s and to enter the WTO at the beginning of the century, despite strong political resistance to these changes. Secondly, in predicting a hard landing, the pessimists ignore the still-healthy balance sheets of households, corporates, banks in China, and the external economy and government. For instance, mortgage loans in early 2011 amounted to only c.13% of banks’ total outstanding loans. These loans are also equivalent to less than 20% of GDP and less than total household savings (see Figure 3). This implies that, even if house prices decline, we are unlikely to see forced and widespread deleveraging that could lead to a meltdown of the financial system and economic activity. Again, public debts are equivalent to only c.18% of GDP. Even after including local government debt (27% of GDP reported by NAO), it remains below the 60% international warning line (see Figure 4). Fiscal revenues have been growing at a rate of 20-30% pa for years. The government also has massive assets, including state-owned ones totalling CNY207.8trn, equivalent to more than six times annual GDP (CNY33.7trn). Clearly, this suggests that government solvency is not at risk in the near term.

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Barclays | China: Beyond the Miracle FIGURE 3 Chinese households, not that leveraged

FIGURE 4 Chinese government debt, still manageable 250

20

Public Debt/GDP, as end of 2010 (%)

18 200

16 14

150

12 10

100

8 6 Jun-05

50

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Mortgage/total outstanding loan (%) Mortgage/GDP (%)

Note: Majority of household debt is mortgages. Source: CEIC, Barclays Research

0 CHN

IND

JPN

USA

DEU

FRA

GBR

ITA

Note: China’s figure includes both official public debt and local government debt. Source: IMF, National Audit Office (NAO), Barclays Research

But that does not mean the structural problems can continue for a long time. If China fails to transform its development pattern over the next five years, then the risks of a major crisis could increase exponentially. In the past, the government always stretched the financial and fiscal systems to contain near-term downside risks. But there is a limit to how much longer this approach can be employed. After the Asian financial crisis, for instance, it took years for China to reduce nonperforming loan levels and contingent fiscal liabilities. But China may not always have the luxury of a long ‘adjustment period’ to deal with such problems. Whether or not China is able to transform its development pattern is critical for growth sustainability. There are many economies in the world, most notably in Latin America, that achieved a successful takeoff in the immediate post-war period but then failed to sustain growth, falling into the so-called ‘middle-income trap’. This is not our base-case scenario for China. We believe China will be able to gradually change its growth model, rebalance its economy and reduce inefficiency over the next 5-10 years. The key will be the reform of factor markets. By providing extra incentives for producers, investors and exporters, factor cost distortions have been an important force driving China’s strong economic growth in past decades. These same forces have also created serious structural problems, such as economic imbalances, huge commodity consumption and various types of inefficiencies.

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Barclays | China: Beyond the Miracle FIGURE 6 The still distorted energy price signal

FIGURE 5 Migrant workers salaries have been rising rapidly 350

Migrant workers' monthly salary (CNY, 1978p) Real salary

300

Polynominal trend

60

60

58

55

56

50

54

250

45

52

40

50

200

35

48

150 100

46

30

44

25

42 Jun-01

50 1980

1985

1990

1995

2000

2005

2010

Source: Lu Feng, "Employment expansion and wage growth (2001-2010)", China Macroeconomic Research Center, Peking University, Beijing, 12 June 2011

Jun-03 Jun-05 Jun-07 Jun-09 Electricity price for resident (CNY/100kwh)

20 Jun-11

Coal price for resident, 1st grade (CNY/100kg, RHS)

Source: CEIC, Barclays Research

Fortunately, we have already started to see changes in the factor markets. Wages have been rising rapidly due to emerging labour shortages (see Figure 5). The government has begun to adjust the prices of resources, including electricity, oil, gas and water (see Figure 6). The authorities also plan to introduce market-based interest rates and increase exchange rate flexibility during the 12th FYP. These changes should gradually remove distortions to the incentive structure for economic entities, and eventually drive the transition of the Chinese economy – from economic miracle to normal development. Assuming this transition takes place, we are likely to witness a sea change in China. If the transition is smooth, then we think the Chinese economy should be able to avoid the ‘middle-income trap’ and move to the next level of economic development. During this process, there is likely to be a series of important changes that could have significant implications for market participants, both at home and abroad. We identify the most important emerging economic trends as: Growth is likely to moderate, although steady growth should continue; 1. Inflation pressures to rise; 2. Income distribution will likely improve; 3. Industrial upgrading to accelerate; 4. The economy will start to rebalance; March 2013

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Barclays | China: Beyond the Miracle 5. Commodity demand could slow visibly; 6. Capital account liberalisation should proceed rapidly; and 7. Economic cycles are likely to become a lot more violent.

The making of an economic miracle When Deng Xiaoping and his colleagues decided to start economic reforms in the cold winter of 1978 in Beijing, China had just ended the decade-long and disastrous “Cultural Revolution”. The poor, closed agrarian economy was on the verge of collapsing. Urban industry churned out large volumes of low-quality, unwanted heavy industrial products, and there were severe shortages of consumer goods. Many farmers could not even feed themselves in a normal harvest year. About 84% of the population lived under the international poverty line of USD1.25 a day. In the following three decades, the Chinese economy underwent a profound transformation (see Figure 7). Per capita GDP measured in 2005 price purchasing power parity (PPP) terms rose from USD525 in 1979 to USD6,200 in 2009. By 2010, China was the second-largest economy in the world (see Figure 8), the largest manufacturing producer, the biggest market for luxury goods and greatest commodity consumer. Despite China’s still relatively modest income level, it is already a ‘large FIGURE 7 Rapid growth and low inflation in the past decade 30 25

GDP (%y/y)

FIGURE 8 A shift in economic power over two centuries 40

Average GDP (%y/y)

%

EU

US

China

Japan

35

CPI (%y/y)

30

20

25

15

20 10

15

5

10

0 -5 1980

5 0 1985

1990

1995

Source: CEIC, Barclays Research

March 2013

2000

2005

2010

0

1500

1700

1870

1950

1995

2016F

Note: The jurisdiction’s share in global GDP. Source: Maddison, Angus, 2006, “Asia in the world economy, 1500-2030”, Asian Pacific Economic Literature, 20(2): 1-37. IMF, World Economic Outlook, IMF, Washington DC, April 2011.

10

Barclays | China: Beyond the Miracle country economy’ whose economic influence is felt in almost every corner of the globe, from Australian wool farmers to American consumers, from European brand name producers to South African goldsmiths.

Growing global economic influence China’s global economic influences are reflected in a number of areas:

• During the past decade, China contributed between one-fifth and one-third of global GDP growth. During the global financial crisis (GFC), its stimulus package quickly reversed the slowing trend of economic growth and helped to support recovery in many neighbouring economies.

• China is already a dominant player in many global markets for consumer goods,

including textiles and clothing, toys and electronics. For years, its low-cost products helped to hold down inflation worldwide. Consumers like Chicago-based journalist Sara Bongiorni found it impossible to completely avoid buying made-inChina products. 1

• China has been a key driver of the so-called ‘super cycle’ in global commodity markets. China consumes about 30% of the world’s commodities (see Figure 9) and accounts for almost 60% of Australia’s exports of ore and metals. Chinese growth, especially its import growth, has become a key indicator of economic conditions in Japan and many other economies in East Asia, Oceania, Europe and Latin America. This has also raised the issue of interdependence of macroeconomic policy between the economies of China, the US and Europe (see Figure 10 and 11).

• With USD3.2trn in foreign exchange reserves, China is also a major exporter of capital and a key player in global capital markets, especially markets for sovereign debt. Some economists have also found that the renminbi (RMB) is as important as the US dollar in Asian policymakers’ exchange rate decisions. 2

According to IMF forecast, based on PPP-data, China is likely to overtake the US and become the world’s largest economy by 2016, when it will account for about 18% of global GDP (see Figure 8). If the same trends continued, China would account for more than one-fifth of the world economy soon after that date. This is the basis for the widespread claim that the 21st century will be the “China Century”.

1

Sara Bongiorni, “A Year without “Made in China”: One Family’s True Life Adventure in the Global Economy”, Wiley, 2008. 2 Takatoshi Ito, “China as Number One: How about the Renminbi?” Asian Economic Policy Review, 2010, 5: 249– 276.

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Barclays | China: Beyond the Miracle FIGURE 9 China’s rising share of global commodity demand 45

%

Aluminium Oil Soybeans Primary energy

40 35

FIGURE 10 China’s domestic demand and net exports 4.4 4.3

Real domestic demand (%q/q, saar)

16

NX (%q/q, saar, RHS)

14 12

4.2

30

10

4.1

25

8

20

4.0

6

15 3.9

10 5

3.8

0

3.7

1990

1994

1998

2002

2006

Note: China’s share in total global demand. Source: EcoWin, Barclays Research

2010

Jun-96

4 2 0 Oct-98

Feb-01

Jun-03

Oct-05

Feb-08

Jun-10

Source: CEIC, Barclays Research

China’s growing global economic influence has led to suggestions that China needs to play a more prominent role in global economic affairs. Fred Bergsten, of the Peterson Institute of International Economics, for instance, recommends that the US and China form a Group of Two (G-2) to jointly manage important global issues. 3 World Bank President Robert Zoellick and its Chief Economist Justin Lin suggested a similar mechanism. 4 So far the Chinese government has rejected such proposals. But there is an increasing recognition in the international community that cooperation between these two countries is critical for resolution of many important global economic problems.

How did China achieve it? The ascendancy of the Chinese economy within a relatively short period from the late 1970s is widely regarded as an economic miracle. Economists have offered various explanations for this extraordinary performance:

• Justin Lin, Fang Cai and Zhou Li argued in their award-winning book “The China

Miracle” that the key was transition from the heavy-industry-oriented development strategy to comparative advantage-oriented development strategy. 5

3

Fred C. Bergsten, Charles Freeman, Nicholas Lardy and Derek J. Mitchell, China’s Rise: Challenges and Opportunities, Peterson Institute of International Economics, 2008, Washington D.C. 4 Robert B. Zoellick and Justin Yifu Lin, “Recovery rides on the ‘G-2’”, Washington Post, March 6, 2009. 5 Justin Yifu Lin, Cai Fang and Li Zhou, The China Miracle: Development Strategy and Economic Reform, The Chinese University of Hong Kong Press, Hong Kong, 1995.

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Barclays | China: Beyond the Miracle FIGURE 11 Interdependence of Chinese and global demand China IP (%q/q, saar)

30

FIGURE 12 Breakdown of total national saving 6

60

4

50

Global-ex China GDP (%q/q, saar, RHS)

25 20

2

15

Government saving (% GDP) Household saving (% GDP) Corporate saving (% GDP)

40

0

10

30 -2

5

-4

0

20

-5

-6

10

-10

-8

0

Jun-00

Jun-02

Jun-04

Jun-06

Source: CEIC, Barclays Research

Jun-08

Jun-10

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: CEIC, Barclays Research

• Barry Naughton suggested the term “growing out of the plans”, ie, allowing incremental growth of the market-oriented, private activities, while maintaining support to the old central planned activities and state-owned enterprises (SOEs). 6

• Jeffery Sachs and Wing Thye Woo, however, pointed out that Chinese economic success was explained not by its policy innovation but rather its convergence to the typical market system of East Asia, which previously underpinned the ascendancy of the other Asian economies. 7 Despite the differences in their angles and perspectives, these and many other economists appear to share a consensus view that the fundamental change leading to the great success of the Chinese economy was its transition from a centrally planned to a market system. This is certainly correct. The central planning system created at least two types of inefficiency problems in the economy: the misallocation of resources among different industries and activities, and productive inefficiency at the micro level. We believe the removal of these problems could result in a dramatic expansion of economic activity. But this is only part of the story. In fact, we think an overemphasis on the role of market liberalisation could prevent a proper understanding of China’s extraordinary economic performance, especially if implications are made for other underdeveloped countries. 6 Barry Naughton, Growing Out of the Plan: Chinese Economic Reform, 1978-1993, Cambridge University Press, 1995. 7 Jeffrey D. Sachs and Wing Thye Woo, “Understanding China’s economic performance”, Journal of Policy Reform, 2000, Volume 4, Number 1, pages 1-50.

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Barclays | China: Beyond the Miracle Many low- income countries probably have freer market systems than China but, for decades, they have failed to achieve significant economic growth. In September 1993, the World Bank published its famous report, “The East Asian Miracle”, which examined the experiences of eight High Performing Asian Economies (HPAEs). 8 The World Bank summarised the essence of the HPAEs’ public policy as “limited price distortion and careful policy intervention”. In our view, the unique policy that contributed to China’s extraordinary economic performance was its asymmetric market liberalisation approach during the reform period – in other words, the almost complete liberalisation of product markets but heavily distorted factor markets (see Figure 12). Free markets for products ensure that production decisions are based on demand and supply conditions in the economy, and resources are allocated efficiently. Distortions in factor markets are a way of providing incentives for economic entities and, sometimes, overcoming market failures. Factor market distortions and, more generally, the active role of government in China are often criticised for causing economic inefficiency. This is true. But we view this as the critical element in China’s economic success. We think that while market liberalisation is important, what distinguishes China from many other low-income economies in achieving economic takeoff has been the role of government. The reason is simple. If the government does not carefully intervene, the market system may not function properly in many low-income economies where market failure is common. The financial system, for instance, is often not well developed to channel savings effectively to investment. To induce economic takeoff, the government needs a relatively free market system, but it also needs carefully designed policies to support economic activities. One good example is China’s FDI policy. In the early years of economic reform, the Chinese government designed a range of preferential policies to attract FDI, including tax holidays, free use of land, subsidised credit, cheap inputs such as energy and water. Government support for FDI projects also reduced problems related to an undeveloped legal system for property rights protection. In typical economic textbooks, such policies are described as policy distortions. But they have been successful. By 2010, cumulated FDI inflows into China reached USD923bn since 1997 (see Figure 13). Today, foreigninvested firms (FIEs) account for more than half of China’s total exports (see Figure 14).

8

World Bank, The East Asian Miracle: Economic Growth and Public Policy, Policy Research Report, The World Bank, Washington DC., 1993.

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Barclays | China: Beyond the Miracle FIGURE 13 China is now the second largest recipient of FDI 1000

FIGURE 14 Share of foreign-investment firms of exports 70

Cumulated FDI, 1997-2010 (USD bn)

900

Foreign-funded enterprise % total exports

65

800

60

700 600

55

500

50

400 300

45

200 40

100 0

35

1997

2001

Source: CEIC, Barclays Research

2005

2009

Jul-96

Jul-99

Jul-02

Jul-05

Jul-08

Jul-11

Source: CEIC, Barclays Research

FDI policy is only one example of the positive role played by the Chinese government in economic development. Over the years, the government has developed a comprehensive policy package to support economic growth. This package includes incentives at two levels:

• At the government level, there is a very clear policy objective set for all officials of

achieving the fastest possible GDP growth. This is built into the political system, through assessment of performance and determination of promotion. It is often noted that provincial governors and municipal mayors act more like corporate CEOs than senior government officials given their focus on boosting local investment and production.

• At the corporate level, generally repressed factor costs, resulting from factor market

distortions, act as subsidies, artificially raising profits from production, returns on investment and the competitiveness of Chinese exports. For years, China’s competitive advantages have included not only cheap labour but also cheap capital, land and resources. In the short term, such a favourable environment induces faster economic growth, although it also creates structural problems over time. It is well known that the Chinese government has focused on maintaining an 8% GDP growth rate. Although in recent years the government has set growth targets below 8%, growth has not dropped below this level for at least a decade (see Figure 15). Government officials often point to job creation and political stability as important motivations for this target. As China has not developed good social welfare systems,

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Barclays | China: Beyond the Miracle high unemployment could lead to economic and political instability. Therefore, job creation is by far the most important policy objective. FIGURE 15 12th FYP target and actual outcomes 8th (91-95)

9th (96-00)

10th (01-05)

11th (06-10)

12th (11-15)

Target (%)

6.0

8.0

7.0

7.5

7.0

Actual (%)

12.3

8.6

9.8

11.2

8.4*

FYP

Note: *Forecast. Source: Barclays Research

The economy needs to maintain strong growth to create jobs. Some officials explain that, in the 1990s, China’s new job market entrants totalled about 8 million a year. Including rural-urban migration and re-employment demand, this means that the country would need to create at least 10 million jobs every year. Historically, in order to create this number of new jobs, the economy had to grow by 8% pa. Of course, we need to make a few qualifications for this calculation. First, the job intensity of the economy varies depending on economic structure (capital-intensive versus labourintensive industries). And second, the number of job market entrants has actually dropped to 4-5 million annually in recent years. But these factors appear to have been ignored by policy considerations, which has reinforced the perception that China needs to achieve 8% growth. There is probably a more fundamental reason for the government’s focus on economic growth. Tsinghua University’s Hongbing Li and his collaborators once raised an interesting research question: Of all the provincial Party Secretaries and Governors, why are some promoted while others demoted after their terms finish? Li and his collaborators pulled together a data set of all provincial Party Secretaries and Governors covering the entire reform period. Not surprisingly, statistical analysis confirmed that the most important variable determining the probability of promotion for those senior officials was GDP growth. 9 Such behaviour is probably driven by performance assessment mechanisms for local government officials. During Deng Xiaoping’s famous tour of Southern China in 1992, he laid down two very important policy guidelines: one “development is a hard principle” and the other “whoever does not implement reforms should step down from their official posts”. For better or worse, this policy system ensures that government 9 Hongbin Li and Li-an Zhou, “Political turnover and economic performance: the incentive role of personnel control in China”, Journal of Public Economics, 2005, 89(9-10): 1743-1762.

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Barclays | China: Beyond the Miracle officials focus relentlessly on achieving rapid economic growth. Senior government officials spend lots of time negotiating with investors and bargaining with higher level governments to attract more investment into their local economies. This can also cause certain problems, such as negligence of economic stability and social justice. It is, nevertheless, very effective in stimulating economic growth.

Distortions in factor markets Parallel to the incentives for government officials was the widespread factor market distortions. These distortions, whether legacies of the central planning system or recent introduction by the government, serve at least two purposes in supporting economic growth in China: 1. Generally repressed factor prices, especially those for capital and energy, lower costs for producers, investors and exporters and, therefore, induce higher levels of economic activity than otherwise would be the case. 2. The government directly plays a role in resource allocation to support economic activity in priority areas, since lower prices inevitably lead to supply shortages in many areas such as bank credit and electricity. We think these are important reasons why the Chinese economy has been so successful in the past three decades. But we should caution against generalising about this policy practice. One, this policy regime is different from the central planning system, which led to the economic disasters in the pre-reform period. Two, state intervention is only useful if it is carefully designed to promote economic growth in a market environment. Three, even in the case of China, such distortions have had serious adverse consequences. But in the initial stage of economic development, it has been very effective at jump-starting economic growth.

Financial repression and underestimation of capital costs Underpricing of capital is probably the most important form of factor price distortion in China today. After more than 30 years of financial reform, China has a very comprehensive financial industry, including different types of banks, securities companies, insurance companies and various forms of money and financial markets. Degree of financial deepening, often measured by the ratio of broad money supply M2 to GDP, is already among the highest in the world. In fact, China’s M2 is already greater than that of the US, although its economy is still only about a third the size of the latter (see Figure 16). Nevertheless, the Chinese financial system exhibits almost all typical signs of financial repression: the authorities maintain heavy regulations over lending and deposit interest March 2013

17

Barclays | China: Beyond the Miracle rates, the state continues to influence lending decisions by the commercial banks, and the government still intervenes frequently in foreign exchange rates. Interest rates were strictly controlled by the state during the early years of economic reform. In 1993, the State Council presented the first plan for interest rate liberalisation with specific proposals for freeing money market rates and bond yields. In 1996, the government established CHIBOR for interbank short-term borrowing. This market, however, remained underdeveloped, judging from transaction volumes and price stability. In 2007, the PBoC had another go at setting up a separate interbank money market, SHIBOR. The hope was that SHIBOR would replace CHIBOR and serve as China’s benchmark short-term rate, which could eventually become the target for PBoC’s rate policy, just like the Fed funds rate in the US. In 1997, the authorities also set up the interbank bond market when the bond yields were freed. One example of underpriced capital is provided by comparing the relationship of GDP growth potential and government bond yields across countries. In theory, nominal GDP growth potential indicates average return on investment. Therefore, risk-free government bond yields should converge with this rate of return. In China, however, the gap is around 8-10 percentage points – assuming nominal GDP growth at 11-13% and the 5-year government bond yield at 3% (See Figure 17). This is high compared with 6.5pp in India, 6.2pp in Thailand, 5.7pp in Malaysia and 2.6pp in Korea at the end of 2008. Clearly, capital is too cheap in China according to these measures.

FIGURE 17 China nominal GDP and 5y government bond yield

FIGURE 16 China and US M2/GDP 200

China M2 (% GDP)

180

US M2 (% GDP)

NGDP growth (%y/y)

30

5y government bond yield (%pa) 25

160 140

20

120 15

100 80

10

60 40

5

20 0 1995

1998

2001

2004

Source: CEIC, Barclays Research

March 2013

2007

2010

0 Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Source: CEIC, Barclays Research

18

Barclays | China: Beyond the Miracle In the Chinese system, however, deposit and lending rates of the commercial banks are often more high profile interest rate indicators. But the commercial bank rates are probably undervalued. To verify this, we can look at two useful indicators. The first is real interest rates. In many years during China’s reform period, real deposit rates were negative or close to zero (see Figure 18). In economics literature, a negative real interest rate is an important indicator of financial repression. Low real interest rates imply that capital is not properly priced for both owners and borrowers of capital. While the low rates often encourage borrowing, depositors are hurt by low returns and are sometimes forced to engage in speculative activities. The other indicator relates to interest rates in the informal lending market. One consequence of negative real interest rates is excess demand for capital, often leading to government intervention in credit allocation. In the case of China, large state-owned, foreign-invested and private enterprises often receive most of the bank loans, while small- and medium-sized enterprises lack access to proper financial services (see Figure 19). In Zhejiang province, where the private sector is more vibrant, only about 20% of SMEs obtain bank credit. The proportion is much smaller for small-sized enterprises. While the one-year base lending rate was below 6% at the start of 2011, the interest rate in the ‘kerb’ market in Zhejiang province was above 20%. This very high interest rate in the informal market reveals two important facts: 1) the official lending rate is too low, although the kerb market rate might not be the equilibrium rate; and 2) underpricing of capital is true only for the formal sector, especially large corporations. A large number of SMEs actually incur very high capital costs. FIGURE 18 Real deposit rates have been low or negative 15 10

FIGURE 19 Effective lending and benchmark rates

Real 1y lending rate (%pa, CPI deflated)

100

Real 1y deposit rate (%pa, CPI deflated)

90 80 70

5

60 0

50 40

-5

30 -10

20 10

-15 -20 Jul-89

0 Jun-08 Dec-08 Nov-93

Mar-98

Jul-02

Source: CEIC, Barclays Research

March 2013

Nov-06

Mar-11

Jun-09 Dec-09

Below benchmark

Jun-10 Dec-10 Jun-11

Benchmark

Above benchmark

Note: The share is based on bank lending rates. Source: PBoC, Barclays Research

19

Barclays | China: Beyond the Miracle Another form of capital cost underestimation, which is probably much more noticeable for international observers, is China’s currency. Currency undervaluation has been the focus of some international policy debate. There are different approaches to measuring equilibrium exchange rates based on purchasing power parity information, structural characteristics of the economy, and/or imbalances. While most economists agree that the RMB is probably undervalued, they disagree on the magnitude of the undervaluation. The normal range of the undervaluation estimated for the RMB is between 5% and 50%. 10

Restrictions on labour mobility and segregation of the labour market During the pre-reform period, there was no labour mobility. The household registration system essentially required that a person who was born into a village should stay in that village until his or her death. Urban wages in pre-reform China were directly set by the state, based on experience, seniority, and type of job. Urban wages at that time were also kept artificially low in order to reduce the cost of industrial production, but the government supplied cheap food and other consumer goods to compensate for the low wages. Rural incomes were even lower. In 1978, when the government decided to start economic reform, urban income was roughly 2.4 times that of rural income (see Figure 20).

FIGURE 20 Urban and rural income gap 20

Income per capita: Urban (CNY th)

18

Income per capita: Rural (CNY th)

16

Urban-Rural Ratio (%, RHS)

FIGURE 21 Minimum wages have been increasing Per month

3.5

14 3.0

12 10

2.5

8 6

2.0

4 2

1.5

0 1985

1990

1995

2000

Source: CEIC, Barclays Research

2011

4.0

2005

2010

2010

CNY

%

Beijing

1160

Shanghai

1280

Shenzhen

1320

2008

CNY

%

CNY

%

21

960

20

800

10

14

1120

17

960

14

20

1100

16

950

26

Major cities

Selected provinces Liaoning

1100

22

900

29

700

19

Zhejiang

1310

19

1100

14

960

28

Guangdong

1300

26

1030

20

860

10

Shandong

1100

20

920

21

760

25

Ningxia

900

27

710

27

560

24

Source: CEIC, Barclays Research

10 William R. Cline and John Williams, “Estimates of the Equilibrium Exchange Rate of Renminbi: Is There a Consensus and If Not, Why Not?”, in Morris Goldstein and Nick Lardy (eds.), Debating China’s Exchange Rate Policy, Peterson Institute of International Economics, Washington D.C., 2008.

March 2013

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Barclays | China: Beyond the Miracle At the beginning of economic reform, the urban and rural labour markets were almost completely segregated, with very limited labour mobility between the two. But this situation started to change from the early 1990s. After Deng’s tour of Southern China, the urban economy began to grow rapidly. Foreign-invested firms, especially those from Hong Kong, Korea and Taiwan, were mostly in labour-intensive industries. These enterprises began to recruit workers directly from farms to take advantage of cheap labour. At the same time, controls over the urban employment system were loosened gradually. Even SOEs started to recruit temporary workers from the countryside. This gave rise to a new phenomenon of massive numbers of migrant workers. According to the National Bureau of Statistics, there were a total of 240 million migrant workers in 2010. In fact, the majority of the workforce in the export sector in China today is migrant workers. The existence of migrant workers provided strong evidence that the household registration system had become ineffective in restricting labour mobility. But importantly, the system still discriminates significantly against workers without official urban household registration. Even though farmers are able to find jobs in urban areas, they are still not treated as urban residents. For instance, their children normally cannot go to the public schools in the cities. Migrant workers are also not entitled to urban housing benefits. During the past years, the government tried to make the social welfare system universally applicable, but the gaps between urban residents and migrant workers remain wide. For instance, in 2009, about 57% of urban workers had pensions. The same was true for only 9.8% of migrant workers. The coverage rates for unemployment benefits were 40.9% for urban workers and 3.7% for migrant workers. And the coverage rates for basic medical insurance were 52.7% for urban workers and 13.1% for migrant workers. If companies strictly followed policies on social welfare contributions, their payrolls would generally have to rise by at least 35-40%, including for contributions to pensions (20% of payroll), medical insurance (6%), unemployment benefits (2%), work injury insurance (1%), maternity benefits (0.8%) and housing entitlement (5-10%). By contributing less than required, especially for migrant workers, companies essentially reduce their cost of labour. It is possible that migrant workers are often underpaid. In many companies that employ both urban and rural residents, migrant workers often receive fractions (often half or even one-third) of what is paid to urban workers. This is possible only because of the household registration system. It is common to hear of half a dozen of migrant workers squeezed into one dormitory room. They save most of their earnings to support the March 2013

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Barclays | China: Beyond the Miracle family back home. Many young migrant workers came to the cities planning to stay 510 years and then return home, either to get married or to start their own businesses. Many, however, change their minds later and want to remain in the cities, having lived there for extended periods. While the household registration system and the resultant differential coverage of social welfare systems clearly discriminate against rural residents, it is uncertain if these institutions actually repress wages at the margin. In theory, there are two possibilities. One is that the household registration system provides an institutional basis for discrimination against migrant workers. This reduces labour cost at the margin. Since migrant workers are mostly employed in market-oriented sectors such as exports, private enterprises and FIEs, cheap labour was an important factor contributing to economic growth during the reform period. The other possibility is that that since the registration system restricts labour mobility it reduces the number of migrant workers and, therefore, increases wages. In other words, without the household registration system, there might be more migrant workers in the urban economy and wages would be even lower. Would lower wages still attract more migrant workers? The critical question is whether the current wages for migrant workers are the minimum (see Figure 21) that farmers would accept for migrating to the cities. In a typical dual economy model, farmers receive subsistence income in agriculture. In order for them to move to the cities, “urban minimum wages” have to be substantially higher than subsistence income in agriculture, since they would incur higher living costs and be exposed to unemployment risks. If migrant workers’ current wages are significantly higher than the “urban minimum wages” in the dual economy model mentioned above, then relaxation of restrictions under the household registration system could result in more migrant workers and lower urban wages.

Price distortions for land, energy and other resources Land is owned by collectives in the countryside and by the state in the cities. Until recently there was no market for land. Land transfer for non-agricultural uses has to be approved by the government. In the past, the local authorities would determine land use fees. But since they were keen to attract more investment, they often provided concessions on land use fees. It was common when local governments competed with each other to attract investment projects by offering tax exemptions and lower land use fees.

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Barclays | China: Beyond the Miracle FIGURE 23 Domestic oil price vs international crude oil prices

FIGURE 22 Average growth rate in land prices 4000 3500

Land price: 35 city average (CNY/sqm) Land price: 35 city average (%y/y, RHS)

90 80 70

3000 2500

0

250

6000

200

Source: CEIC, Barclays Research

5000 150

4000 3000

20

2000

10

1000

0 2001 2002 2003 2004 2005 2006 2007 2008 2009

300

8000 7000

30

500

9000

50 40 1000

Mar 05=100 350

60

2000 1500

CNY/ton 10000

100 Int'l crude price, in USD Int'l crude price, in CNY Domestic Fuel Price (LHS)

50

0 0 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11

Source: Bloomberg, NDRC, Barclays Research

In recent years, however, the local governments have turned to more market-oriented land transfer mechanisms, such as auctions and negotiations, to improve transparency and boost local government revenues (see Figure 22). This practice is more applicable in the case of property development. For industrial use it is still common for the government to apply land use fees. And on average the land use fees are only about 16% of the costs through auction. Manufacturers, therefore, receive implicit subsidies on land inputs. Institutional distortions in domestic energy markets are widespread, although the magnitudes of cost distortions have varied wildly over the years. Of the different types of energy products, coal prices are the closest to market prices. The authorities also set electricity tariffs through public consultation. The most visible and sometimes also most volatile distortions are in oil products. In 1998, in an important step in oil price liberalisation, the State Council announced a formula linking domestic prices to the weighted average of prices in New York, Singapore and Rotterdam. The NDRC would adjust domestic prices, with a couple of months’ delay, if the international weighted average moved by more than 8%. In 2000, the NDRC raised oil prices seven times in order to bring domestic prices closer to international levels. However, when international prices moved violently, the NDRC was reluctant to follow for fear of disrupting economic growth (see Figure 23). For instance, when international crude prices reached their recent peak, at close to USD150 per barrel in 2008, the equivalent domestic prices were only around USD80 per barrel. Oil price March 2013

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Barclays | China: Beyond the Miracle distortions are highly volatile, given the State Council’s formula and fluctuations in the international markets. Moreover, environmental concerns are not a conventional factor of production. However, compensation for pollution should be counted as part of production costs. Over the past three decades, the Chinese authorities instituted a relatively complete set of environmental protection regulations and policies. The problem, however, is the big gap between the intent of these policies and their implementation. Local governments, especially those in underdeveloped areas, are often not willing to protect the environment at the expense of income and GDP growth. Such lapses in policy implementation constitute an effective subsidy to producers. The NDRC and the Ministry of Environmental Protection (MOEP) once estimated the net damage to the environment at 3% of GDP in 2004. Pollution of air, water and soil not only affects economic productivity but also generates serious health problems. Some have argued that environmental degradation in China has contributed to global climate change, and have suggested melting of glaciers in the Himalayas as evidence. Climate change is also said to have led to regular drought in Northern China and frequent floods in Southern China (Woo and Huang 2004).

Crude estimation of factor cost distortions How serious are these distortions? Assessing this is an almost impossible task given that in most cases the equilibrium prices are unknown. Here we cite estimates by Yiping Huang and Kunyu Tao just as an illustration. 11 The numbers are likely disputable but the problems are probably real. Due to complications in labour market conditions, we do not include their estimates for labour cost distortion (see Figure 24). Their estimation results reveal some important patterns. First, of all the distortions, capital market distortions are by far the most important. Capital cost distortions contribute about 40% of total cost distortions on average. This helps to explain the persistent problem of overinvestment in China and also rapid development of capitalintensive industries despite continued job market pressures.

11 Yiping Huang and Kunyu Tao, ‘Factor market distortion and the current account surplus in China’, Asian Economic Papers, 2010, 9(3): 1-36.

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Barclays | China: Beyond the Miracle FIGURE 24 Estimated cost distortions in China, 2000-2009 (% GDP) Capital

Land

Energy

Environ

2000

4.1

0.5

0.0

3.8

2001

3.9

0.5

0.0

3.5

2002

3.9

0.4

0.0

3.3

2003

3.8

1.1

0.0

3.3

2004

3.1

0.9

0.6

3.0

2005

3.0

1.3

1.7

3.0

2006

3.1

2.0

1.6

2.8

2007

3.6

1.2

1.6

2.4

2008

3.4

1.0

0.7

1.9

2009

3.5

0.9

0.7

1.8

Source: Yiping Huang and Kunyu Tao, ‘Factor market distortion and the current account surplus in China’, Asian Economic Papers, 2010, 9(3): 1-36.

Second, energy cost distortions fluctuated widely across years, reflecting volatilities in international oil prices and the varying response of Chinese authorities to these changes. China has already adopted a price mechanism which closely tracks changes in international energy prices. But the authorities hold down domestic prices when international prices surge rapidly. Therefore, energy cost distortions are sometimes asymmetric. When international prices are low, there is little distortion. When international prices are high, distortions increase rapidly. Third, environmental cost distortion was the only item that showed consistent improvement. This is a very important result, assuming the estimates reflect actuality. Despite the perception of a worsening in the environment, the pollution problem has probably reached a turning point, which we attribute mainly to a stepping-up of policy efforts in recent years. The growing public awareness of the problem has probably also helped.

Remarkable successes and growing risks How did such cost distortions affect the economy during the reform period? At the simplest level, we may view the distortions as a production subsidy; that is, cost distortions are like producer subsidy equivalent (PSEs). They boost profits from production. This was essentially why China quickly rose as a global manufacturing centre within a few years following its WTO accession. There was no better place to produce March 2013

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Barclays | China: Beyond the Miracle than in China – labour was cheap; capital was cheap; land was cheap; energy was cheap; producers further enjoyed tax exemptions; and there was no real charge for pollution. Low costs also stimulated investment. Most importantly, capital is cheap. According to the estimates cited above, capital was by far the most important item in total cost distortion over the past ten years. This explains why China moved into heavy industries so quickly in the early 21st century even though the government still hoped to create more jobs. As the investment share of GDP was close to 50%, it is easy to understand why China consumes such large volumes of raw materials. Cost distortions make Chinese products a very competitive in international markets. This was behind the unusual growth in China’s economic openness, with the export share of GDP rising from 8% in 1978 to 35% in 2008, an unusually high level for a large economy. This also explains why China’s international influence is disproportionate to its income level and even its economic size. Close to 70% of Chinese GDP is externallyoriented (exports plus imports), compared with 20-30% for the US and Japan. This also explains why China exports so much capital. But over the years, these distortions also created a series of structural problems, alongside strong economic growth:

• Low costs inevitably lead to overuse and inefficiency of production inputs. This

problem is most clearly highlighted by China’s unusually high energy- and commodity-intensive GDP. That China consumes so many resources at its current income level leads many to worry that the world does not have enough resources to support its future growth.

• Low costs and the associated state interventions also lead to important imbalance

problems. While investment and exports are unusually strong, consumption has been weakening relative to the overall economy for the past decade. Massive investment raises the question of potential bubbles in the economy and large external surpluses invite external disputes with economic partners. The private sectors, which are generally discriminated against in state-dominated resource allocation, also face significant hurdles for development.

• The distortions and interventions may be self-sustaining, as over time special

interest groups are formed to resist further liberalisation. For instance, SOEs enjoy policy preferences and monopoly profits. They have become strong opponents of market liberalisation. Some analysts worry about state capitalism and interlocking interests between the state and the SOEs. March 2013

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Barclays | China: Beyond the Miracle If these problems continue, then the sustainability of Chinese economic growth may well be at great risk. As early as 2001, American lawyer Gordon Chang published a bestseller, “The Coming Collapse of China”, in which he predicted disintegration of the Chinese economy following the country’s WTO accession. 12 So far, the most credible warnings about China’s economic risks have come from Chinese Premier Wen Jiabao. Shortly after taking office in early 2003, Wen undertook a close diagnosis of China’s growth model. Worried about various risk factors, he concluded that the Chinese growth was “unbalanced, unstable and unsustainable”. The particular problems that Wen pointed out include: 13

• Overinvestment;

• Under-consumption;

• High commodity intensity; • Inefficient resource use;

• Large current account surpluses; • Income inequality; • Pollution;

• Corruption among local officials. In the following years, Wen discussed the policies needed to adjust economic structures and improve growth quality in his Government Work Report, delivered at the annual meeting of the National People’s Congress (NPC) almost every year during his tenure. Unfortunately, however, the policy actions taken by the Wen government failed to reverse the trend of worsening growth quality. First, when the government took office in 2003, gross capital formation (GCF) accounted for 38% of GDP. In 2010, the investment share was 48.5%. Investment is one of the key drivers of economic growth as it facilitates capital stock accumulation and technological progress. China’s investment rate rose significantly during the reform period, from about 20% in the early years. Accumulation of capital stock was one of the important contributors to China’s rapid economic growth. Too much investment, however, could be problematic for growth outlook. China’s current investment share is already extraordinarily high, even compared with the high-investment economies in East Asia. During the entire post-war period, there were three economies, in 12 13

Gordon G Chang, The Coming Collapse of China, Random House, New York, 2001. Wen Jiabao, Government Work Report, Delivered at the National People’s Congress meeting, March 5th, 2006.

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Barclays | China: Beyond the Miracle FIGURE 25 Investment share of GDP across Asia economies 60

%

China

Malaysia

Singapore

Thailand

FIGURE 26 Current account as % of GDP % GDP 20

50

Capital and financial account Current account Balance of payment

16

40

12

30

8

20

4

10 1980

1985

1990

1995

Source: CEIC, Barclays Research

2000

2005

2010

0 Jun 99

Jun 02

Jun 05

Jun 08

Jun 11

Source: CEIC, Barclays Research

addition to China, which once had above-40% investment shares. The first was Singapore in the early 1980s, when its investment share was around 48%. It had to experience a dramatic adjustment in the mid-1980s to lower the investment share to below 40%. The other two economies were Malaysia and Thailand in the mid-1990s when investment in manufacturing, real estate and capital markets experienced extraordinary booms, partly helped by inflows of foreign capital. Only a couple of years later, however, both countries suffered financial crises (see Figure 25). Second, the current account surplus grew from about 3% of GDP in 2003 to 10.8% in 2007 (see Figure 26). This ratio moderated in the following years due to the global financial crisis but still stood above 5% of GDP in 2010. Large current account surpluses were initially the result of government policies, especially following the Asian financial crisis. The government deliberately promoted a trade surplus and accumulated foreign exchange reserves in order to reduce risks of a balance of payment crisis. In 1997, China had a total of USD160bn in foreign reserves; by mid-2011, reserves totalled USD3.2trn. These reserves are useful for supporting investor confidence and deterring speculators. However, large foreign reserves have their own problems. They imply that, as a relatively low-income and capital-scarce country, China is lending a large amount of capital to other countries. Since a significant portion of China’s foreign reserves is held in forms of US dollar assets, especially US Treasury bonds, China is exposed to dollar risk. If the dollar starts a journey of long-term decline, it will be almost impossible for China to preserve the purchasing power of its foreign reserves. Finally, since China now holds about USD1.2trn in Treasury bonds – 26% of total foreign holdings of Treasury

March 2013

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Barclays | China: Beyond the Miracle bonds – it will be almost impossible for China to liquidate these assets when needed without incurring serious losses. Third, the Gini coefficient, an economic indicator (ranging from 0-1) measuring income inequality among households or individuals, increased from 0.3 during the early years of economic reform to 0.47 in 2008. Unequal income distribution has a number of adverse consequences. It lowers the general level of consumption, since the wealthier normally have a lower propensity to consume while the poorer do not have enough income for much consumption. Therefore, income inequality seems to be at least one of the factors contributing to under-consumption in China. More importantly, unequal income distribution often leads to social or even political instability. Low- income households often do not benefit equally from economic growth. In fact, the tension between the rich and the poor in Chinese society is already quite high. This is, perhaps, most clearly seen on internet forums, where the wealthy and government officials are targets for criticism.

Why the next five years might be different The 11th FYP delivered some impressive results, such as continued strong economic growth at the time of GFC. However, it failed to achieve the policy objective of changing the growth model. Of the four rebalancing indicators listed by the Program, only one – reduction of energy intensity of GDP by 20% – was achieved. Even this, according to some analysts, was realised through the government’s mandatory order to suspend production in some areas. In our view, the policy failure of the 11th FYP can be traced back to two problems:

• While the government always highlighted the importance of transforming the

development pattern, it was not the most important policy objective. And it was often sacrificed when it ran into conflict with some other policy objectives, such as growth and inflation.

• The government mostly relies on administrative measures to adjust economic

structures. Administrative measures are often inaccurate and have a “stop-and-go” nature. More importantly, without changes in the incentive structure, economic agents’ behaviour remained unchanged. China faces a unique macroeconomic policy trilemma. Since 2003, the Chinese government’s macroeconomic policies have focused on three important objectives: 1) supporting growth, 2) controlling inflation, and 3) adjusting the structure (changing the growth model). However, these objectives often cannot be achieved simultaneously. For instance, the famous Philips Curve dictates that high unemployment (low growth) is March 2013

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Barclays | China: Beyond the Miracle usually associated with low inflation, while low unemployment (high growth) is normally related to high inflation. Thus, when the government prioritises growth objectives (such as during the Asian and global financial crises), it would be almost impossible to achieve the objective of structural adjustment simultaneously. The tradeoff relationship among the three objectives – supporting growth, controlling inflation and adjusting the structure – is what we describe as the “Wen Trilemma”. The second cause for lack of progress in structural adjustment is policymakers’ continued reliance on administrative measures rather than economic incentives. During the past years, the government appeared to us to be sincere and serious about the problems of its development pattern. It also adopted many policy measures to deal with these problems. However, the government had a very clear preference for administrative tools. It rarely touched the incentive structure and, therefore, hardly changed behaviour of economic agents. Some of the problems that the government has been trying to resolve since the Asian financial crisis include overinvestment and excess capacity. These have almost become fixtures of the Chinese economy. During the first decade of the 21st Century, China’s investment rate climbed by 10 percentage points. At the start of that period, China had excess capacity in the sectors of television sets, refrigerators and air conditioners. And at the end of that period, China had excess capacity in the industries of steel, cement and coal. In between those two points, China also suffered from excess capacities in the areas of building materials, automobiles, aluminium, copper smelting. The NDRC would publish a list of industries where it saw high risks of overcapacity every year and would then take policy actions to reduce the excess. These certainly confirm the persistence of the excess capacity problem in China. However, it is puzzling that, after decades of market-oriented reforms, the government is still busy telling businesses where to and where not to invest. Unfortunately, the government might not be the best organisation to judge likely excess capacity in the economy. Peking University’s Lu Feng and his research team pulled together all the policy documents issued by the NDRC and other departments dealing with the excess capacity problems between 2002 and 2009. They then compared official predictions of total demand and capacity with actual outcomes years later (see Figure 27). A general conclusion was that the government was often wildly inaccurate in such judgments.

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Barclays | China: Beyond the Miracle FIGURE 27 Record of the government’s judgment of the excess capacity problem Policy

Official prediction

Actual outcome

April 2002, SPC, etc: Preventing duplicate construction of production capacity in electrolytic aluminium

In 2005, total demand Output 7.81mn tons 5.5mn tons and excess and demand 7.75mn capacity 1.3mn tons tons

Underestimation of demand by 40%

November 2003, NDRC, etc: Preventing ‘blind’ investment in the steel industry

In 2005, production capacity 330mn tons, much higher than expected demand

Gross underestimation of both demand and capacity

Output 350mn tons; demand 340mn tons; and capacity 4.3mn tons

Test result

Demand 7.75mn tons Underestimation of November 2003, NDRC, In 2005, production capacity 9mn tons and and production capacity demand by 30% etc: Preventing total demand 6mn tons 10.79mn tons investment in illegal projects in electrolytic aluminium November 2005, NDRC, etc: Preventing ‘blind’ investment in copper smelting

In 2007, production Demand 3.99mn tons capacity 3.7mn tons, way exceeding expected demand

Significant underestimation of demand

Note: SPC: State Planning Commission; NDRC: National Development and Reform Commission. Source: Lu Feng, A Study on the Excess Capacity in China, China Center for Economic Research, Peking University, Beijing, October 2009.

We believe that the next five years are likely to be different. The main reason is that we have already started to see changes in the factor markets. For instance, the government has already begun to adjust resource prices. Prices of oil and electricity are gradually being adjusted according to market conditions, although the magnitudes still appeared to be insufficient. But this is likely to continue. One very significant change that occurred during the past years is the transition of the labour market from excess supply to excess demand, the so-called “Lewis turning point” in developing economies. It is still a highly debatable subject among economists and policymakers whether China has passed the Lewis turning point. Opponents often point to 250 million farmers in the official statistics. But some labour economists argue that the actual number of farmers left in the countryside is far less than the official statistics suggest and that many remaining are either children or relatively aged people. Stanford University’s Scott Rozzel, a regular surveyor of rural China, once argued there was no surplus labour left in the villages. Regardless, it is clear that businesses already find it increasingly difficult to hire new employees. And labour costs have been on the rise, at around 15-20%, for years, only briefly disrupted by the global financial crisis (see March 2013

31

Barclays | China: Beyond the Miracle Figure 28). For the first time, coastal and inland cities competed fiercely for migrant workers after the Chinese New Year in 2011. Rapid wage increases cause problems at both the macro and micro levels. At the macro level, they create new inflationary pressures and threaten macroeconomic stability. At the micro level, firms are forced to absorb higher costs, affecting their competitiveness. But in general, this is a very positive development for the rebalancing of the Chinese economy:

• Higher wages increase household income and, therefore, should promote consumption;

• If consumption does increase as a result of faster wage growth, it should eventually help reduce the economy’s reliance on investment and exports;

• Higher wages actually contribute to more equal income distribution as wage earners are often in low-income households;

• Cost increases push industrial upgrading, moving from low to high value-added sectors; and

• They (cost increases) also facilitate more balanced regional development, as factories move from coastal to inland provinces.

FIGURE 28 Labour costs on the rise 25

FIGURE 29 Approving rates of the government 120

Average wage (%y/y)

100

20

Central Provincial District/County Township/Village

80 15 60 10 40 5 0 Jun-01

20 0 Jun-03

Jun-05

Jun-07

Source: CEIC, Barclays Research

March 2013

Jun-09

Jun-11

2003

2005

2007

2009

Source: Tony Saich, "Chinese people's trust in their government", 25 July 2011, East Asia Forum, http://www.eastasiaforum.org/2011/07/25/thechinese-peoples-trust-in-their-government/

32

Barclays | China: Beyond the Miracle The next most fundamental change is capital market reform, specifically interest rate and exchange rate liberalisation. The 12th FYP explicitly incorporates introduction of market-based interest rates. The government will probably also make significant moves on the exchange rate and the capital account. These reforms can bring profound changes to the Chinese economy. Liberalised interest rates, for instance, would likely increase household income and, at the same time, reduce incentive for investment. There are still some uncertainties about the pace of these reforms, but the direction and determination appear to be firm and clear. Pessimists would probably point to urgently needed political reforms. We agree. But we are not certain China is going to move in that direction any time soon. However, it is important to point out that, while dissatisfaction in the Chinese society appears to be widespread and serious, the government’s approval rates are not terribly low, according to surveys by Harvard University’s Tony Saich (see Figure 29). More importantly, the central government is trying to deemphasise the importance of GDP growth in assessment of local officials’ performance. Even without significant success in that area, the major liberalisation of the factor market would likely reduce the power of the government in economic activities.

The great rebalancing With the anticipated reforms during the 12th FYP period, we expect the Chinese economy to experience the next transition, from economic miracle to normal development. In this transition process, we expect a number of new economic trends to emerge, which we intend to explore in more detail in future reports. All of these are likely to have important implications for policymakers and investors, both in China and abroad.

• Moderation in growth. The expected and broad-based increases in factor costs will reduce the implicit subsidies enjoyed by producers, investors and exporters. This could slow the pace of economic growth, possibly from the average of 10.4% during the first decade of the 21st century to around 6-8% in the second decade. But slower growth should be higher quality growth and, therefore, more sustainable growth.

• Higher inflation pressures. Higher production costs are likely to lead to higher

product prices, although productivity gains may partially offset that effect. We think the average CPI rate could accelerate from 2% during the past decade to 5-6% in the coming decade, which is in the normal range for many emerging market March 2013

33

Barclays | China: Beyond the Miracle economies. This may also eventually translate into upward pressure in global inflation if China continues to dominate the world consumer goods market.

• Improvements in income distribution. Rising factor prices should be favourable for

household income growth, especially in the form of labour and deposit incomes. In other words, China may embrace the so-called Kuznetz turning point – when income distribution transitions from worsening to improving during the process of economic development. This would have important implications for social and economic stability and the rebalancing of the economy.

• Acceleration of industrial upgrading. Rapidly rising production costs could quickly

erode the competitiveness of many Chinese industries. This should force Chinese industries to climb the industrial ladder, moving from low value-added manufacturing activities into high value-added industries and services. While such a development is critical for China’s growth sustainability, including avoiding the middle-income trap, it will likely create significant stress on both entrepreneurs and investors (see Figure 30).

• Rebalancing of the economy. China will likely see the beginning of a great economic rebalancing, as higher household income stimulates consumption, higher capital costs calm investment and a stronger currency helps to lower external sector surpluses. While rebalancing might be a gradual process, the investment-led growth model should come to an end relatively sooner, given the unusually high investment ratio. External surpluses, however, will likely persist, but probably as a lower proportion of GDP.

• Slowdown in commodity demand. Given the expected continuation of

industrialisation and urbanisation, China’s commodity demand should remain strong. But its pace should slow soon, as GDP growth moderates and the commodity intensity of the economy declines.

• Liberalisation of the capital account. We expect China to achieve basic convertibility of the capital account during the current FYP period, although restrictions on cross-border portfolio flows may remain. This probably means the implementation of floating exchange rate regime at the same time. We think the composition of capital outflows may also become more dominated by portfolio and direct investment. We would need to monitor financial risks more closely following liberalisation. But even if a financial crisis occurred, we would expect it to disrupt China’s growth trajectory only briefly.

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Barclays | China: Beyond the Miracle

• More dramatic economic cycles. China’s economic cycles have been smoothed by government policies in the past decades. But such smoothing is likely to be increasingly more difficult to achieve as factor markets experience significant liberalisation. Therefore, China will probably experience more normal economic cycles like those in other emerging market economies. And given China’s increasing weight in the world economy, a major downturn in the Chinese economy might be the case of the next regional, if not global, recession. FIGURE 30 The seven strategic new industries in the 12th FYP Strategic Emerging Industries – 12th Five-Year Program Biotechnology New energy High-end equipment manufacturing Energy conservation & environmental protection Clean energy vehicles

Government aims to increase these industries’ value-added as percentage of GDP to 8% by 2015 and 15% by 2020.

New materials Next generation information technology Source: Xinhua, Barclays Research

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Barclays | China: Beyond the Miracle

CHAPTER 2

The coming financial revolution

• Chinese financial reforms during the past 30 years have been effective in developing regulatory frameworks and growing business volumes but weak at liberalising markets and improving governance standards.

• The financial system remains largely ‘repressive’: financial institutions act more like policy entities; key interest rates are tightly regulated by the state; and the non-state sector’s access to funding is highly restricted.

• Repressive financial policies are restraining growth and driving many of the risks

fuelling fears of a hard landing. Failure to address financial reform soon could lead China to experience the same fate as many other emerging market economies that saw their growth paths derailed.

• However, we believe China will avoid such a path. We expect its long-awaited financial ‘revolution’ to start sooner than some expect and last over a period of five years. This will include the reform of policies covering interest rates, debt markets, financial products, corporate governance and the capital account.

• Costs of capital are likely to trend higher as China reduces financial repression and rebalances its economy. For some borrowers, this should mean improved access to funding and lower costs.

• Institutions will likely be exposed to greater financial volatility and large adjustments in both prices and allocation of capital could point to significant financial risks. Careful design and implementation of financial reform and regulation will be key to ensuring a smooth transition during this period and minimising the risks of a financial crisis.

• China banks will likely face a strong challenge from deregulated debt markets and interest rate competition, which may force changes in their business models.

This article was originally published on 6 October 2011, with contributions from equity analysts, May Yan and Shujin Chen.

March 2013

36

Barclays | China: Beyond the Miracle

The revolution that needs to happen The recent escalation of market fears about a hard landing in China were likely triggered by a series of worsening risks facing the domestic economy as well uncertainties surrounding European debt markets. Many of the domestic problems are linked, one way or another, to the financial system:

• Declines in bank deposits in recent months suggest that an increasing portion of financial transactions are not being properly monitored or regulated (Figure 1).

• A number of bankruptcies among small- and medium-sized enterprises (SMEs). This trend could worsen, especially if exports were to weaken significantly.

• A weakening housing market could lead to substantial pressure on funding for both property developers and local governments. These problems stem from two factors. Firstly, policy tightening. The People’s Bank of China (PBoC) has been hiking interest rates and reserve requirement ratios, while many local governments have introduced policy restrictions on house purchases. These have led to much tighter funding conditions for enterprises. We saw similar developments during previous tightening cycles, such as the one in mid-2008. Secondly, repressive financial policies look to have exacerbated these problems. For instance, funding costs have risen much faster in the informal ‘kerb’ markets than in the formal banking system during the past months (Figure 2). This diverging trend creates additional operating difficulties for those sectors that are more reliant on the ‘kerb’ markets and also raises overall financial risks for the economy. FIGURE 2 Lending rates in the informal market have surged

FIGURE 1 Bank deposits have become more unstable 3000 2500

New increased Deposit (CNY bn) Deposit growth (RHS,%y/y)

2000 1500

35

30

30

25

25

0 -500

March 2013

20 15

15 10 5

0 -1000 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11

Source: CEIC, Barclays Research

Private lending rate in Wenzhou (%)

20

1000 500

1y benchmark lending (%)

10 5 0 2001

2003

2005

2007

2009

2011

Source: PBoC Wenzhou, CEIC, Barclays Research

37

Barclays | China: Beyond the Miracle The existence of such problems have alarmed some international investors – as similar problems in the past have often led to financial crisis or economic collapse in other countries. We understand this view. But it would be wrong to conclude that China will experience the same type of crisis anytime soon. The key difference between China today and those crisis-affected countries, as we have argued repeatedly, lies in the still healthy balance sheets of households, banks, government and the external sector. However, failure to embark on significant improvements in financial reform now would increase the risk of a financial crisis in the medium to long term. The combination of a large current account surplus, gigantic foreign reserves and, possibly, an undervalued currency, would suggest that China is unlikely to experience a currency crisis any time soon, in our view (Figure 3). Importantly, deposits are leaving the banks at the moment because of interest rate controls, not because of a loss of confidence in the banks. The Chinese banks might not be terribly efficient at allocating capital and, therefore, could see significant increase in non-performing loans in the coming year. But they have the advantage of starting with relatively clean balance sheets. And, most critically, most banks are still supported by the government. The ultimate test for the Chinese economy is fiscal sustainability (Figure 4). But we should not underestimate the seriousness of the financial risks facing the Chinese economy, especially as the government will not always be able to stretch its policies to prevent a financial crisis. If China further delays the much-needed financial FIGURE 4 The government’s fiscal position still manageable

FIGURE 3 Huge FX reserves protect against a currency crisis 3500 3000

FX reserve monthly accumulation (USD bn)

60

250

Public Debt/GDP, as end of 2010 (%)

FX reserve % GDP (RHS) 50

2500

200

40 150

2000 30 1500

100

20

1000

10

500 0 Jun-86

Jun-91

Jun-96

Jun-01

Source: CEIC, Barclays Research

March 2013

Jun-06

0 Jun-11

50 0 CHN

IND

JPN

USA

DEU

FRA

GBR

ITA

Note: China’s figure includes both official public debt and local government debt. Source: IMF, National Audit Office, Barclays Research

38

Barclays | China: Beyond the Miracle reforms, then we think it risks experiencing the same fate as many other emerging market economies that saw their growth paths derailed for similar reasons. As we noted in a previous report – “no price distortion in product markets but careful policy intervention in factor markets” 14 – repressive financial policies have been an important part of China’s overall reform strategy. While this has contributed to China’s spectacular growth performance, it has also led to the growing structural risks facing the economy. Among all the factor cost distortions, those affecting financial variables are the most serious and widespread, in our view. According to estimates by Yiping Huang and Kunyu Tao, for instance, distortions of capital costs were about 3.5% of GDP in 2009, while those of land and energy costs were, respectively, 0.9% and 0.7%. 15 Moreover, these distortions have increasingly hampered economic efficiency and financial stability, as partly evidenced by the problems described above. In 1998, Nick Lardy of the Brookings Institution published a widely circulated manuscript titled China’s unfinished revolution. 16 Lardy detailed a range of serious problems facing China’s financial system that could cause financial crises, including huge non-performing loans (NPLs), low capital adequacy levels and lax risk controls. During the following decade, the Chinese financial system underwent enormous changes. For instance, state-owned commercial banks (SOCBs) raised fresh capital, reduced NPLs, developed modern risk management systems and introduced new ownership structures. However, these reforms failed to trigger a more fundamental financial transformation. In essence, the financial sector still exhibits key characteristics of a highly repressed system:

• Chinese commercial banks still behave like policy banks;

• Key interest rates are tightly regulated, not market-determined; and • Access to financing by non-state entities remains highly restricted.

In other words, the financial revolution Lardy envisioned 13 years ago has not happened.

14

Yiping Huang, Jian Chang and Lingxiu Yang, “China: Beyond the Miracle, Part 1 – China’s Next Transition”, Barclays Research, Hong Kong, 5 September 2011. 15 Yiping Huang and Kunyu Tao, “Factor market distortion and the current account surplus in China”, Asian Economic Papers, 2010, 9(3): 1-36. 16 Nick R. Lardy, “China’s unfinished revolution”, Brookings Institution, Washington DC, 1998.

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Barclays | China: Beyond the Miracle But we think more fundamental changes may take place relatively soon in the Chinese financial industry for a number of reasons. First, many of the repressive financial policies are no longer sustainable. For instance, China used to rely on capital account controls to shield domestic financial institutions from external shocks. This is no longer practical. Volatile hot money flows have not only reduced the effectiveness of capital account controls but have also become a source of instability. Similarly, interest rate regulation has led to deposits leaving the banks. If these trends continue, then overall financial risks could rise rapidly. Second, repressive financial policies are a key obstacle to the transformation of the growth model. In fact, interest rate liberalisation is a key policy task identified in the 12th Five-Year Program (FYP). Financial repression was behind strong investment and economic growth in the past. But capital efficiency has declined significantly – the investment share of GDP doubled during the reform period but growth potential stayed around 10% a year (Figure 5). The state sector continues to take about half of total bank credit, while its contribution to GDP is declining rapidly, which is exacting a high price on economic efficiency. And, finally, the government has a very ambitious agenda, which includes liberalisation of the capital account, internationalising the currency and making Shanghai an international financial centre within the next 5-10 years. To achieve these objectives, China’s financial system will need to go through a major transformation.

FIGURE 5 Incremental capital output ratio (ICOR) 8

ICOR

FIGURE 6 Banks dominate financial intermediation 60

7

CNY trn

2005

2010

50

6 40

5 4

30

3

20

2 10

1 0

0 1980

1985

1990

1995

2000

2005

2010

Note: ICOR is calculated as the annual investment divided by annual increase in GDP, all in nominal terms. Source: CEIC, Barclays Research

March 2013

Bank loan

Stock mkt

Gov't bond

Corp bond

Note: all numbers are end-of-period outstanding figures (stock market is end-of-period market capitalisation). Corp bond includes enterprise bond, short-term bill and medium-term note. Source: CEIC, Barclays Research

40

Barclays | China: Beyond the Miracle We expect the coming financial revolution to bring changes to the following areas: (1) reform and development of the capital markets; (2) development of financial products and risk hedging; (3) introduction of market-based interest rates; (4) improvement in governance of financial institutions; and (5) reform of the exchange rate and liberalisation of the capital account. These reforms should eventually change the behaviour of financial institutions and pricing mechanisms for capital. In this context, the previous financial reforms can only be viewed as a prelude to the main act. We believe this anticipated financial revolution could lead to significant changes in the financial landscape in China and have a profound impact on macroeconomic conditions as well as the financial industry, including: 1. Likely increase in the overall cost of capital, with a varying impact among sectors; 2. Rapid expansion of corporate bond markets and relative shrinkage of commercial banks’ balance sheets; 3. Changes in the business models of banks, as they deal with SMEs and generate more service-based fees; and 4. More cyclical and even violent financial risks following dramatic and widespread adjustments of financial prices.

How has the financial system evolved? Despite many outstanding problems, China’s financial reform has come a very long way since the end of the 1970s. We characterise reforms in the financial sector as strong on quantity but weak on quality: the authorities have made progress in building the frameworks for the financial industry and growing the size of financial assets but have achieved little in changing financial institutions’ behaviour and introducing marketbased pricing for capital. 17 Specifically, we can group financial sector changes into four areas:

• Developing financial frameworks, such as the establishment of a central bank and creation of stock exchanges;

17 Yiping Huang, Xun Wang, Bijun Wang and Nian Lin, ‘Financial reform in China: Progresses and challenges’, Report prepared for the Project on Financial Liberalisation in China, Japan and Korea, Columbia University, New York University and Korea University, 2010-2011.

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Barclays | China: Beyond the Miracle

• Expanding financial activities, such as increases in the number of financial institutions and size of financial assets;

• Restructuring financial institutions, such as reforms of the SOCBs, other commercial banks, insurance and securities companies; and

• Liberalising financial markets, such as the removal of regulations on interest rates and opening up for market competition. Within a relatively short period, China developed a comprehensive financial system that had all types of institutions and financial intermediation channels. At the same time, state intervention remains widespread and heavy. The government still asserts a strong influence on financial prices, institutional behaviour and market functions. Perhaps not unrelated, the proportion of indirect financing (through banks) in the economy has grown much faster than direct financing (through capital markets), as it is easier for the government to intervene in the former than in the latter. When economic reforms started in 1978, China had a mono-bank system consisting of the PBoC, which acted both as the central bank and a commercial bank. Nominally, a couple of other banks also existed. The Bank of China (BOC) was really a brand name used by the PBoC when undertaking external economic transactions, while China Construction Bank (CCB, then called the People’s Construction Bank of China) was a department inside the Ministry of Finance (MOF). In any case, in a centrally planned economy, there was a very limited scope for financial intermediation, as pricing and allocation of capital were determined by the central plan, not the financial system. But this situation changed when the period of economic reform started. From the beginning, the government started to build a comprehensive financial system. It first established five giant SOCBs and more than a dozen joint-stock banks, before introducing many foreign banks into the system. At the beginning of 1984, the PBoC unloaded its commercial operations into the newly established Industrial and Commercial Bank of China (ICBC) and became a more normal central bank. Over time, various departments in charge of financial regulations were also separated out to become independent regulatory bodies – China Securities Regulatory Commission (CSRC), China Banking Regulatory Commission (CBRC) and China Insurance Regulatory Commission (CIRC). From the beginning of the 1990s, the authorities began to develop stock exchanges in Shenzhen and Shanghai. Today, China already has a comprehensive financial system with all types of institutions, intermediation channels and products. But, similar to many other East Asian economies, March 2013

42

Barclays | China: Beyond the Miracle the financial system in China is still dominated by the banks (Figure 6). The stock markets have expanded significantly in terms of number of listings, although market capitalisation has varied materially over time due to violent fluctuations in share prices. One striking feature of the Chinese financial system is under-developed corporate bond markets, which present a key obstacle to the task of interest rate liberalisation. Overall financial deepening of the economy, however, has proceeded dramatically. The proportion of broad money supply (M2) to GDP, for instance, rose from 115% in 1997 to 181% in 2010. China’s M2 is already the largest in the world (Figure 8) and, according to the Economist ranking, three Chinese banks, ICBC, CCB and BOC, were ranked among the world’s 10 largest banks at the end of 2010. 18 While the SOCBs continue to dominate the banking system, other forms of banking institutions have grown rapidly during the reform period (Figure 7). In addition to a dozen joint-stock banks, such as China Merchants Bank and Mingsheng Bank, the authorities also transformed the urban and rural credit cooperatives to form large numbers of new city commercial banks and rural commercial/cooperative banks, respectively. Following its entry to the WTO, China’s banking sector also became increasingly open to foreign investors. But, in general, the foreign banks’ share of total banking assets and liabilities remains negligible. FIGURE 7 Composition of China’s banking industry, 1978-2008 (%) 1978-1995

1996-2008

Deposits

Loans

Assets

Deposits

Loans

Big Four

82.0

91.1

65.1

64.6

64.2

12 Joint-Stock Commercial Banks

1.5

1.2

14.9

15.4

15.8

City Commercial Banks

1.9

1.0

6.6

6.6

6.6

Rural Banks and Cooperatives

18.1

6.3

11.7

11.7

11.6

Foreign Banks

0.2

0.4

1.7

1.7

1.8

Source: China’s financial Yearbook, various years

The SOCBs are very important institutions for financial intermediation and financial stability in China. Over the years, they probably shouldered more policy responsibilities than any other financial institutions, including providing ‘social stability’ loans to failing state-owned enterprises (SOEs). But at the time of the Asian financial crisis, the SOCBs 18

“The world’s biggest banks”, The Economist, http://www.economist.com/node/18898228, 30 June 2011.

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Barclays | China: Beyond the Miracle had become a major source of financial risk. The SOCBs had estimated NPL ratios of 3040% and were judged to be technically insolvent, according to many experts. 19 The initial steps of banking reform focused on capital adequacy and non-performing loans. In 1998, the Chinese government issued CNY270bn special treasury bonds to raise capital adequacy ratios of the SOCBs. In 1999, drawing on the US experience of the Resolution Trust Corporation (RTC), the government established four assets management companies (AMCs) to manage and dispose of the non-performing assets of the SOCBs. 20 These AMCs bought CNY1.4trn of NPLs from the SOCBs in 1999. The government also encouraged the banks to use their pre-tax profits, which were created in part by the guaranteed wide interest spread, to write off NPLs. The average NPL ratio for the SOCBs came down to 19.2% in early 2004 and to 6% by the end of 2008, although these levels were consistently higher than those among the joint-stock banks (Figure 9). FIGURE 8 Financial deepening has proceeded dramatically 190 170

FIGURE 9 NPL ratios remained low by historical standard

M2/GDP

18%

All commercial banks

Bank credit/GDP

16%

State-owned banks

14%

Joint-stock banks

12%

City commercial banks

150 130

10%

110

8% 6%

90

4% 70

2%

50 1997

2000

2003

Source: CEIC, Barclays Research

2006

2009

0% Mar-05

Mar-07

Mar-09

Mar-11

Source: CEIC, Barclays Research

19 Nicholas R. Lardy, China’s Unfinished Economic Revolution, 1998, Washington, DC: Brookings Institution Press. John Bonin and Yiping Huang, ‘Dealing with the bad loans of the Chinese banks’, with John P. Bonin, Journal of Asian Economics, 2001, 12(2): 197-214. 20 These AMCs include China Cinda Asset Management Corporation (under CCB), China Huarong Asset Management Corporation (under ICBC), China Orient Asset Management Corporation (BOC) and China Great Wall Asset Management Corporation (ABC).

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Barclays | China: Beyond the Miracle Alongside this NPL problem resolution, the authorities also required the commercial banks to change their backward-looking four-category loan classification system to the forward-looking, international standard five-category system. The new system was first introduced to the major branches of the SOCBs and officially adopted by all banks in 2002. Following China’s accession to the WTO in December 2001, the government accelerated banking reforms. Policymakers selected BOC and ICBC as pilot institutions for transformation into joint-stock commercial banks at the end of 2003. In preparing for their IPOs, the authorities undertook four steps to strengthen the banks’ balance sheets: official capital injections, approving banks to issue subordinated bonds to boost equity levels, disposal of NPLs through AMCs, and introduction of foreign strategic investors (Figure 10). FIGURE 10 Restructuring measures before IPOs for ICBC, BOC, CCB and ABC Bank

ICBC

Date of reorganization

Oct 28, 2005 Aug 26, 2004 Sep 17, 2004

Jan 5, 2009

Capital injectiona: Amount (RMB billion)

124.0

186.4

186.2

150.6

Capital injectionb: Date

Apr 2005

Dec 2003

Dec 2003

Nov 2008

Disposal of NPLs (RMB billion)c

705.0

308.1

185.8

815.7

43.0

32.8

Investment by Foreign Strategic investors 30.5 (RMB billion)

BOC

CCB

ABC

37.2

IPOs: Capital Increase (%)

44

46

36

42

IPOs: Amount (RMB billion)

173.2

110.0

74.6

149.9

Note: a Funding sources: Foreign exchange reserves (CNY496.6bn) and other public findings (CNY18.0bn). b Issued in the interbank market. c The MOF gave receivables to ICBC (CNY246bn) and CCB (CNY65.5bn) and waived the paid-capital of BOC (CNY141.1bn) and CCB (to doubtful NPLs). Simultaneously, the MOF sold bills to the four banks in amount of CNY616.4bn to offset the impact of the disposal. Source: Okazaki (2007) and Barclays Research

In November 2005, China Construction Bank (CCB) was the first of the ‘Big Four’ stateowned bank to be publically listed on the Hong Kong stock market (as an H-share), followed by BOC and ICBC in 2006, and ABC in 2010. Now, all of the SOCBs are listed commercial banks, although the state retains at least two-thirds of their ownership. Many joint-stock banks and even city commercial banks have subsequently followed a similar path of restructuring.

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Barclays | China: Beyond the Miracle Despite the large number of financial reform steps undertaken, however, the Chinese economy today still exhibits typical features of what Ron McKinnon described as financial repression, 21 including:

• Heavy regulation of interest rates, especially the deposit and lending rates of commercial banks;

• Frequent adjustments to reserve requirement ratios for commercial banks; this was 21.5% (for large banks) at the end of the third quarter 2011;

• High concentration of financial assets in a small number of state-owned financial institutions;

• Significant state influences on the allocation of financial resources, most notably bank credit; and

• Still relatively tight controls on the capital account, especially covering overseas investment by residents. Therefore, more fundamental transformation, ie, the long-awaited financial revolution is still yet to happen.

Repressive policies are now retarding growth in China “Financial repression” or “financial restraint” is a common theme in developing economies. It refers to government financial policies that strictly regulate interest rates, set high reserve requirements on bank deposits, and directly allocate financial resources (Figure 11 and Figure 12). According to Ronald McKinnon, who pioneered studies in this area, repressive policies impede financial deepening, hinder efficiency and, therefore, retard economic growth. Nobel Laureate Joseph Stiglitz, however, has cautioned on premature financial liberalisation by pointing to the increasing frequency of financial crises in past decades following such action in developing countries. He argued that low-income countries might be better able to manage money supply and financial stability under repressive financial policies. 22 In other words, financial restraint can be supportive of growth under certain conditions.

21

Ron I. McKinnon, Money and Capital in Economic Development, The Brookings Institution, Washington DC, 1973. Joseph E. Stiglitz, ‘The role of the state in financial markets’, in Bruno, M. and Pleskovic, B. (eds.), Proceeding of the World Bank Annual Conference on Development Economics, 1993: Supplement to the World Bank Economic Review and the World Bank Research Observer, World Bank, Washington, DC, 1994. Joseph E. Stiglitz, ‘Capital market liberalisation, economic growth and instability’, World Development, 2000, Vol. 28, pp. 1075-1086.

22

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Barclays | China: Beyond the Miracle FIGURE 11 Negative real interest rates have been common 15 10

FIGURE 12 RRR a preferred policy tool and reached 21.5%

real 1y benchmark lending rate (%)

20

1y benchmark lending rate (%)

real 1y benchmark deposit rate (%)

18

1y benchmark deposit rate (%) RRR (%)

16 5

14

0

12

25 20 15

10 -5

8 4

-15

5

2 0

-20 Aug-91

10

6

-10

Aug-95

Aug-99

Aug-03

Source: CEIC, Barclays Research

Aug-07

Aug-11

0

Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11

Source: CEIC, Barclays Research

We may refer to the negative impact of financial repression (or positive impact of financial liberalisation) as the ‘McKinnon effect’ and the positive impact as the ‘Stiglitz effect’. Empirical studies in this area are not conclusive – some confirm negative impacts of financial repression on growth (McKinnon effect), others noted positive impacts (Stiglitz effect), and some found mixed results. 23 In our view, the case of China’s reform experience looks more supportive of the Stiglitz effect: while China has been one of the most successful economies in Asia in the past decade, its financial system has also been one of the most heavily repressed. A study in this area by Yiping Huang and Xun Wang reaches two important conclusions. 24 One, the degree of China’s financial repression declined, albeit at gradual pace, during the reform period. This implies that China is moving ahead with its financial liberalisation. Two, repressive financial policies had a positive impact on economic growth in China in the 1980s and 1990s (the Stiglitz effect). However, after entering the 21st century, they think this impact probably turned negative (the McKinnon effect).

23 M. A. Kose, E. Prasad, K. Rogoff, and S. J. Wei, ‘Financial globalisation: a reappraisal’, IMF Staff Papers, 2009, Vol. 56(1), pp. 8-62. 24 Yiping Huang and Xun Wang, ‘Does financial repression prohibit or facilitate economic growth? A case study of China’s reform experience”, Oxford Bulletin of Economics and Statistics, forthcoming, 2011.

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Barclays | China: Beyond the Miracle FIGURE 13 Contribution of the state to output and lending

FIGURE 14 Financial repression index of China (FREP)

70

70

1.1

60

60

1.0

50

50

40

40

30

30

20

20

10

10

0.6

0

0 2001 2003 2005 2007 2009 Industrial output by state control enterprise as % of total New increased loan from state commercial bank as % total

0.5

Source: CEIC, Barclays Research

Financial Repression Index for China (1978=1.0)

0.9 0.8 0.7

0.4 1978

1984

1990

1996

2002

2008

Source: Yiping Huang and Xun Wang, ‘Does financial repression prohibit or facilitate economic growth? A case study of China’s reform experience”, Oxford Bulletin of Economics and Statistics, 2011.

Huang and Wang started their analyses by constructing a composite financial repression index (FREP), applying a statistical technique called “principal component analysis”. The composite FREP was based on six individual indicators of financial repression: 1. Levels of real deposit rates (negative real rates implying repression); 2. Proportion of interest rates that are controlled; 3. Capital account control measures; 4. Reserve requirement ratios; 5. SOCBs’ share of total bank lending; and 6. Share of loans to the SOEs. FREP was normalised to a 0-1 range, with 1 representing the highest level of repression in 1978 and 0 indicating no repression. The estimated index reveals a number of interesting findings (Figure 13 and Figure 14). China’s financial liberalisation during the reform period was gradual but steady. But the pace of liberalisation accelerated noticeably from the early 1990s. Policy restrictions tightened temporarily during both the Asian financial crisis and the recent global financial crisis. And, assuming the endpoint is above 0, China’s financial liberalisation is probably half-way through, although the remaining half may be the more difficult and significant segment. March 2013

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Barclays | China: Beyond the Miracle Huang and Wang then used the above FREP to examine its impact on economic growth, applying a provincial panel data set covering 1979-2008. The analyses using the entire sample confirmed the positive impact of FREP, implying overall financial restraint boosted economic growth during China’s reform period. However, the authors discovered structural changes in the above relationship around 2000 from the data set (Figure 15). They then conducted the analyses separately for the periods before and after 2000. Indeed, while the impact of FREP remained positive on growth during the period 1979-1999 (Stiglitz effect), it turned negative during the period 2000-2008 (the McKinnon effect). In retrospect, during the early years of China’s economic reform, we think repressive financial policies were helpful for growth for a number of reasons.

• First, low interest rates acted as subsidies for economic activity and boosted growth. • Second, the state helped to channel funds from savings to investment.

• Government controls of financial institutions and capital flows also supported financial and macroeconomic stability. Of course, the repressive policies probably also caused efficiency losses. But these were small relative to the overall benefits. If China had liberalised its financial system completely at the beginning of the economic reform period, we think it would probably have experienced a number of financial crises already. Over the years, however, the relative importance between the costs and benefits of repressive financial policies has reversed gradually, through intensification of capital misallocation, inefficiency of capital use, imbalances in the economic structure and, possibly, development of a ‘political economy’ that resists further reforms.

Growing financial and economic risks Repressive financial policies have clearly become an obstacle to economic growth. More importantly, other risk factors are rising rapidly in China. Here we discuss several important problems that are increasingly contributing to macroeconomic and financial risks. The first relates to the seemingly irrational behaviour of financial institutions. Many Chinese financial institutions have undertaken market-oriented reforms. Nevertheless, most of them still behave more like SOEs than market entities. For instance, despite adoption of modern corporate structures, the SOCBs remain tightly controlled by the state. The senior executives of these banks, including the chairmen and presidents are March 2013

49

Barclays | China: Beyond the Miracle

7%

0 -0.1 -0.2 1978-2008

1979-1999

6%

1%

Pawn Company

0.1

2000-2008

Note: Basic refers to basic regression, while Expanded refers to regression with added explanatory variables such as time trend. Results of statistical tests favour the Expanded regression over the Basic regression. Source: CEIC, Barclays Research

22% 15%

Never borrowed

0.2

29% 21%

Rural Trust Company

0.3

Bank

Expanded

Relatives and Friends

35% 30% 25% 20% 15% 10% 5% 0%

Basic

Folk Lending

0.4

FIGURE 16 SMEs have difficulty obtaining bank lending

Small Loan Firm

FIGURE 15 Estimated impact of FREP on GDP growth

Source: PKU, Alibaba Survey

still appointed by the Party. Important business and personnel decisions are still made by the Party Committees, not by Boards of Directors. A clear example was during the global financial crisis, when the financial institutions would have been expected to turn more cautious. In contrast, Chinese banks all increased their lending aggressively to either support the government’s policy or deliver revenue growth to investors. This dramatic credit expansion of recent years implies serious problems could emerge from the financial system. A second problem is the misallocation of capital. For instance, bank lending still favours the state sector. This has become a big constraint on the efficiency of capital allocation given that SMEs now play a much greater role in driving Chinese growth. And with bank interest rates generally low, there is also a shortage of credit supply from the formal financial sector. For instance, the one-year base lending rate is currently below 7%. At the same time, the lending rate in the unofficial ‘kerb’ market in Zhejiang province is around 25%. But SOEs continue to dominate the banks’ credit allocation, while the more dynamic SMEs find it difficult to obtain bank loans. In Zhejiang province where SME financing is more developed, only about 20% of SMEs had obtained bank loans (Figure 16). Others had to meet their financing requirements through other channels, often at much higher costs.

March 2013

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Barclays | China: Beyond the Miracle FIGURE 17 Off-balance sheet lending vs official new loans 12

CNY trn

FIGURE 18 ‘Hot money’ flows have been volatile 80

10

60

8

40

6

20

4

0

2

-20

0

-40

-2

Non-FDI flow*(USD bn)

Inflow

-60 2008 2009 Bank loans Trust loans

1H10

2H10 1H11 Entrusted loans Bank acceptance bills

Note: We estimate informal lending totals around CNY4trn. It has some overlap with off-balance sheet lending, which includes trust loans, entrusted loans and bank acceptance. Source: PBoC, Barclays Research

*Non-FDI flow=Change in PBoC FX purchase-Trade Surplus-FDI inflow -80 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11

Source: PBoC, CEIC, Barclays Research

A third problem concerns the rapid growth in unregulated financial transactions outside the formal system. Recent media reports about SME bankruptcies in Wenzhou highlight the risks in such informal lending and the potential negative impact on the banking system. Kerb markets always existed in China, especially in the coastal province of Zhejiang. The size of informal lending, however, has often fluctuated depending on overall monetary policy conditions. It should be noted that the ‘kerb’ markets have played an important role in supporting economic growth by providing funds to the dynamic SME sector. But they can also be risky given the absence of proper regulation and extraordinarily high interest rates. We estimate that private lending totals around CNY4trn, or about 8% of current official banking system loans (Figure 17). A fourth problem is that distorted interest rates and exchange rates have led to serious economic imbalances such as overinvestment, under-consumption and large external account surpluses. Initially, the government ’repressed’ interest rates and exchange rates to promote investment and exports. But now investment is 48.5% of GDP and the current account surplus remains above 5% of GDP in 2010. Negative real deposit rates can also be blamed for the increase in speculative activities in asset markets last year. As the potential for large capital gains in stocks and property diminished, domestic investors rushed to speculate on specific products such as cotton, garlic, beans, apple and sugar, with the prices of these products soaring one after another. And an undervalued currency has been the main cause of massive ‘hot money’ inflows (Figure 18). These flows added significant liquidity to the domestic financial system and, at the March 2013

51

Barclays | China: Beyond the Miracle same time, undermined the independence of monetary policy. All these factors have created risks to macroeconomic stability and the sustainability of economic growth. A fifth problem is the declining effectiveness of capital account controls, which have increased volatility in cross-border capital flows and weakened monetary policy independence. As the Chinese economy becomes increasingly open, it is becoming more difficult for the government to enforce capital account control measures. The result is that short-term cross-border capital flows have become much bigger and more volatile, and could ultimately threaten the stability of the financial system. Any weakening in capital restrictions would also diminish the PBoC’s ability to control domestic liquidity conditions and interest rates. In a normal year, the PBoC only sterilises about 80% of RMB liquidity injected through its foreign exchange market interventions. This has also contributed to the increase in inflationary pressures. The growing risks, as a result of the above and many other problems, were evident during the global financial crisis. During the second half of 2008 when the international capital markets experienced the ‘great crash’ and the world economy went into a deep recession, the Chinese government announced a CNY4trn stimulus package (Figure 19). In order to support growth, the government also mobilised the banks to accelerate their lending. Newly extended loans totalled almost CNY10trn in 2009 and CNY7.6trn in 2010, compared with the PBoC’s original plan of CNY5trn for 2009 (Figure 20). Clearly, it would have been far more difficult for the government to mobilise such resources without repressive financial policies. But many of these measures have also created potential risks for China’s economy. FIGURE 19 CNY4trn investment stimulus package…

Health care and social development 11.9%

Rural infrastructure and construction 21.2%

2.0

Public service basic infras 2%

Energy efficiency and eco-dev't 4.4% Economic housing 8.8%

High-tech and service industries restructuring 9.9%

Note: This was implemented over Q4 2008-2010. Source: CEIC, Barclays Research

March 2013

CNY trn

1.6 Post-earthquake reconstruction 33.8%

Railway, highway, airports 7.8%

FIGURE 20 …supported by an extraordinary loan growth

1.2

% y/y

36 32 28 24 20

0.8 0.4

16 12 8

0.0 4 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Newly increased loans Credit growth (RHS) Investment growth under Real GDP (RHS)

Source: CEIC, Barclays Research

52

Barclays | China: Beyond the Miracle Most importantly, repressive financial policies become self-sustaining. As noted, during the global financial crisis the government adopted whatever measures were available to support economic growth. Some of those however, have likely caused significant risks for the economy, such as non-performing loans and large fiscal burdens. In particular, the government has not been able to withdraw these support measures even when the crisis period was over, as a significant slowdown in the economy could quickly expose the risks created earlier. In order to avoid a blow-up of these problems, the government seems to have little choice other than continuing with repressive financial policies. We think it can continue this process for a little while longer, but this will increase the risk of eventually leading to a major crisis.

The needed financial reforms The financial revolution we expect involves a wide range of reform measures. But in essence, it needs to change three aspects of the current system:

• Key financial prices, such as interest rates and exchange rates, should be determined by market forces;

• Allocation of capital should also be function of the market, not state agencies; and

• Financial institutions should operate as market entities, maximising returns and minimising risks. Specifically, we expect important reforms over the next five yeas in the following areas: 1. Capital markets development; 2. Development of financial products and hedging instruments; 3. Introduction of market-based interest rates; 4. Improvement of corporate governance at financial institutions; and 5. Reform of the exchange rate policy and liberalisation of the capital account. The 12th Five-Year Program (FYP) has discussed explicitly and implicitly reforms in all of these areas, although it did not set out a specific timetable. Below, we focus on reforms in the first four areas, as we plan to devote a special report to the question of capital account convertibility. Clearly, for domestic financial reforms, the key is interest rate liberalisation, which, according to our earlier analyses, is also a major source of factor cost distortions in China today. March 2013

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Barclays | China: Beyond the Miracle

Deregulation of interest rates Interest rates are probably the most important element of the cost of capital. Distortions to interest rates, such as China’s state-regulated deposit and lending rates, cause a number of problems. They often lead to inefficient use of capital, since formal bank lending is probably too cheap. They also cause unusually high interest rates in the informal markets, inducing borrowers to speculate rather than produce (see Figure 2). Relatively low bank lending rates create excess demand for bank credit and, therefore, invite state intervention in credit allocation. Introducing market-based interest rates, however, is no easy task. It involves changes in at least three key areas:

• Development of a corporate bond market;

• Improvement of the interbank market (eg, Shibor); and • Removal of regulations on deposit and lending rates.

The development of the bond market not only generates yield curves, but also creates flexibility for bank interest rates by shifting large-sized, longer-term loans away from the banks’ books. Shibor will probably become the target rate for adjusting monetary policy in the future, after the PBoC relinquishes direct control over bank rates. Interest rate liberalisation in China started from 1993, following the strategy of “first foreign currency rates, and then local currency rates, first long-term rates and then short-term rates, first money and bond market rates and then deposit and lending rates”. For instance, the PBoC set up an interbank bond market and liberalised repurchase rates and cash bond rates in 1997, and lifted controls over issuance rate for policy financial bonds and treasury bonds in interbank market in 1998. According to Gang Yi, a deputy governor of the PBoC, about 120 types of interest rates underwent reforms, which included the relaxation of controls or their complete removal, and the merger of several types of interest rates. 25 To reduce state control over bank interest rates, the Chinese government has been building other benchmark rates (Figure 21). Since 1996, the government has established several quasi-market-oriented short-term market rates, such as China interbank offered rate (Chibor) and repo rates. These markets, however, remain underdeveloped, judging from transaction volumes and price stability. In 2007, the 25

Gang Yi, “Market-oriented interest rate reform during China’s reform period”, Financial Research (in Chinese), 2009, Issue 1: 1-19.

March 2013

54

Barclays | China: Beyond the Miracle FIGURE 21 Key short-term interest rates developed 7d interbank repo rate (%) 3m Shibor (%) 3m PBoC bill issue rate (%)

11 10 9

FIGURE 22 IRS transactions based on Shibor have expanded 60

3m Shibor IRS: Nominal Principal (CNY bn)

50

8

40

7 30

6 5

20

4

10

3 2

0 Aug-06

1 0 Sep-06

Sep-07

Sep-08

Sep-09

Source:: CEIC, Barclays Research

Sep-10

Sep-11

Aug-07

6-month 3-year

Aug-08 9-month 4-year

Aug-09 1-year 5-year

Aug-10

Aug-11

2-year

Source: CEIC, Barclays Research

PBoC tried again to set up a separate interbank money market rate, the Shanghai interbank offered rate (Shibor). The central bank announced a set of daily fixing rates based on quotes by several contributing banks. This can be seen as an uncollateralised short-term lending rate among the contributing banks. In recent years, the Shibor market has developed rapidly (Figure 22). Total transactions in this market leapt to CNY115trn in 2010 from CNY71trn in 2007. Fully functioning short-term benchmark rates facilitate the development of the derivatives markets and improve the pricing mechanism in capital markets. Perhaps the most visible interest rates in the Chinese economy today are the deposit and lending rates. During the early years of reform, commercial banks had to strictly follow the base rates set by the central bank. But over the years, the PBoC has taken steps to ease the restrictions (Figure 23). It took the first step to liberalise lending rates as early as 1987. Commercial banks were allowed to float lending rates upward by a maximum of 20%, and this band was adjusted from time to time. In late 2004, the PBoC abolished ceilings for lending rates for all commercial banks, except urban and rural credit cooperatives (the upper bound for urban and rural credit cooperatives was also raised to 2.3-times the base rate). The lower limit for loan rates remained unchanged at 0.9-times the base rate. In our view, the next step in the liberalisation of interest rates should be to remove deposit rate ceilings and lending rate floors. The current regulation ensures that banks can have profitable interest rate margins and avoids price competition among the banks. On the upside, the wide net spreads that the regulations guarantee generally March 2013

55

Barclays | China: Beyond the Miracle have provided banks with healthy margins and fairly strong core earnings – around 60% of banks’ operating profits are from lending-related net interest income. On the downside, banks do not use risk pricing to allocate capital, which may generate poor asset quality and create large systemic risks. FIGURE 23 Interest rate deregulation Market

Time

Event

Phase 1: Liberalisation of interbank market interest rates, government bond issuance rate and financial policy bond issuance rate

Jun 1996

Opening up of interbank offered rate

Jun 1997

Opening up of interbank bond repo rate

Sep 1998

China Development Bank's financial bonds issued for the first time through open bid in the interbank bond market

Oct 1999

Government bonds also issued through open bid

Phase 2: Liberalisation of lending rate and discount rate pricing

Mar 1998

The PBoC reformed the mechanism for formulating the rediscount and discount rates. The rediscount rate, as an independent interest rate, is determined by the central bank. The discount rate is generated by adding basis points to the rediscount rate. The additional bp can be determined by commercial banks so long as the discount rate does not exceed the lending rate (including floating rate) in the corresponding period

1998

The PBoC increased the floating range of lending rates offered by financial institutions, enhancing commercial banks' pricing power and pushing forward the liberalisation of lending rate

1998

Currently, there is no upper limit for commercial banks' lending rates, the lower limit is a 10% downward adjustment. The floating range of lending rates offered by urban and rural credit cooperatives expanded (0.9x, 2.3x)

2004

So far, CNY loans offered by financial institutions have reached the phase that only lower limit of the lending rate is controlled

Phase 3: Liberalisation Oct 1999 of deposit interest rate

March 2013

The PBoC rules that the interest rate offered by commercial banks for deposits from domestic insurance companies in amounts greater than CNY30mn and maturities less than or equal to 5y can be negotiated by the two parties

Mar 2002

Social security funds, pension funds, postal savings banks, etc, can also negotiate the deposit interest rate with commercial banks

Oct 2004

The PBoC allows all deposit-taking financial institutions to float CNY deposit interest rates downward; upward floating is not allowed

56

Barclays | China: Beyond the Miracle Market

Time

Event

Phase 4: Opening up of Oct 2008 restriction on upper limit of deposit interest rate and lower limit of lending rate

The PBoC allows mortgage rates to float downward to a maximum of 30% instead of 15%

Source: PBoC, Barclays Research

Debt market development and disintermediation The development of debt markets plays an important part in the evolution of financial markets (Figure 24). It helps to create a benchmark yield curve, opens up new financing channels and reduces asset-liability mismatch problems at banks, insurance companies and pension funds. Large corporations and investment projects should be able to raise longer-term funding at a lower cost. This would also create more room for interest rate flexibility at the banks. Interest rate liberalisation should be coordinated with capital market reforms. Historically, China’s bond market has had two major problems: banks were the dominant investors and the government was the major issuer. Since the establishment of the interbank bond market in 1997, it has been the largest bond market in China, but it has blocked other participants. Banks held around 68% of total bonds in the interbank bond market. Before 2007, almost all corporate bonds were issued with commercial bank guarantees. With commercial bank guarantees, the credit risk is concentrated in commercial banks, and issuers’ credit quality differentiation is not priced by the market. FIGURE 24 Breakdown of domestic bond market 25

CNY trn

20

FIGURE 25 Medium-term notes expanded rapidly

Short-medium term notes Enterprise bond Financial bond

1.8

Middle-term note (CNY trn)

1.6

Short-term bill (CNY trn)

Central bank bills Gov't bond

1.4 1.2

15

1.0 0.8

10

0.6 0.4

5

0.2

0 Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Note: Enterprise bond refers to bonds issued by stateowned enterprises and government affiliated bodies. Short-medium term notes include short-term bills and medium-term note. Source: CEIC, Barclays Research

March 2013

0.0 Jul-08

Jul-09

Jul-10

Jul-11

Source: CEIC, Barclays Research

57

Barclays | China: Beyond the Miracle Strict issuance rules also hamper the development of a corporate bond market. As a result of the long process required to get administrative approval to issue corporate bonds, the bond market became a channel for government financing. Only a small number of large companies with very high credit quality were allowed to issue bonds in the market, resulting in a small corporate bond market and discouraging financial disintermediation. Overconcentration on certain investors and debt products hinders the use of bond yields as a reference for market interest rates. Government and financial institution bonds, and central bank paper dominate the bond market and account for about 90% of the market. The rest is short-term, high-quality corporate bonds. The market lacks long-term and non-investment grade debt. Limited bond yields cannot differentiate risks among issuers. In recent years, regulators have implemented a number of new measures and reforms to spur the development of a domestic corporate bond market and promote disintermediation. In order to diversify the type of participants, the PBoC allowed securities companies to enter the interbank bond market. In 2010, the Insurance Regulatory Commission also loosened the regulations governing insurance companies’ investments in the bond market. These policies resulted in a significant increase in corporate bonds, especially mediumterm notes (MTNs, Figure 25), in recent years. Permitting commercial banks to participate in corporate bond trading and raising the investment limit for insurance companies is likely to have a significant impact on the demand side of the market. From the issuance side, the PBoC has allowed a greater range of credit to be sold, lifted the minimum size requirement for bond issuance and introduced corporate MTNs in the interbank bond market. In recent years, the corporate bond market has grown significantly, although from a very low base, thanks to the PBoC's encouragement of short-term bill and medium-term note issuance. Total bond funding for corporate non-financial institutions jumped from only CNY200bn in 2005 to over CNY1.2trn in 2010 (Figure 26). FIGURE 26 Bond market statistics (CNY bn)

2005

2006

2007

2008

2009

2010

2Q11

Outstanding Balance Government bond

2,877

3,145

4,874

4,977

5,878

6,773

6,995

Central bank bill

2,263

3,230

3,659

4,812

4,233

4,091

2,675

March 2013

58

Barclays | China: Beyond the Miracle (CNY bn)

2005

2006

2007

2008

2009

2010

2Q11

Financial bond

2,024

2,594

3,366

4,125

5,138

5,931

6,948

381

575

808

1,402

2,659

3,899

4,545

Asset-backed security

7

16

29

42

40

18

10

Other bond

2

3

3

3

4

4

4

7,554

9,563

Corp bond by non-financial enterprises

Total

12,739 15,360 17,951 20,717 21,177

Note: Corp bond by non-financial enterprises includes enterprise bond, short-term bill and medium-term note. Financial bond includes bonds issued by policy, commercial banks and non-bank financial institutions. Source: NAFMII, Barclays Research

Development of financial products and risk hedging In financial reform, it is important to equip financial market players with tools to hedge their risks. Recently, several financial derivative products have developed rapidly. Among those, interest rate derivatives are widely used by investors to hedge interest rate risks. The development of China’s bond market further boosts this derivative market. CNY interest rate swaps (IRS) have been allowed to be traded in the interbank bond market since 2006. A liquid interest swap market can provide a tool for banks and investors to manage interest risks and asset-liability management. Total market transactions in IRS during 2010 were CNY1.5trn, compared with CNY34bn in 2006. We believe further deregulation of interest rates and better risk knowledge among domestic institutional investors will increase the turnover in interest rate swaps. Other financial derivatives are developing gradually. In October 2010, China launched its first credit derivative product, credit risk mitigation (CRM), widely seen as a Chinese version of credit default swaps (CDS). However, transaction volume in CDS in China is very small. The underlying reasons for lack of market enthusiasm is that the limitation on market participants leads to credit risk transferring only within the China banking system instead more widely among financial market participants, reducing the effectiveness of maintaining stability in the economy and the financial system. Another reason could be the difficulty in pricing the new products. Until now, there has been no default in China’s bond market. As a result, no records, such as default rates and loss rates can be determined, and therefore, appropriate pricing becomes difficult. The rapid growth in wealth management and bancassurance products increases the need for banks to monitor their risks (Figure 27 and Figure 28). As the pace of capital market development accelerates, the barriers separating different financial services are

March 2013

59

Barclays | China: Beyond the Miracle FIGURE 27 Rapid growth in wealth management products… 12,000

Total wealth management products issued

10,000 8,000

FIGURE 28 …with all underlying asset categories 100% 80% 60% 40%

6,000 20%

0 1Q05 4Q05 3Q06 2Q07 1Q08 4Q08 3Q09 2Q10 1Q11

Note: The figure represented is the number of products issued instead of outstanding. Source: Wind, Barclays Research

Bond Bill Commodity

Interest rate Credit-related Others

1Q11

3Q10

1Q10

3Q09

1Q09

3Q08

1Q08

3Q07

1Q07

3Q06

1Q06

0%

3Q05

2,000

1Q05

4,000

FX Equity

Source: Wind, Barclays Research

quickly coming down, leading closer relationships and cooperation between banks, insurance companies and trust companies. Apart from traditional lending business, commercial banks are selling different wealth management and bancassurance products in their branches. The total balance of wealth management products managed by banks that are subject to new CBRC rules reportedly was more than CNY2trn in H1 10. Bancassurance accounts for large proportion of total life premium income according to data released by CIRC. Selling these products undoubtedly enhances the banks’ fee and commission income. However, banks face several kinds of risks, including legal, operating and reputational risks, when their customers lose money and then sue them for inappropriate sales practices. Moreover, banks also face substantial credit risk when they are selling loan-related wealth management products. Without currency derivatives, financial institutions in China have difficulty managing foreign exchange risk. Because of foreign exchange controls, the domestic foreign exchange market is underdeveloped, as is the market in FX derivatives. However, since Chinese companies and financial institutions have expanded their business overseas, their foreign exchange exposure has increased dramatically. Demand for FX futures, options and swaps to hedge foreign exchange exposure is rising. Since the Chinese government plans to liberalise its exchange rate, we expect the emergence of a domestic foreign exchange derivatives market.

March 2013

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Barclays | China: Beyond the Miracle

Corporate governance of financial institutions Without proper corporate governance and risk management, a financial institution cannot function as a commercial entity and properly price capital, IPOs and the commercialisation of banks have improved their corporate governance. Shareholding restructuring helped the banks modernise their corporate and management structures. After being listed on the stock exchange, many Chinese banks introduced independent directors and strategic investors. Meanwhile, the CBRC’s examination program, and enhanced surveillance and oversight also forced banks to improve corporate governance. However, there are risks emanating from the growing complexity and scale of financial market and products in China. Since 2000, China’s National Audit Office (NAO) has discovered over several billion dollars in irregular transactions at state-owned banks. Many of these questionable bank activities were obscured by weak internal controls and decentralised IT systems. Loose corporate governance can result in poor profitability and weak asset quality. The current improvements in corporate governance and internal controls at financial institutions likely will not be sufficient to prevent these risks. Further development is needed and management practices should continue to improve. In particular, western-style corporate governance at Chinese banks is challenged by the Communist Party’s involvement and dominance of managerial appointments, as well as the need to balance business decisions with a “national service” requirement. The influence of the state and the party on the operations of the banks and other financial institutions will be a key test for the improvement of governance. The fact that the state is a majority owner and appoints the top managers does not mean that financial institutions should continue to act like policy entities. The state, like other investors, should pursue its commercial interest in these financial institutions, in our view. The state should pursue policy objectives, such as economic growth and income equality, through other policy entities. Otherwise, as evidenced by the experiences during the global financial crisis, most of the previous efforts to try to improve corporate governance could be wasted when the government deals with cyclical policy issues. Such changes are by their nature very difficult and may involve a certain degree of political reform. But the liberalisation of interest rates and exchange rates, and subjecting financial institutions to capital market discipline should be helpful in reducing direct intervention by the state.

Capital account convertibility and exchange rate flexibility The PBoC made the CNY convertible under the current account at the end of 1996 and adopted a managed-float exchange rate regime, with reference to a basket of March 2013

61

Barclays | China: Beyond the Miracle currencies, in mid-2005. But it maintains relatively tight controls over cross-border capital flows and allows limited flexibility in the exchange rate. Over the past few years, this limited flexibility has also become a source of instability and inefficiency. With a very large current account surplus, huge foreign exchange reserves and a rapidly growing economy, China’s currency is widely regarded as undervalued, although the estimated undervaluation ranges between 5% and 50%. An undervalued currency encourages exports but discourages imports. This is probably a key factor behind China’s large and persistent current account surpluses in recent years. An undervalued currency also favours the tradable sector but discriminates against the non-tradable sector. This probably also explains the underdeveloped service sector in the Chinese economy. More importantly, as the economy becomes more open, the effectiveness of capital account controls has weakened, as evidenced by increasing short-term cross-border capital flows. This causes instability in the domestic financial system. In face of rising capital inflows, the PBoC has to increase its intervention in foreign exchange markets in order to maintain exchange rate stability (Figure 29). However, the PBoC typically is only able to sterilise about 80% of the local currency liquidity it injects by buying foreign currencies. This creates difficulties for it in controlling domestic liquidity conditions and in implementing independent monetary policies. Policymakers are now gradually reaching a consensus view on achieving basic convertibility of the capital account within the next five years. “Basic convertibility” means that the authorities may retain restrictions on cross-border capital flows in a

FIGURE 29 Continued FX intervention amid capital inflows 200 USD bn

% pa

-12

FIGURE 30 Large Chinese bank net interest margin (NIM) 1y benchmark lending rate (%)

10

Big banks NIM (%)

9 150

Inflow

-8

100

-4

50

0

0

4

-50

8

8 7 6 5 4

Change in position for FX purchase by PBoC -100 Aug-07

CIP deviation (RHS, inverted) Aug-08

Aug-09

Source: PBoC, Bloomberg, Barclays Research

March 2013

2 1

12 Aug-10

3

Aug-11

0 Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

Source: Wind, Barclays Research

62

Barclays | China: Beyond the Miracle small number of areas, such as portfolio investment, while removing other restrictions. Such a plan, if implemented over the coming years, should accelerate the liberalisation in a number of financial areas, including interest rate and exchange rate policy, and bring about a sea change to the Chinese economy.

Policy and market implications Although we are confident that the financial revolution is likely to take place soon, the exact order and timing of such reforms remain uncertain. This will depend, in part, on evolving external and internal economic and financial conditions, and in part, on policymakers’ judgment of such opportunities. But if five years is a reasonable time frame, then we are likely to see concrete reforms in debt markets, financial products, interest rates and exchange rates relatively soon.

Key changes in the financial sectors Reform is likely to lead to a number of important changes in the financial system. First, the cost of capital is likely to trend higher. Two possible mechanisms could lead to this outcome: 1) removal of financial restrictions (therefore, a rise in real interest rates); and 2) the rebalancing of the economy (and therefore, a decline in savings). But reform is likely to reduce the excess demand for credit and limit the need for ‘kerb’ markets. Therefore, funding costs for SMEs and other enterprises that currently seek financing through informal channels could decline. Large corporations may also be able to access to direct financing more cheaply. Net changes to market interest rates may be ambiguous in the short term. Second, debt markets, especially for corporate bonds and municipal bonds, are likely to grow significantly. Large corporations and large investment projects would probably choose to raise funds from the market, benefiting from both longer maturities and cheaper costs. This should create room for flexible bank interest rates. At the same time, larger debt markets would also generate investment opportunities for insurance companies and pension funds, reducing their current problems of term mismatch. Third, in the near term, however, reform could pose serious challenges for banks. Large banks, especially the state-owned banks that are used to dealing with large SOEs and government entities with relatively low economic and political risks, will likely be forced to change their current business models. Increasingly, they will have to deal with SMEs and other economic entities, and generate more service-based income. Joint-stock banks and many of small city commercial banks will face fierce deposit competition, forcing them to do proper risk pricing for their SME clients. March 2013

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Barclays | China: Beyond the Miracle Finally, removal of the last set of distortions would help improve efficiency. At the same time, it could, increase financial volatility, as the state reduces its intervention and protection. The financial markets and institutions will be forced to withstand greater fluctuations and shocks.

Risks to watch during the transition Financial revolution, while necessary and inevitable, could introduce new risks, as the financial markets are subject to greater volatility and financial institutions are more exposed. In many emerging market economies, financial liberalisation is sometimes accompanied by financial crisis. But to put off reform is no longer a viable option for China. Therefore, it is critical that policymakers monitor the risks closely and design careful measures to minimise the probability of a financial crisis. It is equally important for investors to stay alert to danger during the revolution. Interest rate deregulation can create irrational price competition. In order to support their lending and asset growth, banks may try to attract customer deposits by increasing deposit rates. Funding cost will rise and profit margins will be squeezed. Since interest income remains the core of operating income at Chinese banks, they may seek loan growth and market share instead of risk-adjusted returns. Thin profit and net interest margins weaken the banks’ ability to cope with unexpected market shocks and changes in interest rates (Figure 30). Without sophisticated risk pricing mechanisms, banks could wrongly evaluate credit risks and misprice lending rates, leading to a system-wide increase in nonperforming assets. Since banks are connected via the interbank lending market, the default of one participant could trigger financial difficulties at other banks, possibly leading to a banking crisis. To seek only profit growth, banks may hide their risks off the balance sheet. Recently, the Chinese government adopted tighter monetary policies to rein inflation. It implemented lending quotas to control loan growth. To meet strong loan demand, banks have repackaged their loans as loan-related wealth management products, which are sold to their retail and corporate customers. These products have increased rapidly. The total balance of the loan-related bank wealth management products accounted for one-third of the system-wide loan balance in H1 11. As off-balance-sheet products, these transactions (eg, trust loans, entrusted loans, bank acceptance bills, see Figure 17) do not show up on banks’ balance sheets and are not subject to regulatory requirements on capital, liquidity, and loss provisions. On one hand, banks are not monitoring these off-balance-sheet items closely enough, in our view. On the other hand, the proliferation of these credit-related wealth management products creates a

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Barclays | China: Beyond the Miracle high-risk, unregulated shadow loan market, which could hamper the effectiveness and efficiency of government policy. At the encouragement of central government, and assisted by low interest rates, local governments’ desire for strong GDP growth, and immature risk management system, banks may have allocated bank loans to some weak local-government funding platforms (LGFPs). Under the CNY4trn stimulus in 2009, huge bank loans flowed into the LGFPs to support long-term infrastructure projects. According to China’s National Audit Office, LGFP loans amounted to CNY8.5trn at end-2010, approximately 18% of total loans, and 50% of LGFP loans have a maturity longer than 5y. However, the LGFPs’ repayment abilities have been questioned by the market because of their high debt ratios, tight funding sources and low cash flow coverage for projects. Local governments rely heavily on central government transfers and land sales to make up the gap. However, this may not be sustainable in the long run, raising questions about local governments’ ability to repay debt if these funding sources are disrupted. Although we believe a large NPL carve-out or restructuring is not urgently needed, risks still exists. If LGFP loans cannot be eventually remedied, stagnant financial reform and slow economic growth could lead to significant asset quality problem. Chinese banks’ past restructurings between 1998 and 2008, as well as the experience during the global financial crisis, indicate that the cost of bank bailouts is very high (average 16% globally according to the IMF).

Regulations needed to minimise the risks of financial reform To minimise the risks of a banking crisis and financial disruption, comprehensive regulations should be implemented together with financial market reform. In past few years, regulators have demonstrated their ability to identify the risks in the financial system and implement timely and effective regulations to control the risks before they become systemic risks. To tackle the irrational price competition among the banks during interest rate deregulation, the regulators can request the banks to maintain a minimum level of net interest margin instead of strictly control the lending and deposit rates. Bank can flexibly determine its lending and deposit rates, according to its risk appetite. Banks should be allowed to use higher deposit rates to attract customer deposits as long as they can earn higher yields on their assets, in order to fulfil the minimum net interest margin requirement. Under such as regulation, even small banks can develop their own franchise value, given they have mature risk price mechanism.

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Barclays | China: Beyond the Miracle Regarding unregulated off-balance sheet loans, higher (deregulated) deposit rates may stop the exodus of deposits. Regulators can introduce some ratio guidelines covering off-balance-sheet products that are related to balance sheet/asset size. In addition, the government can require banks to bring credit-related wealth management products back onto their balance sheets, as the CBRC has been doing recently. As a result of complex financial products and the deregulation of cross investments among different types of financial institutions, a super regulator may be needed to monitor overall risks in the financial markets. Regarding LGFP loans, the government needs to reform its unbalanced fiscal model. To make local governments fiscally sustainable, further reforms are necessary, such as the issuance of municipal bonds; the introduction of local taxes, such as a local resource tax, property taxes (a major revenue source for local governments in the US); and an increased share of central government taxes. If these changes were implemented and synchronised with other financial reforms, local governments’ repayment ability could be enhanced and potential LGFP NPLs could be forestalled.

FIGURE 31 Total local government debt by usage

Social housing , science, education, culture and health care 9%

Agriculture and agrigation 4%

Others 22%

Urban infrastructure 33%

Land reserve 10%

Transportation 22%

Source: National Audit Office, Barclays Research

March 2013

FIGURE 32 Some type of debt restructuring is expected Mature by 2016 or afterwards 31%

Mature between 2013-2015 28%

Mature by 2011 24%

Mature by 2012 17%

Source: National Audit Office, Barclays Research

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Barclays | China: Beyond the Miracle

CHAPTER 3

Bubble deflation, Chinese style

• Chinese property markets already exhibit significant risks of a bubble, according to various conventional measures.

• Past property booms were supported by strong income growth, steady urbanization, favourable demography, limited investment alternatives and healthy household balance sheets.

• These factors, however, may turn into negatives in the coming years, generating significant risks of a bubble bursting.

• Restrictions on housing purchases are only a second-best policy option. But they have been effective in lowering property prices and reducing future risks of a bubble bursting.

• We expect property prices to decline by 10-30% during the current cycle, which should not lead to systemic crisis or collapse.

• Households are not likely to be forced to sell, while large developers could survive the downturn. But small developers will probably suffer from significant financial stresses.

• Policy may be adjusted if the average price decline approaches 20%. And the longer-term agenda is set to replace restrictions on housing purchases with property taxes.

• Weakening property markets should slow investment significantly, impacting the global commodity market. But Chinese consumers are likely to stay relatively more resilient.

This article was originally published on 8 November 2011.

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Policy-induced correction Australian economist Ross Garnaut once commented on predictions about the Chinese economy: “Pessimists are more scholarly, but optimists are often right”. He noted that there had been continuous calls for collapse or stagnation of the Chinese economy since the beginning of economic reform. Meanwhile, more upbeat predictions by Dwight Perkins of Harvard University, Justin Lin of Peking University and himself had been repeatedly beaten by the actual performance of the economy. Forecasts of GDP growth during the global financial crisis provided a good case study. At the beginning of 2009, most market economists forecasted full-year GDP growth at well below 8%. Those who stuck to above 8% forecasts were under pressure from their colleagues and the market. The actual GDP growth in that year was 9.2%, revised up from the initial print of 9.1%. We do not underestimate the value of pessimistic calls since they help focus investors’ and policymakers’ attention on important risk factors. But if pessimistic expectations have not materialized for decades, there might be something unique about the Chinese economy that does not fit the conventional analytical framework. After all, China is not a typical market economy. Given China’s underdeveloped legal system, widespread distortions in incentive structure and state intervention in economic activities, who would have predicted the thirty-year economic miracle? There is probably disproportionate incentive for analysts to make pessimistic calls, since they make it easier to get investors’ attention. And sooner or later these pessimistic calls, such as the collapse of a housing bubble, will turn out to be true. The trouble, however, is that waiting for that to happen might prove to be very costly for shortsellers. If investors had positioned for 4.5% GDP in China in 2009, for instance, they probably would have recorded significant losses. Again, some commentators have been calling for a collapse of China’s property markets since 2004. Investors would again have lost significantly had they followed such investment advice. Recently, worries about China’s real estate risks have gathered new momentum. Housing prices have started to decline in an increasing number of Chinese cities during the past few months. There are also media reports about property developers running into significant financial difficulties given tighter liquidity conditions, higher costs of capital, declining housing prices and slower flows of property transactions. And, most importantly, China’s housing bubble has already reached extraordinary levels according to conventional measures such as affordability, vacancy and rental yields. Some commentators describe it as the bubble of the century (Figure 1 and Figure 2). March 2013

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Barclays | China: Beyond the Miracle FIGURE 1 Property prices surged again since Q1 2009… Jan07=100 280 260 240 220 200

Centaline secondary: Beijing Centaline secondary: Shanghai Centaline secondary: Guangzhou NBS secondary: Beijing NBS secondary: Shanghai NBS secondary: Guangzhou

FIGURE 2 …followed by a construction boom 1.8

Floor space starts (Sq m bn)

1.6

Floor space completed (Sq m bn) Floor space sold (Sq m bn)

1.4 1.2 1.0

180

0.8

160

0.6

140

0.4

120

0.2

100 80 Sep-07

0.0 Sep-08

Sep-09

Source: Wind, Barclays Research

Sep-10

Sep-11

1998

2001

2004

2007

2010

Source: CEIC, Barclays Research

Bubbles all burst in the end. This is probably why international investors are often skeptical about arguments that “this time it is different”. But the critical question really is “when” and “how” such bubble corrections will occur. We do not pretend that we know exact answers to these questions. But if, as some suggest, China’s house price/income ratio is already three or more times that of other bubble economies, why hasn’t China’s property bubble burst? Perhaps there are some unique features of the Chinese property markets that have been sustaining growth in property prices? Here are several possible candidates to consider: • • • •

It is possible that Chinese household incomes have been underestimated and, therefore, the bubble might not be as big; Given a lack of alternative investment opportunities, property is the only meaningful form of Chinese household wealth; Demographic change, urbanization and housing upgrading all underscore continued strong fundamental demand for properties (Figure 3); and Even when housing prices are under downward pressure, Chinese households are often not forced to sell given their low leverage ratios (Figure 4).

Without a doubt, the Chinese housing market is entering a difficult period. But such difficulties so far have almost been completely caused by government policies – tightening of monetary policies and restrictions on housing purchase. We cannot rule out the possibility of housing prices declining by 10-30% during the current cycle, March 2013

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Barclays | China: Beyond the Miracle FIGURE 4 Households leverage increased but remained low

FIGURE 3 A shift of demographic trend 1,200

300

China (LHS, Person mn) Japan (Person mn) US (Person mn)

1,000

20

Other consumer loan

% GDP

Automobile loan Mortgage loan

18

250

800

200

600

150

400

100

200

50

16 14 12 10 8 6 4 2

0

0 1950

1965

1980

1995

2010

Source: CEIC, Barclays Research

2025

2040

0 2000

2002

2004

2006

2008

2010

Source: CEIC, Barclays Research

depending on the persistence of policy restrictions and responsiveness of the market to policy adjustment. Such a decline would likely lead to adjustment, but not meltdown, in the housing market. Risks of a bubble bursting might rise significantly over the coming years, as Chinese households lever up, alternative investment opportunities grow, fundamental housing demand weakens and income growth slows. In other words, those factors that underscore strong housing prices at the moment could soon turn negative, adding structural downward pressures on prices. Government restrictions on housing purchase, based on individuals’ household registration, are often criticized by economists as unfair, inefficient and unscientific. We share that assessment. But they have obviously been effective in cooling down the market, evidenced by stabilization and decline of housing prices across the country. There have been pressures at the local government level to readjust restrictions on housing purchases but the central government position appears to be clear, wanting to continue with the policy. Our takeaways are that, one, the government will not sit idle and watch the free fall of housing prices. After all, the policy objective is to stabilize, not to collapse, the housing market. And, two, the government may accelerate the transition of housing policy toward property taxes, to raise revenues and curtail demand, in the coming years.

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Barclays | China: Beyond the Miracle To us, the fact that the government is dealing with the property bubbles now and housing prices are already declining is an encouraging sign. The government’s actions actually reduce the probability of a housing market meltdown in the future, in our view. Our views about the Chinese property market can be summarized as follows. • •

•

•

•

China’s property sector already suffers from a significant bubble, according to conventional criteria, especially in major metropolitan cities. Bubbles have not burst so far because the market has been supported by strong income growth, high savings but limited investment opportunities, continued urbanization and low household leverage. But all these positive factors could turn to negatives, as income growth slows, investment opportunities diversify, leverage ratios rise and demographic supports weaken. The market will likely experience policy-induced correction by 10-30% in the coming year, which should impact economic growth but is unlikely to lead to financial meltdown. Restrictions on housing purchase are probably a second-best choice and may be replaced by property taxes. But interventions now actually reduce the probability of an uglier bursting of the bubble in the future.

Making of property bubbles There is no question that China’s high property prices are a serious concern for policymakers and investors. The housing price index has risen by at least 70% since 2000. Such a price increase almost paralleled the property bubbles which developed in Japan in 1982-1991 and in the US in 1996-2006 (Figure 5). In both the US and Japan, however, those periods of bubble building were immediately followed by painful adjustments, the subprime crisis in the US and the “lost decade” in Japan. These raise important questions about the next step for China’s property prices, leading some China bears to call for imminent collapse of the Chinese housing market. A housing bubble has been a common phenomenon in both developed and emerging market economies. While there are probably unique factors contributing to property bubbles in each country, most such factors fall into three broad categories:

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Barclays | China: Beyond the Miracle •

The first is strong economic growth, which usually pushes up prices of non-tradable goods, such as housing, disproportionately;

•

The second is loose monetary policy conditions, such as low interest rates and abundant credit, which almost always fuel growth in property prices; and

•

The third includes some other policy and economic variables, such as demographics and property taxes.

Rapid increases in property prices are often associated with strong economic growth. This is mainly because properties are non-tradable goods and supply responses are more constrained. For instance, in an economy which is growing by 10%, its aggregate demand, including demand for tradable and non-tradable goods, would probably also expand by 10% a year, assuming uniform income elasticity of 1. Price responses, however, would be very different for tradable and non-tradable goods. Prices for tradable goods should stay unchanged since additional demand can be satisfied by imports if there is excess demand in the domestic market. In the meantime, supply of non-tradable, such as housing, normally is less elastic. Therefore, additional demand should push up prices of non-tradables. And expectation of such price increase should encourage investment or speculative demand. Property bubbles, however, are almost always accompanied by relatively loose monetary policy conditions. In all three cases of property bubbles building in China, Japan and the US, easy money was clearly evident. FIGURE 5 Property bubbles: US, Japan and China 250

FIGURE 6 Credit growth drives property investment 60

Property investment (RHS, %y/y, 3mma) Credit growth (%y/y)

35

50

200

40

30 40

25

150

20

30 100 Japan (1982=100) 50

United States (1996=100)

15

20

10 10

5

China (2000=100) 0 1

3

5

7

9 11 13 15 17 19 21 23 25 27 29

Note: China’s official price statistics underestimates the actual price increases as show in Figure 1. Source: CEIC, Bloomberg, Barclays Research

March 2013

0 Sep-99

Sep-01

Sep-03

Sep-05

Sep-07

Sep-09

0 Sep-11

Source: CEIC, Barclays Research

72

Barclays | China: Beyond the Miracle In the US, it began with the bursting of the Internet bubble. In order to mitigate the adverse effects, the Federal Reserve Bank maintained a loose monetary policy, including historically low interest rates. Some commentators have criticized the Fed for creating one bubble (housing) to counter the negative impact of the bursting of another bubble (the Internet). Some other factors also facilitated housing demand during those years. For instance, the Bush administration continued to encourage home ownership. Deregulation also promoted financial innovation, such as the development of subprime mortgages and subprime debt, which created millions of homebuyers who would otherwise not have qualified under normal circumstances. In Japan, it all started with the Plaza Accord. However, currency appreciation, which probably encouraged capital inflows into the Japanese asset markets, was only part of the cause. A more fundamental contributing factor was the extraordinarily loose domestic monetary policy condition. Fearing the negative consequences of currency appreciation, the Bank of Japan (BoJ) cut rates and increased credit. At that time, easing of monetary policy was viewed by officials as killing two birds with one stone: it was expected to offset some of the tightening effects of a stronger currency and, at the same time, discourage capital inflows and thus reduce pressures for further appreciation. Many singled out the Plaza Accord for causing property bubbles and the following consequences in Japan. Such blame, however, is at least inaccurate. A quick comparison of the German and Japanese experiences in the post-Plaza Accord period reveals several important findings (see Figure 7): • • •

While property bubbles are common in steadily growing economies, they are not inevitable; What contributed to the rapid build-up of the property bubble in Japan was not the Plaza Accord, but domestic policies responding to it; Some other policies, such as rental regulation, mortgage requirements and property taxes helped Germany avoid a serious property bubble.

Indeed, in the period following implementation of the Plaza Accord, both Japan and Germany experienced similar currency appreciation, GDP growth and CPI inflation. But Japan developed a serious property bubble, while Germany’s property prices were much more stable. In addition to less accommodative monetary policies, Germany also introduced policies in three areas to discourage property investment: 1) a fairly conservative mortgage policy, which requires households to have high deposits at the bank (around 50% of the mortgage) before borrowing; 2) the German government March 2013

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Barclays | China: Beyond the Miracle effectively regulates the housing rental market, which limited returns on property investment; and 3) differentiated tax policy in Germany on property purchased for investment reasons. FIGURE 7 Property markets in Germany and Japan Japan

Germany

Currency appreciation, 1985-1991

50%

52%

Macro indicators, 1985-1991

GDP 4.4%; CPI 1.7%

GDP 4.6%; CPI 1.8%

Home ownership rate, 1988

60%

40%

Square meters/person, 1988

16

40

Mortgage policies

Accommodative

Conservative: a fairly high deposit (around 50% of the mortgage) is required first, and mortgage loan-to-value ratio is 60-70%

Rental regulation

No

House renting market is effectively regulated by the government, and increases in rents have to be in line with “market conditions”

Property taxes

Around effective 0.15% fixed asset tax, and 85% “transaction tax” on property bought within 2 years

Around 1.5% land tax, 3-5% “purchasing tax” and 15-25% capital gain tax on property sales for those who bought it within 10 years or lived less than 3 years

Source: Housing demand in Germany and Japan, paper in memoriam of Stephen Mayo, Axel Borsch-Supan, Miki Seko, Aug 2002, Comparison across the international experience on property market regulation, Li Li, 2010, CMB, Barclays Research

China’s first encounter with a property bubble occurred in 1988-1992 in Hainan Island. In 1988, when the island was upgraded into a province to experiment with the “open door” policy, a large number of property developers quickly emerged. Housing prices went from CNY300 per square meter in 1989 to CNY7500 in 1992. When tightening policies started in 1993, the prices collapsed to CNY1000 immediately and then stayed below that level for the following eight years. As late as 2002, the Hainan government was still cleaning up the messes created with the bursting of that bubble.

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Barclays | China: Beyond the Miracle Development of China’s commodity/private housing market started in 1998 26. While the sector has a short history of a little over 10 years, it has been growing very rapidly, contributing to expansion of real economic activities. Currently, real estate investment and construction is about a quarter of total fixed asset investment, or 12% of GDP. Its overall impact on GDP growth is significantly greater given the upstream links with steel, and construction material etc, and downstream links with furniture, electronics and service industries. Exposure of economic agents, including the banks, households, corporate and local governments, to real estate markets has also increased significantly. Like in the US and Japan, there was an extraordinary credit boom in China in recent years, as a policy response to the global financial crisis. Easy credit and low mortgage rates boosted real and investment demand for housing. Property prices recovered and rose rapidly from early 2009. Mortgage financing was introduced in 1998, helping to facilitate household borrowing, and real estate investment trusts (REITs), officially launched in December 2008, have been a popular means for developers to obtain financing as credit has again tightened significantly since 2010. Evidence of investment or speculative property purchases is pervasive, as suggested by the widely reported high vacancy rates and low rental yields. Until recently, the general belief remains that house prices will continue to increase, despite the significant policy tightening in both the property sector and the macro-economy that began from the second half of 2010. Moreover, the Chinese economy has constantly experienced over-heating, with property investment being a main driver in the past decade (Figure 6). The total investment/GDP ratio reached an alarming 48.5% in 2010.

How serious are property bubbles in China? While property bubbles are commonly observed, it is extremely difficult to quantify a bubble. To a certain extent, “property bubble” is a relative term. In practice, analysts and investors often look at various indicators to gauge potential degrees or risks of property bubbles. The most commonly applied indicators include the following. •

Price/income ratio: This is essentially an affordability indicator. If the ratio is too high, housing becomes beyond the reach of the majority of the population. This can be regarded as a sign of a bubble.

26

In the 1998 reform, the government ended the state-provided welfare housing system and started to promote private real estate development. Residential housing built by private developers for sale to the public are called commodity housing.

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Barclays | China: Beyond the Miracle •

•

Rental yield (rental/property value): This is effectively an investment return index. If the yield is too low, then investors are paying too much for property, implying that there is a bubble. Vacancy ratio: This is really a speculation measure. If a high proportion of properties are vacant, then many investors are buying them for potential capital gains. A high degree of speculation also means a bubble.

Obviously, these indicators only suggest the possible risk, not the exact extent, of a bubble. Application of these measures, especially the price/income ratio, suggests that China’s property market already exhibits significant risks of a bubble, especially in large metropolitan cities such as Beijing, Shanghai and Guangzhou. An extended period of rapid house price increases could be an alarming sign of a bubble. However, historical house price statistics do not give a clear picture of price movement. The official National Bureau of Statistics (NBS) house price data often underestimate the extent of the actual price increase, sometimes by a large margin 27 (Figure 1). Several agencies also report house price data, such as Centaline, a major realtor which compiles house price levels based on the firm’s secondary market home sales. But the sample is short and only data for larger cities are available. Figure 1 shows that following a very mild correction in mid-2008, existing home prices surged further, more than doubling in Beijing and Guangzhou from the bottom in February 2009, while rising by more than 70% in Shanghai and Shenzhen. A popular affordability indicator is price/income ratio, calculated by dividing the average house price by household disposable income. Based on 2006–2010 data from 25 cities, we estimated an average affordability for first-, second-, and third-tier cities by dividing the available data into three groups. Several observations can be made from Figure 8. First, housing affordability was low and has deteriorated significantly over 2006-2010. The ratio rose above 8 in 2010 for all three groups, while it is typically at 3-5 in developed economies and 6 in Korea and Taiwan. Second, the pain was felt most acutely in first-tier cities such as Shanghai and Beijing, which have seen a continued surge in prices during most of the reporting period. Prices in Shanghai reached 21 times household income in 2011. Third, the rapid house price increases spread to the secondand third-tier cities over 2009-10, with second-tier cities seeing accelerating and faster price increases after the government imposed stricter property market tightening measures in the first-tier cities. 27 Mounting public complaints have prompted the NBS to start compiling a new set of data series since January 2011.

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Barclays | China: Beyond the Miracle FIGURE 8 Affordability deteriorated nationwide

FIGURE 9 Income disparity stabilized but wealth gap widened

16

Tier 1 cities

20

Income per capita: Urban (CNY th)

14

Tier 2 cities

18

Income per capita: Rural (CNY th)

Tier 3 cities

16

Urban-Rural Ratio (%, RHS)

12

4.0

3.5

14

10

12

8

10

6

8

3.0 2.5

6

4

2.0

4

2

2 1.5

0

0 2006

2007

2008

Source: Wind, Barclays Research

2009

2010

1985

1990

1995

2000

2005

2010

Source: CEIC, Barclays Research

Despite some caveats 28 , there should be general agreement that affordability is a serious issue for average households in China. Surging house prices have led to a widening of the wealth gap in recent years, exacerbating the affordability issue and its socio-political consequences (Figure 9). High-income groups who bought housing units earlier, particularly high quality commodity housing (residential housing built by developers for sale to the public), enjoyed rapid home price increases. To some extent, the luxury apartments in Beijing and Shanghai should be still affordable for the wealthy. The elder generation, who most likely own or bought apartments at cheaper prices from the government in the 1990s, also benefited from home price appreciation, though to a lesser extent. In contrast, the average apartments in Beijing and Shanghai are hardly affordable for the average local households. The average/low-income urban households and younger generations have been largely priced out of the urban commodity housing market. Families who wish to upgrade their apartments to larger sized and higher quality ones have also suffered. Rental yield is often used to identify a bubble from an investment perspective. Low and declining rental yields offer evidence of excessive house price increases and suggest investors seek return on property holdings mainly from expected price appreciation. 28 Arguments are sometimes rightly made for greater affordability than the above data show, given the underestimation of Chinese household income by official data, eg 26% GDP in 2005 data as reported by Wang Xiaolu a reputable scholar, in “Gray income and the household income gap” 2010, National Economic Research Institute, China Reform Foundation. Also, top-tier cities, with its better public resources such as education and health care system attract “well-off” property buyers from around the country whose income and wealth are much higher than the local average population. Finally, if we use income levels of households which actually bought commodity housing, the price/income ratio should turn out to be much lower. But we don’t think these are strong enough reasons to change the picture.

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Barclays | China: Beyond the Miracle FIGURE 10 Rental yields have been low and falling 4.5

Rental yield: Beijing (%)

850

Rental yield: Shanghai (%) 4.0

FIGURE 11 Population growth underpinned housing demand Population aged 20-59 ratio (RHS, %)

800

Rental yield: Shenzhen (%)

62

Population aged 20-59 (Persons mn)

60

750

58

3.5

700

56

3.0

650

54

600

52

550

50

2.5 2.0 Sep-08

500 Sep-09

Sep-10

Source: Wind, Barclays Research

Sep-11

48 1989

1992

1995

1998

2001

2004

2007

Source: CEIC, Barclays Research

This is apparent in the Chinese data. Rental yields have been low and falling from over 5% in early 2000s, as house price increases outpaced rentals. Figure 10 shows that in Beijing and Shanghai, the rental yield has come down to close to 2% in 2011 while in Shenzhen, with a relatively better developed rental market, the ratio is below 3%. The vacancy rate measures the percentage of unoccupied housing units 29 of the total available housing. A high vacancy rate in a stable economy often implies speculative demand and possible over-construction. China bears often cite scary stories about ghost towns, empty buildings, and lightless housing districts at night as evidence of the huge property bubble in the making. Last year’s media report of 64mn residential units having zero meter reading for six consecutive months (later disregarded as false) has drawn wide attention. While an accurate estimate of the percentage of sold but unoccupied residential units is not possible, anecdotal evidence and surveys do suggest that high vacancy rates exist in some high-end properties in first- and some second-tier cities and coastal cities.

Why hasn’t the Chinese ‘bubble’ burst? If China’s property bubbles are already quite serious by international standards, at least in some large metropolitan cities, why were they able to continue to grow? Had no policy restrictions on house purchases been introduced from early 2011 in a large number of

29

This could be sold but unoccupied or built but not yet sold units. Vacancy rates discussed here refers to the former.

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Barclays | China: Beyond the Miracle cities, Chinese property prices would probably have been rising even today. In short, we see four key factors supporting sustained growth of property prices in China: •

Strong income growth;

•

Urbanization, home upgrading and favorable demographic change;

•

Limited investment alternatives;

•

Households’ strong balance sheets.

As commodity housing is a relatively new market, its strong fundamental demand has been underscored by rapid income growth, steady urbanization, favorable demographic change and home upgrading demand. As discussed, income expectation is often a key factor supporting housing demand. And the Chinese economy has been growing by 10% a year for the past thirty years, and households have accumulated large amount of savings Favourable demographic trends have been a major driving force for China’s housing demand. The working-age population, defined as the population aged above 15 and below 65 years old, has increased dramatically in the past three decades (Figure 3). In particular, the population aged between 20 and 59, the group that is most likely to buy housing units, increased rapidly to 820mn or 61.5% of the total population in 2009, up from 600mn or 53% in 1990 (Figure 11). The Population Age Pyramids shows that until 1990, China's population age structure was largely a bottom-heavy one, characteristic of a young and growing population (Figure 12). Moreover, a shrinking in household size, from 3.4 in 1990s to 2.9 in 2010, has also expanded demand for housing. FIGURE 12 A bottom-heavy population age pyramid in 1999

FIGURE 13 Dependency ratio posted a sharp decline

80

-84

70

-74

60

-64

50

-54

40

-44

30

-34

60

20

-24

50

10

-14

40

0

-4

100

China

Japan

US

90 80

15.00 10.00

5.00

0.00

0.00

Source: CEIC, Barclays Research

March 2013

70

30 5.00

10.00

15.00

1950

1965

1980

1995

2010

2025

2040

Source: CEIC, Barclays Research

79

Barclays | China: Beyond the Miracle Demographic developments have also been behind China’s impressive economic and income growth. China has posted one of the largest declines in the dependency ratio in the past 30 years (Figure 13), with the share of the working age population rising from 60% in 1980 to 71% in 2009. Studies have shown that the age structure shift accounts for more than a quarter of China's per capita GDP growth since the mid-1970s. Improvement in living standards made it possible for households to participate in the private housing market following the 1998 housing reform. Figure 3 also shows that China’s fundamental housing demand is strong as suggested by the greater demographic gains compared with the US and Japan during their bubble periods. While Japan also experienced a period of working age population growth before the property bubble burst in 1991, and the US has and will continue to enjoy the benefits of a relatively young population, their growth was at a more moderate pace. Working age population growth has been 4% and 38%, respectively, in Japan and the US since 1980, compared with 63% in China. Urbanization has been an important driving force for housing demand in urban areas. Fast urbanization has resulted in rapid growth in the number of urban households, despite the one-child policy being more stringently implemented in cities. The urbanization ratio, measured as urban area population as a percentage of the total population, has risen from around 20% in the early 1980s to 50% in 2010 (Figure 14). It is estimated that about 150 million people migrated from rural to urban areas in the past decade. This is in contrast to the US and Japan during the bubble periods, where urbanization was already very advanced. Investment demand for housing from both the regular middle class and the very wealthy has been strong in recent years. This partly reflects China’s unique situation characterised by a large amount of household savings having limited investment opportunities. On one hand, a combination of factors – including demographic trends, the rise in the working age population, rapid income growth, widening income disparity, and an underdeveloped social safety net – have boosted household savings, which have remained high at about 20% of GDP (Figure 15). On the other hand, given the closed capital account and under-developed domestic financial markets, Chinese households have limited investment options. Return on bank deposits is low given the deposit rate ceiling set by the central bank and has often been significantly negative. The domestic bond market is small and the equity market is highly volatile. Properties therefore have become a favoured instrument for wealth accumulation. This is exacerbated by the strong upward trend in housing, which fosters a notion that housing prices can only go up. March 2013

80

Barclays | China: Beyond the Miracle FIGURE 14 Accelerating urbanization in the past decade Person mn

CN: Population: Urban

CN: Population: Rural

FIGURE 15 Household and national savings are high 60

Government saving Household saving

1,600 50

1,400 1,200

Corporate saving

40

1,000 30

800 600

20

400 10

200 0

0 50 54 58 62 66 70 74 78 82 86 90 94 98 02 06 10

Source: CEIC, Barclays Research

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: CEIC, Barclays Research

A good illustration of this is the September 2011 PBoC urban depositor survey. Figure 16 shows that housing property remains the most favored asset class by Chinese households, chosen by 23.6% respondents, followed by 21.3% for wealth management products, 14.2% for bonds and 9.2% for equities. It is worth noting that this is despite 75.6% of the respondents believing that property prices are "too high and hard to accept". This shows the strength of investment demand, especially in an era with negative real interest rates and expectations of rising property prices. While property as a wealth management tool was a luxury enjoyed only by a small group of those who “got rich early”, and by foreign capital (given the rapid RMB appreciation), it has become more of a national ‘hobby’ since 2009. Finally, Chinese households have very strong balance sheets. Consumer lending is a new development in China. Households have traditionally not borrowed to consume or buy property until very recently. Consumer loans are roughly about 16% of total outstanding loans, which are, again, about 19% of GDP (Figure 4). This is roughly equivalent to the value of one year’s household savings. Mortgage loans are about 13% of outstanding loans or 15% of GDP. The low leverage ratio provides ample room for future housing demand. At the same time, it helps avoid forced deleveraging, or forced sale of houses, when housing prices decline. This is an important factor supporting stability of the housing market.

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Barclays | China: Beyond the Miracle FIGURE 16 Households’ top picks for asset allocation 30

Q4, 10

Q1, 11

Q2, 11

Q3, 11

FIGURE 17 Estimated over-valuation of house prices 70

Deviation of house price from benchm ark Q1, 10

25

Q2, 10

50 High-end m arket

Mass m arket

20 30

15 10

10 5

Source: PBoC Urban Depositor Survey, Barclays Research

Shanghai

Beijing

China

Guangzhou

Investment in Equity

Beijing

Investment in WMP

Shanghai

Investment in property

Shenzhen

-10

0

Source: “Are house prices rising too fast in China, IMF, 2010?”, Barclays Research

Hence, it is probably not surprising that when linking prices to long-term fundamentals, a 2010 IMF-HKMA research paper 30 found that house prices are not significantly overvalued in China as a whole as of mid-2010. Their panel regression across 35 Chinese cities did find the mass-market segment in some coastal cities (in particular in Shanghai and Shenzhen as well as a few inland cities) may be in the early stages of excessive price growth (Figure 17). To identify the long-term equilibrium house prices, the paper includes real interest rates, population density, real GDP per capita to capture demand factors, land prices for supply/costs factor, and stock prices to capture the potential co-movement of land prices.

These favourable conditions could turn negative soon The bad news is that the favourable factors discussed above are likely to turn negative in the next five years, in our view, creating significant risks of the bursting of property bubbles. One fundamental change is driven by the transition from economic miracle to normal development, which is likely to slow economic growth, lower the national saving rate and increase the cost of capital 31 , specifically: •

Economic growth may moderate from 10% to around 8%;

30

Are house prices rising too fast in China?, by Ashvin Ahuja, Lillian Cheung, Gaofeng Han, Nathan Porter, and Wenlang Zhang IMF WP/10/274, 2010 and HKMA WP 08/2010. This thereafter refers to as IMF-HKMA (2010). 31 China: Beyond the miracle, Part 1- China’s next transition, Yiping Huang, Jian Chang, Lingxiu Yang, 5 October, 2011

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Barclays | China: Beyond the Miracle • • •

Demographic change may become less favorable for housing demand as the proportion of working age population declines; Expectations of financial liberalization may create investment opportunities other than property; Over time, households’ leverage ratio may also rise.

The only positive trend that we think may continue is the steady pace of urbanization. But the positive impact of urbanization might be offset by unfavourable demographic change in the medium term. Also, in the short-term, new rural migrants’ demand for urban commodity housing may be restricted due to their limited income (Figure 9). In such an environment, if housing prices continue to rise further, which means even greater property bubbles, then a housing meltdown may become increasingly likely. As a result of the one-child policy that started in 1978 and the government’s hesitation/reluctance to phase it out despite suggestions from demographic experts, China is now standing on the threshold of an irreversible demographic transformation. In contrast to Figure 13, the 2000 population age data already show a rapidly maturing structure, with the largest shares being the working age group (Figure 18). The trend of a fast aging population has become more visible, to some extent alarming, as seen in the 2009 pyramid, with the structure turning to a top-heavy one (Figure 19). The 2010 Census reports that birth rate fell to 0.57% over the past decade, compared with 1.1% in the previous decade. FIGURE 18 A maturing population age structure in 2000

15.00

10.00

5.00

80

-84

80 -84

70

-74

70 -74

60

-64

60 -64

50

-54

50 -54

40

-44

40 -44

30

-34

30 -34

20

-24

20 -24

10

-14

10 -14

0

-4

0.00

0.00

Source: CEIC, Barclays Research

March 2013

FIGURE 19 Rapid aging as seen from the 2009 data

0 5.00

10.00 15.00

15.00 10.00

5.00

0.00

-4 0.00

5.00

10.00

Source: CEIC, Barclays Research

83

Barclays | China: Beyond the Miracle While the exact timing is uncertain, one thing for sure is that China’s demographic dividend will disappear within the next decade. China’s working age population will probably peak around 2015. According to the United Nations, the elderly (age 65 and older) share of the population, which was 8% in 2010, will double to 16% by 2030 and more than triple to 30% by 2050. This will have important implications for economic growth and social and political stability. China will face significant development challenges associated with an aging population, at a time when the society is still relatively poor with an underdeveloped social welfare system. After the disappearance of the demographic dividend, the total dependency ratio will bottom out and the working-age population will begin to decline (Figure 13), reversing the positive economic effects of the demographic transition. Economic growth is set to slow, savings and investment rates to decline. Fundamental demand for housing from the newly increased population, as well as investment demand based on high savings and low dependency, will face significant downward pressures starting from 2015-2020. FIGURE 20 China's Demographic Indicators Year

1975 1980 1990 2000 2010 2020 2030 2040 2050

Total dependency ratio

113

103

81

68

55

53

58

72

78

Working-age share (%)

57

59

66

67

71

70

67

60

57

Elderly share (%)

5.3

5.9

6.4

6.9

7.8

9.8

15.5

24.2

30.1

Source: UN Population Division (2010)

Some medium/longer-term development trends in the financial market (see Chapter 2: The Upcoming Financial Revolution) will also add pressure to demand for housing property. Domestic financial/bond market development and an opening up of the capital account will provide more investment options for households. The government plans to allow for ‘basic convertibility’ of the capital account in the next five years, as written in the 12th FYP. Outward investment, including portfolio investment, will be encouraged as a means for households to diversify their assets, although restrictions will likely still be placed on cross-border portfolio flows. Liberalisation of interest rates, another important reform to be expected in the next five years, and an expected decline in the savings rates will likely make deposits more attractive and lending rates more expensive as the underpricing of capital is gradually normalised.

March 2013

84

Barclays | China: Beyond the Miracle On the other hand, nationwide property demand will still have some support in the next few years despite a more negative longer-term outlook. First, with 50% of the population living in cities now, urbanization will continue to be a driver for urban housing demand in the next two decades. This is in contrast to the US and Japan, whose urbanization rates were already above 75% when their property bubbles burst, and were thus unlikely to provide strong underlying housing demand (Figure 21). The pace of the urbanization, however, will likely slow from the surge in the past decade. The government has in recent years taken policy measures to facilitate rural migrants’ integration to urban living to sustain a rapid urbanization. Policies to further liberalise the household registration system, provide a better social safety net for migrant workers and their children, and develop public housing, will help to speed up the process. The government target is to increase the urbanization ratio by 1% per year in the 12th FYP, equivalent to 12mn new urban residents per year. Moreover, demand to upgrade to larger sized, higher quality commodity housing remains significant in China. This is despite a very high home ownership rate, reportedly exceeding 89%, compared with 68% in the US, 60% in Japan and 40% in Germany. A survey by the NBS found that as of 2005, 82% of urban households in China have owned/purchased their housing. A significant portion of the properties are those that were developed by the government and SOEs, as opposed to commodity housing, which refers to residential housing built by private developers for sale to the public. Our estimated existing housing stock shows that despite rapid development, private commodity housing still accounts for less than 40% of the total housing stock 32 (Figure 22). FIGURE 21 Urbanisation still has a long way to go

FIGURE 22 Estimated total housing stock

90

16

80

14

70

Other residential completed (sq m bn) Social housing (Sqm bn) Commodity residential completed (sq m bn) 1995 initial stock (sqm bn)

12

60

10

50

8

40 30

6

20

China 1980-2010

10

4 2

0 1920

1935

1950

United States

1965 Japan

Source: UN, Barclays Research

1980

1995

Germany

2010 China

0 1995

1998

2001

2004

2007

2010

Source: MOHURD, CEIC, Barclays Research

32

Estimations on both physical housing stock and value of the stock could vary significantly, depending on assumptions about initial stock, depreciation and housing values to name a few. Available data are poor and limited.

March 2013

85

Barclays | China: Beyond the Miracle

How might bubble deflation play out in China? A brief examination of international experiences suggests that significant correction of housing prices could be triggered by one or a combination of the following changes: • • •

Significant slowdown of economic growth, which lowers households’ income expectations and, therefore, lowers demand for housing; Substantial tightening of monetary policy, which dries up liquidity and, therefore, constrains financing for home buying; Oversupply of properties, at least in the short term, which is normally a result of policies supplying large areas of land or restricting purchase.

The Chinese government has been actively monitoring and, sometimes, intervening in the housing market, learning from its own experiences and those of other countries. While it is arguable whether this is healthy for the medium term, this intervention has been shown to have reduced the risks of a hard lending in the short term. The IMFHKMA (2010) research found that over the past decade, when misalignments in house prices have occurred in China, they have been corrected relatively quickly. This is in contrast to the situation in, for example, the US, where misalignments tend to persist for much longer, ending in a large correction 33. Following significant housing price spikes during the second quarter of 2009, the State Council introduced a number of measures to discourage housing demand, including restricting purchase of second or third apartments by individual households and raising down-payment requirements. These measures were not effective, however. In part, this was because the government did not have a central information system, which makes it difficult to verify whether a household was buying more than one apartment. From April 2011, more than 40 cities introduced administrative restrictions on housing purchases. Taking Beijing as an example, the policy dictates that each household with household registration in Beijing can only buy one new apartment. Migrants living in Beijing are not allowed to buy an apartment unless they can provide documents to prove payment of taxes and social security contributions for the previous five consecutive years. Despite pressures from property developers and local governments to revoke the restrictions as property prices started to decline across the country, the 33

They found “deviation from benchmark prices appears not to be persistent, with a half-life of around 1 quarter on average for China overall; less than the cases of Hong Kong (2–4 quarters) and Singapore (5 quarters). This constant correction of house prices is unlike the behavior observed in several industrial economies before 2008— especially the U.S., New Zealand, and France—where deviations from benchmark prices tended to persist far longer, allowing for an accumulation in vulnerabilities, ending in a large and abrupt adjustment”.

March 2013

86

Barclays | China: Beyond the Miracle central government made it clear that restrictions should continue and might be extended to other second- and third-tier cities. In November 2011, Zhuhai city of Guangdong province joined the other cities in restricting housing purchases (and prices). This took the total number of cities implementing restriction policies to 47. The restriction policy was highly controversial when it was first introduced in early 2011. Most economists criticized the policy for its unfairness, discriminating against migrants and deepening the rural-urban divide, and for its administrative nature. Others also questioned its likely effectiveness, since it might encourage expectations for future price increases. There were reports about real estate agencies helping to prepare fraudulent documents for tax and social security payment. If such practices were to become popular, then the restriction policy might not have any impact. The actual impact, however, is now quite clear. Prices have already started to decline in an increasing number of cities. Since the purpose is to stabilize housing prices, it looks as though the policy has indeed been quite effective, leaving aside issues about fairness, efficiency and accuracy. The key question now is whether this bubble deflation will be limited to price adjustment or will lead to systemic meltdown. Pessimists worry about a housing price correction causing widespread problems in consumption, investment and, most importantly, the financial system. Before we get into that discussion, however, it is worthwhile pointing out that the Chinese situation today is very different from conditions in the Asian economies leading up to the Asian financial crisis in 1997 (Figure 23). While China’s property bubbles today might be comparable to those in Malaysia and Thailand before the crisis, there is no sign of a stock market bubble, and a banking crisis and exchange crisis look highly unlikely. So we probably should not expect a full-blown crisis in China. In order to understand how the property bubble correction in China will likely play out, we need to answer the following questions: •

How much downward price adjustment would the government tolerate?

•

Would price declines force deleveraging among households?

•

Would the property sector suffer significant financial losses?

• •

Would these changes add an unbearable amount of nonperforming loans to the financial system? Finally, what are the likely macroeconomic consequences?

March 2013

87

Barclays | China: Beyond the Miracle FIGURE 23 Incidence of Asset Price bubbles and banking and exchange rate crises during the Asian Financial Crisis* Capital Real credit Property inflow surge growth price bubble Indonesia Korea Malaysia Philippines Thailand Hong Kong

Stock market bubble

Banking crisis

Exchange crisis







































 

Singapore



Taiwan

–

China**

–

  –







  







  



 

 

–



–

–





–

–

–

*Note: the single  indicates a moderate capital inflow or a bubble/crisis, a double  indicates important capital inflows or a severe bubble/crisis, and a – indicates minimal bubble/crisis. ** China’s data refers to the current sitution. Source: IMF and Barclays Research. The original table is from “Lending booms, real estate bubbles and the Asian crisis, Charles Collyns and Abdelhak Senhadji”, IMF WP02/20, January 2002.

The government has never published a range for the expected decline of housing prices as a result of housing purchase restrictions. Our best guess, however, is that the government wanted to see declines averaging 10-20%. Prices are likely to correct more in large cities, where they went up more sharply during the past two years (70-110%). But it is also important to remember that the government’s purpose is not to crash the housing market, since that would cause devastating consequences for the economy at large. After all, the property sector has already become a key driver of economic growth in China. Therefore, we do not expect the government to sit idle and watch the free fall of property prices. If 20% is the government’s psychological limit, then we should expect it to microadjust or even reverse the policy restrictions. However, the market would probably respond with some time lag. It is a common phenomenon that homebuyers do not buy when prices are declining rapidly. So investors would come in only after a certain period. This means that prices may fall further in the short term even if the government aims at 20%. Therefore, our base case is that housing prices could fall by 10-30%. An average decline of 30% would likely bring Chinese housing prices to the levels before the 2009 rally. March 2013

88

Barclays | China: Beyond the Miracle But even if a significant 10-30% price decline occurs, it will not lead to forced deleveraging among Chinese households. In the US, falling house prices after the peak in 2006 have resulted in negative home equity (outstanding mortgage debt exceeds the property value). Home refinancing based on the earlier assumption of price appreciation is no longer an option. Unable to pay for the debt, default and the subsequent foreclosure became unavoidable. Forced sales of properties have added to the inventory for sales, placing downward pressures on home prices, which further lowers home equity. Such vicious cycle has spread from the subprime mortgage market to the national property market, and the household deleveraging was exacerbated by the deleveraging in the financial system. Chinese households have strong balance sheets, in contrast to the savings-short but debt-heavy US households. The outstanding consumer loan (83% home mortgage loan) is at 19% of GDP or around 40% of household disposable income in 2010 (Figure 4), while the US household debt to personal disposable income reached its all-time high of 133% in 2007 34. This reflects a short history of mortgage financing (since 1998) in China, low leverage for home purchase, and an under-developed consumer credit market. Chinese households have also not levered up further and borrowed against home values, unlike in the US. Moreover, Chinese households’ savings have been at 20% GDP per year, and close to 30% of disposable income. Total savings deposits have exceeded CNY30trn in 2010. Households’ leverage for property purchase is low despite some increase in 2009. A high down payment of 30-50% is usually paid upfront. This is partly due to regulation and partly due to culture. The government has minimum down payment requirements of 20-60% against home value 35, compared to 5-10% in some other countries (zero was seen in the US in the period of lax lending conditions). Chinese households also prefer to avoid debt and usually: 1) try to increase down payments to minimize interest payments; 2) tend to pay back their loan ahead of schedules, eg, in 4-5 years. All-cash payments, especially for third and above homes, is common (as high as 50% in various markets according to anecdotal evidences 36) given the existence of a very rich group –

34

See “U.S. Household Deleveraging and Future Consumption Growth”, FRBSF Economic Letter, 2009-16 The government requires 20% down payment against the property value (30% for size above 90sqm) for firsthome buyers. In November 2011, this was raised to 30% for all sizes. The down payment for second home mortgage was raised to 50% from 40% in April 2010, and to 60% in January 2011. Banks were advised to stop lending to mortgages for third home and above since April 2010. 36 Anecdotal evidence show that the ratio increased after the government has strictly enforced purchase restrictions. Home loan and sales data suggest some 45% of homes purchased in Shanghai in H2 2010 were likely paid by cash. 35

March 2013

89

Barclays | China: Beyond the Miracle small in percentage of total population but large enough in importance – to support certain segments of the market. As a result, the situation of negative home equity would not be common in China, even in the case of a 30-40% price decline, hence we don’t expect significant default or forced deleveraging, which would add substantial NPLs to the banks. Negative equity due to falling house prices would be more likely to happen to first-home buyers given the above discussions, but they are the least likely group to walk away from their homes. During the 2008 price correction, when Shanghai and Shenzhen saw an average 20-30% y/y price decline, defaults and foreclosures were very few. There has indeed been a degree of “rush-for-sale” observed by private house owners in recent months, eg, WenZhou SME owners due to their financing difficulties, but their impact looks small and local. Under current market conditions, with expectations of prices falling, multiple home owners are unlikely to rush to put their homes for sale as this would worsen the supplydemand dynamics. At the beginning of the price decline cycle, potential home buyers, including first-time buyers, will likely wait instead of rush-to-enter. Multiple home owners will then be unwilling to sell and suffer a big loss, especially given that the majority of them don’t have payment constraints as discussed. They are most likely to wait for prices to recover. What about property developers? Developers cutting prices after facing a severe liquidity squeeze is a key potential trigger for a meaningful price decline in China, in our view. This had been the case during price corrections in 2005 and 2008. It has been anticipated that continued sluggish property sales would lead to the same sooner or later. In the past few weeks, several major developers have been seen to offer 10-15% discount for new home sales in Shanghai as well as other cities nationwide. While this reflects companies’ near-term sales strategy as developers ultimately care more about sales/profits than some price decline, it has become evident that developers are increasingly facing liquidity difficulties given weak sales following the home purchase restrictions and tight credit conditions 37. Overall, we think large developers could survive the downturn, but small developers will probably suffer from significant financial stresses. Large developers are relatively cash rich, given solid sales over 2009-10. They have in fact posted strong sales so far in 2011 as they’ve expanded to second-third tier cities which were less affected by government

37 Speculations about potential property developer insolvency have intensified since September, after a large and highly leveraged developer Greentown was reportedly singled out under regulator’s check and a smaller one Dalian Rightway reportedly failed to repay a CNY447mn loan.

March 2013

90

Barclays | China: Beyond the Miracle tightening policies. In particular, Wanke saw 40% y/y and 36% increases in sales volumes and revenue, respectively, year to September, and COLI posted 22% and 55% increases, respectively. They could also tap alternative sources of financing, such as offshore financing and domestic trust loans, though the non-bank financing sources have recently been restricted or shut down due to the stricter domestic regulations and European debt crisis. Small developers are running into greater difficulties. First, they also face greater sales pressures, with their market share being taken by large and cash-rich developers in the current tightening cycle (Figure 24). Second, they face greater financing difficulties. Figure 25 shows that the smaller-medium property developers have already seen their cash minus short-term debt turn negative by H1 2011. Further deteriorating market conditions could cause some panic sales by small developers, which could weaken sentiment and push down prices more significantly. But a more likely case is that deteriorating market conditions would accelerate the consolidation in China's highly fragmented property industry (estimated some 50,000 developers). A concern most frequently raised by investors is the exposure of banks to the property sector. Along with the booming property market, the banking sector’s exposure to the property sector has increased over time, especially in 2009, but it is from a low base. The direct exposure, including mortgages and loans to developers, stood at about 20% of total loans in Q3 2011 (Figure 26, 27). The indirect exposure to the property sector, FIGURE 24 Smaller developers face greater liquidity pressure 60 50

Dec-10 Jun-11

Cash minus ST debt (CNY bn)

FIGURE 25 Larger developer gaining market share 50

GFA: Medium/small developers (sqm, mn) GFA: Large developers (sqm, mn) 17.2%

40 40

18.7%

30

30

19.4%

20 20

10

80.6%

0

81.3%

82.8%

10

-10 Large developers

Medium/small developers

Overall

Note: Based on a sample of bond issuers. Large developers include Agile, Cogard, COLI, CRL, Evergrande, Guangzhou R&F, Longfor and Shimao. Source: Company data, Barclays Research, contributed by our property credit analyst, Christina Chiow

March 2013

0 2009

2010

1H 11 annualised

Source: Company data, Barclays Research, chart contributed by our property credit analyst, Christina Chiow

91

Barclays | China: Beyond the Miracle however, is likely to be significant. Loans to the sectors that are closely linked with the property sector, including construction, metal smelting, chemical, are substantial (Figure 28). Moreover, during the lending boom in 2009-1010, total new on- and off-balancesheet lending amounting to CNY12trn in 2009 and 2010. Loans to local government investment vehicles and the corporate sector use land and commercial properties as collateral; thus, falling property values will have significant bearing on the banking system. According to the "Chinese Bankers Survey 2011" released by PricewaterhouseCoopers and the China Banking Association in October, 67.2% of bankers view a sharp property market correction as the biggest potential risk (Figure 29). FIGURE 26 Banks’ direct exposure to property loans 25

FIGURE 27 Property investment by source of fund 100

Developer/total loan (%)

90

Mortgage/total loan (%)

80

20

70 60

15

50 40

10

30 20

5

10 0

0 Jun-05

Jun-06

Jun-07

Jun-08

Jun-09

Jun-10

Jun-11

1998 2000 Domestic loans

2002 2004 2006 2008 Foreign investment Self-raised

Source: CEIC, Barclays Research

Source: CEIC, Barclays Research

FIGURE 28 Loan exposures to property-related sectors

FIGURE 29 Bankers view property correction as biggest risk

Real estate developer Housing mortgage

6.5

12

57.7

Big correction in property market Risk from LGIVs

Construction Smelting & pressing of metals

2.2 2.3 0.9 2.4

Non-metal mineral product Chemical sector Electricity & heat production

5.5

Transport & storage

7.2

Universal & special purpose equipment Others

Source: CEIC, Barclays Research

March 2013

Credit risks from industrial upgrade Liquidity risk from monetary policy normalization High concentration of loans Risks from enterprises' declining profitability Risks from cross credit and capital market operation

Petroleum processing, coking & nuclear fuel Electric machinery & equipment

2010 Others

0.5 1.1 1.5

Risks from banks' collateral value change on market volatility Risks from unreasonable cross-border, -region & -industry operation

0

20

40

60

80

Source: China Banking Association, PwC, Barclays Research

92

Barclays | China: Beyond the Miracle FIGURE 30 Exposure of Asian countries banking system to real estate sector

Year

Property exposure

Collateral valuation

1997

1997

Non-performing loans 1997

1998

Capital-asset ratio 1997

Korea

15-25

80-100

16

22.5

6-10

Indonesia

25-30

80-100

11

20

8-10

Malaysia

30-40

80-100

7.5

15

8-14

Philippines

15-20

70-80

5.5

7

15-18

Thailand

30-40

80-100

15

25

6-10

Hong Kong SAR

40-55

50-70

1.5

3

15-20

Singapore

30-40

70-80

2

3.5

18-22

Year

2010

2010

2010

2011

2010

China

11

~ 80

2.4

3

12

Source: IMF and Barclays Research. The original table is from “Lending booms, real estate bubbles and the asian crisis, IMF WP02/20, Charles Collyns and Abdelhak Senhadji, January 2002”. China’s data are added by authors.

A significant drop in housing prices and a slowdown in property transactions would likely worsen banks’ asset quality via the impact on mortgage delinquencies and loans to developers. NPLs (currently at 3%) will increase following a sharp property price correction. Figure 30 based on an IMF research compares the exposure of Asia countries’ banking system to the real estate sector during the Asian financial crisis. It shows that NPLs in many countries doubled or nearly doubled one year after the 1997 crisis. However, we believe a banking crisis is unlikely in China even in the event of a collapse in property prices. First, as discussed, China’s case is different from the US (2007)/Japan (1991) or EM Asia (1997) where a real estate boom-bust cycle often leads to or reinforces a banking/financial crisis. Without massive deleveraging expected in China, the overall bank exposure to the property sector should still be manageable, compared with its total CNY100trn banking assets. According to the China Banking Regulatory Committee Chairman in October, stress testing results show that a 40% property price decline will not likely cause financial meltdown, be it from a household leverage or developer leverage perspective. Moreover, the repayment capacity of borrowers depends more on their cash flows than on changes in values of the collateral. Hence as long as the economy will not be trapped into a prolonged period of low growth, the concern is unlikely to be of systematic importance. March 2013

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Barclays | China: Beyond the Miracle FIGURE 31 Property is the main form of household wealth 120

Other assets Housing property Securities and insurance investment Bank deposits

FIGURE 32 Rapid rise in household income 30

%

Nominal urban per capita income Nominal rural per capita income

25

100 20 80 15

60

10

40

5

20 0 2002

Source: NBS, PBoC, Barclays Research

2010

0 Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Source: CEIC, Barclays Research

Second, China does not rely on external financing and hence is not vulnerable to a sudden stop in external financing flows. A common feature of the financial crises in many emerging market economies in recent history is that external financing was involved to a significant degree in the boom period, and a sudden stop in such financing often triggered a crisis. China has been a significant net exporter of capital, and capital inflows are mostly in the form of foreign direct investment while external investment is mostly in liquid instruments such as foreign government bonds. Third, in our view, it is hard to imagine that a wiping out of banks’ capital position due to loan losses would lead to a sudden stop in bank lending to the non-bank sector, which is often an important accelerator of a financial crisis. The Chinese banking system has large liquidity locked in the required reserves, which can be released in times of need. Moreover, banks are majority owned by the state, so as long as the public does not lose confidence in the state, a bank run is unlikely in China and a significant credit crunch is not foreseen. 38 An assessment of the macroeconomic impact might be more complicated. Housing property has become the most important asset class that comprises household wealth. The private housing market has existed since the 1980s, but it was not until 1998, when the government finally terminated the welfare housing distribution system, that the private real estate market started to develop and private home ownership began to 38

This doesn’t mean that there is no price to be paid in association with loan losses. The Chinese government policy favours the banking system via interest rate regulation, which gives an unusually large lending spread. However, this comes at a cost to households, which receive low deposit interest at a regulated rate. Moreover, in the event the government needs to recapitalize banks, households will be the ultimate bearers of the costs.

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Barclays | China: Beyond the Miracle FIGURE 33 Land sales important source of revenue

FIGURE 34 Local government debt by usage

Land sales revenue for local government

Local government tax revenue

Revenue transferred from central to local government

Source: Ministry of Finance, CEIC, Barclays Research

Social housing , science, education, culture and health care 9%

Agriculture and agrigation 4%

Others 22%

Urban infrastructure 33%

Land reserve 10%

Transportation 22%

Source: National Audit Office, Barclays Research

become widespread. Since then, part of household wealth (in the form of savings deposits) had been shifted to the formerly non-existent category of private housing. By our rough estimates, the value of urban housing stock reached CNY73trn in 2010, compared with CNY30trn of household savings deposits and CNY36trn total stock market capitalization. Housing wealth now roughly accounts for 54% of urban household assets, by our estimates (Figure 31). Land sales revenue has become an important source of local government financing. While the importance varies significantly by cities and by year, land sales generally account for some 30-40% of local government revenue in the past couple of years. In 2010, land sales revenue (extra-budgetary) reached CNY2.94trn, 35% of the total local government revenue (CNY7.3trn based on tax revenue and central government transfers, Figure 33). We see two implications: 1) land sales revenues have been contributing to spending by local governments, which suggests that a sharp property correction would result in a significant reduction in local government spending, driving down investment growth. 2) Local governments and to some extent central government would not want to see a significant price correction, given the range of social responsibilities, including the funding of the social housing projects expected from the local governments (Figure 34). The impact of falling property price on investment would be significant. Figure 35 shows that since the 1998 housing reform, property investment (averaging 24.4%) has been highly correlated with fixed asset investment (FAI) growth (22.4%) and hence a main

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Barclays | China: Beyond the Miracle FIGURE 35 FAI and investment highly correlated 70

% y/y

Real estate investment

FAI

50

30

10

-10 Sep-98

Nov-01

Jan-05

Mar-08

May-11

Source: CEIC, Barclays Research

FIGURE 37 Property sales leads starts by 2-3 quarters

FIGURE 36 Property prices highly correlated with investment 50

FAI (% y/y) Real estate investment (% y/y) Property price (RHS, %y/y)

20

40

15

30

10

20

5

10

0

120

Property starts (%y/y, 3mma)

100

Property sales (%y/y, 3mma)

80 60 40 20 0 -20

0 Sep-05

-5 Sep-06

Sep-07

Sep-08

Source: CEIC, Barclays Research

Sep-09

Sep-10

Sep-11

-40 Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Source: CEIC, Barclays Research

driver of China’s economic growth. Directly, real estate investment and construction accounted for about a quarter of FAI, and about 12% of GDP. Indirectly, it affects industries both upstream and downstream. We estimate about 20% of GDP is likely related to property investment. Historically, property investment has a positive and strong correlation with housing prices (Figure 36), with both often driven by the same factors – policy/credit easing/tightening. Figure 37 shows that the sluggish national property sales in recent months, if they persist, will lead to a significant slowdown in housing starts. But property investment is more correlated with “under construction” than just “starts” (Figure 38). In our base case, we expect real property investment (including both private and social housing) to slow to around 15% y/y in 2012 from 23% March 2013

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Barclays | China: Beyond the Miracle FIGURE 39 Property prices and consumption not correlated

FIGURE 38 Investment is more correlated with construction 60 50

Real estate investment (%y/y)

25

Floor space under construction (%y/y, 3mma)

20

40 30

Real household consumption (% y/y) Real retail sales (% y/y) Property price (RHS, %y/y)

20 15

15

10

10

5

5

0

20 10 0 -10 -20 Sep-06

Sep-07

Sep-08

Sep-09

Source: CEIC, Barclays Research

Sep-10

Sep-11

0 Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

-5 Sep-11

Source: CEIC, Barclays Research

forecast for 2011. In an unlikely scenario of a sharp property price correction and private property investment falling to zero percent, downside risks will be -1.2pp to our baseline forecast of 8.4% in 2012, other things being equal. Social housing is unlikely to be a significant offset to the expected slowing property investment growth. Last year, the government started 5.9mn units and completed 3.6mn. The government is committed to building 36mn new units of social housing in the 12thFYP. The plan is to start 10mn units in 2011 and likely 10mn in 2012. While we believe public housing will increase over time to meet a substantive part of the total housing demand, we don’t think its contribution to property investment and hence GDP growth will be significant after the initial jump in 2010-11. Assuming a rather optimistic forecast of social housing financing and construction in 2012, social housing investment growth could be at 41% in 2012, compared with around 100% in 2011-12 (Figure 40). We estimate that its contribution to GDP growth could be around 1pp in 2011 and 0.5pp in 2012. We take a more benign view of the impact of a housing price fall on consumption. We think wealth effects associated with changes in housing prices are likely to be limited, in aggregate terms, at least for now. Figure 39 shows that property prices historically have had little correlation with household consumption growth in China, though a degree of positive correlation is observed with retail sales. Property sales are found to be highly correlated with sales of furniture, home appliances and construction materials.

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Barclays | China: Beyond the Miracle FIGURE 40 Social housing and its contribution to property investment Social housing starts

Estimated units under investment

Cost per unit (PPI deflated)

Estimated investment amount

Unit

mn units

mn units

CNY

CNY trn

2008

1.0

2009

3.3

1.6

115161

0.2

2010

5.9

3.1

121495

2011

10.0

6.4

2012

10.0

8.6

% Real estate investment

% y/y

%

0.4

102

7.7

130000

0.8

123

13.3

136500

1.2

42

16

5.1

Source: MOHURD, Barclays Research

In theory, property price adjustments can affect private consumption through wealth effects (falling prices reduce home owners’ perceived lifetime wealth, and constrain their financing/borrowing against home value) as well as income effect (falling prices could result in lower expected income growth, or increase disposable income for potential buyers through reduced savings). These channels vary greatly across countries though. The positive wealth effects from rising house prices have been most evident in the rapid US consumption growth, which was attributable to households’ ability to borrow from the rapidly appreciating home values. In Muellbauer and Murata 2011 and Aron et al forthcoming 39, authors developed models including wealth- and interest-rate effects, and investigates the role of residential land prices. They found the impact of higher house prices on consumer spending in Japan is negative. They attribute that to differences in mortgage markets and tax systems, which discourages home equity withdrawal in Japan but encourages it in the US. China on this basis looks more like Japan than the US, in our view. This is ultimately an empirical question: research so far using data for the past two decades has generally found little evidence of a negative relationship between price and consumption in China. 40 Based on panel data at the provincial level for 1994–2008, the IMF-HKMA (2010) paper analysis shows the overall impact of property price changes on China’s private consumption would be insignificant, with a 10% drop in property

39 Credit, housing collateral and consumption: evidence from the US, Japan and the US, Working paper 1002, Federal Reserve Bank of Dallas, Janine Aron, John Duca, John Muellbauer, Keiko Murata, Anthony Murray, May 2010 40 Does rising house price increase or decrease residents’ consumption? An empirical study based on panel data of 172 prefecture -level cities, Du Li, Chunyang Pan, August, 2010 A study to research the main reasons that affect the residents’ consumption, NBS, Wei Yang, Yu Liu, May 2011

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Barclays | China: Beyond the Miracle prices likely to induce a fall in private consumption of 0.7%. Indeed, Chinese households have been prudent. The rapid surge in home values and household wealth has not led to significantly increased consumption growth in recent years. Another possible explanation is that while a fall in prices likely has a negative wealth effect for existing home owners, potential buyers could benefit from it. Low-income people, younger generations, and new urban residents migrating from rural areas would need to save less for down payments, and these people tend to have a higher propensity to consume than high-income people.

Policy and market implications Our brief analysis of the Chinese housing market suggests that property bubbles are indeed already quite serious, according to a range of conventional measures. We have not seen a major collapse of the bubbles so far because several important factors continue to support housing demand: strong income growth, steady urbanization and favourable demographic change, limited investment alternatives for massive savings, and very healthy household balance sheets. Unfortunately, however, most of these favourable conditions may become negatives in the coming years. Income growth is likely to slow as the economy transitions from economic miracle to normal development. The savings rate will probably fall, while the cost of capital might rise. A declining proportion of the labor force among the total population means structural weakening of housing demand. Financial liberalization could open up many new investment opportunities for households, which at the same time may increase their leverage ratios. All these point to higher risks of bubbles bursting in the coming years, if the bubbles continue to build rapidly. Policy restrictions on housing purchases are probably a second-best choice, as they discriminate against migrants and are too abrupt. But so far they have been effective as more and more cities start to see declining housing prices. Our best guess is that the government might be willing to tolerate an average decline in housing prices across the country of 20%. The actual decline, however, might range between 10% and 30%. Once price adjustment approaches 20%, the government will likely take some action, either micro-adjusting or reversing the policy restrictions. In other words, the government will not sit on the sideline to watch a free fall of housing prices. The policy purpose is to induce some adjustment of the prices, not collapse the market. The longer-term policy agenda is to replace policy restrictions with property taxes,

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Barclays | China: Beyond the Miracle which are already being experimented with in Chongqing. The transition, however, might take three years. The 10-30% decline in property prices we expect will probably not lead to a systemic meltdown of the financial sector or of the economy. The high down payment requirements, about 40% in recent years, mean low probability of negative equity. The low leverage ratios also imply that households would not be forced to sell their property, even with relatively high vacancy ratios. Large property developers should probably be able to survive a downturn of the market, but small developers may suffer significant financial stresses, including bankruptcy. These will add to nonperforming loans of the banks. But a banking crisis still looks unlikely. A property market adjustment is likely to slow the economy significantly next year. Residential investment, which accounts for about 25% of total fixed asset investment, might turn to negative growth around mid-2012. This, in turn, should generate important implications for the global commodity markets. The effects of falling property prices on consumption, however, should be much more limited.

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Barclays | China: Beyond the Miracle

CHAPTER 4

The great wave of consumption upgrading

• Boosting domestic consumption is regarded as the key to rebalancing China’s economy. Official statistics point to persistently declining consumption as a share of GDP during the past decade. However, our findings suggest that consumption is being underestimated and that rebalancing is already taking place in China, heralding a great wave of consumption upgrading over the coming decade.

• Amid ongoing debate about the quality of official statistics, we attempt to

provide a more complete picture of Chinese consumption by piecing together official and unofficial sources.

• A recent landmark study suggests that Chinese household income in 2008 was underreported, translating into a potential underestimation of GDP by 10%. The study also suggests that household consumption may have been underreported by 20%. Further evidence, such as the widening gap between consumption and retail sales growth, and the recent acceleration of income growth, also implies that consumption growth is likely to have been underestimated in recent years.

• Our calculations, using a new series of consumption growth rates, suggest that: 1) the consumption share of GDP declined during much of the past decade; but that 2) it picked up forcefully after 2008.

• This would imply that rebalancing is already taking place in China, as a result of

changes in factor markets leading to increases in household income and improvements in income distribution. We expect this trend to continue and forecast a multi-year, multi-layer wave of consumption upgrading to take place in China in the coming decade, as lower-income/rural/inland households increase their demand for mid- and high-quality consumer goods and services.

• Although the luxury goods market is likely to remain strong, we think Chinese consumption upgrading will also create great opportunities in mid- to high-end products over the next five years.

This article was originally published on 9 January 2012.

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Weak consumption in a strong economy Consumption has been at the centre of the debate about China’s growth model. Commonly identified imbalances facing the Chinese economy include very large current account surpluses (or net exports) and very high investment shares of GDP (Figure 1). While the former makes the Chinese economy vulnerable to external shocks and international criticism, the latter increases risks of overcapacity and inefficiency. “Under-consumption” is a mirror image of these two problems: the higher the shares of current account surplus and/or investment, the lower the consumption share. Boosting consumption, therefore, is a critical step toward a more balanced and sustainable economy. 41 According to the official statistics, the consumption share of GDP declined from 62% in 2000 to 47% in 2010, a fall of 15 percentage points (pp) within a decade (Figure 2). Meanwhile, household consumption slid from 46% to 34% during the same period. This latest share was probably among the lowest in the world, especially compared with consumption shares of GDP elsewhere, 69% in India, 88% in the US, 79% in Japan and 68% in Korea in 2010. The share of China’s government consumption of GDP also declined during 2000-2010 but at a more modest pace. China’s declining consumption share is not a unique phenomenon. China’s experience is generally comparable to earlier episodes in Korea and Taiwan (Figure 3). Korea’s consumption share dropped from about 85% at the beginning of the 1970s to around FIGURE 1 China’s investment and saving ratios 55

FIGURE 2 Consumption shares of GDP in China

Savings (% GDP)

70

Investment (% GDP)

65

50

60 55

45

50 45

40

40 35

35 30 1986

1990

1994

1998

2002

2006

Note: All data used in this report are from official country statistics unless otherwise specified. Source: CEIC, Barclays Research 41

2010

30

Official consumption share (%)

25

Official household consumption share (%)

20 1994 1996 1998 2000

2002 2004 2006 2008 2010

Source: CEIC, Barclays Research

Wen Jiabao, “Government work report”, delivered at the National People’s Congress meeting, March 5th, 2006.

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Barclays | China: Beyond the Miracle 62% at the end of the 1980s. And Taiwan’s share fell from around 75% in 1970s to as low as 62% by 1986. A comparison of China with these other Asian economies raises two questions: 1) why was consumption share in China systemically lower? And, 2) when will the Chinese share reach a turning point? In early 2006, the Chinese government formally incorporated the policy task of economic rebalancing into the 11th Five-Year Program (FYP). 42 Since then, boosting consumption has been a regular objective for macroeconomic policies. Unfortunately, the official statistics revealed no evidence of any improvement. In fact, according to the official statistics, most imbalance problems worsened during 2006-2010. In particular, the consumption share of GDP fell by a further 6pp. Before assessing policy effects, we need to have a clear picture of Chinese consumption. This, however, is by no means an easy task. The quality of Chinese statistics has been the subject of much debate among economists and policymakers. In the past, important doubts were cast on the quality of GDP and CPI data. But the quality of consumption data may be equally questionable. For example, some large consumption expenditure items such as tourism spending and overseas shopping are probably not fully reflected in official statistics. This could mean an underreporting of consumption. Furthermore, there has been a widening gap between retail sales growth rate and consumption growth rate for the past decade. This might suggest that consumption growth is being underestimated. We try to piece together the true picture of Chinese consumption by examining statistical data:

• First, according to one major study (Wang and Woo 2011) 43, China’s household income was underreported by 66% in 2008, which could be translated into underestimation of GDP by 10%. The underreported income was concentrated mainly in high-income households.

• Second, the same study suggested that household consumption was probably underreported by 20% in the same year. These meant a much higher household saving ratio but a marginally lower national saving ratio. Therefore, according to the study, both total consumer spending and consumption share of GDP were underestimated. 42

An outline of the 11th Five Year Plan can be found at the official website of the National Development and Reform Commission (http://en.ndrc.gov.cn/hot/t20060529_71334.htm). 43 Xiaolu Wang and Wing Thye Woo, 2011, “The size and distribution of hidden household income in China”, Asian Economic Papers, 1(10, 2011): 1-31).

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Barclays | China: Beyond the Miracle

• Third, the widening gap between consumption growth and retail sales growth likely implies that the growth rate of consumption has also been underestimated, at least in recent years. We use a weighted average of retail sales growth and service sales growth to proxy consumption growth.

• Application of the above consumption growth suggests that: 1) the consumption

share of GDP declined during much of the past decade; but that 2) the consumption share actually picked up forcefully after 2008. The last finding above is consistent with the recent pickup in household income and acceleration of retail sales. It suggests that the long-awaited rebalancing is already taking place in China, as a result of changes in factor markets, leading to increases in household income and improvements in income distribution. More importantly, we think this is the beginning of a great wave of consumption upgrading in China. We see huge potentials for mid- and high-quality consumer goods and services as households move from low- to high-income levels, rural residents migrate to the cities and inland people adopt coastal life styles.

Common explanations for China’s weak consumption Why don't the Chinese consume more? And why do the Chinese save so much? In fact, the same questions could be asked of other Asian populations that experienced periods in which the consumption share of GDP fell. In Korea, for instance, the consumption share fell from around 90% at the beginning of the 1960s to about 60% at the end of the 1980s. And, again, in Taiwan, the consumption share fell from slightly above 80% to around 60% during the same period. The consumption share of GDP started to rebound in both economies from the late 1980s. It appears that China is travelling along the same path but: 1) China is about 20 years behind the trajectories of Korea and Taiwan; and 2) China’s consumption shares are systemically lower than those of Korea and Taiwan at similar stages. One potential determinant is the “cultural factor” – populations of Asian countries, including China, have typically shown a strong preference for saving, possibly because of a particularly strong “bequest motive” (Barbaugh 2004). 44 However, though this cultural factor may be an important determinant, it is perhaps not a dominant one. Otherwise, we would find it difficult to explain why Asia’s saving rates stayed at relatively low levels until economic growth accelerated. Even in China, the national 44

Rick Harbaugh, “China’s high savings rates”, Paper prepared for conference on “The rise of China revisited: Perception and reality”, National Chengchi University, Taiwan, 2004.

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Barclays | China: Beyond the Miracle savings rate rose sharply from around 35% in the early 1980s to well above 50% in the late 2000s (Figure 1). There are also significant variations in terms of saving rates among Asian nations. In a broader analytical effort, World Bank’s Aart Kraay attempted to explain China’s unusually high saving rate. 45 He first estimated a cross-section regression of gross national saving rates in a large sample of countries on a set of standard variables. He then expressed each of the explanatory variables for China as a deviation from the average across all countries and multiplied these deviations by the estimated coefficients. This yielded a measure of the extent to which differences in China’s saving rate from those of a “typical country” can be attributed to differences in known determinants of saving. After accounting for all these variables, however, Kraay found the regression underpredicting China’s saving rate by nearly 10pp (Figure 4). Most policy discussions about weak consumption in China focus on three factors: precautionary household saving; household income share; and unequal income distribution among households. First, economists such as Olivier Blanchard and Francesco Giavazzi (2005), and Louis Kuijs (2005) attributed China’s decline in private consumption to a rise in precautionary saving. 46 China began its market-oriented economic reform in 1978, but it did not start reforming its social welfare system for another two decades. Before that, urban FIGURE 3 Private consumption shares of GDP in China, Taiwan and Korea China (starts from 1982) Korea

100 90

FIGURE 4 Accounting for China’s saving rate Real interest rate Urbanization ratio

Taiwan

In (real income pc)

80

Real income per capita

70

Old dep ratio

60

Young dep ratio

M2/GDP

Terms of trade 50

Inflation rate Domestic credit

40 30 1960

Residual 1970

1980

1990

Source: CEIC, Barclays Research

2000

2010

-0.10 -0.05 0.00 0.05 0.10 0.15 Contribution to predicted saving rate differential

Source: Adopted from Kraay (2000), Barclays Research

45

Aart Kraay, 2000, “Household saving in China”, World Bank Economic Review, Volume 14, No. 3, pages 545-70. Olivier Blanchard and Francesco Giavazzi, 2005, “Rebalancing growth in China: a three-handed approach”, MIT Working Paper 05-32, Massachusetts Institute of Technology, Cambridge, Massachusetts. And Louis Kuijs, 2005, “Investment and saving in China”, Policy Research Working Paper No. 3633, World Bank, Washington DC.

46

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Barclays | China: Beyond the Miracle residents’ healthcare, pension, housing and education were all taken care of by either the state or their work units. By the mid-1990s, it had become clear that this system was not sustainable. During the second half of the 1990s, the government implemented a wide range of reforms, establishing market-based pensions, unemployment benefits and healthcare systems. In the meantime, the government privatised a large number of small- and medium-sized loss-making state-owned enterprises (SOEs), laying off tens of millions of workers. All these factors immediately boosted demand for precautionary saving – while the old state-supported social welfare systems were immediately dismantled, the new market-based systems have, even now, yet to start operating fully. Therefore, for households, the best protection against future uncertainties is their own savings (Figure 5). The state and the working units gradually stopped the practice of allocating residential apartments to their employees. The development of the housing market probably had a big impact on saving behaviour during the past decade. The total housing-related spending, including money spent on housing purchases, has increased from about 10% of household disposable income in the late 1990s to about 25% in recent years (Figure 5). This represented a form of almost forced saving for households, although not all of it should be regarded as investment, as most apartments are purchased for own use. Second, to some other economists, such as the IMF’s Jahangir Aziz and Li Cui, a declining share of household income in national income, instead of a rising saving rate,

FIGURE 5 Household saving rate and share of housing-related expenses of disposable income 30

Household saving rate (%)

FIGURE 6 Disposable income, consumption and saving rates of Chinese households Saving (% Disposable Income) Disposable income (%GNP) Consumption (%GNP)

85

Estimated housing expense/disposable income (%)

75

25

65

20

55 15

45 10

35 5

25

0 1993

15 1996

1999

2002

Source: CEIC, Barclays Research

March 2013

2005

2008

1993

1996

1999

2002

2005

2008

Source: Barclays Research

106

Barclays | China: Beyond the Miracle was the key contributor to China’s weakening consumption problem (Aziz and Cui 2007). 47 This is consistent with PBoC Governor Zhou Xiaochuan’s argument that, in recent years, the rapidly growing national saving was attributable mainly to changes in corporate saving, rather than household saving. 48 If household income grows slower than GDP or GNP, naturally household consumption won’t be able to keep pace with the whole economy (Figure 6). A declining share of household income is also in line with the central theme of our report series: factor market distortions capped growth of wages and investment returns and slowed growth of household income. Tsinghua University’s Chong-en Bai and Zhenjie Qian discovered that the labor income share declined by 10.7pp during 19952004, although more than half of the drop could be accounted for by changes in accounting method (Bai and Qian 2009a). 49 Financial repression restricted households’ investment returns. Nicholas Lardy of Peterson Institute of International Economics, for example, found that China’s deposit rate regulation probably cost household income the equivalent of 5% of GDP (Lardy 2008). 50 In another study, Chong-en Bai and Zhenjie Qian found that households’ share in national disposable income reached its peak in 1996 and then dropped by 12.7pp by 2005 (Bai and Qian 2005b). 51 Of this total decline, wage income and asset-related income contributed 6.0pp and 3.2pp, respectively. During the period 1996-2005, the share of government revenue increased steadily. Such changes are obviously unfavourable for consumption. And, third, unequal income distribution is another potential factor contributing to weak consumption. There has been noticeable deterioration in income distribution during the reform period. The Gini coefficient of household income distribution rose to 0.47 in recent years from below 0.3 in the 1980s. 52 Meanwhile, if we divide all urban households equally into five groups by income, the gap in household income between the top 20% group and the bottom 20% group widened from 3.6 times in 2000 to 5.7 47 Jahangir Aziza and Li Cui, 2007, “Explaining China’s low consumption: The neglected role of household income”, IMF Working Paper 07/181, IMF, Washington DC. 48 Zhou Xiaochuan (2009), “Thoughts on Saving Rate”, Essay published on the official website of the People’s Bank of China, Beijing, China, 24 March 2009. 49 Chong-en Bai and Zhenjie Qian, 2009a, “Factor income share in China: Stories behind statistics,” Jing Ji Yan Jiu (Economic Research Journal), No. 3, pp. 27–41. 50 Nicholas R. Lardy, 2008, “Financial repression in China”, Peterson Institute for International Economics, Number PB08-08, September 2008, Washington DC. 51 Chong-en Bai and Zhenjie Qian, 2009b, “Who has eroded residents’ income? An analysis of China’s national income distribution patterns,” Zhong Guo She Hui Ke Xue (Social Sciences in China), No. 5, pp. 99–115. 52 Yiping Huang, 2010, “Dissecting the China puzzle: asymmetric liberalization and cost distortion”, Asian Economic Policy Review, Volume 5, Issue 2, pages 281-295.

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Barclays | China: Beyond the Miracle FIGURE 7 Propensity to consume inversely proportional to income level Rural areas Urban areas

150

Propensity to consume (%)

FIGURE 8 Total consumption expenditure and growth, China and other countries

140

15

130

Final consumption (USD trn)

9

Final consumption growth (RHS, %y/y)

8

12

7

120

6

110

9

5

100 90

4

6

80

3

70

2

3

60

1

50 1000

3000

10000 Income (RMB)

30000

100000

Source: Adapted Research Institute of Economy, Trade and Industry, “Income distribution policy, the key to expand consumption”, June 29, 2009 (http://www.rieti.go.jp/en/china/09062901.html#fig ure2), Barclays Research

0

0 China

US

Japan Germany France

India

Source: CEIC, Barclays Research

times in 2008. In rural areas, the gap between the two groups grew from 6.5 times in 2000 to 7.5 times in 2008. And unequal income distribution is negative for household consumption simply because wealthy households’ propensity to consume is much lower (Figure 7).

Controversies surrounding consumption statistics Knowing how to read Chinese statistics has been a lifelong challenge for economists monitoring the Chinese economy. In the past, the quality of GDP and CPI data was frequently debated. 53 But the quality of the consumption numbers may be equally unreliable. Analysts have already provided various pieces of evidence that challenge China’s official consumption data. The Chinese consumer market is widely recognised as one of the world’s most dynamic markets, which is, at least on the surface, inconsistent with the weak consumption assessment. China is already the world’s largest market for automobiles and internet users, and the world’s second largest market for luxury goods. According to the official statistics, China’s total consumption expenditure was USD2.8trn in 2010, the third largest in the world after the US and Japan (Figure 8). In the meantime, Chinese 53

Yiping Huang, “Lies, dammed lies and statistics”, Column for Caing.com, Beijing, (in Chinese), 2 March 2010 (http://www.caing.com/2010-03-02/100121819.html).

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Barclays | China: Beyond the Miracle consumption expenditure grew by an average of 8.1% pa during the period 2000-2010, compared with 2.2% in the US, 1.1% in Japan, 0.7% in Germany and 6.5% in India. Strictly speaking, however, these figures do not refute the weak consumption argument as they only look at Chinese consumption relative to other countries. Other evidence may be more relevant. The first relates to the gap between the real growth of retail sales and consumption expenditure in GDP data. Until 2000, retail sales grew slower than consumption expenditure. But after 2000, this relationship reversed (Figure 9). During 2001-2010, retail sales grew faster than consumption expenditure by an average of 4.1pp. The gap was 7.6pp in 2008 and 2009 and narrowed somewhat to 5.9pp in 2010. Differences between the two variables may not be surprising given their different definitions. But the two have significant overlaps. About 80% of the retail sales value is for consumption and accounts for 60% of total consumption (in GDP data). The remaining 40% of consumption consists mainly of service products (plus self-supplied farm products). Using the above shares, we derive an average growth rate of 1.4% for service consumption. In some years, such as in 2008 and 2009, the growth rate was significantly negative. Such results contradict common sense. The second piece of evidence is potential underreporting of service expenditure. One main area frequently discussed is tourism spending. According to the annual statistical report of the State Tourism Bureau, in 2007, total domestic tourism revenue was CNY777bn, up FIGURE 10 Number of domestic tourists and their spending

FIGURE 9 Real growth of retail sales and GDP consumption expenditure (%) 18

1400

16

1200

14

1000

Number of tourists (RHS, person-time bn)

12 10

2.0

800

1.5

600

1.0

8 400

6 4 1996

2.5

Tourist revenue (RMB bn)

0.5

200 1998

2000

2002

2004

Real consumption (%y/y)

Source: CEIC, Barclays Research

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2006

2008

2010

Real retail sales (%y/y)

0

0.0 1994

1998

2002

2006

2010

Source: CEIC, Barclays Research

109

Barclays | China: Beyond the Miracle 24.7% from a year ago.54 Of this total revenue, spending by urban residents was CNY555bn, while that by rural residents was CNY222bn (Figure 10). Total domestic tourism spending, reported by the tourism agency, was almost equivalent to spending on recreation, education and cultural activities, recorded by the Statistics Bureau – CNY998bn using GDP-byexpenditure data or CNY746bn using household survey data. The tourism agency also reported a total of 41 million outgoing Chinese tourists in 2007. Outgoing tourists’ spending has two parts: tourism expenditure and overseas shopping. Assuming outgoing tourists’ average spending was three times domestic urban tourists’ average spending, the total amount would be CNY112bn. Overseas shopping, however, is much more difficult to estimate. According to Bain & Company (2011) 55 , Chinese spending on luxury goods increased by 35% in 2011. Chinese consumers spent €23.5bn on luxury goods at home, if their spending in Macau, Hong Kong and Taiwan are included. They probably spent a further €12.5bn in overseas markets. 56 These, combined, account for almost 20% of the global sales of luxury goods. In other words, overseas’ spending of at least CNY200-300bn was not reported in the official statistics. The third piece of evidence relates to households’ spending on housing. Judging from the latest data, however, we think the NBS probably has already adjusted official data to take care of this underreporting problem. China did not have a commercial residential housing market until the late 1990s. Before that, most houses/apartments were either self-built or allocated by work units. After the housing reform started in 1998, households had to begin to purchase their own apartments. This became a major drag on Chinese households (Figure 5). Housing purchases, of course, should be regarded mainly as investment, not consumption. But this new item squeezed consumption expenditure by substantially raising the household savings rate. However, if the houses purchased are for ‘own use’, then they are not entirely for investment and the rental equivalent cost should be treated as consumption expenditure. In a typical market economy such as the US, spending on rental equivalent

54 State Tourism Bureau, “2007 China tourism statistical report”, 10 September 2008, Beijing. We choose to examine the 2007 data, instead of more recent data, in order to avoid abnormalities caused by the global financial crisis. 55 “Worldwide luxury goods market poised to surge 10 percent in 2011 as growth in China and mature markets increases, according to newly-released 10th edition of Bain & Company's luxury goods worldwide market study”, October 17, 2011, Bain & Company (http://www.bain.com/about/press/press-releases/worldwide-luxurygoods-market-poised-to-surge-ten-percent-in-2011.aspx). 56 “Chinese Tourists on Global Luxury Spending Spree Driving Revenue at U.S. Retailers”, Luxury & Brands, November 17, 2011 (http://www.ibtimes.com/articles/251631/20111117/chinese-tourists-global-luxuryspending-spree-driving.htm).

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Barclays | China: Beyond the Miracle accounts for about 30% of total consumption expenditure. The problem is that China does not have a well-developed secondary housing market. In particular, the home ownership ratio (inclusive of self-built and state-allocated apartments) ratio is close to 90%, so the household survey data show very small spending on actual housing rental. Household survey data confirm actual spending on housing-related items at around 2.5% of disposable income. In the national accounts data, housing-related expenses are about 18% of total consumer spending. This is certainly more realistic than the survey data but, we think, probably still underestimates actual expenditure. The last piece of evidence was brought about by a landmark study on China’s hidden household income (Wang and Woo 2011). Through two consecutive household surveys, one in 2005 and the other in 2008, the National Economic Research Institute’s Xiaolu Wang concluded that household income was substantially underreported. He suggested several explanations for the underreporting, including technical survey problems, tax avoidance and corruption. By selecting a set of more than 1,500 households from the NBS sample, Wang went out to conduct his own surveys. In order to avoid the problem of some households’ unwillingness to report full income, Wang’s surveyors started by asking about detailed expenditure items. He then used Engel’s law, the well established correlation between household income and food expenditure, to estimate households’ actual income levels (Figure 11). FIGURE 11 Ratio of estimated income to official income in 2005 and 2008 Wang's estimates/ Official data (%)

Hidden income distribution (%)

Household distribution

2005

2008

As of 2008

Bottom 10%

99.1

112.5

0.4

10%-20%

101.8

100.9

0

20%-40%

106.9

117.4

2.3

40%-60%

114

128

5.1

60%-80%

130.6

143.1

10.9

80%-90%

138.7

209.1

18.8

Top 10%

337.7

318.7

62.5

Total

177.7

190.4

100

Source: Xiaolu Wang and Wing Thye Woo, 2011, “The size and distribution of hidden household income in China”, Asian Economic Papers, 1(10, 2011): 1-31).

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Barclays | China: Beyond the Miracle By doing this, he reached at least two very important conclusions. One, if Wang’s results are to be trusted, then China’s household income was significantly underestimated in official statistics, by 77.7% in 2005 and 90.4% in 2008. And, two, the underreporting was disproportionately concentrated in the high-income groups. In fact, the top 10% group’s income was underreported by 218.7% and accounted for 62.5% of the total income underestimation. Wang’s findings have some broad implications. First, income distribution among the Chinese households was much more unequal than the official statistics recognise. The income of the wealthiest 10% of Chinese households is really 65 times that of the poorest 10% instead of the 23 times reported in official statistics. Given that the highincome households have much higher saving rates, unequal income distribution naturally contributes to weak consumption. Second, the size of the Chinese economy is underestimated. According to Wang, NBS provides two sets of household income, one based on household survey data and the other based on flow of funds data in the national account. In 2008, NBS reported roughly CNY13trn of household income from its household survey. The national account reported about CNY18trn, roughly CNY5trn more than the household survey. Wang’s study estimated total household income of CNY23trn, another CNY5trn more than the national account estimate. He reckoned that about 40% of the underreported income was income transferred among households, while the remaining 60% was likely unreported in GDP. These figures imply an underestimation of Chinese GDP by 10%. Finally, consumption was likely also underreported. In order to hide their income, wealthy households would probably choose not to report some consumption items, especially their spending on luxurious goods. Wang estimated that household consumption was underreported by 20% in 2008. Since household income was underestimated by 27.8%, compared with the national account data, the household saving rate was actually even higher. This means that households’ consumption rate was even lower than what was reported by official statistics. The household consumption share of GDP, however, was actually slightly higher, at 38.2%, instead of the officially reported 35%.

Recalculating China’s consumption share of GDP So what is the true picture of consumption in China? By “true picture”, we refer to information in three dimensions: absolute size of consumer spending; consumption share of GDP; and time trajectory of that share. Discussions so far confirm that the March 2013

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Barclays | China: Beyond the Miracle official data are probably distorted in all three areas. Before getting to our own calculation, let’s first take a look at how the official statistics are compiled in China. NBS has three sets of data concerning consumption:

• Retail sales, collected from retail outlets (this will be referred to as retail sales hereafter);

• Household survey, sampled from households (this will be referred to as survey consumption hereafter);

• Consumption, reconciled in national account (this will be referred to as GDP consumption hereafter). These three sets of information are related but are not exactly the same (Figure 31 in appendix). For example, retail sales data cover a range of goods sold in shops. But they represent only part of the consumption basket. Service products, such as education, medical care and tourism, are not covered in retail sales. Meanwhile, retail sales also include certain producer goods, such as building materials, petroleum and chemicals. In addition, retail sales cover data on both household and public consumption. Survey consumption data are directly collected from households, which, by definition, should be a more reliable source of information. However, survey data are often subject to a set of technical problems, such as representativeness of the selected households. Pricing of self-produced goods is also a common problem. The Chinese statistical system is under-developed for service sector information. Most importantly, as identified by Wang, households may accidentally or deliberately underreport consumption expenditure. GDP consumption data should be consistent with other macroeconomic variables. But they are derived data. In estimating consumption, consisting of government and household consumption, NBS starts mainly from the household survey consumption data, while making reference to the retail sales data. This means that the GDP consumption data may be subject to the same types of problems as the household survey. To gain some insight into how the NBS modified the household survey data to reach household consumption under the GDP data, we compare the two sets for urban and rural households (Figure 12). In general, during 2004-2009, urban household consumption data under the GDP system were on average 20% greater than household survey data. The three enlarged items are residence (by 100% since 2006, likely to take March 2013

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Barclays | China: Beyond the Miracle into account missing rental equivalent), healthcare services (by more than 50% in 2008-09) and other items including financial and insurance services (by 170-200% in 07-09) likely to take account of underreporting of the services consumption. Downward revisions were done, interestingly by the same magnitude in the same year since 2006, for all the other items, including food, clothing, household facilities, transport, and recreation. FIGURE 12 Comparison of urban household (HH) consumption by sector, GDP and survey data Total

Food

HH Transport Recreation Clothing Residence facilities Medical etc etc

GDP urban consumption data (CNY) 2004

4,753

1,527

374

675

225

414

459

565

2005

5,328

1,662

2006

6,084

1,773

440

777

247

479

546

606

514

1,076

284

526

653

2007

7,149

685

2,124

610

1,231

352

616

795

778

2008 2009

8,310

2,557

700

1,457

415

758

851

815

9,230

2,715

779

1,617

477

887

1,034

905

Urban household survey data (UHS) (CNY) 2004

3899

1471

373

398

221

287

458

561

2005

4465

1638

450

455

251

338

560

617

2006

5069

1814

526

527

291

362

669

701

2007

6062

2200

632

596

365

424

823

806

2008

7016

2658

728

715

432

491

884

848

2009

7912

2889

828

793

508

552

1085

950

% (Consumption_GDP- Consumption_UHS )/Consumption_UHS 2004

21.9

3.8

0.4

69.5

1.7

44.4

0.1

0.8

2005

19.3

1.4

-2.2

70.8

-1.5

41.8

-2.6

-1.8

2006

20.0

-2.3

-2.3

104.2

-2.3

45.5

-2.3

-2.3

2007

17.9

-3.4

-3.4

106.6

-3.4

45.2

-3.4

-3.4

2008

18.4

-3.8

-3.8

103.8

-3.8

54.5

-3.8

-3.8

2009

16.7

-6.0

-6.0

103.9

-6.0

60.5

-4.8

-4.8

Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle FIGURE 14 Consumption-related retail sales as % of GDP

FIGURE 13 Growth of household facility consumption %y/y 30

Household facility consumption, under GDP

35

Household facility consumption, under household survey Household facility consumption, under retail sales

25

33

20

31

15

Consumption-related retail sales (% GDP)

29

10 27

5 0 1998

2000

2002

2004

Source: CEIC, Barclays Research

2006

2008

2010

25 1997

2001

2005

2009

Source: CEIC, Barclays Research

Changes to rural household data were relatively insignificant but equally interesting (Figure 32 in Appendix). Overall, rural household consumption was only about onethird of urban household consumption. Compared with the household survey data, rural household consumption under the GDP system was revised up by an average of 5%. The main upward revisions occurred to almost every category in recent years. Special revisions were done again to the residence and healthcare sectors, like for the urban household data, while the upward revisions to all the other sectors were identical during the same year. It is noteworthy that healthcare expenditure was revised up by 19% in 2009, compared with 9% and 5% previously. The revision to residence expenditure suddenly turned to a negative 11% in 2009 after years of upward revision, which raises questions about data consistency. The adjustment can also be seen from comparison of growth rates for GDP consumption and survey consumption (Figure 15). In estimating the GDP consumption data, the NBS effectively raised growth rates for household facility and services, residence and healthcare but lowered growth rates for transport and recreation. The last change was somewhat surprising as recreation spending, especially that on tourism, has been growing very rapidly. One bigger problem, however, is the discrepancy exhibited between consumption data and retail sales data. We already showed that, on average, retail sales growth was more than 4pp higher than GDP consumption growth during 2000-2010 (Figure 15). But we know that definitions of the two variables are different. However, the same discrepancies still exist even if we go down to specific categories. Taking household facility consumption as an example, March 2013

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Barclays | China: Beyond the Miracle retail sales showed an average growth of 22.3% during 2005-2009, GDP consumption data showed growth of 16.3%, while household survey data showed growth of 12.8% (Figure 13). The difference between the first two was particularly puzzling: where did the sold household facilities go if nobody consumed them? The proportion of consumption-related retail sales to GDP actually picked up forcefully, from 26.7% in 2008 to 32% in 2010 (Figure 14). This probably means that consumption has actually strengthened during the past couple of years, both in absolute size and relative GDP. This is consistent with our general observation. But the official data point to a continuous decline in the consumption share of GDP. If the retail sales figures are reliable, the official data could be correct only if non-retail consumption expenditure collapsed in 2009-2010. But this is highly implausible. FIGURE 15 Comparison of total household consumption by sectors, GDP and survey data (%y/y) Food

Clothing

HH facility

Transport etc Residence

Medical

Recreation etc

GDP Consumption Data 2005

8.8

17.6

9.9

19.0

15.1

15.7

7.2

2006

6.7

16.7

14.9

19.8

38.6

9.9

13.1

2007

19.8

18.8

24.1

21.6

14.4

17.0

13.6

2008

20.4

14.7

17.9

7.0

18.4

23.1

4.8

2009

6.2

11.3

14.9

21.5

11.0

17.0

11.0

2005-09

12.4

15.8

16.3

17.8

19.5

16.5

9.9

7.0

17.7

11.6

22.5

12.9

12.6

12.2

2006

7.5

14.5

11.5

18.1

12.4

6.1

14.0

2007

15.7

18.2

17.0

21.3

11.7

15.1

14.9

2008

16.6

13.8

11.5

7.6

17.9

13.7

7.3

2009

9.9

13.2

12.6

21.7

9.4

12.1

12.7

Household Survey Data 2005

2010

11.3

17.3

17.4

22.8

13.5

7.6

16.1

2005-09

11.3

15.5

12.8

18.2

12.9

11.9

12.2

Source: CEIC, Barclays Research

So far, we can draw two qualitative conclusions from our analysis of Chinese consumption data. One, the official consumption data are likely underreported. And, two, growth rates of Chinese consumption are probably also underestimated. In order March 2013

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Barclays | China: Beyond the Miracle to gauge the true picture of consumption in China, we try to calculate four sets of consumption shares of GDP for the period 1997-2010 by adopting different assumptions under two scenarios and two different assumptions about GDP data and consumption growth (Figure 16). We adopt two proxies for consumption growth. The first is the growth rate of consumptionrelated retail sales (ie, retail sales excluding producer goods such as petroleum, chemical, etc). The second is a weighted average growth rate of consumption-related retail sales and growth rate of service sales in China. Between the two, we place a greater emphasis on the results derived from the second proxy growth rate. FIGURE 16 Four sets of Barclays estimates of consumption shares of GDP Growth rate A Retail sales to proxy consumption growth

Growth rate B Weighted average of retail and service sales growth to proxy consumption growth

Estimation IA

Estimation IB

Estimation IIA

Estimation IIB

Scenario I Official data for GDP (for all years) and consumption (for 1997) Scenario II Wang data for GDP (+10%) and consumption (+20%, with variations +10% and +30%) Source: Barclays Research

FIGURE 17 Consumption share of GDP: Estimation IA (%)

FIGURE 18 Consumption share of GDP: Estimation IB (%)

Official consumption share (%)

70

70

Official consumption share (%)

Estimated consumption share (%)

Estimated consumption share (%)

65

65

60

60

55

55

50

50

45

45

40 1997

1999

2001

2003

Source: Barclays Research

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2005

2007

2009

40 1997

1999

2001

2003

2005

2007

2009

Source: Barclays Research

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Barclays | China: Beyond the Miracle When applying Wang’s data, we first extrapolate the GDP underestimation by an additional percentage point in every three years, based on findings of underestimation by 9% in 2005 and 10% in 2008. Wang suggested that household consumption was underestimated by 20% in 2008. In that year, the official statistics reported total consumption share of GDP at 48%, of which household consumption was 35% of GDP and government consumption was 13% of GDP. These imply that the adjusted household consumption was 38.2% of GDP and total consumption was 50% of GDP. We take this as the starting point and then derive consumption data for the other years by applying various growth rates. In order to check for robustness, we also include consumption underestimation by 10% and 30%. Estimation IA shows a steady decline of the consumption share from 2002 (Figure 17). But the share picked up sharply after 2008 and by 2009, was already above the previous cyclical peak. Estimation IB shows a straightforward decline in the consumption share after 1997. But the share also started to pick up in 2009-2010, although the rebound was much less dramatic (Figure 18). Between the two, we suspect the weighted average of retail sales and service sales growth rates was probably a better proxy for consumption growth. Likewise, Estimation IIA exhibited a very sharp rebound in the consumption share in recent years, under all three assumptions about underestimation of consumption (Figure 19). But the trajectories before 2008 appear to be a lot flatter. Estimation IIB is probably a more reasonable experiment. Under assumptions of 20% and 30% underestimation of consumption, the consumption shares of GDP were also FIGURE 20 Consumption share of GDP: Estimation IIB (%)

FIGURE 19 Consumption share of GDP: Estimation IIA (%) 75

Adj. C share (10%) Adj. C share (20%)

75

70

Adj. C share (30%) Official C share

70

65

Adj. C share (20%)

60

55

55

50

50

45

45

1999

2001

2003

2005

Source: CEIC, Barclays Research

March 2013

Adj. C share (30%) Official C share

65

60

40 1997

Adj. C share (10%)

2007

2009

40 1997

1999

2001

2003

2005

2007

2009

Source: CEIC, Barclays Research

118

Barclays | China: Beyond the Miracle underestimated, by an average of 3pp and 7pp, respectively, during 2001-2010 (Figure 20). Of all these different sets of estimation, Estimation IIB, especially with the 20% consumption underreporting assumption, is probably the most reasonable. This is the set on which most of our following discussions are based. In all these exercises (but most clearly in the case of Estimation IIB under the assumption of 20% consumption underestimation), we find some very clear and consistent results: 1) the consumption share of GDP declined continuously during the years before 2008, which was consistent with the official statistics; 2) the share was systemically higher than the official share, which means that the official statistics overstated the weak consumption problem; and 3) the share already picked up after 2008. These findings imply that rebalancing of the Chinese economy has already started.

Will consumption improvement be sustained? One question is whether the improvement we observed during the past years was temporary or permanent. An important factor that boosted consumption during the past years was the government’s policy of subsidising purchases of electronics as a part of the CNY4trn stimulus package. According to the Ministry of Commerce, that policy induced a total spending of CNY300bn (or CNY100bn a year). With the subsidy policy ending in late 2011, will consumption improvement reverse in the coming years? We think the improvement will continue. While the subsidy policy was probably a useful addition, we believe the fundamental contributor to improving consumption was rising household income share. Furthermore, the government is considering some new measures aimed at boosting consumer spending. In the first of our “China: Beyond the miracle” series, we argued that the fundamental cause of the imbalance problems, including weak consumption, was widespread and serious distortions in factor markets. These distortions, by repressing production costs, subsidised producers, investors and exporters and, at the same time, taxed consumers. Stagnation of wage income and low deposit rates depressed household income and its share in national income. Such distortions also worsened income distribution among households. A strong implication of the above analysis is that one key to economic rebalancing lies in liberalisation of factor markets. We have argued that the reason why rebalancing did not take place during the earlier years was because the government relied mainly on administrative measures to correct the imbalances. Without changing distortions in the

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Barclays | China: Beyond the Miracle factor markets, incentives for producers, investors, exporters and consumers remained unchanged. But the incentive structure started to change during the past years. First, wages have started to grow more rapidly, as a result of a tightening labour market. Labour shortages first emerged in China in 2004, although the problem, especially the shortage of unskilled workers, worsened in 2009, after a brief disruption in 2008 as a result of the global financial crisis. This was evidenced by competition for migrant workers by both coastal and inland cities, significant upward revision of minimum wages across the country and an acceleration of wage growth. After a long period of decline and stagnation, wage income as a share of GDP began to pick up after 2008 (Figure 21). Second, households’ investment returns also increased rapidly in recent years.During the earlier years, bank deposits were the only available investment for ordinary households. The very low deposit rates, especially often negative real deposit rates, capped household income. This started to change in recent years. Although the authorities did not liberalise the deposit rate, the balance sheet activities, especially wealth management products (WMPs), began to grow rapidly. Growth of off-balance sheet activities, was, in fact, a form of de facto interest rate liberalisation as it introduced market-based interest rates to financial intermediation. As a result of these changes, household income started to improve significantly. Unfortunately, this improvement was observed in daily life but not reflected in official statistics, which continued to report a declining share of household income in GDP.

FIGURE 22 Household income as share of GDP

FIGURE 21 Wage income as a share of GDP has picked up 100

72

Total wage income/GDP (1994=100)

Adjusted household disposable income as % of GDP

70

95

68 90

66 85

64

80

62 60

75 1994

1998

2002

Source: CEIC, Barclays Research

March 2013

2006

2010

2005

2006

2007

2008

2009

2010

Source: CEIC, Barclays Research

120

Barclays | China: Beyond the Miracle However, if we apply Wang’s finding of underestimation of household income and extrapolate 55% underestimation in 2005 and 66% underestimation in 2008 to cover the whole period 2005-2010, we find that the household income share of GDP actually picked up after 2008 (Figure 22). This was consistent with our findings of a pickup of consumption during the same years. Meanwhile, increases in wage and interest rate income should also be favourable for income distribution among households. More importantly, changes in fundamental factors also suggest that the recent consumption improvement is secular and structural. Trying to gauge the determinants of China’s private consumption (over GDP), IMF’s Kai Guo and Papa N’Diaye (2010) estimated an unbalanced panel of 39 economies over 1980-2008. 57 They found that their baseline specification fits China’s consumption profile well. Their results suggest China’s low consumption share is nothing too ‘special’ given the low level of the conditioning variables such as service sector employment and financial development. They estimate that around one third of the fall in private consumption share from 20002007 can be attributed to a decline in household income share, while the remaining two-thirds are due to other factors that either directly or indirectly affect the household savings rate or income. FIGURE 23 Determinants of private consumption (% GDP)

FIGURE 24 Dependency ratio is set to rise 100

Public consumption/GDP Real GDP growth

China

Japan

US

90

Real interest rate

80

Change in terms of trade

70

Old-age dependency ratio Financial development

60

Share of employment in service sector

50

Change in real effective exchange rate

40

External financing Household disposable income/GDP -0.02 -0.01 -0.01 0.00

30 0.01

0.01

Note: Dependent variable is the share of private consumption in GDP. All coefficients reported are statistically significant. Source: Kai Guo and Papa N’Diaye, 2010, “Determinants of China’s private consumption: An international perspective”, IMF Working Paper WP/10/93, Washington DC.

0.02

1950

1965

1980

1995

2010

2025

2040

Source: CEIC, Barclays Research

57

Kai Guo and Papa N’Diaye, 2010, “Determinants of China’s private consumption: An international perspective”, IMF Working Paper WP/10/93, Washington DC.

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Barclays | China: Beyond the Miracle Application of their research findings paints a very promising picture for Chinese consumption in the years ahead (Figure 23), for example:

• Household disposable income/GDP (+): Changes and reforms in factor markets and government policies will likely further lift shares of household income of GDP;

• Real effective exchange rates (+): Appreciation of renminbi will probably be a longterm trend;

• Share of service employment (+): Faster development of the service sector should raise employment share of services;

• Old age-dependency ratio (+): Aging is one of the most serious demographic challenges facing the Chinese economy (Figure 24);

• GDP growth (-): As the economy matures, its growth rate should slow naturally;

• Financial development/real interest rates (+): Reform of repressive financial policies should be favourable for development of the financial system and removal of negative real interest rates. Obviously, most of the above trends, other than population aging and growth moderation, are conditional on government policy actions. But we are confident that these will take place, especially if we take a medium-term perspective. Indeed, with boosting domestic consumption being the key policy priority in the 12FYP, the government has set more binding targets than they did in the 11FYP in the areas of raising household income levels, improving social safety net and promoting service sector development. 58

A strong case for consumption upgrades We expect a dominant theme in the coming years to be consumption upgrading, alongside the likely pickup of consumption growth. While the luxury goods market will continue to grow at a fast pace, supported by expansion of the middle class, we think mid-to-high end goods could grow at an even faster pace given the multilayer consumption upgrade: urban lower income/rural/inland households will

58

The government has committed to improve social safety net, through providing more pension, health care, insurance, public education as well as more affordable housing. It has set target for total labour compensation and household income to grow no less than GDP growth. It has also committed to improve income distribution eg through raising personal income tax threshold values. Promoting service sector development and creating more service employment was also set as a key policy objective in the 12 FYP.

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Barclays | China: Beyond the Miracle upgrade to replicate the consumption path experienced by the current urban affluent/urban/costal households. This consumption upgrading story will be underpinned by rapid household income growth and the rise of the middle class. China’s middle class, if defined as annual income of CNY55k-200k, the equivalent of USD8k-30k, amounted to 135mn households in 2010, according to surveys conducted by McKinsey & Co (2011, Figure 24). 59 And this number is expected to reach 200mn by 2015. In particular, upper middle class (annual income of CNY100k-200k, or USD15k-30k) will rise from 13mn households in 2010 to 76mn by 2015. Looking back on the past half century, consumption upgrading has actually been a recurrent theme in China. The “big ticket items” for Chinese consumers, for instance, have changed quite steadily (Figure 27). Clearly, along with technological progress and income growth, Chinese households have upgraded their consumption demand from home appliances to electrical/digital products, from goods to services, and from meeting modern leisure/entertainment requirements.

FIGURE 25 Middle-income class in China is expected to rise Share of urban household income class Millions of households, Percent 100

223 mn 6

2

273 mn

4

CAGR ('10-'15) Percent 4

28

80

FIGURE 26 Consumption upgrading story in Taiwan 30

%y/y, 5y avg

Food and beverage Health Communication

Household facility Recreation

25 20

43 54

60

15 43

40 20

38

25

0

10

-4

5

0 200k

Source: Yuval Atsmon, et al, Understating China’s growing love for luxury, McKinsey consumer & shopper insight, 2010, Barclays Research

0 1986

1990

1994

1998

2002

2006

2010

Source: CEIC, Barclays Research

59

McKinsey & Company, Consumer & Shopper insight, Understanding China’s Growing love for luxury, March 2011

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Barclays | China: Beyond the Miracle FIGURE 27 Evolution of the ‘big ticket’ spending by Chinese urban households over time 1970s

1980s

1990s

2000s

Bicycle

2010s

TV

Mobile Phone

Housing

On-line shopping

Sewing machine

Washing Machine

Personal Computer

Automobile

Luxury and personalized goods

Watch

Refrigerator

Air Conditioner

Tourism

Green and sustainable goods

Radio

Tape recorder

Camera

Digital products

Services

Source: Barclays Research

Consumption upgrading can also be seen by comparing patterns of consumption expenditure of different income groups (Figure 28). The household survey data show that, as income levels rose, households’ expenditure shares on the necessities goods, such as food, declined sharply, while consumption of services have increased across the board. The expenditure shares increased most significantly for four main categories: 1) household facility and related services; 2) transportation and communication; 3) recreation, education and culture; and 4) others, which probably include financial services. These suggest very clear consumption upgrading trends across households and may provide some hints on how households may move up the chain as their income rises. Findings on the share of healthcare expenditure, which declined as income rose, were somewhat strange. This may be distorted by China’s not yet liberalised healthcare system. However, we see great growth potential for healthcare expenditure as households’ demand for higher quality and more systemic services when they reach higher income levels. Another way of gauging future consumption trends in China is to look at what happened in other East Asian economies when they were at similar stages of development, as measured by per capita GDP. Figure 3 shows that both Korea and Taiwan had similar experiences of declining consumption shares, before consumption started to pick up. They encountered turning points roughly about 20 years ago: Taiwan’s per capita GDP in 1986 was USD4,007 and Korea’s in 1988 was USD4,300. In the following 10 years, consumption patterns changed significantly. But they generally confirmed the consumption upgrading story that we propose above for China: less spending on food and beverages and more spending on household facilities, healthcare, culture and recreation (Figure 26). Similar observations can also be found in Korea. March 2013

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Barclays | China: Beyond the Miracle A key trend derived from the above analysis is a shift of household consumption from goods to services. Both China’s own experiences (Figures 27, 28) and those of other countries suggest a take-off in service consumption when per capita GDP reaches around USD4,000. We expect the service sector to be a new driver of growth in the coming decade. This will be facilitated by favourable policies and liberalisation trends that have already started. China’s export- and investment-led growth boosted the manufacturing sector in the past decade, while development of the service sectors has lagged. The negative consequences of this include rising energy intensity, worsening growth imbalance, slow job creation, as well as less variety, low quality, and expensive service consumption (in areas such as telecoms, healthcare and culture experiences). Recognising this, the government made the promotion of service industry development and service consumption as a top policy priority in the 12th FYP. Favourable tax and industry policies are expected to be rolled out to support this drive. FIGURE 28 Urban per capita spending by low, middle and high income group 2010

Food

Clothing

HH Facility

Medical

Transport Recreation etc etc Residence

Others

(CNY) Low

2668

579

313

415

492

558

674

151

Middle

4810

1424

848

854

1677

1487

1258

442

High

7646

2688

1940

1578

5200

3627

2507

1194

(% of total expense) Low

45.6

9.9

5.4

7.1

8.4

9.5

11.5

2.6

Middle

37.6

11.1

6.6

6.7

13.1

11.6

9.8

3.5

High

29.0

10.2

7.4

6.0

19.7

13.8

9.5

4.5

Note: The household survey data contain eight consumption categories and eight income groups. To simplify the comparison, we group the lowest, poor and low into low income group, lower middle, middle and upper middle into middle group, and high and highest into high income group. Source: CEIC, Barclays Research

The same upgrade story should be expected for rural, inland, and lower income households (which is already underway to some degree), as they tend to have a higher propensity to consume and also a greater aspiration to own better products. An expected improvement in income inequality should add to the momentum of this process. Such a multi-layer consumption upgrade will provide strong support for midhigh level consumer goods and services consumption in the coming years. China’s vast size and regional differences also suggest that the Chinese consumption upgrade story could last for many years. March 2013

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Barclays | China: Beyond the Miracle Luxury goods consumption has been frequently identified as a key area for investment opportunities. 60 Indeed, this has been the segment of the consumer goods market that has shown most resilience and persistent growth, supported by the highincome groups. China has been the fastest growing market for luxury goods. Bain & Company (2011) estimated that the size of the mainland China luxury goods market reached €9.6bn in 2010 (35% y/y growth) and €12.9bn in 2011 (Figure 29) and the Chinese make roughly half of their luxury goods purchases overseas. According to Global Blue, the largest global tax-refund and shopping services provider, Chinese shoppers topped the global tax-free sales in the first 11 months of 2011. Chinese buyers account for 21% of total sales, followed by Russian (15%) and Japan/US/Indonesian shoppers (4% each). Luxury goods consumption will likely remain a robust story of Chinese consumption. With greater spending power and more households entering the middle class, we will probably see more demand for better quality/high-end products, sustaining relatively fast growth in the luxury goods market. However, the luxury goods market has been well focused and exploited by investors. We think greater new opportunities exist among mid- to high-end goods and services, driven by the expected great waves of consumption upgrading.

Policy and market implications Our analyses suggest that Chinese consumption has already started to improve over the past three years, in contrast to the continuous weakening as reported by the official statistics. This implies that the long-awaited rebalancing of the Chinese economy is already taking place. On our estimates, the investment share of GDP was 42% in 2010, compared with the officially reported 48.6% (Figure 30). This finding is consistent with the main theme of our “China: Beyond the miracle” series. The rebalancing of the Chinese economy depends critically on the correction of factor market distortions, a trend that we believe has actually been taking place during the past years, evidenced by rapid growth of wages, rising energy and other resource costs, and the increased role of market-based interest rates. Our analyses also found underreporting of consumption. Total consumption expenditure was, on average, underreported by 5.7ppt, while the consumption share of GDP was underestimated by 3ppt. The extent of underestimation rose significantly over 60 European luxury goods, China boom underestimated – raising targets, Barclays Research, Helen Brand and Julian Easthope , etc, Equity research, European luxury goods, 14 January 2011.

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Barclays | China: Beyond the Miracle 2009-10. We imagine that most of the unreported consumption expenditure occurred at the high end of consumer market, in line with Xiaolu Wang’s finding that hidden household income was concentrated in high-income household groups. We believe that recent strengthening of consumption is only the beginning of a longterm process. Changes like population ageing, moderation of economic growth and appreciation of real effective exchange rates should all be favourable for consumption growth. In addition, policies facilitating a growing proportion of household disposable income to GDP, financial liberalisation and service sector development should also be positive for boosting consumption expenditure. In general, further liberalisation of the economy, especially the factor markets, is key to a rebalancing and sustainable growth of the economy. The Chinese economy is at an important turning point, shifting from export- and investment-led growth toward consumption-driven growth. In the past, some investors have focused a lot on the luxury goods market, which is strongly supported by highincome households. This story should continue. But the new theme we should pay close attention to is the great wave of consumption upgrading – hundreds of millions of Chinese spend hundreds of billions more on mid- and high-end consumer goods and services when their income moves to higher levels continuously. Even as of now, consumers are rapidly expanding their expenditure shares on household facilities and services, transportation and communication, recreation, culture and education, and others such as financial services. FIGURE 30 Estimated GDP breakdown by components

FIGURE 29 Chinese luxury goods market size 14

45

100

12

40

90

35

80

30

70

8

25

60

6

20

50

15

40

10

30

2

5

20

0

0

10

10

4

2006

2007

2008

2009

2010

2011E

Mainland China luxury market size (EUR bn) Mainland China luxury market growth rate (RHS, %y/y)

Source: Altagamma 2011 worldwide market monitor, Bain & Company, October 2011, Barclays Research

March 2013

0 1998 2001 Consumption

2004 Investment

2007 2010 Net export

Source: Barclays Research

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Barclays | China: Beyond the Miracle The consumption upgrading in China could be a multi-level, multi-year and multi-region story. Currently there are huge gaps in income and consumption patterns between lowand high-income households, between rural and urban households and between households living in the coastal areas and those residing in inland provinces. As those lower income/rural/and inland households increase their income, become urbanized and adopt coastal life styles, there would be a huge demand for mid- and high-end consumer goods and services products.

Appendix FIGURE 31 Breakdown of retail sales and household consumption, 2010 Retail sales of consumer goods: above designated size enterprise

GDP by urban household consumption

%

Automobile

29% Food

%

Urban household expenditure per capita

%

29% Food

36%

Petroleum & Related Product 18% Residence

18% Transport & Communication

15%

Food, Beverage, Tobacco & 13% Transport & Liquor (FB) Communication

11% Recreation, Edu & Cultural 12% Ser (RS)

Clothing, Shoes, Hats & Textile (CT)

10% Recreation, Edu & Cultural

10% Clothing (CT)

11%

Household Electric & Video Appliance

7%

Health Care

10% Residence (RD)

10%

Chinese & Western Medicine 5% (CM)

Clothing

8%

Household Facility, Article 7% & Ser (HS)

Others

4%

Household Facility & Service

5%

Medicine & Medical Service

6%

Daily Use Goods

4%

Others

5%

Miscellaneous

4%

Gold, Silver and Jewellery

2%

Financial Service

2%

Cultural & Office Goods

2%

Insurance Service

2%

Cosmetics

2%

Communication Appliance

1%

Construction & Decoration Material

1%

Furniture

1%

Book, Newspaper & Magazine

1%

Sport & Recreational Goods 1% Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle FIGURE 32 Comparison of rural household consumption by sector, GDP and survey data Total

Food

HH Clothing Residence facilities

Medical

Transport Recreation etc etc

GDP rural consumption data (CNY) 2004

1,769

787

92

284

68

101

147

189

2005

1,937

812

104

336

78

120

171

206

2006

2,126

874

121

387

91

141

207

219

2007

2,412

1,000

139

442

107

157

236

220

2008

2,750

1,158

153

510

126

188

261

228

2009

2,883

1,173

167

492

147

236

289

244

Rural household survey data (RHS) (CNY) 2004

1654

781

91

245

68

99

146

187

2005

1905

866

111

276

83

125

183

220

2006

2070

890

123

343

93

140

211

223

2007

2305

993

138

410

107

150

235

219

2008

2577

1126

149

478

122

173

254

221

2009

2753

1128

160

555

141

198

278

235

% (Consumption_GDP- Consumption_RHS )/Consumption_RHS 2004

7.0

0.8

0.8

15.7

0.8

2.2

0.8

0.8

2005

1.7

-6.3

-6.3

21.9

-6.3

-4.6

-6.3

-6.3

2006

2.7

-1.9

-1.9

12.7

-1.9

0.3

-1.9

-1.9

2007

4.7

0.7

0.7

7.6

0.7

4.6

0.7

0.7

2008

6.7

2.9

2.9

6.8

2.9

8.6

2.9

2.9

2009

4.7

4.0

4.0

-11.4

4.0

18.8

4.0

4.0

Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle

CHAPTER 5

Understanding Chinese inflation

• China’s January CPI upside surprise raised important questions about the future inflation. Is it a temporary fluctuation or the beginning of a new trend? We provide a framework for understanding China’s inflation problem and its monetary policy mechanism.

• The quality of Chinese CPI statistics is subject to the usual problems of underestimation of both the share and prices of high-end products and services in the consumer basket. According to our estimates, CPI may be underreported by 1-2 pp at its peak.

• Based on statistical analyses, we suggest that the most important determining

factors of Chinese inflation are excess liquidity, overcapacity and inflation expectations.

• Rapid increases in food prices, such as rice and pork prices, were usually symptoms, not triggers, of inflation. These changes often led to high, broadbased inflation because of dramatic monetary expansion in previous periods.

• The PBoC is a unique central bank as it is not an independent monetary

policymaker. It has multiple policy objectives and applies a combination of price, quantitative and administrative policy instruments.

• Moreover, important decisions on monetary policy are made by the State Council,

which has a tendency to favour micro tools in dealing with inflation: encouraging food production and cracking down on speculation. This often exacerbates the instability of the inflation profile.

• In our view, the key problem of Chinese monetary policymaking today may not be

lack of “independence”. Rather, it is lack of “expertise” among members of the State Council.

• In the short term, we expect inflation pressures to moderate further as liquidity conditions continue to tighten, overcapacity problems intensify and inflation expectations recede.

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Barclays | China: Beyond the Miracle

• However, long-term factors, such as tighter world resource constraints, broadbased increases in the cost of production in China and generally easy money around the globe, point to a period of high and volatile Chinese inflation ahead. Our equity and credit analysts consider the implications of higher structural inflation across various sectors.

• If China was a source of global disinflation in the past decades, it will become a source of global inflation in the next decade.

This article was originally published on 20 February 2012.

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Has inflation really peaked? On 9 February, 2012, the National Bureau of Statistics announced that CPI inflation had rebounded to 4.5% y/y in January, from 4.1% y/y in December (Figure 1). This outcome surprised the market, as it was the first uptick since CPI peaked at 6.5% in July 2011, and also defied analysts’ expectations of a moderation to 4.0% y/y in January. Even our above-consensus call of 4.1% missed the target by a wide margin. Disaggregated data reveal that the rebound of CPI was driven almost entirely by two components of the basket: food prices rose 10.5% y/y from 9.1% in the previous month while recreation prices increased by 0.7% y/y from 0.1% (Figure 2). In addition, prices of household facilities edged up to 2.6% y/y from 2.5%. In contrast, the declining trends in the past few months continued in other components including residence, transportation, medical, clothing and tobacco. Most analysts blamed the timing of the Chinese New Year holiday for the upside surprise, which fell in January this year versus February last year. This was certainly one possible explanation as demand tends to pick up during the festival. However, that the actual result significantly surpassed market expectations implies a gross underestimation of the Chinese New Year effect by most analysts.

FIGURE 2 … on contributions from food and recreation prices

FIGURE 1 January CPI inflation rebounded… 10 pp

% y/y

10

% y/y

8

8

Headline

4.5

4.1

4.2

5.5

6

6

Food

10.5

9.1

8.8

11.9

4

4

Non food

1.8

1.9

2.2

2.7

2

2

Residence

1.9

2.1

3

4.4

0

0 -2

-2 -4 Jan-06 Jan-07 Other Food

Jan-08

Jan-09 Jan-10 Medical Care CPI (RHS)

Source: CEIC, Barclays Research

March 2013

-4 Jan-11 Jan-12 Residence

Jan-12

Dec-11

Nov-11

Oct-11

Recreation

0.7

0.1

0.1

0

Transportation

0.2

0.3

0.5

0.8

Medical

2.6

2.8

3.2

3.5

Clothing

3.3

3.8

3.5

3.7

Household facilities

2.6

2.5

2.9

3.1

Tobacco

3.7

3.9

3.8

3.7

Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle As such, it is important to ask where will inflation go from here? Specifically, was the January CPI surprise a temporary fluctuation or the beginning of a new trend? The consensus view is that inflation pressures will continue to moderate in the coming months. In our base case, we predict CPI to fall to 3.2% in 2012 from 5.4% in 2011. This expectation is driven by our view that slowing demand will ease resource and capacity constraints. Therefore, inflation pressures should moderate alongside economic growth in the year ahead. But others, including some central bank officials, argue that upside risks to inflation remain. So far, the growth moderation has been limited. While the central government may target 2012 GDP growth of 7.5% (Barclays forecast 8.1%), many officials appear to believe that growth could still be around 8.5%, based on our discussions and media reports. Other factors such as uncertainties surrounding wages, food, oil and possible quantitative easing in the developed world could push Chinese inflation even higher if economic growth stabilises quickly. In this report, we attempt to provide simple frameworks for gauging the possible future direction of Chinese inflation and understanding the mechanisms driving Chinese monetary policy. Specifically, we address four questions:

• How reliable is Chinese inflation data?

• What are the fundamental determinants of Chinese inflation? • How does China formulate its monetary policy? • What is the likely long-term inflation trend?

Our findings can be summarised as follows. First, given the generally benign inflation environment of the past decade, we believe the political motivation for manipulating the official inflation data is limited. But data quality is probably still subject to the usual technical issues, such as the underreporting of both share and prices of high-end goods and services in the consumer basket. We think it is possible that the official CPI print underestimates actual inflation by 1-2 percentage points (pp), when inflation is rising. Second, the main fundamental factors determining Chinese inflation are: (1) excess liquidity; (2) overcapacity; and (3) inflation expectations. Many of the other factors frequently mentioned in policy discussions, such as wages, food and energy prices, are either initial triggers or symptoms of an inflation problem. In other words, they can only lead to a broad-based inflation problem if the fundamental factors are present. Therefore, the best policy strategy to contain inflation pressure would be to tighten March 2013

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Barclays | China: Beyond the Miracle liquidity, slow the economy and influence expectations. Policy measures such as subsidising low-income households, ensuring fertiliser supply to grain farmers and controlling certain prices may be useful to ease the pain of inflation, but they are not sustainable long-term macroeconomic policy responses. Third, some unique features of Chinese monetary policymaking have important implications for the economy’s inflation profile. The People’s Bank of China (PBoC) is not an independent central bank and monetary policies have to satisfy four macroeconomic policy objectives simultaneously: growth, employment, price stability and the balance of payments. Instead of using price-based tools such as interest rates, China’s monetary policy still relies mainly on liquidity and administrative measures. The authorities almost never take pre-emptive action and always appear slow to respond to inflation risks. But after the risks rise to certain levels, policymakers often take excessive action in the other direction. As a result, the trajectory of Chinese inflation is often volatile. In short, it could be said that the main problem with monetary policymaking in China today is not lack of “independence”, but lack of monetary policy “expertise”. Finally, we think China could be at the beginning of a period of high inflation for at least three reasons: (1) Chinese growth is hitting resource constraints, such as global commodities and domestic demographics; (2) the removal of factor market distortions may add significant cost pressure across the economy; and (3) easy money at home and abroad may eventually generate very high inflation pressure. How high Chinese inflation might go depends in part on the willingness of policymakers to tolerate slow growth. If China was a source of disinflation for the global economy during the past decade, it is already turning into a source of inflation.

Reliability of Chinese inflation statistics The quality of Chinese statistics is often disputed. There are two broad factors that undermine the reliability of Chinese statistics: one technical, the other political. The Chinese statistical system was originally designed for a centrally-planned economy focused on material production. During the reform period, this system evolved significantly to reflect the new reality of the economy. But such changes appear to have been insufficient. For instance, for many years economists believed that Chinese income levels were underestimated. One important reason was that the statistical system did not do a good job of recording data for services, especially in the informal sectors. Another reason was March 2013

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Barclays | China: Beyond the Miracle difficulties in pricing economic activities during the period of economic transition. When the market was not well developed, it was hard to assess the true value of certain products. Such technical problems are common among developing and transition economies. The political cause of distortions in official statistics might be unique to China. Since GDP growth is such an important indicator in performance assessments, local government officials have a strong incentive to inflate local growth data (see Chapter 1: China’s next transition). This explains why, almost every year, the weighted average of provincial GDP growth rates is higher than the national growth rate. In 2012, even though the central government will likely target GDP growth of 7.5%, at least 19 provincial governments have set growth targets at 10% or above. These same causes are probably also applicable to inflation data. Since inflation data are politically sensitive, government agencies might be reluctant to report the actual numbers when inflation rates are rising strongly. Most government officials believe that serious corruption and high inflation were the two fundamental factors that contributed to the widespread protests of 1989. In 1988, following the government’s attempt to free the price system, CPI reached an historical high of 18%. This caused major social discontent, especially as growth in urban incomes was lagging. This is probably the main reason behind the public’s suspicion about the underreporting of the official CPI data. But this factor is difficult to quantify. During the past decade, inflation was not a major threat to social stability, even when it was considered a key macroeconomic risk in 2004, 2007 and 2011. Because of this, we do not believe that the deliberate underreporting of inflation is a common practice.

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Barclays | China: Beyond the Miracle FIGURE 3 CPI basket: categories, components and weights Category

Components

Food

Grains; meat, poultry and processed products; oils and fats; vegetables; and dining out

30.6

Residence

Rent; private housing; water, electricity and fuel; building, and building decoration materials

17.6

Tobacco, liquors & articles Tobacco; liquor; articles for smoking and drinking

Weight

3.5

Clothing

Garments; clothing materials; footwear and hats; clothing manufacturing services

8.6

Household facilities & services

Durable consumer goods; interior decorations; bed articles; daily use household articles; household services, and maintenance and renovation

5.8

Healthcare & personal articles

Medical instrument and articles; traditional Chinese medicine; cosmetics, sanitation articles; and personal ornaments

9.6

Transportation & communication

Transportation facility; fuel and parts; intercity traffic fares; communication facility; communication services

10.4

Recreation, education & culture

Teaching materials and reference books; tuition and child care; cultural articles; newspapers and magazines; touring and outings

14.0

Source: NBS, Barclays Research

However, the technical reasons for CPI underreporting might be a serious issue. According to our earlier analysis (see Chapter 4: The great wave of consumption upgrading), both household income and consumption data are likely to be underreported significantly. We can think of three examples of this. The first is the level of services activity, which is generally underreported in the economy. The second is overseas spending on tourism and luxury goods. And the last is housing. Currently, spending on residence accounts for about 18% of total expenditure (Figure 3). While this proportion has been revised up over the past years, we believe this level is still below actual spending. Whether such exclusion affects the accuracy of the CPI data depends on changes in the prices of these excluded consumption goods/services relative to those of the included products. It is likely that the prices of luxury goods and services are rising faster than the prices of other consumer goods (see Figure 4). There are also reports that suggest the statistical agency might deliberately choose products with relatively stable prices to

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Barclays | China: Beyond the Miracle represent individual categories of the CPI basket. 61 For this and other reasons, some economists believe that Chinese CPI is probably underestimated. 62 Finally, there is a practical reason why the public often believes that actual inflation is higher than the official CPI number, especially when inflation is rising. Ordinary Chinese get their first impression of inflation from prices of grains, vegetables, fruits, poultry, eggs, meats and dairy products, which they purchase on a daily basis. In China, food inflation usually leads to general inflation (Figure 5). But, in fact, prices of many nonfood products may be rising at much slower rates. During the past decade, for instance, the prices of automobiles and electronics have actually declined as competition intensified and productivity improved. Such factors could have exerted a drag on the overall CPI direction. But consumers do not buy refrigerators or passenger cars on a daily basis. Therefore, when certain food prices increase by high double digits, it is very difficult for them to accept that the inflation rate is still at around a mid-single digit level. This is perhaps why some countries calculate the Price of Consumer Expenditure (PCE), which is more relevant to consumers’ daily spending habits.

FIGURE 4 Prices of luxury goods and services rising faster

25 %y/y

Consumer price index

200 190 180 170 160 150 140 130 120 110 100 90 80

FIGURE 5 Food inflation usually leads general inflation

Cost of living extremely well index

20 15 10 5 0 -5 Jan-00

1997

1999

2001

2003

2005

2007

2009

2011

Source: http://www.forbes.com/sites/scottdecarlo/2011/09/ 26/cost-of-living-extremely-well-index-the-price-ofliving-large-is-up/

Jan-02 CPI

Jan-04

Jan-06 CPI: food

Jan-08

Jan-10

Jan-12

CPI: non-food

Source: CEIC, Barclays Research

61 “Why the public often view inflation data as underestimated?”, Xiaoming Liang, Oriental Morning Post (in Chinese), April 3, 2011, http://epaper.dfdaily.com/dfzb/html/2011-04/03/content_466216.htm. 62 See, for instance, “Experts: CPI inflation probably underestimated by 3 percentage points”, Xinhua News (in Chinese), November 17, 2010, http://news.xinhuanet.com/fortune/2010-11/17/c_12784198.htm. The expert cited in this report argued that CPI was probably underestimated by 3 pp.

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Barclays | China: Beyond the Miracle Rapidly rising housing prices may further complicate the picture. The NBS does a poor job in recording property prices. For example, its report of a 1.5% increase in housing prices in 2009 – many analysts suggested that that official number misplaced the decimal point (Figure 6). Subsequently, the NBS explained that its price index was based on prices reported by property developers around the country and did not take into account location and quality differences. In reality, however, while housing prices may have a strong influence on the public’s perception of inflation, they are not a part of the official CPI basket. This is the common practice around the world, as housing purchases are regarded as investments, not consumption. What is included in the CPI basket is residence expenses, including rental or its equivalent. But rentals in China are very low because of high vacancy ratios and under-developed secondary housing markets. In sum, Chinese CPI data are probably subject to a number of technical problems, such as the underestimation of high-end consumer goods and services’ share of the basket and, possibly, the underreporting of their prices. The view that the official data are probably underestimated most likely reflects the consumer experience of sharper changes in the prices of necessity goods – this is a common phenomenon across countries. The political motivation for the government to deliberately underreport the inflation data is probably not as strong as previously or widely believed. Taking all these factors into account, we think it is possible that the official CPI reading at its cycle peak might be underestimated by 1-2 pp.

What determines Chinese inflation? This might sound like a simple question but answers to it can be complicated. There are at least two competing hypotheses among economists. Monetarists believe the quantity of money is the single most important factor determining price levels in an economy. ‘Structurists’ argue that when productivity growth is strong and overcapacity widespread, monetary expansion may not always lead to high inflation immediately. Yet, others worry about spill-over effects from rising asset prices, such as housing and stock markets.

Some frequently heard explanations One argument that often dominates policy discussion in China is that inflation might be caused by volatile price movements in certain sectors (Figure 7), such as the price of rice in 1988 and price of pork in 2007, which probably had little to do with monetary policy or capacity utilisation at the macro level. Therefore, it follows that policies trying March 2013

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Barclays | China: Beyond the Miracle to ease inflation pressures would be aimed at reducing excess demand in these specific sectors. This thinking was clearly reflected in some anti-inflation policies implemented by the Chinese government. For instance, the stimulus package rolled out in late 2008 and consequent rebound in economic growth in early 2009 had ended deflation by the end of that year. During the second half of 2010, inflation, led by rising food prices, became a major economic problem. On 19 November 2010, the Executive Meeting of the State Council issued a circular that introduced 16 administrative measures designed to stem rising commodity prices and ease inflation pressures. 63 These included:

• Local governments and departments were required to boost agricultural production and stabilise the supply of agricultural products and fertiliser while reducing the cost of agricultural products and ensuring coal, power, oil and gas supplies;

• The cabinet urged local departments to step up vegetable-planting efforts while stabilising winter vegetable production and strengthening grain and edible-oil production field management to ward off supply shortages;

• To reduce delivery costs, vehicles transporting fresh- and live-farm produce were exempted from road tolls from December 1, 2010;

FIGURE 6 NBS does a poor job in reporting property prices Jan07=100 280 260 240 220 200

FIGURE 7 Volatile food prices in China 180 06Sep09=100

Centaline secondary: Beijing Centaline secondary: Shanghai Centaline secondary: Guangzhou NBS secondary: Beijing NBS secondary: Shanghai NBS secondary: Guangzhou

160 140 120

180 160

100

140 120

80 Sep-09

100 80 2007

2008

2009

Source: Wind, Barclays Research 63

2010

2011

Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Grain Edible Oil Meat Chicken Egg Vegetable

Source: CEIC, Barclays Research

For a Chinese version of the policy, please see http://baike.baidu.com/view/4760539.htm.

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• The cabinet ordered local authorities to continue to reduce the price of power, gas and rail-transport for chemical-fertiliser producers while ensuring coal supplies for power generation companies and increasing production of oil, especially, diesel, to guarantee sufficient supply;

• Local governments were told to provide temporary subsidies to needy people and

establish coordinated social-security mechanisms that promised a gradual rise in basic pensions, unemployment insurance and minimum wages;

• Local departments were ordered to adjust prices promptly and to impose temporary

price controls on important daily necessities and production materials where necessary. The most surprising feature of this policy circular was the absence of monetary policy changes, which could indicate that policymakers at that time accepted the thesis that rapid price increases were mainly the result of supply shortages. One popular view was that tightening money supply or raising interest rates would not help increase vegetable supply and, therefore, lower vegetable prices. While sounding a reasonable approach, this was proven to be the wrong policy prescription when, by early 2011, CPI became much higher and more broad-based. As a result, during the first half of 2011, the PBoC was forced to repeatedly adjust monetary policy measures, reserve requirement ratios and benchmark interest rates (Figure 8) in order to contain inflationary pressures.

FIGURE 9 Strong growth drove up inflation

FIGURE 8 The PBoC was forced to repeatedly adjust policies 15 12

1y benchmark lending rate (%) CPI (%) RRR (%, RHS)

25

12

20

9

16 14 12

9 15 6

6 10 3 8

10 3

0

-3 Jan-06

6

5

0

Jan-07

Jan-08

Jan-09

Source: CEIC, Barclays Research

March 2013

Jan-10

Jan-11

0 Jan-12

-3 1998

4 2001 CPI (%y/y)

2004

2007

2010

GDP growth (%y/y, RHS)

Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle A long list of potential causes of Chinese inflation regularly appear in policy discussions. Monetary policy: Many economists subscribe to the view that inflation is fundamentally a monetary phenomenon. Whatever the triggering factors, inflation is always the result of relatively loose monetary conditions. This essentially follows Friedman’s quantity theory of money, ie, money supply has a direct and proportionate relationship with the price level. 64 The policy prescription from this argument is straightforward: the central bank needs to tighten monetary policy to rein in inflation. Growth: If growth is too strong, an economy may be running at a faster pace than can be supported by existing capacity (Figure 9). Therefore, demand could surpass supply in many key sectors and at the aggregate level. In other words, high inflation is a symptom of overheating. And the right policy strategy to control inflation would cool down the economy by either reducing fiscal spending and/or tightening monetary policy. Wages: Rapid wage growth could have two effects on inflation (Figure 10). The first is to increase the cost of production and, therefore, push up product prices. The second is to increase household income and promote consumption demand. Both can result in higher inflation. Policy strategy for addressing wage-induced inflation, however, is much less straightforward as it is hard to directly control wages. But it might be possible to take macroeconomic measures to slow the economy, which, in turn, should lower demand for labour and ease pressure on wages. FIGURE 10 Wage growth also affects inflation

FIGURE 11 Food price appears in every inflation drama

35

30

30

25

25

20

20

Agriculture price by MoA: overall (% y/y) CPI food price (% y/y)

15

15

10

10

5

5

0

0 -5 1978 1982 1986 1990

-5 1994 1998 2002 2006 2010

CPI (% y/y)

Source: CEIC, Barclays Research

Average wage (% y/y)

-10 2005

2006

2007

2008

2009

2010

2011

Source: CEIC, Barclays Research

64

Milton Friedman, “The quantity theory of money: a restatement”, in Milton Friedman, The Optimum Quantity of Money (with a new introduction by Michael D. Bordo), Transaction Publishers, Brunswick, New Jersey, 2006.

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Barclays | China: Beyond the Miracle Food prices: Almost every inflation episode during China’s reform period started with food inflation (Figure 11). Food prices are an important component of the CPI basket. In addition, food inflation often has a second-round effect on overall prices through cost pressures, including those on wages. In order to control food inflation, the government often takes sector-specific measures to reduce food supply shortages. Asset prices: High housing or stock prices may also lead to higher inflation (Figure 12). But the mechanisms might be less obvious. It could be because booming asset markets increase the wealth of households, which, in turn, raise their consumption demand. It could also be because booming asset markets drive resources away from the production of consumer goods. And it could even be due to broad-based expectations for higher inflation when asset prices rise quickly. Since the global financial crisis, there has been a recognition that monetary policymakers need to monitor asset prices more closely. But there is no agreement among economists or policymakers on the best strategy to regulate asset prices. International commodity prices: Higher commodity prices, like food, could raise the cost of production and push up prices of products (Figure 13). One important difference, however, is that shocks to food prices are often internal, while shocks to commodity prices, such as oil, copper or iron ore, are often external. Examples of external shocks could include sharp depreciations of the US dollar or deterioration of political situations in the Middle East. In most cases, China does not have much influence over such shocks. And, therefore, the only policy response is to lower domestic cost pressures by letting the currency appreciate. FIGURE 12 Higher asset prices may lead to higher inflation

FIGURE 13 Higher commodity prices raise production costs

250

12

200

9

150

6

4

100

3

1

50

0

0

-3

-50

-6

10 7

-2 -5 Jan-06

Jan-07

CPI (% y/y)

Jan-08

Jan-09

Jan-10

Shanghai composite index (% y/y, RHS)

Source: CEIC, Barclays Research

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Jan-11

-100 Jan-12

% y/y

% y/y

60 40 20 0

-9 Jan-06

-20 -40

Jan-07 PPI

Jan-08

Jan-09

CPI non food

Jan-10

Jan-11

-60 Jan-12

CRB (RHS)

Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle Quantitative easing: Quantitative easing (QE) by the Federal Reserve Bank (Fed) and the European Central Bank (ECB) can also impact China’s inflation rate as this action can raise international commodity prices, increase capital inflows and expand domestic liquidity.

What do economists discover? Determinants of inflation are an ancient subject in economic literature. However, the subject was brought to new life in the early 21st century when the global economy was awash with liquidity but CPI inflation remained generally stable. There is a growing body of literature exploring this subject, especially the dynamic interaction between excess liquidity, asset prices and consumer prices. For the purpose of this study, we provide a review of the literature on international experiences, with literature of the Chinese case incorporated in discussion of the hypotheses below. Findings of the existing literature are mixed. For instance, through estimation of a global vector auto regression (VAR) model for 15 countries, Rüffer and Stracca (2006) confirmed that excess liquidity was a useful indicator of inflationary pressure at a global level. 65 Baumeister et al (2008), applying a structured VAR framework, also discovered a permanent impact of liquidity on price levels. 66 Meanwhile, also using a global VAR model for developed countries, Belke and Orth (2007) found that a significant increase in global money balances had not yet led to permanent rise in consumer prices. 67 Results on correlation between asset prices and consumer prices are even more divided. Some suggest that asset prices have no impact on CPI inflation by pointing to the experiences of Japan in the 1980s and Britain in the 1990s. Based on both correlation and regression analyses, Cheick (2005) concluded that housing and stock prices could be useful indicators of future inflation, with six- to eight-quarter lags. 68 At the same time, many studies using post-1953 American data revealed negative correlations between inflation and stock prices (Fama 1982). 69

65

Rüffer, Rasmus, and Stracca Livio (2006) What is global excess liquidity, and does it matter? ECB working paper, No. 696. 66 Baumeister, Christiane, Durineck, Eveline and Peersman, Gert (2008) Liquidity, inflation and asset prices in a time-varying framework for the euro area, National Bank of Belgium, working paper No. 142. 67 The study by Belke and Orth (2007) applied the VAR framework by employing quarterly data for 18 industrial countries for the period 1984-2006. Belke, Ansgar and Walter, Orth, 2007, Global Excess Liquidity and House Prices – A VAR Analysis for OECD Countries, Ruhr Economic Papers No. 37. Available at SSRN: http://ssrn.com/abstract=1089102. 68 Cheick, Wague (2005) Asset price volatility and consumer price inflation: is there a predictive link? Journal of Academy of Business and Economics, February. 69 Fama Eugene F. (1981) Stock Returns, Real Activity, Inflation and Money, American Economic Review, Vol. 71, No. 4, 545-565.

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Barclays | China: Beyond the Miracle Does excess liquidity always lead to asset booms? Bruggeman (2007) identified 40 periods of sustained excess liquidity between 1970 and 2005 and found that only about one-third of these periods were followed by an asset price boom. 70 More interestingly, both Belke and Orth (2007), and Giese and Tuxen (2008) concluded that global excess liquidity had a significant impact on housing prices, but not on stock prices. 71 While Belke and Orth found no direct effect of liquidity on CPI, they discovered spillovers from housing prices into consumer prices. Yiping Huang, Xun Wang and Xiuping Hua (2010) (Huang-Wang-Hua study) conducted a comprehensive analysis on the question of what determined China’s inflation rates. 72 They updated Chinese data series to July 2009 and looked at the statistical relations using both year/year and month/month growth data. And finally, wherever possible, they included all potential determining variables of inflation in a single analytical framework, in addition to the usual causality tests. Specifically, the Huang-Wang-Hua study considered four sets of possible independent variables for explaining variations in China’s inflation rates: excess liquidity, output gap, asset prices (housing and stock prices) and monetary policy instruments (interest rates and the exchange rate). They proposed four specific hypotheses in this analysis:

• Large excess liquidity lifts the inflation rate;

• Widening output gap adds to inflationary pressures; • Strong asset markets push up inflation; and

• Interest rate hikes and currency appreciation lower inflation. First, the importance of excess liquidity for inflation is underscored by the “quantity theory of money” (Friedman 1987). 73 The crudest form of this theory states that price levels of an economy are determined by the volume of money relative to the volume of output. 74 This theory was behind the repeated warnings from some prominent Chinese

70

Bruggeman, Annick (2007) Can Excess Liquidity Signal An Asset Price Boom? National Bank of Beigium, Working Paper No.117. 71 The study by Giese and Tuxen (2008) used quarterly data for 6 industrial countries for the period 1982-2006 for a VECM model. Giese, Julia and Tuxen, Christin (2008) Has excess global liquidity fueled asset prices? Evidence from I(1) and I(2) cointegrated VAR models, Oxford 72 Yiping Huang, Xun Wang and Xiuping Hua (2010) What Determine China’s Inflation, China Economic Journal, vol. 3, 69-86. 73 Friedman, Milton (1987). “quantity theory of money”, The New Palgrave: A Dictionary of Economics, v. 4, pp. 320 74 The textbook formulae describing the quantity theory of money is: M*V = P*Q, where M is quality of money in circulation, V is velocity of money, P is price level and Q is real final expenditure.

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Barclays | China: Beyond the Miracle economists about the threat of inflation following the extraordinary bank credit growth in 2009 (for instance, Zhou 2009). 75 Indeed, a causal observation of money supply, bank credit and inflation appears to suggest that liquidity conditions have led inflation in China (Figure14). Some economists have confirmed this suspected causation using sophisticated quantitative frameworks. For instances, Zhang and Pang (2008), applying quarterly data between 1997 and 2007, concluded that excess liquidity had systematically imposed pressures on inflation. 76 Likewise, Zhang (2009) showed that excess liquidity, ignited by dramatic capital inflows, was a significant driver of consumer price inflation in China during 1998-2007. 77 But academic findings have not been consistent or uniform. For example, Li and He (2007) pointed out that excess liquidity did not result in a resurgence of consumer price inflation up to April 2007. 78 Makin (2007) explained the relatively low inflation rate between 2000 and 2006 as a result of expanding real money demand generated by fast economic growth, which was able to accommodate high money and credit growth. 79 The American experience before the 2008-09 financial crisis also cast doubt on the view that the correlation between liquidity and inflation is always significant and positive. Second, the hypothesis on the output gap and inflation is developed from observations of the Chinese economy during the past decade (Huang et al. 2009). 80 China suffered deflation three times, in 1998-99, 2002 and 2008-09. All of these periods coincided with a significant weakening in external demand, as a result of the Asian financial crisis, the mild US recession, and the global financial crisis, respectively. A common theme during these periods was CPI declines following significant slowdowns in exports and, possibly, worsening of overcapacity problems (Figure 15).

75

Zhou, Qiren (2009), “Money looks like honey, but essentially it is water”, Caijing, No. 13 (2009), published on June 21, 2009, Beijing. 76 Zhang, Chengsi and Pang, Hong (2008) Excess Liquidity and Inflation Dynamics in China: 1997-2007, Vol. 16, No. 4, 1-15. 77 Zhang, Chengsi (2009) Excess liquidity, inflation and the Yuan appreciation: what can China learn from recent history? The World Economy, Vol. 32, No. 7, 998-1018. 78 Li, Shi and He, Jinyu (2007) Excess Liquidity Control Requires Multi-pronged Approach, China Economist, Vol.1, No.5, 19-29. 79 Makin, Anthony (2007) Does China’s huge external surplus imply an undervalued renminbi, China & World Economy, Vol. 15,No. 3, 89-102. 80 Huang, Yiping, Minggao Shen and Ken Peng (2009) Macroeconomic performance amid global crisis, in Ross Garnaut, Ligang Song and Wing Thye Woo (eds.), China’s New Place in a World in Crisis, ANU E-Press and Brooking Institutions Press.

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Barclays | China: Beyond the Miracle FIGURE 14 M2 growth, credit growth and CPI inflation 35

10

30

8

25

6

20

4

15

2

10

0

5 0 Jan 06

M2 (% y/y) Credit growth (% y/y) CPI (% y/y RHS) Jul 07

Jan 09

Source: CEIC, Barclays Research

-2

Jul 10

-4 Jan 12

FIGURE 15 Export growth and CPI inflation 10

60 50

7

40 30

4

20 10

1

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-2

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-5 Jan-06

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CPI (% y/y)

Jan-09

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Export growth (% y/y, RHS)

Source: CEIC, Barclays Research

Intuitively, it is easy to explain the correlation between an output gap and inflation. When the output gap (actual output minus potential output) narrows, overcapacity problems are exacerbated. Competition pressures rise and producers are forced to cut prices in order survive. Therefore, it is possible that at times overcapacity problems will overcome excess liquidity in determining inflation. Third, asset prices may affect inflation through different channels, either changes in aggregate demand, ie, consumption and investment, or changes in information content about expected inflation (Cheick 2005). But these effects may not always work in the same direction. For instance, an increase in housing prices signals an increase in lifetime wealth for those who own properties, and should lead to an increase in consumption expenditure. But the part of the population that does not own a house should, in theory, cut down on consumption (Vickers 2000). 81 Empirical findings from China are mixed. Han et al (2008) demonstrated that the relationship between stock returns and inflation changed over time: negative between 1992-99 but positive during 2000-07. 82 Zhang and Zhang (2008) found that higher house prices led to inflation in Shanghai but not in Beijing. 83 Yu (2008) revealed that the effects of housing prices on inflation were stronger than those of stock prices. 84 Finally,

81

Vickers, John (2000) Monetary policy and asset prices, The Manchester School (Supplement), pp 1-22. Han, Xuehong, Zheng, Yanyan, and Wu, Siming, (2008) An Explanation of the Relationship between Stock Returns and Inflation in China:1992-2007, Financial Research (jinrong yanjiu), Vol. 4. 83 Zhang, Hong and Zhang, Huizan (2008) Empirical study of the relationship between inflation and housing prices, Journal of Tsinghua University (Sci & Tech), Vol. 48, No. 3. 84 Yu, Yongding (2000) China’s deflation during the Asian financial crisis, and reform of the international financial system, ASEAN Economic Bulletin, 17(2, 2000): 163-174. 82

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Barclays | China: Beyond the Miracle Zeng et al (2008) discovered a positive response of housing prices to inflation and negative correlation between interest rate and housing prices. 85 Other economists point out that asset prices are inherently volatile and highly susceptible to changes in investor sentiment, independent of any change in fundamental factors (Bernanke and Gertler 2000). 86 Hence, there may be little useful information contained in housing or stock prices for forecasting inflation. Therefore, causations between asset prices and inflation remain an empirical question. Finally, interest and exchange rates are the most common policy instruments used to manage inflation problems in market economies. An undervalued renminbi (RMB) has been cited as the key cause behind China’s high inflation rate (Yu 2008). Others question the effectiveness of these policy instruments given China’s quantitative controls over liquidity and the nature of state-owned enterprises, which might not always respond sensitively to changes in interest or exchange rates.

Excess liquidity, overcapacity and expectations The Huang-Wang-Hua study carried out detailed analyses of China’s monthly data for 1998-2009. The co-integration analysis of the year/year data, for instance, gave the following results:

CPI = −0.073 + 0.358Eliqudity + 0.132Ogap + 0.223Phouse + 0.041PStock

Where CPI is the inflation rate, Eliquidity a measure of excess liquidity, Ogap the output gap, Phouse is housing prices, and Pstock stock prices. All estimated coefficients are statistically significant at a 1% significance level. Without going further into detail of the statistical analyses (interested readers may refer to the original paper), we summarise the main findings of the Huang-Wang-Hua paper. 87 Findings from two sets of examinations (based on y/y and m/m data) are

85

Zeng, Hualong, et al (2008) The effects of monetary policy on asset prices, a study based on dynamics of interest rate, house price and stock price, Financial Development Research, Vol. 10. 86 Bernanke, Ben and Mark Gertler (2000) Monetary policy and asset price volatility, NBER Working Paper no 7559, February. 87 The study applied both year/year and month/month data. According to ADF test, the year-on-year growth variables are non-stationary I(1), but the first order differences are stationary I(0). Therefore we apply the Johansen cointegration approach to identify the long-run equilibrium relations between inflation rate and other variables. We then build ECM model and apply the Granger Causality test to examine short-run dynamic causal relations. The month-on-month growth variables are stationary, with the exception of interest rate and exchange rate. Therefore we first estimate the reduced form of VAR, based on which we conduct Granger Causality test to check the short-run dynamic relations. And then we identify parameters of the structural VAR, based on which we generate impulse responses of CPI to one standard deviation of the explanatory variables.

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Barclays | China: Beyond the Miracle generally consistent with each other. According to the estimated long-run equilibrium relation based y/y data, a 1% increase in excess liquidity, housing prices, stock prices and exports would, respectively, lead to increase in CPI of 0.35pp, 0.22pp, 0.04pp and 0.13pp. Statistical tests also confirm that excess liquidity, exports, housing prices and stock prices Granger cause inflation in the short run. We found similar short-run causation relations for the m/m growth data. The direct effects of real interest rates and real effective exchange rates on inflation are complicated. These two policy instruments in general do not Granger cause inflation, although the real interest rate was found to cause inflation at a 10% significance level, in the case of m/m data. Surprisingly, evidence of CPI Granger causing changes in real interest rates was much stronger statistically. But such results should be interpreted with caution. Since the authorities still pay a lot of attention to the quantity variables of monetary policy (ie, bank loans and money supply), the price variables (ie, interest and exchange rates) could become non-binding. Therefore, it is possible that liquidity measures are still more effective for controlling inflation in China. But we should not assume that interest and exchange rates are not effective. These two tools do affect housing prices while interest rate changes alone can affect stock prices. And the direction of property and stock prices can have a big spillover impact on inflation. But the findings also suggest that further reforms of the monetary policy system are necessary. The impulse response analyses find that shocks to excess liquidity, output gap, exports, housing prices and stock prices have positive accumulated effects on CPI. Interestingly, most responses occur within the first five months and gradually disappear after 10 months. While both housing and stock prices have generally positive impacts on inflation, the monthly trajectories are more complicated with negative effects in some months. Overall, according to structural variance decomposition, the output gap and excess liquidity have the largest effects on inflation while housing prices have the smallest effect. How should we interpret these analytical results? Our key takeaway is that excess liquidity, overcapacity and expectations provide an interesting framework for thinking about China’s inflation problem:

• Excess liquidity almost always leads to certain kinds of inflation in some parts of the economy, sooner or later;

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• Overcapacity can significantly increase competition and generate downward pressure on inflation; and

• Expectations of consumers and entrepreneurs may also have a major impact on future price movements. This is a simplistic but useful version of the analytical framework. For instance, we may apply it to gauge the near-term future of Chinese inflation. The excess liquidity measure fell recently (Figure 16) and the overcapacity problem may have intensified (Figure 17). These moves imply that, if current trends continue, inflation pressure should moderate. However, if domestic and external growth remains stable and monetary policies become more accommodative, inflation could easily surprise on the upside. Defining the expectation variable is somewhat more difficult. Inflation expectations can rise if food prices increase, or wages grow, or the Fed adopts another round of QE policy. Since 2010, the PBoC has focused on managing expectations as a method of controlling inflation pressure. This can be done through statements or pre-emptive policy moves. The key implication of the above framework is that dealing with the inflation problem requires macroeconomic policies. Between mid-2009 and end-2010 when inflation pressure increased significantly, the authorities regarded rising CPI as a result sectorspecific changes in demand and supply. Therefore, in order to control inflation, the government introduced targeted measures to increase the supply of agricultural products. It even implemented measures to crack down on speculative activities. As a result, price spikes shifted from housing to apples, and from cotton to garlic. FIGURE 17 …and output gap narrowed

FIGURE 16 Excess liquidity fell recently… 10 8

Excess money growth (% y/y)

4

CPI (% y/y) 3

11

Output gap (%) CPI (% y/y, RHS)

9

6

7

2

4

5

2

1 3

0

0

1

-2 -1

-4 -6 2001

2003

2005

2007

Source: CEIC, Barclays Research

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2011

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-1 -3 2003

2005

2007

2009

2011

Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle The fundamental reason why inflation pressures escalated was the extraordinary monetary expansion from late 2008. As long as significant excess liquidity exists, inflation problems may result. If the government controls only the prices of some products, then the prices of other products may rise. The same occurred in the earlier periods of major inflation: 1985, 1988, 1993, 2004, 2007 and 2011. Almost every time, inflation started with jumps in food prices. But this was probably a result, not a trigger, of the dramatic expansion in monetary policy conditions initiated in the previous years (Figure 14). Therefore, while dealing with supply shortages in specific product areas is always useful, the most effective measures for dealing with inflation are always macroeconomic policies, especially monetary policy.

The making of monetary policy In a typical market economy, monetary policy is probably the most important policy tool for dealing with an inflation problem, since it affects all three factors determining inflation: excess liquidity, overcapacity and expectations. Central banks around the world are often tasked to maintain price or currency stability, usually through changes in interest rates. But the Chinese system of monetary policy is very different:

• China’s central bank, the PBoC, is not an independent monetary policymaker. Its Monetary Policy Committee (MPC) meets quarterly, at which members express their views on monetary policy but they make no decision;

• Important decisions on monetary policy are made by the State Council. This policy structure is often criticized for the absence of monetary policy independence. But the more fundamental problem may be a lack of expertise in monetary policy at the top;

• Unlike in typical market economies, Chinese monetary policy still relies on a combination of policy instruments, including interest rates, liquidity measures and administrative tools. These are consistent with our finding earlier that liquidity controls remain more effective in China than interest rate adjustments;

• The PBoC introduced a new intermediary target for monetary policy at the end of 2010 – total social financing (TSF), of which bank credit accounted for about 58% in 2011.

The central bank that doesn’t make monetary policy The PBoC was set up on 1 December 1948. But it did not act like a real central bank during the pre-reform period. Although the PBoC did issue RMB currency on behalf of March 2013

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Barclays | China: Beyond the Miracle the government, its main function was to distribute funds according to government directives. Even this function was supplementary since collection and distribution of funds were mainly determined and handled as dictated by the central plans at that time. There were early calls to transform the PBoC into a proper central bank at the 3rd Plenum of the 11th Party Congress in late 1978, during which the Chinese leadership decided to embark on economic reforms. The State Council eventually made a decision in September 1983 and split the old PBoC into two institutions at the beginning of 1984: a specialised central bank, the PBoC, and a new commercial bank, ICBC. In the following years, the authorities made important changes to create a modern central bank. However, the PBoC continued to rely on quantitative measures such as reserve requirements and credit quotas to manage liquidity conditions in the economy. In March 1995, the National People’s Congress (NPC) passed the first Law of PBoC (a revised version was approved in 2003), which granted the PBoC legal authority in making and implementing the country’s monetary policy. It also underscored the central bank’s ‘independence’, especially from the Ministry of Finance (MoF) and local governments. Eventually, the PBoC was transformed into a vertically structured institution with nine branches across the country, all independent of the relevant provincial administration. The PBoC also began to reduce its direct intervention in commercial banks’ daily operations. For instance, credit quotas were abolished in 1998. Over the years, the functions of financial supervision of the banking, security and insurance industries were also separated from the PBoC. Despite the legal definition, the PBoC is not a truly independent central bank. It is a part of the State Council, the cabinet, and its governor reports to the Premier. Most importantly, the PBoC is not a decision maker on monetary policies. The PBoC has a Monetary Policy Committee (MPC), which consists of 15 members, who meet on quarterly basis to discuss macroeconomic development and policies. But they do not make decisions (see Figure 18). According to our understanding, monetary policy formulation in China often follows the following path:

• MPC members discuss options for monetary policy adjustments.

• The Governors’ meeting formulates policy recommendations for the State Council, as conveyed by the minutes of the MPC meeting.

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• The Executive Meeting of the State Council makes the final decision on important monetary policies.

• The PBoC announces and implements the decisions. This decision-making mechanism suggests that unlike the central banks in many market economies, the PBoC’s main role is to advise and implement monetary policy, rather than independently choose the appropriate policy path. The State Council’s role is also open to criticism due to the likely lack of expertise of its members. These are valid points, though we think the implications of a lack of independence might be mixed. For instance, at times when the inflation rate was rising, monetary policy response was often slow. This might be because the State Council lacked the necessary expertise or because it had other policy priorities, such as growth. In the past, these problems have led to rapid worsening of inflation in the early stages, which led to accelerated policy actions in the later stages. FIGURE 18 Members of PBoC’s MPC, as of February 2012 Member names

Institutional affiliations

Zhou, Xiaochuan Governor, PBoC; Chairman, MPC You, Quan

Deputy Secretary-General, the State Council

Zhu, Zhixin

Deputy Director, National Development and Reform Commission

Li, Yong

Vice Minister, Ministry of Finance

Hu, Xiaolian

Deputy Governor, PBoC

Yi, Gang

Deputy Governor, PBoC; Administrator, State Administration of Foreign Exchange (SAFE)

Du, Jinfu

Deputy Governor, PBoC

Ma, Jiantang

Director, National Bureau of Statistics (NBS)

Shang, Fulin

Chairman, China Banking Regulatory Commission (CBRC)

Guo, Shuqing

Chairman, China Security Regulatory Commission (CSRC)

Xiang, Junbo

Chairman, China Insurance Regulatory Commission (CIRC)

Jiang, Jianqing

President, China Banking Association

Zhou, Qiren

Dean, National School of Development, Peking University

Xia, Bin

Director, Institute of Financial Research, Development Research Center of the State Council

Li, Daokui

Director, Research Center on China and the World Economy, Tsinghua University

Source: PBoC, Barclays Research

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Barclays | China: Beyond the Miracle But analysts also question whether an independent PBoC would necessarily improve China’s macroeconomic performance. For instance, many state-owned enterprises (SOEs) still do not respond sensitively to changes in interest rates. The State Council, the country’s highest administrative body, might be in a better position to regulate the behaviour of these types of economic agent.

Objectives and instruments of monetary policy Like the central bank, monetary policy is also a relatively new phenomenon. At the beginning of the economic reform period, the PBoC mainly relied on administrative measures such as credit quotas to control liquidity. Gradually, indirect quantitative measures such as the reserve requirement ratio (RRR), open market operation and central bank credit have emerged as more important tools for monetary policy management. And, recently, the PBoC has also started to focus on further price instruments such as deposit and lending rates and the rediscount rate. Currently, however, China’s monetary policy is still very different from those seen in market economies, as it does not target a market interest rate, such as the fed funds rate in the US. The period after the establishment of the specialised central bank may be divided into three sub-periods according to different monetary policy tasks. The first was the period 1984-1996, when fighting inflation was a regular task for the PBoC. The second was the period 1997-2002, when deflation haunted the Chinese economy and, therefore, the PBoC had to try to lift prices to end deflation. And the third period was after 2003, when maintaining currency stability and controlling inflation became top policy priorities (Yi 2009). 88 When the new PBoC was established in 1984, there was no clearly identified monetary policy objective. In 1986, the government issued ‘Regulation on Administration of Banks’, which defined the roles of financial institutions as “developing the economy, stabilizing the currency and promoting socioeconomic performance”. Later, the government refined these roles to “stabilizing the currency and developing the economy”. In 1993, the State Council for the first time identified the monetary policy objectives: maintaining stable monetary environment and promoting economic growth. Most central bank officials, including the Governor, however, often list four important objectives for monetary policy: promoting growth, supporting full employment, maintaining price stability and, finally, achieving balanced international payments.

88

Yi, Gang (2009), On Financial Reform of China, The Commercial Press, Beijing.

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Barclays | China: Beyond the Miracle FIGURE 20 The PBoC adjusts the appreciation pace

FIGURE 19 Credit growth is set and monitored by the PBoC 2.0

CNY trn

% y/y

36 32

1.6

28

1.2

24 0.8

20

0.4

16

0.0 12 Oct-06 Jul-07 Apr-08 Jan-09 Oct-09 Jul-10 Apr-11 Jan-12 Newly increased loans M2 growth (RHS) Credit growth (RHS)

Source: CEIC. Barclays Research

123

Stronger CNY

6.20

120

6.40

117

6.60

114

6.80

111

7.00

108

7.20

105

7.40

102

7.60 7.80

99 96

CNY NEER (21 July 05=100) USD/CNY spot (RHS, inverted)

93 90 2005

2006

2007

2008

2009

2010

8.00 8.20 8.40 2012

Source: Bloomberg Barclays Research

Experiences of Chinese policymaking during the past decades suggest that these policy objectives are not equal. We may group the above four objectives into three groups: (1) promoting growth and supporting full employment; (2) maintaining currency stability (and controlling inflation); and (3) achieving balanced external accounts (and rebalancing the domestic economy). These groups do not carry equal weights. The policymakers often are most concerned about jobs and growth (1). They are often also deeply worried about price instability (2) when inflation risks rise. While the government repeatedly vowed to resolve internal and external imbalance problems (3), it hasn’t taken any serious actions towards this goal. The PBoC applied a wide range of monetary policy instruments to achieve various policy objectives. The main policy tools include:

• Credit quota: a quantitative target the central bank sets for individual commercial banks or other financial institutions (Figure 19);

• Window guidance: an instruction approach aimed at directly influencing financial institutions’ behavior;

• Required reserve ratio: an indirect method regulating liquidity conditions;

• Open market operations: purchase and sale of securities to affect the liquidity conditions and guidance of the market rates of bills and notes;

• Central bank credit and rediscount business: policy tools for the central bank to inject or withdraw liquidity; March 2013

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• Deposit and lending rates: the base rates set by the central bank for the commercial banks’ interest rates; and

• Exchange rate: the central bank can accelerate or slow the pace of renminbi appreciation responding to changing macroeconomic conditions (Figure 20). We discuss the evolution of these policy instruments during the reform period. First, a credit quota was probably the most frequently used liquidity management instrument in the 1980s. At that time, the central bank set not only the total amount but also the composition of lending for individual commercial banks. This method was often quite effective due to its administrative nature. For instance, when inflation rates soared in 1988, the PBoC took very tight control of the credit quota. This acted to reduce inflation quickly. But such approach also has its own problems, such as inaccuracy and overadjustment. Amid financial development and a deepening reform agenda, intermediate objectives such as the credit quota became increasingly inappropriate. For instance, state-owned commercial banks (SOCBs’) share in the country’s newly extended loans dropped from 78% in 1990 to 51% in 1996. A growing portion of the loans extended by non-SOCBs implied that direct controls over total credit became less effective over time. Development of direct financing channels such as stock and bond markets and increasing interventions in foreign exchange markets also generated difficulties for the PBoC to simply focus on credit control. In 1994, the PBoC first abolished credit quotas for cooperative financial institutions, joint-stock commercial banks and other loan-making institutions. After that, only the big four SOCBs (the big four) and three policy banks were still subject to credit quotas. By 1998, the practice of assigning a credit quota had been consigned to history. This, however, does not mean that the PBoC no longer manages loan volumes. The most recent example was in 2007 when inflation rose steadily. The central bank undertook several measures to control inflation, especially during the fourth quarter of the year. One such measure was re-instalment of credit quotas. Second, similar to the credit quota, window guidance, in which regulators provide advice to financial institutions through direct communication, is a very effective policy tool for controlling loan growth. Even though the commercial banks have undergone significant transformation, including introducing foreign strategic investors and public listings, most banks remain majority-owned by the state and their top managers are still appointed by the Party. The main problem of ‘window guidance’ is its ‘stop-go’ consequences. Application of the window guidance practice has declined significantly March 2013

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Barclays | China: Beyond the Miracle FIGURE 21 Growth rate of money supply: M0, M1 and M2

FIGURE 22 RRR has been most frequently used tool recently

40

32

35

28 20

24

30

20

25

16

20

12

15

8

15 10

4

10

5

0

5 0 1999

25

-4 2001 2003 M2 (% y/y)

2005 2007 M1 (% y/y)

Source: CEIC, Barclays Research

2009 2011 M0 (% y/y)

-8 1985

0 1990

1995

2000

CPI (% y/y)

2006

2011

RRR (%, RHS)

Source: CEIC, Barclays Research

over the past decade. But it has been revived from time to time when the authorities faced tough macroeconomic challenges, such as in late 2007, in order to control liquidity and inflation, and in early 2009 in order to support the stimulus policy. Third, the RRR has been one the most frequently applied monetary policy instruments. In 1996, the PBoC shifted its policy to focus on base money as a key policy target. It also started to monitor more closely various measures of money supply, M0, M1 and M2 (Figure 21). Meanwhile, in order to influence the commercial banks’ lending, the PBoC began to adjust the RRR regularly, giving up its past practice of directly setting credit quotas. The deposit reserve system started in 1984. At that time, the RRR was 20% for corporate deposits, 40% for household deposits and 25% for agricultural deposits. In 1985, PBoC unified the different ratios into one, at 10%. In fact, most commercial banks kept extra reserves with the central bank during the entire reform period. In 1998, the PBoC unified the required reserves and excess reserves into one account. Meanwhile, it lowered the RRR from 13% to 8% (Figure 22). Again, in 1999, the PBoC further reduced the RRR by 2 percentage points to 6%. Clearly, the RRR became an important monetary policy instrument. It should be noted that, unlike the practices in market economies, the PBoC pays interest on both required and excess reserves, although these rates are much lower than rates paid by commercial banks to their depositors. Currently, the RRR is still one of the most frequently applied monetary policy tools in China. When the global crisis hit China in late 2008, for instance, the PBoC lowered the March 2013

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Barclays | China: Beyond the Miracle reserve requirement ratios six times in the following year in order to loosen liquidity conditions. Ever since the deposit reserve was brought about, it has been used to regulate the money supply in the country. At times, the reserve requirement was also applied to offset liquidity injected by intervention in the foreign exchange market. Fourth, open market operations were first introduced in the foreign exchange market in 1994. In April 1996, the PBoC began to transact in the bond market. By way of reverse purchases, the PBoC realised increases or decreases of money supply. Although open market operations were limited with a total amount of less than CNY5bn in 1996, the tentative trial promoted widespread application of this instrument in the subsequent years. After a temporary disruption between the end of 1996 and early 1998, open market operations regained their influence as a monetary policy instrument (Figure 23). The reverse purchase and purchase carried out by the PBoC in the bond market helped the central bank to control the base money and the money supply. Additionally, the development of national bond market was encouraged, which built up a sound layer of foundations for the implementation of open market operations (Figure 24). Open market operation is further developed and diversified by increasing both volumes and frequency of the transactions. From 2003, the PBoC issued central bank papers to affect base money. The maturities of these papers include 3 months, 6 months, 1 year and 3 years. In 2007, the PBoC also introduced repurchase agreements based on special T-bonds. This gradual progression has enhanced the authority’s ability to control base money.

FIGURE 24 Interbank market participant by volume

FIGURE 23 Interbank and repo market yearly turnover 140

CNY trn

Bond repo

Interbank

120 100 80 60 40 20 0 1997

1999

2001

2003

2005

Source: CEIC, Barclays Research

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2007

2009

2011

Rural Other Commerical Financial Bank and Institution Cooperative 17% Bank 2% Foreign funded or Joint Funded Insititution City 10% Commerical Bank 15%

State Owned Commerical bank 16%

Share holding Commercial Bank 40%

Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle Fifth, central bank credit was a further critical policy tool introduced during the period 1984-1996. Credit quotas used to be the most important monetary policy instrument by which the PBoC (or the authorities) managed the country’s liquidity conditions. Over the years, however, the banks gained some autonomy in credit allocation, both within and among regions. ‘Central bank credit’ was created to channel funds from the central bank to the economy. Later, when unsterilised foreign exchange market intervention became an important channel of liquidity injection, the importance of ‘central bank credit’ declined dramatically after 1994. Unlike the credit quota, ‘central bank credit’ was used by the PBoC as a temporary, important instrument to inject base money into the economy when growth of foreign reserves decelerated. In 1998, the PBoC offered CNY78bn to SOCBs and another CNY20bn to small- and medium-sized financial institutions. Rediscount business was introduced alongside the development of commercial paper, becoming one of the official policy tools at the end of 1995. In 1998, the authorities experimented with the mechanism of the rediscount rate determined by the market, depegging from the central bank lending rate. Sixth, in 1993, the State Council drew its first plan for interest rate liberalisation. This plan proposed to first liberalise money market rates and bond yields and then the free deposit and lending rates (Figure 25 & 26). CHIBOR was established in 1996 as an important step towards introducing a market-based interest rate. In 1997, the PBoC set up an interbank bond market and liberalised the repurchase rates (repo rate) and cash bond rates. In September 1998, the PBoC gave up controls over the issuance rate for financial institution bonds and treasury bonds in the interbank market. And in 1999, the Treasury bonds were first issued in the interbank market through a public bidding system. Perhaps the most visible interest rates in the Chinese economy today are the deposit and lending rates. In the early years of the reform period, commercial banks had to strictly follow the base rates set by the central bank. The liberalisation of the deposit and lending rates to the following order of priority: “foreign currency rates before local currency rates, lending rates before deposit rates, and long term, large quantity credit rates before short term, small quantity credit rates.” Between 1996 and 2007, about 120 types of interest rates underwent reform in the sense of relaxed controls, being merged with others or complete removal.

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Barclays | China: Beyond the Miracle FIGURE 25 China’s most important interest rates Interest rates

Explanations

Who set the rates?

Bank interest Base lending and deposit rates, set by the central banks. Commercial rates banks are allowed some flexibility conditional on a minimum interest spread defined by floors of lending rates and ceilings of deposit rates

PBoC

Shibor and Chibor

Interest rates at which commercial banks and other approved financial institutions lend and borrow from interbank markets. PBoC intends to develop Shibor into a benchmark money market rates

Market

Treasury bond yields

There are currently two Treasury bond markets, one interbank and the other stock exchange. Bond yields are determined by demand and supply in the markets but currently turnovers are quite limited

Market

Source: Barclays Research

In 2000, the PBoC liberalised the lending rates for foreign currency loans and deposit rates for large deposits. In March 2002, it further unified policies on foreign currency interest rates between domestic and foreign financial institutions to create a level playing field for all banks. RMB rates also went through a gradual process of liberalisation. The PBoC introduced the first step liberalisation of lending rates as early as 1987. Commercial banks were allowed to float the lending rates upwards by a maximum of 20%. This band was adjusted from time to time in the following years. Meanwhile, reforms of the RMB deposit rates proceeded relatively slowly with limited improvement. In 1999, the PBoC FIGURE 26 Money market rates and bond yield are liberalised 7 6

FIGURE 27 The PBoC set up Shibor 9

3m Shibor (%) 1y benchmark deposit rate (%) 5y govt bond yield (%)

7d Interbank repo rate 3m Shibor 3m CB bill issue rate

%

8 7

5

6

4

5

3

4 3

2

2 1 0 2007

1 2008

2009

Source: CEIC, Barclays Research

March 2013

2010

2011

0 Jan-07

Oct-07

Aug-08

Jun-09

Apr-10

Feb-11

Source: CEIC, Barclays Research

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Barclays | China: Beyond the Miracle re-started the efforts to reform the deposit rates, by first liberalising the large long-term agreement deposit rates. The interest rate has experienced only a limited liberalisation. On 4 January 2007, the PBoC set up Shibor (Figure 27), hoping to eventually replace Chibor. In terms of deposit and loan rates, they were reformed in parallel. In November 2003, interest rate floors for small foreign currency deposits were removed. And one year later, interest rates for the small deposits were completely freed. In terms of the RMB rates, in August 2003, the rural credit-cooperatives in pilot districts could raise the lending rates up to twice of the base rates. In 2004, the PBoC permitted the commercial banks and urban credit cooperatives to deviate their lending rates to in a range of 0.9-1.7x the base rate. For rural credit cooperatives, that range was 0.9-2.0x. On 29 October2004, the PBoC abolished the ceilings on lending rates for all commercial banks, except urban and rural credit cooperatives. The upper boundary for urban and rural credits cooperatives was also raised to 2.3x the base rate. Meanwhile, the lower limit for loan rates remained unchanged, being 0.9x of the base rate. On 29 October 2004, the PBoC removed the floors for deposit rates alongside the abolition of the deposit rate ceiling. But it retained ceilings for deposit rates, normally at 1.2x the base deposit rate (Figure 28). At present, overall interest rates remain highly regulated in China, although the authorities have already made considerable progress in the interest rate reform. The remaining regulations on deposit and lending rates generate at least two types of FIGURE 28 Banks are allowed to deviate their lending rates

FIGURE 29 Base deposit and lending rates 14

100 90

12

80 70

1y benchmark lending rate (%) 1y benchmark deposit rate (%)

10

60 8

50 40

6

30 4

20 10 0 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Below benchmark

Benchmark

Source: CEIC, Barclays Research

March 2013

Above benchmark

2 0 Jan-89

Aug-93

Mar-98

Oct-02

May-07

Dec-11

Source: CEIC, Barclays Research

160

Barclays | China: Beyond the Miracle FIGURE 31 TSF is a broad definition than bank credit

FIGURE 30 Real deposit rates in China 15 10

Real 1y lending rate (% pa, CPI deflated)

16

Real 1y deposit rate (% pa, CPI deflated)

14

CNY trn Other forms of financing Corporate bond and equity financing

12 5

Bank off-balance sheet lending

10

0

8

-5

6

Bank loans

4

-10

2 -15 -20 Aug-89

0 -2 Dec-93

Apr-98

Aug-02

Source: CEIC, Barclays Research

Dec-06

Apr-11

2002

2005

2008

2011

Source: CEIC, Barclays Research

consequence. One, ceilings for deposit rates and floors for lending rates essentially ensure minimum interest spreads for commercial banks (Figure 29). This enables the commercial banks to capture high returns, which is helpful for absorbing the bad assets created in previous decades. And two, real interest rates, especially deposit rates, fall into negative territory from time to time (Figure 30). This is what McKinnon described as a symptom of financial repression. Finally, China introduced the managed float exchange rate regime in mid-2005 and resumed it again in mid-2010 after a period of suspension during the global financial crisis. Although so far the authorities haven’t been actively using the exchange rate as a macroeconomic policy tool, there has been a tendency to allow faster currency appreciation when inflation pressures are high. Currency appreciation is a way of implementing monetary policy tightening. In addition, a stronger currency makes imports cheaper, which should in turn help reduce domestic inflation pressure.

Total social financing From 2011, the PBoC introduced variable total social financing (TSF) as a new intermediary target for monetary policy. Previously, broad money supply and bank credit were regarded as the key intermediary targets. Essentially, TSF is the total amount of funding that the real sector raised from the financial system, which includes bank credit, shadow banking businesses and funds raised from capital markets. The introduction of TSF reflected the reality that non-credit funding was becoming increasingly more important in total financial intermediation.

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Barclays | China: Beyond the Miracle The definition of TSF follows four principles:

• Resident principle: TSF does not cover items such as FDI, foreign debt and funds used to purchase foreign exchanges;

• Financial principle: Treasury bonds are excluded since the issuer is the government;

• Merger principle: TSF does not include debt financing and equity investment among financial institutions; and

• Incremental principle: TSF is defined as the quantitative difference between the beginning and the end of the period concerned. In general, TSF is a broader definition than bank credit (Figure 31), which accounted for 58% of TSF in 2011. Effectiveness of macroeconomic policies could be reduced significantly if the central bank continues to focus narrowly on bank credit. But this change could also affect interpretation of some of PBoC’s policy actions. For instance, two years ago, the reduction in RRR would release more liquidity to the banks and increase bank loans. This would be regarded as an outright monetary expansion. Today, lowering RRR would still lead to greater bank loans. Whether or not this is an expansionary policy action depends on changes in TSF. If an RRR cut does not increase TSF, then it is not a typical expansionary policy action.

Rising inflation risks for China and the world There are some uncertainties about China’s inflation outlook in the near term. Following the framework suggested in this report, our base case forecast of a moderating inflation rate in 2012 is based on the following considerations:

• The central bank remains cautious on monetary policy easing, which means excess liquidity would not increase significantly;

• Economic growth should continue to slow, led by a weakening of exports and investment, which should intensify the overcapacity problem; and

• There is no sudden surprise to inflation expectations, such as skyrocketing prices of oil or food. This base case, however, can change quickly if some of the above factors reverse. For instance, if the economy doesn’t slow, then the overcapacity problem would not deteriorate. And wage increases and other changes may fuel inflation expectations again. So the inflation risks have not gone away completely. March 2013

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Barclays | China: Beyond the Miracle From a longer-term perspective, however, China may be entering a period with relatively high structural inflation. During the past decade, China enjoyed remarkably stable macroeconomic conditions with relatively low inflation but strong GDP growth. Even during the years when inflation was a major risk, CPI peaked at relatively low levels, compared with 18% reached in 1988 and 23% in 1993. Low and stable inflation during the past years was helped by a number of factors: rapid productivity growth supported by rural-urban migration; low wage rates underscored by unlimited labour supply in the countryside; and cheap production costs as a result of factor market distortions. These and other factors not only helped China keep inflation low at home but also made China a source of global disinflation. But all these have already changed or are about to change. First, after more than 30 years of rapid economic growth, the Chinese economy is gradually stretching the resource constraints. For instance, for several years the Chinese demand has pushed up international iron ore prices by 70-100% a year. Similar changes could be seen in other areas such as oil, copper and even gold. In fact, some analysts question if the world has enough resources to support continued expansion of the Chinese economy. At a minimum, however, the increasing constraints of resource supply are likely to turn into inflation pressures in China. Second, demographic changes point to higher labour costs ahead. Despite the question of whether or not China has started to see labour shortage problems, rapid wage growth is apparently evident across the country. This could be strong evidence that rural China is running out of surplus labour. In addition, after enjoying decades of the so-called demographic dividend (rising proportion of labour force in total population), the dependency ratio already started to rise from 2011 and total labour force would begin to decline from 2016. Third, the removal of factor market distortions also means rising higher cost pressure going forward. In Chapter 1: China's next transition, we argued that repressed cost of production, through policy distortions in capital, land, energy and other resource markets, was a key form of subsidy to enterprises. Now the government has started to remove these distortions in an effort to improve resource efficiency and rebalance economic structure. This was evidenced by the recent adjustment of petrol prices, despite a slowing economy and still high inflation. According to our estimations, these distortions were equivalent to 8% of GDP in 2008. Removal of these distortions could lead to a significant rise in production costs. For instance, electricity prices for industrial users in China are already higher than those in the US.

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Barclays | China: Beyond the Miracle Finally, monetary policy conditions have been relatively loose, both at home and abroad. China started its massive monetary policy easing from the end of 2008. The amount of new credit doubled to CNY10trn in 2009 from CNY5trn in 2008. After a brief period of tightening in early 2011, monetary policy easing started again from the second half of 2011. Similarly, other central banks implemented very loose monetary policies during the global financial crisis and have maintained these conditions in the following years. Such easy money is bound to eventually translate into inflationary pressures. The above changes imply that China’s inflationary pressure is likely to rise in the coming years. How much higher it might go depends on how slow a rate of GDP growth the authorities can tolerate. If the government wants to maintain GDP growth above 8%, inflation rates could go well beyond 6% on average. Lower inflation comes with tighter monetary policy conditions and slower GDP growth. If the authorities continue to rely on administrative and microeconomic measures in dealing with macroeconomic problems, China may experience a period of not only higher but also more volatile inflation. In any case, China will likely become a key source of global inflation in the coming years. Indeed, this process has already started. This should generate significant implications for industrial structure as well as macroeconomic conditions in other countries.

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CHAPTER 6

The consequences of demographic change

• The one-child policy accelerated a series of demographic challenges for China, including a gender imbalance, population ageing and an early end of the surplus labour era. While these issues will have consequences for economic growth, we think the potential negative effects have been overstated.

• The elevated boy/girl ratio could lead to increased crime levels. But greater competition in the marriage market may also support economic growth through greater incentives for saving, entrepreneurship and asset purchases.

• The Chinese population is ageing rapidly. This could weigh on growth by reducing the size of the labour force and require increased spending on healthcare and pension provision.

• However, we think China should be able to cope with an ageing population owing to: 1) a second “demographic dividend”; and 2), potential sales of its massive portfolio of state-owned assets.

• Economists and officials disagree on whether China has passed – or is even close to reaching – the end of its surplus labour era. However, one possible indicator of this point, rapid wage growth, is already evident and probably a long-term phenomenon.

• We identify several common economic shifts stemming from these demographic

changes, including slower growth, higher inflation, loss of the low-cost advantage, increasing importance of skills and technology, reduced savings, increased consumption and a smaller current account surplus.

• The expected demographic changes should benefit such sectors as elderly care,

healthcare and medical services, as well as financial services, including pensions, medical insurance and asset management.

• A reduced labour force and rising wages should also force the economy to focus much more on technology-related industries that rely on mechanisation, automation, and research and development. This article was originally published on 25 April 2012.

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The one-child policy In 1978, the year China’s leadership began comprehensive economic reform, the government also adopted the “one-child policy”. The policy officially restricts 89 married, urban couples to only one child, but allows exemptions in some cases, including rural couples, ethnic minorities and parents without any siblings themselves. According to Wikipedia, the policy prevented about 400mn births between 1979 and 2011, equivalent to 30% of the population at the end of 2010. The purpose of this policy was to alleviate social, economic and environmental problems caused by a very large population. A direct result of the one-child policy has been a steady decline in the fertility rate, which fell to 1.8 in the 2000s from 5 in the 1970s. The average number of children in Chinese families has fallen to 1.7 from 5.9 over the past four decades. According to official estimates, about 39.5% of the population is currently subject to this policy restriction. The one-child policy, alongside longer life expectancy, has had a significant impact on the population’s age structure, leading to a decline in young people’s share of the total population and a rise in older people’s share. Of course, the decline in China’s fertility rate should not be attributed solely to the onechild policy. It is normal phenomenon – when incomes grow, fertility rates fall. In other Asian economies, including Korea, Singapore and Taiwan, fertility rates have been falling for decades and are now at very low levels. Even in China, increasing numbers of urban couples voluntarily choose not to have children. In fact, the decline in the fertility rate started before the introduction of the one-child policy (Figure 1). But the combination of policy restrictions and other factors could have drastic consequences. For instance, one analyst has projected that with a 1.3 total fertility rate and a life expectancy 80 years, China’s population could shrink to 13mn by 2300, or 1% of the current size. 90 The one-child policy, and associated decline in the fertility rate, has caused some demographic changes with significant economic implications, including: •

Worsening of the gender imbalance;

•

Changes in the dependency ratio; and

•

The emergence of labour shortages.

89

In urban areas, employees of government departments and state-owned companies could lose their jobs; other couples could have a second child but would pay a fine. 90 http://icaixin.blog.caixin.com/archives/39568?utm_source=mail.caixin.com&utm_medium=referral&utm_cont ent=caixin_news_mail&utm_campaign=caixin

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1. Preference for sons over daughters If left to nature, the sex ratio at birth is normally about 105 boys per 100 girls. The Chinese experience before introduction of the one-child policy was broadly in line with this phenomenon – the sex ratio was 107 boys per 100 girls in 1980. By 2005, however, this ratio had risen to 120 boys per 100 girls (Figure 2). In some provinces, the sex ratio at the birth of the second-child has reached 140-160 boys per 100 girls. This could cause serious social problems as it becomes increasingly difficult for all men to find wives. In 2005, for instance, there were about 40mn men who mathematically could not get married due to a shortage of women. 91 The reasons behind Chinese parents’ preference for sons over daughters are both cultural and economic. Traditionally, only sons carry on the family name, daughters do not. Without sons, family trees simply end (in the movie “Mu Lan”, which is based on a well-known Chinese folktale, an old man has to accept the Emperor’s order to fight against invaders because he does not have a son). More importantly, however, in Chinese society, sons support parents when they become old and daughters normally do not. Therefore, sons are seen as valuable in a country where social security systems are significantly underdeveloped since they effectively serve as a pension plan for parents. This is even more the case in the Chinese countryside than in the cities.

FIGURE 1 Fertility ratio has been declining 8 7

FIGURE 2 Sex ratio at birth has reached 120 boys per girl

Fertility rate: China

Children per woman

125

Fertility rate: Korea

Sex ratio: all (males per 100 females) Sex ratio: aged 0-4 (males per 100 females)

Fertility rate: Singapore

6

120

5 4

115

3 2

110

1 0 1950

1960

1970

1980

1990

2000

Source: Haver Analytics, Barclays Research

2010

105 1950

1960

1970

1980

1990

2000

2010

Source: Haver Analytics, Barclays Research

91 Shang-jin Wei and Xiaobo Zhang, 2009, “The Competitive Saving Motive: Evidence from rising sex ratios and saving rates in China”, NBER Working Paper 15093, June 2009, Cambridge Boston.

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2. The fall and rise of the dependency ratio The one-child policy and associated lower fertility rate naturally led to a lower dependency ratio, which is defined as the proportion of the non-working population to the working-age population. Between 1980 and 2010, the dependency ratio dropped to 38% from 69%. Because of the one-child policy, the youth dependency ratio fell even more dramatically, declining to 27% from 60% during the same period (Figure 3). The lower dependency ratio, (ie, a higher working-age proportion) means a population becomes more productive and is often described by economists as the “demographic dividend”, or the “first population dividend”. Cai Fang, China’s most prominent labour economist, argued that China’s population dividend was an important factor behind its strong economic performance during the reform period. 92 However, this situation began to change after more than 30 years of the one-child policy – population ageing accelerated. While an ageing population is a common phenomenon in many developed and developing economies, the one-child policy has significantly accelerated the ageing problem in China. This triggered the common view that “China might get old before it gets rich”. However, we should not overstate this challenge. An economy normally also gets richer, faster when it gets older. China’s ageing profile in 2030 will probably reach similar levels to that of Japan in the 1990s (Figure 4). But, by then, China should also have become a relatively rich country. FIGURE 3 Dependency ratio vs child dependency ratio

FIGURE 4 China’s ageing problem

100

Total dependency ratio (%)

100

90

Child dependency ratio (%)

90

Total Dependence ratio (%)

80 80

70

70

60 50

60

40 50

30 20

40

10

30 1950

0 1950

1970

1990

2010

2030

Source: Haver Analytics, Barclays Research

2050

2000 China

2050 Japan

2100 Korea

Source: Haver Analytics, Barclays Research

92 Fang Cai, “Population change, demographic transition and the Lewis turning point”, special issue Debating the Lewis turning point in China, China Economic Journal, No 2, Volume 3, 2010.

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3. From labour surplus to labour shortage Another unique factor that has contributed to China’s rapid economic growth during the reform period was the virtually unlimited amount of surplus labour in the countryside. Over the years, transferring farmers to nonagricultural jobs and the migration to cities from rural areas created significant value added in the urban economy, without exacting a cost on the rural economy. At least 250mn farmers found nonfarm jobs during the past 30 years. Because of the massive supply of labour available in the countryside, wages were kept at very low levels. This formed an important foundation for the competitiveness of China’s labour-intensive industries and their exports. However, rapid economic development means that the agricultural labour surplus will eventually be exhausted. Labour economists call the time when the labour market shifts from surplus to shortage the “Lewis turning point”, in honour of the major academic contributions by Arthur Lewis, the Nobel Prize-winning economist. Almost every rapidly growing emerging market economy has reached this turning point – Japan in the early 1960s, and Korea and Taiwan in the early 1980s. Whether or not China has reached the Lewis turning point, however, is a controversial subject. Different findings on this subject will likely lead to very different conclusions on what policies are needed and the economic outlook. In this report, we examine implications of the one-child policy and associated demographic changes for the economy, by focusing on the gender imbalance, dependency ratio and the Lewis turning point. While economists often find some common ground, their views can differ significantly, especially on the above three issues. We will try to review large amount of the literature, before forming our own positions. The central question is how demographic changes in the sex ratio, the dependency ratio and the Lewis turning point are affecting the outlook for the Chinese economy. The conventional view is that: 1. The high male/female sex ratio could cause serious social discontent; 2. The rising dependency ratio might reduce overall labour productivity and, at the same time, increase expenditure on healthcare and pension; and 3. Passing the Lewis turning point should lead to a rapid rise of labour costs and slower economic growth. In other words, these trends appear to be generally negative for the economy. However, we think the picture looks different when each issue is examined closely. March 2013

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Gender imbalance might stimulate growth? Gender imbalance is a new phenomenon. Before the 1990s, the sex ratio at birth in China was not significantly different from the ratio in many other emerging market economies (Figure 5). Even though the preference for having sons probably became stronger after implementation of the one-child policy, the gender imbalance still followed a normal pattern. This started to change in the late 1990s, when the sex ratio rose significantly. Analysts often attribute this to the widespread introduction of ultrasound scanners in hospitals across the country around 1996.

1. Rising sex ratio In an article published in the British Medical Journal, Wei Xing Zhu and Li Lu reported that: “Overall sex ratios were high across all age groups and residency types, but they were highest in the 1-4 years age group, peaking at 126… in rural areas. Six provinces had sex ratios of over 130 in the 1-4 age group. The sex ratio at birth was close to normal for first order births but rose steeply for second order births, especially in rural areas, where it reached 146 (143 to 149). Nine provinces had ratios of over 160 for second order births.” 93 The authors attributed this rising gender imbalance almost exclusively to selective abortions facilitated by application of ultrasound scanners. FIGURE 5 China’s sex ratio vs other countries

FIGURE 6 China’s sex and crime ratios 110

7

110

109

6.5

105

108

6

100

107

95

106

90

105

85

104

80 1950

103

115

Population sex ratio (males per hundred females)

5.5 5

1960

China Germany

1970

1980 Korea France

1990

2000

2010

Japan United States

Source: Haver Analytics, Barclays Research

4.5 4 3.5 3 1988 1990 1992 1994 1996 1998 2000 2002 2004 Sex ratio: aged 16-25 (males per 100 females) Criminal arrest rate (RHS, per 10,000 persons)

Source: Adapted from Lena Edlund and et al (2007)

93

Wei Xing Zhu and Li Lu, 2009, “China’s excess males, sex selective abortion, and one child policy: analysis of data from 2005 national intercensus survey”, British Medical Journal, 38:b1211.

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Barclays | China: Beyond the Miracle A very high boy/girl sex ratio could have a range of social and economic implications. But the key challenge is this: an increasing number of men will not be able to find wives, which could be destabilising socially. In fact, a rising sex ratio is often seen as linked to an increasing crime rate. Some analysis suggests that males are typically more openly aggressive than females, a view which violent crime statistics would seem to support, 94 and this problem may be magnified if men significantly outnumber women in a society. In an interesting paper, Columbia University professor Lena Edlund and her co-authors carefully examined the relationship between the sex ratio and the crime rate in China over past decades. They found that while the one-child policy was a national policy, its implementation was a local one. They also found that the policy’s implementation was not related to individual provinces’ economic characteristics, but was often influenced by the provincial party secretary’s personal characteristics. Most importantly, using annual province-level data for 1988-2004, Edlund and her co-authors showed that a 1point increase in the sex ratio was associated with a 3% rise in violent and property crime rates, suggesting that the rise in “excess” males may account for up to oneseventh of the overall rise in crime. 95 Some analysts have even warned that China’s rising sex ratio might be a security concern for other countries. The number of involuntarily single men in China, currently estimated at 35mn, already exceeds the entire male population of many other Asian countries – and it is still rising. Andrea Den Boer and Valerie M. Hudson, suggested countries with high sex ratios might choose to send their surplus young males to give their lives “in some glorious national cause far from home”. 96 However, they did not provide analytical support or hard evidence for such a provocative statement.

2. Likely effects on savings, entrepreneurship and housing prices Perhaps rising crime is only one consequence of the gender imbalance problem. The increasing sex ratio may also be relevant for many other economic phenomena we observe in China today. Again, Columbia University’s professor Shang-jin Wei and his collaborators (most notably, Dr. Xiaobo Zhang of the International Food Policy Institute) analysed the implications of the sex ratio for savings, entrepreneurship and housing prices. Robert M. Solow, the Nobel prize winner for his pioneering work on the theory of economic growth, once said, “Everything reminds Milton [Friedman] of the money

94

David M. Buss, ed. 2005, The Handbook of Evolutionary Psychology, John Wiley & Sons, Inc., 2005. Lena Edlund, Hongbin Li, Junjian Yi and Junsen Zhang, “Sex ratio and crime: Evidence from China’s one-child policy”, 96 Andrea Den Boer and Valerie M. Hudson, 2004, “The security threat of Asia’s sex ratios”, SAIA Review, 24(2): 27-43.

95

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Barclays | China: Beyond the Miracle supply. Well, everything reminds me of sex, but I keep it out of the paper”. Wei and his collaborators suggested that Solow might have missed something economically significant by not linking the sex ratio with economic growth. 97 Wei’s economic theory of the sex ratio is based on one important concept: competition in the marriage market. His conclusion is that it becomes increasingly difficult for men to find wives as the gender imbalance deteriorates. Therefore, families are forced to improve boys’ competitiveness, which may be strengthened by a boy’s own abilities or the family’s wealth. For instance, if a boy excels in the university entrance examination and is admitted to a top university, his chances of success in the marriage market increase significantly. In one of his earlier papers, Wei also demonstrated that, other things being equal, male athletes from provinces with high sex ratios won more Olympic medals Let’s take a close look at Wei and Zhang’s analysis of saving rates and sex ratios (published recently in the Journal of Political Economy 98). China’s national savings rate increased from less than 40% of GDP in the late 1990s to more than 50% in recent years, and the householdsavings rate rose from 25% to close to 40% over the same period (Figure 7). In most developing economies, national savings rates average at around 30-35%. FIGURE 7 National and household saving rates (% GDP) 60

Government saving Household saving

50

Corporate saving

FIGURE 8 National saving rates (% GDP) 60 50 40

40

30 30

20 20

10

10

0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: CEIC, Barclays Research

China Brazil

Thailand Mexico

Korea Peru

Source: Haver Analytics, Barclays Research

97

Shang-jin Wei and Xiaobo Zhang, 2011, “Sex ratios, entrepreneurship, and economic growth in the People’s Republic of China”, MNER Working Paper Series, Working Paper 16800, Cambridge MA. 98 Shang-jin Wei and Xiaobo Zhang, 2011, “The Competitive Saving Motive: Evidence from Rising Sex Ratios and Savings Rates in China”, Journal of Political Economy, Vol. 119, No. 3 (June 2011), pp. 511-564.

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Barclays | China: Beyond the Miracle Why is China’s saving rate so high? The literature offers three explanations. The first is the life cycle theory – people save when they are young in order to fund consumption after they retire. By implication, following the decline in China’s dependency ratio over the past decade or two, the savings ratio should rise. And this trend may reverse when the dependency ratio starts to rise in the coming decade. The second explanation is the so-called precautionary savings. Traditionally, China’s welfare benefits, such as medical insurance and pensions of government workers and employees of state-owned enterprises (SOEs) were all guaranteed by the government budget or the SOEs. By the mid-1990s, however, it became clear that such a welfare system was no longer sustainable. The government began to build a new marketoriented system, including pension, medical insurance and unemployment benefits. What is still difficult to reconcile, however, is that while the social welfare system improved during the past decade, the savings rate also increased, by about 15pp. The third possible explanation is cultural tradition. This is clearly evident in the relatively high savings rates in many East Asian economies, especially in comparison with similar emerging market economies in Latin America or south Asia (Figure 8). But this cultural factor does not explain why the savings rate increased in China over the past decade. Wei and Zhang found that correlation between China’s savings rate and sex ratio over the past 30 years is about 0.82 (Figure 9). This poses an interesting question – could the two be correlated for a reason? The economic literature, however, offers no clear direction regarding the impact of a competitive marriage market. For instance, if a boy and his family want to buy a big house to impress a girl, then the savings rate should rise. However, if a boy and his family give lots of gifts to a girl and her family, then the savings rate should decline. In other words, savings rates may go either way. The Wei and Zhang study also looked at the preliminary evidence of household savings rates relative to timing of weddings in families (Figure 10). For the families of both the groom and the bride, the savings rate is highest the year before the wedding and then gradually declines. It is also interesting to note that the groom’s family’s savings rate generally is much higher than the bride’s family’s savings rate. This provides some tentative evidence of the pressure young men face in the marriage market – on average, they save half their income in the year before their wedding. However, the bride’s family also has to save for this event. Wei and Zhang provided two pieces of evidence to support their argument that the rising sex ratio contributed to the increasing savings rate in China. First, they use a provincial panel’s data from 1978 to 2006. They used savings rates as the dependent March 2013

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Barclays | China: Beyond the Miracle FIGURE 9 High correlation between sex and savings ratio Sex ratio at birth (20 years lag, normalized)

60

Groom

National saving ratio (normalized)

50

Bride

Saving rate (%)

SD from mean 3

FIGURE 10 Saving ratios before marriage

2 1 0

40 30 20 10 0 -10

-1

-20 -2 1975

-4 1980

1985

1990

1995

2000

2005

Note: Adapted from Wei and Zhang (2012)

2010

-2 0 2 Timing of a wedding (years)

4

6

Note: Adapted from Wei and Zhang (2012)

variable and then included a range of explanatory variables, including the local sex rate at birth (with 20 years’ lag), local per capita income, share of working age population (aged 25-60), changes in the national social security and healthcare system, and others. In short, they found that rising sex ratios explained about 68% of increase in the rural savings rates and 18% of increase in urban savings rates. The second piece of evidence is data on household-level savings decisions, using household surveys in 122 rural counties and 70 cities. Their hypothesis was that a higher regional sex ratio increased the competition among men for potential mates, which may motivate parents with sons to save more than they otherwise would, other things being equal. Although in theory, households with sons should save more, it is difficult to confirm in practice. One argument is that daughters live with their husband’s family after marriage; therefore, parents of brides also may be forced to save for their future financial security. In a separate study, Wei and Zhang suggested that a high sex ratio could encourage private entrepreneurship, for the same reasons it promoted high savings. 99 Using data from two censuses of industrial firms (in 1995 and 2004), they found that the sex ratio is a significant predictor of which regions are more likely to have new private domestic firms (after controlling for other determinants of the birth of new firms). Importantly, they found that an increase in the sex ratio by one standard deviation could explain about 50% of the difference in the rates of growth of new private firms across regions. 99

Shang-jin Wei and Xiaobo Zhang, 2011, “Sex ratios, entrepreneurship, and economic growth in the People’s Republic of China”, MNER Working Paper Series, Working Paper 16800, Cambridge MA.

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Barclays | China: Beyond the Miracle Across households, Wei and Zhang discovered that the combination of having a son and living in a region with a skewed sex ratio raises the likelihood that parents will be business owners or self-employed. They even found that families with a son responded to a higher sex ratio by increasing both the number of days they worked off the farm and their willingness to take a relatively dangerous job (there were no similar responses by families with a daughter). Finally, Wei, Zhang and a co-author also examined the relationship between sex ratios and housing prices. 100 Although housing purchases are considered both consumption and investment, the sex ratio could have a significant impact on prices if housing is regarded as a status symbol. Other things being equal, a large home means a man is more likely to succeed in the marriage market. Therefore, the higher the sex ratio in a region, the greater the pressure for men who live there to purchase a home. In other words, regions with higher sex ratios are more likely to see higher housing prices (relative to income or rent), or even a property bubble (Figure 11 and Figure 12).

3. Key takeaways So what are the important takeaways from this branch of economic research? First, the gender imbalance problem may correct over time, especially as urbanisation accelerates. For instance, Korea had the same gender imbalance problem at the beginning of the 1990s. That problem made it too expensive to have sons relative to having daughters. In the end, the sex ratio gradually became more balanced, with the FIGURE 11 Sex ratio and housing value/income ratio

FIGURE 12 Sex ratio and housing value/rent ratio

Note: Adapted from Wei, Zhang and Liu (2012)

Note: Adapted from Wei, Zhang and Liu (2012)

100

Shang-jin Wei, Xiaobo Zhang and Yin Liu, 2012, “Status competition and housing prices: Evidences from China”, Paper presented at the HKMA Conference on the Chinese Economy, January 13-14, 2012, Hong Kong.

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Barclays | China: Beyond the Miracle wealthy choosing to have sons and low-income families choosing to have daughters. We think the same correction may also occur in China, but probably through a different mechanism: as more rural households move to cities, the gender imbalance may be reduced over time. Second, while high sex ratios are likely socially destabilising and may cause high crime rates (a problem the government must deal with), they may also boost economic activity. Analysis by Wei and associates suggests the gender imbalance probably leads to greater competitive pressure on men in the marriage market. This may induce men to work harder or accumulate more wealth. Increased savings, entrepreneurship and housing purchases should be positive for economic growth, although they may also contribute to problems, including large current account surpluses and property bubbles. Third, rapid urbanisation may weaken the preference for sons over daughters and reduce the impact of the sex ratio on savings. Both mean that urbanisation could lead to rapid decline in China’s savings rate. The Chinese government just launched a new round measures to encourage urbanisation by reforming the household registration system in cities at the prefecture level and below. This could turn millions of migrant workers into urban residents within a relatively short period, and result in them probably adopting urban life styles.

Will China grow old before it gets rich? Ageing is a global phenomenon (Figure 13). 101 Figure 14 shows that the EU and Japan are well along the ageing curve. The average age of the population will reach 45 in Europe and 51 in Japan by 2030. Alarmists have long warned about these daunting demographics. In his book Gray Dawn (1999), Pete Peterson describes global ageing as an iceberg – while it is easy to see above the waterline, it is far more difficult to prepare for the wrenching economic and social costs that promise to bankrupt even the greatest of powers. A notable feature of China’s population ageing is the speed at which it is taking place and the size. China became an ageing society in 2000, when the old age (65 and above) dependency ratio reached 7%. Owing to the sharp decline in the fertility rate and the steady increase in life expectancy, China’s population ageing will take place at an unprecedented pace in the coming decades (Figure 14-16). The share of population aged 65 and above will rise from 8% in 2010, to close to 16% by 2030 and more than 25% by 2050 (Figure 16). Moreover, China also has the largest number of older people 101

For consistency, all population data used in this report are from UN (2012).

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Barclays | China: Beyond the Miracle FIGURE 14 Ageing: Japan, EU, and China

FIGURE 13 Ageing is a global trend 0-14

15-59

60-80

80+

100%

100%

80%

80%

60%

60%

40%

40%

20%

20%

0%

0-14

15-59

60-79

80+

0% 1950 2005 2050 1950 2005 2050 1950 2005 2050

World

Developed

Developing

Source: Haver Analytics, Barclays Research

2000 2025 2050 2000 2025 2050 2000 2025 2050

Euro area

Japan

China

Source: Haver Analytics, Barclays Research

globally. 102 The number of people aged 65 and above is projected to rise from 113mn in 2011 to 229mn by 2030. The common perception of China “growing old before getting rich” paints a bleak picture: with per capita GDP of just USD5,000 and a significantly underdeveloped social welfare system, China could be in a much more disadvantageous position than most other aged or ageing economies. Two of the largest macroeconomic concerns related to China’s rapid ageing are: 1) a potential sharp slowdown in economic growth; and 2) rising pension and social expenses that bankrupt its public finance and the economy? We argue the situation is not as bad as it appears. In the following, we analyse the implications for China, drawing support from economic studies on demographic changes, population ageing and economic growth. Our conclusion is that although the ageing population structure poses significant social economic challenges as well as strains on public finances, there are at least two types of offsetting forces to mitigate the negative impacts. First, ageing may also accelerate the process of “getting rich” as it could induce faster productivity and economic growth: the workforce may become more experienced and assets created by higher savings could be invested and transferred to the next generation. We show that China can still enjoy a rising share of ‘prime age population (35-54 years old)’ for another decade (Figure 15). And in contrast to common belief, “growing old while still poor” could be a blessing for China. Second, we highlight it is

102

Due to the falling birth rate, the UN projections show that China’s total population size will start shrink from 2027, with India replacing China to become the most populous nation in the world in 2021.

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Barclays | China: Beyond the Miracle FIGURE 15 China’s rapid changing age structure

FIGURE 16 China’s elderly population share (% of total) 40

100%

35

80%

China Korea Indonesia Singapore

Japan Philippines Malaysia United States

30 60%

25 20

40%

15 20% 0% 1950 0-14

10 5 1970 15-34

1990 2010 2030 35-54 55-64

Source: UN, Barclays Research

2050 65+

0 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Source: UN, Barclays Research

useful to look beyond the static demographic effect, and incorporate behavioural and policy changes that are likely to happen in response to ageing - the so-called “second dividend”. The negative impact from a declining working-age population may be partially offset by more productive human and physical capital as a result.

1. Age structure change and the economy – growth accounting All else equal, ageing is commonly perceived as negative for economic growth. The typical argument holds that ageing leads to a reduced labour force and savings, hence, output. Our discussions below show that: 1) the working age population (aged 15-64) is the most robust demographic variable; 2) the higher share of prime age workers (aged 35-54) in total labour force will tend to boost growth; 3) the stage and process of demographic transition, including the various drivers of ageing – falling fertility and rising longevity – will have different impacts on economic agents and the macro economy; 4) the full impact is much more complicated, with both accounting and behavioural effects at play. There are typically two approaches employed in the literature to estimate and project the impact of demographic changes on economic growth. The first is econometric analysis with pooled cross section data. Such analyses suffer endogeneity and omitted variables problems because income in turn determines the demographic variables and the age structure. 103 The second relies on calibration and simulations of theoretical

103

Hence, the regression results need to be interpreted with caution as historical correlations may not reflect causality.

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Barclays | China: Beyond the Miracle (endogenous) growth models with varying assumptions on the households’ production and utility functions.

, where Production function in a standard growth model is defined as Y = AK L Y denotes output, A for total factor productivity (TFP), K and L we assume capital and α

(1−α )

labour respectively, and α is the output share of capital. 104 After incorporating human capital (h), it could be transformed into the identity:

d ln(Y / N ) = d ln( A) + α * d ln( K / L) + (1 − α ) * d ln(h) + d ln( L / N )

, where N is the size of the population, and d1n calculates the growth rate of the variable in brackets. This shows that the growth rate of output per capita depends on changes in the share of the working-age population, the capital/labour ratio 105, human capital, and TFP. Demographic changes hence could directly affect growth through the above channels or indirectly influence capital accumulation through saving. The growth rate of working-age population (dlnL/N) is identified as one of the most robust demographic variables in the empirical literature. It is found to be positively and significantly linked to output-per-worker growth in most studies. The IMF (2004) 106, using data from 115 countries for 1960-2000, found per capita GDP growth is positively correlated with changes in the relative size of the working-age population, and negatively correlated with changes in the share of the elderly (Figure 17), reflecting the direct productive impact of the labour force. The youth dependency ratio is found to be significantly and negatively associated with growth in most studies. Therefore, everything else being equal, a society with large share of youth and elderly, or a higher dependency ratio, is likely to experience slower growth than one with a high proportion of working-age population (Figure 18).

104

Standard neoclassical Solow-Swan growth models suggest labour supply, capital accumulation and productivity are drivers of economic growth. These models make a few important predictions. First, increasing capital relative to labor boosts economic growth, since people can be more productive given more capital. Second, because of diminishing returns to capital, economies will eventually reach a so called "steady state” when increase in capital will no longer create economic growth. Technological progress will then be the only driver for long-run growth. Third, poor countries with lower capital per capita will grow faster than rich countries, the so called “catching-up”. 105 The impacts of ageing on K/L ratio are also not so clear cut. A falling share of the working age population leads to a greater capital per worker (Bloom and Williamson 1998), but it reduced savings and investment through the life cycle argument of a rising dependency ratio. 106 International Monetary Fund, 2004, Table 3.1 in Chapter 3 “How Will Demographic Change Affect the Global Economy?” in World Economic Outlook, September 2004.

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Barclays | China: Beyond the Miracle FIGURE 17 Macroeconomic Impact of Demographic Changes – and IMF study (2004) Growth in real GDP per capita Share of working-age population Share of elderly population

Savings/ GDP

Investment/ GDP

Current account/ GDP

Budget balance/ GDP

0.08

0.72

0.31

0.05

0.06

-0.041

-0.35

-0.14

-0.25

-0.46

Note: 1) All regressions are panel fixed-effects regressions. The sample includes 115 countries; the data for each country are averaged over each decade. All demographic variables, as well as several other controls, are instrumented using their lagged values. See the appendix for details of the controls and instruments used in each regression. Bold-faced values are statistically significant at the 10 percent level. 2) The working-age population is defined as the age group 15-64 inclusive. The elderly population is defined as the age group 65 and upward. Increases in the share of either are defined as coming at the expense of the age group 0-14 inclusive. These population shares appear in growth form in the regression for the growth of real GDP per capita, and in level form elsewhere except in the regression for the current account/GDP ratio, where they are expressed as deviations from the world average. Source: IMF (2004)

In addition, a rising dependency ratio and the associated social welfare costs tend to reduce savings and capital accumulation. Life-cycle theory predicts that working-age adults tend to have higher savings than the young and the elderly, which helps to boost investment and economic growth (Figure 18). The IMF 2004 study also shows empirically that a falling share of the working age population and a rising elderly population decreases aggregate savings. However, it is worth noting that increasing life expectancy is found to lead to higher savings rates and the effects could be substantial (Bloom et al 2003 107, see section 4). The impact of ageing on productivity growth (dlnA) is more complicated, with theory divided and empirical results mixed. Older workers are generally believed to be less productive, healthy and innovative. On the other hand, they have accumulated more experience and know-how than younger workers. 108 Hence, the net effect of ageing on productivity is an open question. Besides the direct impact, ageing will affect productivity growth through its indirect impact on savings and investment.

107

Bloom, D. E., D. Canning and B. Graham (2003). "Longevity and Life-Cycle Savings." Scandinavian Journal of Economics, 105(3): 319-38. They add health and longevity to a standard model of life cycle saving. 108 Alessandra Cataldi, Stephan Kampelmann, François Rycx, 2011, “Does It Pay to Be Productive? The Case of Age Groups,” The Institute for the Study of Labor Discussion Paper No. 5938, August 2011.

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Barclays | China: Beyond the Miracle FIGURE 18 China’s dependency ratio set to bottom Old-age dependency (%) Child dependency ratio (%) Total dependency ratio (%)

100 90

FIGURE 19 Consumption and income life cycle trends Consumption and labour income, per capita 1.200

80

Labour income

1.000

70 60

0.800

50

Consumption

0.600

40

0.400

30 20

0.200

10 0 1950

0.000

1970

1990

2010

Source: CEIC, Barclays Research

2030

2050

0

10

20

30

40

50

60

70

80

90+

Age

Note: Adapted from Mason and Lee (2007)

Macro literature on the topic is scarce (see Skirbekk 2008 109 ), with major findings identifying the important role of the (working) age structure. Results generally support the belief that prime-age workers can boost aggregate productivity, while those older than 55 tend to reduce productivity 110. Feyrer (2007 111) found an increase in the size of the 40-49 age group is associated with higher output, as more experienced labour force adds to productivity growth, using a panel of 87 non-oil developed and developing countries. He also shows that differences in age structures may be related to one quarter of the persistent productivity gap between the OECD and low income nations. Another interesting study by Gomez and Hernandez de Cos (2008) 112 argues that population ageing produces intermediary changes to the age structure that can increase economic performance rather than dampen it. Using a large cross-country panel data from 1960-2000, they show an increase in the number of prime age persons (35-54) relative to the younger working age population (15-34) has a positive but diminishing effect on per capita GDP growth. They find a 5% increase in the ratio can account for roughly one quarter of per capita GDP differences across countries over a decade. Two

109 Vegard Skirbekk, 2008, “Age and Productivity Capacity: Descriptions, Causes and Policy Options,” Ageing Horizons, Oxford Institute of Ageing, Issue No. 8, 4–12, 2008. 110 On the other hand, using Canadian data over 1981 - 2001, Tang and MacLeod (2006) found ageing has a modest negative direct impact on productivity growth. Tang, Jianmin. and Carolyn. MacLeod, 2006, "Labour force ageing and productivity performance in Canada", Canadian Journal of Economics, 39, 2, 582-603. 111 Feyrer, James Donald, 2007, “Demographics and Productivity,”, Review of Economics and Statistics, Vol. 89, Issue 1, pp. 100–09. 112 Gomez and Hernandez de Cos, 2008, “Does population aging promote faster economic growth?” Review of Income and Wealth, Series 54, Number 3, September 2008. They show that their results are robust when using difference-GMM estimation to control for endogeneity etc issues.

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Barclays | China: Beyond the Miracle FIGURE 21 Working age structure, China

FIGURE 20 Working age structure, Japan 80

50

Aged 15-64/total (%) Aged 35-54/aged 15-64 (%, RHS)

75

46 1st order maturity

70

42

65

80

50

Aged 15-64/total (%) Aged 35-54/aged 15-64 (%, RHS)

75

46

70

42

65 38

60

34

55

Japanese working age structure

50 1950 t-10

1960

1970 t

t+10

1980 t+20

1990 t+30

38

60

2nd order maturity

2000

30 2010

t+40

Note: Adapted from Gomez and Hernandez de Cos (2008)

55

Chinese working age structure

50 1970 t-40

1980 t-30

1990 t-20

2000 t-10

2010 t

2020

2030

t+10

34 30 2040

t+20

Source: Haver Analytics, Barclays Research

effects were identified: the direct productive impact (‘first order maturity’), and the impact on savings, capital per person, and human capital accumulation through education and learning-by-doing (‘second order maturity’). They use Japanese data to illustrate the first and second order of maturity as replicated in Figure 20. We also plot the same for china as in Figure 21. Moreover, they concluded that there is an optimal prime-to-youth ratio, and beyond or below that, per capita output is lowered (Figure 19). At the micro level, analyses based on the employee-employer data tend to find a humpshaped relationship between job performance and age. That is, a worker’s productivity tends to increase during the initial years in the labour market before it stabilises and often declines towards the end of the working life. Skirbekk 2008, in a complete literature review, found productivity reductions at older ages are strongest in job tasks where problem solving, learning and speed are important, while for work tasks where experience and verbal abilities matter more, there is less or no reduction in productivity among elderly workers. Overall, the key takeaways for this session are: 1) a falling working age population (aged 15-64) has a large negative impact on the growth rate of GDP per capita; and 2) but this can be mitigated by the positive contribution from higher share of prime age workers (aged 35-54).

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2. End of the first dividend, beginning of the second dividend The previous section suggests that the demographic transition and economic cycles could be divided into two phases. The first phase is in the middle of the demographic transition, after the fertility rate has begun to decline but before population ageing intensifies. Most developing economies are still in this phase (Mason and Lee 2007 113). The second phase marks the period of rapid population ageing, this is the phase most industrial countries have reached and that many emerging economies will soon enter. The first phase is generally viewed as a time of economic opportunity, whereas the second phase is viewed as a time of economic hardship, if not catastrophe. During the first phase, the boost to per capita income growth from rising share of the working age population is called the “demographic dividend”, or the “first dividend”. The period during which the first dividend is positive is sometimes referred to as the “demographic window”. 114 115 The empirical literature has generally found that the demographic dividend has been quantitatively important, especially in East Asia. 116 Figure 23 suggests that for China, the demographic window probably opened in the 1960s. Empirical research shows that during the demographic window, China’s favourable population age structure contributed to rapid economic growth. Park and Shin (2011) 117 found that China’s demographic structure boosted per capita output growth by 1pp per annum between 1981 and 2010. However, China’s demographic window will likely close around 2020. The working age population (by a typical definition aged 15-64) is forecast to reach its peak around 2015. The total dependency ratio by the typical definition is expected to bottom over 2010-15. However, Figure 24 shows the size of the 20-60 year group is expected to start shrinking from around 2020. The prime age group, those aged 35-54, on the other hand, appears to peak post 2020, and starts decline more visibly only after 2030.

113

Ronald Lee, and Andrew Mason, 2007, Population Aging, Wealth, and Economic Growth: Demographic Dividends and Public Policy, January, 2007 114 Bloom, D. E. and J. G. Williamson, 1998. "Demographic Transitions and Economic Miracles in Emerging Asia." World Bank Economic Review 12(3): 419-56. 115 Bloom, D. E., D. Canning and J. Sevilla, 2003, “The Demographic Dividend: A New Perspective on the Economic Consequences of Population Change”, a RAND publication. 116 Andrew Mason and Sang-Hyop Lee, Population, Wealth, and Economic Growth in the Asia and Pacific Region, ADB working paper series, No. 280 | October 2011 117 Impact of Population Aging on Asia’s Future Growth, Donghyun Park and Kwanho Shin October 2011

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Barclays | China: Beyond the Miracle FIGURE 22 The effect of prime age workers on growth

FIGURE 23 Working-age population share (% of total)

Growth rate

85 80

China Korea Indonesia Singapore

Japan Philippines Malaysia United States

75 70 65 60 55 50

0

L1

L0

L3

L2

2

Ratio of aged 35-53/Aged 15-34

Note: Adapted from Gomez and Hernandez de Cos (2008) This chart describes the effect of second order maturity on medium term growth rate. The effect of adding prime age workers follows an inverted U shape. A country populated with an optimal level of prime age human capital Lo relative to the younger working population will grow faster than a country that has either too few L1 or too many L2 experienced/prime age workers.

45 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Source: Haver Analytics, Barclays Research

In response to changing age structure and rising life expectancies, behaviours of individuals, corporations and the government are expected to change, which could produce positive economic effects – the so called “second dividend”. This is elaborated in Bloom, Canning and Sevilla (2003), Mason and Wang (2005) 118, Mason and Lee (2011), and Bloom, Canning and Fink (2011). We agree that market mechanisms, changing incentives, and institutional adjustments will bring about new behaviours. We envision the same will happen in China as ageing intensifies, helping to alleviate the negative impacts and boosting growth potential. There are a few typical behaviour changes we could expect. First, individuals may decide to delay their retirement, given improved health and longevity. As shown in Bloom, Canning, Mansfield and Moore (2007) 119, the optimal theoretical response to rising life expectancy is to increase the number of working years and the number of years in retirement proportionately, without changing period-

118

Wang Feng, and Andrew Mason, Demographic dividend and prospects for economic development in China, July 2005 119 Bloom, D. E., D. Canning, R. K. Mansfield and M. Moore (2007). "Demographic Change, Social Security Systems and Savings." Journal of Monetary Economics, 54: 92-114

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Barclays | China: Beyond the Miracle specific savings and consumption behaviour. Kulish, Smith and Kent (2006) 120 model retirement endogenously and study the behaviour of the Australian economy. They show a permanent fall in the fertility rate delays retirement, increases capital intensity, raising wages and lowering interest rates. When falling fertility and rising longevity occur at the same time, they find individuals will spend a similar proportion of their lives in retirement as life expectancy increases, and capital to labour ratio converge to a higher level than the sum of the two events acting alone. Second, besides labour, individuals also contribute to output as savers and investors. Older people tend to hold more assets, such as savings, pensions and insurances. Rising life expectancy may make them build a larger pool of savings to fund more years in retirement (as seen in Japan). Bloom, Canning and Graham (2003) show that increases in longevity lead to higher savings rates. In a stable population these higher savings rates are offset by increased old age dependency, but when longevity is rising, the effect on aggregate savings rates can be substantial. Such behavioural change will raise wealth per capita (Kinugasa and Mason, 2007 121) and capital intensity (Kulish et al 2006) and is growth-enhancing. Third, in an ageing society, households, corporate and government are likely to invest more in human capital. Falling fertility is accompanied by higher income and rising spending per child (Becker and Lewis 1973) 122. Hence, “The [effects] of population ageing are reversed as large cohorts of less productive members are replaced with small cohorts of more productive members (Mason and Lee 2010) 123” Meanwhile, rising life expectancy and delayed retirement produces similar effects on individuals and corporations. And, finally, the scarcity of labour should induce corporations to increase capital intensity and upgrade the value chain. All these changes should boost labour and total-factor productivity, and in turn, raise per capita output growth. 124

120

Kulish, M., K. Smith and C. Kent (2006). "Ageing, Retirement and Savings: A General Equilibrium Analysis." Reserve Bank of Australia Research Discussion Paper (2006-06). 121 Kinugasa, T., and A. Mason. 2007. “Why Nations Become Wealthy: The Effects of Adult Longevity on Saving.” World Development 35(1):1–23. 122 G. S. Becker and H. G. Lewis “On the interaction between the quantity and quality of children” Journal of Political Economy, 81(2, Part II):S279–S288, March-April 1973 123 Lee, R. and A. Mason (2010). "Fertility, Human Capital, and Economic Growth over the Demographic Transition."European Journal of Population 26: 159-182. 124 Paul Romer and Robert Lucas in the late 1980s and early 1990s developed endogenous growth theory, modeling technological advancement (through R&D and innovation) and introduced concept of ‘human capital’, the skill and knowledge (through education) that could make work more productive. The potential increasing rates of return of human capital allows for constant returns to capital, hence growth does not necessarily slow as capital accumulates, but the rate of growth depends on the types of capital a country invests in.

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Barclays | China: Beyond the Miracle Last but not least, economic studies on the second dividend have highlighted the importance of policy and institutional adjustments to the links between ageing and macroeconomic performance. Social and economic policies are often found to be crucial in facilitating the countries to exploit the first dividend and to reap the second dividend (Bloom et al 1998 and 2011).

3. China still has the time and resources dealing with its ageing problem Concerns about the adverse economic consequences from an ageing population are driven by two factors: 1) lower potential growth, and 2) the higher medical/pension burden. These are tough challenges for developed economies such as Japan to face, let alone a developing economy such as China. However, our discussions show that we should not over-estimate the impact of these challenges on at least three factors. • •

•

First, China may continue to benefit from the first demographic dividend, especially as it still enjoys the “advantages of backwardness”. Second, China may be able to create the second demographic dividend by focusing on new sources of growth, such as education, research and development, and elderly services. Third, the Chinese government has a massive portfolio of state-owned assets, which could be used to cover healthcare/pension spending.

We think China can continue to enjoy the first demographic dividend for some time, given its working age population structure will likely remain favourable for at least another decade. Share of the prime-aged workers (aged 35-54) is unlikely to peak until around 2020 (Figure 24). The share of prime-age workers over total workers (age 1564) will remain elevated in the coming decade, in contrast to the case of Japan (Figure 20 and Figure 21). According to the current population profile, the ageing of the Chinese population will probably reach Japan’s 1990 level by 2030 and Japan’s 2010 level after 2040. That is to say China still has some time to prepare before consequences of an ageing population reaches the same degree as in Japan, and by then the Chinese population should also have become relatively affluent. Moreover, compared with Japan and the EU, China’s population ageing started when the economy was still in the developing stage. Growing old while still poor could be a blessing because it leaves room for the economy to catch up through savings and physical capital accumulation. Solow-Swan growth models predict that poor countries with lower capital per capita will grow faster because the return on capital will be higher than in wealthier countries. China’s traditional growth drivers – urbanisation and March 2013

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Barclays | China: Beyond the Miracle FIGURE 25 Urbanisation remains a driver of growth

FIGURE 24 China: labour force by age group 1.2

person bn

90 Aged 15-64: 2015-19

80 70

0.9

60 50

Aged 20-60: 2020-24

0.6

40 30

0.3

Aged 35-54: 2020-24

20 10

0.0 1950

China 1980-2015F

0 1970 Aged 15-64

1990

2010

2030

Aged 20-60

Source: Haver Analytics, Barclays Research

2050

Aged 35-54

1920

1935

1950

United States

1965 Japan

1980

1995

Germany

2010 China

Source: UN, Barclays Research

industrialisation (Figure 25) – will continue to boost growth, offsetting the headwinds from population ageing. China’s “advantages of backwardness” suggest that there is also room for technological advances and human capital formation, as well as efficiency and total factor productivity enhancement. Plus, China still has significant numbers of underemployed rural and urban workers that can potentially be drawn into the labour market (Figure 26), though the number of such workers is arguable as we discuss in the next chapter. Our view appears to be supported by a recent Asian Development Bank (ADB) study. In investigating the impact of changes in the population age structure on economic growth for the 12 developing Asian economies, Park and Shin (2011) estimated the effects of both the old-age and youth-dependency burdens on economic growth using growth accounting and panel regressions from 1981 to 2007. Their results suggest that during 2011-20, China’s demographic changes will continue to raise growth in per capita GDP, by 0.16pp. However, they also find that during 2021-30, the demographic development will decrease the growth rate by 0.79pp. We should note that their study incorporates only accounting effects but does not take into account behavioural effects. Also, we believe China should have significant room to benefit from behavioural adjustment and policy and institutional changes – the second dividend. In particular, the government can adjust its retirement policy (increase the retirement age from the current 50-60), optimise its pension and healthcare finance systems (more private plans and contributions, and right incentives), improve the efficiency of labour markets (reform the Hukou system), spend more on education and R&D, and develop its capital markets, to just name a few areas. It should be noted that pressure and demand for oldMarch 2013

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Barclays | China: Beyond the Miracle FIGURE 26 Labour force participation rate dropped

FIGURE 27 Basic pension fund appears to be self sustaining

Percent employed

1500

100

1200

90

900

80

Pension expense Pension revenue Pension balance (accumulated)

600

70

300

60

0

50 40

Female 1990

-300

30

Female 2005

-600

20

Male 1990

10

Male 2005

0

CNY bn

15

20

25

30

35

40 Age

-900 -1200 45

50

55

60

65+

Note: Adapted from Bloom, Canning and Fink (2011)

-1500 1989

1992

1995

1998

2001

2004

2007

2010

Source: CEIC, Barclays Research

age support begins to emerge during the first dividend period, as already felt in China over the past five years. Therefore, taking action now to allow China to realise the second demographic dividend in the coming decades is ever more important.

Current state of social welfare systems The EU and Japan have often been singled out in discussions on ageing and long-term fiscal sustainability – the European sovereign debt crisis points clearly to these challenges. Although these countries are further along the ageing curve and have much more generous social security and pension entitlements, it is reasonable to question whether China has enough resources to finance the likely increased pension and medical care costs. The rapid ageing of China’s population suggests that its pension and healthcare systems will face increasing funding pressures in the coming decades. It is estimated that while each pensioner was supported by the combined contribution of five Chinese workers in 2010, the number is expected to fall to three by 2020. The sharp increase of the number of retirees relative to the number of workers will require greater social expenditures. Meanwhile, the informal traditional family support system is weakening. As China’s baby boomers begin to retire, the burden of caring for the elderly will fall on the first single-child generation some time in the next decade. Despite being significantly under-developed, China’s society’s pension and social security support system has become more diversified, owing to market-oriented reforms over the past decades designed to increase risk sharing among the March 2013

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Barclays | China: Beyond the Miracle government, households and corporate sector. Using the pension support system as an example, rural residents have traditionally relied on land and family care. Since 2009 they have been covered under the newly established rural pension system. Employees of urban enterprises still largely rely on household savings, but the coverage and benefits of the public pension system have risen steadily in the past seven years as part of the government’s initiatives. Civil servants still enjoy generous public-funded retirement pensions. And increasingly, private pension and enterprise annuity plans are being developed. Turning to China’s public pension plan, although the basic public pension fund appears to be self sustaining, it is already feeling the pressure from an ageing population and rising claims (Figure 27). In fact, the system depends heavily on fiscal subsidies, which are estimated to have exceeded CNY1trn over the past decade. According to the China Pension Development Report 2011, 14 provinces faced a financing gap in their basic pension provision in 2010, with a total country-wide gap of CNY68bn. Local governments have often drawn money from the “individual account” under the basic public pension plan to cover current pension expenses, resulting in a large number of individual accounts with no money. Zheng, Bingwen, head of Center for International Social Security Studies at the Chinese Academy of Social Science has estimated that the total size of empty accounts has probably reached CNY1.3trn. 125 China also needs to balance improvements in coverage and benefits under the social safety net against fiscal sustainability. Even a rough calculation shows that a static increase in pension coverage would lead to a significant shortfall in the public pension fund. In 2010, the fund’s total income was CNY1.34trn (CNY1.11trn from contributions plus a CNY195.4bn fiscal subsidy), and total expenditures were CNY1.05trn. Assuming everyone aged 65 and above is covered (123mn versus 63mn urban retiree covered), there could be a financing gap of CNY800bn. To bring China’s “social expenditures” to near the lower end of the range in highincome countries, the World Bank 126 estimates fiscal spending would need to increase by about 7-8% of GDP by 2030 (Figure 28). That means increasing public expenditures by 2-3pp for healthcare, by 3-4pp to fully finance the basic pension coverage and gradually meet the legacy costs of existing pension obligations, plus 1-1.5pp for education.

125 Liaoning province, for instance, faced a pension shortfall of CNY14.65bn and had to draw money from individual accounts, despite receiving an annual central government subsidy of CNY1.44bn since 2001. 126 China 2030-Building a modern, harmonious, and creative high-income society, the World Bank, 2012

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Barclays | China: Beyond the Miracle FIGURE 28 Size and composition of public expenditures, cross country comparison (%GDP)/*

High income

Upper middle Lower middle

China

Total

41.6

33.1

36.1

25.7

General public service

5.6

5.6

5.5

2.9

Defence

1.6

1.5

2.2

1.3

Public order and safety

1.6

2

2.6

1.3

Economic affairs

4.2

5.3

6.1

7.9

Environment protection

0.7

0.5

0.3

0.5

Housing and community amenities

0.8

1.2

3

1.9

Health

6.3

3.3

3.1

1

Recreation, culture and religion

1.2

0.8

1

0.5

Education

5.4

3.9

5.4

3.7

Social protection**

15.2

9

6.9

4.7

Note: /* Data about all the countries are in 2007 except data about China is in 2008. ** China’s Social protection includes both outlays to pension fund and to health insurance. Adding those financed from general budget, the total public expenditure on health totals around 2.5% of GDP in 2008. Source: World Bank China 2030 (2012), GFS, WDI and World Bank staff estimations

Such increases, as pointed out by the World Bank, could probably be met from the existing budget through efficiency improvements in expenditure programs and reallocation from lower-priority spending, such as for infrastructure investment.

Available sources of finance While fiscal challenges will increase as the economy slows and population ageing accelerates and the weakening in the traditional family support system adds strains to households, we believe that both the private and the public sectors have varying resources that can be mobilised to finance the costs of an ageing population. First, Chinese households have significant amounts of savings and housing assets. In a recent study on longevity and fiscal sustainability, the IMF (2012) 127 estimated the impact of ageing on the fiscal position of several advanced and emerging market economies (Figure 29). It found that the private sector does not appear to have sufficient financial assets to deal with ageing-related costs, as shown in the “Gap” in the fourth column. Japan and Germany have the largest shortfalls, equal to 2-3 times and 1127

International Monetary Fund, 2012, Table 4.2 Longevity risk and fiscal challenges in selected countries, in Chapter 4, “The financial impact of longevity risk”, April 2012

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Barclays | China: Beyond the Miracle 2 times GDP in 2010, respectively. For China, the gap is estimated to be 19-85% of GDP. However, it should be noted that given data limitations, social security benefits and housing assets are excluded from the estimate. And, housing assets generally believed to have accounted for more than 50% of the Chinese urban households’ wealth. FIGURE 29 Pension gap in selected countries

1) Household total financial assets

2) Present/ Discounted value of needed retirement income

United States

339

272 to 363

94

67 to -24

40 to 53

Japan

309

499 to 665

220

-190 to -356

65 to 87

France

197

295 to 393

82

-97 to -196

40 to 54

Germany

189

375 to 500

84

-186 to -331

55 to 74

Korea

186

267 to 357

33

-81 to -170

39 to 52

China

178

197 to 263

34

-19 to -85

34 to 45

(% 2010 Nominal GDP)

3) General Government Gross Debt

5) Increase in Present discounted values given 3year increase 4) Gap 1)-2) in longevity

Note: Range of values in columns (2), (4), and (5) cover, at the low end, a replacement rate of 60 percent of preretirement income and, at the high end, an 80 percent replacement rate for retirees aged 65 or older to maintain preretirement standard of living during the 2010–50 period./*for China, 2009. Source: IMF (2012), National flow of funds accounts: IMF (2010) and IMF staff estimates

Second, the Chinese government continues to be in a strong fiscal position, owing to rapid revenue growth and prudent fiscal management. Fiscal revenue rose by a record CNY10.4trn, or 25% y/y in 2011. The total deficit was just 1.1% of GDP, even after a 21% y/y increase in expenditure to CNY10.9trn. Even after including contingent liabilities, total public debt remains manageable (Figure 30 and Figure 31). Given different assumptions on the pension gap, China's national debt to GDP ratio could range from 65.7-83.2%. This includes local government debt (CNY10.7trn in 2010, but only CNY300mn newly increased debt in 2011 according to Premier Wen), as well as contingent central government liabilities for the estimated pension gap, policy banks’ debt and the Ministry of Railways debt. Third, the government has several options available to finance its rising liabilities, as suggested by international experience (World Bank China 2030). These include raising contribution rates or using general revenues or dedicated social security taxes. The central government could issue more debt, and local governments gradually have been allowed to tap the capital markets for debt financing (CNY250bn in 2012). More March 2013

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Barclays | China: Beyond the Miracle importantly, proceeds from the sale of state-owned enterprises (SOEs) or other state assets could be another important source of financing. Total SOEs assets stood at CNY53.3trn as of 2009. State-owned land sales raised CNY2.9trn in 2010, equivalent to 7.3% of GDP. FIGURE 30 Chinese government’s liabilities As at end of 2010 CNY trn Central government debt Contingent central government liabilities*

% GDP

6.75

16.8

9.5-16.5

22.2-39.7

--Pension gap

2-9

4.9-22.4

--Ministry of Railway liabilities

1.9

4.7

--Policy bank liabilities

5.2

11.5

--State-owned banks' bad loans spin off

0.4

1.1

Local government debt

6.7

16.7

4

10.0

27-34

65.7-83.2

Contingent local government liabilities and others Total

Note: *1) Estimates of the Pension gap vary significantly from CNY2trn to CNY9trn, according to the Center for International Social Security Studies at the Chinese Academy of Social Science. 2) Ministry of Railway liability is based on balance sheet in 2010 3) Policy bank liability is outstanding policy bank bonds: CNY5.2trn in 2010 4) State-owned commercial banks’ bad loan spin-off: total CNY1.4trn by four state-owned banks, and assuming 30% remaining unsolved (based of CBRC’s number in 2006), around CNY0.4trn bad loan spin-off outstanding. Source: State Council, Ministry of Railways, National Audit Office, Barclays Research

Indeed, we argue that a key advantage China has over other economies is that the Chinese government has a vast store of state-owned assets, which have also been growing steadily over the past decade (Figure 32). In theory, the huge stock of stateowned assets represents the most promising way to finance pensions and other fiscal liabilities. Data from the Ministry of Finance show that as of 2009, total SOE assets totalled CNY53.3trn, with CNY27.9trn owned by the central government and CNY25.5trn by local governments. At the moment, China still has a favourable age structure, and the main pension crunch is still two decades away. Owing to its relatively underdeveloped social safety net, we believe China does not face an imminent fiscal problem related to financing benefits. While major efforts are needed to improve the social welfare systems, China may also want to avoid over-reliance on the social welfare benefits enjoyed in many developed March 2013

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Barclays | China: Beyond the Miracle FIGURE 32 SOEs – a massive asset base

FIGURE 31 Debt/GDP ratio by country 250

50

Public Debt/GDP, as end of 2010 (%)

CNY trn

45 40

200

35 30

150

25 20

100

15 10

50

5 0

0 CHN

IND

JPN

USA

DEU

FRA

GBR

ITA

Note: China public debt includes local government debt and contingent government liabilities. Source: State Council, CBRC, Barclays Research

2000 2002 Fiscal revenue

2004

2006 2008 2010 Estimated SOE total assets

Source: CEIC, Barclays Research

economies. These could reduce both the incentive to work and increase pressures on public finance. There are other positive factors expected to boost savings and returns. As the population lives and works longer, more savings could be accumulated. With China gradually developing its financial markets and encouraging overseas portfolio investment, greater diversification and investment opportunities should help to increase returns and lower risks on those assets. China’s National Social Security Fund (NSSF), for example, has achieved an averaged annual return of 9.2% over the past decade (2001-10), according to National Council for NSSF, compared with around 2% estimated for the basic pension fund.

The Lewis turning point – end of surplus labour? A pressing challenge facing the Chinese economy is a rising labour shortage. At the peak of the global financial crisis in early 2009, some officials warned that at least 15% of all migrant workers, or 20mn people, might lose their jobs after the Chinese New Year holiday. This bleak forecast, however, did not materialise. On the contrary, serious and widespread labour shortages emerged throughout 2009. Evidence of the seriousness of problem can be seen in the 15-20% rises in minimum wages in most provinces that year. Migrant workers’ wages grew even faster in many areas. In retrospect, there could be two reasons for the unexpected outcome in 2009. Most economists predicted significant declines in employment because the crisis-affected March 2013

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Barclays | China: Beyond the Miracle export sectors were labour-intensive, while government-led investment projects were mainly capital intensive. Therefore, it was thought that the number of jobs likely to be created by the stimulus package would not be sufficient to offset job losses in the export sector. In fact, while most infrastructure projects, mainly railways, highways and airports, used lots of capital, the construction of these projects was labour intensive. Another possible reason was that China might be approaching the development stage that is marked by labour shortages. China first experienced labour shortages in 2004, mainly in the Pearl River Delta and Yangtze River Delta regions. 128 At that time, most economists attributed this phenomenon to temporary factors, such as asymmetric information, ie, large numbers of “surplus farmers” in remote areas were not aware of rise in labour demand in some coastal provinces. A small group of economists, however, identified this situation as the first evidence of China approaching the so-called Lewis turning point, which is when a country runs out of surplus labour. The most notable among them was Fang Cai, Director of the Institute of Population and Labour Economics at the Chinese Academy of Social Sciences. 129 Ross Garnaut of the Australian National University was also early to make the argument. 130

1. The Lewis turning point The Lewis turning point originated from the work of the Nobel prize winning development economist Arthur Lewis. In the Lewis dual-economy framework, there are two sectors, a modern (urban/industrial) sector and a traditional (rural/agricultural) sector. 131 In the traditional sector, there is surplus labour with zero marginal productivity, ie, a reduction in the number of rural workers does not result in lower agricultural output. This ensures unlimited supply of labour to the urban economy at constant wages. However, as the urban economy continues to expand, it draws more and more labour from the countryside, which eventually exhausts the supply of surplus labour. Therefore, further rural-urban migration results in rising wages in both rural and urban areas.

128

See Yiping Huang, A labour shortage in China, Wall Street Journal, A7, August 6-8, 2004. Fang Cai and Dewen Wang, 2005, “China’s demographic transition: Implications for growth”, in Ross Garnaut and Ligang Song (eds.), The China Boom and Its Discontents, Canberra: Asia Pacific Press. 130 Ross Garnaut and Yiping Huang, 2006, “Continued rapid growth and the turning point in China’s economic development”, in Ross Garnaut and Ligang Song (eds.), The Turning Point in China’s Economic Development, Canberra: Asia Pacific Press. 131 Arthus Lewis, 1954, “Economic development with unlimited supplies of labor”, Manchester School of Economic and Social Studies, 22, pages 139-191. 129

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Barclays | China: Beyond the Miracle FIGURE 33 Conceptual model of the Lewis turning point

FIGURE 34 Annual increase in new workers 15

Newly increased employment (mn persons)

10 5 0 -5 -10 2001-05 2006-10 2011-15 2016-20 2021-25 2025-30

Note: Adapted from Basu (2000)

Source: Hu Ying (2010), “demographic changes in ‘12th Five Years Plan’ Period and Prediction for Population Development”, in Cai Fang ed. China Population and Labour Report in 2010, Social Science Literature Press.

We can probably better understand this point by looking at Figure 33. The horizontal axis OMOR represents the total labour force (in both urban and rural employment). The downward sloping curve is demand for labour by the modern sector and the upward sloping curve is the supply of labour to the modern sector. Rural wage m (on the right axis) is the subsistence wage and w (on the left axis) is urban sector wage. In equilibrium, there is a gap between the two: the urban wage has to be significantly higher than the rural wage to persuade a farmer to move to the city since it has to cover the transaction costs of a move and the possibility of periods of unemployment. For instance, when the urban labour demand curve is A1B1, urban employment equals OML1 while rural employment equals L1OR. Since rural labour is still in surplus, rural wages should stay at m and urban wages remain at w. When the urban economy expands, the labour demand curve shifts to A2B2. At this point, urban and rural employment would be OML2 and L2OR, respectively. Thus, urban and rural wages should remain unchanged. But, note that if the urban economy continues to attract more labour from the rural economy, then the marginal productivity of labour and wages in the countryside would rise along the upward portion of the curve. This means that urban wages also have to increase in order to attract more workers. And L2 is regarded as the Lewis turning point.

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Barclays | China: Beyond the Miracle The Lewis turning point is a sound intellectual concept that helps to understand changes in economic development patterns. In the real world, however, it is difficult to identify the exact turning point since changes in labour markets are often influenced by many factors simultaneously. According to many economists, most of the rapidly growing East Asian economies have gone through the transition from labour surplus to labour shortage during the past few decades. Ryoshi Minami, for instance, suggested that Japan probably passed this turning point at the beginning of the 1960s. Other economists identified the early 1980s as the possible turning point for Korea and Taiwan.

2. Has China passed the Lewis turning point? Debate Fundamentally, the Lewis turning point is driven by a rapid expansion of the urban sector, which quickly exhausts the surplus labour in the countryside. The Chinese urban economy has certainly been growing very rapidly. But the one-child policy also may have played a role in this process, as its impact steadily slowed the growth of the total labour force (see Figure 34). In fact, we expect the total labour force to begin to decline within the next couple of years. This should accelerate the arrival of the Lewis turning point. The initial analyses by Fang Cai and other economists triggered a huge debate on whether China had actually passed the Lewis turning point. Most business people are supportive of the “passed” case, as they claim it is increasingly difficult to hire and even retain workers. Wages have been rising at double-digit rates for several years, which has been one of the biggest challenges facing most Chinese businesses. There are regular reports of coastal and inland cities competing for migrant workers, especially after the Chinese New Year holidays. Some business people have reportedly driven to villages hoping to hire workers directly (and failing in most cases). One American professor, who regularly takes US students on fieldtrips in China, promises to pay USD100 for every farmer aged 18-45 found in the villages he visits. He hasn’t paid out a cent yet, according to the latest update. Most government officials and economists, however, are sceptical that China has passed the Lewis turning point. Economists have created a large body of literature on this subject. Among the studies produced, two of the more significant in terms of content were the special issue “Debating China’s Lewis turning point” in China Economic Journal, guest edited by Yiping Huang and Fang Cai and the special issue “Has China passed the Lewis turning point?” in China Economic Review, guest-edited by Belton M. Fleisher, Robert Fearn and Zhen Ye. These two volumes contain about a dozen articles – some supporting the positive case, others the negative case.

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Barclays | China: Beyond the Miracle Before summarising the key arguments for and against the Lewis turning point in China, we should point out that economists normally look at three indicators to make an assessment of the surplus labour status in a rural economy: 1) number of rural workers; 2) wage rates in the countryside and cities; and 3) gaps between the rural and urban marginal productivity of labour. We look at these arguments one by one.

1. How many farmers are left in the countryside? According to the official statistics, the number of rural residents declined from 790mn in 1978 to 660mn in 2011 (Figure 35 and Figure 36). Most government officials would point to this number and dismiss any discussion about the Lewis turning point as premature. But the actual question is more complicated if three other factors are considered. First, the official statistics do not do a good job in reporting what farmers are doing. Traditionally, data on rural and urban residents are based on household registration status. In other words, a farmer may remain classified as a rural resident as long as he does not obtain urban household registration, even if he has worked in cities as migrant worker for several years. In recent years, cities have begun recognising farmers who have lived there for more than six months as “urban residents” (but without urban household registration). Nevertheless, if a farmer does not go to a city labour bureau to report since he does not get any social welfare benefits, then he would not be recognised as urban resident in official statistics. A comparison of the numbers of migrant workers based on data collected from villages with data collected from cities often reveals a significant gap between the two, at close to 100mn. The official number of migrant workers currently stands at close to 160mn. This means the actual number could be as large as 260mn. This, by definition, reduces the number of farmers left in the countryside. FIGURE 35 Rural population has been declining

FIGURE 36 Agriculture employment has declined Total employment (persons mn)

100

1,600

900

Employment in agriculture (persons mn)

90

1,400

800

Agriculture %Total (%, RHS)

80

1,200

700

70

600

60

500

50

400

40

300

30

400

200

20

200

100

10

0

0

Person mn

CN: Population: Urban

CN: Population: Rural

1,000 800 600

50 54 58 62 66 70 74 78 82 86 90 94 98 02 06 10

Source: CEIC, Barclays Research

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1,000

0 1990

1995

2000

2005

2010

Source: China’s Second National Agriculture Census

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Barclays | China: Beyond the Miracle FIGURE 37 What determines Chinese villagers’ decision to migrate? Total

Male

Female

Log(urban wage)-log(rural wage)

+++

+++

++

Age

---

---

---

Age2/100

+++

+++

+++

Years of schooling

++

+

+++

+++

+

Being healthy

+++

Dummy for males

+++

# of labour force in the family

+++

+++

+++

Married

---

-

---

# of children ever borne

---

---

---

# of children aged 0-4

---

---

# of children aged 5-9 # of children aged 10-16 # of elderly aged >70

---

---

--

Note: + means positive impact on decision to migrate while – means negative impact. +++ or --- means significant at 1% significance level, ++ or – at 5% significance level and + or – at 10% significance level. Adapted from Lee and Meng (2010) 132

Second, even those farmers remaining in the villages are not all engaged in farming. Despite large numbers of people living in many villages, many tend to be engaged in nonfarm employment. This means that further potential for agricultural/nonagricultural migration may be more limited than suggested by official statistics. According to a 2006 survey, about half of the people classified as farmers actually spent less than six months working in agriculture (Figure 38). 133 Total labour inputs in traditional agricultural production, especially for grain production, have declined, accompanied by an increase in capital inputs. This might be interpreted as a rational response when labour becomes scarce or more expensive (at least relative to capital). The decline is most visible in rice production, which is concentrated in southern China, where the economy is relatively more developed. Declining labour input in wheat production is also visible, but it is much less dramatic in corn production. 132

Lee, L., & Meng, X. (2010). Why don't more Chinese migrate from the countryside? Institutional constraints and the migration decision. In X. Meng, C. Manning, S. Li, & T. Effendi (Eds.), The great migration: Rural-urban migration in China and Indonesia; Edward Elgar Publishing Ltd. 133 Meiyan Wang, 2010, “The Rise of Labor Cost and The Fall of Labor Input: Has China Reached Lewis Turning Point?” China Economic Journal, 3(2), pages 137-153.

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2. What is the potential for further rural-urban migration? Even if we assume that there are still many farmers in the countryside, it is debatable how many of them are able to migrate to the cities and find jobs. One important factor is the household registration system, which discriminates against migrant workers in the cities. Migrant workers are not entitled to the same types of social welfare benefits and their children cannot go to public schools in the cities. Therefore, reform of the household registration system would lower the barriers to rural-urban migration and likely encourage more farmers to move to the cities. Some economists have examined determinants of the migration decision. Using survey data on more than 20,000 of Chinese villagers, Lee and Meng (2010) found the following: 1) a greater rural-urban earnings gap increases the likelihood of migration; 2) age has a negative impact on the migration decision, although the square of it offsets the negative impact; 3) better educated people are more likely to migrate; 4) children, especially if below the age of 4, have a negative impact on the migration decision, particularly for mothers; and 5) elderly at home also reduces the probability of migration (Figure 37). These imply that, if changes to the household registration system lead to the migration of whole families (including children below the age of 4 and the elderly aged above 70), then the labour supply in the urban economy may increase. The question is how much. Many economists argue that although there are still many people left in the countryside, most of them are either children or elderly, as it is increasingly difficult to find people between the ages of 18 and 45 in Chinese villages. If that is the case, then the potential boost to the supply of labour to the urban economy might be limited, even if all the household registration restrictions were rescinded overnight.

3. Is there still a significant gap in labour productivity? Differences in labour productivity or wages between the urban and rural sectors are the most important driver of rural-urban migration. This factor has also been one of the most significant contributors to China’s rapid economic growth in past decades. And, therefore, the measurement of productivity differences is probably a more accurate indicator of the potential for further rural-urban migration. Ryoshi Minami was one of the first to apply this approach to gauge a country’s surplus labour (Figure 39). 134

134

Ryoshi Minami, 1986, The Economic Development of Japan: A Quantitative Study, McMillan, London.

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Barclays | China: Beyond the Miracle FIGURE 38 Farmers’ time spent working the land

FIGURE 39 Labour input in the agriculture products 120

3% 17% 32%

1 month 2-3 months

Total labor input (hundred million days)

100 80

4-6 months 7-9 months 10 months and above 28% 20%

60 40 20 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Rice

Source: China’s Second National Agriculture Census

Corn

Wheat

Note: Adapted from Wang (2010)

In a later study, Minami and his co-author Xinxin Ma (2009) applied this approach to China (Figure 40). 135 They first calculated the marginal productivity of labour in agriculture by estimating a production function for agricultural output. They then compared it with the subsistence level of the agricultural population, which was represented by two indicators in their study: 1) per capita net income, and 2) per capita consumption expenditure of rural households. Based on these assumptions, Minami and Ma estimated the ratio of surplus labour during 2001-05 was 64.8% under assumption 1), and 34.6% under assumption 2). They concluded that China’s situation in those years was very similar to Japan’s in 1906-1940. But their conclusion was controversial. For instance, if we look at estimates by Minami and Ma under assumption 2), then the ratio of surplus labour was only about one-third in agriculture. In fact, disaggregated estimates for different regions suggest that surplus labour might already be exhausted in both the Eastern and Western regions. The Central region is probably the only area where there still exist significant surplus labour, according to Ninami and Ma’s analysis.

135

Ryoshi Minami and Xinxin Ma, 2009, “The turning point of Chinese economy: Compared with Japanese experience”, Asian Economics, Vplume 50, Number 12, pages 2-20 (in Japanese). China Economic Journal, Special Issue Debating China’s Lewis Turning Point (guest edited by Yiping Huang and Fang Cai), Volume 3, Number 2, pages 163-179.

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Barclays | China: Beyond the Miracle FIGURE 40 Estimation of surplus labour in agriculture: Japan and China Estimation (1) Total labour Equilibrium force labour force

Surplus labour

Estimation (2) Ratio of surplus Equilibrium Surplus labour (%) labour force labour

Ratio of surplus labour

Japan 1906-1940

2133

917

1216

57.2

1990-1995

45907

11129

34778

75.7

19316

26591

57.9

1996-2000

45671

13077

32761

71.5

24585

21253

46.4

2001-2005

45803

16112

29691

64.8

29913

15890

34.6

Eastern District

15925

6960

8965

56.3

13829

2096

13.2

Central District

17154

2733

14421

84.1

5120

12034

70.2

Western District

12724

6419

6305

49.6

10964

1760

13.8

China

Source: Ninami and Ma (2009)

Zhen Wei, Marco G. Ercolani and Rui Hao (2012) followed the same approach by estimating production functions for both the urban and rural economies of China and then compared the average and marginal productivity of labour in the two areas. Their main conclusion was that China passed the Lewis turning point in 2009. 136 These studies are subject to one important criticism: if the agricultural labour force is overstated in official statistics, then a production-function type of analysis would likely underestimate labour productivity in agriculture (and overestimate labour productivity in the urban sector). And we know the migration population is probably underestimated and the number of farmers is probably over-reported. As evidence, Meiyan Wang (2010) found very significant increases in labour productivity in the production of Japonica rice in China (Figure 41).

136 Zhen Wei, Marco G. Ercolani and Rui Hao, 2012, “The dual economy development during 1965-2009”, in Fang Cai, Tao Yang and Yiping Huang (eds.), Debating the Lewis Turning Point in China, Social Science Academic Press (China).

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Barclays | China: Beyond the Miracle FIGURE 41 Average and marginal labour productivity of Japonica rice

Period

Output Elasticity of Labour

Average Labour Productivity (kilogram/day)

Marginal Labour Productivity (kilogram/day)

Period before 2004 (1980-2004)

0.183

21.22

3.88

Period after 2004 (2005-2008)

0.337

32.21

10.86

Source: Du and Wang (2010)

4. Are rising wages evidence of a labour shortage? Are Chinese wages rising quickly? Probably yes. The average wage in China has been growing faster than GDP for the past few years (Figure 42). But many analysts would argue that urban wages do not say anything about wages of migrant workers. Yang Du and Meiyan Wang (2010), however, gathered some survey data from other institutions and found that even migrant workers’ wages were growing rapidly. 137 Other economists, however, argue that it is not at all clear that migrant workers’ wages have been rising rapidly (for example, Jane Golley and Xin Meng 2011). 138 On the other hand, the International Food Policy Institute’s Xiaobo Zhang and his collaborators found that even in the poor regions such as Guizhou, and even during the slack season, wages have rising recently, especially since 2003 (Figure 43). And they regarded it as very strong evidence that the countryside is running out of surplus labour. 139 Other economists argue that although wages have been rising, it is probably because of various factors lifting living costs in the countryside, rather than labour shortages (Yao and Zhang 2010; Knight, Deng and Li 2011). 140 141 During the past few years, the government implemented various policies to support farmers, including better social welfare systems, educational support and subsidies for agricultural production. It is argued that such policies have raised the opportunity costs for potential migrant workers, which means wages in nonagricultural sectors have had to be raised in order to induce migration. 137

Yang Du and Meiyan Wang, 2010, “Discussions on Potential Bias and Implications of Lewisian Turning Point”, China Economic Journal, 3(2), pages 121-136. Jane Golley and Xin Meng, 2011, “Has China run out of surplus labor?”, China Economic Review, 22(4), pages 555572. 139 Xiaobo Zhang, Jin Yang and Shengling Wang, 2011, “China has reached the Lewis turning point”, China Economic Review, 22(4), pages 542-554. 140 Yang Yao and Ke Zhang, 2010, “Has China passed the Lewis turning point? A structural estimation based on provincial data”, China Economic Journal, 3(2), pages 155-162. 141 John Knight, Quheng Deng and Shi Li, 2011, “The puzzle of migrant labor shortage and rural labor surplus in China”, China Economic Review, 22(4), 585-600. 138

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Barclays | China: Beyond the Miracle FIGURE 42 Real wages of migrant workers in China 1600

FIGURE 43 The coefficient for year dummies 12

CNY

1500

10

1400

8

1300

6

1200

4

1100

2

1000

0

900 800

-2

700

-4

600 2001 2002 2003 2004 2005 2006 2007 2008 2009

-6 1993

NBS

RCRE

Note: Adapted from Du and Wang (2010)

PBoC

1995

1997 Harvest

1999

2001

2003

2005

Slack

Note: Adapted from Zhang, Yang and Wang (2011)

Macroeconomic implications of the turning point The above section underscores the level of debate around whether or not China has passed the Lewis turning point. We remain open minded on the issue, but note the following points that have emerged from these discussions: • • •

•

•

The number of farmers actually in the agricultural sector is likely to be much smaller than the official statistics suggest; Wages have been rising rapidly for urban formal sector employees, migrant workers and even workers in the agricultural sector; Due to regional differences, in China’s case the Lewis turning point might more accurately be called the “Lewis turning period” as various regions pass this point at different times; The removal of restrictions on rural-urban migration might increase labour supply to the urban economy, but we think the flow of extra workers probably would be less than expected; Whether China has or has not yet passed the Lewis turning point, rapid wage increases are likely an existing long-term trend.

Therefore, our tentative conclusion is that China overall has either passed, or is very close to passing, the Lewis turning point. It is possible that some parts of the country have already passed the turning point, while the others are still approaching it. This notion of a “turning period” is supported by analysis by Minami and Ma (2009), who suggested that the Eastern and Western regions of China were quickly running out of surplus labour while the Central region still had plenty of surplus farmers in the villages. March 2013

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Barclays | China: Beyond the Miracle Regardless of the turning point timing, it is more important to understand the macroeconomic implications of this change. Several papers presented at a workshop titled “Debating China’s Lewis Turning Point”, jointly organized by the Chinese Academy of Social Sciences and the Peking University in early 2010 in Beijing, addressed this subject, including those by Ross Garnaut (2010) 142, Yiping Huang and Tingsong Jiang (2010) 143 and Ligang Song and Yongsheng Zhang (2010). 144 The determining factor accompanying the Lewis turning point/period is the transition from stable to rising wages (Figure 44). This trend generates a series of changes. Before the turning point, production costs remain relatively stable, which helps to anchor inflation. However, as wages start to rise rapidly, the higher costs have to be absorbed either by improving productivity or increasing product prices or both. Therefore, it is likely that inflation pressures will rise after the Lewis turning point is passed. But whether this translates into higher inflation depends on monetary policy – if a central bank resists monetary tightening, including appreciation of the currency, then high inflation might be inevitable (Garnaut 2010). FIGURE 44 Key macroeconomic changes before and after the Lewis turning point Before

After

Wages

Stable

Rising

Inflation

Stable

Rising pressure

Corporate profits

Increasing

Declining

Savings/GDP

Rising

Falling

Current account/GDP

Improving

Deteriorating

Consumption/GDP

Falling

Increasing

Investment/GDP

Rising

Falling

Labour-intensive industries

Expanding

Shrinking

GDP growth

Accelerating

Decelerating

Source: Barclays Research

142 Ross Garnaut, 2010, “Macroeconomic implications of the turning point”, China Economic Journal, Special Issue Debating China’s Lewis Turning Point (guest edited by Yiping Huang and Fang Cai), Volume 3, Number 2, pages 181-190. 143 Yiping Huang and Tingsong Jiang, 2010, “What does the Lewis turning point mean for China? A computable general equilibrium analysis”, China Economic Journal, Special Issue Debating China’s Lewis Turning Point (guest edited by Yiping Huang and Fang Cai), Volume 3, Number 2, pages 191-207. 144 Ligang Song and Yongsheng Zhang, 2010, “Will Chinese growth slow after the Lewis turning point?”, China Economic Journal, Special Issue Debating China’s Lewis Turning Point (guest edited by Yiping Huang and Fang Cai), Volume 3, Number 2, pages 209-219.

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Barclays | China: Beyond the Miracle Increasing wages also should result in declining competitiveness of labour-intensive industries, which should push a country to move up the technological ladder in order to stay competitive. This should be good news for other countries with low labour costs. But it may also create new competition pressures for those economies that already have relatively high levels of income and technology (Huang and Jiang 2010). As labour costs are stable before the Lewis turning point, corporate profits may increase, relative to household income. Because the savings rate is normally higher for corporate profits than for household income, this shift may lead to a rising overall savings rate in the economy. Although rising corporate profits may also encourage investment, the net impact is likely to be an improved current account position, ie, a lower deficit or a higher surplus. And, as a country moves beyond the Lewis turning point, its savings rate should decline, the current account deteriorate and consumption’s share of GDP rise (Garnaut 2010). In general, moving beyond the Lewis turning point should lead to somewhat slower growth in an economy. But Ross Garnaut and Ligang Song and Yongsheng Zhang make strong cases that this expected growth slowdown can be mitigated by a number of factors, most fundamentally, a reduction in the current account surplus (meaning more resources for domestic demand) and a greater emphasis on education and research (therefore faster growth in total factor productivity). We think both of these will probably help to support China’s growth, but net-net, we expect growth to shift in to a slower gear.

Demographics pose new challenges, but unlikely to derail growth The Chinese economy is at a critical juncture, not only with regard to the “middle income trap” but also in terms of demographic changes, including a rising sex ratio, an ageing population and the Lewis turning point. Some of the demographic challenges are similar to those faced by Japan, Korea and Taiwan. But the one-child policy has brought forward and worsened some of these challenges for China. Overall, China’s demographic changes could be negative for its society and economy. For instance, the rising boy/girl ratio in China could be a source of social instability, as the marriage market becomes increasingly competitive for men. Again, ageing would weigh on growth through at least two channels: a less productive population that would lower potential growth and an older population that imposes significant healthcare and pension costs. Some analysts argue that the ageing challenge could be more March 2013

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Barclays | China: Beyond the Miracle devastating for China relative to developed economies such as Japan, as China is still a middle-income economy. And, finally, as China runs out of surplus labour in the countryside and its urban wages rise rapidly, both Chinese growth and competitiveness could suffer severely. But we think these common perceptions may exaggerate the problems. Closer examination suggests that these challenges are not entirely negative. In most cases, China still has time, room and the resources to prepare for some of the more adverse effects. In some cases, we think the changes could turn out to be positive and help to push the economy to the next level. They may even create new developments and investment opportunities. All of this has important implications for both policymakers and investors. While the rising sex ratio could be socially destabilising, it may be a source of greater incentives for saving, entrepreneurship and asset purchases. Although we should not overstate the magnitude of such effects, overall, they should be positive for economic growth. And the investment implications are immediately clear: other things being equal, regions with higher boy/girl ratios should have stronger drives for saving, investment and growth, but less incentive for consumption. And this may change over time, especially as China becomes more urbanised – the sex ratios are much less skewed in the cities than in the countryside. This means the gender imbalance may ease when urbanisation accelerates. And this should change saving behaviour and demand for housing. The Chinese population is ageing rapidly. But will this factor cause an abrupt end to China’s strong growth? We think this is highly unlikely. The notion that China will become old before it becomes rich is exaggerated, in our view. Based on the current population, the ageing profile of the Chinese population will probably reach the 1990 level of Japan in 2030 and the 2010 level of Japan after 2040. By those years, however, China should have become a relatively rich economy, unless something has gone terribly wrong. And it is not incompatible that an economy can become richer when it gets older. We can see at least three factors that suggest China’s ageing challenge might not be as grave as some suggest. First, while the Chinese population is ageing relatively faster than most other developing nations thanks to the one-child policy, it will still enjoy a relatively high ratio of the “productive-age population” (35-55 years old) for at least another decade. More importantly, the other side of ageing early is that China is still far from the world technological frontier and, therefore, the potential for technological catch-up, or “advantages of backwardness”, remains significant. March 2013

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Barclays | China: Beyond the Miracle Second, as the ageing challenge intensifies, we may see a range of policy and behavioural changes to mitigate the problem. These are sometimes summarised as the second “demographic dividend”. For instance, many people may choose to work longer as ageing pressures increase. Economic literature already finds that most people like to divide the additional years of lives equally between working and retirement. An older population also means people with more experience and skills. They also have more cumulative savings, especially financial assets, which could be channelled to support economic growth. And, finally, ageing will force a lot more emphasis on education, training and innovation. Therefore, while the number of working days may decline, the quality of them could improve and support faster productivity growth. And, third, one of the greatest challenges around an ageing population is the rapid rise in healthcare and pension costs, which could further reduce resources available for investment and, therefore, reduce an economy’s growth potential. The Chinese government, however, is in a unique position to resolve this problem. It owns huge amounts of state-owned assets. There have been recommendations (eg, World Bank) recently that the government should liquidate these assets to support social welfare systems. Clearly, this won’t be easy. But if this does go ahead, it could kill two birds with one stone – ie, cover increased social welfare system costs and break the state sector monopoly. Of the three demographic changes we discuss in this report, the Lewis turning point is probably the most controversial among policymakers and economists. As per the papers noted, there are disputes on almost all aspects of the subject: Are migrant workers’ wages really rising rapidly? Even if they are, is this the consequence of labour shortages or something else? How many farmers remain in the countryside? Regardless of the number of farmers, how many will actually be able to migrate if they see employment opportunities in the cities? Our position can be summarised as follows. Official statistics probably overstate the actual number of farmers, especially those still doing farming, remaining in the villages. And in many villages, most of the population is either children or older people – there are probably very few people left in villages aged between 16 and 45. Therefore, while reform of the household registration system is important for urbanisation, it is not clear to us how significant this would be in terms of increasing labour supply to the urban economy. Meanwhile, many economic studies find significant productivity gaps between urban and rural economies. But the differences are much smaller if we correct for data errors (ie, more people in the modern sector and fewer people in the traditional sector). The bottom line, however, is that wages are rising, which is critical to the outlook for the March 2013

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Barclays | China: Beyond the Miracle economy regardless of the conclusion reached on the Lewis turning point. In any case, since China is such a large country, we should expect a series of turning points for different regions and, therefore, a turning period for the country as a whole. Passage of the Lewis turning point has significant macroeconomic implications. Continued rapid growth in wages will increase production costs and eat into corporate profits. This will exert significant competitive pressures on businesses and force them to move up the technological ladder. At the same time, higher wages should increase household income and, therefore, be positive for consumption. Higher household income but lower corporate profits is likely to be negative for the overall savings rate. Other things being equal, this should lead to a deterioration of the current account (as is the case for China today). Growth will likely moderate post the Lewis turning point, although a reduction in the current account surplus and improvement in productivity may help to mitigate the change to some extent. Inflation pressures may also rise, depending largely on monetary policy. There are several common economic changes behind the above three demographic challenges, including: •

Slower growth;

•

Higher inflation;

•

Loss of low-cost advantage;

•

Rising importance of research and innovation;

•

Reduced savings;

•

Increased consumption; and

•

Deterioration in the current account.

There are many industries that could benefit from the demographic changes. The most straightforward story is that an ageing population will require more healthcare, medical care, and aged care, which should benefit the relevant industries and promote investment in industries such as private healthcare centres, hospitals and professional elder care services. Increasing wealth and retirement assets also suggest more and better financial services will be demanded. Ageing and changing family structures will require specialised financial planning, and households will need more professional advice given China’s increasingly open capital account (such as relaxations of rules around overseas investment for portfolio diversification). March 2013

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Barclays | China: Beyond the Miracle Society will demand higher returns on assets to pay for the rising pension costs associated with an ageing population. This in turn should be conducive for the expansion of domestic capital markets and asset management industries, and should boost development of the insurance and private pension industries. In developed economies, ageing has also been seen to provide a boost to the leisure and travel industries. Moreover, a smaller labour force, increasing resource constraints, rising wages and improving income distribution will lead to profound changes in the structure of China’s economy: from labour-intensive towards capital- and technology-intensive, from investment-led to consumption-driven. Consumer goods and technology-related industries should benefit. In particular, the scarcity of labour should accelerate R&D in the areas of mechanisation, automation and information technology. A rising middle class and increased wealth per capita will also lead to consumption upgrading and benefit mid- to high-end consumer goods. In contrast, traditional low-end manufacturing, labour-intensive and heavy industries are likely to suffer.

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CHAPTER 7

Will China buy up the world?

• We expect China’s outward direct investment (ODI) to grow steadily over the coming decade, by at least $100bn a year according to the most conservative estimates. Chinese ODI is already among the largest in the world. The country’s emergence as a new giant investor has happened despite its status as a middleincome country and is at least partly attributable to its repressive financial policies and the resultant cheap funding.

• We expect the Chinese government to continue to take actions to facilitate ODI,

including liberalising the capital account, offering more fiscal and financial support, providing information and intermediary services and strengthening investment protection. However, we should not be overly bullish: a premature push of the “going out strategy” by the authorities may increase the probability of investment mistakes.

• The dominance of service, state-owned enterprises (SOEs) and top-three

destinations. According to the official data, more than 70% of total Chinese ODI is originated by SOEs, goes to places such as Hong Kong, the Cayman Islands and British Virgin Islands, and is concentrated in the services industry. SOE investment raises questions about financial accountability, funding costs, state influence and public relations. Having said that, popular concerns about ODI by Chinese SOEs are probably overdone.

• The dominance of SOEs may give way to massive waves of private sector ODI,

starting with manufacturing SMEs. While SOEs will likely continue to dominate Chinese ODI in resource, finance and infrastructure, we believe manufacturing, which currently accounts for less than 5% of ODI, is probably under-reported and set to grow significantly as rising domestic costs in China push factories to other low-cost countries.

• Implications for global and Chinese economies. The current Chinese model of ODI

seeks to develop competitive advantages by acquiring resources, purchasing strategic assets and facilitating exports. It does not involve the migration of production facilities. By contrast, Japanese firms go overseas to reduce production costs and American firms to overcome entry barriers. As the new wave of private sector ODI takes hold, China, too, could see its companies move abroad. This article was originally published on 23 August 2012.

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A new giant investor on the global stage Increasingly large transactions are marking China’s presence on the global stage for cross-border M&A. On July 23, 2012, Chinese oil company CNOOC offered $15.1bn to acquire Canadian oil producer Nexen. The Canadian government now has to weigh its concerns about national security with its desire for greater foreign investment. If completed, this would be China’s largest ever foreign M&A transaction. Two months ago, the Federal Reserve Bank approved the Industrial and Commercial Bank of China (ICBC) to take a controlling interest in the US arm of Standard Chartered Bank. These are only the latest additions to China’s long and growing list of proposed outward direct investments (Figure 1). Some have been successfully executed, including automaker Geely’s takeover of Volvo in 2010 and Lenovo’s acquisition of IBM’s global PC business in 2005. Others failed for various reasons, such as Chinalco’s proposed investment in Rio Tinto in 2009 and Huawei Technologies’ withdrawal of its bid for specific assets of 3Leaf Systems following a request by the Committee on Foreign Investment in the United States (CFIUS), the US government cross-department committee that oversees national security issues concerning foreign direct investment projects.

FIGURE 1 Some high-profile transactions - successful and unsuccessful Successful

Unsuccessful

2005 – Lenovo’s acquisition of IBM’s global PC business

2005 – CNOOC withdrew $18.5bn bid to take over American oil company Unocal

2007 – China Mobile signed an agreement to buy remaining 11.14% of Paktel from Millicom, after acquiring 88.86% of its shares earlier

2007 – Joint bid by Huawei Technologies and Bain Capital to take over 3Com fell apart owing to American concerns about national security

2007 – A syndicate led by State Power Grid paid 2009 – Rio Tinto paid Chinalco $195mn to end $3.95bn for 25 years’ operating rights of the the “Century deal” for Chinalco to take a stake in Philippine Power Grid Rio Tinto 2008 – Sinopec’s take over Canadian oil company TYK for CNY13bn approved by the government

2009 – Beijing Automobile Works’ bid for Opel failed due to lack of agreement with General Motors on intellectual property rights

2009 – PetroChina purchases all the shares of Swiss oil company Addax, via a subsidiary

2010 – Sichuan Tengzhong Heavy Industrials proposal to acquire Hummer fails

2010 – Geely announced its takeover of Volvo and appointed several new board members

2011 – Huawei withdraws its bid for assets of 3Leaf Systems upon CFIUS’ request

Source: Barclays Research

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Barclays | China: Beyond the Miracle Media reports may at times give the impression that many Chinese overseas investment proposals are rejected by foreign authorities. In reality, most transactions go through successfully and with little fanfare. For example, when Chinalco’s failed bid for a stake in Rio Tinto in 2009 captured the world’s attention, the Australian government was, on average, approving at least one Chinese deal a week. But compared with the experience of many other countries, the success rate of Chinese transactions is indeed low – it was 88% in 2009 and 89% in 2010, compared with a 98-99% success rate for US and UK transactions (Dealogic). This relatively ‘low’ success rate may be attributable to the state ownership of some of the Chinese companies involved and their lack of international experience. China is already one of the world’s largest direct investors. In 2010, China’s outward direct investment (ODI) totalled $69bn, overtaking Japan to become the fifth-largest investor globally, following the US, Germany, Hong Kong and France. China’s cumulative ODI amounts to around $342bn since 1982. About $228.9bn was invested overseas during the 11th Five-Year Program (FYP) period (2006-2010), during which Chinese ODI grew by 49% a year. In 2011, Chinese companies invested close to $65bn overseas, which accounted for more than 5% of global cross-border investment, according to UNCTAD data. However, China’s world ranking dropped to ninth as investment by Japan, Switzerland, Belgium and Russia all expanded more rapidly that year. 145 Rising Chinese ODI is probably only the beginning of the story. In a recent study, the HKMA’s Dong He and his co-authors predicted that China’s cumulative ODI may reach $5,149bn by 2020, a net increase of $4,838bn from 2010 or $484bn a year on average during the current decade. 146 A report by the US Asia Society estimated that cumulative Chinese ODI could reach between $1trn and $2trn by 2020. 147 Even this more conservative forecast implies growth of $100bn a year during the current decade. This suggests that, one way or the other, China will become a dominant direct investor, with significant implications for the global as well as Chinese economies. In the meantime, it also raises a number of research and policy questions with regard to Chinese ODI: •

What are the special factors contributing to Chinese ODI? According to international experiences, a country normally imports capital during its early stages

145 UNCTAD, World Investment Report 2012: Towards a New Generation of Investment Policies, New York and Geneva. 146 Dong He, Lillian Cheung, Wenlang Zhang and Tommy Wu, 2012, “How would capital account liberalization affect China’s capital flows and the renminbi real exchange rates?” Hong Kong Institute for Monetary Research Working Paper No. 09/2012, Hong Kong. 147 “China eyes overseas markets”, China Daily, September 7, 2011 (http://www.chinadaily.com.cn/business/2011-09/07/content_13640912.htm).

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Barclays | China: Beyond the Miracle of economic development and turns into an exporter of capital once its economy matures. Although China is still a middle-income country, it is already a major exporter of capital. •

•

•

•

What is the likely true pattern of host country and industry distribution of Chinese ODI? The official data suggest that most Chinese investment is made by stateowned enterprises (SOEs), goes to places like Hong Kong, the Cayman Islands and British Virgin Islands, and is concentrated in service industries. However, this may give a distorted picture, as a large portion of the investment in tax havens often goes on to third destinations, and possibly into different industries. What are the main objectives of Chinese ODI? Internationally, companies often make investments overseas to take advantage of lower production costs (the socalled ‘Japanese model’) and/or to overcome entry barriers to local markets (‘American model’). A feature of Chinese ODI is that many Chinese companies invest overseas without moving their factories abroad. What are the biggest obstacles to Chinese ODI? Domestically, investors still need to obtain approvals from at least three government departments. Overseas, state ownership or strong links with the government can prove a sensitive issue. Chinese investors also need to learn to manage public relations, different regulatory requirements and even labour unions. How will Chinese ODI evolve? Current features of Chinese ODI include the important role of the state sector, a concentration in the resource area and little transfer of domestic production facilities. It will be interesting to see if these aspects evolve over time.

In this report, we attempt to answer some of these questions to gain a deeper understanding of this increasingly important global economic issue. Here we summarise some conclusions. First, as a middle-income economy, China’s high level of ODI is indeed unusual. It is probably the result of repressive financial policies, which have contributed to both the country’s huge foreign exchange reserves and low cost of capital for industry. Any reduction in both financial repression and the external surpluses may slow ODI flows, though slowing economic growth, increasing costs, advancing technology and an appreciating currency should boost ODI. Overall, ODI may continue at around $100 a year on average up to 2020. Second, companies make ODI to exploit their competitive advantages such as technology, brand names and management. Typically, Japanese firms go overseas to March 2013

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Barclays | China: Beyond the Miracle reduce production costs while American firms to overcome entry barriers. Currently, most Chinese companies, undertake ODI to develop competitive advantages, through the acquisition of resources, purchase of strategic assets such as technology and brand names, and to facilitate trade. This explains why most Chinese ODI does not involve the relocation of factories abroad, as the purpose is to strengthen the competitiveness of domestic production. Third, the world’s attention is fixed on Chinese ODI by SOEs in the areas of resources, manufacturing, financial and other services. While political concerns about stateownership may be overdone, state sector investment also suffers from ‘normal’ problems, such as accountability of investment decisions, cost of capital and corporate governance. We think the most successful ODI is likely to emerge from the private sector. As rapid and broad-based increases in production costs continue, this is likely to spark massive waves of private sector ODI, starting from manufacturing SMEs. And, finally, it is best that the authorities do not overly push the “going out strategy”, although they should make it a priority to loosen restrictions on ODI, especially by the private sector, and offer training and information about potential host economies for Chinese ODI. International experiences suggest that ODI is a natural outcome of economic development, following the accumulation of capital, advancement of technology and improvement in business management. But premature ODI can lead to financial losses and political problems. The history of Japanese ODI in the 1980s, especially in the real estate sector in the US, should offer some useful lessons.

Some “stylised” facts about Chinese ODI One of the difficulties in trying to understand trends in Chinese ODI is limited systemic data. The Ministry of Commerce compiles an annual report on ODI. But it only provides aggregate data, as project/firm level data is still treated as a state secret. This is why most of the analyses focus on the aggregate picture. In early 2012, the East Asia Forum produced a Quarterly focusing on “China’s investment abroad”, with eight nontechnical overview articles on Chinese ODI. 148 Some economists have looked more closely at behaviour of Chinese investors, using data compiled for both large projects

148

This Quarterly is available online for viewing at http://www.eastasiaforum.org/quarterly/

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Barclays | China: Beyond the Miracle and small- and medium-sized enterprises (SMEs) from Chinese sources. 149 Others collected data from host economies, such as America or Europe, for their analyses. 150 Chinese ODI is a relatively recent phenomenon. During the first two decades of economic reform, such activity was almost non-existent. In a recent speech at Peking University, PBoC deputy governor and SAFE administrator Yi Gang divided the development of Chinese ODI into three periods: 151 • • •

1984-2000: The key policy focus was on FDI inflows. Cumulative ODI was less than $30bn during this period. 2001-2007: Against the background of WTO-accession, “going out” became a key policy strategy, which facilitated the steady expansion of ODI. 2008-now: The relative decline of asset prices overseas in the wake the global financial crisis provided further encouragement for the rapid growth of Chinese ODI.

Before 2000, annual Chinese ODI had remained well below $5bn a year, according to UNCTAD data. It started to grow rapidly from 2004. In 2007, FDI inflows totalled $83.5bn while ODI was $22.5bn. In 2011, FDI and ODI reached $116bn and $65.1bn, respectively (Figure 2). These patterns in FDI and ODI are the result of deliberate policy choices as well as economic developments. When China started its economic reform, FDI inflows were actively encouraged, while other forms of inflows and capital outflows were discouraged. After the Asian financial crisis in 1997-98, the government pursued a policy of accumulating more foreign exchange reserves in order to support financial stability. Therefore, by the end of 2010 the majority of China’s foreign investment was represented by the foreign reserves position (Figure 3). Portfolio investment in either direction was small in volume, and controlled by the various qualified institutional investor schemes. While FDI has been a major part of the Chinese reform story, now ODI is starting to rise.

149

See, for instance, Yiping Huang and Bijun Wang, 2011, “Chinese outward direct investment: Is there a China model?”, China & World Economy, 19(4): 1-21. 150 For instance, see Thilo Hanemann and Daniel Rosen, 2012, China Invests in Europe, Patterns, impacts and policy implications, Rhodium Group, New York, June 2012 (http://rhgroup.net/wpcontent/uploads/2012/06/RHG_ChinaInvestsInEurope_June2012.pdf). 151 Yi Gang, Speech at the 30th Quarterly China Economic Observer Conference (in Chinese), China Macroeconomic Research Center, Peking University, July 21, 2012. (http://www.nsd.edu.cn/cn/article.asp?articleid=16194)

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Barclays | China: Beyond the Miracle FIGURE 2 China’s outward direct investment, 1982-2011 80

China's outward direct investment, 1982-2011 (USDbn)

70 60 50 40 30 20 10 0 1982

1986

1990

1994

1998

2002

2006

2010

Source: SAFE and Barclays Research

FIGURE 3 China’s foreign investment positions, end-2010 USD bn Direct investment

Portfolio investment

Asset

% GDP

311

5.3

Liability

-1474

25.1

Net

-1166

19.8

Asset

257

4.4

Liability

-222

3.8

36

0.6

Net Official foreign reserves

Total

2847

48.4

Total net foreign assets

Total

1717

29.2

Source: State Administration of Foreign Exchange

Compared with other major players in ODI, China emerged much earlier in its stage of development (Figure 4). Economic theory predicts that a country experiences shortages of capital in its early stage of economic development and has to import financing. As income levels rise, capital becomes abundant and technology advances, the country may be able to export capital, whether in form of direct or portfolio investment.

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Barclays | China: Beyond the Miracle FIGURE 4 World’s largest outward direct investors, 2010 Total ODI (USD bn)

GDP per capita (USD)

United States

304.4

48,387

Germany

109.3

43,742

Hong Kong

95.4

34,049

France

76.9

47,513

China

68.8

5,414

Switzerland

64.8

81,161

British Virgin Islands

58.7

57,626

Largest global investors

Japan

56.3

45,920

Belgium

55.7

45,467

Russia

52.5

12,993

Source: UNCTAD, IMF and Barclays Research

A quick glance at the official statistics reveals some interesting “stylised facts”. First, while the state-owned enterprises (SOEs) still dominate China’s outward investment on a value basis, investment by non-state sectors is rising rapidly (Figure 5). In terms of the number of investments, SOEs accounted for less than 15% of transactions and limited liability companies 54%. This implies that the average investment value of SOEs-driven transactions is much larger than those for other types of firms. This is consistent with common impression that most large resource sector investment deals are undertaken by SOEs, such as Chinalco, CNOOC, and Sinopec. While the world’s attention is focused on investment overseas by SOEs, non-state sector investment may become the next phenomenon in this area sometime in the future. Second, the official statistics suggest that the majority of the Chinese ODI has been in a small number of economies (Figure 6). During the past decade, for instance, Hong Kong, the Cayman Islands and British Virgin Islands were consistently the top three destinations for Chinese ODI. But this does not reveal the true destination of Chinese investment. Both the Cayman Islands and British Virgin Islands are small tax havens. Hong Kong, which often accounted for between one-third and two-thirds of Chinese ODI outflows, was most likely a transitory destination. This probably raises questions about the true geographical distribution of Chinese ODI.

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Barclays | China: Beyond the Miracle FIGURE 5 Investor structure by industrial and commercial registration, 2008-2009 % of total

Share in number

Share in stock

State-owned enterprises

14.8

69.4

Limited liability company

54.0

21.1

Private enterprises

8.4

1.0

Stock limited corporation

8.0

6.1

Cooperative enterprises

5.7

1.1

Foreign investment enterprises

3.3

0.7

Collective-owned enterprises

1.4

0.4

Hong Kong, Macao and Taiwan-invested firms

1.8

0.1

Others

2.7

0.3

Source: Statistical Bulletin of China’s Outward Foreign Direct Investment published by Ministry of Commerce, PR China, and author’s calculation.

FIGURE 6 Host country distribution of Chinese ODI, 2003, 2006 and 2009 (%) 2003

2006

2009

1

Hong Kong

40.3

Cayman Isl

44.4

Hong Kong

63.0

2

Cayman Isl

28.3

Hong Kong

39.3

Cayman Isl

9.5

3

British V lsl

7.4

British V lsl

3.1

Australia

4.3

4

Korea

5.4

Russia

2.6

Luxembourg

4.0

5

Denmark

2.6

United States

1.1

British V lsl

2.9

6

United States

2.3

Singapore

0.8

Singapore

2.5

7

Thailand

2.0

Saudi Arabia

0.7

United States

1.6

8

Macao

1.1

Algeria

0.6

Canada

1.1

9

Russia

1.1

Australia

0.5

Macao

0.8

10

Australia

1.1

Zambia

0.5

Myanmar

0.7

Note: Cayman Isl: Cayman Island; British V Isl: Virgin Island. Source: UNCTAD, World Investment Report, various years. Statistical Bulletin of China’s Outward Foreign Direct Investment published by Ministry of Commerce, PR China, and author’s calculation.

Third, Chinese ODI shows a distinctive industry pattern – a concentration in primary industries and services (Figure 7). Manufacturing accounted for less than 5% of total Chinese ODI, significantly below the average share of developing economies (15%) and that for the entire world (23.2%). The higher share of ODI in the mineral sector is consistent with the general impression of massive Chinese investment in the resource sector. Greater shares for trade and transport services are also evidence of ODI for March 2013

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Barclays | China: Beyond the Miracle purposes of export facilitation in host economies. While manufacturing investment looks low in relative terms, it might be underreported, especially if Chinese firms are making investments in manufacturing through financial holding companies in tax havens. FIGURE 7 Industry distribution of ODI flows, 2006-08 (%) Sector/industry

Developed

Developing

World

China

Primary

7.8

8.4

8.0

18.7

Agriculture, hunting, forestry and fishing

0.0

0.3

0.1

0.6

Mining, quarrying and petroleum

7.8

8.1

7.9

18.1

Manufacturing

24.1

15.0

23.2

4.7

Services

60.0

69.3

60.9

76.6

Electricity, gas and water

0.5

0.9

0.6

1.6

Construction

0.4

1.4

0.5

1.1

Trade

5.6

8.2

5.9

14.0

Hotels and restaurants

0.2

0.2

0.2

0.0

Transport, storage and communications

3.2

3.8

3.3

8.0

Finance

24.4

18.1

23.7

18.9

Business activities

23.5

33.4

24.4

31.3

Public administration and defence

0.1

0.0

0.1

0.0

Education

0.0

0.0

0.0

0.0

Health and social services

0.0

0.0

0.0

0.0

Community, social and personal services

0.3

0.2

0.3

0.2

Other services

0.9

0.5

0.8

1.6

Unspecified tertiary

0.9

2.7

1.1

–

Private buying and selling of property

0.2

0.0

0.2

–

Unspecified

7.9

7.4

7.8

–

Source: UNCTAD, World Investment Report, various years. Statistical Bulletin of China’s Outward Foreign Direct Investment published by Ministry of Commerce, PR China, and author’s calculation.

Economic literature on ODI motivation Before we address the China-specific questions, let’s first take a step back to understand why companies invest overseas. In economic literature, there are a very large number of studies examining motivations, determinants and impacts of foreign direct investment (FDI). In essence, the main purpose of FDI or ODI is to exploit proprietary advantages such as technology, management, brand names or capital. Traditionally, a firm from a developed economy possessing such advantages undertook ODI to expand its production facilities to host countries in order to extract greater returns. Recently, March 2013

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Barclays | China: Beyond the Miracle however, economists have discovered that firms from developing economies may also undertake ODI to develop similar advantages. Normally, ODI is a developed economy phenomenon, especially if we view economic development as a process of advancement of technology and accumulation of capital, as well as increase in income. According to John Dunning’s theory of the investment development path, a low-income economy often is a recipient country for FDI, while a high-income economy usually is an exporter of FDI (Figure 8). This is, first of all, because low-income economies often face capital-scarcity constraints. More importantly, highincome economies are more likely to possess some proprietary advantages. After income reaches certain levels, however, an economy may become either a net importer or net exporter of capital and shift between these two positions over time. FIGURE 8 Typical investment development path Net export

Net capital export Net import Stage of economic development Source: Adapted from John J. Dunning, 1981, The eclectic theory of the MNC, London: Allen & Unwin. John H. Dunning and Sarianna M. Lundan, 2008, Multinational Enterprises and the Global Economy, Edward Elgar, Cheltenham, UK Northampton, MA, USA, Second edition.

The modern theory of multinational companies (MNCs) started with analysing the proprietary resources and capabilities possessed by foreign firms that generated a monopolistic or competitive advantage over indigenous firms in the host countries and counteracted the inherent disadvantages of doing business abroad. 152 This was

152

Richard E. Caves, 1971, “International Corporations: the Industrial Economics of Foreign Investment,” Economica 38(149), PP. 1–27. Charles P. Kindleberger, 1969, American Business Abroad: Six Lectures on Direct Investment, Yale University Press, New Haven, CT.

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Barclays | China: Beyond the Miracle consistent with the experience of early MNCs from the US, Europe, and Japan in the 1970s and 1980s. Before they invested abroad, their advantages and assets were developed at home. They invested overseas mostly in wholly or majority-owned subsidiaries, transferring technology, know-how from headquarters to far-flung operations around the world. 153 The World Investment Report 2006 summarised the competitiveness of MNCs into three areas: 154 4. Expertise and technology-based ownership advantages in a number of industries, including consumer electrical and electronic products, food and beverages, heavy industries and transportation equipment. 5. Advantages gained from access to home country resources and activities where the government could exert great influence. Some of advantages derive from early application of new technologies (a latecomer advantage). Others come from availability of cheap funds, which are ultimately the result of high saving rates, trade surpluses or high commodity prices. 6. Specialization in part of the production value chain. This is often seen in industries like electronics, automobile components, and garments. ODI from developing economies is not a new phenomenon. Companies from Japan and Brazil, for instance, invested overseas in the 1960s and 1970s. But such investment never reached the same scale and significance of Chinese ODI today. In practice, the purpose of ODI by the so-called “third world multinationals” is the same as that by developed world MNCs, ie, to exploit their proprietary advantages. 155 These advantages are often based on low input costs, cheap labour, management and marketing skills adapted to the conditions in the developing world, while some are associated with conglomerate ownership. In most cases, developing country MNCs expanded predominantly into other similar and less developed countries in order to extract benefits from their advantages. 156 One good example is the large number of textile and clothing factories that moved from Hong Kong, Korea and Taiwan to mainland China in the early 1980s. 153

Guillen Mauro F. and Esteban Garcia-Canal, 2009, “The American Model of the Multinational Firm and the New Multinationals from Emerging Economies,” The Academy of Management Perspectives, 23(2), pp. 23-35. UNCTAD, World Development Report 2006, New York and Geneva. Sanjaya Lall, 1983, “The Rise of Multinationals from the Third World,” Third World Quarterly, 5(3), pp. 618-626. 155 Louis T. Wells, 1983, Third World Multinationals: The Rise of Foreign Direct Investment from Developing Countries, MIT Press: Cambridge, MA. Donald J. Lecraw, 1983, “Performance of Transnational Corporations in Less Developed Countries,” Journal of International Business Studies, 14(1), pp. 15–34. 156 Louis T. Wells, 1983, Third World Multinationals: The Rise of Foreign Direct Investment from Developing Countries, MIT Press: Cambridge, MA. Donald J. Lecraw, 1983, “Performance of Transnational Corporations in Less Developed Countries,” Journal of International Business Studies, 14(1), pp. 15–34. 154

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Barclays | China: Beyond the Miracle We may identify further specific motivations for ODI, which include: • • • •

horizontal expansion into other countries to secure or defend a market position (market-seeking ODI); vertical expansion into host economies to exploit local factor endowments such as oil, gas, timber and other natural resources (resource-seeking ODI); extending production facilities to exploit cheap labour and other low cost inputs in ‘hot’ economies (efficiency-seeking ODI);and developing competitive advantages in host countries (technology-seeking ODI).

The last motivation was a recent recognition in economic literature, that a firm will undertake ODI not only to exploit but possibly also to develop its competitive advantages. This is particularly important in understanding how latecomer MNCs overcome their competitive disadvantages by investing abroad. 157 Here, ‘technology’ is broadly defined encompassing production technology, management skills, marketing networks, brand names, etc. Therefore, technology-seeking ODI may also be termed as strategic asset-seeking ODI. Shige Makino and his co-authors found that firms from newly industrialised economies (NIEs) tend to undertake technology- and market-seeking ODI in developed countries but resource-seeking ODI in less developed countries (Makino et al 2002). 158 Technology-seeking ODI is a big motivation for MNCs from Brazil, Taiwan, Poland, Mexico and Romania. 159 An important reason for this type is that there is limited geographical spread of knowledge since R&D activities are still concentrated in advanced economies. Competitive advantages at least should follow if not lead firms’ internationalisation in technology-seeking ODI. To successfully assimilate and manage acquired assets,

157

John Child and Suzana B. Rodrigues, 2005, “The internationalization of Chinese firms: a case for Theoretical Extension?” the Management and Organization Review, 1(3), pp.381–410. Tom Wesson, 1999, “A Model of Assetseeking Foreign Direct Investment Driven by Demand Conditions,” Canadian Journal of Administrative Sciences, 16(1), pp. 1–10. 158 Shige Makino, Chung-Ming Lau and Rhy-Song Yeh, 2002, “Asset-exploitation versus Asset-seeking: Implications for Location Choice of Foreign Direct Investment from Newly Industrialized Economies,” Journal of International Business Studies, 33(3), pp. 403–421. 159 Flavia Carvalho, Ionara Costa, and Geert Duysters, 2010,“Global Players from Brazil: Drivers and Challenges in the Internationalization Process of Brazilian Firms,” UNU-Merit Working Paper No. 016, Maastricht. Michael A. Hitt, M. Tina Dacin, Edward Levitas, Jean-Luc Arregle and Anca Borza, 2000,“Partner Selection in Emerging and Developed Market Contexts: Resource-based and Organizational Learning Perspective,” Academy of Management Journal, 43(3), pp. 449-67.

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Barclays | China: Beyond the Miracle investing firms need to have a certain level of productivity, absorptive capacity and technology transfer skills, so that the entire company, rather than just foreign subsidiaries, can reap the benefits. 160 This implies that an MNC from a developing economy may be able to undertake ODI to build proprietary advantages subject to two conditions. 1) It has access to sufficient funding. 2) Its own capability to absorb more advanced “technology”. The first determines if a developing world MNC is able make ODI while the second determines whether or not it is likely to succeed.

Why Chinese companies invest overseas? So what are the motivations behind Chinese ODI? Here we summarise analyses by Bijun Wang and Yiping Huang, who examined two types of investment, that involving large projects and that by SMEs. 161 At the moment, ODI is dominated by large projects. But SME investment is also rising. Their findings can be summarised as follows. For large ODI projects, the key motivations are: resource-, market- and technology-seeking. In the manufacturing sector, technology-seeking is the most important investment motivation. In either case, efficiency-seeking (investing overseas to take advantage of cheap labor and other production inputs) is not the driving motivation. For ODI investment by SMEs, the most important purposes are to facilitate exports and to enhance their competitiveness.

The case of large investment projects In order to understand the motivations of Chinese ODI, we need to look at micro level data. In a recent study, Bijun Wang and Yiping Huang compiled a micro data set of ODI projects approved by the National Development and Reform Commission (NDRC). Filtering using several criteria generated 293 investment projects, involving total investment of US$99.43bn by 216 Chinese firms between 2003 and the first half of 2011. They supplemented data collected by the statistics bureau with other enterprise information. Wang and Huang applied this data set to determine the motivations of Chinese ODI through two steps. First, they went through all the investment application materials to identify the key motivations as suggested by the applicants. To some extent, this involves some interpretation and guessing of the applicants’ language. In order to

160

Roger Smeets and E.M. Bosker, 2011, “Leaders, Laggards and Technology Seeking Strategies,” Journal of Economic Behavior & Organization, 80(3), pp. 481-497. Bijun Wang and Yiping Huang, 2012, “Chinese outward direct investment: Investing overseas without moving factories abroad”, Paper presented at the ADB conference on Asian Development Issues, May 16, 2012, Manila. Also forthcoming in Asian Development Review. 161

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Barclays | China: Beyond the Miracle validate such identification, the authors tasked different analysts with repeating the exercise and they then consolidated the results. Second, the authors then applied a special statistical analysis (a probit model) to verify the investment motivations as identified in the first step. After the initial step, Wang and Huang concluded that of the close to 300 projects studied, resource-, market- and technology-seeking could be indentified as the main motivations in 41.3%, 29.7% and 26.6% of the cases, respectively (Figure 9). Their respective shares in terms of value of investment were slightly different but the overall ranking was the same. As a motivating factor, efficiency-seeking was almost insignificant. The manufacturing subset of the data reveal similar finding in terms of the efficiency-seeking motive. Here, however, technology-seeking motivation was very important, accounting for more than one-third of the number of projects and close to half of the investment value. FIGURE 9 Initial identification of Chinese ODI motivations Number

Share (%)

Value ($bn)

Share (%)

Overall ODI Market

87

29.7

28.2

28.4

Resource

121

41.3

51.0

51.3

Technology

78

26.6

20.0

20.1

Efficiency

7

2.4

0.2

0.2

Manufacturing ODI Market

49

27.2

6.9

22.2

Resource

61

33.9

9.9

31.6

Technology

63

35.0

14.2

45.5

Efficiency

7

3.9

0.2

0.7

Source: Wang and Huang (2012)

In order to conduct statistical tests to validate the motivations identified above, Wang and Huang then constructed the following independent variables: •

Gross domestic product (GDP), measured in US$;

•

GDP per capita (GDPP);

•

GDP growth rate (GDPG);

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Barclays | China: Beyond the Miracle •

Exports;

•

Share of ores and fuels in host country’s total exports, Xorefuel;

•

Host country’s share in China’s total imports of raw materials, Mrawm;

•

Revealed comparative advantage,

RCAc ,i ,t =

EX c ,i ,t ∑ c EX c,i,t

∑ EX ∑ ∑ EX

c ,i ,t

i

i

c

c ,i ,t

which was suggested by Balassa originally. 162 An index value less than 1 implies relative disadvantage, whereas a value greater than 1 indicates relative advantage. In this study we focus on RCA for high-tech industry, RCA_high; •

Changes in exchange rate from the previous year, exchange; and

•

GDP deflator, inflation.

In the empirical analyses, Wang and Huang applied the probit model. The dependent variable on the left hand side is a 0-1 variable (1 if market-seeking, for instance, and 0 otherwise). Therefore, the parameters estimated on the right hand side indicate the contribution of the explanatory variables to the probability. For instance, if the parameter is positive and statistical significant, then the relevant independent variable contributes positively to the ODI project being market-seeking in nature. In formulating the hypotheses for statistical tests, Wang and Huang made the following prior assumptions (Figure 10):

• For market-seeking motivation, GDP growth and size of GDP of the host countries

should be important positive determinants, while Chinese exports to the host countries should play a negative role. But the impact of the GDP growth rate is unclear;

• For technology-seeking motivation, host countries’ comparative advantages in high

tech industry and their general GDP per capita (which may be a proxy for economic development) should be key determinants; 162

Bela Balassa, 1965, “Trade Liberalization and Revealed Comparative Advantage,” Manchester School of Economic and Social Studies, 33(2), pp. 99–117. Balassa argued that the comparative advantage of a country’s industry could be revealed by the ratio of the share of an individual sector’s exports in total exports for a particular country to that share for the world.

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Barclays | China: Beyond the Miracle

• For resource-seeking motivation, important determinants include the host countries’ resource exports; and

• For efficiency-seeking motivation, they looked for a positive contribution from changes in the exchange rate (depreciation) and negative contribution from GDP per capita and inflation. FIGURE 10 Hypotheses Market

Technology

Resource

Efficiency

GDP(+)

RCA_high (+)

Xorefuel (+)

Exchange (+)

Explanatory

GDPG(+)

GDPP (+)

Mrawm (+)

Variables

Exports (-)

Important

Inflation (-) GDPP (-)

GDPP (?) Source: Barclays Research

Statistical analyses generally confirm the hypotheses proposed above (Figure 10). For market-seeking ODI for instance, both the size of GDP and its growth rate for host countries play significant positive roles, as expected. GDP per capita has a negative significant impact, suggesting that Chinese firms are more likely to seek market shares through ODI in less developed economies. And, interestingly, exports make a significant negative contribution. This implies that market-seeking ODI tends to focus on countries where Chinese exports are relatively small. FIGURE 11 Empirical tests of Chinese ODI motivations Market

Technology

Resource

Efficiency

LnGDP

0.418***

0.08

-0.235

-0.186

(3.98)

(0.53)

(1.47)

(0.53)

LnGDPP

-0.30***

1.02***

0.12

-0.35

(2.64)

(2.60)

(0.81)

(0.78)

GDPG

0.119***

-0.055

-0.141**

0.262

(3.22)

(1.16)

(2.51)

(1.44)

LnExport

-0.27***

0.042

-0.195

0.542

(2.66)

(0.27)

(1.22)

(1.6)

RCA_high

0.184

0.842*

-0.357

-2.364

(0.6)

(1.75)

(0.88)

(1)

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Barclays | China: Beyond the Miracle Market

Technology

Resource

Efficiency

Xorefuel

-0.666

-2.289**

1.304**

0.132

(1.38)

(2.22)

(2.32)

(0.11)

Mrawm

-7.548

-8.243

22.21***

-12.20

(1.58)

(1.43)

(3.87)

(0.24)

Inflation

-0.004

-0.103

0.085***

-0.118*

(0.18)

(1.51)

(2.84)

(1.87)

Exchange

2.164

-0.064

-1.027

1.139

(1.36)

(0.04)

(0.56)

(0.15)

Observations

289

289

289

289

Pseudo R-squared 0.33

0.52

0.63

0.54

Note: All regressions include yearly and industry dummies. The numbers in the parentheses are absolute value of z statistics; and ***, ** and * indicate that the coefficient is significant at the 1, 5 and 10-percent levels, respectively. Source: Wang and Huang (2012)

The case of SMEs from Zhejiang province The above study is based on large investment projects, which are probably the main form of Chinese ODI. In order to examine the case of the SMEs, Wang and Huang looked at a set of firm-level ODI data from 2006 to 2008 for Zhejiang province. ODI from Zhejiang is probably representative of the investing behavior by China’s private sector. Approximately 70% of Chinese private firms undertaking ODI are from Zhejiang and Fujian provinces. From 2006 to 2008, 1,270 ODI investment projects took place, involving a total investment of US$1.75bn. The average investment for each project was a modest US$1.4mn. In comparison, the average value of the large investment projects was US$339mn. The majority of investments (77.32%) overseas are intended to facilitate Chinese exports to foreign markets through setting up trading or trading-related affiliates. Wang and Huang labelled this type of investment “Trade” (Figure 12). The other important type, labelled “Production”, involves activities in the form of manufacturing or processing trade. Forms of investment other than “Trade” and “Production”, such as resource exploration and R&D, do not have large shares.

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Barclays | China: Beyond the Miracle FIGURE 12 Forms of ODI from Zhejiang province Number

Share (%)

Amount (USD mn)

Share (%)

Trade

982

77.3

557.1

31.9

Production

159

12.5

696.3

39.8

Construction

36

2.8

115.4

6.6

Resource

32

2.5

158.8

9.1

R&D

25

2.0

62.5

3.6

Industrial park

7

0.6

44.5

2.6

Other

29

2.3

113.2

6.5

Source: Wang and Huang (2012)

Thus, unlike the resource- or technology-seeking which motivates Chinese large investors to go abroad, market-seeking and efficiency-seeking reflect the country’s SMEs’ appeal. The “Trade” form of ODI aims at securing or defending market position. To some extent, it pertains to market-seeking ODI. But Trade-facilitating ODI is different from the normal type of market-seeking ODI in the sense that the production activities are still retained in China, and the foreign markets are still served through exports. The role of ODI here is to facilitate such exports. We call such type of ODI “Trade-facilitating ODI”. In contrast, the “Production” form of ODI embodies both a market-seeking intent (but moving production facilities abroad) and an efficiency-seeking motive (investing and producing in low-cost economies). The sum of market-seeking (“Trade” and part of “Production”) and efficiency-seeking (part of “Production”) accounts for 90% of SMEs’ ODI in number terms and 72% in dollar terms, while technology seeking (“R&D”) and resource seeking absorb only a small share.

A special case – financial institution ODI One area of ODI that receives increasing global attention is investment by Chinese financial institutions abroad. It started with the China Investment Corporation (CIC), which was launched in 2007 and made quick investments in overseas financial institutions such as Morgan Stanley ($3.5bn for a 9.9% stake) and Blackstone Group ($3bn). More recent transactions include ICBC’s takeover of the US arm of Standard Chartered Bank and Citic Securities proposed acquisition of CLSA Asia-Pacific Markets. By the end of 2011, cumulative FDI into the Chinese financial sector had reached $68.4bn, while cumulative ODI by Chinese financial institutions was $52.7bn. Most of the financial ODI, however, remains controversial, as discussed below. March 2013

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Barclays | China: Beyond the Miracle Investment by CIC and that by ICBC and Citic Securities is somewhat different. CIC was established to better utilise China’s large foreign exchange reserves and achieve greater returns. Therefore, CIC’s stakes in both Morgan Stanley and Blackstone Group have a clear objective of investment returns. However, CIC entered the market at a difficult time, during the early stage of the global financial crisis, and suffered immediate financial losses. But since CIC takes a long-term view on most of its investment, it is too early to be conclusive about its investment performance. In contrast, ICBC and Citic Securities have strong interests to expand their global franchises, so short-term investment returns might also not be a priority. ICBC and Citic Securities’ moves were also probably in line with the government’s “going out” policy. The global financial crisis left most of the Chinese state-owned banks among the top financial institutions, in terms of assets, in the world since they were less damaged by the crisis. Many of them were also hugely profitable, due partly to domestic monopolies and interest rate regulation. This, along with massive cash flows and government support, has fuelled ambitions among them to go global. However, international experience suggests that taking over foreign financial institutions can be much easier than running them successfully. Many Chinese financial institutions still face serious challenges domestically, in terms of risk controls and corporate governance. It is conceivable that many of them will encounter significant difficulties if they purchase foreign financial institutions. Such difficulties could reflect a lack of proper banking business experience, or perhaps insufficient knowledge about international markets. An antithetical foreign environment might also be a factor: for instance, the potentially hostile environment (i.e. protests by ethnic groups) involving Standard Chartered Bank during ICBC’s takeover. We think financial ODI will remain a major trend for some time, and will probably continue to be dominated by the state-owned institutions. However, we are cautious about the possible results, as it takes considerable time to learn to run financial institutions in foreign countries. In the meantime, relatively more “passive” investment, such as CIC’s, could in time prove to be the better option, as CIC does not directly manage the institutions in which it takes a stake, but can recruit fund managers with international experience relatively easily.

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American, Japanese and Chinese models of ODI China started ODI at a relatively early stage of its economic development. For instance, Japan’s ODI started to rise rapidly from 1986 when its GDP per capita was about $16,000. China’s ODI rose quickly from 2004 when GDP per capita was only around $1,500. One common factor shared by Japan from 1986 and China after 2004 was an acceleration of currency appreciation, which increases companies’ overseas purchasing power. Still, it is unusual for a (non oil exporting) developing economy to become a major outward direct investor (Figure 4). Although companies in Japan, Korea and Brazil undertook ODI during the early stages of their economic development, we feel their investment volumes and global significance never reached the status of Chinese ODI today. There are probably many reasons for China having started ODI much earlier in its economic development. We believe the central reason is related to China’s repressive financial policies and associated large foreign exchange reserves. Most developing economies do not undertake ODI because they generally face a shortage of capital. China does not. Following the Asian financial crisis, China accumulated a large amount of foreign exchange reserves. In particular, in recent years the concern has been that SAFE has accumulated too much in terms of official reserves. Low investment returns on these reserves have also led the government to encourage ODI. Finally, relatively cheap valuations of corporate assets overseas after the global financial crisis have further boosted Chinese ODI.

Exploiting competitive advantages Another unique feature of Chinese ODI is “investing overseas but without moving the factories abroad”. Direct investment differs from portfolio investment in the sense that investors take an equity stake in overseas operations and participate in the management of the companies. In many cases, this involves migration of production facilities from home country to host country. Chinese ODI, generally, does not lead to migration of production facilities. The key difference is this: traditionally companies undertake ODI to exploit competitive advantages in host countries, while Chinese companies often undertake ODI to develop competitive advantages at home. Japanese economist Kiyoshi Kojima identified two models for traditional ODI: the American model and the Japanese model. 163 We think this classification is too simplistic. Real-world investment is much more complicated. Nevertheless, the classification is useful for understanding the key features and distinctions of ODI. 163

Kiyoshi Kojima, 1978, Direct Foreign Investment: A Japanese Model of Multination Business Operations, London: Groon Helm.

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Barclays | China: Beyond the Miracle The American model of ODI is driven by a market-seeking motivation. It aims at developing or defending a market position in the host country by overcoming entry barriers. Such barriers could be, for example, transportation costs, which are reduced by moving factories to host countries. The barriers might be tariff or non-tariff restrictions on imported products, such as discrimination against foreign products. 164 Key indicators of the market-seeking motivation in ODI decisions include the importance of market size and affluence of host countries. Economic studies have found positive impacts of GDP and GDP per capita on the location choices of American MNCs but limited roles for other factors, such as cost of labour and raw materials. 165 The Japanese model of ODI is mainly driven by low costs of labour and other production factors in host countries. The post-war reconstruction in Japan was initially accompanied by the rapid development of labour-intensive industries. However, as labour costs began to rise after the so-called Lewis turning point in early 1960s (when the labour market turned from surplus to shortage), Japanese firms moved those industries to Singapore, Taiwan, South Korea and other Asian countries with lower labour costs. In sum, the Japanese economy was forced to move up the industrial ladder. This implies that Japanese ODI was a response to domestic industries losing competitiveness. Kojima called those industries “marginal industry” and proposed the “marginal industry expansion theory” (Kojima 1978). Market-seeking American ODI and efficiency-seeking Japanese ODI differ in a number of ways. Under the Japanese model, those marginally efficient firms that are losing competitiveness and must exit from the home country undertake ODI to survive or improve their competitiveness in host countries. In contrast, for the US it was the leading firms that took the lead in moving overseas. US manufacturing ODI firms mostly focused on highly sophisticated, technology-based products for local markets. In addition, American ODI mainly targets local markets while Japanese ODI is mainly for exports from the host economies. 166 The American and Japanese models of ODI have not remained stable. In fact, in recent years, ODI from Japan has begun to look a lot more like ODI from the US – ie, investors aim at establishing a local market position rather than simply low local production costs in host countries. Interestingly, ODI from many other Asian economies seems to follow the 164

Peter J. Buckley and Mark Casson, 1976, The Future of the Multinational Enterprise, Macmillan: London. See, for instance, Irving B. Kravis and Robert E. Lipsey, 1982, “The location of overseas production and production for export by U.S. multinational firms,” Journal of International Economics, 12(3-4), pp. 201-223. 166 E. Ramstetter, 1991, “Regional Patterns of Japanese Multinational Activity in Japan and Asia’s Developing Countries,” Empirical Studies in Regional and International Economics, The Institute of Economic and Political Studies, Kansai University. 165

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Barclays | China: Beyond the Miracle Japanese model. The share of developing countries in Japanese ODI stock decreased from 55% in 1979, to 34% in 1989, and to 31% by 1996. High-cost developed economies have become more important investment destinations for Japanese ODI in recent decades.

Developing competitive advantages Like ODI from other countries, patterns in ODI from China are also complicated. For instance, the behaviour of SME ODI is like the Japanese model. However, the majority of Chinese ODI is still dominated by large SOEs, which takes three main forms: •

Resource acquisition

•

Advanced manufacturing

•

Trade facilitation.

Clearly, the purpose of Chinese investment is to develop the competitive advantages of domestic industries. This is very different from traditional ODI, which exploits competitive advantages. There are probably three reasons why Chinese ODI aims at strengthening domestic production rather than expanding overseas production. First, the cost level is still more competitive in China than in most other countries. And even when cost pressures rise, such as is happening now in the coastal regions, producers still have the option of moving their factories inland where costs are lower. There is indeed a significant divergence in terms of production costs across the country, as can be illustrated by comparing GDP per capita in Shanghai and Guangdong with those in Guizhou and Yunnan, for instance. There are some countries with much lower cost levels, such as Cambodia and Laos. But they will probably not be the first choice, at least initially, for Chinese investors given differences in culture, tax, politics and infrastructure. Second, overall China still does not have clear competitive advantages globally. Therefore, it needs to invest in order to develop such advantages, by securing stable resource supply, expanding overseas markets by trade facilitation and buying advanced technology/ management and brand names. True, China is a global manufacturing centre. But more than half of the “Made in China” products rely on foreign technology and components. As a result, China’s manufacturers enjoy only slim profit margins, as most of the profits accrue to foreign MNCs for their provision of technology, design and other services. This highlights the relatively ‘passive’ role of Chinese firms and is an obstacle to their ability to engage in core technology work and R&D. Third, an exceptionally large and heavy secondary industry sector in China requires a considerable and secure supply of resources and raw materials. The share of industry March 2013

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Barclays | China: Beyond the Miracle value-added in the country’s GDP averaged 46.5% between 2000 and 2010. In 2009, industry constituted 46.2% of China’s GDP, compared with 20.0% in the US, 26.7% in Japan and a world average of 25.4%.

Case study: Geely-Volvo acquisition On 2 August, 2010, Zhejiang-based Chinese automaker Geely announced it had closed the deal with Ford to purchase a 100% equity stake in its Volvo Car unit for $1.8bn. Geely attracted worldwide attention during every step of this process (Figure 13). The acquirer was an unknown, low-quality, low-price automobile player from China, while the acquisition target, Volvo was a much larger and well-known luxury car producer based in Sweden. Many viewed the deal, which was then biggest acquisition of a foreign auto maker by a Chinese company, as the beginning of a new era of Chinese enterprises becoming significant players in the world market. FIGURE 13 Milestones of the Geely-Volvo deal Time

Milestones

Dec 2008

Ford announced its intention to sell the Volvo Cars unit for $6billion.

Mar 2009

Geely senior management visited Volvo Cars’ headquarter Gothenburg to discuss the acquisition.

Sep 2009

Geely said its parent company wanted to bid for Volvo.

Oct 2009

Geely named as the preferred buyer of Volvo Cars by Ford.

Dec 2009

All substantive commercial terms were finalised for the sale of Volvo Cars from Ford to Geely, after a long and difficult negotiation process.

Mar 2010

Definitive agreement was signed; the sale figure was about $1.8bn.

Aug 2010

The deal was completed after approval from relevant authorities.

Source: China Daily, other media reports

Though the real challenges were still ahead for Geely, in the areas of integrating product segments, brands and technology, and adjusting where necessary its corporate culture, the deal was one of the largest acquisitions by a Chinese enterprise. Looking back, specific industrial (the 2008-09 financial crisis) and individual factors (Geely Chairman Li Shufu’s ambition) certainly contributed to Geely’s successful purchase of Volvo. More importantly and interestingly, however, we believe the motivations behind Geely’s acquisition are shared by many other Chinese corporates, which are also keen to raise their global profiles.

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Barclays | China: Beyond the Miracle •

Access to Volvo’s advanced technology

Volvo used some of the most advanced technologies in the automobile industry, and is well known for its “safe” and “environmentally friendly” designs. Access to these leading technologies should help Geely towards its goal of strategic transformation in moving from a low-end automaker to a high-profile auto giant in China. •

Enhanced Geely brand and domestic market presence

Volvo’s well-established and systematic marketing platform helped to build its brand image as a high-end car offering a high-quality lifestyle. Geely can learn a great deal from this style of marketing and help it compete with other homegrown brands. •

“Go global”

However, acquiring advanced technology and branding skills are not the only synergies available. Chairman Li Shufu pointed out that Geely had wanted to “go global” since it was established, and viewed the purchase of Volvo as a great opportunity to this tend. The acquisition was seen as combining Geeley’s low-cost advantages with Volvo's strong brand for safety and reliability. In time, this could also dispel quality concerns about Geely among foreign consumers unfamiliar with the Chinese automaker. It is worth noting that throughout the acquisition Geely received significant support from the government, including final approval by the authorities. A large portion of the funding was borrowed from financial institutions, which would not have been possible without the government’s blessing. Support from the government plays a key role in Chinese firms’ outward foreign investment, given the regulatory environment in China. That said, as a “privately” owned enterprise, Geely likely faced fewer potential obstacles from foreign governments.

Outlooks, challenges and policies How will Chinese ODI evolve in the coming years? Obviously it is difficult to make firm predictions for some unique developments. But by elaborating on our expectations, we can at least suggest some key factors that may influence the future trajectory of ODI. With an already relatively high level of ODI, large foreign exchange reserves, and the likely continuation of rapid economic growth, China’s ODI is likely to expand steadily. If Chinese ODI continues to rise by 50% a year, it would soon reach extremely high levels. If predictions by HKMA economists turn out to be accurate, Chinese ODI would account

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Barclays | China: Beyond the Miracle for one-third of the world total in the coming decade. 167 This reminds us of previous fears that Japan was going to buy up the world in 1980s, when Japanese ODI was expanding rapidly into the US and many other markets. •

•

•

•

•

•

However, it is usually not good practice to make predictions by linear extrapolation of the most recent experience. A number of factors may impact the future growth of Chinese ODI. For instance: Very large foreign exchange reserves should make it easier for Chinese companies to obtain foreign exchange when they make investments overseas. This is particularly so as reserve management becomes increasingly challenging. Capital account liberalisation and exchange rate policy reform imply fewer restrictions on capital outflows but also less accumulation of foreign exchange reserves and more private sector holding of foreign assets. Continued appreciation of the renminbi generally promotes ODI as it increases Chinese companies’ overseas purchasing power. This happened in Japan following implementation of the Plaza Accord. As the economy develops, China will become even better positioned to undertake ODI due to accumulation of capital stock, build-up of competitive advantages and increases in domestic production costs. If financial liberalisation leads to an easing in the financial repression environment and reduction in external surpluses, this might contribute negatively to Chinese ODI, at least in the short term.

We think it is possible for ODI flows to continue modestly in the coming decade, perhaps averaging $100bn a year before 2020. This would still be an extraordinary level among developing countries, but nevertheless would be consistent with broad international experience at a similar stage of economic development (given current FDI inflows are around $120bn a year). The bottom line is that, while Chinese ODI should grow over time, China is not likely to buy up significant portions of the world’s assets. Indeed, we should not be overly optimistic about Chinese ODI in the short term as it has not reached the stage of economic development that would normally kick-start a period of rapid ODI expansion. If ODI grows too rapidly, especially if it is dominated by the SOEs, there would be concerns about potential investment mistakes.

167

Dong He, Lillian Cheung, Wenlang Zhang and Tommy Wu, 2012, “How Would Capital Account Liberalisation Affect China’s capital Flows and the Renminbi Real Exchange Rates?” Hong Kong Institute For Monetary Research (HKIMR) Working Paper No. 09/2012.

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Barclays | China: Beyond the Miracle We see the pattern of Chinese ODI likely evolving in the coming decade as follows: •

•

•

SOEs are likely to continue to dominate investment in resources and finance, as these projects tend to require large amounts of funding and most private sector companies are still relatively small; Investment in infrastructure may become significantly more important. In the past, Chinese ODI in infrastructure was concentrated in developing countries but efforts are now being stepped up in the developed world; Private sector manufacturing SMEs may form a major wave of ODI outflows in the coming decade as rising costs push many Chinese labour-intensive producers to lower-cost destinations.

These thoughts are based on our view that, while current Chinese ODI can be considered a unique phenomenon, it is likely to converge toward the more conventional patterns over time, as the economy develops and distortion policies disappear. We propose a life cycle thesis of ODI, which may be viewed as an extension of Dunning’s IDP. As an economy becomes a direct investor during its development, its ODI shifts from the Chinese style to the Japanese style and, finally, to the American style. The most important determinants of the evolution of this life cycle seem to be cost and technology. But the distinctions between the different styles of ODI are relative. More than one style ODI can be observed in a real economy at any one time. However, if the life cycle thesis holds, then our prediction is that we may see increasing Japanese-style ODI from China in the coming years: ie, large numbers of small and medium-sized labour-intensive manufacturers move to lower-cost countries. Thus, while Chinese ODI now captures the world’s attention, in the coming decade private sector investment overseas, especially in the manufacturing sector, may become the major trend, mirroring the earlier Japanese ODI model of taking advantage of low production costs in host countries. To some extent, the Chinese economy, particularly its coastal regions, is at a similar stage of economic development as Korea and Japan were in the early 1980s when their labour-intensive manufacturing migrated to the Pearl River Delta after China started economic reform. During the same speech at Peking University mentioned above, Yi Gang made some key recommendations for China’s ODI policy and regulation. These include: •

ODI decisions should be based entirely on market conditions;

•

Ownership should be clearly defined to ensure accountability;

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Barclays | China: Beyond the Miracle • • •

•

ODI projects should be able to generate cash flows needed to cover the costs, especially funding costs; Appropriate exit mechanisms are critical for guaranteeing the safety of funds and returns; Chinese investment overseas should also include consideration for social responsibility, environmental protection, non-profit charity efforts, enterprise image and training; Project safety considerations should also be a top priority, taking into account investment risks related to geopolitics, political coups, and terrorist attacks.

In any case, development of Chinese ODI will not likely be smooth, especially as the country is now a major player on the global stage. Chinese exports experienced dramatic expansion during the reform period, but now there are frequent business conflicts with key trading partners. Even Japanese investment experienced resistance in some parts of the world in the 1980s and 1990s. The near-term challenges faced by Chinese ODI are likely to be much greater due to the state ownership of many Chinese investors and their close ties with the government, and lack of experience operating businesses in foreign countries. The sensitivity around investment proposals by CNOOC and Chinalco was related to their state ownership status, and the difficulties for Huawei were often related to the company chairman’s perceived close ties with the government. We believe much of the concern among host countries’ about Chinese SOEs is overdone. Although still majority state-owned, most Chinese SOEs today are listed companies with modern corporate governance structures and a need to focus on financial performance in order to survive. In that sense, they may not be different from non-state enterprises. In addition, sometimes foreign governments worry that Chinese SOEs might pose problems for national security, including resource security. Such problems are unlikely. After all, the investing companies register and operate in the host countries and, therefore, should be subject to local regulations and laws. That said, it might be in China’s own interest to limit the roles of SOEs in ODI for several reasons: •

Despite the reforms implemented during the past two decades, Chinese SOEs have not completely solved the “soft budget” and “accountability” problems. SOE

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Barclays | China: Beyond the Miracle managers may decide to undertake ODI to expand in overseas markets, without serious considerations of the financial implications. 168 •

•

•

In China’s heavily repressed financial system, the costs of capital for SOEs are probably lower than otherwise would be the case. This could mean that many SOEs are effectively subsidised when making overseas investment, and providing grounds for the complaints about unfair competition in host countries. In fact, this situation is also unfair to domestic non-state companies, For the same reason that SOEs would not necessarily hurt national security in host countries, SOEs’ investment is likely to increase China’s resource security. If an investment is good, then it should also deliver good investment returns. But that does not necessarily mean China would be able to access cheap and stable supplies of resources, even if such resources are owned by Chinese SOEs. Heavy involvement of SOEs in ODI can create unwanted issues in host countries. Indeed it is very difficult to convince foreign officials that SOEs are purely commercially-driven when their managers are appointed by the Chinese Communist Party and their behaviour in domestic markets often suggests the opposite.

The ultimate policy goal should be to create a level playing field for everybody, regardless of ownership. But since SOEs already enjoy a wide range of favourable policy considerations, it would be better for the government to provide more support for investment by privately-owned companies. ODI projects normally need approval from three government departments: the National Development and Reform Commission (NDRC), the Ministry of Commerce and SAFE. According to the capital account management framework, ODI is still strictly regulated. But this is an area where the government could take quick actions in the direction of capital account liberalisation. FDI and ODI flows are associated with reduced short-term volatility and financial risk. The authorities could simply change the approval requirements for the registration process. However, facilitating private sector ODI will not be easy as firms would need to learn to operate in foreign countries, where the legal, business and social environments are very different from China. There have been examples of Chinese investors not knowing how to deal with industrial relations issues, especially with regard to the labour unions of the acquired companies. Most Chinese companies are also not used to managing public 168 There were media reports when some SOEs set up subsidiaries in foreign countries simply because children of top managers of those companies went to those countries to study. So the purpose was for company staff to look after these children and for the managers to find excuses to visit these countries. http://blog.ifeng.com/article/22477623.html

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Barclays | China: Beyond the Miracle relations. Some companies staffed overseas operations exclusively with workers from China (ie, infrastructure projects in Africa), so not generate jobs in the host economies. In June 2012, the NDRC and seven other government departments jointly issued an 18article policy to encourage and support privately owned enterprises in undertaking ODI. These 18 articles cover a wide range of policy areas, including • • • • •

Strengthening guidance and coordination of private sector ODI, and improving enterprises’ independent decision-making; Implementing fiscal and tax policy support for the private sector ODI, and improving service levels for both financial insurance and customs; Simplifying the ODI regulatory framework and improving foreign exchange management; Improving services for ODI projects through bilateral agreements on investment protection and strengthening information and intermediary services; and Improving the management of externally-invested companies and strengthening the safety of Chinese employees overseas and protection of their assets.

However, like most policies in China, whether or not these will ultimately prove effective depends critically on implementation.

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Barclays | China: Beyond the Miracle

CHAPTER 8

Can China manage its fiscal risks?

• China’s fiscal system is sound if looked at on the basis of the government’s balanced budget and relatively low public debt burden. However, the fiscal outlook is more challenging if all contingent liabilities are taken into account.

• The current decentralised fiscal system, which was established in 1994, faces a significant mismatch between revenues and expenditures at the local level. Local governments often have to resort to fee collections, land sales and direct borrowing to meet their spending needs.

• Local governments also lack an accountable fiscal system with hard budget constraints. Standing at an estimated 25% of GDP, we think local governments’ liabilities, if left unchecked, could grow rapidly, posing significant fiscal and financial risks in the medium term.

• In the long run, we think the pension system poses the greatest threat to fiscal sustainability in China. There is already a large funding gap, estimated to be as large as 35% of 2011 GDP, and the population will age rapidly in the coming years.

• China’s government liabilities are already very high. We estimate total liabilities

at 62-97% of GDP, depending on assumptions of pension gaps. Moreover, some current favourable conditions for debt sustainability are likely to change as growth slows, capital account becomes more open and financing costs rise.

• Although we think the probability of a debt crisis in China is low, the risk is real, especially if the contingent liabilities of local governments and the financial system, as well as the pension gap, continue to grow.

• The key to averting the risk of a debt crisis is further economic reforms,

including financial reform, state-owned enterprise (SOE) reform, fiscal and pension reform. Contingent liabilities need to be effectively controlled and managed. Local government soft budget constraints and the ensuing overspend and overborrow need to be addressed.

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• Policies addressing these risks imply more social welfare spending and less fixed asset investment. These are also likely to lead to slower growth. At the same time, we think such reforms, combined with rising wages and improving income distribution, would further promote consumption.

• Such policies could also lead to higher funding costs and increased income

redistribution from the corporate to the household sector. This would squeeze profits further, increase financial risks and promote consolidation in heavy and highly leveraged industries.

This article was originally published on 28 January 2013.

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Mixed picture for China’s fiscal outlook China’s fiscal position is generally perceived as sound. The central government’s budget deficit has been around 1-2% for most of the reform period (Figure 1). The public debt/GDP ratio has stayed under 20%, which is well below the OECD’s warning line of 60% (Figure 2). Such favourable fiscal conditions are the result of China’s strong economic growth, a series of reforms that broadened the tax base and improved tax collection, and a stable macro and policy environment. The establishment of a new tax sharing system in 1994 was a turning point in China’s recent history of public finance. A main objective of that reform was to increase two ratios – 1) fiscal revenue to GDP; and 2) central government revenue to total revenue. It is probably fair to argue that the 1994 tax reform laid the foundations for the gradual increases seen in government revenue during the past two decades. The Chinese government debt situation also looks favourable. Like Japan, China’s public debt is mainly owned domestically – ie, by Chinese institutions and individuals (Figure 3). This usually means that a government can enjoy relatively low borrowing costs and is less vulnerable to changing global liquidity conditions. For China, these benefits are supported by continued financial repression, large domestic savings and a relatively closed capital account (Figure 4). Meanwhile, China’s external debt is relatively small, at around 10% of GDP (2011: 9.5%). Therefore, even a sudden reversal of capital inflows and/or sharp depreciation of the CNY (if China further opens up its capital account) would be unlikely to lead to a surge in debt payments and the kind of balance of payment crisis suffered by many emerging market economies. China’s USD3.3trn foreign exchange reserves also provide a buffer on this front. FIGURE 1 The government deficit has been about 1-2% of GDP % y/y

Surplus (RHS)

70

Govt revenue

FIGURE 2 Public debt as % GDP has remained low

% GDP

50

6.0

45

Public debt (% GDP) Public debt issued (% fiscal expense)

40

Govt expense 50

4.0

30

2.0

10

0.0

-10

-2.0

-30

-4.0

-50

-6.0

35 30 25 20 15 10

1954

1962

1970

1978

1986

Source: CEIC, Barclays Research

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1994

2002

2010

5 0 1987

1991

1995

1999

2003

2007

2011

Source: CEIC, Barclays Research

242

Barclays | China: Beyond the Miracle FIGURE 3 Government debt largely domestically owned

FIGURE 4 Government has enjoyed very low borrowing costs

100%

30

80%

25

60%

20

40%

15

NGDP growth (% y/y) 5y government bond yield (% pa)

20%

10

0% Dec-08

Dec-09

Dec-10

Special member Non-bank financials

Source: CEIC, Barclays Research

Dec-11 Commercial bank Others

Dec-12

5 0 Jun-05

Dec-06

Jun-08

Dec-09

Jun-11

Dec-12

Source: CEIC, Barclays Research

But China also faces some important fiscal risks, especially if contingent liabilities are taken into account. The public debt/GDP ratio, which currently stands at close to 16%, significantly underestimates the government’s potential liabilities. For instance, debts issued by local governments, the Ministry of Railway (MoR) and state-owned policy banks, as well as asset-management companies (AMCs) that hold nonperforming loans from state-owned commercial banks, and the financial system can be all said to represent potential liabilities on the central government’s balance sheet. The Chinese government is also under significant spending pressure to improve social welfare provision, such as healthcare, education and the pension system, which already faces a financing gap. Factoring in all of these areas, we estimate Chinese total government liabilities at 62-97% of GDP, depending on assumptions for the pension gap. In this report, we address the question of fiscal sustainability in China. A critical part of such an effort is to assess the government’s contingent and implicit liabilities. To do so, we apply the fiscal risk matrix framework developed by Polackova (1998) 169 , who distinguished between direct or indirect (contingent) and explicit or implicit government liabilities (Figure 5). Direct liabilities are predictable obligations of a government that will arise irrespective of the state of the world, whereas contingent liabilities are government obligations only if a particular event occurs. Explicit liabilities are defined by law or contract, whereas implicit liabilities represent a moral obligation based on public expectations or political pressures.

169 Polackova, Hana, 1998. "Contingent government liabilities: a hidden risk for fiscal stability, Policy Research Working Paper Series 1989, The World Bank.

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Barclays | China: Beyond the Miracle FIGURE 5 A framework to evaluate a country’s fiscal risks Direct (obligation in any event)

• Explicit (Government • liability created by a law or contract)

Sovereign debt Expenditures legally binding in the long term (i.e. civil servants salaries and pension

Contingent (obligation if a particular event occurs)

• State guarantees for non-sovereign borrowing, including local governments, SOEs, policy banks, and other public sector etc

• Umbrella state guarantees for various types of loans

• Trade and exchange rate guarantees issued by the state

• Other state guarantees issued to private investors and service providers

• State guarantees on private investments

Implicit (A “political” obligation of government that reflects public and interest group pressures)

• Future public pension • Default of a sub-national government or public/private entity • Social security schemes (not legally • • •

binding)

Future health care financing (not legally binding) Future recurrent costs of public investment projects

on non-guaranteed debt/obligations

• Cleanup of liabilities of entities being privatised

• Banking failure beyond state guarantee

• Failure of a non-guaranteed

pensions fund, employment fund, or social security fund

• Possibly negative net worth and/or default of central bank on its obligations

• Environmental recovery, disaster relief, military financing

Source: Modified based on Polackova (1998)

Applying this framework to China, we judge that the biggest explicit contingent risks are liabilities related to borrowings by the MoR and policy banks, and NPLs from the AMCs. The biggest direct implicit risks are pension liabilities amid an aging population. The biggest implicit contingent liabilities come from local government debt and risks associated with the Chinese financial system (Figure 6). Our basic findings are as follows. 1) The government’s overall balance sheet is healthy, even when all current contingent liabilities are taken into account. This is because we March 2013

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Barclays | China: Beyond the Miracle estimate that at this time, the state’s total assets still far exceed its liabilities. 2) This picture is likely to evolve over time. It would be difficult for fiscal revenue to grow faster than GDP on a sustained basis. The value of state-owned assets may also be volatile. 3) Local governments’ soft budget constraints pose the greatest threat to the overall health of the fiscal system. Borrowing by local governments could balloon at any time, given their strong desire and need to spend on economic activities and social welfare. 4) In addition to potential liabilities from the financial system, the funding gap of the pension system probably imposes the greatest potential burden on the government’s balance sheet. 5) We think China can avoid a debt crisis or a growth stagnation scenario, triggered by heavy debt burdens, only if it moves quickly to introduce a range of fiscal reforms in the coming years. FIGURE 6 China: Major fiscal risk matrix Direct Explicit

• Central government outstanding liability

• Expenditure legally binding, eg civil servant salaries and pensions

Implicit

• Future public pension liabilities

Contingent

• Policy bank liabilities • MoR liabilities • NPL liabilities (from the AMCs) • Local government liabilities • Financial system liabilities

Source: Barclays Research

Fiscal decentralisation, Chinese style Before evaluating the fiscal risks, we take a step back to first understand China’s fiscal system and the institutions. The current system was established after the 1994 fiscal reform. The main purpose of the reforms was to avert a crisis, as fiscal revenue had dropped from 32% of GDP in 1978 to close to 10% in 1993. The central government’s share of total fiscal revenue had also declined from above 40% to 22% during the same period. Thereafter, the government initiated a round of tax reforms to reverse these trends and made the fiscal system more sustainable. China’s fiscal system is decentralised through five levels of government: national (central); provincial; prefectural (municipal); counties; and townships (Figure 7). The 1994 tax reform redefined the revenue and expenditure allocation between the central government and local governments. The national government re-centralised the revenue collection process, divided taxes into central government taxes, local March 2013

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Barclays | China: Beyond the Miracle

FIGURE 7 China: Structure of the government Central

Provincial (33)

Prefectural (333)

County level (2010)

Township

Central Government

22 provinces and 5 autonomous regions

4 large metropolitan areas

2 special districts (Hong Kong, Macao)

333 prefectures and municipalities

2010 counties, autonomous counties and cities

Thousands of towns and villages

Source: China Statistical Yearbook 2006, Barclays Research

government taxes, and central-local shared taxes, and established a central-to-local fiscal transfer system. The main tasks of the 1994 reforms included: 1) unifying and streamlining the tax system and introducing a law-based tax collection system to replace one based on administrative discretion and bargaining; 2) simplifying the tax system; 3) raising the “two ratios” – fiscal revenue to GDP and central government revenue to total fiscal revenue; and 4) enabling more reasonable sharing of tax revenues among the different levels of government. One critical change is the division of taxes into three categories: national taxes, which are paid directly to the central government; joint taxes, which are shared by the central and local governments; and local taxes, which are paid directly to local governments. The old taxation bureau was divided into two, accordingly, with one central taxation bureau in charge of collecting state taxes and shared taxes, and a local taxation bureau for local taxes. Such a tax-sharing system can be illustrated by looking at a breakdown of government revenue. Figure 8 lists all the tax revenues that are collected and provides our estimates of revenue shares between central and local governments for each tax category. In 2011, tax revenue accounts for 95% of the central government’s funding and 78% of local governments’ direct revenue. The largest revenue source for the nation as a whole is value-added tax (VAT; shared, 75% to the centre), enterprise income tax (shared, 60% to the centre), and business taxes (shared, 99% to local). The top three national March 2013

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Barclays | China: Beyond the Miracle taxes in terms of revenue are consumption and VAT on imports, the consumption tax, and custom duties, while the top three local taxes are stamp duty, land appreciation tax, and land use tax. FIGURE 8 An illustration of the current tax sharing system Government revenue breakdown, 2011 Central government

Local government

Total

% of CNY share of central bn central revenue

% of CNY share of local CNY bn local revenue bn

%

Tax revenue

4863

54

95

4111

46

78

8974

86

Non-tax revenue

270

19

5

1144

81

22

1414

14

Value-added tax

1828

75

36

599

25

11

2427

23

17

1

0

1350

99

26

1368

13

Enterprise Income tax

1002

60

20

675

40

13

1677

16

Individual Income

363

60

7

242

40

5

605

6

City Maintenance and Construction

17

6

0

261

94

5

278

3

Stamp Duty

43

41

1

62

59

1

104

1

43

97

1

44

0

Business tax

1

3

0

Stamp duty: purchase/sales contract

277

100

5

Land Appreciation tax

206

100

4

Urban and Township Land use tax

122

100

2

Property tax

110

100

2

Farmland Occupation tax

108

100

2

Resource tax

60

100

1

Vehicle and Vessel Usage tax

30

100

1

Tobacco tax

9

100

0

Others

0

100

0

Stamp Duty: Security

Consumption and Value added tax of Imported Product

1356

100

26

Consumption tax

694

100

14

Vehicle purchase tax

204

100

4

Custom Duty

256

100

5

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Barclays | China: Beyond the Miracle Government revenue breakdown, 2011 Central government % of CNY share of central bn central revenue Vehicle and Vessel Usage tax

3

100

0

-920

100

-18

Other

0

100

Sum

5133

Refund of Tax for Export

Local government

Total

% of CNY share of local CNY bn local revenue bn

%

0 100

5255

100

10387 100

Source: MoF, Barclays Research

The 1994 taxation reforms, however, made little progress in clarifying expenditure responsibilities, especially at the sub-provincial level. Moreover, the national government only represents about 20-30% of total government expenditure (Figure 9). The remaining 70-80% of expenditure is spent through the four sub-national levels of government, with the majority taking place at the prefecture/municipal and county levels. FIGURE 9 Top 10 government spending categories, central vs local Central Govt Spending

Total

2011

Local Govt Spending

2011

CNY % bn share

CNY % bn share

1651 100.0 Total

9,273 100.0

National Defense

583

35.3 Education

1,550 16.7

Science and Technology

194

11.8 Social Security and Employment

1,061 11.4

Interest Payment for Debt

179

10.9 General Public Service(GP)

1,008 10.9

Public Security

104

6.3 Agriculture Forestry and Water Conservancy

952 10.3

Education

100

6.0 Urban and Rural Community Affairs

761

8.2

General Public Service(GP)

90

5.5 Transportation(TP)

717

7.7

Grain, Oil & Materials Reserve & Management Service

54

3.3 Medical and Health Care

636

6.9

Social Security and Employment

50

3.0 Public Security

527

5.7

Resources Prospecting, Power & Information Service

46

2.8 Resources Prospecting, Power & Information Service

355

3.8

Agriculture Forestry and Water Conservancy

42

2.5 Housing Security

349

3.8

Source: MoF, Barclays Research

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Barclays | China: Beyond the Miracle One popular argument against the current fiscal structure is that local governments are responsible for providing the bulk of public services, including social security, basic education, health care and public safety, but have very limited revenue and other resources to finance such activities. According to Wong (2007),170 prefectures and counties (third and fourth tiers of the fiscal system) account for nearly all expenditures on social security, including old-age pensions, unemployment insurance, and other income support and welfare schemes. Counties and townships (fourth and fifth tiers) are responsible for providing basic education and public health care for the rural population, which represents 70% of all spending on education and 55-60% on health care. Official data show that China’s central-local revenue and expenditure split saw dramatic changes after the 1994 reforms (Figure 10 and Figure 11). In 1993, the central government took ~20% of total fiscal revenue, but was responsible for ~50% of total expenditure. This pattern was reversed after the 1994 reforms. The central government now collects ~50% of total revenue, but is responsible for ~30% of total expenditure. The local governments, however, now receive less than 20% of their total revenues from local taxes and 30% from shared tax, but need to fund of 70-80% of total expenditure. The prominent feature of China’s fiscal governance structure is clearly decentralisation. To be sure, fiscal decentralisation has been a trend in large economies since the 1980s. Analysing data for about 80 countries over 1990-2008, a 2011 IMF paper171 find most countries, developing or developed, unitary or federal system, had adopted a system of FIGURE 10 Revenues: the central-local government split

FIGURE 11 Expenditures: the central-local government split

100%

100%

90%

90%

80%

80%

70%

70%

60%

60%

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

0%

0% 1979 1983 1987 1991 1995 1999 2003 2007 2011 Local govt revenue

Source: CEIC, Barclays Research 170 171

Central govt revenue

1979 1983 1987 1991 1995 1999 2003 2007 2011 Local govt expense

Central govt expense

Source: CEIC, Barclays Research

Christine Wong, Budget Reform in China, OECD Journal on Budgeting Volume 7 – No.1. 2007 Claudia Dziobek, et al (2011), Measuring Fiscal Decentralisation – Exploring the IMF’s Databases.

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Barclays | China: Beyond the Miracle decentralisation in expenditure and centralisation in revenue. However, China appears to be much more decentralised than most other countries, especially on the spending side (Figure 12, Shah 2004). The more than 70% share of expenditure made at subnational government levels is much higher than the average of 20% in developing countries, 22% in transition economies, and 32% in OECD countries. The government established a tax transfer system after the 1994 reforms, through which the central government returns some of its tax revenue to all local governments and also provides special fiscal transfers to less-developed regions. This is to address local fiscal inadequacy, ensure sufficient public services, and reduce regional disparities. For instance, in 2011, the central government received total revenue CNY5.28trn, of which CNY5.13trn came from direct revenue and CNY150bn from the budget stabilisation fund, which helps to smooth out volatility and balance the budget. Meanwhile, local governments received revenue of CNY9.23trn – CNY5.24trn from direct revenue and CNY3.99trn from central government fiscal transfers. To understand the government’s fiscal profile, we look at a “snapshot” of the general government flows balance sheet (Figure 13). Taking into account direct spending of CNY1.65trn, CNY3.99trn transfers to local governments, as well as the CNY290bn in the budget stabilisation fund, the central government ran a budget deficit of CNY650bn in 2011. For the same period, total expenditure by local governments was CNY9.43trn, compared with total revenue of CNY9.23trn. The deficit of CNY200bn was financed by bond issuance, managed by the MoF on behalf of the local governments.

FIGURE 12 Fiscal decentralisation: China vs other countries Indicator

China

Developing Transition OECD countries Economies countries

Sub national share of government revenue

48

16.6

18.4

19

Sub national share of government expenditure

74

19.6

22.3

32

Source: Adapted from Shah (2004) 172 and Chunli Shen et. al (2012) 173

172 Shah, Anwar (2004). Fiscal Decentralization in Developing and Transition Economies. Progress, Problems and the Promise. Policy Research Working Paper No. 3282, World Bank, Washington, DC. 173 Chunli Shen, et al (2012), Fiscal Decentralisation in China: History, Impact, Challenges and Next Steps.

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Barclays | China: Beyond the Miracle The total fiscal transfer from the central to local governments of CNY3.99trn was substantial. In fact, central-provincial and provincial-local fiscal transfers are the dominant source of revenue for provincial and local governments in China. According to estimates by Qiao and Shah (2006) 174, such transfers financed 67% of provincial, 57% of prefecture and 66% of county and lower level expenditure in 2003.

FIGURE 13 The general government budgeted and actual revenue and expenditure snapshot (2010-12) Revenue

2012 Budget 2011A 2011B 2010A Expenditure

2012 Budget 2011A 2011B 2010A

(in CNY bn unless otherwise stated) Central government level Total

5862

5281

4736

4260 Total

6412

5931

5436

5060

- Direct revenue

5592

5131

4586

4250 Direct spending 1852

1651

1705

1600

150

Transfer to local 4510 government

3990

3731

3235

Budget adjustment fund

50

290

-550

-650

- Budget adjustment fund

270

150

10

Budget Deficit

225 -700

-800

Local government level Total

10278 9233

8117

7296 Total

10528 9433

8317

7496

- Direct revenue

5768

5243

4386

4061 Direct spending 10528 9242

8317

7360

- Transfer from central government

4510

3990

3731

3235

Budget Deficit Total

Transferred to next year

191 -250

11630 10374 8972

Total Budget Deficit

8311

-200

136 -200

-200

12430 10893 10022 8960 -800

-519 -1050 -649

Source: MoF and Barclays research

174

Qiao, Baoyun and Anwar Shah (2006). Local Government Organization and Finance in China. In Anwar Shah, editor, Local Governance in Developing Countries. Washington, DC: World Bank.

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Barclays | China: Beyond the Miracle FIGURE 14 Major sources of national tax revenue Value-added Business Others

%y/y 35

Enterprise Consumption Tax revenue

FIGURE 15 Local government total income , 2011 In CNY bn (as for 2011)

30 Revenue transferred from central to local government 3.99

25 20 15

Land sales revenue 3.15

Local - level government revenue 5.25

10 5 0 1997

1999

2001

2003

2005

Source: CEIC, Barclays Research

2007

2009

2011

Source: CEIC, Barclays Research

However, the transfer scheme suffers from a number of problems and deficiencies, which prevent it from being a predictable and reliable source of financing (Shah and Shen 2006) 175 . These include: 1) a complex and opaque system with few having knowledge of all programs and their underlying allocation basis; 2) lack of central coordination and transparency (only 22.5% of total intergovernmental subsidies from the central government were audited in 2003); and 3) the lack of a regulatory framework to ensure accountability and results. The mismatch between local governments’ revenues and their spending needs, even ignoring their development ambitions, naturally leads to some unfavourable outcomes. These include financial stress, underprovision of basic public services and the prevalence of extra-budgetary/off-budget activities, as well as investments that involves high risk. For instance, elementary schools in many rural areas often suffer from inadequate funding, which is reflected in underpaid staff, poor facilities and inadequate operations. Fiscal challenges tend to be most severe at the township level. It is not surprising, therefore, that many local government administrations, especially among the lower levels, actively seek extra-budgetary revenues. These include fee collection and land sales. In 2011, official data show that land sales revenue (extra-budgetary) amounted to CNY3.15trn, or 25%of total local government income, with the remaining CNY5.25trn coming from local tax and non-tax revenue, and CNY3.99trn from central government transfers (Figure 14, Figure 15).

175

Shah, Anwar & Shen, Chunli, 2006. "Reform of the intergovernmental transfer system in China," Policy Research Working Paper Series 4100, The World Bank.

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Barclays | China: Beyond the Miracle FIGURE 16 Fiscal transfer relative to local revenue and expenditure

FIGURE 17 The allocation of fiscal transfers by region 100%

RMB bn Transfer from central

Local rev

Local exp

350

90% 80%

300

70%

250

60% 50%

200

40% 30%

150

20%

100

10%

50

0% 2000

0 Gansu

Qinghai

Jilin

Liaoning Shanghai

Source: CEIC, Barclays Research

Beijing

2002

Eastern

2004 Central

2006 Western

2008

2010

North east

Source: CEIC, Barclays Research

The fiscal structure of centralised revenue collection and decentralised spending also suggests that the relationship between different levels of government is likely to be both hierarchical in nature and involve a degree of rivalry (Figure 16 and 17). As the division of spending remains largely determined by their relative power, lower levels of government tend to end up with expenditure responsibilities in excess of their revenue. Meanwhile, local governments need to share revenues and resources among themselves and with the state; therefore, richer governments prefer to have more autonomy and independence. The revenue-expenditure mismatch and intergovernmental transfer system also create incentive problems. For instance, local officials are often accountable to their immediate superior, rather than a higher level of government or even the central government. The current political structure and the criteria for promotion of local officials also suggest that local governments often feel little accountability to local residents. Lack of explicit expenditure assignments at the sub-provincial level has also led to a considerable overlap of responsibilities, which tends to lead to underprovision of services. And most fundamentally, the lack of transparency and accountability of the government budget, particularly the soft budget constraints at the local government level, have exacerbated fiscal problems arising from the revenue-expenditure mismatch. China enacted its first Budget Law on 1 January 1995, following the 1994 tax reform. The national budget consists of all the budgets of the central and local government. As stipulated by the Budget Law, the draft and implementation of central and local government budgets must be reviewed and approved by the National People's Congress March 2013

253

Barclays | China: Beyond the Miracle (NPC) and local People’s Congresses, respectively. The central and local budget adjustment plans and final budgets must also be reviewed and approved by the Standing Committee of the NPC and local People’s Congresses. All levels of government need to maintain a balanced budget. Only the national government can run a budget deficit and finance it through domestic and international borrowing; other levels of government cannot borrow directly. The actual budget system, however, suffers from a number of problems. The legislature, the NPC, lacks substantive budgetary authority. NPC approval remains more a formality and does not impose any legal constraints on the government. The Ministry of Finance and the National Development and Reform Commission share decision-making responsibilities, but important decisions are often made outside of the formal budget process. Moreover, the government is often not held accountable for implementing the budget, as evidenced by the large variations between the original and the final budget. And despite improvements over the years, off-budget expenditures continue to be large and generally unreported.

Local government debt the biggest medium-term risk One of the biggest fiscal risks, at least in the medium term, is the borrowing of local governments. Although the Budget Law prohibits local governments from running budget deficits, they often borrow massively. This is mainly because, as we have pointed out, local governments have to assume responsibility for more spending than their revenues can fund. Many local government officials enthusiastically promote economic growth by making direct fixed asset investments, in order to increase their chances of promotion. As a result, local governments have had to resort to alternative sources of financing. For the past three decades, local governments engaged first in fee collection, then in land sales and now in borrowing from financial institutions or the capital markets. The problem with local governments’ borrowing is that they do not have independent balance sheets – all of their borrowings are implicitly guaranteed by the central government. Therefore, in theory, they could borrow almost without constraint. If not quickly contained, this could lead to major financial and fiscal risks.

Details revealed in the 2011 NAO report In June 2011, the National Audit Office (NAO) released a detailed report on local government debt (including contingent debt), breaking it down by borrower type,

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Barclays | China: Beyond the Miracle FIGURE 18 Local government debt rose rapidly in recent years…

FIGURE 19 … exceeding the central government debt by a wide margin

Outstanding local government debt (RHS, CNY trn) 80

12

Outstanding local government debt (% y/y)

70

10 61.9

60

Outstanding local government debt

20

Outstanding central government debt

16

8

50

48.2

12 6

40 33.3

30 20

CNY trn

26.5

24.8

4

23.5 18.9

10 0 1997

1998

2002

2007

Source: CEIC, Barclays Research

2008

2009

2010

8

2

4

0

0 2002

2007

2008

2009

2010

Source: CEIC, Barclays Research

sources, usage and maturity 176. The audit covered governments at the provincial, city and county levels, and included 25,590 government agencies and departments, 6,576 local government investment vehicles (LGIVs, financial entities established by local governments to get around the central government’s no-debt-financing regulation), 42,603 government-subsidised organisations and entities, 2,420 public entities, and 9,038 other entities. It looked at a total of 373,805 projects and 1,873,683 borrowings. Total local government debt stood at CNY10.7trn at end-2010, equivalent to 27% of China's 2010 GDP. Figure 18 shows there was rapid accumulation debt in 1998, in the aftermath of the Asian financial crisis, and in 2009, following the global financial crisis, as falling global demand led to slowing domestic growth. In fact, outstanding local government debt has exceeded central government debt since 2007 (Figure 19). By lender type, the dominant form at 79% (CNY8.5trn) was bank loans (Figure 20). Bond issues accounted for 7% (CNY0.8trn) and borrowings from a higher level government for 4% (CNY0.5trn). If bonds issued by local governments and purchased by banks are included, total bank lending would be about CNY9trn. By borrower/borrowing type (Figure 21), 47% (CNY4.9trn) was borrowing by LGIVs, 23.3% (CNY2.5trn) was borrowing by various local government agencies and departments, and 16% (CNY1.7trn) was borrowing by government subsidised organizations and entities.

176

http://www.audit.gov.cn/n1992130/n1992150/n1992500/2752208.html.

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Barclays | China: Beyond the Miracle FIGURE 20 Local government debt by financing source, 2010 Fiscal borrowing from higher level government 4%

Bond issued 7%

Others 10%

FIGURE 21 Local government debt by borrower type, 2010 Other 12%

Subsidies to special entities 2%

LGIV financing platform 47%

Public service entities 16% Bank loans 79%

Source: CEIC, Barclays Research

Local government 23%

Source: CEIC, Barclays Research

Of the debt, direct local government liabilities account for around 63% (CNY6.7trn; Figure 22), debt guaranteed by local government around 22% (CNY2.3trn), and 15% (CNY1.7trn) is other local government-related borrowing. Municipal governments have incurred the largest amount of borrowing, accounting for 43% of the total debt outstanding, followed by provincial governments, at 30%, and county governments, at 27%. By region, the relatively more developed eastern provinces account for 50% of the debt, followed by western provinces, at 27%, and central provinces, at 23% (Figure 23).

FIGURE 22 Local government debt by nature of liabilities, 2010

FIGURE 23 Local government debt by region, 2010

Western 27%

Other liabilities need to repay 15% Local govt contingent liabilities 22%

Source: CEIC, Barclays Research

March 2013

Central 23% Local govt liabilities 63%

Eastern 50%

Source: CEIC, Barclays Research

256

Barclays | China: Beyond the Miracle FIGURE 24 Local government debt by usage, 2010 Agriculture and agrigation 4%

Others 22%

Social housing , science, education, culture and health care 9%

Urban infrastructure 33%

Land reserve 10%

Source: CEIC, Barclays Research

Transportation 22%

FIGURE 25 Local government debt by maturity, 2010 Mature by 2016 or afterwards 30%

Mature between 2013-2015 28%

Mature by 2011 25%

Mature by 2012 17%

Source: CEIC, Barclays Research

The NAO estimated that the ratio of local government debt to aggregate income is 84%, a level that appears to be manageable. Note the NAO’s estimate of aggregate income includes fiscal revenue, profits from land sales, central government transfers and other income. However, we believe there are significant risks associated with local government debt. About half of the debt (49%) was incurred during the 2009-10 investment boom, and more than half was used for local infrastructure development – urban infrastructure and transportation together accounted for 55% of total debt, while 9% was for social spending (Figure 24). Therefore, at least two-thirds of the debt is likely to have difficulty in quickly generating cash flow, but 42% of them were to mature in 2011-12 (Figure 25). The NAO also identified several major risks associated with local government debt. First, it noted a lack of transparency and the non-compliance of local government financing. Even after State Council issued a notice to strengthen the regulation of LGIVs, local governments still provided non-compliant guarantees for such debt. Second, it said debt issuance and repayment plans are not included in the fiscal budgets of most local governments. Third, it cited a lack of corporate governance at most LGIVs. The NAO also pointed to the low repayment capability of some industries and local governments. For instance, total local government debt issued to fund the construction of expressways was CNY1.1trn. Most of this debt relies on rollovers (issuing new debt to repay old debt) for repayment. In 2010, the rollover rate of expressway debt was as high as 55%. There are no recent official data providing estimates of outstanding local government debt, although the debt likely rose to at least CNY12trn at end-2012 (23% GDP). March 2013

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Barclays | China: Beyond the Miracle FIGURE 27 Surging local government bond issues in 2012

FIGURE 26 Economy-wide funding sources expanded dramatically Bank loans Off-balance sheet lending Corporate bond Others

(CNY trn) 16 14

1,400

LGIV bond issuance (CNY bn)

1,200 1,000

12 10

800

8

600

6

400

4

200

2

0

0 2006

2007

2008

2009

Source: CEIC, Barclays Research

2010

2011

2012

2006

2007

2008

2009

2010

2011

2012

Source: CEIC, Barclays Research

According to Premier Wen, local government debt increased only CNY300mn in 2011, compared with CNY3.4trn in 2009 and CNY1.7trn in 2010. However, local governments have also borrowed heavily through trust financing in 2011-12, and new LGIV bond issuance rose CNY620bn in 2011 and CNY1.4trn in 2012 (Figure 26, Figure 27).

Changing sources of local government financing Other than fiscal revenues, local government financing sources can be summarised as: 1) extra-budgetary revenue (previously, fees, but now revenues from land sales); 2) borrowing from banks; 3) borrowing by local government investment vehicles (through the shadow banking system, such as trusts); 4) bonds issued by LGIVs; and 5) local government bonds issued by China’s Ministry of Finance (the 2012 quota was raised to CNY250bn). In the early years of the reform period, local governments relied heavily on extrabudgetary revenue, such as fee collection, to make up for shortfalls. For many lower level governments, these resources financed half or more of their expenditures. During the past decade, however, land sales became an important source of revenue, accounting for 20-30% of local governments’ total income, on average, compared with ~40% from local fiscal revenue sources (Figure 28, Figure 29). Thanks to the booming Chinese property market and rapid urbanisation, local governments have been heavily involved in real estate development. The massive government stimulus program in 2008-09 led to surge in local government borrowing, with most of it coming from bank lending rather than debt issuance (Figure March 2013

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Barclays | China: Beyond the Miracle FIGURE 28 Breakdown of local government income Local-level govt revenue (CNY trn) Central govt transfer(CNY trn) Land revenue(CNY trn) Land revenue (% total revenue, RHS) 24 23

15

12

21

9

27

21

19 17

32

25

3000

24

2500

Land revenue (CNY bn)

120

124

100

86

69

63

70

80

2000

60 40

39

1500 12

9

8

0 2003

140

Land revenue (%y/y, RHS)

16

16

3

2001

3500

28

20

13

6

FIGURE 29 Land sales revenue have surged in recent years

2005

2007

Source: CEIC, Barclays Research

2009

2011

20

1000

4

500

0

0

9

16 -7

0 -20

-25

-40 2001

2003

2005

2007

2009

2011

Source: CEIC, Barclays Research

26). The National Audit Office reported that bank loans accounted for 79% of the CNY10.7trn outstanding local government debt by the end of 2010. The 2009-10 credit boom and surging local government debt have raised concerns about potentially large defaults, an increase in nonperforming loans and the impact on the banking and financial systems. In 2011, the central government started to strengthen regulatory controls on bank lending to local governments and their investment vehicles. The China Banking Regulatory Commission (CBRC) prohibited banks from making new loans to unqualified local governments and LGIVs. However, after a somewhat quieter 2011, local governments’ borrowing rebounded strongly in 2012, as falling fiscal revenue added to their financial strains and slowing growth pushed them to start infrastructure investment projects to revitalise the economy. This time, they found financing through trusts and shadow banking activities, as well as bonds issued by LGIVs. Meanwhile, regulations were relaxed a bit in November 2011, with the CBRC allowing commercial banks to roll over qualified loans instead of strictly enforcing its previous “no rollovers” policy. The surge “shadow banking”, coupled with the heavy involvement of local governments in those activities, triggered a new round of regulations and supervision. On 31 December 2012, China's top economic planning body, its finance and bank regulators and its central bank (NDRC, MoF, CBRC and the PBoC) issued a joint statement that there had been an increase in unauthorised fundraising by local governments, and imposed strict regulations.

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Land finance and extra-budgetary revenues Until the 2000s, extra-budgetary revenue was a main source of financing for subnational levels of government. Fee collection was widespread, especially in the late 1980s and 1990s. Usually, the fourth- and fifth-tier governments rely more on fees as a source of revenue than the provincial or regional governments, which can collect taxes. Aside from charging fees, local government have also used sales of state assets to supplement general revenues. In particular, the sale of land leases and the use of land has become the biggest source of extra-budgetary revenue as urbanisation and the booming property market have boosted land values. Many believe that local governments’ involvement in land and real estate development contributed to China’s property bubble and elevated property prices. Although their importance varies significantly by city and year, on average, land sales have accounted for ~30% of local government revenue in the past couple of years, although that share could be as high as 70-80% for some lower-tier governments. Total land-derived revenues have been important even for first-tier cities. This is because in addition to land sales receipts, local governments also collect a series of taxes from real estate-related construction and business activities. However, as the government started to tighten the property market in April 2010 and imposed home purchase restriction in early 2011, land sales revenue has fallen markedly.

Bank lending remains the dominant financing source Banks remain a dominant financing source for local governments and their investment vehicles (LGIVs), given the strong relationship between state-owned banks, local enterprises and local governments, as well as China’s still largely bank-centred financial system. The National Audit Office found that 79% of the total local government debt of CNY10.7trn in 2010 came from bank lending. Out of the CNY8.5trn in total bank lending, CNY5trn was direct local government loans, CNY1.9trn guaranteed by local governments while CNY1.5trn was other government-related loans. In addition, local governments issued CNY760bn of bonds during the period, and some were purchased by banks. Local governments’ ability to continue to borrow from banks depends to a large extent on government policy. Owing to its concerns about the risks to the banking system and to fiscal stability, the central government started to control excessive local government borrowing from late 2010, announcing more detailed regulations during 2011-12. Also, banks were asked not to lend to local governments or their investment vehicles given the CBRC guidelines to improve risk management. March 2013

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Barclays | China: Beyond the Miracle FIGURE 30 CBRC’s new guideline on the five categories of LGIV loans, March 2012 Category

Cash flow coverage

Guidelines

Category -1

100% cash flow coverage with project Can obtain new bank loans provided yielding return they pay back their loans on time

Category -2

100% cash flow coverage with completed project, but not yet yield return

Can obtain new loans within granted quotas

Category -3

100% cash flow coverage with uncompleted project

Can only roll over the loans once if their projects been completed

Category -4

Less 100% cash flow coverage with Can restructure the loans project attractive to private investment

Category -5

Less 100% cash flow coverage with project not attractive to private investment

Cannot extend new loans and must consult with local governments to pay back loans in instalment

Source: CBRC, Barclays Equity Research – China bank team

The significant economic slowdown and rapid cooling property market since 2011 have added financing strains on local governments, as they struggled to repay existing loans – 45% of local government debt matured during 2011-12. With many investment projects at risk of not being completed, the economy at risk of slowing further and to avoid defaults, the CBRC shifted its earlier stance of “no debt rollovers” to permit rollovers of selected borrowings in November 2011. In March 2012, the CBRC issued detailed guidelines, requiring banks to strictly follow the rules for each of the five LGIV categories (Figure 30).

Trusts became a popular channel of financing With few available funding channels and mounting repayment pressures, local governments (especially the lower tier, such as county governments) turned increasingly to trust companies as a major source of funding in 2011-12. Trust sector assets under management rose from CNY4.8trn in 2011 to CNY6.3trn by Q3 2012 (Figure 31), with a significant amount of lending to higher-risk entities, such as developers or LGIVs that lack access to bank credit. According to the China Trust Association, more than 35% of trust assets represent funding for infrastructure and real estate construction, with local governments likely having significant involvement in both. In particular, government-trust cooperation products, trusts that are directly associated with local government financing, have increased faster than overall trust products since Q1 12. By end Q3 12, total government-trust cooperation products had reached CNY390bn, up March 2013

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Barclays | China: Beyond the Miracle

RMB bn

160

120

140

100

120

80

2011

3Q12

Nov-12

2010

Jul-12

2009

Sep-12

2008

May-12

2007

Jan-12

2006

Source: CEIC, Barclays Research

0

Mar-12

0

Nov-11

20

0

20

Jul-11

40 1000

40

May-11

60

2000

60

Jan-11

80

Mar-11

3000

Nov-10

100

Jul-10

4000

Real estate sector Infrastructure

Sep-10

5000

Financial sector Industrial and commercial Others

Sep-11

180

Trust asset (%y/y, RHS)

Jan-10

6000

Trust asset (RMB bn)

Mar-10

7000

May-10

FIGURE 32 Newly issued combined unit trust investments by sector

FIGURE 31 Trust sector asset under management expanded strongly

Source: Barclays Equity Research – China bank team

40% y/y. Figure 32 also shows that a significant amount of total unit trust investments were in infrastructure, especially after the NDRC accelerated project approvals in March 2012. Meanwhile, the same trend can be found in the data on trust loans, which revived in 2012 after the CBRC’s curbs on trust since mid-2010 muted activity. Despite the well-known credit risks associated with such financing, so far, both borrowers and investors seem to be happy. Local governments got the capital they need to finance infrastructure investment and boost growth, and investors are earning a solid return – at least 8-10%, versus the 3% benchmark lending rate. Given that the minimum threshold for investing in trust was raised to CNY1mn, the ultimate financers (ie, clients of the trusts) typically are high-net worth individuals and institutions. Since local governments guarantee these lines of credit, many investors take for granted that higher levels of government, or the central government, stand ready to rescue should there be any default. A number of near-default cases in 2012 were bailed out, either by asset management companies or local banks. However, the collapse of Guangdong International Trust and Investment Corporation in 1998 and its creditors’ recovery rate of just 12.5% after it went bankrupt should be remembered.

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Barclays | China: Beyond the Miracle FIGURE 33 Local government-related bonds issued (2012 vs 2011) Bonds issued (CNY bn)

2011

As % of total

2012

2011

2012

y/y growth 2012

Local government debts

200

250

32.3%

16.7%

25.0%

Bonds issued by LGFV

420

1,246

67.7%

83.3%

196.6%

Enterprise bonds

250

841

40.4%

56.2%

236.0%

Corporate bonds

4

5

0.6%

0.3%

24.6%

Medium-term notes

102

266

16.4%

17.8%

161.3%

Short-term commercial paper

64

130

10.3%

8.7%

103.5%

ABS

–

4

0.0%

0.2%

NA

620

1,496

100.0%

100.0%

141.2%

As % of total bonds issued

7.9%

18.5%

11ppts

As % of non-FI corporate bonds issued

11.2%

27.3%

16ppts

Total

Source: Wind, Barclays Equity Research – China bank team

LGIV bond issues received strong government support LGIV bond issuance also surged in 2012, reaching CNY1.25trn, double the amount issued in 2011(Figure 33). Adding the CNY250bn bond issued by the MoF on behalf of local governments, total local government-related bond issuance reached CNY1.5trn in 2012, up 141% y/y, and accounted for 18.5% of total bonds issued during that period (versus 7.9% in 2011). According to estimates by our China bank team, local government-related bond issuance accounted for 27% of nonfinancial corporate bond issuance in 2012 177. Data show that more than half of the funds raised in 2012 were used for capital goods investment (ie, building and construction projects), followed by transportation (ie, highways, airports, 19%), financial services (21%), property (5%) and public utilities (5%). Of total new LGIV bond issuance by credit rating, we note that the proportion of newly issued long-term bonds with lower ratings (AA and AA-) increased to 51% in 2012 from less than 33% in 2011 (Figure 34). This suggests weaker credit quality in the new issues, as the LGIVs that cannot get bank loans had to tap the bond market for financing.

177 See China Banks: Financial disintermediation: acceleration of corporate bonds - good or bad? 28 November 2012. Figure 30-34 were provided by the Barclays Equity Research – China bank team.

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Barclays | China: Beyond the Miracle FIGURE 34 Bonds issued by LGIVs by credit ratings Issuance amount (CNY bn) 2007 2008 2009 2010 2011 AAA

40.1

30.5 181.2 76.5

78.5

As % of total issuance amount 2012

2007 2008 2009 2010 2011 2012

117.3 48.8% 26%

44%

20%

16%

9%

AA+

–

27.8 134.1 137.5 161.9

320.8

0.0% 24%

33%

37%

34%

26%

AA

–

10.6

605.7

0.0%

9%

11%

23%

31%

49%

0.0%

45.9

85.6

151.2

AA-

–

–

1.2

1.5

7.5

26.1

0%

0%

0%

2%

2%

A-1

42.1

49.3

45.1

75.0

69.4

136.4 51.2% 42%

11%

20%

14%

11%

–

0.5

–

14.0

39.6

0%

0%

3%

3%

Non-rated Total

0.0%

0%

82.1 118.2 408.0 376.1 482.4 1,245.9 100% 100% 100% 100% 100% 100%

Source: Wind, Barclays Equity Research – China bank team

Besides the demand factors, the surge in LGIV bond issues was owing to strong government support to direct financing. Regulators had ordered a halt to such issuance in mid-2011, given an expected rise in default risks. But the halt was removed as the NDRC effectively endorsed this type of financing by streamlining the application process in August 2011. In theory, LGIV bonds are backed by local government assets and credit, but they could involve significant risks for the reasons discussed earlier. However, the NDRC’s (accelerated) approval of LGIV bond issues sent a strong signal to the market that the credit is backed by the government. That has helped to settle market fears about default risks and boosted demand; however, it could also lead to excessive risk-taking.

Explicit contingent liabilities Ministry of the Railway debts MoR’s liabilities reached CNY2.4trn in 2011 and are expected to reach CNY2.8trn by 2012, based on estimates by our equity analysts. According to the 12th Five-Year Plan, the MoR is committed reaching the target of 120,000km of operational rail lines by 2015. This implies building a total of 28,400km of new rail lines, corresponding to an investment of CNY2.3trn during 2013-15, and an increase in its liabilities to CNY3.8trn by 2015 (see Asia Themes: Funding China’s railways – where’s the gap?, 31 October 2012). A detailed look at the MoR’s balance sheet and cash flow statement reveals that its cash flow can barely meet its needs, which implies that the ministry will have to rely on external financing. The MoR generated CNY152bn of cash from its “operation” in 2011, and our equity team estimates it will generate CNY181bn in 2012 and CNY206bn in 2013. But those levels are not enough to cover its expenses of paying interest and March 2013

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Barclays | China: Beyond the Miracle FIGURE 36 Rising pension expenses amid population aging

FIGURE 35 Policy bank bond issues grew steadily 10 9

Policy bank bond (CNY trn)

20

Policy bank bond (%GDP, RHS)

18 16

7

14

6

12

5

10

4

8

3

6

400

2

4

200

1

2 0 2000

2002

2004

2006

Source: CEIC, Barclays Research

2008

2010

2012

16

Pension expense (% fiscal expense, RHS)

14

1200

8

0

Pension expense (CNY bn)

1400

12

1000

10

800

8 600

6 4 2

0

0 1990

1993

1996

1999

2002

2005

2008

2011

Source: CEIC, Barclays Research

repaying principal (2011: CNY275bn; 2012 Barclays estimate: CNY300bn; 2013 Barclays estimate: CNY364bn).

Policy banks debts There are three policy banks in China – China Development Bank (CDB), Export-Import Bank of China (EXIM) and Agricultural Development Bank of China (ADBC). Each has a unique function that requires fund raising. Traditionally, the CDB was responsible for supporting large infrastructure projects, but it has begun to diversify its portfolio of investments towards those of a more commercial-based bank. EXIM provides financial services to facilitate technologically advanced exports and imports, and ADBC supports the development of agriculture and rural areas in China. All three banks report directly to the State Council; therefore, borrowing by these banks is implicitly backed by state credit, allowing them to raise funds at rates only slightly higher than the Ministry of Finance. According to chinabond.com, the outstanding amount of these institutions’ bonds has been growing at an annual rate of 20-30% in recent years and reached CNY9.2trn (10.5% of GDP) by 2012, up from CNY7.5trn (15% of GDP) in 2011 and CNY5.8trn (14.5% of GDP) by 2010.

AMC liabilities The central government also faces potential liabilities, given its role in the banking system. As part of the effort to restructuring the banking sector, the State Council transferred CNY1.4trn of nonperforming loans from the big four state-owned banks to four newly created asset management companies (AMCs) in 1999. According to the March 2013

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Barclays | China: Beyond the Miracle CBRC, the recovery rate was below 30% as of 2006, and no more recent data have been published. In 2010, the AMCs issued CNY858bn bonds, mostly bought by the four banks. Following a series of structural changes, the four banks are now the largest holders of the AMCs’ bonds, and three are also major equity owners of the AMCs.

Pension liability the biggest long-term risk It is widely believed that unfunded pension liabilities, combined with a rapidly aging population, pose the biggest challenge to China’s fiscal sustainability. This concern was confirmed by some recent research on China’s national balance sheet, initiated by the BoYuan Foundation and carried out independently by two research groups in 2012. While employing different methodologies and assumptions, both reached similar conclusions: 1) pension expenses are rising rapidly (Figure 37), and rising obligations likely have exceeded the accumulated assets; 2) population aging will be the dominant driver of the estimated widening pension gap; 3) without reforms, the current pension system will impose a massive fiscal burden, seriously undermining China’s fiscal sustainability. According to the study by Cao Yuanzheng and team (2012) 178, China’s pension gap, defined as Fund Balance minus Net Pension Benefit Obligation (NPBO) was already CNY16.5trn in 2010 (details below). Assuming unchanged pension polices and 6% annual GDP growth, the pension gap could widen to CNY68.2trn by 2033 (close to 40% GDP then). Results from Ma Jun and the FuDan university research group 179 show that although the current pension financing gap is small, without further reform, the accumulated pension gap during 2013-50 could amount to as much as CNY39.2trn (the present value of future pension revenue minus expense every year), or 83% of 2011 GDP. Their research suggested that the retirement age should be raised to ease the financing pressures and, among other measures, the government should also transfer shares in state-owned companies to the National Social Security Fund and restructure public institutions.

The unsustainable pension system While China’s social security system remains relatively underdeveloped, dramatic changes over the past decade have broadened pension coverage significantly. In 2009 180, less than 30% (290mn) of adults were covered by the government’s pension

178

Cao Yuanzheng, Zhong Hong, et al, Restore the national fiscal health, 2012 Ma Jun, Zhang Xiaorong, Li Zhiguo, A Study of China’s National Balance Sheet, 2012. http://www.mohrss.gov.cn/page.do?pa=402880202405002801240882b84702d7&guid=e578e8be726c4689a 32b91e8f7882a45&og=8a81f3f133d01e170133d36b52df04c8. 179

180

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Barclays | China: Beyond the Miracle programs, and rural residents relied primarily on their land and their families. But by the end of 2011 181, 698mn people, over 55% of adults, were enrolled in one scheme or another, according to the Ministry of Human Resources and Social Security in June 2012. Among them, 414mn were rural residents. That is an addition of over 380mn people in just two years, following the rollout of a new rural pension programme in 2009. Meanwhile, nearly 300mn urban residents enrolled in a variety of urban pensions, which rest on several “pillars”, including a social security net, basic pensions and supplementary pensions funded by the government, enterprises and individuals. Established in the late 1990s, China's current urban pension system consists of individual accounts, into which employees pay 8% of their salaries, as well as social pool accounts, to which companies contribute ~20% of their employees' total salaries (the exact percentage can vary across provinces) 182 183. In the countryside, local governments pay a basic pension, which often varies depending on their financial health. Although individual accounts are supposed to be kept intact until retirement, many were found empty as local governments have "borrowed" money from these accounts to pay the pensions of today’s retired or diverted it to other uses, such as paying the bills, speculating in property or outright fraud 184 . Unfunded liabilities in individual accounts exceeded CNY2.2trn in 2011, about CNY500bn more than the previous year. According to Zheng Bingwen of the Centre for International Social Security Studies at the Chinese Academy of Social Sciences, individual accounts held assets of just CNY270bn at the end of 2011, even though some CNY2.5trn had been paid into them. The pension system needs to pay so-called legacy costs 185 – pension liabilities for those under the previous pension regime, which are estimated to range from 82% to 130% of 2008 GDP according to the World Bank (separate research put by Liu (2008) suggested the gap was around 25-50% of 2006 GDP), depending on the assumptions.

181

http://w1.mohrss.gov.cn/gb/zwxx/2011-05/24/content_391125.htm. http://www.people.com.cn/GB/shizheng/252/7486/7498/20020228/675965.html. 183 http://www.gov.cn/jrzg/2005-12/14/content_127311.htm. 184 http://finance.ifeng.com/news/macro/20121218/7445407.shtml. 185 These occur as the pension system has transferred from pay-as-you-go system: the older generation’s pension expense is no longer covered by the payment from current generation, but the system still needs to pay off these obligations. 182

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Barclays | China: Beyond the Miracle FIGURE 37 Official pension balance is still positive 2000

CNY bn

1500

FIGURE 38 China’s dependency ratio is on the rise

Pension expense

100

Pension revenue

90

Pension balance (accumulated)

80

1000

70

500

60

Old-age dependency (%) Child dependency ratio (%) Total dependency ratio (%)

50 0

40 30

-500

20

-1000

10

-1500 1990

1993

1996

1999

2002

Source: CEIC, Barclays Research

2005

2008

2011

0 1950

1970

1990

2010

2030

2050

Note: Old-age population is defined as aged above 65, and child population is defined below age 15. Source: CEIC, Barclays Research

China also operates a dual-track pension system. The government covers all publicsector pensions. Unlike private-sector workers, civil servants do not need to make contributions, but are still covered by the state budget after retirement. The replacement rate (the ratio of pensions to pre-retirement wages) for civil servants is as high as 80%, while it is 43% for the rest of the workforce (in 2011). There is also a need to address the issue of inadequate returns on contributions to the current urban system, while controlling investment risks. Under the current system, urban workers will retire on about 43-60% of their final wage, which requires that their contributions earn high rates of return to keep up with wage growth. However, most of the contributions were in bank deposits or government bonds and could barely keep up with inflation. In 2000, the central government set up the National Social Security Fund (NSSF) 186, which is able to invest in more diversified investment products, and they’ve managed to achieve returns averaging 8% in the past decade.

Population aging will add significant strains China’s pension system has a wide range of problems, including low contribution rates, insufficient coverage, fragmented management and “empty” individual accounts, and a low returns on investment. But China’s rapidly aging population probably poses the biggest threat to the system (Figure 38, 39, 40). Improving life expectancy and the falling fertility rate imply a heavy financial burden on the next generation.

186

http://www.ssf.gov.cn/cwsj/ndbg/201206/t20120618_5601.html

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Barclays | China: Beyond the Miracle FIGURE 39 Elderly population share by country (% of total) 40 35

China Korea Indonesia Singapore

Japan Philippines Malaysia United States

FIGURE 40 China’s rapid changing age structure 100% 80%

30 25 20

60% 40%

15 10 5 0 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Source: CEIC, Barclays Research

20% 0% 1950 0-14

1970 15-34

1990 2010 2030 35-54 55-64

2050 65+

Source: CEIC, Barclays Research

Aging is a global phenomenon. The EU and Japan are well along the aging curve, and neighbouring Korea and Singapore face similar problems. However, owing to the sharp decline in the fertility rate and the steady increase in life expectancy, China’s population will age at an unprecedented pace in the coming decades, which will take place when China is still a middle-income country with a less well-established social security system. China already has the largest number of old people globally – China’s population aged 60 and above is projected to rise from 113mn in 2011 to 340mn by 2030 and 439mn by 2050. The share of population aged 60 and above will rise from 8% in 2011 to close to 16% by 2030 and more than 25% by 2050 187. Moreover, the NBS shows that China’s working age population is already shrinking – it fell by 3mn to 937mn in 2012. This implies a rapid rise in the old-age dependency ratio. The rapid aging of China’s population suggests that its pension and healthcare systems will face increasing funding pressures in the coming decades. It is estimated that while each pensioner was supported by the combined contribution of five Chinese workers in 2010, the number is expected to fall to three by 2020 and to two by 2030. The sharp increase in the number of retirees relative to the number of workers will require greater social expenditures. As China’s baby boomers begin to retire, the burden of caring for the elderly will fall on the first single-child generation some time in the next decade.

187

Yang (2009), Review public servant pension scheme from the perspective of fiscal expenditure, Tsinghua University, United Nations

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Barclays | China: Beyond the Miracle Filial piety – the duty of respect, obedience, and care for one's parents and elderly family members – is considered the first virtue in Chinese culture. However, family support for the elderly has been weakened after dramatic social, economic, and demographic changes. This year, the government added to the “Law on Protection of the Right and Interests of the Aged” that family members should look after their elderly parents, both physically and mentally. In addition, children who live far away from their elderly parents should pay them regular visits, while employers should offer them the necessary holidays.

Estimating the pension liability Estimations of pension liability and its associated gap vary considerably, depending on assumptions of economic, institutional and demographic variables, such as growth rates, pension coverage, the age structure of covered workers. Two measures are generally applied. The first is implicit pension debt (IPD), which calculates the present value of total implicit pension liabilities under a pension system. A common practice in estimating the IPD is to use the Pension Reform Option Simulation Toolkit (PROST), a generic PC-based projection model developed by the Social Protection Unit of the World Bank. Wang, et al 188 (2001) estimated China’s IPD at about CNY7trn, or 71% of 2000 GDP; and Song 189 (2001) estimated a total IPD of CNY9trn, or 117% of 1997 GDP. Sin 190 (2005) from the World Bank also incorporated the pilot pension-transition scheme under The Liaoning Pilot and did a scenario analysis. His results show that different reform and transition mechanisms can result in an IPD that ranges from CNY12trn (110% of 2001 GDP) to CNY14trn (132% of 2001 GDP). Another measure is the pension financing gap, which calculates the financing requirements of an ongoing pension system throughout the projected period (ie, revenues less expenditures). Below, we summarise the estimations made by Cao Yuanzheng (2012) as an example. Cao categorises the population into Old Men, Middle Men and New Men in accordance to State Council’s Document #38 in 2005. He then calculates the pension liabilities as the net pension benefit obligation (NPBO) by adding the three groups’ liabilities together (ie, New Men’s NPBO equals to pension obligations under basic scheme they are entitled minus further pension expense they will pay). Cao then calculates the pension gap by deducting the total NPBO from the accumulated pension fund balance. He concluded that by 2010, the pension financing gap already amounted to CNY16.5trn, and without further reforms, it would widen to CNY68.2trn by 2033, or 39% of 2033 GDP. 188 189 190

Xiaojun Wang, Principles of Pension Accruals, the People’s University Press, 2001 Xiaowu Song, Facilitate the social security framework, Enterprise Management Press, 2001 Yvonne Sin, China, Pension liabilities and reform options for old age insurance, The World Bank, 2005

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Barclays | China: Beyond the Miracle FIGURE 41 Old Men, Middle Men and New Men Definition Old Men

Retired before 2005

Middle Men

Employed before 2005 and retired after that

New Men

Employed after 2005

Source: Cao Yuanzheng, Zhong Hong, et al (2012)

However, it is worth noting that financing gap estimates are highly sensitive to: 1) assumptions of fund investment returns and discount rates; 2) the population model applied; and 3) the general projection model used. Also for systems that are still expanding, using the financing gap as a fiscal sustainability benchmark can be misleading, since the projection period may include only income contributions from newly covered workers, without reflecting the total payout period for these workers when they retire. However, the results from both Cao and Ma are similar: without further reforms to China’s old age insurance system, it will become a major challenge to China’s fiscal sustainability in the medium to long term because of the transition costs of reforms and, more importantly, China’s rapidly aging population. Without further reforms, the pension system could seriously undermine China’s fiscal sustainability.

Overall assessment and investment implications Although the Chinese central government’s public debt amounts to only 16% of GDP (in 2011), its total liabilities, including contingent liabilities, amount to as much as 70100% of GDP (Figure 42). This would exceed the OECD’s usual warning level of 60%. We believe the government’s liabilities should be a serious concern for policymakers and investors, as the associated fiscal and financial risks could lead to major macroeconomic problems. Of course, contingent liabilities differ from public debt. For the time being, at least, the government does not have to pay interest on those liabilities. It is also possible that some of the contingent liabilities will be resolved along the way should the economy continue to grow at 6-8% in the coming decade and will not require additional government resources. However, if unchecked, these liabilities could also grow, especially given the current fiscal and institutional regime, and become a major systemic risk.

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Barclays | China: Beyond the Miracle FIGURE 42 Chinese government’s total liabilities As at end of 2011 CNY trn Central government debt

% GDP

7.4

16

Contingent central government liabilities*

22-38.5

47-81

--Pension gap

0-16.5

0-35

--Ministry of Railway liabilities

2.4

5.1

--Policy bank liabilities

7.5

15.9

--State-owned banks' bad loans spin-off

1.4

0.8

-Local government debt

6.7

14.2

4

8.5

29-46

62-97

-Contingent local government liabilities and others Total

Note: *1) Estimates of the Pension gap vary significantly from 0 to CNY16.5trn (results from Cao and Ma) based on different assumptions and methodologies 2) Ministry of Railway liability is based on balance sheet in 2011 3) Policy bank liabilities are outstanding policy bank bonds: CNY7.5trn in 2011 4) Local government debt and contingent liability is assumed to be unchanged from 2010, given that Premier Wen said newly increased local government debt is less than CNY300mn. Source: State Council, Ministry of Railways, National Audit Office, Barclays Research

In addition, the World Bank 2030 report 191 suggests that China needs to increase its social spending. In order to bring China’s “social expenditures” to near the lower end of the range of high-income countries, the World Bank estimates fiscal spending would need to increase by about 7-8% of GDP by 2030 (Figure 28). That means increasing public expenditures by 2-3pp for healthcare, by 3-4pp to fully finance the basic pension coverage and gradually meet the legacy costs of existing pension obligations, plus 1.0-1.5pp for education. Such increases, as pointed out by the World Bank, could probably be met from the existing budget through improvements in the efficiency of expenditure programmes and reallocation from lower-priority spending, such as for infrastructure investment. Combining the contingent liabilities with potential new spending demand points to significant fiscal burdens for the Chinese government in the coming decades.

191

China 2013– Building a Modern, Harmonious, and Creative High-Income Society, The World Bank, 2012.

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Barclays | China: Beyond the Miracle FIGURE 43 Size and composition of public expenditures, cross-country comparison (%GDP)/*

High income Upper middle Lower middle

China

Total

41.6

33.1

36.1

25.7

General public service

5.6

5.6

5.5

2.9

Defence

1.6

1.5

2.2

1.3

Public order and safety

1.6

2

2.6

1.3

Economic affairs

4.2

5.3

6.1

7.9

Environment protection

0.7

0.5

0.3

0.5

Housing and community amenities

0.8

1.2

3

1.9

Health

6.3

3.3

3.1

1

Recreation, culture and religion

1.2

0.8

1

0.5

Education

5.4

3.9

5.4

3.7

Social protection**

15.2

9

6.9

4.7

Note: /* Data are for 2007, except China, where data are for 2008. ** China’s Social protection includes both outlays to pension funds and to health insurance. Adding those financed from general budget, the total public expenditure on health totals around 2.5% of GDP in 2008. Source: World Bank China 2030 (2012), GFS, WDI and World Bank staff estimations.

FIGURE 44 Debt/GDP ratio by country

FIGURE 45 National assets by sectors

250 Govt 8%

200

Overseas 4%

Household 21%

150 Commercial banks 25%

100 50 0 CNH

IND JPN USA DEU FRA GBR Public Debt/GDP, as end of 2012 (%)

ITA

Note: China public debt includes local government debt and other explicit contingent liabilities. Source: State Council, CBRC, Barclays Research

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Corporate 42%

Source: Cao Yuanzheng, Zhong Hong, et al (2012)

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Will China suffer a debt crisis? So what are the chances that China will face a debt crisis in the coming years? Our overall assessment is that, while the probability is low, the risk of a debt crisis is real. But if the public debt and contingent liabilities remain majority owned by domestic residents, then China is more likely to experience growth stagnation like Japan instead of an outright debt crisis. There are several factors supporting our case for a low probability of fiscal stress in China. First, despite the high level of total government liabilities – CNY23-46trn – so far, the government’s balance sheet remains healthy (Figure 44). For instance, the latest available MoF data show that in 2009, assets of state-owned enterprises (SOEs) totalled CNY53.3trn, of which CNY27.9trn belonged to the central government and CNY25.5trn belonged to local governments. In other words, right now, the central government’s assets are still sufficient to cover all the liabilities. In an earlier study on China’s national balance sheet, Cao Yuanzheng (2012) estimated the government’s total assets were CNY24.5trn in 2008 against liabilities of CNY6.9trn (only includes direct and explicit liability). This implied that the government had net assets of CNY17.6trn that year, equal to 56% of GDP. In addition, Cao also estimated China’s total national assets at CNY294trn in 2008 (Figure 45). Of this, corporates held the largest share, at 42%, followed by households (21%), commercial banks (25%), government (8.3%), and overseas holdings (4%). Cao put total national liabilities at CNY153trn that year. Thus, the country had net assets of CNY141trn. Second, the Chinese government remains in a strong fiscal position, owing to rapid revenue growth and prudent fiscal management. Fiscal revenue rose by a record CNY10.4trn, or 25% y/y, in 2011. The total budget deficit was just 1.1% of GDP, even after a 21% y/y increase in expenditures to CNY10.9trn. Even including contingent liabilities, total public debt remains manageable. Using different assumptions of the country’s pension gap, the ratio of China's national debt to its GDP ranges from 62% to 97%. And, third, the government has several options available to finance its rising liabilities. Drawing from international experience, the World Bank (2012) suggested that China could raise contribution rates, or use general revenues or dedicated social security taxes to cover contingent liabilities, in addition to direct transfers of state-owned assets. The central government could issue more debt, and local governments could gradually be allowed to tap the capital markets for more debt financing (CNY250bn in 2012).

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Barclays | China: Beyond the Miracle In addition, if the economy continues to grow rapidly and Chinese households maintain significant amounts of savings and housing assets, then it would also be relatively easy for the government to resolve the debt risks. In a recent study on longevity and fiscal sustainability, the IMF (2012) estimated the impact of ageing on the fiscal position of several advanced and emerging market economies (Figure 46). It found that the private sector does not appear to have sufficient financial assets to deal with ageing-related costs, as shown in the “Gap” in the fourth column. For China, the gap is estimated to be 19-85% of GDP. However, it should be noted that given data limitations, social security benefits and housing assets are excluded from the estimate, and housing assets are generally believed to account for more than 50% of Chinese urban households’ wealth. FIGURE 46 Pension gap in selected countries

(% 2010 Nominal GDP) United States

1) Household total financial assets

2) Present/ Discounted value of needed retirement income

5) Increase in Present discounted values given 3year increase 4) Gap 1)-2) in longevity

3) General Government Gross Debt

339

272 to 363

94

67 to -24

40 to 53

Japan

309

499 to 665

220

-190 to -356

65 to 87

France

197

295 to 393

82

-97 to -196

40 to 54

Germany

189

375 to 500

84

-186 to -331

55 to 74

Korea

186

267 to 357

33

-81 to -170

39 to 52

China

178

197 to 263

34

-19 to -85

34 to 45

Note: Range of values in columns (2), (4), and (5) cover, at the low end, a replacement rate of 60 percent of preretirement income and, at the high end, an 80 percent replacement rate for retirees aged 65 or older to maintain preretirement standard of living during the 2010–50 period./*for China, 2009. Source: IMF (2012), National flow of funds accounts: IMF (2010) and IMF staff estimates

But some other factors could contribute significantly to the debt risks. For instance, fiscal balances could deteriorate over time. Even the national saving ratio could go down. These could have a negative impact on fiscal conditions. A sudden slowdown in economic growth, for instance, could force the government to assume explicit responsibilities for some contingent liabilities. The most important contribution, however, would come from an uncontrolled rise in contingent liabilities. Incentives may lead to unconstrained borrowing by local governments and the rapid accumulation of nonperforming loans in the financial system. The same applies to the pension fund financing gap. Even state-owned assets March 2013

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Barclays | China: Beyond the Miracle may shrink if they are not managed properly or if the SOEs lose competitiveness. In order to effectively reduce the debt risk, the government needs to first stop contingent liabilities from growing further by pushing ahead with reforms in a number of areas. For example,

• Local governments should have an accountable budgeting system so that their

borrowing and spending behaviour would face real limits. They also will have to broaden tax bases, such as introducing property and resource taxes. They should also be allowed to raise capital directly from the market, based on their own balance sheets and not the central government’s.

• The financial system, especially the large state-owned commercial banks, needs to

enhance corporate governance standards and improve risk management systems in order to contain nonperforming loans.

Investment implications If the government is successful in furthering economic reforms, it may be possible for China to avoid a debt crisis or growth stagnation as a result of a heavy debt burden. But even then, such reforms would have significant implications for the economy and market. First, expected reform measures addressing fiscal risks may have the opposite effect on potential growth. Increasing spending on social welfare and decreasing spending on investment, for instance, could lower growth potential. But policies liberalising the financial system and limiting nonperforming assets might increase growth potential by improving the efficiency of capital allocation. Overall, the net impact of all these policy actions is likely to be slightly negative for growth potential, at least in the medium term. However, it should make growth more sustainable. Second, increasing fiscal spending on healthcare, education and pension should point to stronger consumption. Assuming the current trends of rising wages and improving income distribution continue, then consumption may rebound more visibly among the middle range of the consumption spectrum rather than at the super-rich end. Third, as a trend, the overall share of government spending in the economy should rise, adding to ongoing cost pressures. This would reinforce our expectation that the squeeze on profit margins is structural, not just cyclical. In the past, the profit margin squeeze has been driven by adjustments in the costs of labour and capital. In line with the expected policy actions on income distribution, policies aimed at resolving fiscal risks should also promote income redistribution from the corporate to the household

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Barclays | China: Beyond the Miracle sector. This, in turn, should accelerate technological upgrading in order for industries to stay competitive. And, finally, as the government spends more to finance its contingent liabilities, the cost of capital in China should rise. This is also in line with what we would expect following financial liberalisation. As we have argued before, higher costs of capital may further squeeze corporate profits, increase financial market volatility and result in the consolidation of some heavy and highly leveraged industries.

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Barclays | China: Beyond the Miracle

CHAPTER 9

Can China avoid the middle-income trap? • This report concludes the series China: Beyond the Miracle 192.

• Can China continue to grow while avoiding the ‘middle-income trap’ that occurs when a developing country fails to upgrade to high income status as a result of lack of competitiveness and innovation? We believe that China should be able to reach high-income status over the next decade or so by narrowing its technological gap with advanced economies.

• China is breaking away from its old growth model. Long-awaited structural improvements, including a narrowing of the current account surplus, a growing contribution of consumption to GDP and declining inequality, are already under way, but may be underappreciated by investors.

• While institutions matter for long-run growth, optimal institutions may be different for economies at different stages of development. In our view, political reform will be necessary to sustain economic growth in China, but we do not think current political institutions have exhausted the country’s growth potential yet.

• Science and technology have taken off much earlier in China relative to the experience of other emerging Asia economies. Moreover, the diffusion of existing technology should remain a powerful economic driver for some time to come. As China moves up the value chain, we think it will probably shed labourintensive industries faster than most expect.

• While we are reasonably confident about China’s growth outlook, we should not

underestimate the immense challenges the country faces, including corruption and income disparity. We highlight three major risk factors that could potentially derail the growth train: continuous degradation of the environment; the unchallenged monopoly power of state-owned enterprises; and potential risks of financial crisis.

192

A slightly different version of this report was released as Chapter 3 of the Equity Gilt Study 2013.

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Barclays | China: Beyond the Miracle

• Overall, we believe that China’s economy is unlikely to collapse, even though it may continue to look different from western advanced economies. As the economy grows and rebalances, consumption should show secular improvement, the currency exhibit a strengthening trend and heavy industries may experience consolidation.

This article was originally published on 22 February 2013.

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Barclays | China: Beyond the Miracle

China’s new growth challenge In 2012, Chinese economic growth decelerated by more than many government officials and market participants had anticipated at the start of the year. Although the government set the official growth target at 7.5%, most officials forecast annual growth in the 8.0-8.5% range. Year-on-year growth ended at 7.8%, bottoming at 7.4% during the third quarter. However, the slowdown did not cause a major disruption to the economy and revealed at least two important changes: first, China’s growth potential has probably come down to 7-8% from 10%; second, below-8% growth might not cause the much-feared unemployment problem. The growth slowdown also suggests that the Chinese economy is in the middle of a major and broad-based structural transformation, as we argued in our China: Beyond the Miracle series. In those reports, we forecast that the economy was about to shift from economic ‘miracle’ to normal development 193 and anticipated that rapidly rising wages, resource-pricing reforms and other factors would lead to fundamental shifts in the economy, including slower growth, higher inflation pressure, improved income distribution, more balanced economic structure, accelerated industrial upgrading and more distinct economic cycles. A major concern, however, is whether China can sustain economic growth and avoid the ‘middle-income trap’ – the economic stagnation that can occur when a developing country reaches middle income levels (the high middle-income group is currently defined as annual per capita income of ~$4,100 to $12,500 194, according to the World Bank) but is thwarted by rising wages and falling cost competitiveness on the one hand, and a lack of skills and innovation on the other. According to some analysts, the following factors might cause sharp growth deceleration in China in the years ahead: •

•

The one-child policy has caused rapid ageing of the population. Official statistics suggest that the working age population declined by 3.5mn in 2012 from 941mn in 2011. The national saving ratio, at 53%, is unusually high and will likely come down as rebalancing continues. This implies that investment growth should also moderate.

193

“China’s next transition”, Part 1 of China: Beyond the Miracle report series, September 2011, Barclays, Hong Kong. Growing beyond the low-cost advantage-How the PRC can avoid the middle-income trap, Juzhong Zhuang, Paul Vandenberg, Yiping Huang, October 2012, ADB and PKU.

194

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Barclays | China: Beyond the Miracle •

International experience suggests that a very high leverage ratio, like China’s 180% M2-to-GDP ratio, could cause financial and economic stresses. 195

•

China’s political institutions might not be favourable for inducing innovation, which is set to become a key driver of economic growth.

The Chinese economy has been remarkably successful in its takeoff phase, lifting GDP per capita from $220 in 1980 to $6,000 in 2012 (Figure 1) 196 and making China a key driver of global economic growth (Figure 2). While many economists would attribute this success to the country’s reform policies, we argue that the low-cost advantage has played a critical role in driving the rapid expansion of Chinese manufacturing of recent decades (Figures 3 and 4). However, economic conditions are changing. For example, in the face of rapidly rising production costs, labour-intensive manufacturing factories in coastal China have three choices: moving west to inland provinces; moving to countries with lower costs; or moving up the industrial ladder.

FIGURE 1 GDP growth 12

FIGURE 2 China’s contribution to global growth, 2007-2011

(% y/y)

7

10

(pp)

5

8

3 6

1 4

-1

2 0

-3 China

India

1980-1990

Malaysia 1990-2000

Korea

Brazil

2000-2011

Source: Zhuang, Vandenberg and Huang (2012)

2007

2008 China

2009 2010 Rest of the World

2011

Source: Zhuang, Vandenberg and Huang (2012)

195

Carmen M. Reinhart and Kenneth Rogoff, This time is different: Eight centuries of financial folly, 2009, Princeton University Press, Princeton, New Jersey. 196 Juzhong Zhuang, Paul Vandenberg and Yiping Huang, “Growth beyond low-cost advantages: Can the People’s Republic of China avoid the middle-income trap?” October 2012, Asian Development Bank and Peking University, Manila and Beijing.

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Barclays | China: Beyond the Miracle FIGURE 3 Index of hourly manufacturing labor compensation costs, 2010 (US=100)

FIGURE 4 Annual average real interest rates (lending), 1990-2010 (% pa)

100

15

90 80

12

Middle income countries

High income countries

70 9

60 50

6

40 30

3

20 10

US

Germany

Korea

UK

Japan

Chile

Argentina

Thailand

Indonesia

Philippines

China

India

China

Philippines

Mexico

Taiwan

Brazil

Korea

Singapore

US

Source: Zhuang, Vandenberg and Huang (2012)

Malaysia

0

0

Source: Zhuang, Vandenberg and Huang (2012)

In a way, what is occurring in China’s coastal area now is a repeat of what happened in Hong Kong, Korea and Taiwan (HKT) 30 years ago. All three economies later became high-income economies. International experience, however, suggests that the success rate of overcoming the middle-income trap is quite low. According to the World Bank and the Development Research Centre of the State Council (DRC), of 101 middle-income economies in 1960 (based on GDP per capita relative to the US) only 13 had become high-income economies by 2008, including HKT, Japan and Singapore in Asia. 197 The remaining 88, including Malaysia, the Philippines and Thailand (MPT) in Asia, failed to do so (Figure 5). Whether China will graduate to high-income status will depend critically on its ability to graduate from low value-added manufacturing and move into high value-added manufacturing and services. This requires changes in two interrelated areas: one is to alleviate structural risks, such as imbalances, inefficiency and inequality; the other is to encourage technological innovation and industrial upgrading.

197

China: 2030 – Building a modern, harmonious, and creative high-income society, The World Bank and Development Research Center of the State Council, the People’s Republic of China, March 2012, Washington D.C.

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Barclays | China: Beyond the Miracle FIGURE 5 Income per person relative to the US, 1960 and 2008 (log of %) 5.0

4.0

Income per person relative to the United States, log of %

Taiwan S. Korea Oman

2008

Botswana

3.0

United States Switzerlan Switzerland

Middle-income to high-

Greece

Staying rich

Isreal

Malaysia

Kuwait

Argentina China

Brazil

Low-income to middle-

2.0

Middle-income

N. Korea

Low-income "trap"

1.0

Burundi

Niger

1

2

Becoming poor

1960

0.0 0

3

4

5

6

Source: World Bank, Barclays Research

Lessons from the other countries The term “middle-income trap” was originally coined by the World Bank to describe growth stagnation in Latin America. Most low-income countries are agrarian. Economic development often involves the migration of farmers into the urban sector, generating significant productivity gain while labour costs remain very low given virtually unlimited supply. Therefore, by developing labour-intensive and low value-added urban sectors, the economy can grow rapidly. This process can continue until the countryside runs out of surplus labour (as happened in Japan in the early 1960s, in Korea and Taiwan in the early 1980s and in China right now). At that point, labour costs start to rise sharply and the country quickly loses competitiveness in labour-intensive industries. The key factor determining whether a country can escape this trap lies in its ability to achieve technological progress and industrial upgrading. If it can climb up the value chain, its new industries should be competitive, even with higher labour costs, allowing it to graduate into the high-income group. If it fails to progress in these areas, it will be unable to compete with either low-income or high-income economies, remaining stuck in the middle-income range.

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Barclays | China: Beyond the Miracle According to a report by Zhuang, Vandenberg and Huang (2012), 28 of 125 countries globally have been at middle-income levels since 1987. 198 Of these, 18 were middleincome economies as early as 1962, meaning that they have been stuck at the middleincome level for at least 50 years (Figure 6). Of these 18 countries, 12 are in Latin America, three in Africa and the Middle East, and three – Malaysia, Philippines and Thailand (MPT) – in Asia. FIGURE 6 High and middle income country groups High income

Middle income

Group 1 HI before/in 1965 n=17

Group 2 HI after 1965 n=14

Group 3 MI continuously 1987-2009 n=28

Europe Austria Belgium Denmark Finland France Germany Italy Netherlands Norway Sweden Switzerland United Kingdom

Europe Croatia Czech Republic Hungary Poland Slovakia

Europe Belarus Lithuania Romania Russia

N. America/Oceania Australia Canada New Zealand United States

Greece Ireland Portugal Spain Asia Hong Kong Japan Korea Singapore Taiwan

Asia Malaysia Philippines Thailand Africa/Near East Jordan Lebanon Morocco South Africa Syria Tunisia Turkey

Latin America Argentina Bolivia Brazil Chile Colombia Costa Rica Dominican Republic El Salvador Guatemala Mexico Panama Paraguay Peru Uruguay

Near East Israel Note: Includes only countries with populations exceeding 3mn; excludes members of the Organization of the Petroleum Exporting Countries. Source: P Vandenberg, L. Poot and J. Zhuang, “The middle-income trap: Characteristics, policies and lessons for the People’s Republic of China”, 2011, Asian Development Bank, Manila.

198

Some materials presented in this subsection are adapted or drawn from Juzhong Zhuang, Paul Vandenberg and Yiping Huang, “Growing beyond the low-cost advantage: Can the People’s Republic of China avoid the middle income trap?”, Asian Development Bank and Peking University, 2012, Manila and Beijing.

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Barclays | China: Beyond the Miracle Currently, there are about 31 high-income economies worldwide. Of these, 14 moved from middle- to high-income levels after 1965. Nine of these are in the European periphery, with the remaining five from East Asia: Hong Kong, Japan, Korea, Singapore and Taiwan. Japan emerged from the devastation of World War II to reach high-income status in 1968 – a period of just 23 years. Korea reached the middle-income level in 1962 and became a high-income economy 32 years later, in 1994. Taiwan, Hong Kong and Singapore were firmly middle-income in 1962 and became high-income economies in the 1970s and 1980s. For decades, Malaysia, Philippines and Thailand have failed to move up the value chain. This could simply be because they have not focused on innovation. In 2006, R&D expenditure accounted for 0.63% of GDP in Malaysia, 0.11% in the Philippines and 0.25% in Thailand. By contrast, the ratio was 3.4% in Japan, 3.0% in Korea and 2.2% in Singapore. But the causes of low R&D can be wide-ranging, including insufficient government input, lack of human capital, lack of intellectual property protection, macroeconomic instability and social and political chaos. The experiences of successful economies suggest that several key ingredients are required to support innovation, upgrading, and the transition to a high-value economy. 199 First, macroeconomic, political and social stability are necessary for an economy to overcome the middle-income trap, as instability will disrupt investment decisions, production planning, and market demand. Indeed, many Latin American countries that have failed to move beyond the middle-income development stage have suffered from hyperinflation, macroeconomic instability, debt crises, high income equality, and political instability. Second, the government needs to invest in physical infrastructure, the social environment and human capital. Industrial upgrading requires human capital for research, development, production and management, which calls for a strong education system. Infrastructure, including transport, communication and power, is also vital for firms to boost productivity and compete globally. Sound legal and regulatory systems are needed to protect intellectual property rights and encourage technological innovation. Most of these tasks cannot be accomplished by the private sector alone and require significant government effort. Third, a well functioning market system is necessary to allocate resources efficiently, organize production and trade, and provide price signals and incentives for producers

199

Zhuang, Vandenberg and Huang (2012).

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Barclays | China: Beyond the Miracle and consumers. While the government has many roles to play, international experience suggests that resource allocation and other economic decisions are best left to the market and the private sector. An efficient financial system is needed to facilitate investment, production and trade. More important, R&D activities require financial services that differ from those needed for low value-added manufacturers. Financing channels need to be diversified to better manage risk and support investment in innovation. Finally, a focused industrial policy may be helpful. This remains a contentious issue but an increasing number of economists recognize that industrial policy has an important role to play in successfully transforming an economy and avoiding the middle-income trap. Such policies may involve sector- and industry-specific interventions to support innovation and upgrading. Varied industrial policy measures have been used in developing economies, including targeting priority industries, providing subsidized credit, trade policy, support for R&D, state ownership, and information sharing. In our view, the experience of recent decades calls for a reassessment of the Washington Consensus (on the basis of which Washington-based institutions often provided policy advice to developing countries). Key elements of the Washington Consensus include privatisation, liberalisation, free markets, fiscal discipline and minimal state intervention. Yet most economies overcoming the middle-income trap have not rigorously followed these policy prescriptions. East Asia’s economic success also shows that government can play an important role, especially in urging structural transformation where markets alone are insufficient. 200

Underappreciated structural improvement Implications of improving income distribution In mid-January, Ma Jiantang, China’s Commissioner of the National Bureau of Statistics, reported estimates of Gini coefficients for 2003-12. These showed a steady deterioration of income distribution from 0.479 in 2003 to 0.491 in 2008 and steady improvement after that, to 0.474 in 2012 (Figure 7). 201 These estimates were harshly criticised by many Chinese economists as they appeared to contradict the general impression of continuously worsening income distribution. For instance, a recent study by Southwest

200

Daniel Rodrik, “Industrial policy for the twenty-first century”, 2004, John F. Kennedy School of Government, Harvard University, Massachusetts. 201 Script of Ma Jiantang’s press conference in Chinese can be found at the official website of the National Bureau of Statistics of China: (http://www.stats.gov.cn/tjdt/gjtjjdt/t20130118_402867315.htm).

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Barclays | China: Beyond the Miracle University of Economics and Finance reported a Gini coefficient of 0.61 in 2010. 202 One criticism of the official NBS finding was ignorance of income equality in household wealth, such as property. Another was under-reporting of income at the high end. FIGURE 7 Gini coefficients estimated by the National Bureau of Statistics, 2003-2012 0.50

Gini coefficients, 2003-2012

0.49

0.48

0.47

0.46 2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Source: NBS, Barclays Research

We are not in a position to judge the accuracy of the estimated Gini coefficients; however, the trend of the coefficients provided by the NBS looks reasonable to us (though we will have to wait and see if declining inequality has become a new trend). In fact, we believe these data constitute evidence of a largely underappreciated trend of structural improvement in recent years. Such improvements include, among others, improvement in income distribution, increases in the share of household income in national income and the share of consumption in GDP, narrowing of current account surpluses, and the declining energy intensity of the economy. A key policy objective of the government of outgoing Prime Minister Wen Jiabao has been to transform the development pattern. Despite spectacular growth, senior government leaders have over the past 10 years repeatedly noted that the current growth model is ‘uncoordinated, unbalanced, inefficient and unsustainable’. 203 Unfortunately, policy initiatives achieved little improvement in growth quality, at least according to official data. 202

This survey, however, only includes about 8,000 households in one year. For a more detailed discussion of the structural risks facing the Chinese economy, please refer to the relevant parts of Part 1 of the Beyond the Miracle report ‘China’s next transition’, September 2011, Barclays, Hong Kong. 203

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Barclays | China: Beyond the Miracle In our Beyond the Miracle series, we offered two explanations for the apparent lack of progress in terms of economic structure. First, the government has in recent years often advocated three key policy objectives: supporting growth, controlling inflation and adjusting economic structure. However, at the best of times the government might be able to achieve only two of these aims, not all three simultaneously. Therefore, whenever there was a conflict, government officials would most likely sacrifice the objective of structural adjustment. Second, distortions in factor costs are at least partly responsible for extraordinary growth performance and a deteriorating economic structure. Correction of these structural problems also requires changes to factor costs to alter the behaviour of economic agencies. In our view, Wen Jiabao’s policy initiatives have achieved limited results, primarily because he focused mainly on administrative measures, not incentive structures, such as input costs. For example, the government tried to control the overinvestment problem by approving fewer projects. This did not work because incentives for investment remained very strong. Our latest analysis, however, suggests that structural improvement has begun, albeit not as a result of policy initiatives. The main trigger of the improvement has been change in factor markets, including rapid wage growth stemming from increasing labour shortages, and de facto interest rate liberalization as a result of growing shadow banking businesses. These change incentive structures for corporations and households and income distributions at different levels, leading, in turn, to improvements in economic structure.

Consumption recovery and structural rebalancing Important structural changes are happening. For instance, household income as a share of GDP has started to pick up mainly because of rapid wage growth. The current account surplus narrowed from 10.8% of GDP in 2007 to 2.6% in 2012. Mainly because of this, PBoC Deputy Governor Yi Gang argued that the yuan exchange rate was near equilibrium, while US President Obama’s former top economic advisor, Lawrence Summers, noted in January 2013 that the yuan was not as undervalued as it was five years earlier. 204 Another rebalancing in recent years relates to regional disparity, with the rural-urban income gap narrowing notably (Figure 8). In addition, China’s reform success was until recently a story of the coastal regions. However, inland economies are now growing faster than the coastal economies, thanks to the government’s ‘go west’

204 “Yi warns of currency wars as yuan close to ‘equilibrium’”, 28 January 2013, Bloomberg, http://www.bloomberg.com/news/2013-01-26/china-s-yi-warns-on-currency-wars-as-yuan-in-equilibrium-.html.

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Barclays | China: Beyond the Miracle FIGURE 9 Growth in Eastern, Central and Western China

FIGURE 8 Rural – urban income gap narrowed Income per capita: Urban (CNY th)

25

4.0

Income per capita: Rural (CNY th)

14

Urban-Rural Ratio (%, RHS)

20

2012 China GDP growth (%y/y)

16

3.5

Western

Central

Eastern

12 10

15

3.0

10

2.5

5

2.0

8 6 4 2

1997

2002

Source: CEIC, Barclays Research

2007

2012

Xinjiang

Sichuan

Hubei

Anhui

Jiangxi

Jiangsu

Beijing

Chongqing

1992

Zhejiang

1987

Shanghai

1.5

0

0

Source: CEIC, Barclays Research

policy, the migration of manufacturing industries, and rich resource endowments in western China (Figure 9). Official data also suggest that the contribution of consumption to GDP growth increased from about one-third in 2009 to 51% in 2012. Two Chinese economists, Tian Zhu and Jun Zhang of Shanghai, have gone further, arguing that China’s consumption share is grossly underestimated as a result of underreported residential spending, consumption covered by institutional spending and technical issues in the household survey method. They note that the consumption share estimated by the Penn World Table was 60.9% in 2010, compared with the official figure of 47.4% and 58.9% in the Penn World Table in 1990. Our research finds that the consumption share of GDP began to rise after 2008, although this is not yet fully reflected in official statistics. 205 By comparing three sets of consumption data collected and compiled by the NBS, we find significant gaps between retail sales and national account consumption data. Although the latter are derived mainly from household survey data, some previous studies pointed to possible underreporting of both household income and consumption. By assuming new growth rates for consumption (a weighted average of consumption-related retail sales growth and service sales growth), we find that the consumption share of GDP fell during much of the past decade, as suggested by official data, but rebounded from 48% in 2008 to 52% in 2010 (Figure 10). 205 China: Beyond the Miracle: Great wave of consumption upgrading, Yiping Huang, Jian Chang, Lingxiu Yang, January 2012.

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Barclays | China: Beyond the Miracle FIGURE 10 Consumption share of GDP by estimate by Barclays 70

FIGURE 11 Household consumption share estimate by former PBoC MPC member, David Li 55

Official consumption share (%)

Reconstructed consumption share (%) Official consumption share (%)

Estimated consumption share (%) 65

50

60 45

55 40

50

35

45 40 2000

2002

2004

2006

2008

Source: Barclays Research

2010

30 1990

1993

1996

1999

2002

2005

2008

2011

Source: Li & Xu study

Our analysis encountered widespread scepticism after its initial dissemination. Some commentators found it difficult to accept our finding given their strong impression of sharply worsened structural problems following the CNY 4trn stimulus package adopted in late 2008. Others argued that structural improvement was impossible since the government had not undertaken more decisive reforms. However, five months later, David Li, a former member of the PBoC’s Monetary Policy Committee, published a similar study applying a different approach. By recalculating Chinese household consumption expenditure, he concluded that household consumption share rebounded from 36% in 2007 to 38.5% in 2011 (Figure 11).

Causes of rebalancing in China Both our study and that of David Li point to recent wage increases as the main trigger of an increase in the consumption share of GDP. According to the study by Li and Xu, alongside a rebound of the consumption share of GDP, labour income also picked up from 41% in 2007 to 47.1% in 2009 (Figure 12). One special mechanism is the change in labour market conditions. When an ‘unlimited labour supply’ exists, rapid industrialisation is accompanied by a stable wage rate and, therefore, a declining share of wage income in GDP. This is reversed when a labour shortage emerges: wages rise rapidly and the share of wage income in GDP starts to grow.

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Barclays | China: Beyond the Miracle FIGURE 12 Labor income and consumption shares of GDP

FIGURE 13 Structural shift in Korea and Taiwan’s economies

55

90

50

80

Private consumption % GDP

70

45

60 40

50 35 30 1990

40

1995 Consumption/GDP

Source: Li & Xu study

2000

2005 Labor income/GDP

2010

30 1960

1970 1980 1990 2000 2010 China (starts from 1982) Korea Taiwan

Source: CEIC, Barclays Research

In fact, this was exactly what happened in Korea and Taiwan in the mid-1980s, when their consumption shares started to recover. That was also when those two economies experienced the so-called Lewis turning point, when labour markets shift from surplus to shortage (Figure 13). The same has happened in recent years in China, with the labour shortage problem intensifying since mid-2009. Rapid wage growth increased the share of household income in the economy and contributed to a rebound in the consumption share of GDP, although this rebalancing is only at the beginning. Rapid wage growth was probably also behind the recent improvements in income distribution highlighted by the NBS, since low-income households rely more on wage income and high-income households rely on investment returns or corporate profits. If the past trend was households subsidising corporations, then the new trend is redistribution of income from corporations to households as rising labour costs increase wage income but squeeze corporate profits. This is probably why, in rapidly developing economies, the so-called Kuznetz turning point (when income distribution shifts from deteriorating to improving) often follows the Lewis turning point. It is interesting that the real boost to consumption in recent years came from changing labour market conditions and associated wage increase, not from government policies. This is, however, consistent with our argument that factor costs might be one of the most important factors behind the growing structural risks. Therefore, correction of factor costs should also help alleviate some of the structural problems. Clearly, rebalancing is still at an early stage. For instance, the consumption share of GDP, at 52% in 2010, on our estimates, was significantly below the 70-90% range in March 2013

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Barclays | China: Beyond the Miracle most developing and developed economies. This gap may be narrowed, in part, through continuous wage adjustment. Expected interest rate liberalization, which will likely lead to high deposit rates, at least, should further facilitate rebalancing. Further changes may also be required to transform the development pattern completely. This could involve measures to improve income equality beyond the primary round of income distribution, development of social welfare systems such as pension, medical insurance and education, and financial and capital account liberalization. Rebalancing and reduction of other structural risks are only the first steps toward sustainable growth. If China relied mainly on increasing factor inputs to rise to a high middle-income economy, at GDP $6,000 per capita in 2012, it now has to depend more on productivity growth to double the current income level and graduate to high-income status. On a positive note, as Justin Lin has noted, China still has huge potential to grow. 206 Its current level of industrial labour productivity is only about 10% that of the US and still below the levels of Malaysia, Argentina, Brazil, Thailand and Indonesia (Figure 14). Realizing that potential, however, could be a very arduous task. FIGURE 14 Growth and level of industrial labour productivity in China and selected economies Average labor productivity growth (2000-2009) Productivity level (% US level, market exhange rate, RHS)

10 8 6

FIGURE 15 Standards of living in Barbados and Jamaica diverge after independence 120 100

1.0 0.8

80 60

Natural log of index of real GDP per capita (%)

0.6

4 40 2

0 -20 Japan

Singapore

Chile

Korea

Malaysia

Brazil

Argentina

Thailand

China

Indonesia

Philippines

-2

Source: Zhuang, Vandenberg and Huang (2012)

0.2 0.0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

0

206

0.4

20

Barbados

Jamaica

Source: Peter Blair Henry and Conrad Miller, “Institutions versus policies: A tale of two islands”, American Economic Review, 2009, 99:2, pages 261-267.

Justin Yifu Lin, Demystifying the Chinese Economy, 2011, Cambridge University Press, New York.

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Political and economic reforms For some scholars and policymakers, the Chinese economic experience of the past three decades provides an alternative model to the Washington Consensus. Joshua Cooper Ramo, for instance, published The Beijing Consensus in 2004. 207 Although there is no precise definition of the Beijing Consensus, it has evolved to mean alternative plans for economic development in emerging markets. Critics, however, often argue that the socalled important features of the Beijing Consensus are simply problems yet to be addressed in a half-reformed economy.

Will China fail? In Why nations fail, Daron Acemoglu and James A. Robinson (AR) argued that “growth under extractive political institutions, as in China, will not bring sustained growth, and is likely to run out of steam.” 208 Their central thesis is that institutions influence behaviour and incentives in real life and forge the success or failure of nations. Perhaps the most important contribution of AR’s analytical framework is the distinction between inclusive and extractive institutions. Inclusive economic institutions are those that allow and encourage participation by the great mass of people in economic activities that make best use of their talents and skills and that enable individuals to make the choices they wish. 209 Inclusive economic institutions are good for growth because they give people the freedom to choose what they do best and also promote education and technological progress, two important engines of growth. In contrast, extractive economic institutions are designed to extract income and wealth from one subset of society to benefit a different subset. Politics, in the meantime, is the process by which a society chooses the rules it lives by. AR refer to political institutions that are sufficiently centralized and pluralistic as inclusive political institutions, and refer to the institutions as extractive political institutions when either of the above conditions fails.

207

Joshua Cooper Ramo, The Beijing Consensus, 2004, The Foreign Policy Centre, London. AR’s theory that institutions determine long-run growth runs right into the heart of the popular institutional economics. Acemoglu received the John Bates Clark Medal in 2006 for his work on institutions and growth, which is awarded to economists under forty judged to have made the most significant contribution to economic thought and knowledge. He is widely speculated in the economist community as a potential candidate for the Nobel Prize in Economics. 209 Furthermore, to be inclusive, economic institutions must feature secure private property, an unbiased system of law, and a provision of public services that provides a level playing field in which people can exchange and contract; it also must permit the entry of new businesses and allow people to choose their careers. 208

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Barclays | China: Beyond the Miracle AR conclude that nations fail when they have extractive economic institutions, supported by extractive political institutions that impede and even block economic growth. Why don't all societies create economic institutions that bring prosperity? The answer lies in the fact that different institutions have different consequences not only for the prosperity of a nation, but also for how that prosperity is distributed and who has power. Economic growth creates both winners and losers. Therefore, powerful groups often stand against economic progress and against the engines of prosperity. AR argue that rapid growth is possible in China because of a significant move away from the most extractive economic institutions, even without transformation of the political institutions. But in AR’s view, this growth will not be sustained, for two reasons. First, sustained economic growth requires innovation, and innovation cannot be decoupled from creative destruction. Second, the ability of those who dominate extractive institutions to benefit greatly at the expense of the rest of society implies that political power under extractive institutions is highly coveted, making many groups and individuals fight to obtain it. We think AR makes an important point that political reform needs to eradicate problems such as corruption, monopoly and disparity and to sustain rapid economic growth. But we also believe that AR’s analytical framework may be too simplistic and their overall assessment of the Chinese growth outlook too pessimistic. First, there could be more than one form of ‘good’ institution supporting long-run growth, especially at different stages of development. For example, Hong Kong, Korea, Singapore and Taiwan did not have inclusive political institutions when they were about to graduate into high-income status. We are also unsure whether Britain’s institutions at the time of the industrial revolution were more inclusive than the institutions in many Asian countries today. In our view, what China needs to undertake in the next stage of economic development is technological diffusion, not original innovation. As Jeffrey Sachs has noted, innovation and diffusion require different types of institutions. 210 Original research and innovation are highly uncertain, so the only way to succeed is to encourage large-scale experimentation. Meanwhile, technological diffusion has a clear target: comprehension, replication and adaption. Therefore, the state may be able to play a greater role in directly supporting technological diffusion. In other words, while institutions matter, optimal institutions may be different for economies at different stages of development.

210 Jeffrey D. Sachs, “Government, geography and growth: The true driver of economic development”, Foreign Affairs, September/October 2012.

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Barclays | China: Beyond the Miracle Second, while institutions are undoubtedly important, macroeconomic policies may exert just as much influence on economic performance. In an interesting study, Peter Blair Henry and Conrad Miller compared economic performance between two Caribbean islands. 211 Barbados and Jamaica are both former British colonies, gaining independence in 1966 and 1962, respectively. Both inherited almost identical economic and political institutions: Westminster Parliamentary democracy, constitutional protection of property rights, and English Common Law. In the 40 years after independence, the standard of living in the two countries diverged (Figure 15). Jamaica recorded average real income growth of 0.8% per year during the entire sample period, while Barbados achieved 2.2%. The difference, according to Henry and Miller, stemmed almost entirely from differences in macroeconomic policies, not institutions. A quick examination of economic performance of the transitional economies during the last two decades may push the above argument even further. Many of the transitional economies in Central and Eastern Europe clearly have more ‘inclusive’ economic and political institutions than those in the transitional economies in Asia, according to AR’s definitions. The former group, however, had consistently weaker growth performance than the latter group, especially China. Third, we think AR’s analytical framework has a major shortcoming, ie, the onedirectional causation from politics to economic institutions to growth performance. There is no feedback from economics to politics. And this is probably why they often fail to explain how political changes take place. For instance, in the book, AR described at length how Deng Xiaoping engineered a political ‘revolution’ in the late 1970s before introducing economic reforms. But they do not address why Deng Xiaoping started economic reform. We think the reason behind Deng Xiaoping’s reforms was that the economy was on the verge of collapse and he saw no alternative. The Chinese political system has evolved for the same reason. For example, the Communist Party now actively recruits members from among private entrepreneurs, conducts direct elections at the village level and allows a certain degree of monitoring by social media.

Re-defining the role of the government in the economy Our overall take is that political reforms are important for maintaining social and political stability, but economic policy choices can still play a major role in facilitating economic growth.

211

Peter Blair Henry and Conrad Miller, “Institutions versus policies: A tale of two islands”, American Economic Review, 2009, 99:2, pages 261-267.

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Barclays | China: Beyond the Miracle To that end, both the World Bank and the Asian Development Bank, in collaboration with some Chinese institutions, made important policy recommendations in 2012 (Figure 16). The two sets of recommendations have significant overlaps. Both highlight the importance of supporting innovation and industrial upgrading. They also focus on structural reforms to improve the functioning of markets, macroeconomic policy reforms, the greening of the economy and maintaining good relations with the rest of the world. The World Bank also singles out social security for all, while the Asian Development Bank emphasises the importance of services, urbanization and equality. Incoming Premier Li Keqiang has set urbanization as a key policy theme for the next 10 years. This essentially means giving 200-300mn migrant workers official urban resident status and bringing even more rural residents into the cities. This should support economic growth by increasing consumer spending, growing the service sector, etc. But it will also require substantial reforms and investment, including in urban infrastructure, housing and social security systems. One option for organizing the reform agenda is to redefine the relationship between the government and market, as suggested by the Central Committee’s Political Report to the 18th Party Congress last October. The relationship between the government and the market has been a hot topic since the beginning of economic reform. Essentially, economic reform is about the government making room for the market to play a greater role in allocating resources, products and income. However, the Chinese reform approach has been gradual. The state continues to play an active role in economic activities. That approach has generated good results in terms of achieving economic growth but also created problems that could hinder future economic growth. FIGURE 16 Some policy prescriptions for avoiding the middle-income trap in China World Bank & Development Research Center

Asian Development Bank & Peking University

Accelerating the pace of innovation and creating Stepping up innovation and industrial upgrading an open innovation system Implementing structural reforms to strengthen the foundations for market-based economy

Deepening structural reform, especially reforms of enterprises, labour and land markets Developing services and scaling up urbanization Reducing income inequality

Expanding opportunities and promoting social security for all Strengthening the fiscal system

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Maintaining macroeconomic ad financial stability

296

Barclays | China: Beyond the Miracle World Bank & Development Research Center

Asian Development Bank & Peking University

Seizing the opportunity to “go green”

Promoting green growth to conserve resources and protect the environment

Seeking mutually beneficial relations with the world

Strengthening international and regional economic cooperation

Source: “China 2030: Building a modern, harmonious and creative high-income society”, the World Bank and the Development Research Center, 2012, Washington DC and Beijing; “Growing beyond the low-cost advantage: Can the People’s Republic of China avoid the middle income trap?” Asian Development Bank and Peking University, 2012, Manila and Beijing

We expect the government to redefine the relationship between the government and market in the coming years at three levels. The first is to liberalise the factor markets and complete the transition to a market economy. During the past three decades, the government has completely abandoned restrictions on product markets but intervened in factor markets. Distortions to factor markets, including subsidies to corporations and taxes on households, boosted economic growth but also led to various imbalances, inefficiency and inequality problems. If China had a no-market economy during the prereform period and a half-market economy during the past three decades, it is now, in our view, time for China to move to a full-market economy. We believe the transition to a full-market economy will require the scrapping of the household registration system, a major obstacle to labour mobility. Financial liberalisation is also critical for efficient allocation of financial resources. This may involve interest rate liberalisation, exchange rate reform, reform of financial institutions’ corporate governance and liberalisation of the capital account. Given the political reality, we do not anticipate a major wave of privatisation of state-owned enterprises (SOEs) any time soon. Instead, the government will probably try to create a level-playing field for SOEs and non-SOEs by focusing on reforms in two areas: input cost distortions and monopoly power. The second task will be to establish a new macroeconomic regulatory system, including a professional monetary policy-making mechanism and accountable budgetary systems for government at all levels. This is crucial not only to facilitate the transition to the fullmarket economy but also to control some growing macroeconomic risks. For instance, in retrospect, the stimulus package introduced in late 2008 was quite successful in boosting economic growth in 2009. But it also created fiscal, credit and inflation risks. One of the reasons for this was that the authorities mobilised SOEs, financial institutions and local governments to achieve macroeconomic policy objectives. But many of these institutions did not have hard budget constraints. Therefore, we believe it is important

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Barclays | China: Beyond the Miracle to make SOEs, financial institutions and local governments accountable for their own decisions. It is also necessary to divorce macroeconomic policies from these institutions. The third plank is to change the way the government intervenes in economic activities, from directly supporting production and investment to promoting technological innovation and industrial upgrading. In the past, the government’s active role in mobilizing resources for economic activities was a positive factor for economic growth, especially at the early stage of economic liberalisation and market development. However, as economic development moves to the next stage, technological innovation and industrial upgrading will require more decentralised efforts. By definition, innovation is a risky business. Unlike manufacturing production, it is difficult to plan. This does not mean there is no room for the government to play a role, however. The government could focus more on supporting infrastructure development, promoting education and research, facilitating financial services and enforcing protection of intellectual property rights. Again, the government may still design industrial policies to support industrial upgrading.

Early takeoff of science & technology Although future growth will have to rely more on productivity growth and industrial upgrading, China still enjoys a hefty backwardness ‘advantage’. That is to say, it can probably count on technological diffusion to drive economic growth for a long time to come. Unlike pushing the world technological frontier, diffusion is about learning existing technologies from others, which requires different skills and institutions.

Productivity growth and Science & Technology takeoff Despite criticisms that Chinese growth has relied mainly on resource inputs, the economy has actually performed quite well in terms of productivity growth in recent decades. Estimates by Dwight Perkins and Thomas Rawski suggest that total factor productivity (TFP) contributed 40% of GDP during 1978-2005. 212 This is in line with World Bank and DRC findings (Figure 17). According to the World Bank, total factor productivity has contributed more than half of China’s industrial growth in recent decades. This differs markedly from what Paul Krugman might call ‘Soviet-type growth’. 213

212

Dwight Perkins and Thomas G. Rawski, “Predicting the Chinese economy by 2025”, in Loren Brandt and Thomas Rawski, China’s Great Economic Transformation, 2008, Cambridge University Press. Paul Krugman, “The myth of East Asian miracle”, Foreign Affairs, November/December 1994.

213

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Barclays | China: Beyond the Miracle FIGURE 17 Sources of growth: GDP and industry (pp) Total Output

Output per worker

Contribution to Growth of Output Per Worker

Physical Capital

Education

Factor Productivity

GDP 1978-2004

9.3

7.3

3.2

0.2

3.8

1993-2004

9.7

8.5

4.2

0.2

4.0

1978-2004

10.0

7.0

2.2

0.2

4.4

1993-2004

11.0

9.8

3.2

0.2

6.2

Industry

Source: World Bank and Development Research Center, “China 2030”, 2012, Washington DC and Beijing

Of course, TFP growth could result from a combination of technological progress and labour migration from rural to urban sectors. The changing mix of Chinese industrial output and exports confirm its steady climb up the value chain. China already accounted for close to 20% of global high-tech exports in 2009 (Figure 18). The World Bank and DRC have noted that “Chinese manufacturers of transport and telecommunications equipment, consumer electronics and textiles and garments are aggressively engaging in backward and forward integration moving from the assembling and testing of standardised products to the design and manufacture of differentiated parts and components and new products that generate higher profit margins.” 214 Peter K. Schott found that China’s export similarity index with the OECD countries in the US market increased from 0.28 in 1981 to 0.55 in 1991 and 0.75 in 2001. In 2001, only two other emerging market economies had higher similarity indices with OECD countries– Mexico (0.8) and Korea (0.8). 215 Admittedly, R&D in China is still low relative to many advanced economies. But data suggest that it is already experiencing a takeoff in R&D, which is happening much earlier than international experience would suggest. In 1996, R&D expenditure accounted for 0.6% of GDP. In 2006, it more than doubled to 1.4%. This was still lower than Japan’s 3.0%, Korea’s 3%, Singapore’s 2.2% and America’s 2.6%. However, it was already significantly ahead of many developing countries (Figure 19).

214

World Bank and Development Research Center, China 2030, 2012, Washington DC and Beijing. Peter Schott, “The relative sophistication of Chinese exports”, NBER Conference on China, 2004, Massachusetts MA.

215

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Barclays | China: Beyond the Miracle

4.0

(%)

(%)

3.5

20

1996

2006

Thailand

25

FIGURE 19 R&D intensity in China and selected economies

Philippines

FIGURE 18 Share of global high-tech exports, top 10 countries, 2009

3.0 2.5

15

2.0

10

1.5 1.0

5

0.5

Source: Zhuang, Vandenberg and Huang (2012)

US

Singapore

Malaysia

Korea

Japan

0.0 China

Netherlands

Malaysia

UK

Korea

France

Japan

Singapore

US

Germany

China

0

Source: World Bank

In a recent study, Jian Gao and Gary Jefferson examined China’s R&D expenditure behaviour in a cross-country sample. 216 They found that, on average, a country’s R&D started to take off (ie, to exceed 1% of GDP) when its purchasing power parity (PPP) measured income per capita was at $8,000 in 1999 prices. Yet when R&D spending began to take off in China, its PPP measured per capita income was $3,600 (Figure 20). Gao and Jefferson offer three explanations for this somewhat unusual phenomenon. The first is the relatively low illiteracy rate, at 16.5% in 1999. This was the result of government efforts to improve the education system both pre- and post-economic reform. The second is market size. This probably relates to the commercial motive to produce in close proximity to large markets. 217 . The third is proximity to dynamic economies. One of China’s greatest assets is its close physical and cultural proximity to Hong Kong and Taiwan and, to a lesser but still significant degree, to Korea, Japan, and Southeast Asia.

216

Jian Gao and Gary H. Jefferson, "Science and Technology Takeoff in China? Sources of Rising R&D Intensity." Asia Pacific Business Review 13(3), Special Issue: Global R&D in China (2007): 357-372. 217 This may explain why science & technology takeoff has not occurred in certain smaller OECD countries (e.g. Norway, Australia, Belgium, Australia, and New Zealand) while it has occurred in all but one of the largest OECD economies.

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Barclays | China: Beyond the Miracle FIGURE 20 R&D expenditure in China and selected economies (% GDP) 4 United States

3

2

Germany Japan

South Korea

China

Singapore

1 Brazil

India

1930 1934 1938 1941 1943 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0

Source: Gao and Jefferson (2004)

FIGURE 21 Resident patent filing per R&D expenditure, 2003-07 Resident patent filings per R&D expenditure, 2003-2007

Log resident patent filings 1,000,000

Japan Republic of Korea

10,000

100

Armenia Mongolia Tajikistan Uganda

1 1

China

United States of America Russian Federation Germany United Kingdom France Brazil Ukraine Canada Denmark New Zealand Kazakhstan Netherlands Norway Belarus Israel Romania Bulgaria Belgium Croatia Greece Portugal Latvia Slovakia Iceland Lithuania Estonia Luxembourg Cyprus Log R&D expenditures 100

10,000

1,000,000

Source: Rio Tinto, Barclays Research

Patents and research returns In absolute terms, China is already among the three largest R&D spenders in the world, alongside the US and Japan. Even if measured by resident patent filing per R&D expenditure, China is also among the top group (Figure 21). China is the only middleincome country in that top group. This is probably even more important evidence of the early takeoff of science and technology in China. March 2013

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Barclays | China: Beyond the Miracle We do not find it surprising that most Chinese patents are still concentrated at the lower end of the value chain (Figure 22). Indeed, China dominates the low-value segment of patent filing and is catching up rapidly in the medium-value segment. It is still an insignificant player in the high-value segment. This is consistent with China’s level of economic development and economic structure. The good news is that the private sector is playing an increasingly important role in R&D. In 2009, private enterprises accounted for 59% of those engaging in innovation and 61% of the personnel (Figure 23). Their shares in R&D expenditure and number of patents were smaller but still quite significant.

FIGURE 22 Patent family applications by value and country absolute volume Intermediate Value

High Value

Low Value

Year

CN

DE

US

CN

DE

US

CN

DE

US

1990

5

2139

5784

51

10101

40232

27343

32021

40232

1991

5

1781

4747

37

10445

39887

33158

35216

39887

1992

7

1727

4696

59

10614

42843

43215

38082

42843

1993

4

1868

4314

47

11014

48298

44879

40573

48298

1994

5

2056

4200

69

11766

55841

42237

42400

555841

1995

3

2107

3888

64

12073

62261

41296

43300

62261

1996

4

2100

2980

74

14003

61888

46287

47106

61888

1997

8

1851

2977

97

15218

68525

48099

49319

68525

1998

6

1836

3799

121

16349

65965

50476

51057

65965

1999

5

1543

3743

160

17167

66363

59659

52417

66363

2000

2

1421

3312

269

16807

65797

74843

51879

65797

2001

10

980

2564

333

16143

62624

87826

49961

62624

2002

15

644

2361

461

14896

59977

109524

46721

59977

2003

13

556

2027

759

15603

50830

133444

47140

50830

2004

27

629

2142

1347

17345

49273

147734

50054

49273

2005

25

606

1722

2528

18321

50098

187067

47245

50098

Source: World Bank and Development Research Center, “China 2030”, 2012, Washington DC and Beijing

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Barclays | China: Beyond the Miracle FIGURE 23 Distribution of innovation inputs in China, 2009 # enterprises

Share

R&D personnel

Share

R&D expenditure Share

Unit

%

‘000

%

bn

# patents

Share

%

Unit

%

Total

429378

100

1914

100

405

100

118245

100

SOEs

8860

2.06

175

9.13

36

8.92

6478

5.48

Private

253366

59.01

356

18.62

61

15.08

26528

22.43

HMT

33865

7.89

199

10.39

39

9.58

11179

9.45

Foreign

40502

9.43

284

14.86

69

16.94

17965

15.19

Source: China Statistical Yearbook of Science and Technology, 2010

One critical factor that will help determine the sustainability of China’s science & technology takeoff is returns to R&D. According to a recent study by Gary Jefferson and Kaifeng Zhong, of six Asian cities surveyed, Seoul had the highest R&D capability, followed by Shanghai, Guangzhou, Beijing, Chengdu and Tianjin. 218 Returns to R&D personnel were also the highest in Seoul. However, because of the lower personnel costs, average returns were much higher in all five Chinese cities than in Seoul (Figure 24). FIGURE 24 Firm-Level R&D: Comparison of Seoul and five Chinese cities R&D capability index

Estimated personnel return ($)

Salary of R&D personnel ($)

Return/ salary

Seoul

31.88

37,639

20,847

1.81

Shanghai

25.15

24,086

5,655

4.26

Guangzhou

6.63

14,984

3,249

4.62

Beijing

0.00

13,479

3,494

3.86

Chengdu

-7.92

9,676

3,102

3.12

Tianjin

-10.26

8,818

1,569

5.62

Source: Gary Jefferson and Kaifeng Zhong, “An investigation of firm-level R&D capabilities Asia”, Chapter 10 in Global Production Networking and Technological Change in East Asia, Shahid Yusuf, M. Anjum Altaf and Kaoru Nabeshima, eds., 2004, Washing DC, World Bank-Oxford University Press.

218

Gary Jefferson and Kaifeng Zhong, “An investigation of firm-level R&D capabilities Asia”, Chapter 10 in Global Production Networking and Technological Change in East Asia, Shahid Yusuf, M. Anjum Altaf and Kaoru Nabeshima, eds., 2004, Washing DC, World Bank-Oxford University Press.

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Barclays | China: Beyond the Miracle Macroeconomic data on productivity, output mix and product quality all seem to confirm that Chinese R&D has been useful in supporting economic growth and industrial upgrading. Several empirical studies applying firm-level or province-level data also suggest the number of R&D personnel or expenditure had positive impacts on total factor productivity or patent output or negative impact on costs. 219 These positive impacts are particularly evident in a number of sectors, including semiconductors, automobiles and telecommunication equipment. According to the China Intellectual Property Office, China accounted for 3.15% of the world’s total patents in 2007-09. But its share reached 17.3% in digital communication, 7.7% in telecommunication and 5.7% in electrical engineering.

What could derail the growth train? Although we are confident that China will avoid the middle-income trap, we do not under-estimate the risks facing its economy in the coming years. The experiences of countries that failed to make the jump to high-income status suggest that their inability to innovate and upgrade can be attributed to three broad factors: (1) macroeconomic, political and social instability; (2) persistent inefficient allocation of resources; and (3) insufficient support to physical infrastructure and human capital development. The Chinese economy faces a long list of risk factors, such as worsening corruption and serious income inequality. These, and other risk factors, could disrupt China’s growth trajectory. However, we think policy reforms and economic forces should be able to address many of these issues. For instance, with assistance of rapid increase in wage rates, expected interest rate liberalisation and further reforms, we think China is probably close to the Kuznetz turning point when income distribution switches from deterioration to improvement. Similarly, the government recently stepped up its efforts to crack down on corruption. An implicit acceptance of social media as a monitoring mechanism for government officials is particularly encouraging, although in itself this will be insufficient to eradicate corruption. And, finally, the protection of intellectual property rights has improved significantly. After joining the WTO in late 2001, China set up a nationwide court system for dealing with intellectual property right issues. International experience also suggests that such protection can strengthen significantly when indigenous intellectual property rights become dominant. There are, however, some risk factors that might be more difficult to resolve and could pose more systemic threat to growth sustainability. Following are three such risks.

219

For a summary of these findings, please refer to Jian Gao and Gary Jefferson (2007).

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Barclays | China: Beyond the Miracle Irreversible environmental damage. One of the major consequences of China’s rapid economic growth during the past few decades is serious and widespread degradation of the environment. According to one count, 16 out of the world’s 20 most polluted cities are in China. Air pollution may be relatively easy to address, considering the experiences of major cities such as New York, London and Tokyo dealing with similar problems during the post-war period. But other environmental damage could be much more difficult to reverse. For instance, water shortages have already led to a rapid drop of underground water table levels in Northern China. Underground water supplies in about two-thirds of China’s cities are also considered seriously polluted. These problems, if not tackled quickly, are likely to reduce life quality, hamper productivity, drive away investment and, eventually, dim the growth outlook. Increasing cost of state-owned enterprises (SOEs). SOEs played an important role in maintaining economic stability during the reform period. They have now become a drag on the efficiency of the overall economy. As SOEs have evolved into an important interest group, they are also obstacles to further reforms. The state sector is generally profitable, thanks to implicit input subsidies and monopoly power, not necessarily its own competitiveness. In relative terms versus the private sector, the SOEs suck in more resources but churn out less in output. This is a significant limiting factor on the nonstate sector’s growth potential. It is best demonstrated by credit allocation in the banking sector and the, related, development of informal lending. SOEs may also contribute to fiscal risks, as both the state sector and local governments continue to face soft budget constraints, and become a source of social tension. Risk of financial crisis. This risk cannot be avoided completely, whether or not the government pushes ahead with financial liberalisation. Financial risks are already on the rise in China, reflected in “excessive borrowing” by heavy industries and local governments. The rapid growth of the shadow banking sector also suggests that further delaying financial reform is no longer an option. International experience also suggests that liberalisation of interest rates, the exchange rate or capital account can be accompanied by significant increases in financial instability. It remains an open question if China’s banks and its financial system more generally could withstand the shocks likely brought about by financial liberalisation and opening. In our view, the government’s ability to control and alleviate risks in these three areas – environmental damage, the SOEs and financial shocks – will determine China’s chance of maintaining its growth sustainability. If the above risks explode, China’s growth could collapse, at least in the short term, with devastating implications for the rest of the world. March 2013

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Toward a high-income economy Our analysis suggests the following three conclusions. First, we find that the longawaited structural improvement is already under way and may have been underappreciated. This means that the Chinese economy is breaking away from its past imbalanced, uncoordinated, inefficient and unsustainable growth model. One key trigger of this change is rapid wage growth stemming from the emerging labour shortage. This not only redistributes income from corporations back to households but also improves equality among households. The back-door liberalization of interest rates, in the form of growing shadow banking businesses, further increases household income and squeezes corporate profits. Although rebalancing has so far been driven mainly by changes in factor markets, economic reforms will be critical for furthering structural improvement. These should include removing remaining factor cost distortions, liberalising the financial sector and improving social security systems. We do not think outright privatisation of SOE is feasible in the near term. But the government likely will move steadily toward the creation of a level-playing field by removing input cost subsidy and reducing the monopoly power. Second, although it is unlikely that China will adopt Western-style democracy any time soon, we expect its leaders to implement some political reforms in the years ahead. Such steps may be necessary to ease social economic tensions and facilitate continuous economic growth and could include the gradual extension of direct election to higher levels of government, having more candidates than posts in high-level internal elections, increased tolerance of social media, stepped-up efforts against corruption, and improvements in the transparency of budgetary and other decision processes. We do not think Chinese political institutions have already exhausted their potential to foster growth. The experiences of East Asia suggest that more than one form of political institution can support long-run growth. This is particularly true if the economy is still in the technological catch-up stage. Moreover, although institutions are very important, economic policies under the same institutions can still make a big difference in terms of economic growth, as illustrated by the comparison of historical macroeconomic performance between Jamaica and Barbados. And while politics determine economic institutions, which, in turn, affect growth, economic activity may also influence politics. This is why we think political reforms are likely in the coming years. Finally, the takeoff of science and technology in China has occurred much earlier than international experience would suggest. This is probably because of China’s high literacy rate, large market size and proximity to dynamic economies. In fact, China is March 2013

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Barclays | China: Beyond the Miracle already among the world’s leaders in R&D expenditure and research productivity, despite its middle-income status. Its patent-filing activity dominates that of the US and Germany in the low-value segment and is catching up rapidly in the medium-value segment. Most important, private enterprises are playing an increasingly important role in China’s R&D activities. It is also important to recognise that China can still rely on technological diffusion to climb the value chain. This may require different sets of skills and institutions from pure innovation. Still, China needs to overcome a few hurdles in order to support technological diffusion (innovation) and industrial upgrading. These include better protection of intellectual property rights, more diversified financial services, more government supports to education and basic research. In his book New Structural Economics, Justin Lin proposed that the government play an active role in guiding industrial upgrading by providing hard and soft infrastructure for enterprises based on comparative advantages. 220 Currently, China’s GDP per capita is $6,000. If we apply the World Bank’s criterion of slightly above $12,000 as the entry level to high-income status, then China needs to double its real per capita income. We think this could happen before 2020 if we assume growth potential at 7-8% and modest currency appreciation of, say, 3% a year. By then, the Chinese economy would be at least as large as that of the United States. In our view, the favourable factors set out in this report could easily carry the Chinese economy through 2030, when growth potential should fall to 5-6% but per capita income should rise to $22,000, similar to Korea’s current income level.

Implications for investors In our view, the key takeaway of our research is that China is unlikely to collapse, even though it may continue to look different from western advanced economies. The experiences of many East Asian economies in the post-war period already demonstrate that there may be more than just one workable route to sustainable economic growth, especially when the economy is still at the catch-up stage. The global financial crisis also indicates that western institutions may themselves have defects. Most important, Chinese institutions, including political institutions, have been dynamic and flexible in responding to the changing conditions, at least since the late 1970s. One strong argument for a collapse of China or Chinese growth is its high leverage ratio, illustrated by its M2/GDP ratio at 180.1% in 2011. This might be a potential risk, but to 220

Justin Yifu Lin, The Quest for Prosperity: How developing economies can takeoff? 2012, Princeton University Press, Princeton.

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Barclays | China: Beyond the Miracle show that it is not a sufficient condition for collapse one need look only at the same ratio for Germany: 179.8% in 2011 and 167.7% in 1999. In fact, a high M2/GDP ratio often reflects a financial system dominated by banks not markets. Meanwhile, continued (albeit slower) economic growth and structural rebalancing should support secular improvement in consumption. Continued wage growth, interest rate liberalisation and the government’s policy on income distribution should support continued rapid growth of household income. In the near term, the luxury sector will likely be dented by income redistribution away from corporate profits as a result of rising production costs and the government’s anti-corruption drive. The medium to high sectors of consumer goods should benefit more as household income rises. Our earlier analyses reveal that when household incomes rise, they spend disproportionately more on appliances, communication and transportation, education, culture and tourism, and financial services. Over time, however, as income levels approach the $10,000 threshold, the consumer base for luxury goods could expand markedly. China’s strong ability to innovate and upgrade imply that it could lose low-end manufacturing relatively quickly. Although many labour-intensive factories have been moving to inland provinces, this may not last for long as costs are rising across the country. But China will probably not lose its manufacturing altogether. Instead, we expect it to move up the value chain quickly to supply more sophisticated products. Relatively speaking, China is already doing well in patents filing in digital communication, telecommunication and electrical engineering. If current trends continue, China’s technology may also advance rapidly in some other areas, such as automobiles. Thus, if US manufacturers regain competitiveness, the main worry might not stem from China but from those economies stuck between China and the US on the value chain. Finally, as the economy continues to grow and upgrade, the currency should appreciate steadily. Its current account may stay close to balance, although we think surpluses are more likely than deficits in most years. Outward direct investment (ODI) should rise quickly, probably surpassing inward foreign direct investment (FDI) sometime during the next five years, as the government liberalises the capital account, labour-intensive manufacturers migrate to low-cost destinations and other Chinese companies seek resources, markets and technology. Following financial liberalisation, further growth should emerge in capital markets and direct financing. Banks’ relative importance could decline and the cost of capital in the formal sector should rise. The latter may lead to financial pressure on and consolidation among the mostly state-owned capitalintensive and highly leveraged heavy industries.

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KEY CONTACTS Jon Scoffin Head of Research, Asia-Pacific +65 6308 3217 [email protected]

Emerging Asia Economics Nigel Chalk Head of Emerging Asia Research +65 6308 2625 [email protected]

Rahul Bajoria Regional Economist – India, Malaysia, Thailand +65 6308 3511 [email protected]

Jian Chang Regional Economist – China, Hong Kong +852 2903 2654 [email protected]

Joey Chew Regional Economist – Singapore +65 6308 3211 [email protected]

Kieran Davies Regional Economist – Australia, New Zealand +612 9334 6164 [email protected]

Yiping Huang Chief Economist, Emerging Asia +852 2903 3291 [email protected]

Wai Ho Leong Senior Regional Economist – Korea, Malaysia, Singapore, Taiwan +65 6308 3292 [email protected]

Siddhartha Sanyal Chief Economist, India +91 22 6719 6177 siddhartha.sanyal@ barclays.com

Prakriti Sofat Regional Economist – Indonesia, Philippines, Sri Lanka, Vietnam +65 6308 3201 [email protected]

Lingxiu (Steven) Yang Regional Economist – China, Hong Kong +852 2903 2653 [email protected]

FX Strategy

FI Strategy Igor Arsenin Head of FI Strategy, Emerging Asia +65 6308 2801 [email protected]

Rohit Arora FI Strategist, Emerging Asia +65 6308 2092 [email protected]

Nick Verdi FX Strategist, Asia-Pacific ex-Japan +65 6308 3093 [email protected]

Hamish Pepper FX Strategist, Asia-Pacific ex-Japan +65 6308 2220 [email protected]

Emerging Asia Credit Strategy Krishna Hegde, CFA Head of Asia Credit Research +65 6308 2979 [email protected]

Avanti Save Credit Strategy +65 6308 3166 [email protected]

Japan Economics Kyohei Morita Chief Economist, Japan +81 3 4530 1688 [email protected]

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Yuichiro Nagai James Barber, CFA Economist, Japan +81 3 4530 1542 +81 3 4530 1064 [email protected] [email protected]

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