Why China now needs a consumption story

File photo: A woman walks near a construction site of apartment buildings in Beijing. China’s economic model of funding high investment through high savings isn’t really working anymore, given that only so many roads, factories and apartments can be built.   (Reuters)
File photo: A woman walks near a construction site of apartment buildings in Beijing. China’s economic model of funding high investment through high savings isn’t really working anymore, given that only so many roads, factories and apartments can be built. (Reuters)

Summary

  • The country’s economic models aren’t working any longer and there is only one way out of the conundrum

Mumbai: As per the International Monetary Fund’s World Economic Outlook released in early October, China is expected to grow by 5% in 2023. This growth forecast is in constant terms adjusted for inflation and in the Chinese currency yuan. A growth of 5% in 2023 is better than growth of 2.2% in 2020 and 3% in 2022. On the flip side, it’s much lower than the growth of 9.2% per year achieved from 1982 to 2022, when the Chinese economy grew close to 33 times.

Further, the forecast for the next few years isn’t very inspiring—China is expected to grow by 4.2% in 2024, with growth expected to slow down to 3.4% by 2028.

This is quite a fall for a country which grew rapidly for decades at end. In this piece, we will try and understand why; what is China doing about it and what will make it work.

Difficult to sustain

The history of economic growth tells us that countries rarely grow at greater than 6% per year on a sustained basis. As Lant Pritchett and Lawrence Summers write in a research paper titled ‘Asiaphoria meets regression to the mean’: “Episodes of super-rapid growth (>6%) tend to be extremely short-lived." Other than China’s spurt over the last four decades, Taiwan and South Korea are the only two countries which grew at greater than 6% per year for decades at end. Taiwan grew at greater than 6% per year from 1962 to 1994 and Korea from 1962 to 1991.

In that sense, China “holds the distinction of being the only instance, quite possibly in the history of mankind, but certainly in the data, with a sustained episode of super-rapid (> 6%) growth" for a period of four decades. The point being that as any economy grows bigger, it finds it tougher to continue growing at a fast pace. This seems to be happening to China now.

Now, what are the specific factors pulling China back? Over the years, as China became the factory to the world, Chinese exports rose at a very rapid rate. Take a look at chart 1, which plots the Chinese exports (goods and services) in absolute terms and as a percentage of gross domestic product (GDP).

In 2022, Chinese exports stood at $3.71 trillion, or 20.7% of the GDP. GDP is a measure of the economic size of a country. While Chinese exports have continued to grow in absolute terms, their share of the GDP has fallen over the years. They had peaked at 36% of the GDP in 2006.

 

Chinese exports and US imports.
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Chinese exports and US imports. (Satish Kumar/Mint)

Exports conundrum

There are several reasons for the same. The global growth—particularly the growth in developed countries, China’s main export destinations—has slowed down since the financial crises of 2008, leading to a slowdown in Chinese exports growth. From 2007 to 2022, Chinese exports grew at 7.5% per year (in current dollar terms, not adjusted for inflation). If we look at the period of 15 years up to 2007, Chinese exports had grown at 22.8% per year. Of course, the earlier growth was on a lower base. What this also tells us is that there is only a certain amount of Chinese exports that the world can absorb.

Also, in the post-covid world, countries are trying to reshore—that is produce more within the country than import from outside—and be less dependent on goods made in China. This has impacted Chinese exports this year. Chinese exports from January to September were at $2.5 trillion or 5.7% lower than the same period in 2022.

Now take a look at chart 2 which plots US imports (goods and services) from China. Over the years, US imports from China grew big time. But things started changing from 2019 onwards, due to the former US President Donald Trump’s confrontational policy towards China, and the spread of the pandemic. In 2018, US imports from China stood at $558.3 billion. In 2022, they stood at an almost similar $563.6 billion, having fallen in between. Indeed, in 2023, US imports from China are likely to be lower than 2022.

From January to August this year, US goods imports from China have stood at $275.8 billion or a fourth lower than the same period last year. This when US goods imports during 2023 have fallen 6.2% to $2.1 trillion. So, clearly the US is looking to source imports from destinations other than China. Over the years, US goods imports from China have formed 95-97% of its overall imports from China.

Now, a caveat needs to be kept in mind. Some goods are exported from China to other countries first before they reach the US. The official data does not capture this. Nonetheless, the US policy of moving trade away from China is not going to change any time soon.

Other than the US, the European Union (EU)—an economic union of 27 member states that are located primarily in Europe—is China’s other big trading partner. In 2022, it imported $626 billion worth of goods from China. With China’s overt support of Russia, in its war with Ukraine, the trust between the EU and China has faded. This can create further problems on the export front for China.

Failing model

Typically, when countries see their exports contract or slow down, they tend to let their currency depreciate against the dollar, which leads to exports becoming cheaper, giving them an upward push. At least, that’s how it’s supposed to work in theory.

At the beginning of the year, one dollar was worth 6.90 Chinese yuan. Currently, it is worth around 7.32 Chinese yuan. But even this depreciation hasn’t helped push up exports.

On the flip side, a depreciating currency hurts consumption as imports become more expensive. In effect, as economist Michael Pettis, posted on X, formerly Twitter, a depreciating yuan “shifts income from households (who are net importers) to manufacturers (who are net exporters)".

So, exports cannot really rescue the Chinese economy. The Chinese Communist Party (which is effectively the government as well) realizes this and over the years has tried to make up for falling exports, as a proportion of the GDP, by increasing investments. In fact, investments touched 47% of the GDP in 2010 and 2011, and in 2021, they were still at a very high 43%.

“Chinese investment, at 42-44% of GDP, is one-third higher than that of even the highest-investing economies of the world, [which] rarely invest above 30-34% of their GDPs," Pettis notes.

Over the years, given China’s financial system, the legal framework, corporate governance practices, the kind of politics the country practices, and several other factors, fresh investments are delivering lesser bang for every buck. In the last decade, a lot of this investment has been channelised into residential real estate, leading to excess residential real estate being built and lying unused, putting many real estate companies in trouble. Many top real estate companies have defaulted on their borrowings.

The larger point here being that China’s economic model of funding high investment through high savings isn’t really working anymore, given that only so many roads, factories and apartments can be built before they stop being useful.

Further, gross savings peaked at 52% of the GDP in 2008 and were still at a very high level of 45% of the GDP in 2021. Now, savings are essentially incomes that aren’t spent or consumed. So, if the government of a country chooses to push savings up in order to fund investments, then private consumption is bound to take a beating. And this explains why China’s private consumption was stagnating at around 38-39% of the GDP from 2016 to 2021. In 2022, it fell to 37%, the lowest since 2014. This, as per the Foreign Affairs magazine, is “nearly 30 percentage points below the global average".

Further, China’s National Bureau of Statistics stopped publishing the Consumer Confidence Index—a series launched 33 years ago—in March earlier this year, as a result of weak data coming in.

The way out

In large economies—like China is—private consumption usually forms the largest part of the GDP, which isn’t true in the Chinese case. The only way out of the current conundrum is for the Chinese to consume more. The government realizes this and at the annual Central Economic Work Conference in December 2022, it was decided that “the country will focus on boosting domestic demand next year by prioritizing the recovery and expansion of consumption".

In July, an 11-point plan was released jointly by 13 government departments. As per a Bloomberg news report, this plan will encourage local authorities to help people to refurbish their homes. In addition to this, “households will get support to buy new smart home appliances". People will be provided incentives to buy goods and services made in China, from electric cars to domestic tourism.

In fact, for an economy to be driven by private consumption over the long term implies that consumption has to grow faster than the overall economy which, in turn, has to grow faster than investment. For this to happen, the average Chinese needs to feel more confident about the future, in the process encouraging higher spends.

As the New Yorker magazine puts it: “For years, economists have urged the government to stop relying on real-estate investment and bloated state-run companies, and to increase health and retirement benefits so that ordinary households consume more, spurring the private sector."

Also, the one-child policy that ran from 1980 to 2016, has played its role here. Many Chinese couples now have only one child. This implies that this one child has to take care of two parents, and possibly even four grandparents. Given this, many Chinese parents tend to be very careful while spending money, in order to save up for their retirement years, thus discouraging spending.

Further, even if the government puts higher health and retirement benefits in place, that could take years until it makes people feel confident about the future and leads to increased private consumption.

Also, China’s growth has not been equitable, with the top 10% of its population owning 70% of the national wealth. Further, the bottom 50% earns 25,520 yuan, whereas the top 10%, on an average, earns 370,210 yuan, which is nearly 14 times more.

This is China’s K-shape economic structure, where a section of the population has done considerably better than the others and that section can only consume so much. As Martin Wolf writes in the Financial Times: “An enormous proportion of national income goes to the controllers of capital and is being saved by them…Income now needs to accrue to those who will spend it."

But this is easier said than done, especially as Pettis puts it in a piece written for the Carnegie Endowment for International Peace: “The constituencies that have benefited disproportionately from the older model—and have amassed a disproportionate share of political power in the process—are likely to block an adjustment to this model".

This includes many local governments, which through the sale of land-use rights, have become very powerful. But as the number of construction projects comes down, these institutions will have fewer resources at their disposal. Also, a genuine encouragement of consumption would imply the Chinese government having to let private firms—both big and small—thrive, particularly in services businesses, and have far lesser control over the way the economy shapes up than it is used to now.

These are structural anomalies and can’t be set right quickly. The system, as it has existed for decades, needs to change dramatically.

Vivek Kaul is the author of Bad Money.

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