Depending on your perspective, there are any number of difficulties facing China. We group our views into seven areas that can generally be viewed as structural constraints to Chinas sustainable growth. Each of these areas has been a crucial driver in Chinas past high growth. At the same time, they were achieved through various distortions to the operations of a market economy. We expect many of these distortions to be forced to correct by market forces. However, after 30 years of development, institutional inertia has been accumulated and major reforms are now required in order to unleash further growth potential.
Export-led model exhausted
China had relied on robust global demand and continuous gains in market share to boost exports and related activities in manufacturing and investment. Chinas exports in 2011 were 104.8 times in USD terms or 454.4 times in RMB terms those in 1980, a CAGR of 16.2% in USD terms or 21.8% in RMB terms.
Nominal GDP growth was 16.2% in those 31 years. Export growth has intensified since China entered the WTO in 2001. In the decade since, export CAGR was as high as 20.3% in USD terms or 17.6% in RMB terms, compared to 15.2% in nominal GDP.
As a share of Chinas economy, exports went from 8% of GDP on average in 1981-85 to 19% in 1986-95. The share surged to 28% in 2001-05 after China entered the WTO, and peaked at 30% in 2006-10. Then, the share declined slightly to 26% in 2011 and is poised to continue falling to 25% in 2012.
We believe Chinas weakening export growth is more than just a cyclical phenomenon, as it is driven by structural constraints. Protectionism is clearly on the rise, with WTO complaints against China being raised by the US, the EU and many emerging countries. Chinas exports to its traditional markets, including the US, the EU and Japan, are becoming more and more difficult. Second, Chinas export competiveness has been weakened by substantial cost increases, especially in labour. Third, processing-trade investors are facing a less friendly business environment in China than before. Fourth, RMB appreciation has also undermined export competitiveness. Last but not least, since 2008 the Chinese government has changed its export strategy and policy: the aim is no longer to take a greater share of global exports and accumulate foreign reserves, but to aim to find a balance between exports and imports. Chinas growth must depend on domestic demand, consumption in particular. For this shift in stance, China has reduced export-promotion policies, including adding restrictions to exports of products that consume high energy, cause high levels of pollution, and are low value-added products.
Diminishing labour cost advantages
Being the root cause of the structural decline in Chinas export growth, labour cost increases have become one of the key parameters in gauging the countrys potential. News of labour unrest and industrial relocation, such as those at Foxconn, has frequently made headlines. Labour costs are clearly rising in China, most visibly in the manufacturing sector. The common refrain is that with urbanisation advancing and demographic trends shifting, China has entered its Lewis turning point, where the supply of labour tightens relative to demand and raises the cost of labour. However, the imminent challenge for China is not to contain labour cost increases, but to create sufficient service sector jobs so that a bigger population can contribute to sustain relatively fast economic growth. In turn, more people will be able to benefit from continued economic development.
Increasing constraints from resources and environment
Chinas growth model is resource and carbon-emission intensive. Unabated fast economic growth over the past three decades came at a high price for energy, resources, and the environment. With its GDP one-third of the US, China overtook the US as the worlds biggest energy consumer in 2010 and surpassed the US as the worlds largest carbon emitter in 2007. China also possesses a number of world No 1 titles in consumption of other commodities, such as being the worlds biggest iron ore and aluminum consumer. Being the worlds most populous country, Chinas per capita endowment of many resources is poor compared to the world average.
The thirst for resources quickly pushes up Chinas dependence on imports. More than 55% of crude oil consumption last year came from imports. Fifteen years ago, China was a net exporter of oil. The reckless pursuit of economic growth, rather than quality of growth, continues to test the extremes of the environment. Even using Chinas own standards, the quality of 55% of ground water is rated poor or very poor. Only four out of 31 provinces meet the PM2.5 standard recommended by the WTO.
The public is growing increasingly concerned about the hazardous effects of pollution on health. China is increasingly being pressured by the international community due to the spillover effect of emissions. In these circumstances, it is mission impossible for China to maintain the resource- and emission-intensive models in the next decade.
Income and wealth disparity
Chinas astonishing growth over the past three decades was accompanied by an extraordinary widening in the gap between rich and poor. At its extremes, the concentration of wealth in a small part of society constrains consumption, discourages labour force participation, increases the risk of capital outflow, and encourages financial speculation and systemic risks. The root of the disparity is in the distribution of economic gains, both in the primary stage as labour compensation and in the secondary stage as taxes and social welfare. To avoid further widening of the wealth rift, fundamental reforms are needed to improve distribution.
There are significant imbalances in income distribution at the primary stage, where labour gets an insufficient share of the economic benefits. Further down the process, secondary distribution through taxes and the welfare state are also skewed towards those who get more out of primary distribution. Individual income tax collection misses large portions of high-income earners because of the inability or unwillingness to contain gray income. There is little wealth tax, such as that on property, inheritance or stock capital gains. Further, 90% of public social security payments are made by households, while the government pays 10% and enterprises pay none. Social subsidies accounted for only 1.9% of national income in 2009. With the majority of savings at the command of the government and enterprises, few people can decide on how to distribute the bulk of Chinas capital, which reinforces the incumbent authorities and interest groups.
Difficulties in continuing investment-led growth
Over the past two years, amid intensifying external and domestic slowdowns, markets have been surprised by how little Chinas policymakers have promoted investment. The difficulty in pushing investment to achieve policy objectives should not have come as a surprise. After all, no other country has invested more than 40% of its GDP consistently for a decade and had plans to do so for a few more years.
Investment is the process of converting money into capital, which is central to economic growth. In Chinas 30 years of extraordinary growth, investment was the primary policy instrument, whether for export manufacturing, property, urbanisation, or countercyclical macro management. However, as Chinas economy matured and its productive capital stock reached its current scale, it has become increasingly difficult for the state to allocate capital to projects that can generate sufficient returns after considering a wide range of rising costs. Concerns are rife over the side effects of investment, including overcapacity, inefficiency, asset quality, environment, social equity, and opportunity cost, to name just a few.
In all, we see potentially sharp declines in Chinas investment growth, as efficiency becomes a more important element of investment decisions. This is not just a function of macro market forces, but also because investment is becoming less gainful at the personal level. Overcapacity is significant in some sectors, but the high rate of depreciation would make renovation and retiring old capacity a big part of investment. This too, however, would generate lower returns, as both physical and opportunity costs are rising. Also, financing would become a major constraint as Chinas traditional land-financing model is nearing exhaustion. All this need not be completely negative, however. A more rationalised investment environment will free up resources for China to develop services and consumption.
Financial risks rising
The diminishing role of land financing is central to the rising financial risks in China. The extraordinary credit expansion in recent years, especially since the global financial crisis, has been based on unrealistic return expectations. Yet, continued financial support for investment and growth are necessary to prevent a sharp deterioration in employment and social stability. Since banks are constrained for capital to fund the demand for credit, the responsibility of supporting growth is being increasingly placed on direct financing and off-balance sheet credit, which is essentially securitisation. Such a trend is raising systemic risks, as the opacity of off-balance sheet financing is making regulation more difficult and monetary policy transmission less effective.
As Chinas economy grows, its financial system is quickly transforming from a collateral-based system to one based on credit. Nonetheless, there are not enough credit-market instruments to allow the economy to wean off bank loans. The lack of a junk bond market, a securitisation market, and a commercial paper market is the root cause of the extraordinary rise of WMPs.
Chinas regulatory framework was built on doors. Opening and shutting these doors would decide whether something can or cannot be done, enforced by administrative means. If there is no door or if a door is closed, the markets would go find and use a window or a crack or any opening. The regulators often ignore these openings until there is trouble. Then they would wall over the window or fill the opening, often without opening new doors. However, the market is always faster and smarter. Because of the administrative nature of regulations, both markets and regulators are not accustomed to pricing credit. The result is always the expansion of an opaque area of financial activity that neither the market nor the regulator understands.
As such, Chinas policymakers need to recognise the superiority of markets and allow the markets to price capital. In a very welcome and much-delayed series of measures, China pushed forward liberalisation reforms in the capital account and for interest rates in 2012. However, the deposit rate is still capped, the exchange rate is still being fixed by the regulators, the credit market is still lacking key segments, and capital is still not allowed to freely enter and leave. The regulators also need to shift from controlling behavior to promoting the appropriate incentives.
Government is less able to engineer growth
One of the key reasons for three decades of economic success in China is the active role of the government. The government chose to allocate capital to infrastructure and manufacturing, which built the foundation for fast growth in output and improved living standards. However, the economy is now much larger and far more complex for the government to properly weigh the comprehensive costs and benefits, and decide on which projects should receive capital. Instead, the government should use its still-ample coffers to build the institutions that would facilitate more efficient and equitable allocation.
The reason that the government promotes growth is to gain legitimacy. As China has experienced repeatedly in its 5,000-year history, a poor population makes fodder for change. Long and strong dynasties saw extensive periods of prosperity. Economic growth promised those results but did not improve living standards for enough number of people. Therefore, the thesis that growth produces legitimacy is challenged.
Fortunately, the Chinese government has stronger economic power than most of the governments in the world to face these challenges.
Fiscal revenue and deposits: Overall government revenue grew 18.5% annually between 1990-2011, while nominal GDP grew 16.6%. In 2011, fiscal revenue accounted for 22% of GDP. Fiscal deposits amounted to 3.5% of total deposits or 6.6% of GDP by August 2012.
FX reserves: By September 2012, Chinas FX reserves are worth 44% of its GDP. However, this wealth is difficult to use, as any large-scale sale of FX assets would cause precipitous capital losses, and if the proceeds are converted to the RMB for domestic use, the RMB exchange rate would surge and damage Chinas exports. The only feasible way is to spend it on imports or investments abroad, which would help with global rebalancing and generate investment income and profits for Chinese enterprises and households.
State-owned assets: Just the 117 centrally owned enterprises under the oversight of the State-owned Assets Supervision and Administration Commission of the State Council boast assets of RMB28t and profits of RMB917b in 2011. These figures do not factor in the thousands of local-government SOEs, the thousands of SOEs under the various ministries, or the governments stakes in the banks.
These massive resources were the outcome of the development of the past three decades. Government can transfer this wealth through taxation and expenditure to favour households and the private sector in order to promote more efficient and sustainable development. The key question is whether a strong enough leadership can be found to implement this redistribution.
Chen Xingdong is Chief China Economist, Ken Peng is Senior Economist and Jacqueline Rong is China Economist, BNP Paribas.This is an edited extract from the BNP Paribas report on China, Seeking balance: Challenges, reform and potential