by Sara Eisen
Figure 6-2 Selected Asia: Share of Export Value Added in GDP
(Percent of GDP)
Sources: Japan External Trade Organization (JETRO), Asian Input Output Table (2000), OECD, UN Comtrade, and CEIC Data.
This large contribution of China’s exports to the country’s overall growth reflects a rapid growth in exports (on average by 18.5 percent since the end of the 1990s), and also an increase in the domestic content of these exports. This, in turn, has led to a substantial expansion of China’s global market share. China’s share of exports in global markets has nearly quadrupled over the past 15 years, rising from around 3 percent in 1995 to about 12 percent in 2009 (see Figure 6-3), and it has doubled since China’s entry into the World Trade Organization (WTO) at the end of 2001. Maintaining such a trajectory would require lower prices in a range of industries, which could be achieved through a combination of increases in productivity, lower profits, and higher implicit or explicit subsidies to industry. While unprecedented gains in market share may yet occur, the evidence from key Chinese industries such as steel, shipbuilding, and machine tools suggests that it will be difficult to accommodate price cuts within existing profit margins and productivity gains. For example, Guo and N’Diaye (2009) show that while profit margins in these industries range between 5 and 10 percent, the price cuts that would be required to maintain market share gains would be on the order of 15 to 45 percent.
Figure 6-3 Market Share of Selected Economies Since Growth Takeoff
(Percent)
* NIEs are newly industrialized economies
Investment Is One of the Highest in the World
Investment in China as a share of GDP has reached about 50 percent of GDP, up from slightly less than 30 percent in 1982. This level of investment is high by most standards, including when compared with other countries with a similar development strategy and countries with similar income levels (see Figure 6-4). Investment is financed primarily through retained earnings and bank loans. Most of the investment has been concentrated in the manufacturing sector, encouraged by various cost advantages, including a low cost of capital and utilities, pollution, energy, and land; tax incentives; and an undervalued currency, as well as a large pool of savings.
Figure 6-4 Investment-GDP Ratio
• Land and water. In China, all land belongs to the state, and local governments have the discretion to sell industrial land use rights to companies for up to 50 years. In many cases, industrial land is provided for free to enterprises to attract investment. For water, the price in China is about one-third of the average of a sample of international comparators.
• Energy. Cross-country data on the cost of energy show that the price of gasoline in China is relatively low, although it is similar to that in the United States. For electricity, the cost is also somewhat below the average of international comparisons, although discussions with private counterparts reveal that many companies are able to negotiate significant discounts to the regulated price. Having said this, China is making progress in bringing energy costs in line with international levels: oil product prices have been indexed to a weighted basket of international crude prices, natural gas prices were increased by 25 percent in May 2010, and preferential power tariffs for energy-intensive industries have been revoked (see Figure 6-5).
• Capital. By various cross-country measures, the cost of capital in China appears low. Using data on 37,000 firms across 53 countries, IMF staff estimates show that the real cost of capital—defined as a weighted average of the real cost of bank loans, bonds, and equity—faced by Chinese listed firms is below the global average (see Figure 6-6).3 Capital looks especially cheap when compared to its high productivity in China. In particular, country-specific estimates of the marginal product of reproducible capital (i.e., capital adjusted for land) show that the real rate of return on investment in China is much higher than real loan rates, with the discrepancy being larger than in many economies.
Figure 6-5 Price of Energy in China Compared to That in Other Nations
Figure 6-6 Real Cost of Capital
(2005–2009)
How long can China sustain such a high rate of investment? Persistent high rates of investment run the risk of creating overcapacity in many sectors because domestic or external consumption might not rise fast enough to absorb the new output. This will exert deflationary pressure; increase nonperforming loans in the banking system, as companies will be less profitable than anticipated at the time the projects were being financed; and ultimately lead to deterioration in the general government’s fiscal position. Such a buildup of excess capacity would also have consequences for the rest of the world, as excess capacity in the manufacturing sector in China would further dampen tradable prices in global markets, potentially creating trade tensions.
Corporate Savings in China Are High
There are numerous reasons for China’s high corporate savings. First, the low cost of capital gives Chinese firms a competitive edge and creates incentives for capital- and energy-intensive means of production (see Figure 6-7). Studies estimate that the total value of China’s factor market distortions (labor, land, energy, capital, and so on) could be almost 10 percent of GDP.4 Second, there is a lack of market contestability (i.e., competition), with many firms enjoying oligopoly positions in domestic markets,5 while at the same time smaller firms (which have limited access to financing) save to ensure that they can fund profitable projects. Finally, corporations are not subject to the same contestability of ownership that is seen in other systems, which may lead these firms to have less incentive to distribute profits in the form of dividends.
Figure 6-7 Cost of Capital in China Relative to That in Other Countries
Household Consumption Is Much Lower than It Should Be
China’s private consumption as a share of GDP has declined from around 55 percent in the early 1980s to around 37 percent in 2008 (see Figure 6-8). The decline in the country’s share of private consumption during the early development stages is not in itself a surprise—savings naturally rise at early stages of development, as households move away from subsistence levels of income, and greater capital accumulation is needed to finance investment and growth. However, the size of the fall in China’s private consumption share stands out. Reasons put forward to explain the downward trend in China’s share of private consumption relate both to households’ saving rate and income and to statistics.6 Be that as it may, recent cross-country evidence suggests that the low consumption-to-GDP ratio in China has relatively little to do with country-specific behavioral factors. Instead, the evidence shows that it can largely be explained by the low, and declining, share of household disposable income and a rising saving rate. The high household saving rate in China in part reflects precautionary saving to offset the lack of social safety nets. Limited access to financial services, including consumer credit and housing finance, may also play a role.
Figure 6-8 Cumulative Change in Ratio of Private Consumption to GDP: Estimated Contribution of Household Disposable Income and Household Saving Rate
Source: Guo and N’Diaye (2009).
On the Supply Side, China’s Export-Oriented Growth Model Has Resulted in a Small Services Sector, and Growth Is Less Employment-Intensive than It Should Be
These households’ large savings are limited both by the lack of investment opportunities at home and capital controls on investment abroad. This, together with a low cost of capital, the underpricing of other factor inputs, and an undervalued exchange rate, has provided Chinese firms with a competitive edge in global markets and created incentives for capital-intensive means of production. The share of the tradable sector in China’s GDP is more than 10 percentage points above the world average for low- and middle-income countries, and as a corollary, the share of services in GDP is generally lower (see Figure 6-9). With the services sector typically being more labor-intensive, China’s export-oriented growth has naturally translated into a relatively low employment growth compared to other
economies’ experience and China’s fundamentals. China’s average annual GDP growth of 11 percent over the past 7 years has been associated with only about 1 percent increase in employment (see Figure 6-10).
Figure 6-9 Excess Share of Industry in GDP
(In Percentage Points; Country Industry Share Minus Industry Share of Peer Group)
Source: World Bank, World Development Indicators, and IMF staff calculations
Figure 6-10 GDP Growth Relative to Employment Growth
How to Address These Imbalances
There has been progress on rebalancing growth in China.
• China has made commendable progress in expanding its social safety nets in recent years. It has allocated greater resources to its pension, healthcare, and education systems since the outbreak of the financial crisis. A new government health insurance program has been launched nationwide, with the objective of achieving near-universal coverage by the end of 2012, and subsidies for a core set of prescription drugs have been introduced. On pensions, full portability of benefits has been introduced to enable greater labor mobility. The existing government pension scheme is being expanded to cover urban unemployed workers across the country by the end of 2012, while the newly introduced rural pension scheme now covers 60 percent of all counties. This should help lower precautionary savings.
• Recent trade data indicate that China’s trade surplus is narrowing (see Figure 6-11), and it is likely that the surpluses will continue to fall in 2012–2013, well below what IMF staff had projected at the conclusion of the 2011 Article IV consultation (5.1 percent of GDP in 2012 and 5.25 percent of GDP in 2013). The trade surplus amounted to about US$138 billion through November, down 18 percent from the same period in 2010.
• This narrowing of the trade surplus occurred despite limited exchange-rate appreciation and was possible mainly because of deteriorating terms of trade, continued high levels of investment, and slower gains in market share. The slower gains in market share could in turn reflect waning benefits from China’s entry into the WTO, relocation of global production capacity, and rapid productivity gains. Although these structural forces could mean a much lower medium-term current account surplus compared with IMF staff forecasts at the time of the 2011 Article IV consultation, the yuan appreciation and structural reforms put in place need to be sustained to promote a lasting rebalancing of the Chinese economy. To successfully accomplish this rebalancing and secure medium-term growth prospects, the incentive structure that guides household and corporate decisions will need to be reshaped with additional reforms to social insurance, the financial sector, and factor pricing, as well as further exchange-rate appreciation.
Figure 6-11 Current Account and Components
(Percent of GDP)
Additional Reforms in Healthcare, Pensions, and Education
• Health. Access to healthcare needs to continue to improve through training personnel and providing adequate incentives for skilled medical staff to relocate to rural areas. Further reductions in out-of-pocket expenses can be achieved through lower copays on medical procedures and drugs and more comprehensive insurance coverage for catastrophic and chronic conditions.
• Pensions. The complexity of rules and regulations covering the multiple national, provincial, private, and public pension programs can be simplified to encourage greater participation in pension schemes covering all categories of workers—urban, rural, and migrant.
• Education. More comprehensive education subsidies would ease saving impulses, particularly among young households.
Barnett and Brooks (2010) show that higher government spending on healthcare reduces urban household saving in China significantly. A 1-yuan increase in government health spending is associated with a 2-yuan increase in household consumption.
Financial-Sector Reform
In recent years, China has taken several steps toward a more market-based financial system. Bank balance sheets have been strengthened by parceling out bad loans (amounting to around 15 percent of GDP in 1999) to asset management companies, and banks have subsequently been recapitalized. The major banks have been listed on international stock exchanges, and the system has become more commercially oriented. However, the existing system of financial intermediation continues to hold back rebalancing. The use of administered deposit and lending rates combined with credit quotas favors large corporations at the expense of households and smaller service-sector firms.7 This system of intermediation has placed the economy on a path toward excess capacity, diminishing marginal productivity of capital, and deteriorating credit quality. A continued reliance on the existing financial framework could eventually lead to a fresh wave of bank recapitalizations and additional wealth transfers from households to the banks and corporations. Such an outcome would further set back the transformation of the growth model.
Building on the steps already taken, there is a need to proceed immediately with further financial liberalization and reform. Financial reform is a lengthy and complex process that will need to be carefully guided through preemptive policy action. Starting now will ensure that the process can be largely completed during the twelfth Five Year Plan period (which runs from 2011 to 2015). If disintermediation pressures and financial innovation do set the agenda, the risk of an uncoordinated, disorderly, and chaotic reshaping of financial arrangements must be avoided by enacting adequate regulatory and supervisory oversight.
Therefore, financial liberalization should proceed with caution. Insights from other economies that have undertaken financial reforms suggest the need for a clear sequencing to minimize the risks of financial instability, undue asset prices, and macroeconomic volatility. While there is no unique, optimal path of liberalization, a possible sequencing of financial reform laid out in the staff report for the 2011 Article IV consultation with China is as follows:
• Liquidity absorption and the monetary framework. With a stronger yuan, the People’s Bank of China can absorb the significant excess liquidity in the system through a greater use of open-market operations, as the Federal Reserve does. With tighter liquidity conditions, monetary policy can begin using price-based tools such as interbank rates to affect the flow of credit in the economy. Essentially, the central bank would have more control over money and liquidity in the system.
• Regulatory framework. Regulatory and supervisory capability will need to be ramped up to safeguard financial stability as liberalization proceeds. Components of an enhanced regulatory framework would include improved monitoring and data collection, routine stress testing, increased oversight for systemic institutions, and closer interagency coordination to close the gaps in coverage.
• Financial market development. As the regulatory framework is strengthened, alternative channels of financial intermediation that reduce the reliance on banks should be promoted. Developing a deep and liquid fixed-income market that trades securities across the maturity spectrum with the active participation of pension funds, insurance companies, and mutual funds will be an essential objective. This will need to move in step with reforms in bank-based intermediation, particularly the liberalization of interest rates. Failure to deregulate interest rates will create disintermediation pressures as households seek higher-yielding financial investment opportunities, such as wealth management products, outside the traditional banking system.
• Capital controls. With a strong regulatory framework in place, overseeing a financial system that offers a wide menu of financing and investment options, capital account liberalization could be advanced, and the yuan could be more fully internationalized. The process should start with easing restrictions on foreign direct investment and long-term flows before steadily increasing the QFII (qualified foreign institutional investors) and QDII (qualified domestic institutional investors) quotas to open up short-term portfolio flows. Eventually, the quotas should be dismantled altogether.
Input Costs and Corporate Reforms
Factor price and corporate governance reforms will shift resour
ces away from capital-intensive sectors. If input costs were to rise closer to levels in comparable economies, and if the cost of capital were aligned with its high return, this would reduce the excess revenue earned by exporting firms and move investment toward domestically oriented sectors. The impact of these measures would be even greater if they were combined with corporate governance reforms that would extract more substantial dividend payments from large firms, in conjunction with administrative reforms that would reduce barriers to entry into the service sector.
Yuan Appreciation
The yuan has been undervalued, with clear implications for progress in other areas of reform. Pinning down the degree of undervaluation of a currency is not easy, particularly for countries that are undergoing rapid structural change. However, for China there have been three main reasons to believe that the yuan has been undervalued.