CRISIL YOUNG THOUGHT LEADER COMPETITION-2012
How should China transition to a consumption driven
economy
A Dissertation
Anshul Garg
IIM KOZHIKODE
Contents
1. Executive Summary
2. Introduction
2.0 Current economic condition
2.1 Existing Chinese Growth Model
2.2 Current Analysis
3. Problems with current model
4. Potential for Consumer Growth Model
5. Solutions
5.0 Process of creative destruction
5.1 Managing Structural issue
5.2 Chinese consumer Empowerment
5.3 Preventing consumers from spending abroad
5.4 Reducing government support for state-owned industries
6. Conclusion
7. References
1 Executive Summary:
Prerequisite for China to rebalance the economy to meet the rising demand of middle class
For a long time exports and state-funded fixed asset investments in infrastructure and real estate has been the
main factors on which Chinese economic growth has depended on but now that model is running out of steam.
Due to increase in domestic wages China’s cost advantages as a low-value-added manufacturer has been
eroded. Fixed-asset investments are consuming too much energy, polluting the environment and concentrating
wealth among the leaders of state-owned enterprises who dole out these big infrastructure contracts for lucrative
benefits. So now it is imperative on part of Chinese leaders to shift the country toward a new growth model that
will depend more on domestic consumption and technology innovation and less on exports and fixed asset
investments. This will have a direct positive impact on middle class. Chinese companies should try to move up
the value chain from lower-end to higher-end manufacturing as it will lead to increase in employee salaries
expanding job and wage opportunities for average Chinese citizens. This will trickle down to increase people’s
purchasing power and hence allowing Chinese companies to decrease their dependency on export markets and
sell more of their goods domestically. It will also help to tackle the impediment of wealth being concentrated in
the hands of a well-connected few at the expense of ordinary Chinese.
Technological innovation plays an important role in this transformation. China has primarily been a
manufacturer for western goods but now if they can shift not only toward higher-end goods but also focus on
indigenous Chinese designs, then firms will be able to reap a larger share of those profits. Today western firms
get a large share of the profits for every unit of Chinese good sold as they have the intellectual property rights
for most of the higher-technology goods China produces. If China can generate more of domestic profits then
that would provide new revenue streams for the Chinese economy. A modern, high-tech, consumer-driven
economy requires independent regulatory governance and judicial structure but it will be very hard for an
authoritarian regime like China to provide the required platform. One of the biggest stumbling blocks is
providing a good and apt domestic atmosphere for technology modernization. Investments in innovation will
deliver good returns only when China has a good legal system to protect intellectual property rights.
The current economic scenario prevalent bears testimony to the fact that there is plethora of deficiencies in the
current growth model. It can produce results only in the short term but over the long term it is not really
supportable as most of the money is used in promoting investment boom and hence neglecting the consumers
and the domestic market. All this will lead to inflation and bad investments. So it is high time for the Chinese
government to focus on removing systemic barriers to a more competitive innovation environment. There is
immense potential in the domestic market which can be leveraged and consumer driven model offers very
promising path as there is large consumer base and they are eager to spend and improve their standard of living.
They should aim to re-balance the economy by channeling the resources properly and changing different tax
related policies. Chinese consumers must be given more spending power my implementing different structural
changes, controlling inflation, increasing wages and adjusting taxes. This will increase their purchasing power
and escalate domestic spending. Problem is that shift will be difficult and will create economic turmoil and as
Government believe in stability and economic growth it will be a tough call for them but it will definitely be a
profitable move as per future prospects.
CHINA CURRENT ACCOUNT TO GDP
CONTRIBUTIONS BY DIFFERENT PARAMETERS IN GROWTH
2 Introduction:
2.1 Current Economic Condition:
As Chinese government prepares for its upcoming political transition, this alteration will come with extra
burden as the country’s new leaders will be asked to handle an economic downturn in which Chinese growth
could hit lows not seen since the 1989 Tiananmen Square crisis. After an incessant era of unprecedented growth
which exceeded IMF expectations for growth for 10 straight years, China’s economy is moving towards a
downward spiral and analysts have suggested the growth rate for this year may only be 7.5%. If this prediction
proves to be accurate then it will be China’s lowest growth rate in more than 20 years.
China’s GDP for the second quarter declined to 7.6% in July which is the lowest level since the global financial
crisis in 2009. At the same time IMF has reduced its 2012 growth forecast for China by 0.2% to 8%. In June,
the consumer price index went up by 2.2%. The prices increased around 2.2% in cities and 2.0% in rural areas.
The food prices skyrocketed by 3.8%, while the non-food prices augmented by 1.4%. The prices of services
grew by 1.9% whereas for consumer goods it went up by 2.3%. In the beginning of 2012, the overall consumer
prices grew by 3.3% over the same period of previous year. The central bank has already cut interest rates as a
precautionary measure as rising concerns related to the slowdown in the world’s second-largest economy is
worse than predicted. While China has been adversely affected by external factors such as Eurozone crisis, its
current slowdown can be attributed to various internal structural issues with a suppression of domestic
consumption adding fuel to fire.
CHINA GDP ANNUAL GROWTH RATE
CHINA INFLATION RATE
2.2 Existing Chinese Growth Model: China over the past 2 years has been able to maintain high level of
growth in-spite of severe global economic downturn. It has been quoted as the manufacturer of the world. China
was strongly affected by the global financial crisis but it still was able to overcome the negative repercussions
by having a lending boom which powered an investment boom. It was a good prudent move as an initial
response to the global financial disaster, but going to 2010 it became an abnormal path and this stimulus, which
was intended to be the savior of China during tough times, became a new growth model for China’s future
growth. The main growth driver has been an investment boom that was engineered in response to the financial
downturn but now this investment boom is buckling under its own weight.
CHINA GOVERNMENT SPENDING
CHINA GOVERNMENT BUDGET
2.3 Current Analysis:
A slowing Chinese economy may not be necessarily a bad prospect as in recent years, China’s increasing
growth rates have been driven by unsustainable investments in infrastructure and real estate. Hence if the
country can shift away from this current model towards something more sustainable then that will be a positive
development. But the problem is that this shift will not be easy to achieve as for Chinese Communist Party that
has ventured its legitimacy on keeping the economy booming, any slowdown will give birth to new political
challenges. At this point in addition to managing growth rates, Chinese leaders will also have to figure out how
to deal with a growing middle class that is starting to demand a higher quality of life and a larger chunk of the
benefits of China’s economic prowess. There are ample areas of potential growth in the Chinese economy such
as agriculture, services, healthcare, retail and logistics but the problem is that growth will not be so easily
achieved as pumping money and boosting investment. Unfortunately, the focus in past few years has not been
on achieving more sustainable growth
3 Problems Associated With Current Model
The current growth model can produce some effective results over the short term but over the long term it is not
really sustainable as it relies on pumping out money to fuel more and more investment. Majority of GDP
growth in China right now is being generated simply by the amount of investment that is going out the door.
This approach does not take into account whether investments are good or bad and what return on the
investment is going to be in future. It just measures the money that is being pushed out of the door for
investment. So in coming years there will be some good investments but there is high probability that China
will run into declining return and maybe even negative returns. So there are speculations bolstered by reasons
that a lot of the investments that are being made currently in China may not actually pay off, either in terms of
cash flow or economically. Hence there is this aggravating concern about bad debts in the system. Government
may become powerless to stop a downturn caused by high local government debts leading to economic hard
landing
CHINA GOVERNMENT EXTERNAL DEBT
CHINA GOVERNMENT DEBT TO GDP
Also China has expanded its money supply to increase the investments. It has been expanded by more than 50%
over the past year and hence inflation is bound to happen. The repercussions are evident in increasing level of
consumer inflation. The money has been poured into investments and assets resulting in asset inflation,
escalating prices of housing of real estates and other commodities like gold.
CHINA MONEY SUPPLY
The Chinese Communist Party also has a lot of worries related to independent courts turning against it due to
change in growth model which will indirectly change norms for intellectual property rights aiming to promote
technological innovation. But as there is no judicial independence in China, investors cannot trust Chinese
courts to enforce intellectual property rights laws in a fair and impartial manner. Chinese leaders want Chinese
companies to come up with their own engineering secrets because it will enhance the incentive for some
companies to enforce the ownership rights. This is precisely what is happening in the case for private-sector
companies who would have to invest their own funds or take out large loans to develop new technologies and
this type of reinforcement is necessary if China wants to progress up the technology value chain. Government
has also proclaimed about its new goal of making China one of the world’s most innovative countries by 2020.
For this the focus should not be on concentrating more R&D funds toward state-owned enterprises which has
not worked well so far but rather on eradicating the systemic barriers which will help to create a more
competitive innovation environment and provide an impetus to enforce intellectual property rights.
4 Potential for consumer model:
Consumer spending has the major contribution in economic activity of a mature economy. American consumers
were the main holders of the U.S. economy and they also helped drive China's growth rate by consuming a large
portion of its exports. Presently U.S. consumers are in a dismal state of affairs and hence cannot be counted on
to consume more Chinese goods. On the other hand Europe's economic degradation also makes it an
unfavorable market for consumption of Chinese goods. Hence China has to change from an export-driven
economy to a domestic-consumption-driven economy and impetus falls to the Chinese consumer, whose
spending comprises just 44% of the country's GDP. Consumer model can increase GDP as
CHINA POPULATION
CHINA CURRENCY (EXCHANGE RATE)
1
Increasing urbanization: 300 Million new urban middle class residents in next ten years and hence huge
demand potential for household items, food, clothing, health, service items.
2 Appreciation of the Chinese currency for a long period will make imported goods cheaper.
3 Large percentage of population in age group of 20’s and hence they are now ready to spend.
4. Consumer credit: In China 90% of government backed bank loans are made to housing purchases and so
there is no consumer credit program besides the housing mortgage and car loans. In 2003, only about 20%
of automotive purchases were financed by loans, with the remaining 80% paid in cash by consumers. The
default rate on automotive loans has been high around 30% and 50% as Chinese consumers are not
concerned about the consequences of bad credit. Chinese banks also lack adequate information systems to
maintain a credit rating of its consumers.
5. Industries to gain: There are signals in the Chinese economy that people are having more income to spend
on discretionary items such as
Clothing: This industry has been traditionally on two extreme ends: the very cheap clothes of local brand
and the very expensive foreign brand clothes. Now there are more brands “in between.”
Household items: As the migrant workers settles in a city home, they would need washing machines,
refrigerators, air-conditioners, laptops, and more.
Health, medicine: As Chinese gets “bigger,” and have more discretionary spending; they will become more
health-conscious.
Luxury goods: It is estimated that Chinese will consume 20% of world’s luxury goods in 2020, up from 2%
today. China’s income inequality is huge but a big population base means although the percentage of
wealthy is small, in China it is still a large number.
CHINA CONSUMER SPENDING
CHINA CONSUMER CONFIDENCE
The consumer confidence measures the level of optimism that consumers have about the performance of the economy. It is high when
unemployment rate is low and GDP growth is high. It is a useful indicators of how much consumers are likely to spend.
5 Solutions: The manner in which China can and should promote more innovation and domestic
consumption of its goods
The current path of growth in China is unsustainable. China needs to make an adjustment from an export-driven
and investment-driven growth model to a domestic consumption-driven growth model. It is a very promising
prospect as there are around 1.3 billion people who want to improve their standard of living and prosper, so if
China can actually tap on that buying power, it can become a very strong instrument of growth for China and
rest of the world economy.
HOUSEHOLD FINAL CONSUMPTION EXPENDITURE (% OF GDP) IN CHINA
DISPOSABLE INCOME OF RURAL AND URBAN PEOPLE
5.1 Process of creative destruction:
A lot of Chinese companies that have been exporting their exports are thoroughly embedded into global supply
chains. They don’t own their brand or product and they also don’t have marketing or distribution within China.
Hence they either have to develop those things or they go out of business. So capital and labor can be
reallocated to other parts of the economy such as new service industry that will cater to a more domestic
consumption-driven Chinese economy
Policy: By process of creative destruction China will see a correction which will be good for it as
overinvestment in real estate, the endless accumulation of foreign currency reserves are not good and
sustainable trends. A correction will involve adjustment which will create a lot of turmoil in the economy and
hence it will be difficult for Chinese government to implement as they vouch for economic stability. But in the
end that’s how China will have to adapt for exploiting the opportunity in Chinese markets for consumer growth.
It will involve a reorientation of the Chinese economy towards consumers and away from supplying the rest of
the world
5.2 Managing Structural issue:
China’s export-led growth model aimed to suppress consumption in order to maximize investment and then
make up the difference through selling abroad. Chinese economy planned to march towards channeling
resources away from the household sector which are Chinese savers and consumers towards investors and
producers to boost production and turbo-charge GDP growth.
Policy: Re-balance the Chinese economy by channeling those resources back to the household sector through
changing exchange rate policy, interest rate policy and the tax policy.
CHINA INTEREST RATE
CHINA WAGES
5.3 Chinese consumer Empowerment:
China needs to put more money in people's pockets and increase their purchasing power so that they feel
comfortable enough to spend it resulting in increase of domestic consumption.
Policy: It can be achieved by lowering taxes, providing direct stimulus, and increasing wages. Decreasing the
VAT and other state consumption taxes, will have a direct positive impact on consumer spending
CHINA RETAIL SALES (YOY)
5.4 Preventing consumers from spending abroad:
According to China Union Pay Chinese consumers spent nearly around $50 billion overseas last year which
increased by 66% from 2010. China's growth in retail was around 17% during the same time but it was
sufficiently less as compared to growth in foreign spending. The Chinese are traveling more because they want
to buy goods that are not available in China or are too expensive because of heavy taxes and import duties
levied. According to the Chinese Ministry of Commerce Prices for luxury goods in China are around 50%
higher as compared to the U.S. and a whopping 72% higher than in France. The World Luxury Association
estimates show that the Chinese consumer contributed around 62% to total luxury sales in Europe last year.
Policy: To give a temporary boost to consumer spending the Chinese government should send out stimulus
checks like the U.S. did during last recession. For a long term solution, the wages should slowly rise and a
minimum wage should be approved so that more people can afford to buy things that they manufactured all
these years. The policy revamp should be balanced and introduced progressively to ensure that inflation does
not negate the gains in consumer spending
5.5 Reducing government support for state-owned industries:
For most of the time Hu Jintao and Premier Wen Jiabao focused more on social stability and less on economic
reform. When problems emerged they spent money to find a temporary fix for them instead of making difficult
political adjustments. This lackadaisical behavior led to China’s 2008 stimulus package, which minted around
$586 billion over two years to keep the economy running throughout the global financial crisis. Around 80% of
those stimulus funds were held in reserve precisely for construction and infrastructure projects. To finance some
projects Government issued treasury bonds and ordered state banks to bolster the rest by providing long-term,
low-interest loans to the companies’ concerned. Most of the stimulus projects were contracted to state-owned
enterprises due to influence of China’s local governments and banks
Policy:
a) Banks should be allowed to choose projects based on profitability rather than political connections and
Chinese leaders should make sure to transmit spending from state-owned enterprises and local governments to
private-sector innovation.
b) China must shift from giving power to government officials to pick companies based on personal
connections to letting the market pick the best based on finest technology. It will help China to climb up the
value chain to become a major global innovator
MANUFACTURING; VALUE ADDED (% OF GDP) IN CHINA
Remark: It will be a difficult task as there are very powerful interest groups in China which involves local
officials and heads of local state-owned enterprises who strongly resist any reforms that redistribute wealth at
their expense. Every time Beijing comes up with a new solution, vested interests become a stumbling block. If
new incoming party leaders cannot find solutions to this political logjam, then economic growth may slow
dramatically which will have a major consequence not only for the economy, but also on the political system.
6 Conclusions:
China's consumers spending must increase if economic hard landing has to be avoided. But for that to happen a
number of reforms has to be instituted to change the perspective of nation's consumers from savers to
shopaholics. More policy changes are required to give Chinese consumers with the needed buying power to
keep the country's economic engine from running out of steam and hence intimidating to unsettle the already
flimsy economic retrieval in the West. The Chinese government should shift the focus from fickle export
market and should stimulate more internal economic growth through increased consumer expenditure. The 20%
drop in Chinese exports since 2007 reflects that focus should be on the Chinese consumer to repair the
economic cracks left from waning export growth. Beijing should plan to fill those gaps by increased
government spending. Investments can be made in infrastructure, education, social housing, security and
healthcare as the consumer spending increases. The key to raising the consumption share of growth will be to
get household income to rise from its unprecedentedly low share of GDP. This requires increase in wages,
revaluation of Renminbi and reduction in the financial repression tax that households indirectly pay to
borrowers in the form of artificially low interest rates. The financial repression tax is both the major source of
China’s economic inequity and a foundation of China’s remarkable growth, even though in recent years much
of this growth has been generated by superfluous and futile investment. To redress the domestic imbalances and
reduce wasteful spending Beijing should increase the real interest rate at the earliest. But these measures will
necessarily slow growth and create economic turmoil.
7 References:
1) http://www.economist.com/blogs/freeexchange/2012/10/rebalancing-china
2) http://www.economist.com/node/21555770
3) http://www.economist.com/node/21555915
4) http://www.economist.com/node/18928514
5) http://www.economist.com/blogs/freeexchange/2012/10/chinaseconomy?zid=306&ah=1b164dbd43b0cb
27ba0d4c3b12a5e227
6) http://www.chinadaily.com.cn/business/2012-10/26/content_15849662.htm
7) http://www.mckinsey.com/insights/mgi/research/urbanization/preparing_for_urban_billion_in_china
8) http://www.americanprogress.org/wp-content/uploads/2012/08/ChinaLeadershipReport.pdf
9) http://articles.businessinsider.com/2012-02-06/markets/31028775_1_trade-import-growth-shift
10) http://www.kpmg.com/cn/en/issuesandinsights/articlespublications/documents/china-12th-five-yearplan-consumer-markets-201104.pdf
11) http://www.economist.com/node/21542819
12) http://www.kpmg.com/CN/en/IssuesAndInsights/ArticlesPublications/Documents/luxury-consumers0804.pdf
13) http://www.economist.com/news/china/21565277-economic-repression-home-causing-more-chinesemoney-vote-its-feet-flight?zid=306&ah=1b164dbd43b0cb27ba0d4c3b12a5e227
14) http://www.cnbc.com/id/49252136/China_India_Consumer_Spending_to_Triple_by_2020_Study
15) http://www.guardian.co.uk/world/2012/aug/17/chinese-foreign-travel-surges
16) http://www.tradingeconomics.com/china/
17) http://www.imf.org/external/pubs/ft/reo/2012/APD/eng/c4_0412.pdf
18) http://economistsview.typepad.com/economistsview/china/