China's recipe for higher consumption and steady economic growth

East Asia Forum

The slowdown of economic growth in China, since the global financial crisis, is obvious. The average growth rate dropped from above 10 per centto 9.3 per cent between 2008–2011, and then to 7.7 per cent in both 2012 and 2013, according to China’s National Bureau of Statistics. In the first half of 2014, the growth rate was 7.4 per cent.

The external reason for the growth slowdown is weak demand in international markets. The internal reason is the structural imbalances that have persisted in the economy for years. These structural imbalances are primarily reflected by three key realities. The first is the heavy reliance of economic growth on exports and investment. Second is the rapidly decreasing return on capital due to massive investment. Third is the low proportion of domestic household consumption in GDP.

China’s consumption rate gradually decreased from 78.9 to 62.1 per cent between 1952–1978, while the savings rate gradually increased. During the earlier reform period in the 1980s and 1990s, the consumption rate generally remained above 60 per cent, and then dropped significantly to 48.2 per cent from 2000–2010, a reduction of 14.1 percentage points. In the meantime, the share of household consumption in GDP fell from 46.4 to 34.9 per cent, the lowest level since the 1950s. The gross savings rate rose to 51.8 per cent of GDP in 2010, which was a rare situation in the world. It is only in the last couple of years that consumption rates have marginally rebounded.

The government-led investment expansion in the past decade, and the very loose monetary policy during the global financial crisis period, did not fundamentally solve the problem of insufficient aggregate demand. Instead, these both led to serious overcapacity in the manufacturing industry. Thus, the key issue is to resume a balanced structure between savings and consumption.

Insufficient consumption mainly arises from the current pattern of income distribution, due to both imbalanced income distribution between the government, corporations and households, and great income inequality. There are five related issues.

First, until recently, in the past few decades wages in China grew slower than economic growth, leading to a declining share of GDP for both household income and consumption. Meanwhile, the shares of both government and corporation revenues in GDP increased consistently from the mid-1990s.

Second, government expenditure in investment in fixed assets grew even faster than revenue, whereas expenditure for public services, social security and transfer payments grew relatively slowly. Local governments have strong incentives to promote local economic growth and offer preferential policies to large investment projects and enterprises. But this is disadvantaging labour-intensive small businesses in market competition, which is unfavourable to employment growth and balanced income distribution. All these factors have contributed to the decline of the share of household consumption in GDP.

Third, widening income disparity is also an important factor for the low consumption ratio. From 1985–2010, China’s Gini coefficient for income distribution rose from 0.31 to 0.48. Due to diminishing marginal propensity to consume, this negatively contributed to the consumption ratio. In 2011, the savings rate of the lowest tenth of urban households ranked by annual income was 6.5 per cent, while that of the top 10 per cent of households was as high as 40.2 per cent. This implies that the greater the income inequality, the higher the savings rate and the lower the rate of household consumption.

Fourth, firms with monopolistic resources — such as those in the banking, insurance, oil and gas, and telecommunication industries — have been enjoying rapidly rising profits, contributing to rising corporate savings.

Finally, China’s social security and public services systems are underdeveloped. In particular, a majority of the 160 million urban migrant workers from rural areas have been left out of the urban medical insurance and endowment insurance systems and do not have access to unemployment benefits. This forces them to save in order to safeguard themselves against financial hardship and reduces their consumption.

For China to solve the problem of insufficient domestic consumption demand, and thus to sustain fast economic growth, the key issue is to push forward institutional reforms and policy adjustments. Necessary and effective measures include reforms of the government sector, as well as the fiscal, taxation, household registration and social security systems. This will be needed to rationalise government spending, promote market-oriented resource allocation, and improve the social security, public services and transfer payment systems, in order to improve the pattern of income distribution.

If these reforms can be successfully implemented, China can be expected to remain in the fast lane of economic growth in the coming decades.

Wang Xiaolu is Deputy Director and Senior Fellow at the National Economic Research Institute, China Reform Foundation, Beijing. Zhou Yixiao is a doctoral candidate in economics at the Crawford School of Public Policy at the ANU.

This article originally appeared on the East Asia Forum. Republished with permission.