China is between a rock and a hard place. Neither the export market nor its domestic market is growing fast enough to absorb the increasing supply that will flow from China’s fixed investment program. If China cannot find a way to solve the above problem, China is in big trouble as its going to have large amounts of non-performing loans, write downs and bankruptcies. They may then be forced to cut TIFA - with severe consequences for GDP growth.

It will come as no surprise if China is going to be even more aggressive in pursuing a growing share in the global export markets. At the same time they will attempt to stimulate domestic demand. Pursuing both objectives at the same time, however, will be difficult. To stimulate domestic consumption fast enough to catch up to TIFA, China will have to increase minimum and median wages at a faster rate than what TIFA (+-24%) and GDP-capital formation (+-20%) is growing. That will be a major impediment for any effort to increase China’s share in the export markets as it would blunt one of China’s relative advantages, namely cheap labour. This might also have a negative effect on future foreign direct investment (FDI). The only way to neutralise such wage increases is to depreciate the Chinese Yuan (RMB), especially against the US$ and Euro. Unless their allies (multinationals invested in China) help them to keep developed countries’ governments at bay, a trade war is a likely consequence. The latter is discussed in more detail in Part X of “Dominant Causes of the Credit Crisis”.

The problems associated with investment in residential estate are even bigger as China is primarily dependant on the domestic market to absorb the excess residential space that is flooding the market and that will continue to do so at an increasing rate in the foreseeable future. As this topic requires a more in depth analyses we will expand on this issue in a future article.

Fast growth in household consumption – the key to China’s future

Unfortunately, China has a dismal record in trying to increase its household consumption’s share of GDP, thus far. As shown above, household consumption’s share of GDP has dropped from 45% to 33% by 2011, and there is little reason to believe that China will be more successful in reversing this trend in the near future.

Let us start with the big picture. There is simply no way that domestic consumption which is currently growing at around 11% per annum, can absorb the supply that flows from an escalating TIFA that is growing at more than double that pace. Chart CH8 below highlights a further problem. The growth in value added by all Chinese sectors exceeds the growth in total domestic compensation by an increasing margin. Total compensation has dropped from around 60% of the “value added” to around 48%. A major portion of this value added was reinvested in TIFA, creating further capacity in manufacturing, real estate, infrastructure, utility production etc. In short, the capacity to produce goods and services; and the actual production of goods and services are outpacing the domestic income to consume it at an increasing pace. Up to now, this excess production was mainly absorb by increasing investments and exports but for reasons discuss above this cannot continue indefinitely.

Add to this the expansion of credit by the People’s Bank of China (PBC) that was used to stimulate the economy, especially from 2009 onwards. Most of these loans went to state controlled enterprises that mainly used it for TIFA –adding to the further expansion of capacity and infrastructure. Chart CH9 illustrates the rapid pace at which credit was expanded over the last three years.

From chart CH10 below it seems as if the PBC, from time to time, choses to inject a bigger dose of credit into the economy to ensure that China’s GDP grew at the desired rate. However, the collectability of a substantial part of these loans is in doubt and this situation could get lot worse in future if China fails to find a market for all the supply that will eventually flow from TIFA.

There is also strong anecdotal evidence that China has a vast shadow banking industry that contributes to TIFA in especially the private enterprise sector. These shadow loans may be at even bigger risk of loss if China fails to find a market for the expected increase in goods to be produced by this sector. Fitch Ratings estimates that as much as 30% of total loans could go “nonperforming”.

China’s increasing savings rate

China’s personal savings rate has increased steadily over the last two decades. Although growing savings helped to fund China’s exceptional growth, it had a major downside. The more savings grew the less consumption grew relative to income and GDP growth. While China’s increasing personal savings flow mostly into TIFA (directly or indirectly), its consumers’ relative ability and/or willingness to consume the increased production of goods and services, are waning. Chart CH11 shows the growth in the savings rate up to 2008. Based on provisional data it seems that this upward trend is continuing.

Due to this high savings rate, funding for China’s expanding investment programs have not been a problem. While interest rates for depositors remain below the inflation rate and the return on TIFA exceeds it (given that creative accountings might be a factor), savings will tend to flow to fixed investments.

Many studies have been done on China’s high personal savings rate and corresponding low consumption rate, but few if any has come up with concrete answers. From some of the studies and subsequent press articles it appears as if Asian societies have a greater preference for savings than western societies. Reasons given for the high savings rate include China’s one child policy (one child to look after old age parents); higher mandatory contributions to pension funds; lack of national safety net and higher savings for education.

One of the most dominant causes of increased savings, that often escapes the attention, is the fast growing inequality of income distribution in China. This unequal distribution is reflected in the increasing Gini-coefficient that is currently estimated at between 0.45 and 0.6 depending on which source you use. The figure of 0.45 is already higher than the so-called “international warning line” of 0.4 and a Gini coefficient 0.6 makes China the country with the greatest income inequality in the world. Less than three decades ago it had one of the lowest Gini coefficients at around 0.2. It was still relatively low in the middle nineties when the Gini reading for China was only 0.3. That the figure could escalate to 0.6 (or 0.45) over little more than a decade is indicative of the fast pace at which income inequality grew.

According to Li Shi, a professor on income distribution and poverty studies with the Beijing Normal University, the top 10% ‘s income was 23 times that of the bottom 10% in 2007; compared to 7.3 times in 1998. This data once again demonstrate the ferocious pace at which income inequality grew in the space of nine years.

Not only did the gap between the average urban wage and average rural wage widen over the last decade, but also the gap between migrant workers’ wages in urban areas and average wages of urban dwellers. For example, in many provinces the gap between minimum wages for migrant workers and average wage for urban workers has widened considerably over the last 15 years. In 1992, wages for migrant workers were equal to 50% of average wages for urban dwellers but by 2008 it was as low as 28%. Chart CH12 reflects the widening gap between minimum wages for migrants and average urban wages in Shanghai from 1995.

What does a widening income gap or income concentration got to do with savings? When individuals or families earn increasingly more income, they are more able and willing to save. A man who earns one million dollars a month will most likely save a greater share of his income than a man who barely earns a subsistence income. Let us illustrate this by way of an example.

Let’s assume a country, named “AB”, has a total personal income equal to 2$ million per month. Ten men earn 50% of the total personal income (100,000 dollars each) of AB  and one million people earn the other 50% which is evenly spread (one dollar each) between them. The one dollar is just enough for them to survive – so they save nothing.  Assume that the ten men’s cost to live a luxurious life is $50,000 per month and that they save the rest ($50,000). AB’s total personal savings would therefore amount to $500,000 or 25% of total personal income.

Now let’s assume that AB’s personal income doubles to 4$ million per month, but the top ten income earners now receive 70% (50% previously) of total personal income. The other million’s personal income now amounts to $1.20 ($4mil x 30%/1mil) per person instead of the previous S1.00 per person. Each one decides to save only 1c of the extra 20c in income because they have other urgent needs to satisfy first. The more fortunate ten men now earn $280,000 ($4mil x 70%/10) each per month and after adjusting their desired spending from $50,000 to $60,000, they decide to save $220,000 each. AB’s total savings as a country would now be $2,210,000 (2.2 mil + 10,000) which represents 55.25% of total personal income whereas they saved only 25% of total personal income in the previous period.

The moral of the story is that if a bigger share of income is allocated to a small group – savings will go up, because it enables the few to save a higher percentage of their income. That’s why the personal savings rate of AB went up from 25% to 55.25%. If the additional $2 million was divided equally between the two groups it is unlikely that the bottom million income earners would have saved 94.4% (170/180) of their additional $1.00 income. They would probably have spent the major portion of the additional one dollar on more pressing needs – increasing consumption by about $1million instead of savings. If the entire increase in income of $2 million were allocated to the bottom one million, giving them $3 each, it’s unlikely that the savings rate of AB would have increased by more than a few percentage points. It is more likely that the consumption amount would have doubled.

The massive concentration of wealth in China, where less than 1% of the population now owns around 70% of household wealth (some sources claim it is “only” 40%), confirms that China went through a similar process of skewed income distribution - resulting in the accumulation of most savings in the hands of a small group of individuals or families. A rapid increase in income inequality would also correlate with the growth pattern in the personal savings rate as depicted in chart CH11. A similar process of wealth concentration also took place in the United States and other developed nations over the last three to four decades. The consequences of wealth concentration for the United States were discussed in more detail in Part II, III, IV and VIII of the “Dominant Causes of the Credit Crisis”.

The upside of the above is that China could conceivably increase its consumption substantially to more desired levels, if it would be willing to distribute a bigger part of personal income to the lower income groups. Although some believe that China will do whatever it takes, it is more likely that China will avoid adjusting income distribution in a meaningful way. They would have to raise minimum and median wages by a substantial margin - cutting severely into enterprises’ profits. This will make its export products less competitive and may alienate FDI-investors which played a major role in China’s economic progress. More importantly, the Chinese business elite will have to sacrifice a substantial part of their income and possibly a small part of their wealth. It is highly unlikely that they would appreciate such a change even though it would be in their interest over the medium to longer term. Wealth fever blinds the best of men when they have to sacrifice in the short term for long term prosperity. According to some reports, the business elite are close to the Chinese leadership. Most of them, apparently, made their money from their close relationships with government officials. If true, it’s unlikely that these cosy relationships will be put in jeopardy. 

Income concentration has become a worldwide phenomenon which has increased in strength over the last three to four decades. It has reached fever pitch in the last decade. The only time in modern history that wealth and income inequalities were this high, was in 1928, before the onset of the Great Depression; and the only time it was successfully reversed were during World War II and the three subsequent decades when taxes on top income earners escalated to very high levels. The prevailing international mood is anti-tax, anti-income equality, anti-wealth redistribution, anti-benefits to lower income groups and pro austerity as long as it does not involve more taxes for higher income groups. It’s highly unlikely that China will follow a different route.

It is unlikely that China’s top earners received most of their income from employee compensation but rather from business and investment profits. Chart CH13 shows to what extent a decrease in employee compensation versus total disposable income is followed by a decrease in consumption’s share of GDP. There can be little doubt that a significant rise in wages (especially minimum and median wages) relative to total income will increase the consumption component of GDP substantially.

A steep increase in China’s domestic consumption is of critical importance to China’s long term growth. It is also important for world growth because the growth in demand outside China is not enough to absorb the flood of supply that will flow from China’s incredible growth in TIFA. It may well dump the world into a sinkhole of deflation.

China will no doubt attempt to raise consumption by measures that include higher wages, but it’s probably going to be too little too late. It is more likely that China will eye the export market. But they need a much larger and faster growing export market than the existing one which means they will be aggressive in trying to gain additional market share. Substantial depreciation of the Yuan is a real possibility and so is a trade war. The alternative to a depreciation of the Yuan and/or a material rise in consumption is low growth and even a major contraction over the medium to longer term.

We will expand more on the sustainability of growth in the residential estate sector in a subsequent article.

© Copyright David Collett 2012.

Whilst every effort was made to ensure the accuracy of this article, neither this document; nor its author, David Collett; nor any publisher of this article; offer any warranties (whether express, implied or otherwise) as to the reliability, accuracy or completeness of the information appearing in this article. Neither do any of the above parties assume any liability for the consequences of any reliance placed on opinions expressed or any other information contained in the above article, or any omissions from it. Its content is subject to change without notice. Any information offered, is intended to be general in nature and does not represent any investment or business advice of any nature whatsoever. If you choose to rely on such information you do so entirely at your own risk. Neither David Collett nor any third party involved in publishing this article, assume any responsibility or liability for the outcome of such reliance.

-- Posted Friday, 17 February 2012 | Digg This Article | Source: GoldSeek.com

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