Challenges to China’s consumption-led growth

27 Jan 2016

To improve is to change; to be perfect is to change often – Winston Churchill

SUMMARY

  • China has had some initial success in shifting its economic structure to services from manufacturing. However, it has made far less progress in boosting private consumption.
  • A key reason for this macroeconomic disconnect between surging services and lagging consumption is the rise in urban savings, despite robust per capita income growth. This reflects not only a lack of consumer confidence but also a legacy of decades of lopsided growth that has favoured output growth at the expense of labour compensation.
  • Relaxing the household budget constraint through banking reform, among other structural reforms, may be an effective medium-term policy to boost private spending. Sunrise sectors, such as consumer staples, services, healthcare and software should shape China’s new consumption landscape.

China’s tertiary sector out-grew the secondary sector in 2013 (Chart 1), showing a clear progress on economic structural rebalancing. After bottoming at 36% of GDP in 2010, the share of consumption has risen to 38%, while that of investment has peaked (Chart 2). The gains in services, as reflected by the tertiary sector, have been particularly strong in wholesale and retail trade, finance and real estate. The shift towards services will continue, broadening out to healthcare, education, IT services, domestic tourism and leisure and transportation. China’s tertiary sector is expected to grow towards 60% of GDP from about 50% now in the next decade.

The unwilling consumer

However, it is unclear if this expenditure-switching process will deepen, as China’s consumers have remained unwilling to spend. While the GDP share of the tertiary sector has risen by almost 6 percentage points since 2010, the share of consumption has only risen by 2 percentage points. This gap represents a yawning household savings rate.

China’s urban savings rate has been rising on the back of strong per-capita income growth in recent years. This reflects a preference for precautionary saving over discretionary spending (Chart 3), and is a rational response by the majority of Chinese households to their uncertain future, which is not supported by a reliable social safety net. Given China’s demographic structure, under-developed financial market and weak welfare state, high precautionary saving is likely to persist in the medium-term.

Saving for retirement has become an overriding objective for most workers. In the past, the Confucian tradition of filial piety meant that children were proxy savings vehicles, as they were expected to support their ageing parents. However, after more than three decades of one-child policy, retirees now cannot expect much support from their children, many of whom subscribe less assiduously to the Confucian tradition. Meanwhile, the country lacks a strong pension system to pick up the slack.

Some observers also argue that workers are increasing their savings due to longer life expectancy and surging medical costs. From a macroeconomic perspective, this does not yet seem to be a crucial factor constraining consumption, as the share of spending out of disposable income on medical costs has not risen despite the rise in the absolute amount of medical spending (Chart 4).

Labour income has shrunk

One crucial macroeconomic factor hurting consumption may be the fall in the share of GDP represented by labour income (Chart 5), despite years of robust economic growth (until recently). This has eroded private consumption power, and is likely the result of China’s lopsided growth model and financial repression.

More than 35 years of distorted industrial policy has favoured investment over labour income growth and relied on wage suppression to subsidise output and exports. Financial repression has boosted investment and output growth at the expense of Chinese household savings by suppressing its real rate of return to almost zero.

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