China: The NPC - Marginal Changes
Andy Xie (Hong Kong)
The third annual plenum of the tenth National People’s Congress (‘NPC’) is now under way. The main policy speech, which was given by Premier Wen Jiabao on March 5, did not signal a significant departure from the policies of the past two years, which put stability at the forefront and shifted resources at the margin to areas that might threaten social stability. Rural income has been receiving special attention for two years and will continue to do so. Work safety in the coal-mining industry, food safety, and pollution have been added to the list of issues to receive special attention. Overall, the government policy is still about redistributing income from the rich eastern provinces, which account for 20% of the national population but 80% of exports to other areas.
On the macro front, the speech recognized the need to maintain a tightening bias but did not hint at any major policy initiatives to restrain investment demand. There was some recognition that tightening should rely more on market mechanisms than administrative measures. In his speech, Premier Wen paid special attention to financial reforms, which are critical for market forces to play a meaningful role in China’s monetary policy.
Maintaining the Tightening Bias
Premier Wen recognized that fixed investment could surge again after two years of torrid growth and that there is significant inflationary pressure in the pipeline. However, the emphasis on stability suggested that there would be no significant new measures to deal with overheating. Political pressure on local governments, as reflected in the Premier’s warning on mindless pursuit of GDP growth with wasteful investments, is likely the most important tool in cooling the economy. If local governments heed the advice, credit demand would slow and, even with ample liquidity, the money multiplier would decline to cool demand.
However, the target for this year’s loan growth is Yn2.5 trillion ($302 billion) and is not so different from the growth of Yn2.7 trillion in 2003 and Yn2.2 trillion in 2004, when the economy was overheating substantially. Of course, the base is different; the loan growth was equal to 50% of the gross fixed capital formation in 2003, 31% in 2004, and, if fixed investment grows by 15%, 31% again in 2005. Relative to 2003, corporate earnings had to rise by 10% of GDP equivalent to sustain investment growth. The big profit growth last year came from the energy and materials sector. The sharp rise in the import prices of raw materials will squeeze this sector in 2005; hence, the need to borrow is much greater in 2005. The target of Yn2.5 trillion loan growth is relatively tight for this year. Several local governments have been cutting their growth targets for 2005 by one third off the 2004 growth rates. However, it is still too early to say if they will implement what they say.
While the speech signaled the end of the expansionary fiscal policy since 1998, the adjustments were too tiny (about 0.3% of GDP) to make a difference to aggregate demand. Considering that fiscal revenue rose by 21.4% last year, the government could restrain demand substantially more just by holding off expenditure growth. It is a reflection of reality that most fiscal revenues are earmarked for provincial governments. The discretionary expenditure at the central government level is quite small.
Interest Rate Will Likely Rise
Because the central government suppressed any rise in prices in the intermediate industries, China’s inflation rate did not fully reflect the cost pressure in the economy due to rising raw materials prices. However, it will be more difficult to hold down final prices this year. Many intermediate industries had a cushion from low contract prices last year. As contract prices have to catch up with spot prices this year, the central government will have to allow intermediate industries to raise prices. The government is targeting a 4% inflation rate. Our forecast is 3.5%.
While the inflation rate is relatively low, it still makes the current interest rate too low. However, with a fixed exchange rate and rapid inflow of hot money, it is difficult to raise interest rates. Despite raising deposit reserve ratios twice and increasing deposit and lending rates once, the benchmark 7-day interbank bond repo rate is still at 1.8%, close to an all-time low.
Obviously, with a fixed exchange rate, China cannot control its money supply under normal circumstances; the Fed determines China’s monetary policy. But, speculation has exaggerated China’s money supply. The hot money inflow, while sensitive to the Fed monetary policy, is more sensitive to China’s policies on exchange rate and property. The government has been ambiguous on both, which has encouraged speculation and hot money inflow. If China wants to decrease hot money inflow, it should eliminate the possibility of a substantial currency appreciation and/or crack down on property speculation.
China will not undertake a major currency appreciation under any circumstance, in my view. The market expectation is based on the false premise that China’s productivity gain should lead to currency appreciation. However, the extreme situation of labor surplus passes the productivity gains to multinational companies and western consumers. The ambiguity in China’s policy keeps speculators excited, which pumps liquidity into China’s monetary system.
The other anchor in the China bubble is property. External observers assume – falsely, in my view – that, as China grows, China’s property prices will converge with those of other developed economies. This assumption ignores China’s size. Ceteris paribus, international prices would more likely converge to China’s prices. One way of preventing property speculation would be for China to impose a high capital gains tax on property flipping but decrease the tax rate according to ownership time, reaching zero for properties owned more than eight years. This would encourage homeownership and eliminate speculation at the same time. If China announces such a policy, it would immediately drive out a big chunk of the hot money and China’s money supply would decline.
More than interest rate policy, cracking down on speculation is far more effective in controlling China’s money supply, in my view. However, as inflation is still substantial and the Fed continues to raise interest rates, China also has to raise interest rates. We believe that the government will raise deposit rates by 71 bp on average this year.
Easing Rural Hardship
The current government has tried to improve rural income for the past two years. The most important policy was to increase grain prices through its inventory policy. The agriculture tax was decreased and will be abolished next year. However, the plight of the rural population has barely changed. The rural cash income per capita grew at 4.1% during 1997-2002, jumped by 8% in 2003, but barely grew in 2004. The rural cash income per capita is less than one-third of the urban disposable income per capita.
The premier announced that China had entered the era of industry subsidizing agriculture. Most subsidies will likely be through fixed investment. Building roads, schools, and health clinics will likely be the most tangible forms of subsidies. The government is also trying to encourage agro-processing industries to boost rural income.
I believe that all the government measures will ease, but not fundamentally change, the plight of China’s vast peasantry. The huge numbers of surplus labor and the declining competitiveness of township and village enterprises (TVEs) are the main factors in deteriorating rural fortunes. The TVE sector employed 135 million people in 1996, up from 70 million in 1985. Employment has stagnated since and was a mere 136 million in 2003. Many big TVEs that were touted as successful role models are struggling financially.
The success of the TVE sector was an historical accident. China began reforms in the rural sector first. It started with re-introducing household farming. As rural productivity surged, the surplus labor went into light manufacturing industries based on the TVE model. The owners of a TVE are usually rural government organizations. Their success was due to the low efficiency of the urban state-owned enterprises (SOEs). In most light manufacturing industries, the TVEs took over completely (e.g., textile). As the SOEC sector disappeared, the TVEs no longer had a free lunch and had to compete against each other to survive. Competition has led to aggressive investment, which is not good for job creation. This rural job machine has reached its natural limit, in my view.
Focusing on agriculture productivity is unlikely to solve the rural income problem. There are just too many people for the land. Furthermore, as scaling-up is likely the channel for increasing rural productivity, the surplus labor situation will possibly only become more serious.
There are two channels to address the surplus labor situation: (1) migration and (2) rural service consumption. The urban sector has been creating about 8-10 million jobs per annum. As the urban population is not growing due to the two-decade-long, one-child policy, urban employment growth has attracted substantial migration from the rural sector. However, urban job creation has merely kept up with labor force growth. Hence, the rural surplus labor, conservatively estimated at 150 million, has not really eased.
Productivity upgrading and farming modernization could provide the basis for rural consumption-led demand growth. Many towns have been growing rapidly for that reason. However, if this effect is significant, it will likely only be temporary. China’s agriculture endowment is simply too poor to support such a large rural population. The ultimate solution has to be urbanization.
In that regard, it is vital that China should not have high property prices, which increase the hurdle for rural-urban migration. So, the best policy is to create a flexible land market that can respond to market forces and so ensure that property prices are affordable.
Wealth Inequality Needs to Be Addressed
The debate on inequality has certainly gone beyond the traditional urban-rural divide. Since the SOE reforms in 1998-99, China’s wealth distribution has become much more concentrated. The explosive issue is not inequality per se but how the inequality has taken place. There is a strong perception that perhaps most private wealth has been acquired unfairly. The social resentment against it is building.
China’s massive labor surplus makes it extremely difficult to acquire wealth simply through hard work or ingenuity. There are always some people who work harder than you or are smarter than you. This is why entrepreneurial successes are often ephemeral. Hence, gaining privileges has become the main channel for acquiring wealth.
The scarce resources are land, licenses for monopolies, and cheap bank loans. If someone gains access to these scarce resources, he or she could accumulate wealth. However, why would government officials give favors to one particular person? It is possible, therefore, that corruption has played a central role in private wealth accumulation.
In many cases, wealth accumulation has occurred via taking over state assets, often through superficially legitimate transactions between state-owned and private companies. In some cases, such private enterprises are monetizing platforms for government officials, and the titular owners are merely proxies.
The perception that wealth is linked to corruption is quite pervasive in China today. It is the biggest threat to China’s stability, in my view. As long as the economy is growing briskly, the resentment does not surface visibly. However, China will have a downturn just as any other economy. China must address this social grievance as soon as possible. Otherwise, a cyclical economic downturn could become a prolonged political crisis, similar to that experienced in Indonesia in the past seven years.
The best way to deal with the issue is to give the state-owned assets back to the people as soon as possible. Then, many of the best and brightest in China would focus on real business development to accumulate wealth rather than through the shortcut of taking from the government. And, more wealth for the people would help China become a more consumption-oriented economy. It is one stone for two birds.
Other Social Issues
The Premier mentioned work safety (mainly in coal-mining), pollution, and food safety as top policy issues. The massive coal-mining casualties have become politically sensitive. The government is even promising money to fix the problem; 70% of coal production is from small and unsafe mines. Often, someone with government connections receives a concession and then hires desperate farmers to work under dangerous conditions. When an accident happens, it is not always reported. China reported 6,000 casualties in the industry but we do not know the real number of deaths. If every lost life is compensated as in OECD countries, China’s coal industry may create negative value.
Eight of the top ten most polluted cities in the world are in China, according to the UN. The main reason for the pollution is lack of property investment for pollution control. What people complain about is not greenhouse gas but dust and sulfur that float in the air. China needs to invest around US$200 billion (or 11% of GDP) to make coal burning ‘clean’, in my estimation.
The other major complaint that people have is that drinking water is polluted. This is again an issue of under-investment. Many uncompetitive companies just dump pollutants into rivers to cut costs just to survive. In short, most of the pollution problem is from businesses under-investing to stay alive. The government can solve this problem through effective policing. However, as local governments may often be related to these polluting enterprises, the progress on that front is likely to be slow.
The food safety problem also originates from businesses cutting costs to stay alive. Often, such businesses may be assisted by local governments to sell products that are not genuine and sometimes poisonous. The big accidents that come to public attention have pushed the central government to address this issue. Again, with local governments possibly involved in such businesses, progress is likely to be slow.
The above issues demonstrate the weakness in China’s system: governments and businesses are often the same people. In a market economy, a government is supposed to be an impartial regulator and enforcer of rules and laws that maximize social welfare. However, when a government is also the business, it can maximize the short-term gain at the expense of the society. Without fundamental political reforms (unlikely in the foreseeable future, in my view), businesses cutting corners will always cause social problems. |
