Economic Report

ER-681 June 2009

China’s Future Growth:

Savings, Investment, and
Its Rebalancing Goal

By:
Yingying Xu
Economist
yxu@mapi.net

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MAPI
China’s Future Growth: Savings, Investment,
and Its Rebalancing Goal
Introduction
In 2008, China celebrated the 30th anniversary
of its historical economic reforms. Over the past
three decades, expanding at an average annual
growth rate of 10 percent, China has made itself
the second largest economy in the world, based on
the purchasing power parity (PPP) standard. The
major driver of growth has been a significant
increase in the rate of capital accumulation in the
industrial sector, which has been fueled by the
rapid rise in the national savings rate. The
contribution to growth from household consumption
has been declining steadily to a low level not seen
in any major economy in the world. Instead,
exports have been a strong source of growth and
destination for the increased production from rising
fixed asset investment.
Only in recent years has it become more and
more obvious that China’s industry-led, capital-
intensive growth model with high savings and
investment rates, comes at a price. Increasingly
concerned with the negative impacts of relying
heavily on investment and exports, In 2004,
China’s top leaders formally called for a
rebalancing of the country’s sources of growth and
made one of the top priorities in its eleventh five-
year plan (2006-2010) to promote household
consumption, expand the service sector, and grow
at a more sustainable and equitable pattern. If this
were to be accomplished, fixed asset investment
and (related) exports would be a lesser factor in
Chinese economic growth. However, despite the
government’s efforts to stimulate consumption and
constrain investment spending in recent years, the
share of savings in GDP has continued to rise,
although the investment share has edged down
somewhat, leading to a widened saving-investment
gap. China’s policy initiatives have been criticized
for being too modest to change its underlying
growth dynamics.
China’s real economy has been hit hard by the
continued global turmoil and economic crisis,
mainly through the freefall in global demand and
the resulting weakness in market-based investment
and sentiment, notably in the manufacturing sector.
Therefore, boosting domestic demand and
domestic consumption is key not only for the
medium-term objective of rebalancing, but also is
important in helping to dampen the alarming
slowdown and to prop up economic growth in the
short term. International interest, especially from
chronic trade deficit nations like the United States
1 ER-681
and the United Kingdom, is high in China’s
rebalancing, because one key to move sustainable
growth in deficit countries is the ability to
supplement domestic demand from exports to high
growth countries such as China and India.
Recently, there is much talk that China should use
the crisis as a broad catalyst to accelerate the pace
of reform, and there already have been some
positive changes. However, the progress of the
transition will not likely be fast and smooth, not only
because of the resistance from many vested
interest groups who benefit from the old growth
model and thus push for the status quo, but also
because of the complexity of tasks lying ahead.
During this transitional period, multinational firms,
which have made significant contributions in
helping China to produce products for the global
market, will need to cooperate with Chinese firms
in more creative ways to meet China’s huge and
growing domestic demand when they both are
facing a tougher business environment in China.
The structure of this report is as follows. The
next section will explain the necessity for China to
rebalance toward a more sustainable and equitable
economy. Then a detailed analysis of China’s high
national savings rate will be presented. The last
section reviews the progress that has been made
during this transition process and gives some
explanations why China still has a long way to go
to achieve its rebalancing goal.
China’s Past Economic
Growth Pattern
Several studies have analyzed the sources
behind China’s rapid growth and largely agree that
a significant increase in the rate of capital
accumulation in the industrial sector has been the
major driver. As shown in Figure 1, fixed asset
investment averaged 36 percent of GDP in the
1980s before trending up quickly in the 1990s, and
the share has exceeded 42 percent since 2003.
On the contrary, the contribution of domestic
demand to economic growth has been declining
steadily, with the share of household consumption
in GDP dropping from more than 50 percent in the
early 1980s to only 35 percent in 2007, the lowest
share of any major economy in the world. Mirrored
to China’s low consumption-to-GDP ratio is its high
domestic savings, which outpaced investment
growth and reached an unprecedented 50 percent
of GDP in 2007. Economic theory proves the
mutual reinforcing relationship between savings
MAPI 2 ER-681

investment rates, comes at a price. First,

Figure 1 with investment booming, excess capacity ER-681

Evolvement of China’s Domestic Savings, Investment and and overinvestment emerged in a number
June 2009

Household Consumption of important industries.2 The resulting

60 overproduction has not only driven down
product prices and eroded industrial profit
Household Consumption
margins, but has also made Chinese
Gross National Savings producers more vulnerable to external
50 shocks as they become increasingly
Percent of GDP

dependent on international markets. Take

the steel industry as an example. China
became the world's largest steel maker in
40
1996, and at the end of 2008, its excess
capacity in crude steel production reached
160 million tons, exceeding the 118 million
Gross Capital Formation
metric tons of annual output in Japan, the
30
second largest steel producer in the world.
1992
1984
1985
1986
1987
1988
1989
1990
1991

1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
After the global financial crisis intensified
Sources: United Nations and MAPI Calculations
in September 2008, however, the average
steel price contracted by more than 30
percent, and exports dropped from 20
percent of total output in August 2008 to
Figure 2
Household Consumption
only 5 percent in February 2009. As a
Gross Capital Formation
in East Asia In East Asia result, annual profits in 2008 for the
80 80 industry as a whole declined by 13.7
South Korea percent, while in 2007 a 45 percent
70 70
Hong Kong
increase had been observed. Some
researchers believe that this excess
Percent of GDP

60 60
Percent of GDP

capacity has contributed at least partly to

South
50
Singapore
Korea 50
the slowdown in China’s Total Factor
Productivity (TFP) growth,3 a critical factor
40 40 in explaining China’s fast growth. TFP
Japan
Singapore slowed from nearly 4 percent per annum
30 30 during the first 15 years (1978-1993) of
China’s rapid industrialization period to
20
20
Hong Kong
only 3 percent thereafter.4
10
Taiwan
10 Second, the industry-led growth pattern
is particularly intensive in the use of energy
1971

1975

1979

1983

1987

1991

1995

1999

2003

2007
1971
1975
1979
1983
1987
1991
1995
1999
2003
2007

and raw materials, which will not only

Sources: United Nations and IHS Global Insight
and growth, and normally argues that a rise in the
savings rate is necessary in order to finance rising
domestic investment and thus support economic
“takeoff.” What has been surprising is the extent of
the increase in both the savings and investment
rates in China, which even surpassed what its
neighbors in East Asia had experienced at the
peak of their era of rapid industrialization
(Figure 2).1
Only in recent years has it become more
obvious that the industry-led, capital-intensive
growth model characterized by high saving and
1 4
Newly Industrialized Economies (NIEs) have shown
a common pattern of rising saving rates during their
take-off periods.
threaten China’s energy security but also
contribute to harming domestic and global
environmental sustainability and public
health. China’s energy consumption growth rate
jumped from an average 3.5 percent in the 1990s
2
According to the most recent estimate from China's
industry ministry, about 30 percent of the nation's
aluminum production capacity, 20 percent of cement
and plate-glass capacity, and 70 percent of
semiconductor capacity is in idle.
3
Growth in TFP represents output growth that is not
accounted for by the growth in inputs, such as capital
and labor.
Jianwu He and Louis Kuijs, “Rebalancing China’s
Economy—Modeling A Policy Package,” World Bank
China Research Paper No. 6, September 2007.
MAPI
Figure 3
Energy Efficiency/CO2 Indicators in 2007 at PPP
0.4
0.3
Koe/GDP*
0.2
0.1
0.0
China India
Primary Energy Intensity
CO2 Intensity of Industy (to value added)
*The ratio of energy in kilogram of oil equivalent (koe) to 2007 GDP in Purchasing Power Parity (PPP).
Source: Enerdata
to almost 10 percent during 2000-2005, despite
similar GDP growth rates during these two
periods. By 2006 energy consumption already
exceeded the higher bound projection for 2010,
which was made in the early 2000s by various
government agencies. In 2007, its primary energy
intensity, defined as energy consumption per unit of
GDP, even surpassed that of the United States. As
a result of the soaring petroleum use for auto-
mobiles and the massive increase in the use of coal,
which accounts for two thirds of its energy
consumption, China became the largest emitter of
greenhouse gases in 2007, and its CO2 emission
per capita is almost four times as high as the level in
India (Figure 3). Its air quality is among the worst in
the world and has had incalculable adverse effects
5
on public health. China has also become the
world’s largest consumer and a major net importer
of most primary industrial commodities.6 The
increasing dependence on the global market to
meet its surging material demand generated by the
resource-intensive growth model makes China more
vulnerable to the commodity price volatility and
supply uncertainties intrinsic to the global market,
and imposes serious constraints on its future
development.7
5
Currently China is home to 13 of the world’s 20 most
polluted cities. Numerous Western style environ-
mental laws passed recently have been poorly
enforced.
6
Includes oil, aluminum, copper, lead, nickel, tin, and
zinc.
7
It is generally believed that China’s recent efforts to
lock in energy supplies by investing in Africa, Latin
America, and the Middle East will contribute little to
meet its huge domestic demand.
3 ER-681
Third, the capital-intensive growth
ER-681 model has absorbed less labor and
June 2009
generated only modest gains in
employment in recent years, limiting the
absorption of surplus workers from the
agricultural sector into the labor force and
contributing to rising urban-rural
inequality. Although higher capital
intensity is generally believed to help
push up labor productivity, heavy
industries producing investment goods
employ far fewer workers than do light
industries producing consumer goods
and the service sector. Therefore,
U.S.
China’s annual employment growth
Energy Intensity of Manufacturing declined from 2.5 percent during early
CO2 Intensity of Houshold Consumption years of reform to 1 percent between
1993 and 2004 and to only 0.7 percent
on average since 2005, although its
share in world manufacturing production
keeps increasing. As shown in Table 1,
the employment elasticity of output in the industrial
sector, defined as a ratio between employment
growth rate and the output growth rate, has fallen
more than 50 percent in the past three decades,
meaning that the number of jobs created in China
for each unit of output growth is only half of what it
was 30 years ago.8
The slow pace of job creation, combined with
sluggish wage increases, caused total employee
compensation to drop from 45 percent of GDP in
2001 to only 35 percent in 2007 (Figure 4). Some
economists believe that slower household income
growth played a larger role in the declining
household consumption share in GDP than a
conscious desire by households to increase their
savings rate.9
In recent years, China’s growing trade surplus
has received lots of attention from the public, from
economists, and from politicians around the world,
and the undervalued currency is usually quoted as
a key contributing factor. Exchange rate
manipulation has become a contentious political
issue and raises trade tensions between China and
its major trading partners, including the United
States and the European Union (EU). However,
most economists believe that there is no single
explanation for the trade surplus, and it helps to
look at this issue from a savings and investment
8
The negative employment elasticity in the
agricultural sector is within expectations, considering
the labor oversupply before 1978 and the subsequent
labor migration to the industrial and service sectors.
9
Jahangir Aziz and Li Cui, “Explaining China’s Low
Consumption: The Neglected Role of Household
Income,” IMF Working Paper No. 07/181.
MAPI 4 ER-681

Table 1
Growth of Output and Employment in China, 1981-2007

Agriculture Industry and Construction Service

1981- 1991- 2001- 1981- 1991- 2001- 1981- 1991- 2001-
1990 2000 2007 1990 2000 2007 1990 2000 2007
Employment
Growth (Annual) 3.0 -0.7 -1.9 6.1 1.6 3.6 8.2 5.2 3.3
Value Added
Growth (Annual) 6.3 3.8 4.1 9.6 13.6 11.1 12.3 10.2 10.5
Employment
Elasticity* 0.5 -0.2 -0.5 0.6 0.1 0.3 0.7 0.5 0.3
*Measured as the ratio between employment growth rate and output growth rate.
Source: China Statistical Yearbook (2008)

case, after entering the World Trade

Figure 4 ER-681
June 2009 Organization (WTO) in 2000, its exports
Employee Compensation and imports both rose rapidly with imports
70
growth outpacing exports growth until
2004. During this period, a rise in savings
was paralleled by a rise in domestic
60
United States investment, leaving a savings surplus,
Percent of GDP

hence the trade surplus remained constant

Japan
50 as a share of GDP at less than 3 percent.
Increasingly concerned with the negative
China
40 impacts from relying heavily on investment
and exports, China’s top leaders formally
Philippines called for a rebalancing of the country’s
30
India
growth sources in 2004 and made it one of
the top priorities in its 11th five-year plan
20 (2006-2010) to promote household
2007
1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

consumption, expand the service sector,

and grow at a more sustainable and
Sources: United Nations and MAPI calculation equitable pattern. Despite the
government’s efforts to stimulate
perspective. Based on the GDP accounting consumption and constrain investment spending in
identity,10 the trade balance equals the difference recent years, however, the share of savings in GDP
between domestic savings and investment, implying has continued to rise although the investment share
that savings not absorbed in investment at home will has edged down somewhat, leading to a widened
be directed abroad as a net capital outflow. The savings-investment gap. Correspondingly, the trade
counterpart of a net capital outflow is an excess of surplus jumped to 5.6 percent of GDP in 2005 and
export revenues not spent on imports.11 In China’s continued to rise to 9.4 percent in 2007 (Figure 5).
China’s rebalancing road has thus proven to be more
10
The term “accounting identity” is used in economics challenging than initially expected.
to refer to equalities that are by definition. GDP by
definition can be calculated by adding up all Understanding China’s High
expenditures on goods and services, and the four Savings and Low Consumption
main components are consumption expenditures by What causes China’s high savings rate has
households (C), government purchases of goods and been a subject of controversy, but most
services (G), gross private investment spending researchers agree that frugal Chinese households,
principally by firms (I), and net exports (X-M). The who save more than 20 percent of their disposable
equation to sum this up is GDP=C+G+I+X-M. income, have played a key role (Figure 6).
11
The expenditure approach to calculate GDP
identifies GDP=C+G+I+X-M, and the term (GDP-C-G)
is the output that remains after private and national savings. It is easy to get S-I=X-M by
government expenditure and thus is called S, which is rewriting the above equation.
MAPI
Empirical studies show evidence that
among a long list of factors that can affect Figure 5
household consumption, lack of a social Exports, Imports and Trade Balance
safety net and precautionary planning for
future uncertainties are particularly 1,600
relevant in China, while the impacts of 1,400
other long-run variables, such as cultural
Billions of U.S. Dollar
1,200
factors, habit formation,12 and
1,000
demographic transitions triggered by
China’s one-child policy, appear to be
quantitatively small though not
negligible.13,14 In 2007, nearly 50 percent
of urban and rural residents were not
covered by any health insurance.
China’s pension system covered less
than 50 percent of employees in urban
areas while the rural workforce was
basically kept outside the national
system. The majority of the rural people Sources: China’s Customs Statistics, United Nations
age 60 and more depend on family
support and less than old age
insurance.15 International experience has
already proven the effectiveness of the
comprehensive health insurance in reducing the
demand for precautionary savings and increasing
current consumption.16 A recent study predicts that
12
Habit formation theory believes that consumption
reacts slowly to rising income so that savings rates
may still increase during a period of high income
growth.
13
Loayza Norman, Klaus Schmidt-Hebbel, and Luis
Serven, “What Drives Private Saving Across the
World?” Review of Economics and Statistics, May
2000; Rhee Wooheon, “Habit Formation and
Precautionary Saving: Evidence From the Korean
Household Panel Studies,” Journal of Economic
Development, Vol. 29, No. 2, pp.1-19; Yuji Horioka
and Junmin Wan, “The Determinants of Household
Saving in China: A Dynamic Panel Analysis of
Provincial Data,” January 2007, Journal of Money,
Credit, and Banking, forthcoming; Aart Kraay,
“Household Saving in China,” World Bank Economic
Review, Vol. 14, No. 3, September 2000, pp. 545-
570.
14
For a detailed discussion about the impact of the
demographic shifts, see Cliff Waldman, “China’s
Demographic Destiny and Its Economic Implications,”
Business Economics, Vol. 40, No. 4, pp. 32-45,
October 2005.
15
“Pensions at a Glance: Asia/Pacific Edition,” OECD,
2008.
16
Shin-Yi, Chou, Jin-Tan Liu, and James Hammitt,
“National Health Insurance and Precautionary Saving:
Evidence From Taiwan,” Journal of Public Economics,
No. 87, 2003; Adam Wagstaff and Menno Pradhan,
“Health Insurance Impact on Health and Non Medical
5 ER-681
ER-681
June 2009
12
10
8
Percent of GDP
6
4
800
2
600
0
400
-2
200 -4
0 -6
2004
2006
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2008
Exports Imports Trade Balance
the elimination of the risk of health expenditures
exceeding 20 percent of income would have
lowered China’s median savings rate in 2005 by
3.5 percentage points.17
Although the household savings rate in China is
high compared to other countries, it has varied only
slightly for the past decade and cannot fully explain
the 11 percentage points increase of the national
savings in GDP since 2002. A breakdown of total
savings by sector reveals that high savings by
corporations contribute significantly to China’s
savings share increase in recent years. Based on
the latest available data, corporate savings
reached 19.7 percent of GDP in 2005, up from 11.6
percent in 2002 (Figure 7).18 This level is unusual
not only by China’s own standard but also by
international standards, even when compared to a
rapidly industrialized country like India (Table 2). A
Consumption in a Developing Country,” World Bank
Policy Research Working Paper, No. 3563, 2005.
17
Marcos Chamon and Eswar Prasad, “Why are
Saving Rates of Urban Households in China Rising?,”
NBER Working Paper 14546, December 2008,
http://www.nber.org/papers/w14546.
18
The data comes from flow of funds table reported
by China’s National Bureau of Statistics. Release of
these tables usually lags that of other macroeconomic
aggregates by two years. In 2004, the method to
calculate GDP was revised, resulting in a 17 percent
increase in the product measure of GDP relative to
the magnitude used previously. Some economists
argue that the discrete leap in the share of enterprise
savings since then is due largely to expanded
statistical coverage of enterprise activity rather than to
changes in enterprise behavior.
MAPI 6 ER-681

reform era.20 On the other hand, state-

owned and collective-owned enterprises,
ER-681
Figure 6 June 2009 which still account for 40 percent of
Cross Country Comparison of Household Savings Rate China’s total investment, have retained a
30 bigger share of the rapidly growing
earnings under very limited
25 shareholdership and a tradition of low
Percent of Disposable Income

South Korea
China
dividend payments.21 According to a
20 recent study, in 2007 152 state-owned
enterprises (SOEs) directly subordinate
15
Japan
to the central government’s agency
Germany earned profits totaling more than 4
10
percent of GDP and, for most of them,
5
the remittance rate to the government
United States owners was set at just 5 percent of after-
0 tax profits.22 The retained earnings are
1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008
used to expand capacity and contribute
to further investment by enterprise
managers, who face little outside scrutiny
Sources: OECD Economic Outlook Database and China Statistical Yearbook (2008) and have the incentive to enlarge their
own domain through investing.23 At the
same time, China’s private companies
ER-681 tended to use internal sources to finance
June 2009
Figure 7 their future investment as well, rather
Savings in China Fixed Asset Investment in China than borrowing from banks, because
50
China’s current financial system, which is
50
dominated by state-owned banks and an
40
6.2
equity market, give preference to big
40 5.0
firms, most of which are large SOEs, and
4.7 3.6 alternative financing mechanisms such
Percent of GDP

5.7 6.3 19.1 3.2

Percent of GDP

30 30 3.1
as corporate bond markets are still far
12.3
20
13.5 11.6 28.5 from mature. As a result, more than 50
20
24.2 24.6 26.3 percent of China’s total investment
10 20.9
comes from self-generated funds, while
18.2 10
14.8 16.3 the shares from bank lending and foreign
9.2
5.1 5.0 5.1 capital have dropped significantly
0 0
1998 2000 2002 2005 1998 2000 2002 2005
(Figure 8).
Household Corporate Government Household Corporate Government

Sources: China Statistical Yearbook and MAPI Calculation

recent report from the World Bank concludes that 20

In China, after-tax profits of the corporate sector
the high corporate savings rate is closely related to rose by about 6 percent of GDP between 2003 and
a higher share of investment in GDP and the 2006. See “Corporate Saving and Investment:
steady rise in corporate profits.19 On the one hand, Recent Trends and Prospects,” OECD Economic
with the industry sector expanding quickly under Outlook 82, 2007.
the industry-led, capital-intensive growth strategy, 21
In China, the state usually has a large ownership of
a greater share of value added was generated from the capital, especially for SOEs, and it did not start to
capital instead of labor. At the same time, Chinese collect dividends until 2007.
corporations in general have improved their core 22
Barry Naughton, “SASAC and Rising Corporate
profitability as they restructured themselves and
Power in China,” China Leadership Monitor, No. 24,
have become more profit-oriented during the 2008.
23
For a detailed discussion, see Bert Hofman and
19
Louis Kuijs, “How Will China’s Saving-Investment Louis Kuijs, “A Note on Saving, Investment, and
Balance Evolve?” World Bank Policy Research Profits of China's Enterprises,” Far Eastern Economic
Working Paper 3958, July 2006. Review, October 2006.
MAPI 7 ER-681

Table 2
Sectoral Composition of Gross Domestic
Savings and Investment
(percent of GDP)

Household Corporate Government Total

China (2005)*
Savings 20.9 19.1 6.2 46.8
Investment 9.2 28.5 5.0 42.7
India (2007)
Savings 23.8 7.8 3.2 35.5
Investment 12.5 7.8 4.5 35.9
U.S. (2007)
Savings 2.5 11.2 0.5 14.2
Investment 4.5 10.9 3.4 18.8
*The latest data available.
Sources: China Statistical Yearbook (2008), Reserve Bank of India Annual Report (2007-2008),
Bureau of Economic Analysis, U.S. Department of Commerce and MAPI calculations.

on housing to the rise in savings rates

among young households in China.24
Figure 8 ER-681
June 2009 At the same time, Chinese
Source of Funds for Fixed Investment in China households have to put most of their
100 savings in bank deposits as there are
90
very few alternative investment tools.
80
Their incomes from financial investment
are not only hurt by the lack of portfolio
70
diversification, but also by the low and
Percentage

60
negative real returns on bank deposits
50
which are determined by China’s
40
exchange rate regime and the resulting
30 monetary policy impasse. China
20 adopted a fixed exchange rate regime
10 under which its currency was pegged to
0 the U.S. dollar before 2005. When
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
faced with a fast rising external surplus
after 2002, the Chinese central bank
Self-generated Funds Foreign Investment State Budget Bank Loans Others
intervened heavily in the foreign
Sources: China Statistical Yearbook and MAPI Calculation exchange market by purchasing dollar-
denominated assets to maintain a
China’s slow progress in financial system relatively fixed nominal exchange rate
reform is another element that is widely believed to and prevent the RMB from appreciating too quickly.
have impacted the behavior of households and At the same time, it tried to use sterilization
enterprises and exacerbate the imbalance between instruments, such as issuing central bank bonds
savings and investment. A direct way for China’s and raising reserve ratios, to control growth in the
financial system to stimulate household domestic monetary base and mop up extra liquidity
consumption is to facilitate more consumer credit caused by the accumulation of official foreign
markets. China did not have consumer credit reserves, but it only achieved partial success due
markets until 1997. By the end of 2008, household to the small size of the underdeveloped capital
debt was only 20 percent of GDP, even lower than market and the ever-increasing sterilization costs.
the 27 percent average level in emerging Asia
(Figure 9). The positive and significant effect of
greater credit availability on household 24
Lekshmi R. Nair, “Financial Sector Liberalization
consumption has been identified in India, and and Household Savings in India,” Indian Institute of
Chamon and Prasad (2008) attribute the higher Capital Markets, 9th Capital Markets Conference
prices and the stricter down payment requirements Paper, 2006, and Chamon and Prasad, op. cit.
MAPI 8 ER-681

response to the negative returns on bank

ER-681
deposits. When the stock market
Figure 9 June 2009 collapsed in late 2007 and the housing
International Comparison of Household Debt, 2007 market started to correct itself due to
monetary policy tightening, household
100
savings unsurprisingly grew by 28
percent in 2008, more than three times
80
faster than the growth rate in the previous
year, despite a record low real return
Percent of GDP

level (Figure 11). For Chinese

60
enterprises, when the domestic inflation
rate rises rapidly, the relative fixed
40
corporate deposit rates they face imply
low and even negative real rate of returns
20
on their bank savings. It is, therefore, a
rational choice for firms to reinvest their
0
China U.S. Japan Korea Taiwan Thailand Malaysia
own retained earnings, even when the
profit margin is thin.
Sources: IMF and People’s Bank of China
China’s Difficult
Rebalancing Road
Since 2005, the Chinese government
has been putting more effort into
Figure 10 ER-681 boosting domestic consumption and has
June 2009
China’s Interest Rate and Inflation Rate adopted a series of public policy
measures to achieve the rebalancing
8 goal. In 2007, government expenditures
1-Year Lending Rate
on social services increased from 0.9
6
percent of GDP in 2005 to 2.1 percent.
Percent Change (Year/Year)

4
1-Year Deposit Rate Spending on education and health care
reached 2.9 percent and 0.8 percent of
2 GDP, respectively, up from 2.1 percent
0
Consumer Price Index
and 0.6 percent in 2005.25 By
comparison, the United States spent
-2 more than 7 percent of GDP on social
-4
Producer Price Index insurance in 2003, 5.9 percent and 6.9
percent of GDP on education and health
-6 care, respectively, in 2004.26 According
2005
1998

1999

2000

2001

2002

2003

2004

2006

2007

2008

to a recent evaluation report by the World

Bank, China is on the right track to meet
Sources: IMF, International Financial Statistics, and The People’s Bank of China the targets laid out in the latest five-year
plan (2005-2010) for expanding basic
public services, and is even ahead of
The extra liquidity created high inflation pressure, schedule in the areas of health
but the central bank was reluctant to raise the protection, disease prevention, and education
benchmark interest rate, worrying that higher (Table 3).27 Other initiatives to raise household
interest rates would attract more speculative capital income, including elimination of agricultural taxes,
inflows and further force official foreign exchange reductions in the personal income tax, and
intervention. Therefore, although the benchmark increases in minimum wages, went into effect as
deposit rate for savings accounts was raised
steadily between 2002 and 2007, the increase was
less than half of the pace for inflation over the 25
China Statistical Yearbook (2006, 2008).
same period, which caused 26
Human Development Report 2007/2008, United
decline in the real rate of return from 2.75 percent Nations.
in 2002 to -0.6 percent in 2007 (Figure 10). The 27 th
boom in China’s stock and housing markets during “Mid-Term Evaluation of China’s 11 Five Year
Plan,” World Bank, Report No. 46355-CN, December
this period can be seen at least in part as a
2008.
MAPI 9 ER-681

Table 3
Indicators for Improvements in China's Basic Public Services

Coverage Rate 2005 2007

Social Protection
Basic Old Age Insurance (Urban, % of Urban Population) 31.0 34.0
Unemployment Insurance (Urban, % of Urban Employment) 39.0 40.0
Work Injury Insurance (Urban, % of Urban Employment) 31.0 42.0
Minimum Living Standard Guarantee Program "Dibao" (Rural, % of Rural Population) 1.0 5.0
Health Protection
Basic Medical Insurance (Urban, % of Urban Population) 25.0 29.0
Medical Assistance Program (Urban, % of Urban Population) 0.3 0.9
New Rural Cooperative Medical System (% of Rural Population) 30.0 70.0
Medical Assistance Program (Rural, % of Rural Population) 1.5 5.0
Education Program
Gross Enrollment of Senior High School* 59.8 66.0
Gross Enrollment of Higher Education (College and Above)* 22.0 23.0
*Gross enrollment refers to the percentage of total number of students attending school to the population of school age
students.
Sources: World Bank, China Statistical Yearbook, and MAPI Calculation

Figure 11 ER-681 share in GDP has been kept relatively

China’s Saving Account and Equity Market
June 2009
stable, households continue to hold
35 4000
back their consumption, and its share
in GDP declined by a further 5
30 3500 percentage points by 2007. China
thus relied more and more on external
Percent Change (Year/Year)

3000
25
Billions of U.S. Dollar

2500
markets to support its high growth
20 rate. Net exports accounted for 20
2000 percent of its expansion during 2005-
15
1500 2007, almost four times higher than
10
1000
the level in the early 2000s. The
World Bank concluded that “there has
5 500 been little rebalancing away from
0 0 industry and investment towards
services and consumption. This, in
1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

turn, has made it difficult to meet the

Household Savings Shanghai Stock Market Cap objectives on energy efficiency, the
environment, and reducing the
Sources: IMF, People’s Bank of China, and MAPI Calculation
external imbalances.”28
China’s policy initiatives have been
criticized for being too modest to
well in 2004. In 2007, a program was formally change its underlying growth dynamics. Although
established to channel savings of centrally the absolute public expenditure on social
governed SOEs into public consumption spending protection and education has increased
via dividend payments to the state. Local significantly in the past several years, its share of
governments are expected to use this as guidance GDP is only about half of the average level in other
and determine their own formulas for profit developing countries, including countries in
remittance from local state-owned firms. Southeast Asia. Nicholas Lardy, a senior fellow
Despite all these efforts, however, China has from the Peterson Institute for International
experienced even more unbalanced growth since
2005, as shown by the widening gap between
28
savings and investment. Although the investment Ibid, p. 6.
MAPI
Economics, pointed out in a recent paper that the
agricultural tax cut for rural residents was almost
offset by the record increase in other taxes, and
the reduction in the personal income tax would only
increase household income by 0.13 percent of
GDP in 2006, a trivial amount compared to the
income tax cut equivalent to 3 percent of GDP that
was enacted in the United States in 2001. The
increase in the minimum wage, he concluded,
would not likely have a significant positive effect on
household consumption expenditures given the low
ratio of the minimum wage to the average wage
rate and the small share of the workforce earning
the minimum wage.29 At the same time, the efforts
to lower the retained earnings of Chinese firms
were enhanced by the unification of corporate tax
rates at a lower combined effective level which
reduced the nominal tax rate for domestic firms
from 33 percent to 15 percent. Additionally,
several other tax policy changes rolled out after the
global financial crisis intensified, including the
deduction of capital spending from the base for the
value-added tax, and the increased tax rebates for
some exported products.30 The financial sector,
which has witnessed drastic restructuring of the
banking system and significant reduction of the
non-performing loan ratios in recent years, is still
waiting for further progress. In 2008, China’s
financial market sophistication was ranked 109 out
of 134 countries by the World Economic Forum,
although its overall competitiveness was among
the top 30. The low ranking was due to restrictions
on capital flows, inadequate regulation of securities
exchange, and concerns about the soundness of
the banking sector. Related to the weakness is the
need to strengthen private institutions, including
protection of minority shareholders’ interests and
stronger accounting and auditing standards.31
Another important area which many believe
needs more rigorous policy actions is the exchange
rate. In theory, a more flexible exchange rate
policy will allow the central bank to raise interest
rates to moderate the investment boom and,
compared to other monetary policies such as credit
controls, this tool is in general more direct and
efficient. The appreciation of the renminbi (RMB)
will increase competition from imports and
29
Nicholas Lardy, “China: Toward a Consumption-
Driven Growth Path,” Peterson Institute for
International Economics, Policy Briefs, Number PR06-
6, 2006.
30
The nominal tax rate for foreign-invested firms was
15 percent before the reform, compared to 33 percent
for domestic firms.
31
World Economic Forum, “The Global
Competitiveness Report 2008-2009,” 2008.
10 ER-681
concomitantly reduce competitiveness in export
markets. In turn, this will not only reduce the
growth of savings by stimulating household
consumption and slowing down domestic output
growth, but also help to resolve the global
imbalance problem. China reformed its exchange
rate regime in July 2005, switching from pegging its
currency only to the U.S. dollar to referencing it to
a basket of foreign currencies. The RMB had
appreciated about 19 percent vis-à-vis the dollar32
and around 20 percent on a real effective basis
since then (Figure 12).33 However, the share of
exports in China’s GDP continued to increase
during this period, and China accounted for a
larger share in the U.S. trade deficit as well.
Popular explanations for the relative
unresponsiveness of trade to the exchange rate
change include the insufficient appreciation of the
RMB which could not cancel out the continuous
depreciation of the U.S. dollar that happened
before September 2008 and a much slower
appreciation of the real effective exchange rate
relative to its long-run equilibrium level.34,35
Therefore, the Chinese government is urged
consistently by its trading partners to accelerate
the pace of the currency appreciation and take
32
The RMB has been essentially stable since July
2008 in response to the dollar strengthening against
other currencies.
33
Real effective exchange rate is usually defined as
the weighted average of a country's currency relative
to an index or basket of other major currencies
adjusted for the effects of inflation. The weights are
determined by comparing the relative trade balances,
in terms of one country's currency, with each other
country within the index.
34
Nicholas Lardy argued that the growth of
productivity in China’s exporting sector was
sufficiently high to absorb the effect of the rising value
of the RMB. See Bergsten, C. Fred, Charles
Freeman, Nicholas R. Lardy, and Derek J. Mitchell,
“China's Rise: Challenges and Opportunities,”
Peterson Institute for International Economics, 2008.
35
Another hypothesis is related with the triangular
trade pattern formed in East Asia in the past decade,
in which advanced countries in the region export
capital and intermediate goods to China and ASEAN-
5 countries for further processing before exporting
them to global markets. This trade model is more
responsive to the patterns of global economic growth
and less sensitive to the exchange rate changes
compared with the traditional trade in final goods for
domestic consumption. For a detailed discussion,
see Yingying Xu, “Exchange Rate Readjustment and
Expansion of Intra-Regional Trade in East Asia,”
MAPI Economic Report 663, October 2008.
MAPI 11 ER-681

allowing banks to charge higher rates.

However, banks were not very
Figure 12 ER-681
responsive to the policy change and
China’s Exchange Rate Movements June 2009

remained reluctant to lend to private

130
companies, mainly because of the slow
125 improvement in the market mechanism
RMB Appreciation Real Effective
Exchange Rate to price the risk associated with those
120
Index, August 2005=100

loans and the inadequate legal

115 framework to protect banks from
Nominal Exchange Rate Versus US$
110 defaulted loans.38 Some economists
even question the importance of
105
investment reductions in affecting
100 China’s savings-investment balance,
95
arguing that the very success of the
Nominal Exchange Rate Versus Euro administrative restrains on investment39
90 is one critical factor behind the widened

Apr-09
Apr-06

Apr-07

Apr-08
Oct-05

Jun-06

Oct-06

Oct-07

Oct-08
Dec-05
Feb-06

Dec-06
Feb-07

Jun-07

Dec-07
Feb-08

Jun-08

Dec-08
Feb-09
Aug-05

Aug-06

Aug-07

Aug-08
gap between savings and investment
observed since 2004, Without a
significant impact on consumption,
Sources: Federal Reserve Bank of St. Louis and Bank for International Settlement exchange rate flexibility will not likely
offer the desired resolution to China’s
more significant steps in reducing its huge trade external imbalance.40 A report from the
surplus. A recent study by Cline and Williamson Asian Development Bank concluded that the real
concluded that the RMB needs to appreciate constraint to growth in Asia is not domestic savings
another 31 percent against the U.S. dollar and per se, but the weakness in financial systems and
another 18 percent on a real effective basis to the related legal and regulatory structure, which
achieve the targeted change in the current account cannot efficiently transform savings into loans for
balance.36 education, housing, and private investment and
Although there is no doubt about the necessity pool social risks through financial instruments such
for China to appreciate its currency and eventually as insurance covering medical care, pensions, and
adopt a free floating regime, several scholars have unemployment.41 This is consistent with Woo’s
indicated reservations as to how effective the view that the growth of competitive domestic
currency appreciation is going to be in China’s private banks should be the most important and
current rebalancing efforts. Wing Thye Woo, a efficient solution for China’s switch to a new growth
senior fellow from Brookings Institution, argued that engine.42
higher interest rates linked to the currency China’s real economy has been hard hit by the
appreciation will not necessarily reduce the continued global turmoil and economic crisis,
investment demand in a partially reformed mainly through the freefall in global demand and
economy like China when SOEs can “privatize the the resulting weakness in market-based investment
profits from successful investments through and sentiment, notably in the manufacturing sector.
accounting shenanigans and socialize their losses
from unsuccessful investments through new bank 38
In 2007, a standard rate system, Shanghai
loans.”37 In fact, the inability of using interest rates Interbank Offered Rates (SHIBOR), was introduced
to affect investment was previously observed in by the central bank, but so far it has not been widely
China. In 2004, the central bank removed ceilings accepted or used.
on loan rates, trying to encourage lending to 39
Including higher reserve ratio, credit quotas, and
smaller, more risky firms in the private sector by closing down of investment projects such as
unauthorized development zones.
40
36
William Cline and John Williamson, “New Estimates Calla Wiemer, “The Saving Story Behind China’s
of Fundamental Equilibrium of Exchange Rates,” Trade Imbalance,,Working Paper, Lee Kuan Yew
Policy Brief, PR08-7, Peterson Institute for School of Public Policy, National University of
International Economics, July 2008. Singapore, May 2008.
41
37
Wing Thye Woo, “Understanding the Sources of Shikha Jha, Eswar Prasad, and Akiko Terada-
Friction in U.S.-China Trade Relations: The Exchange Hagiwara, “Saving in Asia and Issues for Rebalancing
Rate Debate Diverts Attention from Optimum Growth,” Asian Development Bank Working Paper
Adjustment,” Asian Economic Papers, Vol. 7, No. 3, No. 162, May 2009.
42
Fall 2008, pp. 65-99. Wing Thye Woo, op. cit.
MAPI 12 ER-681

Therefore, boosting domestic demand and

domestic consumption is not only key for the
medium-term objective of rebalancing, but also
important in helping to dampen the alarming
slowdown and prop up economic growth in the
short term. Recently, there has been much talk
that China should use the global economic crisis as
a broad catalyst to accelerate the pace of reform,
and some positive changes are already at work.
China’s $586 billion stimulus package was revised
earlier this year from the initial draft, and spending
on technology innovation and social expenditures,
including healthcare and education, will be
doubled.43 In addition, more consumption-oriented
measures, such as subsidies to rural household
appliance purchases, are in progress, and a series
of detailed plans have been announced to repair
China’s ailing health care system and correct the
distortions in natural resources pricing.44
The rebalancing progress, however, will not
likely be fast or smooth. There is persistent
resistance from many vested interest groups which
benefit from the old growth model, thus pushing to
preserve the status quo. The complexity of tasks
lying ahead involves significant policy initiatives in
many areas and necessary institutional reforms,
such as removing barriers to private participation in
service sectors. Multinational firms, which have
made significant contributions in helping Chinese
firms to produce products for the global market, will
probably have to cooperate with Chinese firms in
more creative ways to meet China’s huge internal
growth potential. Both domestic and multinational
firms will have to face a tougher business
environment in China during the transitional period
from an industry-led to a consumer-driven
economy.
In short, the transition from an investment- and
export-led growth path to a more balanced one in
which domestic consumption plays a more
prominent role is likely to be a long one. American
firms will have to be patient as the multiple
initiatives outlined in this paper to achieve
rebalancing in China take hold. Consequently, any
hope for a near-term boost to American growth
from a more robust consumer sector in China is
likely to be disappointed.

43
Barry Naughton, “The Scramble to Maintain
Growth,” China Leadership Monitor, No. 27, 2009.
44
A new fuel pricing mechanism was announced in
May, under which prices would be adjusted if global
crude prices fluctuate more than 4 percent over 22
straight working days. Benchmark prices of gasoline
and diesel were raised by 7 percent to 8 percent on
June 1.