Table Of ContentEmergingMarketsResearch
March2013
China: Beyond the miracle
YipingHuang,JianChang,StevenLingxiuYang
PLEASEREFERTOTHELASTPAGEFORANALYSTCERTIFICATION(S)ANDIMPORTANTDISCLOSURES.
Barclays | China: Beyond the Miracle
FOREWORD
China has become a key locomotive for global growth, in many ways taking over the
role traditionally played by the United States in business cycles. It is now the world’s
second largest economy, and has grown much faster than any other major economy
over the past couple of decades. China’s role as a key driver of global growth brings
with it increased scrutiny by investors and economists: a significant slowdown in China
– never mind a collapse - would have significant implications for economies and
financial markets around the world. This was most recently seen in 2012, when slower
economic growth – fostered in large part by policy tightening to alleviate inflation
pressures and structural imbalances – generated fears of a “hard landing” that served as
a headwind to financial market performance for much of last year.
The extremely rapid growth in China – as welcome as it has been during an otherwise
disappointing recovery from the Great Recession – represents the first stage of
development in the evolution of the economy from closed to open, from fully controlled
to market, and from agrarian to industrial. This initial stage is already giving way to a new
phase of slower, more sustainable growth, with different drivers. It is critical for the global
economy and financial markets that China’s transition is managed in a way that allows
the necessary adjustments to happen gradually and without de-stabilizing effects.
The Beyond the Miracle series - written by Yiping Huang, Jian Chang and Steven Lingxiu
Yang and launched in September 2011 - carefully analyzes the transition that China is
undergoing from various perspectives, and also discusses the economic and financial
market implications. It argues that China will successfully make the transition from
‘economic miracle’ to normal development in the next decade (Chapter 1). But there is
an important caveat: China must embark on a multi-pronged set of reforms if the
country is to move to a slower, more sustainable growth rate that deemphasizes trade,
construction and investment and instead places a greater weight on consumer
spending as a source of growth.
Each chapter provides an in-depth analysis of the task at hand – from financial reform
(Chapter 2), to housing reform (Chapter 3), to the pivotal role of consumption in
rebalancing China’s economy (Chapter 4). For China to avoid becoming a source of
inflation in the future, its monetary policy-making, too, will need to be reformed
(Chapter 5). China’s ageing population will also mean an end to its surplus of cheap
labor, heralding a new era of rapidly rising wages (Chapter 6). In turn, this could put
additional pressure on the country’s fiscal outlook, as it seeks to meet growing pension
liabilities (Chapter 8).
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Barclays | China: Beyond the Miracle
These challenges notwithstanding, the Beyond the Miracle series is optimistic on the
outlook for China. It argues that the Chinese economy is in the middle of a major and
broad-based structural transformation that will lead the country to a more sustainable
growth potential of 6-8%, from a double-digit pace previously. As China continues to
grow and upgrade, its outward direct investment should rise quickly (Chapter 7). And
by narrowing the technological gap with the advanced economies, China should be able
to avoid the “middle income trap” and graduate to the global high-income group within
the next decade (Chapter 9).
China’s Beyond the Miracle series is ambitious, both in scope and depth. Given the
critical role now played by China in the world economy and financial markets, I highly
recommend it as essential reading for investors, as well as anyone interested in current
and future economic and market trends.
Larry Kantor
Head of Research, Barclays
March 2013 2
Barclays | China: Beyond the Miracle
CONTENTS
Chapter 1: China’s next transition ......................................................... 5
Emerging economic trends ............................................................................................................ 6
The making of an economic miracle .......................................................................................... 10
Distortions in factor markets ....................................................................................................... 17
Remarkable successes and growing risks ................................................................................. 25
Why the next five years might be different ............................................................................... 29
The great rebalancing .................................................................................................................... 33
Chapter 2: The coming financial revolution ...................................... 36
The revolution that needs to happen ......................................................................................... 37
How has the financial system evolved? ..................................................................................... 41
Repressive policies are now retarding growth in China ......................................................... 46
Growing financial and economic risks ....................................................................................... 49
The needed financial reforms ...................................................................................................... 53
Policy and market implications ................................................................................................... 63
Chapter 3: Bubble deflation, Chinese style ........................................ 67
Policy-induced correction ............................................................................................................. 67
Making of property bubbles ......................................................................................................... 71
How serious are property bubbles in China? ............................................................................ 75
Why hasn’t the Chinese ‘bubble’ burst? .................................................................................... 78
These favourable conditions could turn negative soon ......................................................... 82
How might bubble deflation play out in China? ...................................................................... 86
Policy and market implications ................................................................................................... 99
Chapter 4: The great wave of consumption upgrading .............. 101
Weak consumption in a strong economy ...............................................................................102
Common explanations for China’s weak consumption .......................................................104
Controversies surrounding consumption statistics ..............................................................108
Recalculating China’s consumption share of GDP ................................................................112
Will consumption improvement be sustained? .....................................................................119
A strong case for consumption upgrades ...............................................................................122
Policy and market implications .................................................................................................126
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Barclays | China: Beyond the Miracle
Chapter 5: Understanding Chinese inflation .................................. 130
Has inflation really peaked? ........................................................................................................132
Reliability of Chinese inflation statistics ...................................................................................134
What determines Chinese inflation? .........................................................................................138
The making of monetary policy .................................................................................................150
Rising inflation risks for China and the world.........................................................................162
Chapter 6: The consequences of demographic change ............. 165
The one-child policy .....................................................................................................................166
Gender imbalance might stimulate growth? ..........................................................................170
Will China grow old before it gets rich? ...................................................................................176
The Lewis turning point – end of surplus labour? .................................................................193
Demographics pose new challenges, but unlikely to derail growth .................................205
Chapter 7: Will China buy up the world? ........................................ 210
A new giant investor on the global stage ................................................................................211
Some “stylised” facts about Chinese ODI ...............................................................................214
Economic literature on ODI motivation ...................................................................................219
Why Chinese companies invest overseas? ..............................................................................223
American, Japanese and Chinese models of ODI ..................................................................230
Outlooks, challenges and policies .............................................................................................234
Chapter 8: Can China manage its fiscal risks? ............................... 240
Mixed picture for China’s fiscal outlook ..................................................................................242
Fiscal decentralisation, Chinese style .......................................................................................245
Local government debt the biggest medium-term risk .......................................................254
Pension liability the biggest long-term risk.............................................................................266
Overall assessment and investment implications .................................................................271
Chapter 9: Can China avoid the middle-income trap? ................ 278
China’s new growth challenge ..................................................................................................280
Lessons from the other countries .............................................................................................283
Underappreciated structural improvement ............................................................................286
Political and economic reforms .................................................................................................293
Early takeoff of science & technology ......................................................................................298
What could derail the growth train? .........................................................................................304
Toward a high-income economy ..............................................................................................306
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Barclays | China: Beyond the Miracle
CHAPTER 1
China’s next transition
• This is the first in a series of reports titled China: Beyond the Miracle that will
analyse the major structural issues facing the Chinese economy.
• We think China is about to experience a transition from ‘economic miracle’ to
what can be considered normal development in the next five to ten years. This
process will not only transform the Chinese economy, but will also have
significant implications for the rest of the world.
• The key to the upcoming transition lies in the anticipated reform of factor
markets, including rapid wage growth, interest rate and exchange rate
liberalisation, and market-based resource prices.
• We identify a number of important trends that will emerge during the transition
process. Growth is likely to moderate steadily, economic cycles will probably
become more violent, and inflation pressures could escalate, as a result of
widespread increases in factor costs.
• Industrial upgrading is likely to accelerate, with a rapid move into high value-
added manufacturing and service sectors, and faster development of inland
provinces. We also expect income distribution to improve.
• The economy should see the beginning of great rebalancing, which is likely to
mean an end to investment-led growth but much stronger consumption. As a
result, demand for commodities could slow.
• China will likely achieve basic convertibility of the capital account over the next
five years, and its capital outflows are likely to primarily take the form of direct
and portfolio investment.
This article was originally published on 5 September 2011.
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Barclays | China: Beyond the Miracle
Emerging economic trends
As economies show visible signs of weakening trends around the world, market
participants, economists and policymakers are again looking for likely policy actions by
the Chinese government. We think China probably would respond quickly if global
economic conditions deteriorated sharply. However, it probably will not be able to
repeat the action it took three years ago at the height of the global financial crisis, given
elevated inflation, large local government borrowing, an expected deterioration in the
quality of banking assets, worsened structural imbalances and the upcoming leadership
transition.
Beyond short-term cyclical considerations, the biggest challenge facing Chinese
policymakers is how to transform the economic development pattern, as identified by
the 12th Five-Year Program (FYP). Some market participants are sceptical that China
can ever achieve this policy objective. Since the government failed to improve the
growth model during the 11th FYP, why should it be different this time?
The current economic development pattern, however, is no longer sustainable. Despite
China’s great success in achieving rapid growth during the past decades, its economy
has developed a number of structural problems, including a high investment ratio, large
current account surplus, unequal income distribution, high resource intensity, serious
environmental degradation and widespread corruption. The Politburo meeting in late-
July 2011 also reiterated its concerns about China’s uncoordinated, unbalanced and
unsustainable development pattern.
Many of these structural problems have worsened sharply since the global financial
crisis as a result of the aggressive fiscal and monetary expansion implemented to
support economic growth. Investment’s share of GDP, for instance, rose from 41.7% in
2007 to 48.5% in 2010 (see Figure 1). Asset bubbles and excess capacity have become
more serious and widespread (see Figure 2), and prompted many predictions of a hard
landing. For instance, James Chanos, founder of Kynikos Associates, a New York-based
investment company, has predicted a slump due to excessive property investment in
China. Similarly, James Rikards, former General Counsel of hedge fund Long-Term
Capital Management, warned that China was in the midst of “the greatest bubble in
history”.
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Barclays | China: Beyond the Miracle
FIGURE 1 FIGURE 2
GDP: Unsustainable investment-led Continued build-up of a property bubble
growth
100 25 House price/household income
80 20
60 15
40 10
20
5
0
Investment Private consumption 0
-20 Government consumption Net export Mar-07 Mar-08 Mar-09 Mar-10 Mar-11
1980 1985 1990 1995 2000 2005 2010 Shang hai Beijing Guang zhou
Source: CEIC, Barclays Research Note: We assume an average house size of 70 sqm.
Source: CEIC, Wind, Barclays Research
While acknowledging these serious – and even worsening – structural risks, we do not
see a high probability of a hard landing or a fiscal/financial crisis in the near term. In our
view, the pessimists are wrong on at least two fronts. One, they often underestimate the
flexibility and resilience of the policy regime. Chinese policymakers have proved their
ability to respond and adjust in the face of crisis risks, as evidenced by their decision to
adopt the household farming system at the beginning of the 1980s, to privatise loss-
making state-owned enterprises (SOEs) in the mid-1990s and to enter the WTO at the
beginning of the century, despite strong political resistance to these changes.
Secondly, in predicting a hard landing, the pessimists ignore the still-healthy balance
sheets of households, corporates, banks in China, and the external economy and
government. For instance, mortgage loans in early 2011 amounted to only c.13% of
banks’ total outstanding loans. These loans are also equivalent to less than 20% of GDP
and less than total household savings (see Figure 3). This implies that, even if house
prices decline, we are unlikely to see forced and widespread deleveraging that could
lead to a meltdown of the financial system and economic activity. Again, public debts
are equivalent to only c.18% of GDP. Even after including local government debt (27%
of GDP reported by NAO), it remains below the 60% international warning line (see
Figure 4). Fiscal revenues have been growing at a rate of 20-30% pa for years. The
government also has massive assets, including state-owned ones totalling CNY207.8trn,
equivalent to more than six times annual GDP (CNY33.7trn). Clearly, this suggests that
government solvency is not at risk in the near term.
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Barclays | China: Beyond the Miracle
FIGURE 3 FIGURE 4
Chinese households, not that leveraged Chinese government debt, still
manageable
20 250 Public Debt/GDP, as end of 2010 (%)
18
200
16
14
150
12
10 100
8
6 50
Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11
Mortgage/total outstanding loan (%) 0
Mortgage/GDP (%) CHN IND JPN USA DEU FRA GBR ITA
Note: Majority of household debt is mortgages. Note: China’s figure includes both official public debt
Source: CEIC, Barclays Research and local government debt. Source: IMF, National
Audit Office (NAO), Barclays Research
But that does not mean the structural problems can continue for a long time. If China
fails to transform its development pattern over the next five years, then the risks of a
major crisis could increase exponentially. In the past, the government always stretched
the financial and fiscal systems to contain near-term downside risks. But there is a limit
to how much longer this approach can be employed. After the Asian financial crisis, for
instance, it took years for China to reduce nonperforming loan levels and contingent
fiscal liabilities. But China may not always have the luxury of a long ‘adjustment period’
to deal with such problems.
Whether or not China is able to transform its development pattern is critical for growth
sustainability. There are many economies in the world, most notably in Latin America,
that achieved a successful takeoff in the immediate post-war period but then failed to
sustain growth, falling into the so-called ‘middle-income trap’.
This is not our base-case scenario for China. We believe China will be able to gradually
change its growth model, rebalance its economy and reduce inefficiency over the next
5-10 years. The key will be the reform of factor markets. By providing extra incentives
for producers, investors and exporters, factor cost distortions have been an important
force driving China’s strong economic growth in past decades. These same forces have
also created serious structural problems, such as economic imbalances, huge
commodity consumption and various types of inefficiencies.
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Barclays | China: Beyond the Miracle
FIGURE 5 FIGURE 6
Migrant workers salaries have been The still distorted energy price signal
rising rapidly
350 Migrant workers' monthly salary (CNY, 1978p) 60 60
300 RPoealyln soamlairnyal trend 5568 5505
54
250 45
52
40
50
200 35
48
150 46 30
44 25
100 42 20
Jun-01 Jun-03 Jun-05 Jun-07 Jun-09 Jun-11
50 Electricity price for resident (CNY/100kwh)
1980 1985 1990 1995 2000 2005 2010 Coal price for resident, 1st grade (CNY/100kg, RHS)
Source: Lu Feng, "Employment expansion and wage Source: CEIC, Barclays Research
growth (2001-2010)", China Macroeconomic Research
Center, Peking University, Beijing, 12 June 2011
Fortunately, we have already started to see changes in the factor markets. Wages have
been rising rapidly due to emerging labour shortages (see Figure 5). The government
has begun to adjust the prices of resources, including electricity, oil, gas and water (see
Figure 6). The authorities also plan to introduce market-based interest rates and
increase exchange rate flexibility during the 12th FYP. These changes should gradually
remove distortions to the incentive structure for economic entities, and eventually drive
the transition of the Chinese economy – from economic miracle to normal development.
Assuming this transition takes place, we are likely to witness a sea change in China. If
the transition is smooth, then we think the Chinese economy should be able to avoid
the ‘middle-income trap’ and move to the next level of economic development. During
this process, there is likely to be a series of important changes that could have
significant implications for market participants, both at home and abroad. We identify
the most important emerging economic trends as:
Growth is likely to moderate, although steady growth should continue;
1. Inflation pressures to rise;
2. Income distribution will likely improve;
3. Industrial upgrading to accelerate;
4. The economy will start to rebalance;
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