Charting China’s five-year plan

Bernard Hickey at Interest.co.nz yesterday alerted me to an interesting presentation by the Brookings Institution on China’s latest 5-year plan, which has been widely discussed as focussed on sustainable growth and reducing inflation, rather than going for growth for the sake of it.

The presentation contains a series of excellent charts summarising China’s progress and issues.

Below are some key extracts and charts. The full presentation and chart pack is provided at the bottom.

The plan in a nutshell:

The plan lays out the momentous challenges that China faces in short-term macroeconomic management and longer-term structural transformation of the economy. This plan could herald a turning point in China’s economic development as it represents a marked shift in emphasis from high growth to the quality, balance and sustainability of that growth…

The plan document is comprehensive and lists a large number of reform priorities. The emphasis on controlling prices through various policies clearly indicates that the major short-term priority for the government is to manage inflationary pressures.

The plan contains a set of medium-term objectives but has limited detail on specific courses of action for achieving those objectives. There is much more specificity about the actions being undertaken or under contemplation for attaining short-term objectives such as controlling inflation.

The longer-term objective of the plan is to reorient growth to make it more balanced and sustainable from different perspectives–economic, social and environmental. It will be a major challenge to put in place the reforms needed to rebalance the growth model and shift away from capital-intensive production, reduce the reliance on exports, generate more employment and allow more of the benefits of growth to filter down to the average household…

Short-term Challenges:

The major short-term policy challenge is to bring inflation under control. Chinese policymakers are understandably nervous about CPI inflation at a level above 5 percent. As in many other emerging markets, overall price dynamics are being driven by food prices. Food expenditures on average constitute about one-third of total consumption expenditures for Chinese households, so this is a major component of the CPI basket and food price inflation feeds into higher overall inflation by influencing wage demands. So far, nonfood inflation remains modest at about 3 percent (Figure 1).

…The government has responded aggressively to contain inflation by clamping down on growth in monetary aggregates and bank credit (Figure 2). The policy complication is that tightening credit could hurt employment growth by reducing credit flows to small and medium sized enterprises, especially those in the private sector. Moreover, standard monetary policy tools are typically not very effective at dealing with food price increases.

Structural Transformation:

A major priority laid out in the plan is to rebalance growth to reduce the reliance on investment and exports and instead increase the share of private consumption to GDP. This is seen as necessary to ensure greater social stability by increasing the benefits that accrue to the average household from China’s red-hot GDP growth. In addition, shifting away from a capital-intensive production structure is important for ameliorating the destructive environmental consequences of rapid growth…

There are two distinct features of the Chinese growth process in the decade before the crisis, when GDP growth averaged about 10 percent per annum. First, investment accounted for more than half of overall GDP growth during the 2000s, with net exports playing an important role as well from 2005 to 2007 (see Figure 3). Private consumption, by contrast, has not been a key driver of growth. Second, even high GDP growth has not translated into much employment growth, with overall net employment growth averaging only about 1 percent over the last decade.

The growth model fostered by government policies has resulted in a rising share of investment and a declining share of private consumption in GDP (Figure 4).

Moreover, weak employment growth and high investment growth have resulted in labor income falling as a share of national income and personal disposable income falling as a share of GDP (Figures 5-6). Thus, the Chinese government has had to cope with the twin challenges of boosting domestic consumption in order to make growth more welfare enhancing for its citizens and of generating higher employment growth in order to maintain social stability.

To counter the aftershocks of the crisis, the Chinese government embarked on a massive fiscal and monetary stimulus program in the latter half of 2008. In addition to an increase in government spending, state-owned banks were directed to make credit freely available. The banks went on an unprecedented lending spree, amounting to nearly $1.5 trillion (or about one-third of China’s GDP) in 2009. With cheap and plentiful money, along with subsidized inputs such as energy and land, conditions were ripe for a massive investment boom, which amounted to nearly 90 percent of GDP growth in 2009.

This investment boom is to some extent feeding on itself—so long as financing is available for construction and infrastructure projects, investment in ancillary industries pays off. But a slowdown in the investment machine as the government tightens credit supply could result in excess capacity in industries such as steel, aluminum and hard glass. Down the road, this could dampen employment and household income growth. Banks fear a resurgence of bad loans on their books if consumption demand doesn’t grow fast enough to soak up output from the new factories.

Moreover, the Chinese household saving rate has trended upward in recent years; the economic uncertainty associated with the crisis and the weak global economic recovery are likely to increase savings for precautionary purposes (Figure 7).

External Balance, Dependence on Exports:

In short, the stimulus kept the Chinese economy humming along but in some ways actually worsened the balance of growth by tilting it even more towards growth led by investment rather than private consumption. The concern is that any dampening of domestic consumption growth could eventually increase the dependence on export-led growth, exactly the reverse of the balanced private consumption-led economy that Chinese leaders want. The reliance on exports, as noted earlier, is also because it is a key source of net job growth.

One dimension of growth rebalancing on which there has in fact been progress is related to China’s external balances. The trade surplus fell from its peak level of over 7 percent of GDP in 2007 to 3 percent in 2010 (Figure 8).

…[One] view is that China’s shrinking trade surplus is largely a cyclical phenomenon. China has grown strongly, sucking in huge quantities of imports, while its major export markets in the euro zone and the U.S. are just getting back on their feet after the global financial crisis…

My view is that both China’s trade and current account surpluses will rebound as cyclical factors unwind, especially if China manages to clamp down on credit growth and cools its economy while the U.S. and Europe solidify their recoveries (all of which remain slightly dubious propositions at this stage)…

The Currency Regime and Capital Account Convertibility:

China continues to intervene massively in foreign exchange markets to counter pressures for renminbi appreciation. China accumulated $448 billion of foreign exchange reserves in 2010, matching the pace in 2009 (Figure 10). The merchandise (goods) trade surplus of $185 billion accounts for less than half of this reserve accumulation in 2010 (the overall trade surplus on goods and services was lower at about $165 billion)…

…the implication of such rapid accumulation is that capital continues to seep into China through a variety of channels despite all the controls on inflows. Managing capital flows and their impact on domestic liquidity and inflation will be a major challenge for the Chinese government during 2011, especially if it continues to strongly resist currency appreciation…

China’s currency policy threatens to upset the delicate balance between keeping growth strong and inflation at moderate levels. China’s strong growth prospects and resurgent trade surplus will pull in large amounts of capital inflows from abroad, adding to the liquidity in the financial system and increasing the risks of higher inflation and asset market bubbles…

Financial Sector Development and Reform:

Financial sector reform remains a key priority that is highlighted in the twelfth five-year plan…

China’s banking system appears well capitalized and the ratio of nonperforming loans relative to assets for the overall banking system is quite low. These figures mask a number of well-known problems, including persistent incentives to lend to state-owned enterprises rather than private sector enterprises, weak risk management capacity that results in credit to small and medium sized enterprises being rationed, and asset portfolios that include a significant amount of subpar assets that may turn into nonperforming loans if economic growth slows down.

Interest rate liberalization is an important element of banking reforms. At present, there is a ceiling on deposit rates and a floor on lending rates, resulting in a comfortable and noncompetitive spread that helps the profitability of banks. One effect, as noted earlier, is that households earn low or negative inflation-adjusted rates of return on their copious deposits in the banking system. Another is that the absence of price competition makes the banking system less efficient…

The plan recognizes the need to broaden and deepen financial markets in order to improve their overall functioning and enhance their contribution to balanced growth. But this remains an aspiration rather than an objective backed up by a well-defined strategy.

Industrial Policy:

…The industries that the government wants to develop into future pillars of the economy have a hi-tech or environmental focus. They include (i) energy conservation and environmental protection, (ii) new-generation IT, (iii) bio-tech, (iv) high-end manufacturing equipment, (v) new energy (including nuclear and renewable energy), (vi) new materials, and (vii) new-energy automobiles. The government intends to set up special funds to develop these new strategic industries. These funds will encourage start-ups and also complement private investment in these industries…