Will China switch to a consumer-led economy?

Its economic model has overemphasised investment for years, making growth increasingly unbalanced

The short-term economic signals out of China have not been reassuring. Policymakers bungled a stock market bailout over the summer. The central bank made a surprise devaluation of the currency. Growth slipped to its slowest pace since 2009.

These developments rattled global markets and unnerved investors. But the bigger question is, what, if anything, has changed in the long-term outlook for China’s growth?

Some experts on emerging markets look at China’s sputtering growth rate and see signs of deeper problems ahead. Others are undeterred, taking China’s current economic deceleration in stride. To them, it is a natural and necessary part of the switch to a more sustainable development path.

“The last couple of decades were all about ever-faster growth in everything in China, and the next couple of decades will be about slower growth rates in almost everything,” said Andy Rothman, a San Francisco-based strategist at Matthews Asia, one of the biggest investment firms in the US dedicated to Asia.  “We need to get comfortable with that,” he added. “The Communist Party is comfortable with that, but over here, we’re freaking out about it.”

Indeed, the once-torrid growth in industrial and manufacturing output has been cooling off for several years, falling under 7 per cent. China’s leaders have just set an annual growth target of 6.5 per cent in the next five-year plan, running through 2020. But after decades of debt-driven investment, economists are trying to size up whether China can shift to a new model in which consumer demand becomes the main engine of economic growth, as in most developed countries.

Bob Browne, the chief investment officer at Northern Trust in Chicago, describes the question of the Chinese consumer as “one of the fundamental long-term decisions an investor has to make about China.” “You can’t be agnostic or neutral on it: Is that transition to a services-based economy, as the middle class expands, going to continue inexorably — with bumps along the way — or not?”

Browne is among those who see China’s slowdown as a near-term risk, but his longer-term faith in its ability to make the transition to a consumption-led growth model is unchanged.

“Clearly with China, it’s more of a top-down-driven economy, but so were Korea and Japan for much of their postwar development,” he said. “That transition from a manufacturing- and investment-dependent economy to a services and consumer-led economy is fairly consistent.”

China has a long way to go. Its state-directed economic model has overemphasised investment for years, and this has made growth increasingly unbalanced. The result is that private consumption today accounts for only around 38 per cent of China’s gross domestic product. That is a sharp contrast to the industrialised nations of the Organisation for Economic Cooperation and Development, where consumption on average accounts for more than 60 per cent of GDP.

Addressing this imbalance poses pressing risks for China. Because of a reliance on state investment — often in wasteful projects or loss-making industries — the country accrued record levels of debt, which stands at nearly 300 per cent of GDP.

That debt burden looks increasingly precarious as economic growth slows, raising the risk of deflation, or falling prices, which can lead companies to curtail investing and individuals to spend less. Deflation also makes debt relatively more expensive to repay — even at a time when revenue and profit at many businesses are crumpling.

“Given the economy is slowing down and deflation is a major risk, if the government cannot push through necessary reforms, China may well follow the Japanese path of having a balance-sheet recession,” said Li-Gang Liu, the chief economist for greater China at the Australia and New Zealand Banking Corp in Hong Kong. He was referring to a type of recession where spending on debt repayment takes priority over new purchases or investments.

Liu forecasts that private consumption will rise to about 44 per cent of GDP in the next five years — a slow but significant shift because consumption is expected to outpace the economy’s general growth rate, replacing investment as the key engine. This forecast, like others that see China making the gradual shift to a consumption-led growth model, rests in part on changes underway in how ordinary citizens manage their finances.

On average, Chinese households save roughly 30 per cent of their disposable income, the most of any major country. By comparison, the net saving rate is nearly 6 per cent in the United States, 7 per cent in Europe and just over 2 per cent in Japan. But there are signs that a younger, urbanised generation — one that has not experienced the privation of the past — is taking a less conservative approach to spending than their parents or grandparents did.

That includes people like Yu Ying, 22, who dyes her hair blond and works as a hostess and greeter for corporate functions and other events, making as much as 6,000 renminbi ($940) a month. Asked about her saving and spending habits while on a shopping trip to Sanlitun, a popular Beijing neighbourhood of cafes and shops, Yu said: “I don’t save. I can’t save any.” 

But even if younger Chinese are more free-spending, analysts say getting most Chinese to open their wallets more will require financial and other regulatory overhauls that Beijing has so far shied from undertaking. Among the priorities are easing or abolishing the nationwide system of household registration, or hukou.

The system as it stands generally prevents new migrants from the countryside from gaining access to urban school placements, healthcare and other social services, which can be provided only in one’s official place of residence. Analysts say liberalising this system would deliver a tremendous stimulus to labour mobility and also help reduce the need for migrants to save so much to meet healthcare and other costs.

“China needs to let people live where they can make the most money, which obviously they don’t do now,” said Derek M Scissors, a resident scholar at the American Enterprise Institute in Washington.

The risk of failing to execute on these and other reforms, he said, is falling into a phenomenon known as the middle-income trap, where growth and earnings reach a plateau before a country can become broadly wealthy and achieve developed-nation status.

“That’s what I mean by stagnation: China doesn’t continue to climb the ladder of prosperity; it stalls,” he said. “Of course, the Chinese have the capacity to reinvigorate the economy,” he added. “But they’re not implementing those kinds of reforms, and you cannot be a heavily indebted, aging middle-income country and continue to do well.”