Is investment-based stimulus needed?

The Chinese government took its foot off the brake earlier in the year in response to the deteriorating external environment facing the nation’s economy. It front loaded its fiscal spending, eased access to credit, and accelerated investment approvals. Local governments started announcing stimulus packages and relaxed some property measures. Against these developments, the debate continues whether China should again ratchet up investment.

The government, on the other hand, has been relatively firm in its resolve to moderate investment growth and promote consumption, keep property market measures in place, and address income inequality. Can such a position be justified in the face of the current uncertain global environment? Yes.

Let us look at China’s consumption, which is at the center of the government’s rebalancing efforts and often accused of being too low. At about 47 percent of GDP, consumption in China is indeed low compared with 63-68 percent in Japan and South Korea when their respective per capita GDP was around the same level as China in 2011.

However, a different comparison, taking into account each country’s 20-year peak growth period, tells a different story. China’s consumption spending from 1991 to 2011 rose 9.0 percent a year in real terms, well surpassing the 6.3 percent in South Korea (1966-86) and 6.9 percent in Japan (1956-76). This, by any measure, is a very impressive achievement.

The reason for the low share of consumption to GDP is because of China’s own success. Led by investment, China’s GDP growth during its peak growth period averaged 10.4 percent, well exceeding the 8.2 percent in Japan and 9.5 percent in South Korea. This is even more remarkable when one considers that China was able to lift its economy at this speed with a population that is 35 times larger than that of South Korea and 13 times larger than that of Japan.

Unfortunately, like everything else in life, there are side effects of this success story that may be becoming increasingly unsustainable. In fact, China’s ratio of investment to GDP was high, but not excessive, until the early 2000s and broadly comparable with those of Japan and South Korea during their peak growth periods.

Acceleration of investment started in 2000 and in more recent years, it was further lifted by the need to contain the spillover from the global financial crisis. Well aware of this, efforts were geared toward rebalancing under the 12th Five Year Plan (2011-15). However, there are no easy policy solutions to the challenges facing the economy, and shifting its reliance from investment to consumption will take time.

In fact, declining consumption as a share of GDP in and of itself is not a problem. But the purpose of economic growth is ultimately to maximize social welfare, which, in turn, means making goods and services available to people, that is, consumption, to improve public quality of life. If consumption falls relative to income, it means people are expecting more consumption in the future, including after their retirement, through investment now. If that future consumption cannot be realized, then foregone consumption today will have been wasted.

Future consumption can only be guaranteed if current investment is efficiently allocated. This is best achieved by relying on market price signals. Market signals work properly only if there are no rigidities in prices and when competition is encouraged. This does not mean an absence of regulations, but rather, a regulatory system that is transparent and simple.

Opening up domestic sectors to competition would also help enhance productivity in the service sector. Indeed, resource allocation becomes increasingly challenging as the economy matures and its structure becomes more complex, a stage now reached by China. One possible measure of efficiency in resource allocation is the contribution of current and past investment (capital stock) to current GDP growth. According to this measure, we note that the marginal contribution from investment to GDP growth has been falling gradually and by 2016, based on the long-term trend, a 1 percentage point increase in investment is expected to contribute only 0.75 percentage point to GDP growth.

Another issue related to low consumption share to GDP has to do with growing income disparity. Beneath the rapid economic growth, consumption gaps between rural and urban households, and between the rich and the poor, have been widening. The consumption expenditure of the “lowest income group” (according to the household survey definition) now accounts for less than 20 percent of the “high and highest income group”, down from more than 40 percent in the early 1990s.

Similarly, consumption expenditure per capita of rural households relative to those of urban households has fallen from 70 percent to a low of 50 percent in recent years. This reflects an even faster decline in income share. Since the rich tend to spend less, the growing income share of the rich has inevitably led to a fall in the consumption share of GDP.

Finally, it is expensive to maintain a high ratio of investment to income. During most of its peak growth period, China supported investment with its own savings. Households and the corporate sector each accounted for about 40 percent of national savings, and the government for the rest. The large savings by the corporate sector is attributed to a de facto financial transfer from households to corporate through the low interest rate structure that provided cheap capital. Although households also benefited from rapid economic growth, which in turn was attributable to large corporate sector investment, a larger share of the growth dividend went to the corporate sector through this channel.

Furthermore, the surge in investment after 2008 to counter the negative impact of global slowdown relied largely on monetary stimulus. The total social financing doubled from 6.8 trillion yuan ($1.07 trillion) in 2008 to 14.1 trillion yuan in 2009. While credit growth has been curtailed since then, the economy still has a liquidity overhang, albeit at a lower velocity. Liquidity growth beyond the productive capacity growth of the economy tends to inflate asset prices, which, in turn, attracts investment to reap capital gains. The property market boom during 2010-11 is a case in point.

The points above support the current government’s prudent position. But that does not mean policies should be limited to fine tuning irrespective of changing circumstances. For instance, should the global environment deteriorate substantially over the course of the year, a clearly defined stimulus package through the budget could address both the concerns noted above and provide adequate defense against the negative spillover. Such a package could include policies that would continue to strengthen the social safety net, reduce social security contributions that could be supplemented by larger dividend transfer from State-owned enterprises, increase infrastructure investment in rural areas where employment effect could be larger, and beef up social housing program that could also help the property market. After all, China still has the fiscal space to do so.