Can China Fight Inflation While Re Balancing Its Economy

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Can China Fight Inflation While Rebalancing its Economy?

Pieter Bottelier International Economic Bulletin, March 31, 2011Comments

China launched its Twelfth Five Year Plan (FYP) in March. The new FYP aims to decrease China’s dependence

China Fight Inflation While Rebalancing its Economy?... http://carnegieendowment.org/ieb/?fa=show&id

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on exports and investment, rebalancing the economy toward services and domesticconsumption. But will the need to address pressing near-term challenges—namely,inflation and high housing prices in large cities—conflict with these medium-termgoals? The answer is no, not necessarily. Even though the policy outlook is uncertain,several long-term dynamics make rebalancing likely.

The Twelfth Five Year Plan

China’s twelfth FYP aims to restructure the country’s growth path. It targets 7 percentGDP growth on average per year over the period, with an emphasis on consumptionand services as drivers of growth. The FYP aims to increase the service sector’s share of GDP and the

urbanization rate, which will both bolster consumption, by 4 percentage points each, raising them to 47 percentand 51.5 percent, respectively by 2015.

The FYP also aims to significantly improve the livelihood of China’s citizens. Specifically, it sets targets of 45million new jobs in urban China, an unemployment rate below 5 percent (the official rate is 4.2 percent at present),and 36 million new affordable housing units.

In addition, by 2015, the plan aims to: increase R&D spending from about 1.7 percent to 2.2 percent of GDP;reduce energy intensity by 16 percent and carbon dioxide emissions by 17 percent per unit of GDP; increase

renewables’ share of total energy use from 8.3 percent to 11.4 percent; and increase forestry cover by about 1percentage point, to 21.7 percent.

Near-Term Challenges

Against this background of long-term, structural economic reforms, inflation remains a serious concern. Foodprice increases continue to lead the CPI and, as the chart below shows, each of the three major inflation indicescrept up marginally in January and February. There is no clear indication that inflation will moderate in the comingmonths. In his annual Work Report to the National People’s Congress in March, Prime Minister Wen Jiabao

stated that controlling inflation remains the government’s top near-term priority.

After almost a year of central

government efforts to cool urbanreal estate speculation, pricesfor apartments in tier 1 citiesfinally moderated—and, in somecities, actually fell a little—in thefirst quarter of 2011. But, giventhe large monetary overhang stillin the system, the increased

land-lease revenues that localgovernments can earn by drivingup property prices, and other distortions in China’s economy,Beijing’s struggle to control urbanresidential property prices is far

from over.

Efforts to control inflation andurban real estate speculation, if well-designed, need not conflictwith the structural reformsnecessary for economicrebalancing. If there is a conflict,

however, it will probably be in housing policy and related areas. Additional monetary tightening to combat inflation


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could raise the interest rate on the banks loans that local governments use to finance new affordable housingunits, which could then hinder Beijing’s affordable housing goal. Whether this occurs remains to be seen, however.

The Previous Five Year Plan

The previous FYP (2006–2010) also noted the need to make China’s growth path more sustainable, but little if any progress was made toward rebalancing over the period. Consumption’s exceptionally low share of GDP—one of the main indicators of imbalance in China’s economy—continued to drop through 2010, falling from

53 percent in 2006 to an estimated 47 percent in 2010.1

The first half of 2009 offeredhope that household

consumption’s share of GDPwould rise—given that householdconsumption’s growth outpacedGDP growth for twoquarters—but the gradualwithdrawal of stimulus-relatedsubsidies and decliningconsumer confidence slowed

consumption growth appreciablyin mid-2009. Consequently, asshown below, householdconsumption’s share of GDPprobably fell again in 2010 to alittle below 35 percent.

The same factors—reduced or terminated subsidies anddeclining consumer confidence—were still at play inthe first quarter of 2011,

particularly as relatively highinflation led consumer

confidence to decline.

China’s current account surplus as a percentage of GDP—another metric of imbalance—also points to the needfor a more concerted effort by China’s policy makers. The surplus would likely have narrowed little if at all without

the crisis-induced collapse in international trade. After the crisis, the ratio increased again, reaching 5.2 percent in

2010, as shown below.2

Prospects for Rebalancing

When making these arguments, however, it is important to emphasize that China’s exceptionally lowconsumption/GDP ratio is not due to slow consumption growth—consumption growth is actually much higher inChina than in the United States and other large economies—but rather to China’s high, investment-driven GDP

growth.3

In addition, China’s limited progress on rebalancing during the eleventh FYP was due, in part, to the globalfinancial crisis. The crisis led Beijing to reverse some of its rebalancing policies to protect employment andrestore growth momentum—a reversal that hopefully will not be required during this FYP period.

Continued financial repression and conflicts of interest between Beijing and local governments also stood in the


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way of implementing key aspectsof the earlier rebalancingstrategy. While these factors arestill relevant today, Beijing seemsmore aware of their negativeeffects on rebalancing and morewilling to address them.

In addition, several long-termdynamics will push for rebalancing in the years ahead,almost regardless of Beijing’spolicy stance.

Already, services are seeingimprovements relative tomanufacturing: Employment andwages are growing faster inservices than in manufacturing, atrend that is likely to intensify. In

addition, services will get aboost from the expansion of health and home care help for the elderly as the populationages and China’s traditional,family-based system of caregives way to commercialservices.

Meanwhile, a number of factorsare likely to lead to greater consumption growth. First, wage

growth: even in manufacturing,where education and income

levels tend to be lower than inservices, real wages grew faster than GDP in 2010. Second, therapidly increasing availability of consumer finance—totalconsumer loans outstandingincreased from less than 5percent of household disposableincome in 1999 to a still-modest

43 percent at the end of

2009—could lift consumption growth, as it did in Korea and other emerging economies.

Policy changes may also catalyze consumption. For instance, China plans to significantly reform its income taxsystem this year, with an eye to reducing social inequality and promoting private consumption. In addition, Chinaplans to continue increasing the budget share of health and other social services, which has been shown to

reduce the need for precautionary household savings.4 Decreased savings should raise consumption, particularlyas some of the factors that led to an increase in savings over the past decade—such as the large wealth transfer from the state to urban households that occurred when urban housing was privatized—will not be repeated.

Furthermore, China’s extraordinarily high investment rate, almost 50 percent of GDP in 2010, will likely fall asmonetary tightening in the near future increases the cost of capital.


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RMB appreciation will also push structural economic change in the right direction. Notwithstanding Beijing’s stilltoo-timid nominal exchange rate policy, the real RMB is now appreciating at a 10 percent annual clip against thedollar. China’s real effective exchange rate (REER) will likely follow suit. Given that domestic inflationarypressures are unlikely to subside soon, undervaluation of China’s real exchange rate could become a thing of thepast in the next few years, aiding rebalancing efforts.

Finally, planned adjustments in the incentive framework for government officials will reward them more for

achieving rebalancing than for raw GDP growth, as in the past. This reorientation, combined with the twelfthFYP’s reduced growth target—7 percent, compared to the official target of 7.5 percent for the eleventh FYP andrealized growth of over 10 percent for that period—will give political cover to those who wish to emphasize socialdevelopment and environmental protection over investment and GDP growth, which economic rebalancingrequires.

China’s goal of rebalancing is wise and achievable. With economic factors already pushing for it, policy makersmust now be careful not to obstruct the process.

Pieter Bottelier, former chief of the World Bank’s resident mission in Beijing, is a nonresident scholar in

Carnegie’s International Economics Program and senior adjunct professor of China Studies at the School of

Advanced International Studies (SAIS) at Johns Hopkins University.

1 These numbers refer to total consumption, i.e. household consumption plus government consumption. Household consumption

accounted for about 85 percent of total consumption in 2007.

2 On January 31, 2011, SAFE, the agency responsible for recording China’s balance of payments, announced on its website a

downward revision of the current account surplus for 2009, such that the 5.2 percent current account surplus/GDP ratio for 2010

represents an increase, not a decrease, over the original balance of payments for 2009. Final numbers are not yet available.

3 This observation has major implications for the design of China’s economic rebalancing strategy. While somewhat higher

consumption growth should be achievable, the main adjustment has to come from reducing investment (and hence GDP) growth and

changing the growth pattern from manufacturing and construction to greater reliance on the service sectors.

4 Recent research by Steven Barnett and Ray Brooks of the IMF shows that household consumption expenditures and government

spending on social services, especially health services, are positively correlated (Chapter 7 in Rebalancing Growth in Asia. Economic

Dimensions for China, edited by Vivek Arora and Robert Cardarelli, IMF, 2011.)

Resources available for this publication

IssuesEmerging and Developing Economies Crisis and Recovery Trade and Currency Asia ChinaGlobal Recovery Global Imbalances

Author Pieter Bottelier

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Can China Fight Inflation While Re Balancing Its Economy

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