China’s growth has become pricier of late. Fixed-asset investment (FAI) – money plowed into roads, hardware, buildings and machinery – has long been a staple of Chinese GDP, as it is in most developing countries. But the financial crisis and plummeting exports forced China to throw even more cash at infrastructure to sustain growth. FAI now accounts for half of GDP, up from 41% in 2008.
The economy needs a new source of fuel. The West is unlikely to clamor for more exports anytime soon, and FAI cannot drive growth indefinitely – overcapacity is already the norm for many industries. To China bears, the risk of a “hard landing” looms large.
Optimists say the risk can be ameliorated by judicious adjustments to the growth model. The bumper-sticker policy of the day is encouraging domestic consumption by developing the service sector. Service industries employ about 25% more people per unit of GDP than manufacturing; by increasing the service sector from 43% of GDP to 47% by 2017, China can allow growth to slow but maintain employment. But a closer look reveals significant opposition to this seemingly innocuous proposal.
Empowering the consumer makes for a lovely sound bite, but it will involve tradeoffs that China has so far hesitated to make – namely, reforming interest rates. At present, the central bank maintains a floor on lending rates (6.31%) and a ceiling on deposit rates (2.75%). This effectively ensures three things: First, bank loans make a guaranteed 3% profit. Second, a fat margin encourages banks to lend, in turn enabling China’s FAI addiction.
Third, this all comes at the expense of the consumer. Because the ceiling on deposit rates lags behind inflation, Chinese consumers are losing money on their bank deposits, which depresses their inclination to spend. If this seems backward, it is not. In the West, high debt levels mean consumers get pummeled when interest rates rise. But Michael Pettis, a professor of finance at Guanghua School of Management, points out that this is not true in China. Given the high savings rate here, lifting interest rates make households feel wealthier, and therefore spurs spending.
Interest rates would need to change before any shift occurs in China’s growth model. Lifting deposit rates will increase personal incomes, while narrowing the spread between deposit and lending rates will encourage more responsible lending and reduce investment’s share of GDP. Better returns on bank deposits could also dissuade people from putting money into stocks and property, stopping bubbles before they form.
However, while raising rates and making capital more expensive would encourage consumer spending, it would have the opposite effect on indebted businesses. Higher interest would cut into profits and increase non-performing loans (NPLs) in the banking system. On the ground this could mean layoffs and higher unemployment – nullifying any positive effect on consumption.
NPLs could also create cash problems that could come back to haunt consumers. Rumors are circulating that Beijing will spend up to US$450 billion bailing out indebted local governments. Closing out the NPLs could eventually require the country to raise taxes, hurting consumption. Because of its currency controls, China cannot sell bonds internationally or convert its forex reserves to get more renminbi. Nor can it print money without aggravating inflation.
Alternatively, the government could let banks spin off some of the NPLs but leave others on the books. Banks would then need to earn themselves out of this hole, but their main source of funding at present is net interest income – the very spread between the lending and deposit rates that is crippling the Chinese consumer.
This explains why leaders have been reluctant to lift real interest rates into positive territory, despite serious inflation. Unemployment is even more dangerous than dissatisfaction caused by rising prices. When the consumer price index increased 5.5% in May, the central bank raised reserve requirements for banks, but left interest rates untouched. Raising reserve requirements is useful for sterilizing hot money inflows, but it has less influence than interest rates on inflation.
Procrastination is understandable, especially given the government’s strong cash position. But a smooth transition to a consumer-driven economy is nothing to take for granted.