Getting Away with it, for Now
November 02, 2010
By Pasquale Diana
| Europe, London
Morgan Stanley visited Budapest on October 27-28 and held meetings with a senior advisor to the government, two MPC members, NBH research staff, two senior representatives of the asset management community and representatives from the Fiscal Council. This note goes through our main conclusions from the trip. Feel free to call for more colour.
Modus Operandi Still the Same, Communication Issues Remain
Economic policy unfortunately still looks erratic, communication could be improved: The government follows its instinct, at times good, but its actions are often perceived by market players and investors to lack sufficient strategic planning, we think. The relationship with international lenders has not improved, and the notion that the government will continue to deal with the EU, and avoid the IMF whenever possible, still reigns supreme. We think that there is a fundamental flaw with this policy: the EU will not be more lenient than the IMF on economic policy issues. Also, as the bulk of IMF money matures in 2012-13, we question the wisdom of a policy that alienates the Fund, given that, should market conditions deteriorate between now and 2012, the authorities may well have an interest in rescheduling loan repayments to the IMF. In addition, markets still pay a lot of attention to what the IMF says, so whether it likes it or not, the government has a clear incentive to be in the IMF's good books.
Most economic agents have taken a very dim view of the changes to the pension system (more on this below). Similarly, the ‘crisis taxes' were seen as negative for both growth and inflation, and carrying a negative message for future FDI into the country. As an example, there remains significant uncertainty about how the bank tax will be levied based on 2009 assets both this year and next, but there is no guidance on 2012 yet. Potentially, parent banks in Western Europe may be tempted to shrink their asset base in Hungary if they thought that future taxes will be levied on future asset bases.
All in all, our takeaways from the meetings were that decision-making seems very centralised, the communication between ministries could be improved, and there remains scope on the part of the government for improving communication with the investors.
Monetary Policy: Closer to a Rate Hike than the Market Thinks
The NBH reaction function, as we have spelled out many times, rests on two main pillars: The risk environment and the CPI outlook. The MPC will cut rates if the CPI outlook is benign, only if doing so does not jeopardise financial stability and weaken the HUF. And conversely, it may choose to hike rates even if the CPI outlook is benign, should financial stability concerns suggest that a higher return on HUF assets is needed. The reason for such an emphasis on HUF and financial stability is, of course, the well-documented stock of FX loans: cutting rates to stimulate the economy at the risk of weakening the forint is simply not an option in a country where household loans in foreign currency (mostly CHF) as a share of GDP now stand at 23% (versus 12% in Poland, 13% in Romania and 0% in the Czech Republic).
Revisiting the last three NBH meetings: While the background is clear, the recent history is quite instructive in gauging how the NBH's thinking has evolved. In August, the staff revised the official CPI forecast to above 3%, mostly on the back of stronger external price pressures (weaker HUF). In a very unusual move, the majority on the Council openly chose to distance themselves from the inflation forecast, on the grounds that it was "too high". In particular, the dissenting members argued that the FX pass-through had fallen, and that a weaker HUF carries fewer CPI risks, given how wide the output gap is. Also, the same members thought that a ‘wait-and-see' attitude was called for, given that the government may well announce some meaningful fiscal tightening in the following weeks. Therefore, the August meeting produced a split vote, with P. Bihari and Simor voting to hike ( 25bp), lonesome dove Banfi voting to cut (-25bp) and the rest of the Council deciding to hold. In September, due to a combination of better risk appetite and the government's stated intention to bring the deficit below 3% of GDP in 2011 (a "milestone", according to P. Bihari's comment at that time), no one supported a rate hike. In October, however, there was once again a rate hike motion (the minutes are out on November 17).
What's changed? In essence, the government's ‘fiscal mix' for 2011 is seen as clearly pro-inflationary: This is because of two factors: first, the ‘crisis taxes' carry risks of spillover to final prices, as companies seek to make up for lost profits: the NBH (and the Fiscal Council) think that this effect may add around 0.3pp to inflation next year. Also, the tax reform has unambiguous pro-growth elements: while at first it looked as though only the rich would benefit (with a lower marginal propensity to consume), the introduction of family allowances ensures that everyone, except the poorest with no children, will be paying lower taxes next year. The boost to consumption that is likely to follow (assuming that the tax cut is not saved) may also raise price pressures. In addition, some members note that the last two retail sales releases have shown improvement on the spending side already.
The November inflation report will be key: Some of those who decided to give the government the benefit of the doubt, hoping for structural spending cuts and a very different fiscal policy mix, will likely be disappointed. These members may once again choose to put their trust in the inflation forecast and revert to strict inflation targeting: so, if the November CPI projection show inflation once again below 3% over the medium term (certainly possible), a rate hike would be a very serious prospect indeed. We will preview the November Inflation Report in more detail over the next weeks, but overall we feel that a rate hike is significantly closer than most commentators expect. Note also that locally the MPC does not seem at all influenced by the prospects of QE elsewhere, as they are viewed as less relevant to Hungary. And even if global QE should result in some upside pressure on the currency, we do not feel that at these levels there would be much opposition to it, both on inflation grounds as well as income effects (FX mortgage repayments would fall from their current elevated levels). Therefore, Hungary would probably not feel constrained by the trilemma that our global economics research team have laid out in their recent pieces (see "No ‘Currency War'...Yet", The Global Monetary Analyst, October 6, 2010).
If we were to see a rate hike by year-end, what sort of hiking cycle do we expect? Not an aggressive one, we think. The 3% target may be ambitious, but it is not miles away. Some on the NBH already note the fall in services price inflation, the moderation in wage growth and the rise in labour supply as constructive from a medium-term inflation standpoint. A near-term hike would therefore serve to anchor expectations, more than anything else. It would also mark a return to a more standard approach to monetary policy (inflation targeting). The clearest objection to a rate hike is that the economy is still weak, of course. Also, core inflation measures are soft and potentially a rate hike may fuel HUF gains. These are all valid points. Yet, we note that: i) the NBH targets headline, not core; ii) at these levels some currency gains are not detrimental to the export outlook; and iii) 25bp would hardly have a material impact on the economy, given continued impaired credit creation. Once again, a rate increase would be about the NBH sticking to its inflation-targeting mandate, more than anything else. So, while we still pencil in some rate adjustment in 2011 (100bp in total), the probability of a hike before year-end seems higher to us than most commentators perceive.
Fiscal Policy: Near-Term Fixes Hide Long-Term Problems
In our meetings, we found broad-based conviction on the government's ability to meet both this year and next year's fiscal targets (3.8% and 2.9% of GDP, respectively). Recall that, in order to stick to its targets, the government plans to collect HUF 61 billion from telecom companies, HUF 70 billion from energy companies, HUF 30 billion from retail chains and HUF 200 billion from banks, starting this year, for a total of HUF 361 billion of one-off tax increases (1.4% of GDP). In addition, the government suspended the payment to private pension funds starting in November, and until at least the end of 2011 - these are worth HUF 30 billion per month, or HUF 360 billion in 2011 alone (1.4% of GDP). Our current understanding is that these pension contributions are on top of the amount raised by crisis taxes in order to cap the deficit to 2.9% of GDP. So, unless these funds are spent (or the underlying trend is much worse than the government thinks), there is a serious risk of an undershoot next year, i.e., a lower deficit than planned.
Long-term issues remain, however: Once all the ‘crisis taxes' are out, there is a serious shortfall of around HUF 700 billion per year (c.2.5% of GDP). We found no clarity at all on measures to fill this structural hole, which will emerge fully in 2013, and we do not think it is likely that any will be announced any time soon.
Another, very serious long-term issue is what will happen to the pension system after December 2011, when in principle the government should once again start making payments into the privately funded second pillar. Recall that up until now, employers pay a 24% contribution to the social security system. Employees pay a 9.5% contribution, of which 8% the state collects and then passes onto the private pension fund managers (the compulsory ‘second pillar'). These are collected and invested in Hungarian government bonds (roughly 50% of the total funds), domestic and foreign equities, and corporate bonds. The total assets under management are around HUF 2.7 trillion (€10 billion).
The ‘state' portion, where contributions are three times as high, works as a standard PAYG system (defined benefit, or DB): current taxpayers pay for current retirees' pensions. The private portion is made up of individual accounts and will pay on the basis of a defined contribution (DC) system (you take out what you put in, plus the returns earned), so the state cannot use it to pay for current pensions. In countries (as in most of Western Europe) where there is no compulsory second pillar, the state collects more money under the first pillar and uses that money in the PAYG system. However, given the demographics, that system is clearly unsustainable in the long term. Even so, by collecting more money today from taxpayers to pay for current retirees, Western European countries have to borrow less than, say, Hungary or Poland. These extra costs to the deficit are often referred to as ‘pension reform costs', and were the reason behind the recent disagreement with Eurostat. Indeed, it looks as if it was Eurostat's refusal to allow CEE countries to explicitly exclude pension reform costs from official deficit/debt calculations that persuaded the Hungarian authorities to go ahead with this plan, without any warning to local pension funds (or indeed the IMF, we think).
Towards full-scale nationalisation? Is this the first step towards full-scale nationalisation of the pension funds? And if so, what would happen? These are all legitimate questions, to which we found neither answers nor clarity in any of our meetings. If we assume that the end-game is the reversal of the 1997 pension reform, there are of course several options. One is that the government could simply continue to divert all contributions to the state social security system even after 2011, and offer attractive terms to induce people to move their stock of savings currently invested in the private pension funds back into the state system. Presumably, those holdings could be liquidated, although probably in very gradual fashion, to avoid adverse consequences for equity and bond markets. The government would still be liable for those accumulated pension liabilities, but were the investments to be liquidated, the money may be used for other purposes, we think.
Nationalisation may temporarily improve the fiscal ratios significantly: In the extreme, if the government used all the funds for debt redemptions, its current debt/GDP ratio would fall by around 10% of GDP. Of course, continuing to bring the contributions into the state pillar would also reduce the deficit ratio by around 1.5% of GDP per annum relative to what the deficit would have been otherwise (assuming of course that the extra cash is not used to fund more spending or a tax cut). Over the weekend, some comments by Economy Minister Matolcsy lent weight to the hypothesis that the government plans to use those funds to redeem debt. Matolcsy said that he expects a large part of those who are currently invested in the ‘second pillar' to choose to return to the state system, which could bring around HUF 2 trillion into the state coffers (7.5% of GDP), to be used to reduce debt. No more details were given. If that happened, essentially the second pillar savings would be used to lower debt/GDP in return for a promise for higher pensions in the longer term, delivered under the old PAYG system.
So, nationalisation (whatever form it takes) would bring short-term improvements in both deficit and debt/GDP ratios. Unfortunately, however, nationalisation would imply a reversal of the 1997 pension reform and a de facto shift from a (partly) defined contribution to a defined benefit system which is probably not viable in the long run. The European authorities have often praised the CEE countries for reforming their pension systems, so any steps taken towards undoing this reform are not ideal. Our meetings in Budapest confirmed that the universal reaction to these proposed changes was extremely negative.
Strategy Implications: Sell EUR/HUF Tactically
With a higher chance of a more hawkish MPC, coupled with our more constructive outlook on the external risk environment and CEE FX (see the latest CEEMEA Investor), we think that the best way to be tactically bullish on Hungary in the near term is by selling EUR/HUF. A 25bp hike would help to improve the positive carry on the position as well, but we do not believe that it would be damaging to growth. In fact, as detailed in the economics section of this note, a stronger forint (particularly versus CHF) could lift household consumption as their mortgage obligations fall. Further, looking at the past performance of the HUF relative to the rest of the CEE region following surprise rate hikes from the NBH, we can see that the last three surprise hikes (one of them was the 300bp emergency hike in October 2008) were accompanied by forint outperformance versus other CEE currencies.
The evidence is less conclusive when looking at the whole spectrum of hawkish surprises from the NBH, but we think that the currency performance is driven by the backdrop against which a hike occurs. Given the positive news on the budget, and the benign external environment, we think that any near-term hike will be followed by currency strength. Even if a hike is not forthcoming as early as in November, we think that the NBH will be more hawkish, potentially signalling a hike further down the road. This should be supportive of the currency as well.
Given the various emergency taxes, it looks likely that the budget deficit will print at 2.9% of GDP or lower in 2011. With the uncertainty regarding the pension fund changes (more below), we think that the FX market is a better place to implement our tactically bullish trade. Our first target is 265 on EUR/HUF. In terms of timing, given that the major event risk is the uncertainty regarding the Fed's QE2 this week, we suggest waiting until after the announcement on Wednesday before pulling the trigger.
The impact on the bond market is not clear-cut: More anchored inflation expectations on the back of a potential rate hike could support the long end of the curve, but we prefer to wait for more clarity on the private pension fund changes, as they could potentially present some negative risks on bond demand. On the proposed changes to freezing of social security contribution to the second pillar pension plans, our takeaways are:
• There will be no inflows into the private pension plans over the next 14 months (HUF 360 billion), thus reducing the demand for HGBs by around HUF 180 billion (around 50% of their portfolios are allocated to HGBs);
• The liquidity of the bond market could be negatively impacted as one of the main natural buyers of HGBs will be absent (local pension funds hold around 15% of total local government debt outstanding);
• Around HUF 360 billion of the ‘savings' due to the payment freeze will be counted as revenues by the government. If more than 50% of the ‘savings' are used to reduce the financing needs and subsequently government supply, this would be positive for the bond market, as the reduction in supply will be higher than the potential fall in demand;
• If Hungarians decide to move back to the state pension system, there will be no liquidation of assets to prevent a fire sale of bonds and equities. As these instruments will not be converted into cash in the near term, the government will not be able to spend them.
Overall, the net impact of the pension plan change is not obvious, we think. The fall in bond demand is a negative development, but this could be accompanied by a reduction in supply on the back of the proposed pension plan changes. The amount of supply reduction depends on how much the government decides to use the HUF 360 billion of ‘savings' to reduce financing needs. What is clear, however, is that the likely deterioration in market liquidity may deter investors from rushing into the market until a clearer picture emerges.
Hungary's Second Pillar Pension Plan - Some Background
Owing to the pension fund reform in early 2008, the local pension funds started to shift away from a 70:20:10 mix of bond:equity:other investments, towards a higher allocation to equities and lower allocation to bonds. Under the reforms, there are different types of portfolios:
• Growth portfolio (minimum 40% of AUM in equities): for contributors with more than 15 years to retirement;
• Balanced portfolio (10-40% of AUM in equities): for contributors with 5-15 years to retirement;
• Classic portfolio (maximum 10% of AUM in equities): for contributors with less than five years to retirement.
Given the relatively young workforce in Hungary, many would have moved into the growth portfolio. Since the reform became compulsory in 2009, we have seen a reallocation away from government debt into other assets, in particular mutual funds. The latest data show that the local pension funds currently allocate around 50-55% of their portfolios to local government bonds.
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Chinese Economy through 2020 (Part 3): A Golden Age for Consumption
November 02, 2010
By Qing Wang
| Hong Kong, Shanghai
Introduction and Overview
What are the megatrends that could define the Chinese economy through 2020, in terms of both growth trajectory and the structure of the economy? To what extent can we extrapolate China's economic success of the past three decades to the coming one? What are the potential pitfalls and risks down the road? How can investors best position themselves for the potentially profound transition and transformation of the economy?
We aim to address these issues in a series of reports under the umbrella Chinese Economy through 2020. In the first, we argued that China's economic growth rate potential is set to slow but should nevertheless average 8% per annum through 2020, with a profound structural evolution that leads to rising shares of consumption-GDP, service sector-GDP, and labor income-GDP (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
In the second installment (Chinese Economy through 2002 (Part 2): Labor Supply to Remain Abundant, October 10, 2010), we made the case that China will continue to benefit from a low demographic dependency ratio and abundant labor supply through 2020. The expected deceleration in the growth of the working-age population is unlikely to become a headwind to overall economic expansion in China.
This third report aims to assess how consumption will take off over the next decade as a driver of growth. We make the following key points:
1) The Chinese economy can prepare for a golden age for consumption over the next decade. While economic growth potential is set to decelerate, consumption will accelerate to take the baton from investment and exports as the power for headline growth, as both empirical evidence and theoretical analysis suggest that the Chinese economy is at an inflection point beyond which consumption is likely to outperform strongly over the next decade.
2) Our base case scenario is that China's total consumption will equal two-thirds that of the US level and account for about 12% of the world total by 2020. In terms of incremental consumption, China overtook the US in 2008 and will represent 20% of world consumption by 2020.
3) A Golden Age for consumption would feature two key aspects: a) the strong expansion of consumption; and b) a profound evolution in the structure of consumption. To realize the former would entail strong household income growth and/or a lower saving ratio. We identify eight drivers that would help usher in a golden age for consumption in China: 1) economic growth; 2) wage increase; 3) development of service industries; 4) public expenditure; 5) income redistribution; 6) aging population; 7) level of economic development and 8) urbanization. We group these eight drivers under three pillars that underpin a golden age for consumption in China: a) rising income; b) lower saving ratio; and c) consumption upgrade.
4) Large regional disparities make China special. To this end, we develop a framework to help understand the dynamic regional evolution of consumption.
5) We revisit the issue of ‘under-consumption' in China and reiterate our belief that China's private consumption is substantially underestimated.
China's Consumption Has ‘Underperformed'
China's economic achievements since the launch of economic reform in 1978 have been extraordinary. By 2009, nominal GDP had reached US$3,679 in 2009, or 16 times 1978's level of US$226, representing a real GDP CAGR of 9.5% across the period, outperforming not only the developed economies but also developing peers by a wide margin.
Investment and exports have been the primary drivers of China's strong growth, while consumption growth has underperformed: its share of GDP declined by nearly 14pp from 2000 to 2009.
In consequence, by 2009, China's consumption-GDP ratio was significantly below not only those of high-income countries (e.g., the US) and middle-income peers (e.g., Malaysia) but also those of low-income ones (e.g., India).
These comparisons have helped form a consensus among most China observers that there is serious under-consumption in China and that a substantial boost to consumption is required to ensure more sustainable and balanced growth. On this subject, some China observers have become much more concerned as they fear that this is not only an issue of rebalancing China's economy over the long run but also of economic stability in the short run. Some China bears even predict that the Chinese economy is about to implode, as the consumption-GDP ratio in China is simply so unusually high and thus fragile that economic growth could easily collapse in the face of a major shock.
While we share the consensus view that China's consumption is relatively weak, we dismiss the rather alarmist view that the Chinese economy is so seriously imbalanced as to pose a threat to economic stability in the short run. This is because we believe that China's official statistics substantially understate the true magnitude of consumption (especially the consumption of services) in China. We address this in China's Under-Consumption Overstated in this report (see Special Topic Two).
China's Consumption at an Inflection Point: Empirical Evidence
China's economy is at an inflection point beyond which we believe consumption is likely to outperform strongly over the next decade.
As argued the first installment of the Chinese Economy through 2020 series, the Chinese economy is at an inflection point similar to that of Japan in 1969 and of Korea in 1988. (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010). History suggests that, beyond this inflection point, the economic structure tends to undergo profound transformation, with the three key ratios of the economy - consumption-GDP, service sector-GDP, and labor income-GDP - rising rapidly.
For instance, Japan's consumption-GDP ratio increased from 60% in 1969 to 69% in 1979, and Korea's from 60% in 1988 to 65% in 1998, as consumption growth began to significantly outpace overall economic growth.
China's Consumption at an Inflection Point: Theory
In our view, a country is justified in accumulating physical capital and wealth at the early stage of development to pave the way for the transition towards the more consumption-driven growth. For a developing economy, saving is an essential and integral part of industrialization process. History has shown that the only way to industrialize an economy is to increase the capital-labor ratio so that poor farmers can be equipped with industrial machines and equipment to produce goods that have higher value than farming. To install that piece of machinery, you need to save and invest.
There are a number of theories that shed light on the development stages of a country, with the most popular ones including the ‘U curve' theory, Rostow's Stages of Growth, and Chenery's Division of Industrialization Stages.
•· The ‘U curve' is the most straightforward theory explaining the trajectory of economic transition, in which the investment intensity of the economy (or investment-GDP ratio) keeps rising during the early state of industrialization until an inflection point is reached, beyond which the consumption intensity of the economy (consumption-GDP ratio) starts to bottom out.
•· The Rostow's Stages of Growth is one of the major analytical frameworks that explain the pattern of economic development. It postulates that economic modernization occurs in five basic stages of varying length, featuring ‘traditional society', ‘preconditions for take-off', ‘take-off', ‘drive to maturity', and ‘age of high mass consumption'. Rostow asserts that countries go through each of these stages fairly linearly and describes a number of conditions that would likely occur to investment, consumption and social trends at each stage.
We unify the two theories -‘U curve' and ‘Rostow's Stages of Growth' - into one framework to help illustrate the potential consumption trends in China. According to Rostow's Stages of Growth theory, an economy's development divides into five stages. China appears to be passing Stage III of ‘take-off' and is poised to transition into the Stage IV of ‘drive to maturity'. The ‘drive to maturity' features a "rebalancing among sectors, great poverty reduction, improving living standard as the society no longer needs to sacrifice its comfort in to order to strengthen certain sectors". Fitting the Rostow's Stages of Growth into the ‘U curve' framework, the consumption intensity declines in the stages of ‘pre-conditions for take-off' and ‘take-off' but is set to rebound in the stage of "drive to maturity".
Size Up China's Consumption through 2020: Three Illustrative Scenarios
We construct three scenarios to help illustrate how consumption in China will likely evolve through 2020 relative to that of US and the world economies. These scenario analyses are based on the forecasts we laid out in the first installment of the Chinese Economy through 2020 series, which benchmark the footprints of the transition experiences of developed economies such as Japan and Korea (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
The key parameters under different scenarios are summarized below:
•· Base case (70% probability): We expect annual real GDP growth and CPI inflation at 8.0% and 3.5% per year in our base case. Meanwhile, benchmarking with the experiences of Japan and Korea during the take-off period of consumption, the increment of consumption intensity per year is set at 0.7pp per annum, which would bring consumption intensity to 56% by 2020 from 49% in 2009. The USD/CNY exchange rate is expected to reach 5.5 by 2020.
•· Alternative scenario I - current trends continue (20% probability): The Chinese economy continues ‘business as usual' with no material change from the previous decade - featuring strong growth (GDP: 9.5%Y), modest inflation (CPI: 2.5%Y), and no meaningful transformation of the economic structure (consumption intensity slides 0.5pp per annum to 44% in 2020). RMB exchange rate mechanism reform is slower than expected such that the USD/CNY rate reaches 6.0 by 2020.
•· Alternative scenario II - a Japanese-style adjustment (10% probability): A Japan-style transition featuring a drastic deceleration of growth (GDP 6.5%Y) and structural adjustment (consumption intensity improve 1.4pp per annum to 63% in 2020). Such a scenario could be catalyzed either by very proactive (perhaps draconian) policy intervention to artificially correct the structure of the economy or external shocks such as a complete meltdown in external demand and sustained surge in international commodities prices due to supply shocks. The pace of RMB FX reform accelerates under Alt II (RMB/USD at 5 by 2020).
US/World growth: In the aftermath of the global financial crisis, we assume that US trend growth is low, averaging 2.7% of real GDP growth and 1.6% of CPI inflation during 2010-20. This assumption is based on the IMF's latest World Economic Outlook for 2010-15 with a moving average of previous three years for 2016-20. Meanwhile, reflecting the need for US households to repair balance sheets by saving more, we assume that the consumption intensity in the US would decline by 0.5pp per annum. Finally, we assume the trend growth of world GDP of 4.5% with 2.9% of average CPI inflation during 2011-20 (the IMF forecasts during 2010-15 and the rolling average of previous three years for 2016-20), while the consumption intensity would stay unchanged at its current level.
The Results from Our Scenario Analyses
•· China's incremental consumption in US dollar terms overtook that of the US for the first time in 2008. While incremental consumption for the US was negative in 2009 as the result of the financial crisis, China still managed to maintain expansion, suggesting that it had replaced the US as a primary driver of global consumption growth. Going forward, we expect China's incremental consumption to dwarf that of the US thanks to faster headline GDP growth and rising consumption intensity as the underlying economic structure evolves. By 2020, we estimate that China's annual incremental consumption should be roughly double that of the US under our base case scenario.
•· Total consumption: In our base case scenario, China's consumption would reach two-thirds of the US's level by 2020 from about 9% in 2000 and 20% in 2010. Meanwhile, the contribution of China to world total consumption will rise to 12% by 2020 from 3% in 2000 and 5.4% in 2010, while the US contribution will decline to 18.3% by 2020 from 27% in 2010.
•· Additional colors from alternative scenarios: In terms of incremental consumption, China will reach 1.2 times of US and 12% of world total under Alternative Scenario I but 2.5 times of US and 24% of world total under Alternative Scenario II. In terms of total consumption, China will reach 49% of US and 9% of world total under Alternative Scenario I but 74% of US and 14% of world total under Alternative Scenario II.
•· Of particular note, we envisage that Alternative Scenario II would feature a ‘Japanese-style adjustment', namely despite a relatively sharp slowdown in headline GDP growth, consumption growth remained very robust, as the consumption-GDP ratio rose rapidly after the inflection point was crossed.
A Golden Age for Consumption: Three Pillars
China's consumption is at an inflection and we believe that it is about to enter a Golden Age for consumption, in our view. We come to this conclusion by drawing on the development experiences of Japan and Korea, which, we believe, are most relevant to gauging the long-run outlook for China. While the analyses under different scenarios help to quantify the potential size of aggregate consumption in China through 2020, they are mostly for illustration purposes. The key remaining question is how this Golden Age for consumption will materialize. More specifically, what are the potential drivers for consumption in practice?
A Golden Age for consumption would feature two key aspects: a) strong expansion of consumption; and b) profound evolution of consumption structure, in our view. To realize the former would entail strong household income growth and/or a lower saving ratio. We identify eight drivers that would help to usher in a Golden Age for consumption in China: 1) economic growth; 2) wage increase; 3) development of service industries; 4) public expenditure; 5) income redistribution; 6) aging population; 7) urbanization; and 8) level of economic development. We group these eight drivers under three pillars that underpin a golden age for consumption in China: a) rising income; b) lower saving ratio; and c) consumption upgrading.
Pillar I: Rising Income
The primary source of consumption growth stems from household income growth. Since compensation of labor is the most important source of income for the vast majority of Chinese households, household income in China is primarily a function of overall economic growth, labor-intensify of the economy and wage rates. Looking ahead, we expect all three factors to provide robust support to rapid income growth in the next decade.
(1) Economic Growth
Under the base case scenario, we believe that the Chinese economy will still be able to maintain an average of 8% growth per annum over the next decade: That is a slowdown of slightly more than 2pp from the average growth achieved in the previous decade. We expect the deceleration in China's growth to be slower than that displayed by either Japan or Korea. Average CPI inflation over the next decade would be 3.5%, a significant acceleration from the average inflation rate of 1.9% over the previous decade. The higher inflation rate mainly reflects a labor market that is increasingly normalized. At this pace of development, China's nominal GDP would triple from its current size, reaching Rmb103 trillion. Assuming an average 3% appreciation of the renminbi against the US dollar per annum, Chinese nominal GDP in US dollar terms would quadruple its current size, reaching US$20 trillion by 2020 (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
(2) Development of Service Industries: Job-Rich Growth
China's service sector is underdeveloped. Since the sector tends to be labor-intensive, this has made China's growth largely ‘jobless'. Looking ahead, as the service sector develops, the labor intensity of the economy will likely increase, helping to boost household income growth, in our view.
•· Despite three decades of rapid development, the tertiary industry (service) represented just 42% of total GDP in 2009, not only far below the advanced economies (such as the US and Japan) but also developing peers (e.g., India). Even compared to the levels in Japan 40 years ago and Korea 20 years ago, China's service sector is lagging.
•· The service sector is labor-intensive, thus its lack of development helps to explain the ‘jobless' growth in China over the past two decades (see Chinese Economy through 2020 (Part 2): Labor Supply to Remain Abundant, October 10, 2010).
•· Looking ahead, we expect service sector growth to outpace overall economic growth such that service sector growth as a percentage of GDP will keep rising, by following the developmental experiences of Japan and Korea.
•· Development of the service sector should help to improve the labor intensity of the economy and boost the share of aggregate labor compensation in national income.
(3) Wage Increases
Labor market normalization has been underway for several years in China, which should underpin sustained wage growth over the long run. The unit labor cost in the industrial sector started to register largely positive growth since 2004, which represents the beginning of the end of surplus labor supply in China, in our view. Moreover, since then, a seasonal labor shortage, especially in coastal areas (i.e., around Chinese New Year), has become the norm instead of the exception (see China Economics Should We Be Worried about Large Minimum Wage Hikes? June 7, 2010).
Looking ahead through 2020, we believe that labor supply in China will remain abundant and unlikely become a binding constraint that would cause overall economic growth to slow down sharply (see Chinese Economy through 2020 (Part 2): Labor Supply to Remain Abundant, October 10, 2010). That said, as labor market normalization is underway, wage growth in China is more likely to be strong - in line with labor productivity growth - instead of being depressed by the large pool of surplus labor, which has been the case over the past 30 years, in our view.
On the policy front, a key policy priority under the 12th Five-year Plan is to make sure labor compensation increases in line with overall economic growth. To this end, a large majority of provinces in China raised local minimum wages this year, and the authorities are reportedly mulling over approving a Wage Bill, which features a collective wage negotiation mechanism.
Pillar II: Lower Saving Ratio - Household Saving Ratio to Peak Out
A declining saving ratio would boost consumption growth, given income growth. We expect Chinese households' saving ratio to peak out and even start to decline through 2020. The potential trends of three important factors over the coming decade will help bring about a lower household saving ratio, in our view. First, more government expenditure on public goods (e.g., express rail train, social housing) and services (e.g., education, healthcare) would help to lower the precautionary savings of households. Second, income redistribution would help to lower the overall saving ratio, as the saving ratio of high income households tends to be higher than that of low-income households. Third, as population aging kicks in, the average saving ratio tend to decline.
(1) Government Expenditure on Public Goods and Services Helps to Reduce Precautionary Savings
Government expenditure helps to reduce precautionary savings by households. The social welfare system has gone through profound changes during China's transition from planned to market economy. Under the planned economy, social welfare such as education, medical services, housing and pensions were largely free such that personal expenditures on those were almost negligible. The subsequent reform of the public welfare system has made education, medical services and housing much more expensive than before or even unaffordable for the poor. Consequently, households have to save more to pay for those used-to-be public goods and services. Precautionary savings have increased sharply as a result, crowding out consumption. For example, given the low penetration of commercial medical insurance in China, the portion of health expenditure financed by the government (45% in 2007) was very low in China, which requires household to set aside noticeable amount of additional saving for the health expenditures of family members.
In recent years, the government has realized the importance and urgency to mend its social welfare system to unlock consumption. Ambitious plans are being implemented in: (1) Healthcare reform aiming at full coverage of basic medical services; (2) Pension reform to address the problems stemming from aging society; and (3) Aggressive push-forward in social housing programs to provide affordable housing to low-income households. As these policy initiatives are being progressively carried out, it should reduce uncertainty and boost confidence of households and therefore lower the current precautionary savings ratio.
(2) Income Redistribution
Income inequality in China has widened over the past decade. Addressing this has become, and will likely remain, a key policy priority.
•· The Gini Coefficient, the measure of the income inequality, has been rising since the debut of economic reform in late 1970s. The indicator has passed the red line of ‘40%' in the 2000s, suggesting that income disparity in China is already quite serious. While China stopped publishing the Gini Coefficient in 2005, we estimate that this indicator may have reached over 50% by 2009, or close to the levels of Latin American countries such as Brazil, Peru and Argentina.
•· Since the propensity to consume is much higher in low-income households than high-income ones, the rising income inequality has a negative impact on consumption growth. There is empirical evidence that every increase of 1pp of Gini Coefficient would reduce the propensity to consumption by 0.5-0.7pp.
•· The Chinese authorities have realized the importance of income distribution for sustainable economic growth, especially the underpinning of consumption growth. Besides strengthening the social safety net that is targeted at the poor, we expect several tax measures to be implemented soon: a) the minimum threshold for personal income tax will be raised substantially to reduce the tax burden on middle- and low- income households; b) the marginal tax rate for high income bracket will be raised to quite a high level; and c) a real estate tax, or some special forms of property tax, could be implemented in 2011, as a means to tax the stock of wealth (as opposed to flow of income) owned by the rich.
•· Putting these policy measures in place would help China to achieve a more balanced income distribution featuring a large pool of middle-class households by 2020, according to MS Asia/EM equity strategy team, led by Jonathan Garner.
(3) Aging Population
The demographic profile is perhaps one of the most important factors in explaining the evolution of saving rates for an economy, especially a developing or emerging market economy. In particular, cross-country data show a clear pattern that as a country's dependence ratio rises, its saving ratio tends to decline.
China formally became an ‘aging society' in 2005, according to the UN definition of >10% of the total population being aged above 60. According to the UN, China's dependency ratio will bottom in 2010 and triple to 31.1% by 2050. The rising dependence ratio suggests that the overall saving ratio in China will peak out in the coming years and start to decline perhaps as early as the second half of the next decade.
Pillar III. Consumption Upgrade
A Golden Age for consumption in China would have two key aspects: a) the rapid expansion of aggregate consumption; and b) a profound and rapid change in the structure of consumption, or consumption upgrade. Consumers' preference and taste for different products and services typically reflects the level of economic development. In this regard, China is perhaps special in that as the economy develops, a massive structural shift is also taking place. That is rapid urbanization, which will have important impact on the structure of consumption beyond the implications of the level of development.
(1) Level of Economic Development
Reflecting sustained economic growth, the living standards of Chinese households have improved substantially since the early 1980s.
•· The Engel's coefficient, which is defined as the proportion of expense on food to the consumption expense and an index used to evaluate the living standards of households, has registered a significant decline for both urban and rural residents.
•· There has been a broad-based consumption upgrade. Compared with the consumption structures in1992 and 2009, while the share of necessities like food, clothes and home appliances declined, the shares of residence, healthcare and recreation, education and culture - representing a more advanced form of consumption - have risen markedly.
•· Compared with the consumption structure of more advanced economies, the consumption upgrade in China apparently has a long way to go. Passenger car penetration is a case in point. During the 10 years after they reached the same level of development as China today, the number of passenger cars per 1,000 persons increased by 3.5 times in Japan and 6.5 times in Korea.
•· We find that the consumption structure of China's urban households in 2007 was close to that of Japan in 1971. Specifically, food and clothing accounted for 37-38% of total private consumption; and housing was 15-16% for both urban China in 2007 and Japan in 1971. For healthcare, transportation & communication and recreation, education & culture, urban China in 2007 was only higher than Japan in 1971 by 1-2pp.
•· Assuming that the evolution of China's urban consumption upgrade would follow Japan's pattern, we may envisage what urban China's consumption structure would look like in 2020 by benchmarking that of Japan in 1984: the share of daily necessities should continue to fall, with food and clothing down 6.4pp and 1.2pp, respectively. The winner is healthcare, which would gain 2.6pp, followed by residence (2.1pp) and transportation & communications (2pp). In other words, healthcare, property and auto & telecom will likely benefit most from China's consumption upgrade over the coming decade.
China has been experiencing fast urbanization in the past two decades, with the urbanization ratio surging from 26.4% in 1990 to 46.6% in 2009, averaging 1% per year. Over 270 million rural residents moved into urban areas during 1990-2009. Nonetheless, China's urbanization remains low, not only relative to developed economies like the US, Japan and the UK, but also to Asian neighbors like Korea, Malaysia and the Philippines. China's urbanization is still roughly at the same level as that in the US 100 years ago.
If the current pace of urbanization is sustained in the next decade, with the urbanization ratio rising 1% per year, China's urbanization rate should reach 58% in 2020. If, however, the average pace were to accelerate to 1.5% per year, which is likely, especially given that urbanization is now given a high policy priority, we estimate that the urbanization rate would be able to reach 63% by 2020. This would imply that 12-20 million rural residents would be urbanized per year through 2020 (see China Economics: One Country, Three Economies: Urbanization as a Primary Driver of Growth, March 3, 2010).
There is a large gap in income and consumption levels between urban and rural households in China. In 2009, rural household income and consumption per capita was only 38% and 51% of that of urban households, respectively. Other than for housing, rural per capita consumption of major goods and service was barely that 50% of urban households. The penetration of major durable goods in rural areas lags far behind that in the urban sector.
We therefore expect that consumption upgrading in rural areas should mainly be reflected in the improvement in penetration of relatively low-end durable goods (air conditioners, washing machines, refrigerators) which have now largely reached a saturation point in urban sector.
The still sizeable difference in development stage between urban and rural areas suggests that the evolution of China's consumption upgrade will differ from those of other advanced economies like Japan and Korea, where the producers of consumer goods have to either look for external demand or retrench production once domestic demand is satisfied. In China, while urban residents are seeking more advanced consumption in the form of high-end durable goods and more services, the consumption upgrade in rural areas in the context of urbanization continues to generate strong demand for goods that have reached saturation level in urban area. In this context, China's consumption upgrading is expected to benefit the entire industrial chain from low-end to high-end and even from goods to services.
Special Topic One: A Golden Age for Consumption: A Regional Perspective
China is a big country in terms of both territory and population. Equally important is the massive regional disparity in terms of levels of development (see Strategy and Economics: One Country, Three Economies: Play the Regional Disparity in China, May 26, 2010). If we make a case for Golden Age for consumption in China, it is important to examine this issue from a regional perspective. We therefore dedicate a special section to discussing the potential dynamic trajectory of consumption across different regions in China.
Besides the historical reasons, the economy of the eastern region took off much earlier than the central and western regions, as the eastern region was the first to benefit from economic reform and the open-door policy. In terms of GDP per capita, the provinces of the eastern region averaged US$6,468 in 2009, double the average of the central (US$3,043) and western regions (US$2,818).
Since the eastern region is the most developed of the three, it is perhaps natural to expect that it would have the greatest consumption intensity (i.e., consumption-GDP ratio). In fact, the average consumption share of the eastern provinces is lower than for the central and western regions.
We explain the seemingly perverse relationship between consumption intensity and economic development through the framework of The Dynamic Trajectory of Regional Consumption Intensity as follows (see our full report for accompanying chart):
Construction of the Framework
•1) If we plot the ratio of consumption to GDP (Y axis) against the GDP per capita (X axis), it is interesting to observe that 36 provinces constitute a conspicuous ‘U' curve (slightly tilting to the right-hand side).
•2) Taking a step further, we may divide the space into four quadrants with two lines (Vertical: US$ 4000 GDP per capita; Horizontal: 48.6%, which is the national average consumption to GDP ratio).
•3) Then the space is divided into four quadrants: Quadrant A and D represent that consumption to GDP ratio is above national level while quadrant B and C are opposite; quadrant A and D represent that GDP per capita is below US$4,000 while quadrant B and C are opposite.
•1) The majority of western provinces (yellow spots) and some less-developed central provinces (dark blue spots) concentrate in the ‘quadrant A', which features high consumption intensity but low GDP per capita.
•2) Several central provinces appear in ‘quadrant B', which features low consumption intensity and low GDP per capita.
•3) The majority of eastern provinces are concentrated in ‘quadrant C', which features low consumption intensity but high GDP per capita.
•4) The three most developed provinces, Shanghai, Beijing and Guangdong (all from the eastern region), are grouped in ‘quadrant D', which represents high consumption intensity and high GDP per capita.
The Dynamic Relationship Between Four Quadrants
•1) ‘Quadrant A' is the ‘over-consumption' stage (high consumption intensity but low income) while ‘quadrant C' is the ‘under-consumption' stage (low consumption intensity but high income). ‘Quadrant B' is the ‘transition' stage between ‘quadrant A' and ‘quadrant C'. Finally, ‘quadrant D' should be the ‘mature' stage, with a relatively balanced economic structure.
•2) The ‘over-consumption' stage here does not suggest the over-growth of consumption but the leanness of the contributions from investments and net exports. This also explains why some less-developed countries are found to have a relatively high consumption intensity than advanced industrial economies.
•3) For the ‘over-consumption' provinces to take off would entail aggressive investment and possibly strong growth of net exports, as the result of which consumption intensity may drop significantly and the provinces may move from ‘quadrant A' to the ‘transition' stage in ‘quadrant B', featuring both low consumption intensity and GDP per capita.
•4) Aggressive investments and exports may bring strong economic growth, which would be reflected in rising GDP per capita. However, since the growth of investments and exports may still outpace consumption by a wide margin, the provinces may enter the ‘under-consumption' stage in ‘quadrant C', featuring low consumption intensity but high GDP per capita.
•5) When the marginal return on investment starts to peter out and export growth falters, the transition of economic growth shall take place by returning to consumption. Then the economy may upgrade from ‘quadrant C' into ‘quadrant D', where consumption intensity improves quickly.
•1) The consumption intensity of provinces in different regions should evolve along the ‘U' curve by following the trajectory of ‘A → B → C → D'.
•2) Not all provinces are likely to enter a golden age for consumption simultaneously over the next decade. Provinces in ‘quadrant C', or the ‘under-consumption' stage, will likely among the first to brace for a Golden Age for consumption with most rapid consumption upgrade. Provinces in ‘quadrant B', the ‘transition' stage, will likely also register strong consumption growth, but aggregate expansion is perhaps more profound than structural upgrade. Provinces in ‘quadrant A' are unlikely to enter a golden age for consumption until perhaps toward end of the next decade.
•3) It may take longer for China to achieve a take-off of consumption (relative to GDP) similar to Japan or Korea due to pronounced regional differences. This echoes the point we made in the first installment of our Chinese Economy through 2020 series (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010). This is because while the consumption intensity of eastern provinces in ‘quadrant C' will rise when moving into ‘quadrant D', the consumption intensity of western provinces in ‘quadrant A' will decline when moving into ‘quadrant B'. These two offsetting trends point to a more extended period of rebalancing in China compared to the case for Japan or Korea.
Special Topic Two: Under-Consumption Overstated
While we share the consensus view that China's consumption is relatively weak compared to other economies, we, however, dismiss the rather alarmist view that the Chinese economy is so seriously imbalanced as to pose a threat to economic stability in the short run. This is because we believe that China's official statistics substantially understate the true magnitude of consumption (especially consumption of services) in China.
We addressed this issue in a report published in 2009 (see China Economics: China's Under-Consumption Over-Stated, September 13, 2009). In that report, we reached the following conclusions:
•· First, Chinese official statistics for personal consumption expenditure substantially underestimate its true magnitude and impact, primarily due to the underestimation of consumption of services - especially housing and healthcare - in China.
•· Second, a comparison of consumption of non-services, tradable goods between the US and China - which is, in our view, more relevant to assessing the impact on the rest of world - indicates that the gap between the US and China is much smaller than suggested by headline overall consumption data.
•· Third, under a bottom-up approach, a like-for-like comparison of specific types of goods and services consumed by households in both countries indicates that the magnitude of China's personal consumption relative to that in the US could be much greater than is commonly perceived by the market.
We estimate that China's private consumption-GDP ratio could be underestimated by at least 10 percentage points, or personal consumption is underestimated by as much as 30%). In the same vein, we believe that China's investment-GDP ratio may have been overstated by the official statistics by as much as 10 percentage points.
If we do a simple exercise - adding 10 percentage points to consumption-GDP ratio while subtracting 10 percentage points from investment-GDP ratio - the trends of the adjusted consumption-GDP and investment-GDP ratios are amazingly similar to those of Japan and Korea when the two at a stage of development similar to China today.
We believe that the bulk of the underestimation is due to underestimation of consumption of services, especially private consumption-related services (e.g., housing). If we do a similar adjustment to the production structure by adding 10pp to the service-GDP ratio while subtracting 10pp from the industrial sector-GDP ratio, the trends of adjusted service-GDP and industrial-GDP ratios are also amazingly similar to those of Japan and Korea when the two economies were a similar stage of development.
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