Tuesday, September 14, 2010

The Myth of "Decoupling" and the Chinese Consumer

The "China decoupling" story holds that as China's households grow wealthier then China will no longer need export markets in the E.U. and the U.S. The story is appealing but the facts don't support it.

For years, many have argued vociferously that China's economy will "decouple" from that of the U.S. and the E.U. The theory--more like a quasi-religion in some analysts' minds--is that as China's consumers grow wealthier they will absorb all its vast production, and as a result China will no longer be dependent on exports.

There's just one problem with this theory: it rests entirely on a superficial understanding of the Chinese economy and the limited role of households in its Central-State planned economy.

Many who hold that China will not only decouple from the U.S., but that its hundreds of millions of newly minted middle-class consumers will actually pull the U.S. out of its deflationary slump with their insatiable demand for consumption. Here is a typical mainstream listing of China's growth as a reason the U.S. won't slip into recession again.

A single statistic completely undermines the "China will decouple from the U.S. because Chinese domestic demand will absorb all its production capacity" story:

The proportion of the China's GDP contributed by the household sector (wages, salaries and consumption) peaked at 56 percent in 1983 and has since dropped to 36 percent—roughly half the size of the consumer economy in the U.S.

That means that China's households are receiving a smaller piece of the pie as China's GDP grows, even the annual average wages of workers in urban areas of China increased from 12,422 yuan ($1,832) in 2002 to 29,229 yuan ($4,311) in 2008.

By comparison, according to the Social Security Administration, the average wage in the US in 2008 was $41,335--almost ten times the average urban wage in China, which is considerably higher than rural wages.

It's not just that wages as a share of GDP are low; the inescapable need to save further reduces consumption. China's households do not all enjoy ample healthcare coverage or retirement benefits. Indeed, only direct employees of the State or local governments have coverage and pensions; those unfortunate enough to have worked for State-owned enterprises which have closed have found they have little to no medical insurance or pension.

That's because State-owned enterprises funded their employees' healthcare and pensions much like U.S. companies. Even though the government owned the business, the Central State did not take on those obligations when they sold or closed thousands of ineffeicient State-owned enterprises; those obligations were either dumped on the buyers (who usually balked) or they simply vanished.

While China's leadership is planning to offer basic healthcare for the 300 million citizens not covered by current healthcare insurance, many Chinese families must save cash to pay for household medical costs. The planned coverage won't pay for treatment of chronic diseases.

Indeed, there are two ways to enter a typical big-city Chinese hospital; either waltz in and pay cash, or go to the end of the line for those without cash. the days of the Central-State-supplied "barefoot doctors" providing rudimentary healthcare for all citizens are as long gone as the Ming Dynasty.

As a result, Chinese households are prodigious savers: China boasts a savings rate of 38%, fully ten times that of the U.S. But Chinese savers have few choices on where to invest their money: they can either leave it in a savings account which draws 2.25%, less than the inflation rate of 3.1%, or invest in real estate or domestic stocks.

The money pouring into property has created an unprecedented asset bubble in housing, which rose 12.4% year-on-year in May, according to China's National Bureau of Statistics.

Half of the flats in Shanghai and Beijing are empty.

Although owning vacant flats is widely viewed as a form of savings in China, as Americans have learned to their sorrow, speculative real estate is inherently risky: it can drop in value, decimating the owner's equity.

Such a decline in Chinese real estate would cut deeply into household capital, further reducing the desire and ability to consume more goods and services--Chinese or Western.

Economist Michael Pettis, who lives and works in China, has explained how the Chinese banking authorities have in essence pushed the costs of cleaning up bad loans onto the Chinese households by reducing interest paid to less than inflation.

By limiting the number of investment options, authorities funnel much of the household savings into banks via savings accounts. By paying interest that is less than inflation, then the authorities are handing banks billions of yuan of "free money" which they can re-invest or loan out at much higher interest rates, earning high profit margins on the households' massive savings.

Thus there is a connection between low consumption and high savings rates: since Chinese households earn a negative return on their savings, they are forced to save even more to compensate. As Pettis recently explained: "Chinese consumption dropped from a very-low 45% of GDP ten years ago to an astonishing 36% last year just as—no coincidence-- Chinese households were forced to clean up the last banking crisis."

In other words, China's financial authorities have as a matter of policy suppressed consumption by providing a weak social safety net and by channeling household savings into banks that pay a negative rate of interest on that capital.

Whether intended or not, this policy encourages households hoping to earn a return equal to inflation to speculate in real estate. As analyst Andy Xie recently noted, channeling China's household capital into real estate development is hurting the country's long-term prospects by diverting the capital from other more productive uses. Ultimately, Xie says, this decreases capital efficiency and thus lowers domestic consumption.

Those proclaiming the coming decoupling and rise of the Chinese consumer neatly glide over the fact that investment, including foreign direct investment (FDI), accounts for 44% of China's economy, a higher level than Japan or South Korea ever reached in their modernization drives. This is an economy that is exquisitely dependent on massive inflows of capital to sustain its growth; the entire household sector is a mere 80% of direct investment.

Even more startling to those who believe China has too much cash laying around, much of this investment is borrowed. China's mostly state-controlled banking system made loans last year that were worth one-third of economic output, and this year they are on track to hit 20% of GDP—a total of roughly $2.5 trillion in new credit over two years.

This means that the central state banks made loans that cumulatively totaled more than 55% of the total household income of the entire nation. In other words, the breakneck pace of growth in China is heavily dependent on debt-fueled investments. Should the return on investment drop due to weak demand for Chinese exports or real estate development, then that weakness will further weigh upon Chinese households' income.

Unsurprisingly, much of this debt is in danger of default: Chinese Banks Face Default Risk on 23% of $1.1 Trillion Loans (Mish).

Take a small share of China's GDP, a dependence on risky real estate speculation for higher yields than those offered by savings accounts and an economy heavily dependent on unprecedented levels of direct investment, and you get the picture not of a robust consumer which can absorb all of China's mighty production, but instead an economy very dependent on debt, investment and exports, and a vulnerable household with many reasons to save and few to spend.

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