Global Economics

China's Economy at an Inflection Point

Under its new five-year plan, China's economy will shift away from reliance on export growth, write columnists Anil Gupta and Haiyan Wang

The world's second-largest economy is now at a strategic inflection point. China's National People's Congress, the country's legislature, on Mar. 14 approved the latest five-year plan. That will just add more momentum to the ongoing structural changes in China's economy, which will almost certainly grow at a slower pace in the next five years than it has during the past five. In his recent statements, Premier Wen Jiabao signaled the expected slowdown by noting that the official target for annual GDP growth during the next five years will be 7 percent, down from the target of 7.5 percent in the previous five-year plan. Our analysis suggests that, unlike earlier five-year periods, when the actual growth rate far exceeded official targets, the coming five years are likely to see a much closer alignment between the two. There are several reasons for this. No. 1, there will be a sharp slowdown in the rate of growth in exports from China. With an average annual growth rate of about 20 percent over the past 10 years, China's share of world exports increased from 3.5 percent in 2000 to more than 9 percent in 2010, making it the largest exporter in the world. Continued growth at this rate would increase China's share to 25 percent by 2020, a political impossibility. A sharp slowdown in export growth rate is therefore inevitable. Furthermore, over the past 10 years China dramatically boosted its investment in infrastructure and real estate as well as feeder industries such as steel and cement. While we expect China to continue building out its infrastructure as well as providing housing to more of its citizens, the growth rate in these investments will be sharply lower during the coming decade than over the past one. Demographic trends will also take their toll. The proportion of China's population that is of working age (i.e., between 15 and 64 years) has been growing since 1980 and reached a peak in 2010. This proportion is now declining and will continue to act as a drag on GDP growth. Stronger Social Safety Net

A second major change is also underway. As part of a serious drive to reduce growing economic inequities in the society, China is strengthening the social safety net for its citizens. This change is being implemented through several measures. The government has set up a rural pension scheme that provides a basic monthly pension of 60 yuan to 300 yuan to every enrollee. In addition, reforms are under way in the urban pension system—such as portability of pensions across provinces. The government has also launched a comprehensive reform of the health-care system to ensure that the entire population will be able to receive reliable and affordable health care by 2020. Importantly too, during 2010, a large number of provinces have increased the mandatory minimum wage 20 percent or more; along with the enactment and enforcement of a new labor law, workers now have much greater protection from abuses by employers. The new five-year plan is also likely to raise the threshold for taxes on personal income. The combined effect of all of these reforms will be to reduce the imperative to save and to boost consumption by the vast low- and middle-income segments of China's population. Third, China is emerging as one of the world's leaders in its commitment to become more energy efficient and reduce the carbon intensity of its economy. The new five-year plan proposes to cap the country's energy use at 4 billion tons of coal equivalent a year by 2015 (up from 3.25 billion in 2010). This target will result in a very aggressive push in such areas as electric cars and green buildings. The new plan also proposes that nonfossil fuels will account for 11 percent of primary energy consumption by 2015 and 15 percent by 2020 (up from 8 percent last year). Even though China already has the world's largest installed capacity for wind power, massive investments can be expected to boost energy capacity in all nonfossil areas, including wind power, solar power, hydropower, biomass, and geothermal power. Fourth, China is making a concerted drive to transform itself from an economy propelled by low-cost manufacturing to an economy whose comparative advantage will also derive from innovation. The State Council has identified boosting indigenous innovation as one of the most important goals for the country. China's expenditure on research and development grew from 1.1 percent of GDP in 2002 to 1.4 percent in 2010 and is targeted to reach 2.5 percent of GDP by 2020. The nearly 20 percent annual growth in R&D expenditures is accompanied by an explicit (albeit controversial) program to encourage and induce leading multinational companies to transfer technology to China in return for market access. Evidence of progress is already evident in such areas as telecommunications and aerospace technologies. Coming Rollups

Fifth, Chinese policy makers are systematically engineering a consolidation of many capital intensive industries—such as steel, cement, autos, and earth moving equipment—which are far more fragmented in China than in almost any other country. Consolidation is seen as yielding many benefits—economies of scale, more energy efficient and environment-friendly production, more professional management, and a greater likelihood of emerging as a global champion. The consolidation process has already started and is likely to pick up steam during the next five years. Ironically, a by-product of this consolidation process is likely to be a further increase in the role of state-owned enterprises in these commanding heights of the economy. Sixth, the Chinese government is pulling all available levers to boost outbound foreign direct investment. Several objectives are driving this push: to diversify the investment of China's vast foreign exchange reserves away from primary reliance on U.S. treasuries; to acquire guaranteed access to raw materials such as iron ore, copper, and oil; and to create Chinese global champions that can compete worldwide with such companies as Toyota (TM), Caterpillar (CAT), and Cisco (CSCO). According to a World Bank report, China moved up from the world's 21st-largest source of FDI in 2006 to the 13th-largest in 2010. Given the country's abundance of capital and a determined policy push, we anticipate that China is likely to move into the ranks of the top five by 2015. For multinationals, the shift from exports to domestic consumption will increase the importance of treating China as a core market. Companies will find it beneficial to align their China strategies with the government's policy agenda. While market opportunities are likely to be abundant in most industries, we anticipate that some sectors, such as health care, financial services, and travel and tourism, are likely to grow at a much faster rate than the GDP.

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