Two-pronged approach to demand-side management

China should increase household consumption and reduce its reliance on investment

ZEMG YI/FOR CHINA DAILY

China should increase household consumption and reduce its reliance on investment

China outlined a new dual circulation development paradigm last year, under which domestic market and indigenous innovation are to be the main drivers of development, complemented by the external market. More recently, it highlighted the need for demand-side management in policy statements to complement reform on the supply-side. Increasing household consumption and reducing the reliance on investment demand should be a key objective of the demand-side management.

In 2019, China's actual household final consumption expenditure-including in-kind transfers from government and non-profit institutions (such as education, health, and social protection)-was only 47 percent of GDP, despite its recent increases. The figure was 70 percent for OECD countries and 63 percent for developing Asia (excluding China), according to recent data of the World Bank, Organization for Economic Cooperation and Development and the Asian Development Bank.

China's household disposable income, including in-kind social transfers, stood at 68 percent of GDP and household savings 21 percent in 2018, compared with 77 percent and 7 percent, respectively, for OECD countries. The data for developing countries are incomplete. For the eight less wealthy OECD countries, the two figures were 73 percent and 4 percent, respectively. Thus, the main reason for China's low household consumption is its much higher household saving rate than other countries. Its adjusted household disposable income as a share of GDP is also lower, but the difference is not that significant.

China's household savings increased from 19 percent of GDP in the early 1990s to 25 percent in 2010. Since then, it has declined somewhat. The increase was a result of multiple factors, including rapid income growth (because of habit persistence, consumption growth is slower than income growth), rising income inequality (rich households save more than poor households), and rising share of the working-age population (the working age population saves more than the population at other ages). Gaps in social protection and consumer credit also led to high precautionary savings.

The decline in the household saving rate after 2010 is likely due to changes in the following factors. China's GDP growth and share of the working age population started to decline after peaking in 2010. Social protection and safety nets as well as consumer credit have also improved. Inequality declined somewhat too.

China's growth will moderate and the share of the working age population will decline further. These will help reduce the household saving rate. But inequality remains high and the social protection and safety nets need to improve further. These, plus high housing prices in cities, can keep the household saving rate high.

Increasing household consumption requires reducing other components of GDP. China's government final consumption expenditure as a share of GDP, after deducting in-kind transfers to households, is comparable to other countries. Hovering around 1 percent to 2 percent of GDP, its net exports are not too far from equilibrium levels. Thus, the key to increasing household consumption is to reduce capital formation.

China's gross capital formation has been at more than 40 percent of GDP since 2004. It reached 47 percent in 2011, declined somewhat in recent years, but remained at 43.3 percent in 2019, compared with 22 percent for OECD countries and 30 percent for middle-income countries. The high investment rate has enabled China's capital stock to grow at more than 10 percent annually for decades-a key driver of growth and innovation. However, growing excess capacity in many sectors and rising economy-wide incremental capital-output ratio-from 3.9 during 2001-05 to 6.4 during 2015-19-have led to calls for reducing the investment rate and improving the efficiency of investment.

China requires continued large investment-its capital stock in per capita terms is still substantially lower than developed countries. But it should be able to gradually reduce its gross capital formation from the current 43.3 percent of GDP to 35 percent in the next 10 years, without constraining growth.

China can adopt a two-pronged approach, reducing income inequality while improving the efficiency of investment.

Measures to reduce inequality include intensifying poverty reduction efforts, expanding the middle-income group, and increasing public spending on education and health. China eliminated extreme poverty in 2020. The next step is to adopt a higher poverty line, such as the $3.2 per day per person (in 2011 purchasing power parity terms) used by many middle-income countries, and to update it from time to time in accordance with rising incomes.

The OECD estimated that China's middle-income group accounted for 48 percent of its total population in 2017, and the figure was 61 percent for OECD countries. The key to expanding the middle-income group is to create more urban jobs to absorb rural labor. China should also rationalize its tax structure and increase the role of personal income tax in wealth redistribution. Currently China's personal income tax is less than 2 percent of GDP, compared with 8 percent for OECD countries on average.

China's public spending on education and health, at 4 percent and 3 percent of GDP, respectively, is still much lower than 5.1 percent and 7.6 percent of the OECD averages. China can gradually raise compulsory education from the current 9 to 12 years, and work toward achieving 100 percent of the universal health coverage while reducing urban-rural gaps and regional disparity.

The key to improving the efficiency of investment is to increase its market-orientation. China's State-owned enterprises are less profitable than private firms in most industries. Apart from SOEs having to bear more social responsibilities, weaker incentives and softer budget constraints call for continued reform. China should deepen financial sector reform, increasing the role of the market in credit allocation and reducing administrative interventions.

China's development has entered a new stage. Demand-side management will make supply-side reform more effective, and is critical for raising the quality and sustainability of growth.

The author is joint chief economist of the International Finance Forum and former deputy chief economist of the Asian Development Bank. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.

 


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