Can China Fight Inflation While Rebalancing its Economy?... http://carnegieendowment.org/ieb/?

fa=show&id=43348

International Economics Bulletin

Weekly Economic Commentary & Analysis from the Global Think Tank
Home
Topics & Regions
Emerging and Developing Economies
Africa
Asia
China
Latin America
Middle East and North Africa
Russia
Advanced Economies
United States
Europe
Japan
Crisis and Recovery
Great Recession
Global Recovery
Crisis in Europe
Global Economic Governance
G20
International Organizations
Global Finance
Capital Flows
Financial Markets
Trade and Currency
International Trade
Exchange Rates
Global Imbalances
Development
Food Security
Aid
Climate Change
Subscribe

Can China Fight Inflation While Rebalancing its Economy?

Pieter Bottelier
International Economic Bulletin, March 31, 2011
Comments

China launched its Twelfth Five Year Plan (FYP) in March. The new FYP aims to decrease China’s dependence

1 de 6 31/03/2011 12:14 p.m.

Can China Fight Inflation While Rebalancing its Economy?... http://carnegieendowment.org/ieb/?fa=show&id=43348

on exports and investment, rebalancing the economy toward services and domestic
consumption. But will the need to address pressing near-term challenges—namely,
inflation and high housing prices in large cities—conflict with these medium-term
goals? The answer is no, not necessarily. Even though the policy outlook is uncertain,
several long-term dynamics make rebalancing likely.

The Twelfth Five Year Plan

China’s twelfth FYP aims to restructure the country’s growth path. It targets 7 percent
GDP growth on average per year over the period, with an emphasis on consumption
and services as drivers of growth. The FYP aims to increase the service sector’s share of GDP and the
urbanization rate, which will both bolster consumption, by 4 percentage points each, raising them to 47 percent
and 51.5 percent, respectively by 2015.

The FYP also aims to significantly improve the livelihood of China’s citizens. Specifically, it sets targets of 45
million new jobs in urban China, an unemployment rate below 5 percent (the official rate is 4.2 percent at present),
and 36 million new affordable housing units.

In addition, by 2015, the plan aims to: increase R&D spending from about 1.7 percent to 2.2 percent of GDP;
reduce energy intensity by 16 percent and carbon dioxide emissions by 17 percent per unit of GDP; increase
renewables’ share of total energy use from 8.3 percent to 11.4 percent; and increase forestry cover by about 1
percentage point, to 21.7 percent.

Near-Term Challenges

Against this background of long-term, structural economic reforms, inflation remains a serious concern. Food
price increases continue to lead the CPI and, as the chart below shows, each of the three major inflation indices
crept up marginally in January and February. There is no clear indication that inflation will moderate in the coming
months. In his annual Work Report to the National People’s Congress in March, Prime Minister Wen Jiabao
stated that controlling inflation remains the government’s top near-term priority.

After almost a year of central

government efforts to cool urban
real estate speculation, prices
for apartments in tier 1 cities
finally moderated—and, in some
cities, actually fell a little—in the
first quarter of 2011. But, given
the large monetary overhang still
in the system, the increased
land-lease revenues that local
governments can earn by driving
up property prices, and other
distortions in China’s economy,
Beijing’s struggle to control urban
residential property prices is far
from over.

Efforts to control inflation and

urban real estate speculation, if
well-designed, need not conflict
with the structural reforms
necessary for economic
rebalancing. If there is a conflict,
however, it will probably be in housing policy and related areas. Additional monetary tightening to combat inflation

2 de 6 31/03/2011 12:14 p.m.

Can China Fight Inflation While Rebalancing its Economy?... http://carnegieendowment.org/ieb/?fa=show&id=43348

could raise the interest rate on the banks loans that local governments use to finance new affordable housing
units, which could then hinder Beijing’s affordable housing goal. Whether this occurs remains to be seen, however.

The Previous Five Year Plan

The previous FYP (2006–2010) also noted the need to make China’s growth path more sustainable, but little if
any progress was made toward rebalancing over the period. Consumption’s exceptionally low share of
GDP—one of the main indicators of imbalance in China’s economy—continued to drop through 2010, falling from
53 percent in 2006 to an estimated 47 percent in 2010.1

The first half of 2009 offered

hope that household
consumption’s share of GDP
would rise—given that household
consumption’s growth outpaced
GDP growth for two
quarters—but the gradual
withdrawal of stimulus-related
subsidies and declining
consumer confidence slowed
consumption growth appreciably
in mid-2009. Consequently, as
shown below, household
consumption’s share of GDP
probably fell again in 2010 to a
little below 35 percent.

The same factors—reduced or

terminated subsidies and
declining consumer
confidence—were still at play in
the first quarter of 2011,
particularly as relatively high
inflation led consumer
confidence to decline.

China’s current account surplus as a percentage of GDP—another metric of imbalance—also points to the need
for a more concerted effort by China’s policy makers. The surplus would likely have narrowed little if at all without
the crisis-induced collapse in international trade. After the crisis, the ratio increased again, reaching 5.2 percent in
2010, as shown below.2

Prospects for Rebalancing

When making these arguments, however, it is important to emphasize that China’s exceptionally low
consumption/GDP ratio is not due to slow consumption growth—consumption growth is actually much higher in
China than in the United States and other large economies—but rather to China’s high, investment-driven GDP
growth.3

In addition, China’s limited progress on rebalancing during the eleventh FYP was due, in part, to the global
financial crisis. The crisis led Beijing to reverse some of its rebalancing policies to protect employment and
restore growth momentum—a reversal that hopefully will not be required during this FYP period.

Continued financial repression and conflicts of interest between Beijing and local governments also stood in the

3 de 6 31/03/2011 12:14 p.m.

Can China Fight Inflation While Rebalancing its Economy?... http://carnegieendowment.org/ieb/?fa=show&id=43348

way of implementing key aspects

of the earlier rebalancing
strategy. While these factors are
still relevant today, Beijing seems
more aware of their negative
effects on rebalancing and more
willing to address them.

In addition, several long-term

dynamics will push for
rebalancing in the years ahead,
almost regardless of Beijing’s
policy stance.

Already, services are seeing

improvements relative to
manufacturing: Employment and
wages are growing faster in
services than in manufacturing, a
trend that is likely to intensify. In
addition, services will get a
boost from the expansion of
health and home care help for
the elderly as the population
ages and China’s traditional,
family-based system of care
gives way to commercial
services.

Meanwhile, a number of factors

are likely to lead to greater
consumption growth. First, wage
growth: even in manufacturing,
where education and income
levels tend to be lower than in
services, real wages grew faster
than GDP in 2010. Second, the
rapidly increasing availability of
consumer finance—total
consumer loans outstanding
increased from less than 5
percent of household disposable
income in 1999 to a still-modest
43 percent at the end of
2009—could lift consumption growth, as it did in Korea and other emerging economies.

Policy changes may also catalyze consumption. For instance, China plans to significantly reform its income tax
system this year, with an eye to reducing social inequality and promoting private consumption. In addition, China
plans to continue increasing the budget share of health and other social services, which has been shown to
reduce the need for precautionary household savings.4 Decreased savings should raise consumption, particularly
as some of the factors that led to an increase in savings over the past decade—such as the large wealth transfer
from the state to urban households that occurred when urban housing was privatized—will not be repeated.

Furthermore, China’s extraordinarily high investment rate, almost 50 percent of GDP in 2010, will likely fall as
monetary tightening in the near future increases the cost of capital.

4 de 6 31/03/2011 12:14 p.m.

Can China Fight Inflation While Rebalancing its Economy?... http://carnegieendowment.org/ieb/?fa=show&id=43348

RMB appreciation will also push structural economic change in the right direction. Notwithstanding Beijing’s still
too-timid nominal exchange rate policy, the real RMB is now appreciating at a 10 percent annual clip against the
dollar. China’s real effective exchange rate (REER) will likely follow suit. Given that domestic inflationary
pressures are unlikely to subside soon, undervaluation of China’s real exchange rate could become a thing of the
past in the next few years, aiding rebalancing efforts.

Finally, planned adjustments in the incentive framework for government officials will reward them more for
achieving rebalancing than for raw GDP growth, as in the past. This reorientation, combined with the twelfth
FYP’s reduced growth target—7 percent, compared to the official target of 7.5 percent for the eleventh FYP and
realized growth of over 10 percent for that period—will give political cover to those who wish to emphasize social
development and environmental protection over investment and GDP growth, which economic rebalancing
requires.

China’s goal of rebalancing is wise and achievable. With economic factors already pushing for it, policy makers
must now be careful not to obstruct the process.

Pieter Bottelier, former chief of the World Bank’s resident mission in Beijing, is a nonresident scholar in
Carnegie’s International Economics Program and senior adjunct professor of China Studies at the School of
Advanced International Studies (SAIS) at Johns Hopkins University.

1 These numbers refer to total consumption, i.e. household consumption plus government consumption. Household consumption
accounted for about 85 percent of total consumption in 2007.

2 On January 31, 2011, SAFE, the agency responsible for recording China’s balance of payments, announced on its website a
downward revision of the current account surplus for 2009, such that the 5.2 percent current account surplus/GDP ratio for 2010
represents an increase, not a decrease, over the original balance of payments for 2009. Final numbers are not yet available.

3 This observation has major implications for the design of China’s economic rebalancing strategy. While somewhat higher
consumption growth should be achievable, the main adjustment has to come from reducing investment (and hence GDP) growth and
changing the growth pattern from manufacturing and construction to greater reliance on the service sectors.

4 Recent research by Steven Barnett and Ray Brooks of the IMF shows that household consumption expenditures and government
spending on social services, especially health services, are positively correlated (Chapter 7 in Rebalancing Growth in Asia. Economic
Dimensions for China, edited by Vivek Arora and Robert Cardarelli, IMF, 2011.)

Resources available for this publication

Issues
Emerging and Developing Economies Crisis and Recovery Trade and Currency Asia China
Global Recovery Global Imbalances

Author
Pieter Bottelier

Comments

Add Comment
Post your comments (2500 character limit - Comments are moderated and may not appear

immediately - Screen names appear with your comment) Enter screen

5 de 6 31/03/2011 12:14 p.m.

Can China Fight Inflation While Rebalancing its Economy?... http://carnegieendowment.org/ieb/?fa=show&id=43348

name:

(Nevermind this field if you have CSS turned off)

Characters used:

Post your comment using the "add comment" buttons.

Comment Policy

Comment Policy Comments that include profanity or personal attacks or other inappropriate
comments or material will be removed from the site. Additionally, entries that are unsigned or contain
"signatures" by someone other than the actual author will be removed. Finally, we will take steps to
block users who violate any of our posting standards, terms of use or privacy policies or any other
policies governing this site. You are fully responsible for the content that you post.

Report Abuse

Add Comment
Post your comments (2500 character limit - Comments are moderated and may not appear

immediately - Screen names appear with your comment) Enter screen

name:

(Nevermind this field if you have CSS turned off)

Characters used:

Source: carnegieendowment.org/publications/index.cfm?fa=view&id=43348

Carnegie Endowment for International Peace

© 2011 All Rights Reserved.

6 de 6 31/03/2011 12:14 p.m.