China needs real growth that only a shift away from investments can deliver
Andy Xie says without resolve to reform a system that favours investment over other drivers of growth, Beijing cannot hope to curb deflation by cutting interest rates, for example
The People's Bank of China has just cut interest rates again. It may support the stock market for a few days, but it won't reverse the deflationary trend in the economy. It won't even have much of an impact on lending rates. Political power, not market force, drives China's credit system.
China can only ease deflationary pressure by increasing the share of household disposable income in the economy. Short of that, stimulus measures will only worsen the situation. Monetary easing will merely prop up insolvent companies and prolong overcapacity-induced deflation. Fiscal subsidies for distressed businesses or local governments will lead to the same outcome.
In the long run, China must reform to remove the system bias for maximising investment. Fixed-asset investment should be reduced to one-third of gross domestic product, from half, and disposable household income increased from 40 per cent to 60 per cent. As long as investment is bigger than what the economy can sustain, bubbles, deflation and financial crises will continue to haunt the economy.
China experienced deflation between 1998 and 2003. Many experts learnt the wrong lesson from that. Instead of attributing its origin to the wild speculation and investment orgy between 1992 and 1994, they blamed the subsequent macro tightening to deal with the bubble. When inflation returned in 2004, the dominant view was to keep it going. The popular saying was that China's economy was easy to cool but hard to warm up.
Rampant monetary growth in China causes inflation now and deflation later. China's system is to allocate an increasing share of the money supply to investment; that is, a monetary boom functions as an inflation tax on labour to subsidise investment. The resulting overcapacity leads to lasting deflation.
When deflation hits, the policy of popular demand is to increase money supply. Alas, it works the other way round. China's financial system channels resources overwhelmingly into investment. Even lending to the household sector does so via property purchases. When overcapacity is the cause of deflation, prolonging it won't solve any problem.
Worse, the main borrowers in China, local governments and state-owned enterprises, don't really worry about paying back. They assume that the creditors would roll over the old debt. The worst hardship is fewer new loans. Hence, they don't worry about interest rates. Most private enterprises behave similarly. This gigantic moral hazard problem is the reason that interest rates are not declining much in spite of the intensifying deflationary pressure.
The only way to ease deflationary pressure is to increase household demand. It can only be achieved through increasing disposable household income. China's disposable household income is exceptionally low by any standard. The government should aim to increase it to 50 per cent in five years and 60 per cent in 10.
First, China should cut employees' contributions to social funds by half for three years. These contributions keep savings rates artificially high when investment is excessive and trade surplus is surging. Such contributions are supposed to look after an ageing population in future. But, if the savings are wasted in bad investments, the money wouldn't be there in any case. Further, the shortfall could be met by gradually lengthening the retirement age, which is necessary anyway.
Second, China should cut the top marginal rate on income tax to 25 per cent from 45 per cent, and the rates for other brackets proportionally. Income tax revenue is 6 per cent of total tax revenue, because rich people put expense spending through their business holdings and effectively pay a 25 per cent tax rate. The statutory rates only apply to the emerging white-collar workers. Hence, high-wage white-collar jobs have been pushed offshore. It doesn't make sense to have a policy with no upside and only downsides.
Third, value-added tax should be cut to 13 per cent from 17 per cent. China's VAT is effectively a consumption tax. When the economy is facing overcapacity and too little consumption, why keep the consumption tax so high?
The main argument against tax cuts is that local governments are already facing fiscal shortfalls. However, we should ask whether they ought to be spending so much. Most cities that are growing rapidly have little competitiveness. They are no different from white elephant projects. Now is an opportunity to stop such wasteful spending.
Further, when an economy faces deflation, a fiscal deficit is justifiable. China may need to increase its fiscal deficit by 3 per cent of GDP to stop the trade surplus from rising rapidly. This is not only good for stabilising domestic demand, but also critical for stabilising the country's imports from neighbours. China's regional influence is anchored on strong imports. But the recent trend has been the other way. To maintain China's influence, fiscal stimulus is necessary.
In the long run, only limiting government power could set China's economy on a healthy path. China's competitive labour force is driving its growth by gaining market share in the global economy. Through monetary inflation, taxes, fees and forced savings in contributions to social funds, government power allocates a disproportionate income to investment, whether it's necessary or not. The inefficiency from this will eventually overwhelm the labour competitiveness and trap the economy in stagnation. Without redefining power, economic reforms won't lead to meaningful change.
