How to Get the Chinese to Spend More

It is commonly accepted that, in order for there to be global economic rebalancing, China must shift its focus from exports to domestic consumerism. Doing so would benefit China as it would no longer be dependent on unpredictable foreign demand.

In the wake of the global financial crisis and the correlated fall in demand for Chinese exports, the mainland recognized the need to boost domestic spending and introduced massive subsidies to achieve that end. One industry that benefitted from the subsidies was the auto industry. Car sales on the mainland grew 45% last year and 48% in the first half of 2010 - a reflection on the massive extension in demand caused by the equally massive subsidies. However, as the effect of the subsidies wears out, demand will inevitably contract. In fact, mainland car sales may contract by as much as 20% in the second half of this year. Clearly the use of subsidies to spur demand is unsustainable and is in no way a long-term solution.

One of the key reasons for the current low share of domestic consumption as a proportion of GDP is the high household savings rate. China's gross national savings soared from 39.2% of output in 1990 to 53.2% in 2008, way beyond the American savings percentage which was only 12.2% in 2008 (Source: Agence-France Presse, 9/8/2010). Luckily for China, this dizzyingly high savings rate looks set to reduce. Indeed, between 1995 and 2005, workers saved a large proportion of income just in case they got fired. Those were the days when China seemed to have a limitless labour supply. Those were the days that correspond to the horizontal part of the Keynesian long-run aggregate supply curve (see diagram below). Now, however, with labour becoming increasingly scarce, workers will feel less uncertain about their job security, hence, they will save less and spend more.

Unfortunately, rising worker job security alone won't be enough to set China on the right track. Inequality in China is also preventing demand from being what it should be. In April, government affiliated experts said that the Gini coefficient (a commonly used measure of income inequality where a value of 0 is equivalent to perfect equality) had reached 0.47 - above the globally recognised warning level of 0.4. The income of China's richest 10% was 23 times that of the poorest 10% in 2007, while in 1998 the gap was only 7.3 times (Source: Li Shi, professor on income distribution and poverty studies, Beijing Normal University). In other words, the rich have too much and can't spend all of it (and therefore save some of it) and the poor have too little and wish they could spend more. A more progressive taxation system should be adopted whereby the richest got taxed more. The extra revenues would be used as transfer payments to the poorest (which they would readily spend). It is common knowledge that the poor spend more on domestic goods while the rich spend a larger share of income on imports. Hence, if a larger share of spending was done by the poor, the benefits to China would be greater as there would be fewer leakages and a stronger multiplier effect.

If China were to adopt this more progressive tax scheme, it would not only be in line with the fundamental values of the CCP but would also result in more sustainable growth. If China doesn't act quickly, it may have to face overinvestment and the misallocation of capital - the same perils that haunted Japan in the latter parts of the 20th century. If that happens, it will be to no one’s advantage.