China Morgan Stanley
リンク: Morgan Stanley.
Summary & Conclusions
Rising internal tension over inequality and external friction over
’s trade success suggest that China
’s government-led and export/investment-driven development model may be reaching its limits. It is in China
’s interest to change the model before the tension reaches the point of triggering an economic crisis. China
’s development model has concentrated financial power in the government and related enterprises. It has led to insufficient consumption, concentration of wealth and income, a rising trade surplus, and frequent asset bubbles, which damage the nation’s financial health. China
The model is causing considerable inequality in income and wealth by international standards. The perception that privileges rather than fair competition is the cause of inequality is leading to an increase in social incidents, which may affect economic growth in coming years.
’s excessive dependence on trade for employment growth is increasing friction with its major trading partners. China
’s trade surplus may surge in 2006 and 2007 because of an investment slowdown triggered by overcapacity. The tension with China
’s trading partners may spin out of control. China
Some changes to the development model are urgently needed. If the internal contradictions within
’s development model escalate, they could trigger an economic crisis that China
cannot afford. It is necessary and in China
’s interest to adjust the development model to prevent a potential economic crisis and sustain high economic growth. China
The key change is to shift economic power to people from government. The following three policy changes could diffuse the tension within and without, and sustain
’s high growth for the next twenty years: China
1) Increase rural income support to 3% of GDP or Yuan 1 trillion by 2010 from 1.6% or Yuan 300 billion in 2005 by issuing rural support fiscal bonds. Such deficit spending is essential to stabilize the countryside during
’s urbanization process, in my view. It could cut China
’s trade surplus also, easing tension with its trading partners. China
could earmark a bank deposit interest rate tax and introduce a national property tax for interest payment on such bonds. China
2) Triple minimum wage by 2010. When there is labor surplus, the labor market becomes a race to the bottom, causing income concentration and insufficient consumption. As minimum wages affect migrant workers most, a rising minimum wage is critical to stabilizing the countryside. While some loss of competitiveness in trade could decrease employment in the export sector, it could be more than offset by the effect of rising consumption.
3) Return government-controlled wealth of about Yuan 15,000 per person to people. The central and local governments’ controlled wealth (listed and to-be-listed state-owned enterprises, land, and natural resources) could total over 100% of GDP, more than total household bank deposits. Through collecting the wealth into a national fund, distributing the shares of the fund equally among the population, and imposing reasonable conditions for monetization by households,
could quicken urbanization by giving farmers the wealth to acquire urban properties and lead to a consumption boom that may last for a decade. China
Withering Household Sector
The household sector has been shrinking relatively in
’s economy. The urban disposable income per capita dropped to 76% of GDP per capita in 2005 from 85.3% in 1995, the rural cash income per capita dropped to 23% of GDP per capita from 30.8% during the same period. The perception that privileges rather than fair competition cause inequality is leading to rising social incidents, which may affect economic growth in coming years. The withering household sector is due to China
’s growth model. If the trend continues, it would magnify the problems that China
faces today and may eventually derail China
’s economic growth. China
’s development model is based on: (1) government mobilizing resources to grow capital stock; (2) government using incentives to attract foreign capital for export production to use the capital stock; and (3) the state-owned financial system capturing the money from export for a further investment push by the government. China
This system has led to an increasing proportion of financial resources and economic activities affiliated with government and related enterprises, that is, the proportion of money that goes through households in the economy is declining. The decoupling between household income and GDP reflects this dynamic.
One byproduct of this model is rising income and wealth concentration.
’s data on either are patchy. Some government agencies accept that the Ginni coefficient in China
is over 0.4 (zero indicates perfect income equality and one indicates total income concentration in one person). Some private studies find the number much higher. Several studies on bank deposit distribution also suggest a very high concentration of wealth. China
Because
has surplus labor, the labor market tends to be a race to the bottom. It is difficult for hard work to pay off. On the other hand, given the government’s overwhelming influence over the market, anyone with government privileges could achieve great wealth in a fast growing economy. China
While household money flow has shrunk relative to GDP, new expenditure items that households must bear have mushroomed. Healthcare, education, and housing are the three items that did not feature prominently in household expenditure ten years ago (government and state-owned enterprises looked after such items then), but have become the most important expenditure items today.
The squeeze has caused household consumption to decline to about 39% of GDP in 2005 from 46% in 1995 and 52% in 1985. Insufficient consumption has become a major problem for
’s economy. Overcapacity and deflationary pressure are the mirror image of the pressure on household’s consumption ability. China
Rising Social Tension over Inequality
The massive economic growth in
has not decreased social tension. The Ministry of Public Security reported 87,000 ‘mass incidents’ in 2005, up 6.6% from 2004. A popular theory in China
claims that a developing country usually sees rising social tension at per capita income between US$1,000-3,000. According to this theory, the best approach to deal with the social tension is to maximize growth and push through the US$3,000 per capita income as soon as possible. This theory carries a lot of currency in China
and partly explains China
’s unwillingness to take action against asset bubbles. China
This theory is wrong and dangerous, in my view. Many countries within this income range show high social tension. But, the causality is probably the other way around. Because these countries could not solve their social problems, they cannot develop to push through US$3,000 per capita income barrier.
Within
, China
already has a per capita income above US$3,000. But, it has experienced quite serious ‘mass incidents’ in recent years, mirroring the trend in other provinces. Guangdong
Province
Land disputes are a common trigger for ‘massive incidents’. This reflects the heavy hand of the government in the economy and the perception that the wealth from land acquisition is unfairly distributed.
Delay or default in paying workers is another common trigger.
does not have independent labor unions. The labor market is often a race to the bottom due to the labor surplus. Some employers take advantage of desperate migrant workers and employ them with promises of wage compensation in future. When their businesses do not work out, they default on the workers. One major reason for the labor shortage in China
is the reaction of migrant workers towards uncertainty in receiving compensation. Guangdong
should improve the system to defuse these common triggers for ‘mass incidents’. But, the underlying cause of wealth and income inequality is even more important. If these triggers are defused, other triggers may emerge and ‘mass incidents’ may not decline. As long as the benefits from economic growth are so unevenly distributed and without fair competition, social tensions will likely remain high. China
Every society has tensions, and the trend and level of such tensions are very important. The trend in
is up. We do not know the maximum tolerable level of Chinese society towards income and wealth inequality. But, China
should not take risk in allowing the trend to continue, in my view. The hope that reaching a US$3,000 per capita income level will solve the problem may not work. China
simply cannot afford to take any chances, in my view. China
Rising Trade Friction
As resources concentrate in government and related enterprises, and the household sector is unable to provide the demand to deliver good returns to such resources, the economy will need to depend on exports to sustain the system.
has used generous fiscal incentives to attract foreign capital to produce in China
for export. China
’s rapid capital formation keeps production costs low, which is an extra incentive for manufacturing to relocate to China
. China
This dynamic has caused
’s exports to increase to US$762 billion in 2005 from US$149 billion in 1995. In addition to the level of trade, the trade surplus has mushroomed to US$102 billion in 2005 from about a balanced trade ten years ago. The surplus is likely to surge again this year as investment decelerates in response to overcapacity. China
’s major trading partners, the China
in particular, are complaining about US
’s surplus. The China
has targeted US
’s currency as a feasible solution. A revaluation by China
would only cause deflation in the country without decreasing its trade surplus. Indeed, the surplus would increase as deflation forces more cutbacks in investment, which would increase trade surplus. China
I believe that the excess investment could be about US$100 billion in 2005. If the investment normalization happens,
’s trade surplus could double over next three years. This would inflame further friction with China
’s big trade partners and intensify international pressure on China
to revalue its currency, even though it may not solve the problem and adversely affect other economies. China
Be bold, Just Do It
Procrastination has become a common feature in
’s reforms in recent years. The unification of tax treatment for foreign and domestic enterprises is a good example. As China
experiences a large and rising trade surplus, it does not make sense to subsidize foreign capital to increase export production. In the domestic market, tax privileges for foreign enterprises have created unfair competition for local enterprises. The lack of competitive local enterprises after 25 five years of high economic growth is partly caused by this uneven playing field. Why can’t China
just get rid of this anachronism? China
should unify its tax rates for foreign and local enterprises at the National People’s Congress in March 2006, in my view. Instead of foreign enterprises paying a 15% profit tax and local enterprises 30%, China
should make everyone pay 22-25%. China
Rural reform is another area. The government approach has been an attempt to make farming more productive. While the intension is good, it simply will not solve the problem, in my view.
’s rural problem is simply too many people, and too little land. More effective farming would not improve the plight of farmers. It will simply lead to lower prices for farm products, which would shift the productivity gains in the rural sector to the urban sector. China
Income support has to be the main policy for stabilizing the countryside. As urbanization decreases rural population, the support could decline with it. The government says that rural support totaled Yuan 300 billion or 1.6% of GDP in 2005. This number might appear large. But,
can do a lot more. The country is experiencing about 5% of GDP in its current account surplus. Why should China
send so much money abroad, when farmers are so desperately poor? China
can and should increase the support to Yuan 1 trillion by 2010 or about 3% of 2010 GDP, in my view. China
I believe
can earmark two sources of tax revenue for interest payments on fiscal bonds for rural support. Government, enterprise and household deposits total Yuan 27 trillion. The interest income on this would total Yuan 405 billion, and the interest income tax at 20% would yield Yuan 81 billion. China
The 20% tax on interest income was introduced a few years at the excuse of encouraging consumption. I was opposed to it then. I thought that it would simply take away more money and give it to the government, which would be bad for consumption. Evidence shows that this tax does not encourage consumption but has increased speculation. The government should either abolish it or earmark the revenue for rural support. Considering the stability challenge in the countryside, the latter is more desirable, I believe.
can and should phase in 0.5-1% property tax and use the proceeds for covering the interest payment on rural support fiscal bonds. The total property value is probably close to 100% of GDP — a 0.5% property tax could collect Yuan 90 billion in revenue. China
The two revenue sources of Yuan 170 billion could support issuing Yuan 4.2 trillion in rural support fiscal bonds at a 4% yield. Through issuing these bonds, the surplus savings that now turn into a trade surplus could turn into domestic demand from the rural sector. This policy could solve
’s two biggest problems simultaneously: stabilizing the countryside and easing friction with China
’s trading partners. China
Raising minimum wages is another key step to shift the Chinese economy towards consumption. Standard economic theory is against setting minimum wages, because it may distort relative prices between labor and capital, decrease labor demand, and increase unemployment.
The standard economics theory breaks down when labor surplus cannot be solved by decreasing wages due to the friction in absorbing
’s labor into the global economy. In theory, the equilibrium wage in such a setting is zero. In practice, the wage just covers the cost of living necessities. The reality in China
is quite close to such equilibrium. China
Maintaining a reasonable minimum wage in a labor surplus situation is good for everyone. When wages are near zero and money flows to a small number of people in the economy, it leads to oversupply, deflation, excess liquidity, and asset bubbles. Increasing minimum wages increases consumption and stabilize the economy.
In coastal regions, I believe
should aim for a minimum wage of Yuan 2,000/month or (US$250/month) by 2010, about three times the current level of prevailing minimum wages. Most workers who are subject to minimum wages are migrant workers. Remittance income is the most important reason why the countryside is still stable, I believe. Raising minimum wages should be the most important part of the strategy to stabilize the countryside and boost consumption. China
Lastly,
should distribute government-controlled wealth among the population to create the foundation for a mass consumption-led economy. Without wealth, consumption is weak. China
’s household sector began with zero wealth two decades ago, because the government owned everything. While the household sector has increased wealth to about 200% of GDP, the bulk belongs to a small minority. China
A study by The Boston Consulting Company claims that 0.6% of the households own 60% of the private wealth. All other studies on income and wealth distribution inevitably lead to the conclusion that
’s population does not have the wealth foundation to support a consumption-led growth model. The Chinese government has the means to redress the problem, I believe. China
The central and local governments own large state-owned enterprises, land, and mineral resources. The total could be Yuan 15,000 per person. If the government gives such wealth to the people, it would lead to a consumption-led boom for a decade or longer.
In addition, it would quicken urbanization. The money could allow a large number of farmers to purchase urban properties and become normal urban residents rather than rootless migrant workers who live in factory constriction-site dormitories.
’s challenges are serious but solvable, in my view. Through the appropriate policy changes, China
should be able to overcome insufficient consumption, low rural income, rising inequality, and rising trade friction with its trading partners. China
Important Disclosure Information at the end of this Forum
Election Euphoria
The election is drawing closer, possibly as early as March, and the degree of economic revival is palpable. Political business cycles do seem somewhat evident. Except for 2001, when the economy was in recession, domestic demand growth momentum usually improves with a localized peak in the election quarter, or the quarter before or after it. Intentionally engineered or not, the strong momentum left over from 2005 bodes well for 2006. However, the sustainability of momentum boils down to: 1) what is causing the current expansion; 2) how far fiscal stimulus will drive it; and 3) whether longer-term policy measures will continue the revival. From these aspects, economic growth prospects look robust, in our view.
A Matter of Timing or Fiscal Stimulus?
Government finances usually ‘worsen’ in the election quarters, which could indicate an injection of some sort of stimulus, but we do not think the amounts have been that significant. On an annual basis, government finance balances do not consistently deteriorate in election years. The government has quite a well-known disdain for stimulus. Budgets have on average been balanced for the past six years. Anti-cyclical budgets and off-budget expenditures usually are only seen in recessions, like in 2001. Intuitively, with the election really a one-party game, the impetus to tweak the economy for short-term election purposes isn’t that strong. To be fair, the political business cycle is as much a function of government stimulus as it is of deliberate timing with the general economic expansion. We note that better-than-expected growth in 2H05 has been due to benign volatility in the pharmaceutical sector in 3Q and the broader manufacturing sector in 4Q, that is, external demand, rather than Government intervention. Global momentum should keep growth going for 1H06 at least.
However, we think this election could be somewhat of an anomaly. The Budget just announced, is more stimulative than even 2001 when measured in terms of the deficit (-1.4% vs -0.9% of GDP) and in terms of the amount of direct cash handouts. S$2.7 billion worth of New Singapore shares were given out in 2001. This year, the Progress Package is worth S$2.6 billion (~1.3% of GDP) in mostly cash handouts. With the bulk to be disbursed on May 1, this is the most significant measure of the Budget in terms of short-term economic impact. We believe this introduces some upside risk in private spending, which we have not factored into our 2006 estimate.
Monetary Policy is Not an Election Tool
Monetary policy is not normally relaxed before elections: all elections have seen a tightening bias in monetary policy in the preceding three quarters except for 2001 (1.9% depreciation). But it is hard to imagine how much advantage a slow depreciation of 1.9% over four quarters can really confer. The government does not believe in manipulating monetary policy to boost exports. The import intensity of exports is high. The fact that imports account for 50% of the final goods bought in
should give a rough indication of the former. Depreciation raises import costs, which offset the higher export revenue from depreciation. This high leakage is why Singapore
has to have a strong currency to curb import-led inflation in the first place. Our industry analysts point out that depreciation might not be as unprofitable as we think. Imported components are sometimes consigned by the end buyer, in which case, import costs don’t accrue to the makers and appreciation helps to expand profit margins. Nonetheless, given the government’s policy of expanding investment overseas, a stronger currency probably suits better. Singapore
Expect ‘Keynesianism’ of a Different Sort
Fiscal stimulus in the 2006 Budget is a boon, and we expect Keynesianism of a different sort to solidify growth. We see 2006 growth as largely Government inspired.
’s domestic demand has been highly leveraged to the global cycle but the Government is trying to hedge against this with property reflation measures and a focus on tourism. This is spurring a mini construction boom in tourism infrastructure and retail. We don’t think private property construction will pick up significantly in the next 9-12 months given the 9% oversupply, potential supply in the pipeline and high ownership level (93%) — although we don’t rule out that investment buying could turn this around in the longer term. Nevertheless, tourism infrastructure and retail should help fixed investment expand 4.5% in 2006. At the same time, property reflation would help loosen the purse strings given the large share of housing assets in net household wealth. We expect growth to be less subjected to global cyclical winds due to the fundamental shift in dynamics as domestic demand lends more support (from 30% of growth in 2005 to 75% in 06). Singapore
Equity Market Performance Lacklustre Around Elections
An analysis of
stock market performance around elections points to no discernible positive election effect. Quite the opposite, the market has generally declined around elections. Indeed, in the past seven elections since the mid-1970s, the market has on average declined by 10.2% in the six months preceding the election, and by 2.7% in the 6 months after. Singapore
Furthermore, while the market has tended to follow the performance pattern of regional and global markets, it has generally underperformed its peers. We compare
’s performance to the US S&P500 as a proxy for global markets, and Singapore
’s Hang Seng Index as a proxy for regional markets. We find that average market performance was subdued around Hong Kong
elections, with the Singapore
up 2-3% in the 6 months before and after elections, and US
up a larger 7-8%. Nonetheless, both the Hong Kong
and Hong Kong generally outperformed US
. Singapore
As such, the impending election could point to a bearish market outlook for
. However, we do not expect a repeat of past performance patterns in 2006. First, as pointed out above, the 2006 pre-election budget is almost unique with its significant fiscal stimulus. Second, we believe some one-off events caused some of the historic poor performance. In 1997, for example, the post-election performance was adversely affected by the Asian crisis, while the 1984 election coincided with the start of a recession. In 2006, however, we expect solid regional performance and strong Singapore GDP growth. Singapore
Market Outlook: Overweight
Singapore
Indeed, in our regional model portfolio we are overweight the
market for four reasons. First, we expect strong economic growth, led by robust, above trend global growth (Morgan Stanley is forecasting 4.1% real global GDP growth in 2006, following 4.3% in 2005), fiscal stimulus (equal to 1.3% of GDP), and a recovery in the construction industry (property policy measures and tourism construction). This should translate into strong earnings growth — our analysts’ forecast of market earnings growth of 8.7% in 2006 seems very achievable. Second, we find valuation to be reasonable, though not cheap given a P/E of 14.5 times on 2006 Morgan Stanley earnings estimates. Third, short-term interest rates have already risen significantly, with 3-month SIBOR rising from 0.75% in mid-2004 to 3.4%. Although Singapore
has tightened at a slower rate than the US Federal Reserve, its low inflation (1.3% YoY in December, versus the Singapore
at 3.4% YoY) and appreciating currency mean that rates are already around neutral levels and should remain lower than in the US
. Fourth, we expect the corporate performance of US
companies to continue its secular improvement, with further capital returns to add to the 3.4% historic dividend yield. Singapore
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