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China’s Domestic Demand: What’s the Hold Up?

August 21, 2009

One of the most insightful and articulate commentators on China’s economy is my counterpart at Peking University, Michael Pettis.  In a Wall Street Journal op-ed in March, he offered this succinct summary of the current situation:

China’s recent economic problems come courtesy of declining American demand for Chinese exports, and have sparked renewed talk of how Beijing needs to shift from export-dependent growth to a greater focus on domestic consumption. If only saying it could make it so. In reality, history has shown that such transitions are wrenching, and China will be no exception.

Everyone wants to see growth in Chinese domestic demand.  China’s leaders see it as an immediate solution to the slowdown in exports and employment, and as a way to reduce the country’s exposure to future external shocks.  Pettis and other economic observers, including myself, see it as necessary to correct an unsustainable imbalance in the global balance of savings and consumption.  Time magazine even speculates, in a recent cover story, that China might be able to “save the world” if only it can get its own consumers to buy more.

So why should it be so hard?  Why should boosting Chinese domestic demand require, as Pettis suggests, a “wrenching” transition?  China certainly does not lack for consumers, and collectively, at least, they’re rich (the country is sitting on over US$2 trillion in foreign currency reserves).  And at least part of China’s stimulus package is designed to give consumers rebates and other incentives to go out and spend.  But later in that same op-ed Pettis observes, “China can and will eventually make the transition away from export-led growth, but no one should expect it to be quick or easy.”  Why not, exactly?  That is the question I’d like to explore in depth today.

Pettis himself attributes the difficulty, correctly, to factors deeply embedded in China’s export-led growth model.  But in doing so, he tends to focus his attention on the demand side of the equation.  In another Wall Street Journal piece, he notes that “consumption is still repressed thanks in part to very low deposit rates, constraints on consumer financing and low wages.”  In particular, he notes how China’s preoccupation with funding manufacturing industries led it to neglect the development of consumer finance lending and the country’s service sector. 

All of these are valid and important points, but only half of the picture.  It’s natural, when talking about consumption, to look immediately towards the demand side of the equation.  In everyday language, we tend to use “consumption” and “demand” as synonyms.  In fact, the amount demanded or consumed (think “q” on your supply-demand charts) is as much as function of supply as demand.  And it’s the supply side of the equation — which determines where along a given demand curve the economy ends up — where the really big problem lies.

When we talk about Chinese domestic consumption “picking up the slack” for exports, we tend to imagine a Chinese company losing a foreign customer for its product, only to gain a replacement customer in China.  Hence we wonder, what’s the problem?  Why can’t the Chinese, who seem to have plenty to spend, just buy what they used to sell abroad for their own consumption?

The answer becomes clear when you look at who China’s export producers actually are.  The vast majority of them are contract manufacturers.  They do not sell their own products abroad under their own brand names, using their own sales and distribution channels.  They make somebody else’s product and ship it to them abroad.  Many of them have no direct contact with the end buyer, but contract through an intermediary.  In most cases, they played no role in design and have no rights to the product itself.  Having come on-line during a booming period of globalization, when capacity was stretched thin, their experience in marketing was usually limited to picking up the phone to take orders.  These descriptions do not just apply to sweatshops producing low-end consumer goods.  Even highly skilled Chinese companies making advanced parts and components tend to be deeply embedded in global supply chains, often with dedicated production lines for specific foreign customers.

The situation is so extreme that Chinese who travel abroad often go shopping for better-quality made-in-China goods that they can’t find back in China, in order to bring them back home.  Even when such goods do appear in Chinese stores, they often cost more (in absolute terms) than they would abroad, because they have to be re-imported.

The point here is not to criticize Chinese exporters.  These businesses have responded to the opportunities the global marketplace has presented to them, and their operational capabilities represent a huge leap forward compared to the China of 30 years ago.  The point is that a sizeable portion of China’s production based is geared almost exclusively to feed into highly developed external markets.  Reorienting them to serve China’s less developed domestic markets will be no easy feat.  Chinese exporters will have to reinvent themselves, dramatically altering their business models and mastering entirely new business skills.  They will struggle with the long lead times and new investments involved in acquiring new customers or developing brands.  Many existing companies will fail and go out of business, while entirely new ones will emerge to seize the new opportunities.

Pettis is absolutely right that China’s service industries, which could help expand domestic consumption, are extremely underdeveloped.  They represent a prime area where new companies can come to the fore.  But the problem goes far deeper than suppressed demand.  As I pointed out in my previous post on SME lending, Chinese banks need to radically reform their collateral-based approach to lending, which excludes asset-light service companies from access to capital.  Boosting domestic consumption will mean that banks, too, must push outside their “comfort zone” to adjust to new market conditions.

The process of “creative destruction” necessary to boost domestic consumption will be uncertain and disruptive.  The problem is that China’s government, at this moment, is scared to death of uncertainty and disruption, and is doing everything it can to minimize them.  The whole thrust of the stimulus has been to freeze the economy in place, as it was before the crisis, by extending working capital loans to keep failing companies afloat and front-loading the next generation of infrastructure development to keep existing industrial capacity filled.  China seems to want to “lock in” the economic accomplishments of the past 30 years, with “no company left behind.”  But as long as it continues to do so, it prevents capital and other resources, including labor, from being reallocated into sectors that serve domestic demand.

Every month, analysts pour over the latest statistics released for signs that China’s efforts to stimulate domestic demand, including rebates or cuts in purchase taxes, are bearing fruit.  But even if these temporary measures were to succeed in permanently shifting the domestic economy’s demand curve, which is unlikely, the supply curve hasn’t budged.  Their effect, therefore, is likely to be temporary and limited, NOT the structural change everyone is looking for.  In fact, that structural change is being blocked by the rest of China’s stimulus, including export rebates and a flood of cheap loans, designed to preserve employment.  The net effect is negative.  In his March WSJ piece, Pettis describes implicitly the supply-side dilemma I just tried to make explicit:

The service sector is almost nonexistent and it is proving fiendishly hard to boost consumption directly. So in Beijing’s effort to support domestic demand, most stimulus spending goes to investment and to the manufacturing sector, especially to the large state-owned enterprises that dominate the economy . . . The effects of these measures in terms of boosting “excess” production — in other words, production beyond China’s ability to consume domestically — far outweigh Beijing’s direct attempts to stimulate household spending via measures like subsidies on appliance purchases and cutting purchase taxes on cars . . . As much as Beijing would like to change its model, it cannot do so quickly except by tolerating a massive collapse in manufacturing output.

The debate over China’s economy is often framed in terms of success or failure — China saving the world versus China crashing and burning.  But I prefer to speak in terms of seized or missed opportunities.  I sometimes wonder, for instance, what would happen if instead of providing life-support to troubled companies, the Chinese government just let some of those companies fail and spent the same money on temporary support payments and small business start-up loans to unemployed workers.  Nobody would starve, nobody would have cause to riot, but at least they would be freed to do something productive rather than stand around a dormant factory all day long. 

Back in the early 1980s, China also had an unemployment problem, of sorts.  Millions of people were returning from the countryside, where they had been “sent down” during the Cultural Revolution, and many were unable to secure jobs with state “work units” due to their dubious political status.  The government responded — almost by accident — by allowing them create their own employment by peddling goods on the street.   These getihu (single household units) were initially spurned as delinquents and undesirables, but eventually were allowed to hire employees of their own.  Many of these entrepreneurs built hugely successful private companies, some even listed on the Hong Kong exchange or Nasdaq, becoming multi-millionaires in the process.  Why couldn’t the same thing happen again, if we let today’s export workers turn their creativity loose on China’s domestic market for goods and services?  What kind of miracle are we holding back by freezing them in place?

One of the major reasons lurking behind the Chinese preference for the status quo — not just in official thinking, but popular thinking as well — is the ingrained notion that exports are “good” while imports are “bad.”  This may have made sense 30 years ago, when China desperately needed to earn precious foreign exchange to pay for much-needed machinery and other investments.  But it makes no sense now, when China’s compulsion to keep exporting forces it to pile up more foreign currency than it wants. 

In the midst of this current crisis, China’s leaders, and its population, see boosting internal demand for Chinese-made goods as an immediate way to save Chinese jobs and perhaps de-link themselves from the world’s economic troubles.  But in order to resolve the underlying imbalance in global savings and consumption that Pettis and others point out, rising Chinese demand must not only absorb more of China’s own production, it must also spend more on imports from abroad.  This would be, in effect, another way to shift the domestic supply curve outwards.  When the Chinese hear this, however, it sounds to them like foreigners are “stealing” part of China’s recovery.

I have written in other posts about how Chinese companies actually need foreign competition in order to spur their business to a higher level and facilitate the development of domestic consumer markets.  A classic example of this is the Chinese fast food industry, where the presence of McDonald’s and KFC has inspired countless Chinese emulators catering to the new consumer trend they introduced.  But on a macro level, as well, China needs imports.  In a recent post on his website, Pettis mentions that he has been reading Akio Mikuni and R. Taggart Murphy’s book Japan’s Policy Trap: Dollars, Deflation, and the Crisis of Japanese Finance.  One of my favorite books, at least along these lines, is Murphy’s The Real Price of Japanese Money, which covers similar ground.  In it, he shows not just how structural factors, such as cheap lending, fueled a persistent trade imbalance, but how the proceeds from that imbalance (the accumulation of foreign currency from trade surpluses) fueled a domestic bubble in both stocks and real estate.  If China wants to avoid a similar trap, it needs to come to terms with the fact that greater domestic consumption will mean more imports, and that this is actually a “good” thing. 

Everyone agrees, in principle, on the need for China to boost domestic consumption.  But making that actually happen — allowing it to happen — is much tougher than it looks, because it involves disruptive change and an openness to new ideas about what China’s economy will look like.  It’s an interesting fact of psychology that, once human beings find something that works, they tend to keep doing it.  The problem comes when circumstances change and whatever they were doing stops working.  Do they recognize the change and try something new?  Or do they just keep doing what used to work?  The answer marks one of the main differences between success and failure not only among individuals, but companies and countries as well.

I’ll close by making an equally important but much broader point.  Over the past year, in response to the global financial crisis, we’ve seen a resurgence of Keynesianism and its focus on demand-side solutions.  “Supply side economics” has been ridiculed and declared dead.  But as important as fiscal and monetary stimulus may be in priming the pump, or keeping the pump from clogging in the first place, by keeping credit and revenue flowing when markets over-contract, the health of the supply side — and its ability to adapt unhindered to changes in economic conditions — remains vitally important.  Stimulus may avoid the unnecessary destruction of wealth due to panic, but ultimately an economy must create wealth to prosper, and stimulus measures must be careful not to get in the way.

2 Comments leave one →
  1. Brad permalink
    August 22, 2009 1:43 am

    Very well explained!

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  1. Changing Trends in China’s Lending Boom « Patrick Chovanec

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