Leading Indicators of Economic Rebalancing in China

Nicholas Borst (Federal Reserve Bank of San Francisco)



It can be difficult to keep up with the torrent of Chinese economic data. For every statistic showing economic recovery there is another which indicates that growth is still slowing.

To cut through the noise, it’s important to identify which indicators show that the Chinese economy is rebalancing towards a more sustainable growth model. This means higher levels of consumption, less investment in real estate, and faster growth in the service sector.

Without such a shift, economic growth in China is likely to slow further over the medium term regardless of government efforts to stimulate the economy.  Ever higher levels of investment cannot be indefinitely sustained and exports will be insufficient to drive growth in the current weak global economy. Consumption must emerge as the primary driver of new growth.

We have yearly data on the share of household consumption and investment in GDP. Unfortunately the lag time on this data is too long for it to be a useful leading indicator for economic rebalancing. While not perfect, the following high-frequency statistics can serve as proxies for rebalancing:

1. Disposable Income Growing Faster than GDP

If disposable income is growing faster than GDP it indicates that the wage share of GDP will be increasing and, absent an increase in the savings rate, this will correspond with a rising share of consumption.

The National Bureau of Statistics (NBS) releases quarterly data on disposable income for urban households. For the first half of this year, disposable income has indeed been growing faster than GDP, reversing the trend of the past two years. It remains to be seen if this will continue if GDP growth picks back up in the second half of the year.

Indicator = Slightly Positive (4/5)

2. Positive Real Interest Rates on Deposits

Positive real interest rates are critically important for economic rebalancing. The on-average negative real interest rates over the past decade have been a blow to household income and wealth and served as the catalyst for speculative investment bubbles in the real estate market. Keeping interest rates above inflation for a significant period of time will not only boost incomes but also dissuade savers from taking their money out of the banks and speculating in the property market.

For inflation we can use the consumer price index (CPI) released monthly by NBS. For the interest rate, the benchmark one-year rate on savings deposit issued by the People’s Bank of China (PBoC) is a good proxy for overall deposit rates. Looking at the data, real interest rates have indeed been slightly positive over the past several months. However, this is most due to the sharp fall in inflation rather than higher rates being offered.

Indicator = Slightly Positive (4/5)

3. Residential Real Estate Investment Growing at a Slower Pace than GDP

Growth in residential real estate has been the key driver of economic growth over much of the past decade. This sector has grown unsustainably fast, reaching a point where China is investing 11 percent of GDP in residential real estate. Just for perspective, this is more than either the United States or Spain invested at the height of their housing bubbles. The housing sector must come back down to reality along with all the sectors (steel, cement, etc.) that have grown unsustainably alongside it.

NBS releases a monthly series on resident real estate investment. Investment growth has moderated significantly since last year when it was growing 35 percent year on year. Despite having fallen to the low double digits, investment continues to grow faster than GDP. Thus residential real estate investment is continuing to grow as a share of GDP.

Indicator = Slightly Negative (2/5)

4. Loans to Small Enterprises Growing Faster than Total Enterprise Loans

Economic growth in China needs to shift away from large industrial firms towards smaller firms. Smaller firms on average pay a higher percentage of their profits in wages than more capital-intensive large firms. Small firms are also a good proxy for private enterprises while large and medium firms have a much higher percentage of state-owned enterprises.

To discern if small enterprises are growing more quickly than larger firms, we can analyze whether they are receiving a growing share of total loans. The PBoC numbers on loans by enterprise size are released quarterly. The trend here is quite positive, with loans to small enterprises growing 5 percent faster than total enterprise loans.

Indicator = Positive (5/5)

5. Faster Growth of the Tertiary Sector than the Secondary Sector

As a result of distortionary polices, industry has grown much faster in China than services. In fact, the service sector has stagnated for much of the past decade, leaving China with a much less developed service industry than most countries at comparable levels of economic development. Faster growth in this area will be essential to rebalancing as the service sector pays out a higher level of profits in wages than capital-intensive industry and generates more employment. Moreover, a rapidly growing service sector should reflect also reflect rebalancing because households increase their consumption of services (relative to goods) as their incomes grow.

To ascertain to growth rate of the service sector relative to the industrial sector, we can use the growth of the secondary sector of the economy (manufacturing and construction) versus the tertiary sector (services). Both of these numbers are released on a quarterly basis by the NBS. Looking at the data, after growing more slowly than secondary sector for most of 2011, the tertiary sector growth has picked up in the first two quarters and grown moderately faster.

Indicator = Slightly Positive (4/5)

Overall: While several of the above indicators are positive, most are only slightly so. Except for loans to small enterprises, none of these leading indicators shows a dramatic shift towards rebalancing. If rebalancing is occurring, it is only at the very initial stages and transpiring much more slowly than is optimal. As of right now, the overall grade for rebalancing in China is a C (19/25).

We'll keep track of these indicators and put out a quarterly update.

Indicator Grading Scale:

Negative = (1/5)

Slightly Negative = (2/5)

Neutral = (3/5)

Slightly Positive = (4/5)

Positive = (5/5)

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