Global Support, Internal Challenges – Current China Situation

The most arduous undertaking for any country or economy is the structural change and the act of rebalancing. The Dragon Economy has been focused on these for almost half a decade now – trying to transform its growth model, which is today based largely on exports and high investment into been driven by its own consumers. Accomplishment is indispensable if the economy wants to avoid the feared middle-income trap. It is the slowdown that most growing economies encounter when they reach the income levels comparable to that of  China as of today.

The domino effect has been diversified.

China has seen success in its sweats to shift the industrial structure from manufacturing to otherwise, which has now since long been regarded as the root of modern consumer societies. Nevertheless, the country has made less progress in boosting internal domestic consumption.

The service sector has been impressive now, with its share of GDP being above 50% in 2015. In statistical comparison, that is twice the increase that was envisioned in the 5 Year Plan. These gains have been strong in the sectors such as wholesale / retail trade, finance and real estate. Economists now suggest that the country should now focus on broadening into IT, domestic transportation, hospitality, for the sector as a whole to climbs toward a much higher share of GDP. On the other hand, domestic consumer-led growth has been much slower to emerge.

With the ability and proficiency in central level planning, China has been clever at manufacturing shifts in its industrial structure, but it has apparently been far less adept in duplicating the gene of a modern consumer philosophy, explicitly, in altering the behavioural norms of its public.

The lack of connect between the service sector growth and the lag in growth in the private consumption has been supplemented by a steady rise in urban saving rate. This has occurred in spite of a significant increase in the per capita income of the Chinese economy, driven by service based employment and the income leverage of urbanization. Dragon kin have been unenthusiastic to convert this newfound income into unrestricted spending. China’s saving rate in a weather of vigorous per capita growth reflects a determined preference towards precautionary saving. Regrettably, this is a response to the uncertain future faced by the families, underlined by the lack of a reliable social safety. In addition, anxiety over insufficient provisions for retirement benefits and health is set to deepen as a rapidly aging population now has started to enter the vulnerable phase of life.

The good news is that the new 5-Year Plan, which is to be enacted in 2016, explicitly looks to address the concerns laid above. Early indications from the Fifth Plenum of the Communist Party, suggest that the plan will focus on consumer-led rebalancing and a strong social safety net. The proposed consolidation of rural and urban plans for retirement benefits and health care is particularly significant in this regard. For 270 million migrant workers in China, benefit portability could be key in shifting the fear and precautionary saving to safety and spending.

More importantly the breakthrough in reshaping societal norms was in the generation planning policy, which is replacing the one-child limit with a two-child limit beginning soon. Aimed at addressing the serious aging problem, the ultimate consequence of this long-overdue shift cannot be minimized.

Over the past four decades, powerful growth model has yielded progress in terms of economic development, but implementation of the shift from production base to consumption base is vital if China is to avoid the middle-income trap. That only means overcoming the caution of Chinese households in the face of an uncertain future.

To add on to the obligation, which was limited to internal transformation, now the IMF’s decision to add the Renminbi to the basket of currencies that determine its reserve asset, the Special Drawing Right, has captured headlines. The Drawing Right in itself has not dominated discussions since its creation, so does the decision really matter? In fact, given the very limited role, the move will have few effects in the short run, however, in the longer run, the attention this decision has attracted could shoot the use of SDR. At least for now, the decision amounts to an endorsement the progress China has made toward renminbi internationalization.

Since China joined the WTO, its GDP has surged three times. China became the world’s largest exporter and only last year, it overtook the US in PPP terms to become the world’s largest economy. The acknowledgement by the IMF, that the renminbi meets all existing criteria for inclusion in the SDR is another step forward. However, it is important to note, that meeting the criteria does not place it on par with, the US dollar or with any of the other SDR currencies – in terms of international usage. On the contrary, despite massive GDP and trade volume that the country handles, the currency share in foreign-exchange market remains insignificant and the process of internationalizing is far from being complete.

Taking the above in circumstance, the IMF could have easily have rejected the renminbi’s bid for inclusion in the basket. But the IMF seemed eager to bring the country on board. What brought about the change of heart? The explanation, lies largely in the devaluation. Moving away from the peg, China demonstrated the willingness to allow the market to establish the exchange rate in the long run.

Now that the renminbi has been accepted into the basket, China will obviously want to prove that it can manage dramatic currency depreciation and continue to make progress toward internationalization.

A slow and steady depreciation would create psychological anticipations of further weakening, which will thereby fuel capital outflows and undermine willingness to use renminbi in foreign trade. The offshore market, which has strengthened over the years, would lose value, thereby forcing the Central Bank to channel exchange reserves toward that market to offset the decline.

Despite these challenges, leaders anticipate that, the renminbi’s inclusion will help to bring about the steady appreciation and, serve as a kind of certification of credibility to support its continued internationalization. Nevertheless, what will drive the continued rise will not be the SDR, but China’s own internal long-term economic performance. Undeniably, as argued by various economists, China’s share of GDP is what makes the currency likely to become a global reserve.

In short, the inclusion of the renminbi in the basket does matter. IMF has reinforced global expectations by demonstrating its confidence in the renminbi’s continued rise and lent implicit support to the currency’s progress and therein indirectly supporting the psychology of the people to discretionary spending. Whatever challenges the country faces, steady march of China to the forefront of the global economy is set to continue.