China needs short-term boost to domestic demand

"The recovery in Chinese domestic demand is fragile and at an early stage", says Frank Gong, chief China economist at J.P. Morgan, and "a short-term boost to consumer spending is needed to prevent the spread of deflationary expectations".

Gong, who was sharing his thoughts about the recently ended annual session of China's National People's Congress to a packed press conference in Hong Kong last week, has a radical plan for stimulating short-term demand, which he believes the Chinese government is considering.

Income tax cuts for the wealthy, he thinks, are a poor tool because beneficiaries would be likely to save the extra cash, while coupons issued to buy necessities would produce no net-spending because again money would be saved. Instead, he argues, coupons should be given out for discretionary spending, which would act as subsidies for major purchases.

Unfortunately, they might also be viewed as subsidies for those who can afford luxury items anyway, that is, a subsidy for the rich. But Gong reckons that political sensitivities could be assuaged by giving a tax cut to the poor as a quid pro quo.

Certainly, the economy needs long-term structural adjustments -- investment in social, educational and medical institutions, and allocations to insurance, pension and unemployment benefits -- so that people can feel safer. A more secure population is likely to feel more confident about spending, and less determined to save for a rainy day.

Also encouraging, says Gong, is that the unemployment situation is now much more manageable than in the 1990s when China's state-owned enterprises laid off urban labour during a process of privatisation and reform. This time, job-losses are concentrated among migrant workers who could be hired again by the government in the construction industry -- which will be given a fillip by the Rmb4 trillion ($584 billion) fiscal stimulus package announced last December -- and who have been returning to their farms anyway where their incomes are being cushioned by subsidies for agricultural produce.

But, government expenditure for long-term objectives is not enough, says Gong. It is essential to stimulate short-term consumption. Already there are ominous signs with inflation declining, and housing developers slashing prices by 10%-15% in order to reduce inventories.

The good news is that it's not too late for the government to act. Transaction volume in the housing market has been on the up since November, which suggests that people believe the discounts are one-offs which need to be taken advantage of -- hence deflation expectations are not yet evident. As Gong points out, people do not buy in a falling market, so they must assume that prices will pick up this year. He estimates that it will take about 20 months to clear nationwide residential inventory based on daily transaction volumes in January -- and just 10 months in Shenzhen.

However, that mindset can soon change if prices continue to fall. And Gong is worried that policymakers are too complacent, and too anxious about future inflation -- they are factoring in a rate of 4% this year, when his worst case scenario is only 1%.

Other suggestions are to liberalise utility and energy prices which are artificially low; to induce a recovery in property prices by making mortgage interest payments tax-deductable (mortgage payments are currently no lower than rent payments); and for local authorities to offer more residential cards, which are prerequisites for accessing education and medical services and even car registrations, in order to encourage greater urbanisation and housing demand. An increase in card issuance in Shanghai in 2001 was such a powerful boost to the property market that it had to be stopped to deflate a dangerous bubble.

Last year, consumption made up just 38% of China's GDP, which is low compared with India's 55%, and even more so compared with developed countries where it exceeds 70%. Also in sharp contrast, China's gross savings rate is around 50% and its household savings rate is 30%; in the US, the savings rate is moving from negative to 3%-5% and could reach 6%-8%, which is bad news for China's exporters.

So in order to achieve the official target of 8% GDP growth this year, it seems plausible that the Chinese need to increase their discretionary spending. The problem, says Gong, is that the Chinese authorities will do too little too late.