In 2017, the second year of the 13th Five-year Plan (2016-2020), China will step up efforts on supply side structural reform directed toward the market-oriented allocation of resources. The rest of the world is closely watching China’s position of both her economy as a whole and the supply side reform. As Vice Chairman of the Finance Committee of the NPC, I have seen there are a growing number of warning signs that suggest the economy will require special attention and action in 2017.
China’s food crop output, mainly cereals such as rice, wheat and corn, dropped by 1.8 percent in 2016, for the first time after 12 years of continual increase. There are several reasons for this. The higher prices of domestically grown crops compared to imports is the first of these reasons. In the past few years, the prices of wheat, corn, soy and rice grown in China were higher than imports within the quota allowed by China’s WTO agreement. This has made domestic grain less attractive for firms that use the crops for food or industrial processing. China’s agricultural sector is less technologically efficient than countries like the US or Canada, and the land less fertile. As the cost of growing grain is still rising, the “firewall,” the 65 percent tariff on any imported grain that is beyond the WTO quotas, will become ineffective.
The second reason is the excessive official grain reserves held by the government as a result of the 12-year rise in output. By the end of 2016, almost an entire year’s worth of grain was kept in reserve. Purchasing and maintaining such a huge amount in storage cost nearly US$29 billion in fiscal spending and more than US$188 billion in bank loans. In addition, the burden of producing so much grain has resulted in over-farming that has exhausted the land and hindered attempts to improve productivity.
The third reason is the widening gap between demand and supply. In recent years, China has imported more than 60 million tons of soy and 15 million tons of grains annually. The net imports of grain, cotton, edible oil, sugar and milk are equivalent to the output of 60 million hectares, or half of China’s arable land. The imports may increase to the equivalent of around 67 million hectares of arable land by 2020 as the urbanization and industrialization process will spur a rise in consumption. All this means China is very vulnerable to any food crisis. There is insufficient supply on the international market to fill the gap for such a large population in the event of disaster. Even if there were, transportation would be not easy to arrange.
The 12-year increase in grain output was a record for China. The reduction in 2016, albeit slight, is a wake-up call about lingering problems in China’s agriculture and food safety systems. With only 40 percent of the global average of arable land per capita and 7 percent of the world’s total arable land, China needs to feed 22 percent of the world’s population. Excessive farming has already led to severe fertility depletion, water loss, soil erosion, overexploitation of ground water and agricultural pollution. Without addressing these issues, China’s agricultural development is unsustainable.
The quality of infrastructure, labor, organizational capacity, technology and management systems in rural areas is not strong enough to develop modern agriculture in China. The rising cost of agricultural production and lower returns from agriculture in comparison to other businesses has already put China’s food safety at risk. Agriculture is the foundation of the country and provides quasi-public goods, but it remains weak and under-developed. Given this, there is an urgent need to build a market-oriented pricing system for agro-producers, to restructure the types of produce being grown, to encourage economies of scale in farming and to improve the social and economic benefits that come from the sector.
The surplus in China’s grain supply and the low international grain prices have provided a window for China to implement crop rotation and allow land that suffers from severe ground water drainage, heavy-metal pollution and ecological degradation to lie fallow. This is the best way to protect China’s agricultural capabilities for future generations.
The 3.2 percent growth of fixed asset investment by the private sector was 4.9 percent slower than the total in 2016, dragging the share of the private investment to 61.2 percent of the total from 64.5 percent in 2015. This is the first time that this has happened for years.
This can be largely attributed to the discrimination against private companies. Private investors are blocked by powerful obstacles. For example, nearly 80 percent of bank loans go to State-owned enterprises, leaving only about 20 percent for the private sector. Projects sponsored by governments and State-owned enterprises have squeezed rather than driven private investment.
Weak market demand has also divested the real economy of private investment and it has flooded into speculative products or abroad. Private investors are more keen on overseas ventures than on spending their money at home.
The expensive and difficult access to financing remains a lingering problem for private investors. Direct financing through stock and bond markets, which are normally cheaper, is not well-developed. As for indirect financing through banks, there’s an urgent need for more private financial institutions and to encourage commercial banks to support private enterprises.
It is clear that the economy as a whole is unlikely to rebound before private investment does. The costs of enterprises doing business as part of the real economy must be brought down, while the virtual economy must be contained. In recent years, the profitability of the real economy has been standing at 3 percent to 5 percent, not enough to repay the 5 percent to 6 percent bank lending rates. Some enterprises then sought higher returns in real estate or the capital market.
Political factors also need addressing to encourage private investment. Local government officials are afraid of being held accountable if anything goes wrong with projects. They are hesitant to launch new projects even if the funding and land are all in place. This is particularly true for projects where private investment plays a significant role. The key is to get government at all levels motivated to act.
While the money supply has been ballooning for nearly 20 years, analysts are worried about two key indicators of liquidity. Cash in circulation and corporate demand deposits constitute “narrow money.” They combine with other deposits, including term deposits and ordinary people’s deposits to make “broad money.” Since the second half of 2015, the former has grown much faster than the latter.
The pro-growth policy in recent years has injected huge amount of liquidity into the market. However, companies that have received large amounts in cheap loans this way have been reluctant to use the money to expand investment or employ more people in China. Instead, they put the money in their demand deposits with banks (hence the fast rise of narrow money), re-lend it to money-thirsty small and medium enterprises, buy high-yield wealth management products or seek offshore merger and acquisition opportunities. This situation, labeled a liquidity trap in orthodox economics, is one in which loose monetary policy fails at encouraging consumption and investment, thus hindering China from escaping the current economic difficulty.
This liquidity trap has consequences. When interest rates remain very low, enterprises, local governments and households have found little reason for sitting on their cash or deposits, but more incentive to use the money for speculation. Financial institutions have then taken the chance to tout their high-yield wealth management products with high risks to banks, enterprises and big depositors looking for such quick and easy ways to build their wealth. “Universal life insurance,” which works more as an investment vehicle than an insurance policy, is an example. Insurance companies lend their clients’ money to real estate developers or other financial players. Capital has been circulating around the virtual economy, but very little of it has been trickling down into the real economy.
Another risk of this liquidity trap is looming inflation. The broad money has rocketed to as much as more than 200 percent of China’s GDP as compared to about 120 percent in 2008. It is much higher than the equivalent figure in the US, the EU and Japan. Although both the production price index (PPI), an indicator of corporate revenues, and the consumer price index, the main inflation indicator, are still low, it is estimated that nearly US$5.8 trillion is on the demand accounts of institutional depositors. This huge amount of capital can not only slosh around assets like real estate at any time and push up their prices, but it can also sows the seed of longer term inflation.
The liquidity trap, combined with the flooding of capital into the virtual economy as a result of excessive liquidity, is alarming enough. The consumer price index (CPI) has remained below two percent in the past two years, but this is largely because overcapacity has forced enterprises to undercut one another. However, the price of food still rose more than 5 percent during this period. Since April 2016, the price of commodities has also gone up. Rising prices have already spilled over into durables like appliances and rents in the second half of 2016. In December 2016, the PPI increased to 5.5 percent, after a 5.9 percent decrease in December 2015. The rising PPI is likely to push up the CPI in 2017.
2016 saw an ebb in China’s foreign trade for the third year in a row and the surge of China’s outbound foreign direct investment for a second year. Signs of a rebound of imports and exports did not appear until the second half of 2016. China’s outbound investment in 2016 outstripped capital inflow in terms of both value and speed of growth. The gap is much more staggering if overseas transactions not included in the official data are taken into account, including the purchasing of real estate by households, illegal banks and the cash taken abroad by individual citizens. As a result, China’s official foreign exchange reserves fell to below US$3 trillion in January 2017, the lowest since February 2011, after seven months in a row of drops.
Chinese investors have shown more enthusiasm than expected to head overseas. Their overseas mergers and acquisitions nearly tripled in 2016 from 2015 and were more than the total of 2014 and 2015 combined. This happened when China’s own growth began to slow down and the yuan depreciated.
Chinese buyers have targeted highly diversified sectors to serve their ambition to improve their technology and branding. They not only acquired internationally well-known companies, but real estate, cinemas, vineyards and football clubs.
However, there is resistance against active mergers and acquisitions initiated by Chinese buyers. Some imprudent or poorly-planned projects are not proceeding smoothly. Concerns over fast-rising Chinese investment in the US and Europe have caused a halt to some Chinese-funded mergers and acquisitions.
Some Chinese enterprises chose to migrate or move their capital overseas because they lack confidence in domestic economic prospects or the protection of private property rights. This has happened while China’s mid-west regions need a lot of investment and China still needs further development – the question of balancing inward and outward investment deserves more attention.
In 2016, for the first time since 2011, Chinese residents’ average income, weighted by inflation, did not rise as fast as the country’s GDP – which itself had already slowed down for a seventh year. Though distribution is an issue, the economic slowdown itself largely underlies income decrease. Changes to China’s economic structure and growth, as well as greater energy and environmental constraints, are taking their toll on Chinese consumers’ pockets.
Gains from farming are very limited for farmers. Poor agricultural productivity has resulted in uncompetitive prices for home-grown grain compared to imported grain, as already mentioned. It is hard for the government to spend more public funding on further increasing official floor prices of buying grain to encourage farming. In addition, China has already exhausted the ways to provide agricultural subsidies allowed by the WTO. Rural residents’ income growth has been slower than the growth of the salaries of migrant workers in urban areas.
For urban residents, including migrant workers, salaries are their main source of income. However, enterprises have had to reduce their work hours and pay to cope with the weakened market demand and profitability. If the economic slowdown continues, the shrinking wages will worsen into shrinking payrolls. This will hit residents’ income in urban areas even harder.
It is also more difficult than ever for urban residents to cash in on their household businesses or asset management. This is because of the limited investment choices, economic slowdown and fluctuation in the capital and property markets.
Finally, there is not much space for further increase in public spending on social security. In recent years, more budget spending has been used to increase pensions of enterprises’ retirees, subsistence allowances for rural residents and the fiscal contribution to the basic health insurance of unemployed urban and rural residents. More spending has become more difficult as fiscal revenues have not grown as fast as before. This is particularly true for the less-developed western regions that are more reliant on transfers of money from the national coffers.
The Communist Party of China has repeatedly stressed its commitment to doubling incomes by 2020 from 2010 and keeping income growth at the same speed as GDP growth. The challenge now is how to achieve this by more effective distributive policies when the economy is shifting to a more moderate track. Once residents suffer from shrinking income and a widening income gap, the risk in the distribution will directly affect social stability and the process of building a comprehensive well-off society.
The author is the vice-chairman of the Finance Committee of the National People’s Congress of China.
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