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China’s reforms: 2012 leadership and the next phase of growth

10 September 2012

Linda Yueh

Big changes are in the offing in China with a new set of leaders due to take over this year. But, with regard to the economy, the terms of the debate have already been set – the 12th Five Year Plan launched last year will guide the economic policy of the country through to 2015. Timing these plans to not coincide precisely with the leadership changes ensures that there is economic continuity. In other words, the current leadership candidates will have already contributed their input to the Five Year Plan, which is how stability is ensured amidst political change. Within this timeframe, the Chinese economy requires re-balancing to sustain a strong growth rate in the coming decades, and the slowdown in the West makes the re-orientation towards growth by domestic demand a much greater imperative. Financial sector and macroeconomic reform will be key, and understanding these changes will be important for the European Union’s strategy towards the world’s second-largest and fastest growing economy.

Re-balancing the economy

The estimated 20 million workers who lost their jobs in the export sector and the hit to Chinese GDP during the 2008 global financial crisis have reinforced the impetus behind the already planned re-balancing of the Chinese economy. The main focus of the 12th Five Year Plan is to transform the economy into a more sustainable model so that the country can pursue solid growth for another 30 years.

The structure of the Chinese economy can evolve to become more akin to the United States and Japan, which are both large economies whose growth is primarily driven by domestic demand but which at the same time are among the largest (third and fourth, respectively) traders in the world. China could reduce its exposure to the volatility of the world economy by following a path to strengthen both internal and external demand, which can cause the portion of growth to be driven by domestic demand to increase even as trade could expand in absolute terms. Such restructuring would allow China to continue to benefit from global integration which includes learning from the technological advancements of developed economies and to continue its ‘catch up’ growth, while maintaining a larger base of domestic demand to shield it from the worst excesses of external shocks.

Reorienting towards domestic demand means boosting consumption in China, i.e. reducing the savings tendencies of households and firms. Consumption fell from around 50 percent of GDP in the 1980s and early 1990s to nearly one-third by the late 2000s. In developed economies, consumption is typically between one-half to two-thirds of GDP, by comparison. Consumption dropped as the motives for saving were undiminished by the export boom, and total savings rose instead. Reforming the internal and external sectors would help to re-balance the Chinese economy.

Domestic reforms

The policy reforms needed to increase aggregate demand in this framework centre on reducing the savings rate of households and firms to generate higher output in the context of a smaller trade surplus. Greater government spending can also increase consumption and investment if undertaken to support income and the efficiency of capital markets.

Household savings have averaged 19 percent of GDP since 1992, after the significant opening up of China associated with the decline in consumption. The savings rate was high, but it increased further by 8 percentage points of GDP from 2000, increasing from 14 percent to 22 percent of GDP by 2007 at the onset of the global financial crisis. For firms, the average savings rate was lower at around 15 percent of GDP from 1992-2007, but grew quickly to reach 22 percent of GDP by the mid-2000s. The remainder of the savings derives from government, whose savings rate had been around 5 percent since 1992, but increased dramatically from 5.2 percent in 2000 to 10.8 percent in 2007. Taken together, China’s savings rate increased from 38 percent of GDP in the 1990s to peak at nearly 52 percent by the late 2000s. Startlingly, the savings rate increased by 17 percentage points during the 2000s (34 percent in 2000 rising to 51.9 percent in 2007), which mirrors the fall in consumption as a share of GDP from around 50 percent of GDP in the early 1990s to 35 percent by the late 2000s. Household savings are high due to precautionary savings motives, e.g., saving for retirement, health, education, due to an inadequate welfare state.

For firms, reforming capital markets is critical. For both sectors, the reforms require adjustments to both the internal and the external balances, in line with the analysis of the open economy model in the previous section.

Financial reforms

Further liberalisation of interest rates would improve credit allocation to non-state sector firms and reduce the savings incentive for firms too. Although interest rates were partially liberalised, including in 2004 when the ceiling on inter-bank lending rates was lifted, there are still limits in terms of the ‘floor’ on the lending rate. Interest rates reflect the internal rate of return to investment, so such controls distort lending decisions. These restrictions preserve bank margins in the same way that capital controls preserve the deposit base, but they lead to high rates of corporate saving.

The allocation of capital should be more efficient even though the rate of investment may not increase. This suggests greater output for the same amount of invested funds. For instance, the return on assets is high in China, but it is greater for all types of private firms than state-owned enterprises (SOEs) and collectives. Yet, SOEs continue to receive disproportionate amounts of credit despite being less productive. The political linkages among top cadres who run SOEs and the legacy of central planning continue to bias the system towards state-owned enterprises despite their poor efficiency. Without interest rate liberalisation and further reforms of the financial system, the extent of financial repression distorts credit allocation and induces savings by private firms, which has contributed as much as households to the increase in the savings rate in the 2000s. Wages below the marginal product of labour also generate profits, but capital market reform will reduce the distortions to the savings behaviour of firms, particularly if it is linked to capital account reform.

China’s outward investment

Gradual capital account liberalisation, in particular the ‘going out’ policy that is encouraging Chinese firms to operate as multinational corporations, can reduce savings if firms are permitted to operate in global markets and are allowed to access funding from better-developed overseas credit markets. In other words, firms can raise money on capital markets and not just rely on China’s banking system with its controls on credit.

Most outward FDI remains state-led investments in energy and commodities, but the maturing of Chinese industry indicates that the trend is changing as China seeks to move up the value chain and develop multinational companies that can follow in the footsteps of other successful countries like Japan and South Korea. These countries, unlike most developing countries, managed to join the ranks of the rich economies through possessing innovative and technologically advanced firms that enabled them to move beyond what is termed the ‘middle income country trap.’ Nations start to slow down in growth when they reach a per capita income level of $14,000 (PPP-adjusted) which China is expected to reach by 2020. The process of growth through adding labour or capital (factor accumulation) slows or reaches its limit, and they are unable to sustain the double digit growth rates experienced at an earlier period of development. By increasing productivity instead through developing industrial capacity and upgrading that is stimulated by international competition, it is more likely that a country can maintain a strong growth rate.

The need for energy as well as upgrading industrial capability is the primary incentive for China to invest overseas. Nevertheless, by the end of the 2000s, the share of commercial outward investment remains small while state-owned firms continue to constitute the bulk of outgoing FDI. The shape of things to come, though, points to China becoming a net capital exporter and to the ‘going global’ of its firms that could herald an era of Chinese multinational corporations.

There has been explosive growth of outward FDI since the mid-2000s, which points to not only SOE investment in commodity sectors but also commercial mergers and acquisitions (M&A) by private companies like Lenovo and Geely. Becoming a net capital exporter is also viewed as a mark of a country reaching a certain level of industrial development as its firms are able to operate and compete on world markets. With outward FDI accelerating and close to overtaking inward FDI, this is indicative of a more widespread upgrading of China’s industry.

There are also macroeconomic benefits. Capital account reform would not only reduce the motive for corporate savings but also cut the portion of the current account surplus that is funded through the purchase of US Treasuries by allowing capital outflows in the form of investments instead of accumulated in foreign exchange reserves. As the portion of foreign reserves held in foreign debt falls, there should also be a decline in Chinese demand for euro-denominated assets. The exchange rate should also become more flexible with greater capital account liberalisation since the capital account and the current account will require the RMB for transactions. Recent measures to increase the use of the RMB in trade arrangements already point to the growing internationalisation of the Chinese currency. Therefore, exchange rate and interest rate reforms together should produce a better balance between China’s internal (savings/investment) and external (balance of payment) positions and help to re-balance the economy.

Implications for the European Union

The debate has shifted from trade to outward investment from China, and this is where the European Union can leverage its own market access. The openness of European markets is relatively more attractive than the US for China and investment is greatly needed in the European economies. To ensure that the EU garners the most out of the investments, Europe should have a unified set of principles so that the Chinese do not arbitrage around EU states to gain an upper hand and the Europeans engage in a ‘race to the bottom’, something that has plagued developing countries where they give away too many concessions and fail to reap the full benefits from the foreign investment. In Europe’s case, such a concerted stance is necessary to ensure that France and the UK, for instance, do not end up competing with each other to their detriment.

Devising clear investment principles, something that is lacking on the international level, can also help manage expectations on both sides. China has not always done well with its investments in Africa and faces a backlash in places like Australia, so this would be welcomed. For instance, is it the source of the funds that matter or the effect on the ‘playing field’ in Europe? Knowing that state financing is not the issue will also be useful as some, perhaps, a sizeable part of Chinese investment will be state-financed to achieve the government’s aims.

There are also ways in which the EU can help the Chinese achieve their aims that will also benefit Europe in return. For instance, Chinese corporations’ lack of transparency is one of the reasons for resistance to Chinese investment in Europe. To aid Chinese private firms, better corporate governance would help, and the EU can share its expertise on this front. Secondly, the gradual opening of the capital account that overseas investments implies will also require financial market depth, an attribute that Europe with its leading financial centres possesses. More steady management of the process could also ease concerns and facilitate more investment from private Chinese firms that would enhance China’s growth as more efficient firms gain a global footprint and benefit Europe as the recipient of the investment. China is also integrating its outward investment policy with its reserves management in managing its balance of payments. Working with China can help the country allocate its resources more optimally among reserves, outward investment and greater portfolio flows. A more stable China benefits all countries and Europe could help shape one of the toughest areas of debate within China. Finally, China is seeking expertise to develop its services sector, an area in which European firms can help and where they can potentially gain access to this large and under-developed market.


China can evolve as a fast-growing, large, open economy – developing domestic demand while upgrading industry and promoting globally competitive firms.  Unlike small, open, export-led economies which do not affect the global terms of trade, it can have a far-reaching impact as a global economic player. Given China’s still low level of development, global integration would benefit its own development as well as that of the world. It may have achieved something extraordinary in growing so strongly over the past 30 years, but there is still considerable scope for ‘catch-up’ growth and hence the importance of not only attracting investment via the ‘open door’ policy, but also the increasing emphasis on ‘going out.’ Thanks to this strategy, its global investments and corporate expansion will re-shape the global landscape, and the EU can play a role in helping and benefiting from that process. The EU is not only China’s largest export market, it also is an attractive and sizeable market for Chinese outward investment. This places the EU in a strong position to help China grow, in the various ways mentioned earlier. In this way, both regions could benefit, e.g., Europe could receive much-needed investment funds and China could develop its external investment capacity.

Linda Yueh is Director of the China Growth Centre and Fellow in Economics at St Edmund Hall, University of Oxford, and Adjunct Professor of Economics at the London Business School.