Morgan Stanley has a series of reports under the umbrella Chinese Economy through 2020. Their base case scenario is that China’s total consumption will equal two-thirds that of the US level and account for about 12% of the world total by 2020. China’s economy will be driven more by consumption than production in 10 years due to the support of the six factors: demographics, urbanization, infrastructure, social security, education and consumer finance. Lou Gang, a strategist with Morgan Stanley China said there is still room for further improvement of infrastructure, such as high-speed railway, ultrahigh voltage(UHV)) grid and pollutant drainage equipment, in addition to China’s massive investment on infrastructure in recent years. Meanwhile, with the progress and reform of the pension, health care and education systems along with the further construction of a social safety net, China’s enormous deposits held by residents will be released and give an unprecedented push to consumption. China’s urbanization will rise from 47 percent to 63 percent. According to the report, Morgan Stanley believes that driven by the urbanization process, China will see its fixed asset investment double and its consumption triple by 2020, making 14 percent of the world’s GDP.
In the first, we argued that China’s economic growth rate potential is set to slow but should nevertheless average 8% per annum through 2020, with a profound structural evolution that leads to rising shares of consumption-GDP, service sector-GDP, and labor income-GDP (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
In the second installment (Chinese Economy through 2002 (Part 2): Labor Supply to Remain Abundant, October 10, 2010), we made the case that China will continue to benefit from a low demographic dependency ratio and abundant labor supply through 2020. The expected deceleration in the growth of the working-age population is unlikely to become a headwind to overall economic expansion in China.
This third report aims to assess how consumption will take off over the next decade as a driver of growth. We make the following key points:
1) The Chinese economy can prepare for a golden age for consumption over the next decade. While economic growth potential is set to decelerate, consumption will accelerate to take the baton from investment and exports as the power for headline growth, as both empirical evidence and theoretical analysis suggest that the Chinese economy is at an inflection point beyond which consumption is likely to outperform strongly over the next decade.
2) Our base case scenario is that China’s total consumption will equal two-thirds that of the US level and account for about 12% of the world total by 2020. In terms of incremental consumption, China overtook the US in 2008 and will represent 20% of world consumption by 2020.
3) A Golden Age for consumption would feature two key aspects: a) the strong expansion of consumption; and b) a profound evolution in the structure of consumption. To realize the former would entail strong household income growth and/or a lower saving ratio. We identify eight drivers that would help usher in a golden age for consumption in China: 1) economic growth; 2) wage increase; 3) development of service industries; 4) public expenditure; 5) income redistribution; 6) aging population; 7) level of economic development and 8) urbanization. We group these eight drivers under three pillars that underpin a golden age for consumption in China: a) rising income; b) lower saving ratio; and c) consumption upgrade.
4) Large regional disparities make China special. To this end, we develop a framework to help understand the dynamic regional evolution of consumption.
5) We revisit the issue of ‘under-consumption’ in China and reiterate our belief that China’s private consumption is substantially underestimated.
China’s Consumption Has ‘Underperformed’
China’s economic achievements since the launch of economic reform in 1978 have been extraordinary. By 2009, nominal GDP had reached US$3,679 in 2009, or 16 times 1978’s level of US$226, representing a real GDP CAGR of 9.5% across the period, outperforming not only the developed economies but also developing peers by a wide margin.
Investment and exports have been the primary drivers of China’s strong growth, while consumption growth has underperformed: its share of GDP declined by nearly 14pp from 2000 to 2009.
In consequence, by 2009, China’s consumption-GDP ratio was significantly below not only those of high-income countries (e.g., the US) and middle-income peers (e.g., Malaysia) but also those of low-income ones (e.g., India).
These comparisons have helped form a consensus among most China observers that there is serious under-consumption in China and that a substantial boost to consumption is required to ensure more sustainable and balanced growth. On this subject, some China observers have become much more concerned as they fear that this is not only an issue of rebalancing China’s economy over the long run but also of economic stability in the short run. Some China bears even predict that the Chinese economy is about to implode, as the consumption-GDP ratio in China is simply so unusually high and thus fragile that economic growth could easily collapse in the face of a major shock.
While we share the consensus view that China’s consumption is relatively weak, we dismiss the rather alarmist view that the Chinese economy is so seriously imbalanced as to pose a threat to economic stability in the short run. This is because we believe that China’s official statistics substantially understate the true magnitude of consumption (especially the consumption of services) in China. We address this in China’s Under-Consumption Overstated in this report (see Special Topic Two).
The key parameters under different scenarios are summarized below:
•· Base case (70% probability): We expect annual real GDP growth and CPI inflation at 8.0% and 3.5% per year in our base case. Meanwhile, benchmarking with the experiences of Japan and Korea during the take-off period of consumption, the increment of consumption intensity per year is set at 0.7pp per annum, which would bring consumption intensity to 56% by 2020 from 49% in 2009. The USD/CNY exchange rate is expected to reach 5.5 by 2020.
•· Alternative scenario I – current trends continue (20% probability): The Chinese economy continues ‘business as usual’ with no material change from the previous decade – featuring strong growth (GDP: 9.5%Y), modest inflation (CPI: 2.5%Y), and no meaningful transformation of the economic structure (consumption intensity slides 0.5pp per annum to 44% in 2020). RMB exchange rate mechanism reform is slower than expected such that the USD/CNY rate reaches 6.0 by 2020.
•· Alternative scenario II – a Japanese-style adjustment (10% probability): A Japan-style transition featuring a drastic deceleration of growth (GDP 6.5%Y) and structural adjustment (consumption intensity improve 1.4pp per annum to 63% in 2020). Such a scenario could be catalyzed either by very proactive (perhaps draconian) policy intervention to artificially correct the structure of the economy or external shocks such as a complete meltdown in external demand and sustained surge in international commodities prices due to supply shocks. The pace of RMB FX reform accelerates under Alt II (RMB/USD at 5 by 2020).