Abheek Barua: China's next revolution?

China will become a larger market for low-end consumer goods, and companies would do well to cash in on this.

If Chinese Premier Wen Jia Bao's report to the National People's Congress in early March is to be believed, his government seems serious about switching to a new model of growth. If this transition takes place, the ramifications for the global economy could be significant. Indian companies need to think seriously about the opportunities and threats that this "new" China will present.

A bit of background is perhaps necessary to understand what China is trying to embark on. Over the last couple of decades, China's searing growth was driven essentially by investment spending and exports. As a result, domestic consumption got the short shrift. The average share of domestic consumption in GDP in the period between 1991 and 2003 was roughly 44 per cent, compared to 64 per cent in India. This meant that while headline economic growth remained impressive, it excluded large swathes of the population from participating in it. The manifestation has been a high degree of inequality in China's income distribution that could, over the next few years, snowball into acute social and political turmoil.

A simple statistic about the rural sector (perhaps the most neglected in China's growth binge) should drive home the point about inequality. Rural China accounts for 50 per cent of the population but just about 20 per cent of retail sales. China's Gini Coefficient, a measure of income inequality, stood at about 45 in 2004, compared to 34 in India. The coefficient takes on a value of zero when there's no inequality in distribution and a value of 100 when there is extreme inequality.

The obsession with exports and investments has also left the Chinese economy with huge overcapacity in a number of sectors, particularly those dominated by state-owned enterprises (SoEs). This includes most of the commodity sectors""things like steel, aluminium, and so on. Overcapacity has had an adverse impact on company profitability and these unprofitable companies have contributed to the non-performing loans sitting on Chinese banks' books. China's reported ratio of non-performing loans (net of provisions) is close to 20 per cent compared to less than 2 per cent for India. Excess capacity has also eroded the pricing power of Chinese producers and bred a fundamental tendency towards deflation, both in export goods and commodities. If the global economy has continued to see a benign inflationary environment despite strong growth, China's excess capacity has had a significant role to play in it.

This growth pattern has also spilled over to energy use. The production of "investment goods" like steel and aluminium is typically far more energy-intensive than consumer goods. The skew in income distribution has meant a bias towards bigger cars, which also happen to be bigger guzzlers of oil. The Chinese government has made some effort in the past to improve energy efficiency but in terms of energy consumed per unit of GDP, China remains close to the top of the global league tables.

China's new macroeconomic strategy, likely to become operational in the new 11th Five-Year Plan, wants to confront all these challenges head on. In terms of broad macroeconomic strategy, it wants to make a serious bid to transition from an investment- and export-driven economy to a consumption-driven economy and follow a "people-oriented strategy", as Prime Minister Wen's report described it. It hopes to achieve this through a number of different policies. First, there is a direct thrust on pushing up consumption by raising income levels of segments where pent-up consumption demand is high. The rural sector, for instance, is likely to see a large increase in subsidies and direct spending. In 2006 alone, spending on the rural sector is likely to increase by 15 per cent to about $42 billion. Health and education services in the rural segment are being revamped completely, which could lower the cost of these services and leave more disposable income in the hands of the rural population. Government employees are scheduled to get a large pay hike; the social security apparatus is being overhauled""all this will ramp up urban incomes and consumption.

On the supply side of the balance, a number of things are planned. For one, the Chinese government is discouraging fresh investments and production in sectors that have excess capacity or are energy guzzlers. (There is incidentally a fair bit of overlap in the two categories.) It has for instance withdrawn export tax rebates on metals exports. The entire fuel pricing structure is being revamped and this should jack up costs for downstream producers. As far as the direct government funding of investments goes, the issuance of long-term treasury bonds to fund investments is set to dip from Rmb 80 billion to Rmb 60 billion. A whole set of taxes and incentives to ensure that the energy consumption per unit of GDP goes.

Instead of dwelling further on specific measures, let me briefly talk of the implications of this transformation. If the government is indeed able to push these reforms through, and China's growth blueprint changes, the economy's role as one of the principal sources of demand for global commodities and industrial products could dwindle. If this coincides with the correction in global commodity prices, which is long overdue, it could trigger a deflationary episode in the prices of industrial intermediates. Over the longer term, however, the Chinese supply of these products is also likely to come off and this could have a stabilising effect on commodity prices.

More generally, if the government does cut down excess capacity, the pricing power of Chinese producers, both in the domestic and export sectors, will increase. As this happens, China will begin to "export" inflation, instead of keeping global prices in check. This would happen not only for commodities and industrial goods. Finally, China will slowly become a much larger market for low-end consumer goods, and companies around the world would do well to cash in on this. All this will not happen overnight and as it does pan out over the medium term, it will have a profound effect on the global economy.