Chinese Economics Calling Income Distribution Reforms to Boost Economy
Chinese economics Xu Gao on addressing the disconnect between corporate and household sectors
This post was originally a speech during the event held by the China Center for Economic Research at Peking University. Speaker Xu Gao (徐高) is the adjunct professor at the Center. He is also the chief economist at BOC International. (This episode only contains half of the speech. If you think that’s helpful, please press the like button, and I will upload the other half soon.)
During his speech, Xu argues that the key issue facing China's economy is insufficient consumption, which has led to long-term insufficient domestic demand. This problem has persisted since the 1990s and has become even more pressing in the aftermath of the pandemic. The root cause is the low share of consumption in China's GDP, which is nearly 15 percentage points lower than the world average. This indicates that the fruits of economic growth have not fully benefited people's welfare.
China's high savings rate, which exceeds 40% and is roughly twice the world average, is the flip side of its low consumption. Among the components of domestic demand, consumption is the ultimate demand, while investment is the derived demand. China's long-term low share of consumption in GDP has led to insufficient domestic demand.
The disconnect between China's corporate and household sectors is a major factor contributing to the country's high savings. In most countries, there is a negative correlation between corporate and household savings. However, in China, both are very high and lack this correlation. This is largely due to the significant presence of state-owned enterprises (SOEs), whose equity is mostly held by the state rather than households. As a result, SOE profits and dividends do not directly boost household wealth and consumption. Additionally, the highly concentrated equity of many private enterprises also limits their contribution to household consumption.
China lacks effective market forces to regulate consumption and investment. In a well-functioning economy, the investment return rate should guide the allocation of national income between consumption and investment. This regulation is typically achieved through corporate dividends to households. However, in China, the disconnect between the corporate and household sectors hinders this mechanism. Over the past two decades, corporate dividends received by households have been negligible despite corporate profits accounting for a significant share of GDP.
Consequently, China's investment scale has remained excessively high, leading to over-investment and low returns. Enterprises' reduced willingness to invest, coupled with the difficulty of corporate savings flowing to households, has resulted in insufficient domestic demand.
To address these issues, China has three potential strategies:
The "top strategy" focuses on promoting consumption through income distribution reforms that benefit households.
The "middle strategy" aims to stabilize growth by stimulating investment when income distribution reform progress is limited.
The "bottom strategy" involves stopping or suppressing investment before substantial progress is made in income distribution reform.
The speaker argues that the bottleneck of China's economic growth lies on the demand side, not the supply side. Attempts to explain the slowdown in China's growth using supply-side factors, such as population aging, are misguided and can lead to misjudgment.
In conclusion, He believes that China's long-term economic growth is constrained by insufficient domestic demand, primarily caused by low consumption. The disconnect between the corporate and household sectors, along with the lack of market forces regulating consumption and investment, has led to high savings, over-investment, and low returns. To address these issues, China must focus on income distribution reforms that benefit households and promote consumption-driven growth. The country's policymakers have three strategies to choose from, each with its own implications for the economy's trajectory. Ultimately, the path China takes will shape its economic landscape in the future.
Original speech
On the occasion of the 30th anniversary of the China Center for Economic Research's establishment. Today, I plan to comprehensively report my analytical framework for China's medium- to long-term development. In fact, once the medium- to long-term analytical framework is clear, it becomes relatively easy to use this framework to answer short-term questions. My overall framework is quite simple: given the premise that China's income distribution structure leads to insufficient consumption, China currently has only three strategies to choose from: the top, middle, and bottom strategies. The fundamental reason why China's economy is currently facing significant downward pressure is that we have inappropriately moved toward the bottom strategy. Next, I will start by discussing the problem of insufficient consumption caused by China's income distribution.
Insufficient consumption is the key issue for China's economy
A few years ago, the central government document clearly stated that China's economy faces triple pressures of supply shocks, demand contraction and weakening expectations. Now that the pandemic has passed, the supply shocks have dissipated. However, the pressures of demand contraction and weakening expectations have become even heavier.
Demand contraction is not a new problem. From the second half of the 1990s until now, China's economy has always faced weak domestic demand. Against the backdrop of insufficient domestic demand, when external demand is not strong, China's economy will fall into a situation of insufficient total demand and sluggish growth. Therefore, the constraint on China's long-term economic growth lies on the demand side, not the supply side.
The total demand of the economy comes from only three components: consumption, investment and net exports. Among them, consumption and investment are domestic demands, while net exports are external demands. The root of China's insufficient demand is insufficient consumption, meaning the share of consumption in China's economy is too low.
Cross-country data shows that at per capita GDP levels above $10,000 (in constant 2005 prices), the average share of household consumption in GDP in countries around the world is around 55%. However, as China's per capita GDP level rises, the share of household consumption in GDP continues to decline, now nearly 15 percentage points lower than the world average. Even if government consumption is added, calculating the share of China's total consumption in GDP, it is still almost 15 percentage points lower than the world average. A low share of consumption in GDP means that the fruits of economic growth have not fully benefited people's welfare. Logically speaking, the goal of economic growth is to meet people's aspirations for a better life. And people's aspirations for a better life are mainly reflected in expectations for higher consumption, i.e. eating better, dressing better, playing better, etc. If a country's share of consumption in GDP is low, there will be a disconnect between the growth of the total economy (reflected in GDP) and individuals' personal feelings.
Because national gross savings are defined as national gross income minus consumption, a low share of consumption means a high share of savings—these are two sides of the same coin. China's current savings rate (share of savings in GDP) exceeds 40%, roughly twice the average savings rate of other countries in the world.
Among the two components of domestic demand, consumption and investment, consumption is the ultimate demand, while investment is only a derived demand. Under normal circumstances, the purpose of investment is to obtain investment returns. When the rate of return on investment is low, the willingness to invest will be relatively low. If income cannot spontaneously transfer from investors to consumers at this time, turning into more consumption, there will be a situation of insufficient domestic demand where both consumption and investment are weak. Therefore, China's long-term low share of consumption in GDP will lead to long-term insufficient domestic demand.The disconnect between the corporate and household sectors leads to high savings in China
To analyze the causes of China's low consumption and high savings, we can start from either consumption or savings. Here, we take China's savings as the object of analysis to reveal the reasons for China's low consumption and high savings.
A country's total savings come from savings made by the three major sectors: households (consumers), businesses, and the government. Since government savings are generally small in scale, the country's total savings are mainly composed of household savings and corporate savings. Household savings are household income minus household consumption. Corporate savings are corporate income minus corporate consumption. The corporate income here is based on the national economic accounting definition, which is actually the profit after corporate dividends, not the revenue in the corporate financial statements. Also, since corporate consumption is equal to zero, corporate savings are actually equal to corporate profits after dividends.
In cross-country comparisons of corporate and household savings, China's uniqueness is clearly evident. In the data of most countries in the world over the past decade or so, it can be found that there is a negative correlation between corporate savings and household savings: countries with a low share of corporate savings in GDP have a relatively high share of household savings in GDP; countries with a high share of corporate savings in GDP generally have a low share of household savings in GDP. China has a very high share of both corporate and household savings in GDP, and there is a lack of negative correlation between the two as in most other countries in the world—this forms a stark contrast to the situation in most other countries in the world. The reason why there is a negative correlation between corporate savings and household savings in most countries in the world is that when corporate equity is held by households, the income distribution between the corporate and household sectors does not affect the wealth level of households. Let's illustrate this with a simple example.
Suppose there is an extra 100 yuan of income out of nowhere in the economy. In the first case, this 100 yuan of income flows to the household sector and is deposited in the bank by the household sector. In this way, the assets of the household sector increase by 100 yuan (an increase in household bank deposits), and the total wealth of the household sector increases by 100 yuan.
In the second case, the 100 yuan of income does not flow to the household sector, but to the corporate sector, and is deposited in the bank by the corporate sector. At this point, the assets of the corporate sector increase by 100 yuan (corporate deposits). But the story doesn't end there. As corporate assets increase, the value of corporate stock will also increase by 100 yuan. And if corporate equity is held by the household sector, the total assets of the household sector will also increase by 100 yuan, eventually increasing the wealth of the household sector by 100 yuan as well.
Therefore, if corporate equity is held by the household sector, regardless of whether income flows to the household sector or the corporate sector, it will eventually become household wealth. In other words, as long as corporate equity is in the hands of the household sector, both corporate savings and household savings are household wealth, and the distribution of income between the corporate and household sectors does not affect the total scale of household wealth. In economics, this conclusion is called "piercing the corporate veil". But the prerequisite for the above conclusion to hold is that corporate equity must be held by the household sector. The large presence of state-owned enterprises makes China's situation clearly different from what this precondition requires. State-owned enterprises are of course owned by the whole people, but most of their equity is held by the state. As a result, most of the dividends of state-owned enterprises flow to the state rather than the household sector, and the profits of SOEs after dividends have no direct connection with the household balance sheet, making it difficult to directly boost household wealth.
Of course, SOEs have supported national economic development through various forms, such as paying wages, paying taxes, and distributing dividends to the state. However, the problem is that China's household sector cannot directly feel the wealth-enhancing effect of SOEs. And the level of household consumption is determined by the scale of their wealth. Thus, the dividends and savings of SOEs have a relatively weak driving effect on household consumption. This is an important reason for China's low consumption.
In addition, since China's market-oriented reforms have only been around for just over 40 years, the equity of many private enterprises is highly concentrated. Consumption is mainly done by the broad masses of ordinary consumers. The equity of these private enterprises, which is highly concentrated in the hands of a few people, also makes it difficult to directly bring wealth effects to the broad masses of ordinary consumers and thus has limited contribution to household consumption.
Due to the above two reasons, especially because of the large overall scale of China's SOEs, the connection between the wealth effects of China's household and corporate sectors is relatively weak. As a result, although China's corporate savings as a share of GDP is not low, these savings are difficult for the household sector to use directly. Therefore, China's household sector itself still needs to accumulate a large scale of household savings. The large-scale corporate savings and household savings together make China's total savings abnormally high.China lacks market forces to regulate consumption and investment
For any economy, how much of national income should be turned into consumption and how much should be turned into investment should depend on the level of the investment return rate. In other words, how much consumption and investment should each account for as a share of GDP should be instructed by the price baton of the investment return rate. When the investment return rate is high, the economy should invest more and consume less; when the investment return rate is low, the economy should invest less and consume more. Only with such a market mechanism for regulation can the share of investment and consumption in the economy be kept at the optimal level on a sustained basis.
We all know that consumption is mainly done by the household sector and investment is mainly done by the corporate sector. In the primary distribution of national income, the share of wage income obtained by households and the share of capital returns obtained by enterprises in the economy are roughly constant and do not change much with changes in the rate of return on capital. Therefore, the regulatory effect of the rate of return on capital on consumption and investment can only be realized through secondary income distribution, especially through dividends from the corporate sector to the household sector in the secondary income distribution.
When the rate of return on investment is relatively high, the corporate sector should pay less dividends to the household sector, thus turning more of the income obtained by the corporate sector in the primary distribution into investment. Conversely, when the rate of return on investment is relatively low, the corporate sector should pay more dividends to the household sector, thus allowing more income to flow from the corporate sector to the household sector, thereby reducing the scale of investment and increasing the income and consumption of the household sector. It can be said that the market-based regulation of the rate of return on investment on the scale of consumption and investment is achieved precisely through changes in the scale of corporate dividends to households in line with changes in the rate of return on investment. Without this market regulation mechanism, the share of consumption and investment in the economy will deviate from the optimal level.
For the above market regulation mechanism to take effect, the prerequisite is that most of the corporate equity is held by the household sector, so that the household sector has a say in corporate dividend decisions and can demand that corporations pay dividends to them when corporate dividends are needed. In the previous discussion of China's high savings problem, we have actually made it clear that the disconnect between China's household and corporate sectors makes it difficult for this market regulation mechanism to play a role.
Data from China's flow of funds tables can prove this point. Over the past two decades or so, although the share of corporate profits in China's GDP has been fluctuating around 20%, the corporate dividends received by China's household sector (including dividends from SOEs and private enterprises) have never exceeded 0.5% of China's GDP, which is negligible. Therefore, although China is now over-invested and the rate of return on investment is low, and logically China should reduce investment and increase consumption, in reality, due to the lack of smooth dividend channels from the corporate sector to the household sector, the transfer of income from the corporate sector to the household sector is hindered, so the income obtained by the corporate sector in the primary distribution continues to be rigidly turned into corporate savings and investment on a large scale. As a result, China's investment scale, due to the lack of regulation by the rate of return on investment, has long been at an excessively high level. This is the main reason for the excess savings and excess investment in China.
Of course, micro-economic entities (even state-owned enterprises) more or less care about the level of their own rate of return on investment. When the rate of return on investment is low, the willingness of micro-enterprises to invest will still decrease somewhat. It's just that the corporate sector as a whole, due to the inability to effectively transfer its income to consumers through dividend channels, can only continue to hold most of its savings in its hands. The sluggish willingness of enterprises to invest, coupled with the difficulty of corporate savings to flow to the household sector, will lead to a tendency in the economy for the scale of investment to be smaller than the scale of savings, thus turning excess savings into insufficient domestic demand.The top, middle and bottom strategies for China's economy
Based on the above analysis, we can see that the key bottleneck in the operation of China's economy is that in the secondary distribution of income, the scale of income transfer between the corporate and household sectors is not sensitive to the rate of return on investment, resulting in a lack of market-based regulation mechanism for the distribution of income between the corporate and household sectors. This lack of market mechanism causes China's household income and consumption to account for an excessively low share of GDP, leading to long-term insufficient consumption. And insufficient consumption in turn evolves into insufficient domestic demand, thus making China's economic growth face long-term demand constraints.
Therefore, the bottleneck of China's economic growth lies on the demand side, not on the supply side. Focusing on the supply side and trying to find the cause and prescription for the current Chinese economy from the supply side (such as trying to use population aging to explain the slowdown in China's economic growth) is going in the wrong direction and can only lead to misunderstanding and misjudgment.
The total demand of the economy consists of three parts: consumption, investment and external demand (net exports). Among them, consumption and investment can be controlled by China itself, while external demand is mainly influenced by foreign countries. Starting from the logical starting point of China's insufficient consumption, China has three strategies to choose from: the "top strategy" is to truly promote consumption transformation through income distribution reforms that benefit the household sector; the "middle strategy" is to stabilize growth by stimulating investment when progress in income distribution reform is limited; and the "bottom strategy" is to stop stimulating investment (or even suppress investment) before substantial progress is made in income distribution reform.