Economist's latest survey of the Chinese economy probes the art of policymaking and suggests more efforts needs to be made to adjust interest and exchange rates, increase household incomes and bump up consumer spending to ensure that reforms are to continue along a smooth track.

Stephen Green

If Nicholas Lardy did not exist, one would feel the need to invent him. Every few years, the Peterson Institute-based economist publishes a comprehensive status report on China's economy.

In China's Unfinished Economic Revolution (1998), Lardy focused on the need for state enterprise reform and the parlous state of the country's banking system. Integrating China Into the Global Economy (2002) dug into impact of WTO membership and enterprise reform. In his latest book, Sustaining China's Economic Growth After the Global Financial Crisis (2011), Lardy turns to the urgent need for "rebalancing" the economy and boosting household consumption.

Although this new book has things to say about everything from high-speed rail construction (generally a good thing, despite the corruption mess) to electricity price reform (stalled, a bad thing), all roads in Lardy's text lead to the issue of how to rebalance China's off-kilter economy.

His answer is to raise household incomes and encourage consumer spending, mostly by getting two essential prices right: interest rates and the exchange rate. The book can also be read as an assessment of the Wen Jiabao government as it enters its last year.

China has a number of interrelated imbalances: an over-dependence on exports, fixed asset investment, and industrial production; and insufficient household income, consumption, services jobs and social security.

The worst imbalance is the fall in household disposable income by some 10 basis points during the 2000s from the eight prior years (as Chart 1 shows). Half of this decline resulted from the drop in the share of total national income going into wages. The other half came from the fall in net interest on household savings and government transfers.

In turn, the decline in household disposable income explains three-quarters of the drop in consumption's share of GDP. Lardy attributes the other quarter to the rising household savings rate.

From this diagnosis, Lardy turns to the question of what can be done to boost household incomes.

Fiscal reform would help in rebalancing, but it is not where the main policy action is.

Room to adjust the tax system is limited, Lardy argues. Only 7.7 percent of wage earners paid personal income tax in 2011 after the lower threshold was raised (yet again) to 3,500 yuan (US$556) a month in 2011 - equivalent to US$6,700 a year.

The corporate tax rate of 25 percent is already quite low. The business tax, levied on revenues rather than profits in the services sector, is now starting to be transformed into a more rational value-added tax.

This is all correct, but we would raise a few additional points.

One of the reasons why personal income tax accounted for only 7 percent of all taxes in 2011 is endemic tax evasion. No one seems to declare rental income, for instance, or declare the real value of a property at the time of sale.

Moreover, there are no capital gains or inheritance taxes - common mechanisms elsewhere to ensure the super-wealthy pay their fair share. All of this means a low marginal tax rate for low- and high-income groups, with a much higher rate for the middle class. This needs solving.

A better place to look for policy adjustments, Lardy argues, is in the social security payments that firms and employees are required to make. If these are fully paid, the cost is equivalent to some 42 percent of the wage bill - a heavy burden.

An alternative way to finance work-related pensions and other social benefits would be with the profits of firms that are, in name at least, owned by "the people."

But the government has so far categorically failed to make large state-owned enterprises contribute any of their profits to the general budget. Current "dividend" payments by about 1,600 of an estimated 6,000 state firms are small and just ploughed back into loss-making parts of the state sector.

Social security spending is going up, but slowly.

Total social spending rose from 5 percent of GDP in 2003 to 6.6 percent in 2010, according to official figures (as Chart 2 shows). Broad rural and urban health insurance systems have been rolled out and gradually funded.

Monthly pension payments to retired urban workers have risen from an average 963 yuan in 2007 to 1,540 yuan, outpacing inflation.

This may be a good thing, but it's a mystery why retired urban workers - who usually have their own housing - are entitled to such largesse while migrant workers are still hardly touched by the social security system.

More can be done, but it will require both money and reforms. For instance, the government's long-standing goal has been to raise public education spending to 4 percent of GDP.

In 2011, such spending likely stayed at 3 percent. This potentially massive spending boost should be accompanied either by extending the current nine years of free, compulsory education to secondary school, or by the opening of schools to the non-resident children of migrant workers. Unfortunately, neither is on the cards.

Domestic price adjustment doesn't really help so far.

Some analysts point to adjustments in China's wages and other input prices as evidence that rebalancing is already happening. Exports will slow and household incomes will rise without big-bang reforms, they argue.

Lardy does not buy this argument. He rightly points out that China's manufacturing wages appear to be rising at about the same pace as labor productivity, some 10 percent a year from 2000 to 2010. Unit labor costs in other emerging markets also have remained unchanged, so there has been no real change in China's comparative advantage.

Getting interest and exchange rates right is key to rebalancing.

Interest rates. From 2004 to 2010, the average one-year bank deposit rate dropped to a negative 0.3 percent in real terms from 3 percent from 1997 to 2003. Low real deposit rates squeezed household incomes, encouraged higher household savings and led to over-investment in real estate. Housing has partially replaced deposits as the predominant asset class of China's urban middle class, Lardy argues.

The exchange rate. During 2004-2010, the yuan exchange rate was at least 20 to 25 percent undervalued, Lardy estimates. The cheap exchange rate led to capital being thrown at the tradables sector (and away from domestic services), and low interest rates magnified the trend.

On the real estate front, with the large overhang of empty properties, housing price deflation could have a long-term negative impact on both investment and household spending. Lardy steers clear of calling the sector a bubble, but he does see housing as a key short-term risk to the economy.

So what is stopping the great rebalancing? Lardy's main answer: Discrepancy in policies at government levels.

Opposition to yuan appreciation has likely come from the Ministry of Commerce, the National Development and Reform Commission and various industry associations, he claims.

State-owned firms are believed to be lobbying against losing control of unparalleled wealth (generated with cheap credit). Cutting through this morass of special interests is not easy, but the success of an efficient government will depend upon it.