Understanding China: Key trends under common prosperity
- “Common Prosperity” is a new ideology to safeguard long term stability with three emerging trends
- The use of monetary policy to propel credit fuelling property market boom no longer applies
- Return of export-led growth model
- Redistribution of wealth through tax reforms
Three emerging trends under common prosperity
“Common Prosperity” is a new ideology championed by Beijing as a guiding principle to navigate the country into the next stage. For certainty, it does not mean China will go back to the days of communism. Based on observations from a series of regulatory crackdowns lately, the authority aims at: (1) removing elements of moral hazards in policy design. For example, market participants and businesses focus narrowly on economic/earnings growth. The means of achieving them is not important because central bank always flushes market with liquidity to keep asset prices resilient. The mantra of “too big to fail” and “implicit state guarantee” is thus strongly embedded in investors’ mentality. (2) To prevent the rapid formation of a special elite class similar to US business magnates in the latter half of 19th century and post-Soviet business oligarchs from threatening the authority of the central government. (3) To achieve a more equitable society. The improvement of headline GINI coefficient is inadequate. It fell to a low of 0.462 in 2015 before rebounding to 0.465 last year. Disposable income ratio between the top and bottom 20% of the population remains as the highest amongst major economies. They are going to deep dive into socioeconomic domain to right the wrongs.
That paradigm shift is a big deal because it affects many vested interest groups. The challenges are daunting because it is much easier to wear down physical obstacles than game-changing mindsets. The future has become much uncertain ahead because there were no empirical precedents for guidance. However, there are three likely emergent trends:
Monetary policy is likely to focus on inflation targeting and general liquidity management. There are no actions taken even though M1 and M2 had been advancing in single digit, even slower than nominal GDP growth in the past 2 quarters. In fact, the authority stated M2 growth should be largely on par with the nominal growth GDP rate earlier this year. However, the gap between the nominal GDP growth and M2 growth was 11.8%ppts in 1Q, before declining to 5.0% ppts in 2Q. To compare, M2 was advancing faster than nominal GDP on average by 2.0% ppts in the decade before COVID. During the episode of RMB depreciation between 3Q15 and 4Q16, M2 was growing much faster than nominal GDP by 4.7% ppts. It is clearly that the importance of adhering to the execution of “three red lines” policy aimed squarely to lower the leverage of property developers carries more weight than general slowdown of the economy. Monetary policy should not be run contradicting to deleveraging goal. It will not be used as a tool to propel credit-driven growth going forward, which had partially resulted in total outstanding debt as a share of GDP reached historical high of 335.1% by end-2020 (the no. then slightly retreated to 328.9% in 2Q21). Mirroring this, over 40% of Chinese household assets are concentrated in the property market. Meanwhile, condominium prices in the affluent part of Shenzhen are now 57 times of average annual income.
Although deceleration of economic activities seen lately would normally call for steady rate/reserve requirement ratio cuts, the stance of PBOC has been restrained. The scale of liquidity injection to the financial systems to calm market down is not particularly large. The 1-Y Loan Prime Rate stayed unchanged in the past months compared to 30bps cut during the first 3 months of COVID outbreak in early-2020. Investors should not assume central bank will always loose the tap to rescue whichever under all circumstances. That is not to say they will do nothing but “contexts” matter seriously in decision making. Magnitude will likely be measured and gradual when actions are taken.
China will become more pro-trade
If credit fuelled property boom is not the strategy of driving growth anymore, China must be reliant on trade more than ever. It has proven in the past 4 decades trade drove economic growth endogenously, enriching the living standard of the Pearl River Delta or the Great Bay Area in present day. Beijing’s application to CPTPP is a testament of her commitment to trade. The 11 members of the CPTPP account for over 10% of world GDP, and it will be almost 30% with China. The requirements of CPTPP are more stringent than RCEP as the former has higher compliance standard in intellectual properties, labour rights, and source code sharing etc. That does not deter China’s aspiration to join. In fact, they did not make this decision hastily.
They had been constructively upgrading a bilateral trade agreement with New Zealand since the beginning of 2021, as New Zealand (one of the four founding members) is the depository for CPTPP. Likewise, foreign minister also visited Singapore in mid-September to seek accession support as Singapore will hold the chairmanship of CPTPP in 2022. Although dominant role of state-owned enterprises alongside strong presence of industrial policies run against the principles of CPTPP, there are always exemption clauses in large trade deal. That explains why economies with big state sector such as Vietnam and Mexico could become members. Nowadays, it is hard for participants to reap full scale of economic benefits should China is excluded from any big trade deal. This is also the reason why ASEAN invited China to join RCEP. In fact, China’s share of total trade with ASEAN already surpassed that of the EU and the US in 2020, at 14.7%. We expect the share will reach 22.1% in by 2030.
Wealth Redistribution by the Visible Hand
Reforms of taxation and welfare net are also forthcoming. The tax phenomenon of “light on capital and heavy on labour” will likely change gradually with a strong conviction this round. According to a study by Beijing Normal University, there are around 600 million people in China earning less than CNY1,000 per month, which accounted for 42.9% of total population. That explains why personal income tax only accounted for less than 10% of tax revenue. Also, the personal income tax system has progressive rates between 3% and 45%, much higher than 20% tax on capital gains on interest/dividend income. Authority will likely broaden tax base and reduce the progressive rate on personal income tax in a gradual manner.
As far as fiscal spending on welfare net is concerned, it accounted for 22% of total fiscal spending, much lower than OECD’s range between 30% to 45%. Such spending will have to increase to cope with ageing population. Given the complexity of the tax system, and the administrative challenges of broadening the tax base, pace of reform will likely be gradual. As a result, the concept of “Third distribution” or donations from enterprises in short, has now become a hot topic. According to China Charity Alliance data in 2019, total domestic and foreign donations amounted to CNY170 billion or around USD26 billion. Academics argue such amount is deemed small due to absence of inheritance tax in China.
Against such backdrops, businesses in general should budget potential tax increments, mandatory welfare expenditure pertaining to employees alongside more donations (especially large private enterprises) to the state.
The concept of Common Prosperity is a benevolent clause. To what extend economic growth will be hit given such a seemingly shock therapy approach is a common concern. The crux of the issue is comprehension of the new system dynamic. Some argue such interventionist approach would dampen economic growth and suppress innovation/entrepreneurship. Should China choose to ignore market failures, inequalities will consequentially breed social discontents hampering stability and hindering development. The seemingly interventionist path that Beijing has chosen undoubtedly renders some degree of resources misallocation. On the other hand, repeated exercises of quantitative easing by western central banks do not lead to better allocation of resources. It only further widened the income inequality gap.
There does not exist a perfect system. Ultimately, it is all about choosing compromises that minimise the development disruptions in the short term for the sake of reaching the utopia in the long haul.
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