Where can we find Chinese spending power?

Will China embark on a big stimulus package in the face of growth slowdown? This is the crucial question that our previous post touched on a month ago. As time went by and no real action was taken, that scenario became less and less likely.

So why wouldn’t the government launch a big stimulus, despite urgings from various experts and advisors? Why doesn’t the government try harder to prevent a Japan-style “balance sheet recession”? We found an interesting article by a famous blogger 慕峰 Mu Feng that might explain some of the thinking processes behind the government’s hesitation.

The core idea of Mu Feng is that China’s historical sequence of events is opposite from that of Japan. In fact, big stimuli were already tried many times, and the government sector was already heavily leveraged. Big public infrastructure works were already built. It was previously because of this, during the 2015-2016 period a plan was initiated to essentially transfer large amounts of public debt to the households, pushing housing prices to unsustainable levels and limiting household demand. So the room for further leverage today is quite limited.

What can be done now? At the end of the article, Mu Feng proposed a radical policy suggestion that may help unleash domestic demand, at the expense of local governments and the wealth of property-owning households. Spoiler alert: it won’t be pretty.

Mu Feng’s real identity is not known, but his writing is quite influential among policy circles. One of his previous long articles How to understand China's governance model and its real challenges today (translated by Ginger River Review) is what I consider a masterpiece in explaining a better framework to understand China’s challenges today.

The original title is 消费能力去哪里了 Where does spending power go? Our team has translated it in full for you.

Where does spending power go

By Mu Feng

A few days ago, Mr. Larry Fink, CEO of BlackRock, stated in an interview with Nikkei that there is a trend of funds shifting from the Chinese stock market to the Japanese stock market. According to the Nikkei, Mr. Fink stated that market expectations were originally high for China, which was in the process of changing its epidemic prevention and control measures and promoting economic recovery, but optimism was later overturned because domestic consumption in China has not recovered as expected. Therefore, overseas investors are expressing concerns about the slowdown of China's medium-to-long-term growth. Additionally, with Warren Buffett heavily investing in Japanese trading companies, a global investment frenzy in Japan has begun.

Does geopolitical security have an impact on capital flow? Does the Sino-US (G2) competition restrict the impact of US dollar investment on capital flow? Of course, they do. We have already discussed these two aspects in-depth before, so we will not elaborate on them in this article.

The issue that this article wants to discuss is: where does our consumption power go?

Chinese Mainland is different from any other country. As a latecomer, the Chinese Mainland economy has always relied on three aspects: exports, real estate, and services. Services are at the end and are where the first two trickle down two. So the key lies in export and real estate.

I. Changes and current situation of exports

Looking at exports, mainland China has similarities with advanced countries such as Japan, South Korea, and Germany that heavily rely on foreign trade, in that overseas demand determines the level of exports. This is a manifestation of globalization at the current stage, meaning that global product demand actually only comes from a few countries. In other words, the production capacity of foreign trade countries corresponds to global demand, not just domestic demand. The focus of global demand is on advanced countries because their economic status, established by their scientific, military, and corporate management capabilities, still makes them high-income countries. High income for the people means high spending power. The same daily products produced in mainland China may sell for 1 RMB on Pinduoduo, but may sell for 1 USD or 1 EUR on Amazon, and may sell for 0.5 or 0.8 USD on TEMU. Therefore, under this structure, overseas consumer spending power determines the income from foreign trade and the income of exporting enterprises. The reality is that although overseas pandemic control has already ended, due to the short-term impact of the Russia-Ukraine war and, more importantly, the restructuring of globalization, many productions have already relocated from mainland China. Saying "relocation" is not entirely correct. Specifically:

1. For the highly controversial technology industry in G2, there is not a relocation, but rather a restructuring by multinational technology companies. For example, semiconductor companies from Europe, America, Japan, South Korea, and Taiwan are beginning to relocate more semiconductor factories to the United States, Germany, and Japan. They originally planned to have more layouts in mainland China, but now they are unwilling to do so, which reduces the production capacity that originally could have been in mainland China. This is a problem of unrealized expectations, not an issue of relocation.

2. Domestic manufacturers also voluntarily relocate. This is real relocation, mainly to Southeast Asia in the early stages, and gradually expanding to other regions such as Mexico and Hungary, and possibly to other regions in the future. When it comes to the relocation of local enterprises, public opinion on the internet is very negative, linking this behavior to “润run". This is not in line with the facts. The two most important reasons for this active relocation are: (1) the comprehensive cost of overseas production may be lower; (2) it can avoid a series of import restrictions. The overseas cost of products depends on two major aspects: the local production cost and the tariffs of the export destination country. After the Lewis Turning Point was crossed in mainland China in 2014, coupled with the "price increase and destocking" assistance since 2016, the comprehensive cost of local production has increased significantly due to the substantial increase in local real estate prices. The profits of many low-priced products were already thin. At this time, if overseas countries learn from what mainland China did in the 1980s and establish industrial parks with various tax and fee reduction policies, and if the local labor quality is still acceptable and labor is cheap enough, then this part of the production will automatically relocate. Mainland China once ate the benefits of globalization in this way. Today, if you cannot control your costs well, naturally others will eat this benefit. This is quintessential globalization. On the other hand, due to the protection for domestic manufacturers by developed countries (especially the United States, including the European Union), a series of import conditions have been set in recent years, especially differentiated tariff measures. Therefore, placing the final part of production (or some earlier parts) in these tariff-preferred areas (such as Mexico and Portugal) will be more advantageous, so this kind of relocation has also become more common. From a global perspective, this is beneficial to the economic development of these countries and regions that were once forgotten by globalization. The author calls this "multilateral embedding under globalization reconstruction". Many old readers should already be familiar with this.

Both of these two trends are long-term. If mainland China does not make significant structural adjustments to its economy, these trends will last for at least ten years, which is a common view among overseas investors. Why ten years? Because it's hard to say how many years exactly, so let's say ten years for now.

So what will these trends bring? The growth rate of foreign trade in China's domestic market will slow down. Please note that we are only talking about China's domestic market, not Chinese enterprises. Because it is beneficial for Chinese mainland enterprises to go abroad and profit from overseas markets, just like in the past the European and American countries participated in globalization and division of labor, moving the back-end of the industrial chain to Asia, which made the cost lower. Although the number of local production jobs was greatly reduced, the profit of enterprises increased. So what does the slowdown of foreign trade of the domestic market mean? It means there is now a surplus of local production capacity that caters to overseas demand. What does surplus production capacity bring? It brings a decline in demand for production jobs, which means that layoffs will begin. This is the current situation we are facing.

What is the solution?

As for the government, they must "fight for national rights" and strive to address any factors that restrict exports by negotiating with relevant countries. This may be somewhat useful. However, in the context of globalization restructuring, the direction is clear - in the long run, external demand will decrease. In other words, even if we try our best to maintain our current level of exports, without substantial breakthroughs it is impossible to achieve the same growth rate as before. This is the impact on our expectations for foreign trade, and it’s not necessary to raise this issue as a matter of national sentiment. This is only a structural contradiction under globalization. We want to develop, and so do others. If we only follow others' paths and leave them no way out, we will eventually be blocked and have no way out as well. Foreign trade countries have all experienced this stage. Germany, Japan, and South Korea have all gone through this history. In the end, only by innovating and creating demand, and meeting differentiated demands can we move forward. If you still want to copy, then copy this history.

For enterprises, in order to survive, they have to rely on the market. Meeting differentiated demands are almost the only choice. Otherwise, [with the surplus in] China's current production capacity, any industry will soon be over-competitive. Differentiated demands are nothing more than two aspects: meeting consumers' more subtle demands or creating demands. A country's innovation ability is reflected in creating demands in the industry. For example, IBM and Silicon Valley entrepreneurs created the PC market, and Steve Jobs led the creation of the smartphone market. We currently have such enterprises emerging, such as DJI. However, there are still very few enterprises in mainland China that have the ability to create demand. If our next generation does not have their own interests from an early age, does not rely on personal interests for guidance and impulse, and only focuses on getting high scores and certificates from an early age, the economic and employment environment they will face will be worse than this generation. Because our generation can still benefit from the population dividend and the period when individual dividends could be obtained by relying on an economic scale [while the new generation cannot]. Therefore, even though some parents may think that "raising chicken babies" will at least have a good result, the final result is likely to be that everyone only has the worst result.

In light of all of the above, it is not difficult to imagine the spending power of employees working in the export sector.

II. Changes and current situation of real estate

The author has always believed that real estate 涨价去库存 destocking through housing price increase in 2015 was actually a bad choice. In 2015, in first-tier cities and at the latest in 2017, in second-tier cities, residential prices are still within a reasonable range. The so-called reasonableness refers to the rent-to-sale ratio, the income-to-house price ratio, and the rent-to-monthly payment ratio. These three indicators were all very reasonable at that time. It can be said that young people at that time were full of longing for the future. After “housing price increase and destocking”, the prices in first-tier cities were difficult to support even with “six wallets”. Half of the graduates from Peking University and Tsinghua University chose to leave Beijing during this period, not including those who went abroad to study. So what is the current situation of housing prices in mainland China? Nowadays, our media criticizes South Korea's "full rental" problem every day. The correct term should be the "Jeonse" system, which seems to be causing the collapse of the Korean economy. So let's compare which country has a more serious real estate problem. I will give a set of data on the current housing price-to-income ratio: Seoul, which our media thinks is going to collapse, has a housing price-to-income ratio of 14 times; Taipei is even higher, around 21 times. Now please pay attention: Shenzhen is 36.5 times, Shanghai is 35.2 times, Beijing is 29.4 times, Xiamen is 28.9 times, Hangzhou is 22.2 times, and Guangzhou is 20.3 times.

Over the past few years, the author has extensively quoted overseas data in their articles, with the aim of "borrowing foreign warnings for domestic use", for the purposes of early warning, for the government, for the internet platforms, or for the education industry. [redacted] In 2016, the author suggested that young people take the initiative to go to second-tier cities, believing that China, as a country with such a large scale, should not have only three or four first-tier cities, and many regions have development potential. However, after the price increase and inventory reduction, the ratio of housing prices to income in second-tier cities has rapidly become similar to that of first-tier cities, missing the best opportunity to "exchange space for time".

“Destocking through price increase” is a way to repair the financial sector at the expense of rapidly increasing household debt. So what has the financial sector (and its behind-the-scenes parts) been doing in these past few years after being repaired? In recent years, Richard Koo's book has been translated into Chinese, and it seems that every expert must mention "balance sheet recession" to satisfy the audience. Various suggestions for "preventing balance sheet recession" have emerged. However, the problem is that after the bubble economy in Japan burst, the household balance sheet was in a terrible state, and the government intervened to maintain stability. But the history of mainland China is that after the 2008 financial crisis, the government sector had already expanded excessively. It is precisely because of this excessive expansion that we hope to repair the financial sector by relying on destocking and housing price increase and shifting the burden to the household sector. That is to say, the order of events we have experienced is the opposite of Japan's. Now, experts still shout out that ordinary people have no money and the government needs to exert more effort. The problem is that the government has already exerted effort. Haven't you seen how much progress has been made in water, electricity, gas, highways, high-speed railways, and 5G network infrastructure? How else can they exert more effort? Build subways in all cities below the fourth-tier?

So, the real question today is that after the expansion of the government sector in 2008, a huge amount of physical infrastructure assets were formed, but the balance sheet did not look good. Therefore, in 2015, the price was increased to reduce real estate inventory and the residents were asked to repair it. The residents were also very supportive and all of their “six wallets” contributed, but of course, they have no ability [to be of help] now.

In the first two months of this year, China International Capital Corporation released a "China Wealth Report (2023)". [Redacted] This morning, I discussed this report with some (wealthy) friends. Some people think that the average wealth of only 23,000 yuan (~$3,000) per person for 1.3 billion people, who make up 92% of the total population, is not very true. However, from my understanding of the income situation in the third-tier cities and below in the central and western regions, this is quite true. Because elderly people and children without income are also included in the average. When traveling and on business trips to various places, I especially like to look at the "recruitment notice" posted on many walls, which is a good way to understand the actual income of the people. In many popular tourist cities in central and western China, many jobs still only pay around 1500-2000 yuan per month. And don't forget that our vast rural population does not have the same pension benefits as urban residents, but they are also part of the 1.4 billion Chinese people, and cannot be forgotten in statistics. The government has also publicly stated that there are 600 million people who earn only 1000 yuan per month. In the third-tier cities and below, so-called real estate "property" cannot be considered as any "asset" (you can say it in accounting terms, but that's not really correct). Would you invest in it? Look at the ratio of rent to sale, can it be rented out? Can it be sold? So, how is the real estate market price below the third-tier cities determined? When we first talked about real estate in 2016, we said that those areas are priced by developers, and have nothing to do with the people. Unlike the United States, where people are accustomed to mortgaging their property for cash to consume, Chinese people do not do this no matter what.

So now do you know why consumption is so painful? Because the balance sheets of most ordinary people have already expanded to the limit, and their disposable income is actually very low. If not for “destocking through price increase” and "six wallets," many young people who came to big cities through the college entrance examination from small places, as well as their parents and grandparents who still lived in small towns, would have enough income to dream about the future, and their consumption power could have greatly alleviated the current pain of reduced external demand. But the current situation is that their consumption power has already been greatly reduced, and it is impossible to replace the part of production capacity that satisfies the restricted foreign trade. Of course, this is also the reason why Pinduoduo can rise, and it is also the reason for the significant decline in the birth rate and the early arrival of the era of low fertility.

So where did consumption go? Consumption depends on disposable income. Why are our experts afraid to face this core problem? Why do real estate and financial experts still have hope for "Central Bank, love me again"? To put it bluntly, even if the Central Bank loves you ten times, how much can you increase the income-to-house price ratio, which is already the highest in the world, for the Chinese people?

III. How to Resolve Debt Problem

Currently, there are different opinions among local governments, experts, and the central government on how to resolve the debt problem. The local governments and many experts believe that the central government should issue special national bonds to take over the massive debt of local governments so that local governments can regain their vitality. I would like to comment on this viewpoint.

Firstly, how did local debt come about in the first place? Clearly, we have already destocked through the price increase. Theoretically, our financial sector should have been repaired well, so how come our local governments and financial institutions fell into such a big debt problem? Wasn’t the goal of the destocking idea based on professional opinions of the financial sector? Wasn’t it a way to pass on the baton of the future to local governments and financial institutions at the great expense of households? So what have they been doing in the past few years?

So what is the precondition of the central government taking over local debts? Let's go back to a fundamental question: why do humans need debts, and why do we need to fulfill them? Isn't it easier to just cancel the debt when we are in pain? We can then start anew without any debt, right? [Redacted.] The reason why debts must be fulfilled is because of moral constraints. If debts can be ignored without being cleared and various pressures are used instead, it will be just like debt conversion in the previous round, which solved the problems for local governments and financial institutions, but in reality, only encouraged even bigger problems in the future.

Someone said that if we don't intervene, there will be a liquidity crisis. This is not wrong. In this era, who doesn't know a few lines from Ben Bernanke's theory? [Redacted]

Honestly, the decision-makers [in the central government] may still not trust some local governments and financial institutions. The rapid formation of this massive debt problem is not in line with the original intention. There are moral issues, responsibility issues, and ultimately trust issues. As the saying goes, the solutions that experts can come up with are not impossible for decision-makers to think of. [Redacted] However, after going through all of this, aren't these same people still in charge? Will the baton still be passed down to them after all?

So what should we do? I think there are many other internal debates and struggles going on here that outsiders will not have information about. But I just want to point out that many experts’ hope today that a special national debt can solve all problems is not realistic. Reality is much more complex than imagination. The back and forth between the financial sector and the household balance sheets has already happened in the past. It was not something that you experts only considered after reading Richard Koo's book last year or this year. It was already used in the last round of crisis resolution. Our historical sequence is different from Japan's, please remember this.

IV. Possible Solutions

Here, I can only talk about the solutions I can think of, after all, there are too many people smarter than me. This solution is actually quite difficult, but it is definitely in line with the original intention [of policies]. Our current biggest problems include: first, both expected and actual external demand are declining and have long-term implications; second, we hope to rely more on domestic demand recovery (increase internal circulation efforts), but the reality is that the recovery is insufficient; third, whether it is from the perspective of residents or finance sector (including local governments), debt pressure has reached its limit; fourth, aging and declining birth rates are accelerating rapidly, and the number of new population will drop significantly.

To address the four fundamental issues mentioned above, the author believes that there is another way, which is to return to the original intention. In short, it is necessary to significantly increase the disposable income of residents with an insignificant increase in debt. This is difficult to achieve in other countries, but in socialist China, it is entirely feasible.