China’s 12th Five-Year-Plan – Will It Help With the Global Trade Imbalance?

Amongst all the political upheaval in the Middle East and North Africa, with people rising against dictatorial regimes in Tunisia, Egypt, Libya, Yemen and elsewhere, this week China embarked on its annual legislative session.  The legislative session of the National People’s Congress, which officially enacts legislation, will rubber-stamp the government’s 12^th Five-Year-Plan (2011-2015), which was decided at the Communist Party meeting in October, 2010.

Details won’t be made public until the conclusion of the legislative session (which usually lasts 10-14 days), but some elements of China’s next five-year economic plan have been made public.  The three elements worth highlighting are a lower growth rate and a more balanced/sustainable economic model, meaningful reductions of pollution through better energy conservation, and a more aggressive fight against inflation.

A New Growth Model:

• Set a GDP growth target of 7% (down from the current actual GDP growth rate of 10%).  To do that, the government will have to divert money away from construction and corporate subsidies, and instead use public funds to increase household incomes.

• Cut import tariffs to reduce input-costs, while boosting consumer demand and reducing China’s reliance for growth on exports which generates trade surpluses and contributes to the global trade imbalance.

• Improve the income of farmers and migrant workers, who have benefited the least from China’s phenomenal economic growth, by increasing minimum wages.  In particular, provinces across China have announced a string of double-digit wage increases this year as part of the government desire to increase incomes among the rural regions and migrant workers in the cities.

• Increase spending on health-care and full nationwide social welfare insurance to reduce the need for “precautionary savings” and encourage more Chinese consumer spending.

• Raise the minimum threshold for personal income tax.  This could exempt hundreds of millions of people from having to pay taxes, and boost household spending.

New Energy Priorities:

• Introduce targets for energy efficiency and consumption that will push China’s energy consumption from non-fossil fuel sources to 12% by 2015.  Key sectors expected to benefit include: hydro and nuclear power, power grid technology.

• In particular, there will be significant growth in nuclear power (from 10 GW to 40 GW), 63 GW of new hydroelectric power, 48 GW of wind capacity and 5 GW of solar power.  Unfortunately, coal generation will continue to provide 260 GW, although its share of China’s energy mix is expected to fall from 72% to 63%.

• Double the share of natural gas in Chinese energy consumption to 8% by 2015, up from 4% that it was last year.  This will make China a natural buyer of large quantities of Russian gas, and an inevitable competitor to Europe, which already relies heavily on gas from Russia.

• Introduce taxes of up to $820 (up from just $100) on vehicles with larger than 2 liters (energy inefficient) engines.

• Introduce a tax linked to carbon emissions, first via pilot programs in special regions and industries.

Fighting Inflation:

• The most important short-term priority for the government is to address increases in food price, which Beijing intends to do through price controls.

• In order to control inflation, the government intends to keep using the tools and methods that it has been employing thus far: manage liquidity, use price controls, curb real-estate speculation, and “adjust and improve” property tax policies.  Furthermore, the budget for this year shows a 35% increase in spending on low-income housing.

• However, no specific lending targets for banks have been outlined by the government yet.  New loans topped a 7.5 trillion RMB ($1.1 trillion) ceiling last year and excessive bank lending is considered by some to be a contributing factor to China’s inflation.

Analyst are already predicting that this Five-Year-Plan will be the most significant in China’s modern history, marking the moment that China finally decided to abandon its fast export-led growth strategy in favor for a more sustainable growth model.  However, this new effort by China to rebalance its economy in not addressing the root cause of its monetary problem (inflation), and will not facilitate the rebalancing of global trade, which has been so critical to the overall world recovery.

The root cause of China’s inflation is its weak-currency policy, which is feeding an artificially large trade surplus.  This policy hurts both China by producing an overheated, inflation-prone economy, and the rest of the world by increasing unemployment in many other countries.

Theoretically, inflation is the market’s way of undoing currency manipulation.  According to Paul Krugman, China has been using a weak currency to keep its wages and prices low in dollar terms; market forces have responded by pushing those wages and prices up, eroding that artificial competitive advantage.

China’s leaders are trying to prevent this outcome, to protect exporters’ interest, and because inflation is even more unpopular in China than it is elsewhere.  Don’t forget that it was inflation that fueled public discontent with the government, bore the 1989 protests in Tiananmen Square.

China is already hurting its citizens through financial controls.  For example, interest rates on bank deposits are limited to just 2.75 percent, which is below the official inflation rate of 4.9%.  Rapidly rising prices, even if matched by wage increases, are making the situation much worse for Chinese consumers.

Unfortunately, Beijing is not willing to deal with the root cause and let the RMB rise.  Instead, they are trying to control inflation by raising interest rates and restricting credit.  This is destructive for China, because credit limits are proving hard to enforce and are being further undermined by inflows of hot money from abroad.  With efforts to cool the economy falling short, China has been trying to limit inflation with price controls, which also rarely work.

Furthermore, this is destructive from a global point of view as well: with much of the world economy still depressed, the last thing the world needs is major players pursuing tight-money policies.  The solution to China’s monetary problem (and to the global recovery) is to let the currency rise!

But, any rebalancing efforts will face serious opposition from special interests domestically, primarily the State Owned Enterprises and regional and local officials.  The SOE’s benefit from lax environmental regulations, cheep energy and government subsidies, and an overall export led growth strategy.  On the other hand, local officials are not always willing to change, have old ideas about growth and tend to favor pet projects that need massive investments.  Couple that with China’s one-party state that refuses to do anything that looks like giving in to U.S. demands, and you have a recipe for certain continuation of the status-quo.

The focus of the new Five-Year-Plan is promising, but its success is questionable.