How to resolve the dilemma? We think that clear communication about goals and tools would help markets understand the Fed's commitment, which matters more than the size of initial purchases and should give officials the flexibility they need. By underscoring its resolve to achieve specified goals, the Fed could imply how long it will hold on to the assets it purchases. For example, downward revisions to the Fed's inflation forecasts for 2010 and 2011 would imply that policy will be more aggressive for longer to cut off any deflation tail risk. Equally, the maturity distribution of purchases should matter more than the initial size and pace of the program. Skewing purchases to the longer end of the yield curve could increase the bang for buck.
QE eases broad financial conditions. QE1 might provide guidance to estimate the impact of new large-scale asset purchases (LSAPs). Studies suggest that QE1 trimmed nominal Treasury yields by about 50bp, although the econometrics aren't robust enough to narrow a wide range of estimates. It's worth remembering that the decline in Treasury yields is far from the only channel through which QE1 worked; the easing in financial conditions more broadly was as important, and it may be more important today. Easing channels included boosting risky asset prices, depreciating the dollar, and promoting easier financial conditions abroad. It's no coincidence that equity and credit markets bottomed and the dollar peaked (on a broad, trade-weighted basis) just before the FOMC announced that it would buy Treasuries and scale up its purchases of mortgage-backed and agency securities at its meeting on March 18, 2009. Moreover, QE1 had a powerful impact on inflation expectations, judging by the 120bp increase in 5-year, 5-year forward inflation breakevens between March 2009 and April 2010. (Note that distant forward breakevens have risen by nearly 90bp from their August 2010 lows.)
QE removes duration. In addition, because LSAPs work by taking duration out of the market, the maturity distribution of purchases might be as important as the volume. We agree with Chairman Bernanke and Brian Sack, who heads the New York Fed's Markets Division, that LSAPs work through a "portfolio balance" effect. In Chairman Bernanke's words at his speech this summer in Jackson Hole, the "degree of accommodation delivered by the Federal Reserve's securities purchase program is determined primarily by the quantity and mix of the securities the central bank holds or is anticipated to hold at a point in time (the "stock view"), rather than by the current pace of new purchases (the "flow view")." In other words, "by purchasing long-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding long-term securities".
It follows that by lengthening the maturity of the securities the Fed holds in its portfolio, it can get more duration bang for every buck it buys. A recent study by Laurence Meyer and Antulio Bomfim of Macroeconomic Advisers shows that "nearly 60% of the Treasuries bought in the first round of asset purchases had a remaining life of six years or less". The authors translate that into a mean duration of about four years and show that, even if the Fed respects its self-imposed restriction that prohibits it from owning more than 35% of the outstanding amount of any individual Treasury security, the Desk could construct a portfolio with as much as eight years of duration. Moreover, as we noted earlier this month, this rule can be waived at any time and thus does not represent a significant barrier to concentrated purchases. Indeed, there are only about US$550 billion of Treasuries outstanding with a remaining maturity of greater than 10 years. So, if the Fed was to concentrate its buying in this sector, it could have a powerful impact on long-term yields.
Channels of monetary policy blocked or dysfunctional. The decline in long-term yields and easing in financial conditions should have a positive impact on credit-sensitive demands of the economy. However, it is difficult to quantify the economic stimulus that this will provide, because some traditional channels of monetary policy are blocked or dysfunctional. For example, the plunge in mortgage yields is having a smaller impact on refinancing activity than in the past. Tougher mortgage origination criteria - including ensuring that the loan is no more than 80% of the appraised value of the property, plus verification of the borrower's FICO score and income - have limited the number of eligible borrowers. Originators faced with ‘putbacks' from the GSEs (Fannie and Freddie) on prior loans are understandably skittish to extend credit to less-than-pristine borrowers. And the uncertainty around mortgage foreclosures and putbacks may further tighten the availability of mortgage credit.
What do policy rules say about size of stimulus needed? Traditional policy rules may provide some guidance for how much additional stimulus is needed, but with a wide range of error. New York Fed President Dudley suggests that US$500 billion of purchases would provide as much stimulus as a reduction in the federal funds rate of between half a point and three-quarters of a point. An estimated, traditional Taylor Rule prescribes that under the present circumstances - if policy rates could be negative - they should be -6% or even lower today. Combining these two models suggests that several trillion in asset purchases might be required to achieve the Fed's dual mandate. Given the blockages in monetary policy transmission channels, such estimates may have some validity, especially if policies to fix housing imbalances are unavailable. Yet, those estimates are obviously subject to substantial error.
Yields likely to drop further. The recent sell-off in Treasuries suggests that the market has scaled back its expectations for the size and scope of QE2. However, we believe that the actual start of the program will trigger further significant yield declines, especially if the Fed is as resolute as its prior rhetoric. Our conclusion seems to conflict with the notion that the likely size and scope of the Fed's plan are already ‘in the price'. But results from some simple regressions suggest that the Fed's extensive discussion of QE2 over the past two months, apart from its influence on the expected path of policy out two years, has had little direct impact on the level of 10-year nominal or real yields.
Uncertain and muted impact, but potential help from abroad. The economic impact of the change in financial conditions is highly uncertain; the fractures in the monetary policy transmission mechanism probably mean that QE won't yield much bang for buck. For example, Meyer and Bomfim at Macroeconomic Advisers in September estimated that a US$2 trillion asset purchase program might: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, they admit that these may be "high-end estimates" because they don't take into account the unique nature of the current credit environment and the potential blockage of some of the normal transmission channels. Thus, one could argue that several trillion in asset purchases is needed, as suggested by our prior analysis. We would add that uncertainty about the fate of expiring tax cuts - if it persists - may negate some of the impact of QE2.
Beyond its direct impact on the domestic economy, however, QE2 may indirectly promote faster US growth through a less-recognized, international channel: The Fed's actions are strengthening currencies abroad and forcing policymakers to choose whether to accept currency strength, adopt easier policies, or implement capital controls. Many central banks in both EM and DM economies (e.g., Australia, Canada, Korea) are accepting currency strength and/or choosing easier policies to resolve this ‘trilemma', or impossible trinity. As our colleagues Alan Taylor, Manoj Pradhan and Joachim Fels noted recently, "while the policy responses have been diverse, the net effect is a further loosening of the domestic monetary policy stance in many emerging market economies (except China), which should amplify the effects of the US monetary easing, and a depreciation of the US dollar that should support US exports and global rebalancing". At the same time, such pressures do risk fanning currency tensions or even triggering protectionist measures, which would be extremely negative for global markets and the global economy. That's all the more reason for the Fed to be clear about its goals this week.
Introduction and Overview
What are the megatrends that could define the Chinese economy through 2020, in terms of both growth trajectory and the structure of the economy? To what extent can we extrapolate China's economic success of the past three decades to the coming one? What are the potential pitfalls and risks down the road? How can investors best position themselves for the potentially profound transition and transformation of the economy?
We aim to address these issues in a series of reports under the umbrella Chinese Economy through 2020. In the first, we argued that China's economic growth rate potential is set to slow but should nevertheless average 8% per annum through 2020, with a profound structural evolution that leads to rising shares of consumption-GDP, service sector-GDP, and labor income-GDP (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
In the second installment (Chinese Economy through 2002 (Part 2): Labor Supply to Remain Abundant, October 10, 2010), we made the case that China will continue to benefit from a low demographic dependency ratio and abundant labor supply through 2020. The expected deceleration in the growth of the working-age population is unlikely to become a headwind to overall economic expansion in China.
This third report aims to assess how consumption will take off over the next decade as a driver of growth. We make the following key points:
1) The Chinese economy can prepare for a golden age for consumption over the next decade. While economic growth potential is set to decelerate, consumption will accelerate to take the baton from investment and exports as the power for headline growth, as both empirical evidence and theoretical analysis suggest that the Chinese economy is at an inflection point beyond which consumption is likely to outperform strongly over the next decade.
2) Our base case scenario is that China's total consumption will equal two-thirds that of the US level and account for about 12% of the world total by 2020. In terms of incremental consumption, China overtook the US in 2008 and will represent 20% of world consumption by 2020.
3) A Golden Age for consumption would feature two key aspects: a) the strong expansion of consumption; and b) a profound evolution in the structure of consumption. To realize the former would entail strong household income growth and/or a lower saving ratio. We identify eight drivers that would help usher in a golden age for consumption in China: 1) economic growth; 2) wage increase; 3) development of service industries; 4) public expenditure; 5) income redistribution; 6) aging population; 7) level of economic development and 8) urbanization. We group these eight drivers under three pillars that underpin a golden age for consumption in China: a) rising income; b) lower saving ratio; and c) consumption upgrade.
4) Large regional disparities make China special. To this end, we develop a framework to help understand the dynamic regional evolution of consumption.
5) We revisit the issue of ‘under-consumption' in China and reiterate our belief that China's private consumption is substantially underestimated.
China's Consumption Has ‘Underperformed'
China's economic achievements since the launch of economic reform in 1978 have been extraordinary. By 2009, nominal GDP had reached US$3,679 in 2009, or 16 times 1978's level of US$226, representing a real GDP CAGR of 9.5% across the period, outperforming not only the developed economies but also developing peers by a wide margin.
Investment and exports have been the primary drivers of China's strong growth, while consumption growth has underperformed: its share of GDP declined by nearly 14pp from 2000 to 2009.
In consequence, by 2009, China's consumption-GDP ratio was significantly below not only those of high-income countries (e.g., the US) and middle-income peers (e.g., Malaysia) but also those of low-income ones (e.g., India).
These comparisons have helped form a consensus among most China observers that there is serious under-consumption in China and that a substantial boost to consumption is required to ensure more sustainable and balanced growth. On this subject, some China observers have become much more concerned as they fear that this is not only an issue of rebalancing China's economy over the long run but also of economic stability in the short run. Some China bears even predict that the Chinese economy is about to implode, as the consumption-GDP ratio in China is simply so unusually high and thus fragile that economic growth could easily collapse in the face of a major shock.
While we share the consensus view that China's consumption is relatively weak, we dismiss the rather alarmist view that the Chinese economy is so seriously imbalanced as to pose a threat to economic stability in the short run. This is because we believe that China's official statistics substantially understate the true magnitude of consumption (especially the consumption of services) in China. We address this in China's Under-Consumption Overstated in this report (see Special Topic Two).
China's Consumption at an Inflection Point: Empirical Evidence
China's economy is at an inflection point beyond which we believe consumption is likely to outperform strongly over the next decade.
As argued the first installment of the Chinese Economy through 2020 series, the Chinese economy is at an inflection point similar to that of Japan in 1969 and of Korea in 1988. (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010). History suggests that, beyond this inflection point, the economic structure tends to undergo profound transformation, with the three key ratios of the economy - consumption-GDP, service sector-GDP, and labor income-GDP - rising rapidly.
For instance, Japan's consumption-GDP ratio increased from 60% in 1969 to 69% in 1979, and Korea's from 60% in 1988 to 65% in 1998, as consumption growth began to significantly outpace overall economic growth.
China's Consumption at an Inflection Point: Theory
In our view, a country is justified in accumulating physical capital and wealth at the early stage of development to pave the way for the transition towards the more consumption-driven growth. For a developing economy, saving is an essential and integral part of industrialization process. History has shown that the only way to industrialize an economy is to increase the capital-labor ratio so that poor farmers can be equipped with industrial machines and equipment to produce goods that have higher value than farming. To install that piece of machinery, you need to save and invest.
There are a number of theories that shed light on the development stages of a country, with the most popular ones including the ‘U curve' theory, Rostow's Stages of Growth, and Chenery's Division of Industrialization Stages.
•· The ‘U curve' is the most straightforward theory explaining the trajectory of economic transition, in which the investment intensity of the economy (or investment-GDP ratio) keeps rising during the early state of industrialization until an inflection point is reached, beyond which the consumption intensity of the economy (consumption-GDP ratio) starts to bottom out.
•· The Rostow's Stages of Growth is one of the major analytical frameworks that explain the pattern of economic development. It postulates that economic modernization occurs in five basic stages of varying length, featuring ‘traditional society', ‘preconditions for take-off', ‘take-off', ‘drive to maturity', and ‘age of high mass consumption'. Rostow asserts that countries go through each of these stages fairly linearly and describes a number of conditions that would likely occur to investment, consumption and social trends at each stage.
We unify the two theories -‘U curve' and ‘Rostow's Stages of Growth' - into one framework to help illustrate the potential consumption trends in China. According to Rostow's Stages of Growth theory, an economy's development divides into five stages. China appears to be passing Stage III of ‘take-off' and is poised to transition into the Stage IV of ‘drive to maturity'. The ‘drive to maturity' features a "rebalancing among sectors, great poverty reduction, improving living standard as the society no longer needs to sacrifice its comfort in to order to strengthen certain sectors". Fitting the Rostow's Stages of Growth into the ‘U curve' framework, the consumption intensity declines in the stages of ‘pre-conditions for take-off' and ‘take-off' but is set to rebound in the stage of "drive to maturity".
Size Up China's Consumption through 2020: Three Illustrative Scenarios
We construct three scenarios to help illustrate how consumption in China will likely evolve through 2020 relative to that of US and the world economies. These scenario analyses are based on the forecasts we laid out in the first installment of the Chinese Economy through 2020 series, which benchmark the footprints of the transition experiences of developed economies such as Japan and Korea (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
The key parameters under different scenarios are summarized below:
•· Base case (70% probability): We expect annual real GDP growth and CPI inflation at 8.0% and 3.5% per year in our base case. Meanwhile, benchmarking with the experiences of Japan and Korea during the take-off period of consumption, the increment of consumption intensity per year is set at 0.7pp per annum, which would bring consumption intensity to 56% by 2020 from 49% in 2009. The USD/CNY exchange rate is expected to reach 5.5 by 2020.
•· Alternative scenario I - current trends continue (20% probability): The Chinese economy continues ‘business as usual' with no material change from the previous decade - featuring strong growth (GDP: 9.5%Y), modest inflation (CPI: 2.5%Y), and no meaningful transformation of the economic structure (consumption intensity slides 0.5pp per annum to 44% in 2020). RMB exchange rate mechanism reform is slower than expected such that the USD/CNY rate reaches 6.0 by 2020.
•· Alternative scenario II - a Japanese-style adjustment (10% probability): A Japan-style transition featuring a drastic deceleration of growth (GDP 6.5%Y) and structural adjustment (consumption intensity improve 1.4pp per annum to 63% in 2020). Such a scenario could be catalyzed either by very proactive (perhaps draconian) policy intervention to artificially correct the structure of the economy or external shocks such as a complete meltdown in external demand and sustained surge in international commodities prices due to supply shocks. The pace of RMB FX reform accelerates under Alt II (RMB/USD at 5 by 2020).
US/World growth: In the aftermath of the global financial crisis, we assume that US trend growth is low, averaging 2.7% of real GDP growth and 1.6% of CPI inflation during 2010-20. This assumption is based on the IMF's latest World Economic Outlook for 2010-15 with a moving average of previous three years for 2016-20. Meanwhile, reflecting the need for US households to repair balance sheets by saving more, we assume that the consumption intensity in the US would decline by 0.5pp per annum. Finally, we assume the trend growth of world GDP of 4.5% with 2.9% of average CPI inflation during 2011-20 (the IMF forecasts during 2010-15 and the rolling average of previous three years for 2016-20), while the consumption intensity would stay unchanged at its current level.
The Results from Our Scenario Analyses
•· China's incremental consumption in US dollar terms overtook that of the US for the first time in 2008. While incremental consumption for the US was negative in 2009 as the result of the financial crisis, China still managed to maintain expansion, suggesting that it had replaced the US as a primary driver of global consumption growth. Going forward, we expect China's incremental consumption to dwarf that of the US thanks to faster headline GDP growth and rising consumption intensity as the underlying economic structure evolves. By 2020, we estimate that China's annual incremental consumption should be roughly double that of the US under our base case scenario.
•· Total consumption: In our base case scenario, China's consumption would reach two-thirds of the US's level by 2020 from about 9% in 2000 and 20% in 2010. Meanwhile, the contribution of China to world total consumption will rise to 12% by 2020 from 3% in 2000 and 5.4% in 2010, while the US contribution will decline to 18.3% by 2020 from 27% in 2010.
•· Additional colors from alternative scenarios: In terms of incremental consumption, China will reach 1.2 times of US and 12% of world total under Alternative Scenario I but 2.5 times of US and 24% of world total under Alternative Scenario II. In terms of total consumption, China will reach 49% of US and 9% of world total under Alternative Scenario I but 74% of US and 14% of world total under Alternative Scenario II.
•· Of particular note, we envisage that Alternative Scenario II would feature a ‘Japanese-style adjustment', namely despite a relatively sharp slowdown in headline GDP growth, consumption growth remained very robust, as the consumption-GDP ratio rose rapidly after the inflection point was crossed.
A Golden Age for Consumption: Three Pillars
China's consumption is at an inflection and we believe that it is about to enter a Golden Age for consumption, in our view. We come to this conclusion by drawing on the development experiences of Japan and Korea, which, we believe, are most relevant to gauging the long-run outlook for China. While the analyses under different scenarios help to quantify the potential size of aggregate consumption in China through 2020, they are mostly for illustration purposes. The key remaining question is how this Golden Age for consumption will materialize. More specifically, what are the potential drivers for consumption in practice?
A Golden Age for consumption would feature two key aspects: a) strong expansion of consumption; and b) profound evolution of consumption structure, in our view. To realize the former would entail strong household income growth and/or a lower saving ratio. We identify eight drivers that would help to usher in a Golden Age for consumption in China: 1) economic growth; 2) wage increase; 3) development of service industries; 4) public expenditure; 5) income redistribution; 6) aging population; 7) urbanization; and 8) level of economic development. We group these eight drivers under three pillars that underpin a golden age for consumption in China: a) rising income; b) lower saving ratio; and c) consumption upgrading.
Pillar I: Rising Income
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