Discussion of China's economy inevitably focuses on imbalance, the idea that the savings rate and investment are too high. Every policy wonk worth his salt is busy offering solutions to get China to consume more. However, while there are imbalances in the Chinese economy, the main cause is not what most people think. China's consumption as a proportion of GDP is not purposely repressed. Rather, it is a function of the way the country is urbanizing.
This misunderstanding partly explains the mystery of why instead of moderating, the imbalances have become even more extreme. Yes, China's consumption is lower than investment: The share of personal consumption in GDP has fallen, while personal savings rates have risen. This is bound to show up in the trade surplus, which is the difference between what a country produces and what it consumes.
But conventional wisdom follows this up by arguing that consumption is low primarily because both exchange rates and interest rates are held down. Critics then suggest that raising interest rates to provide savers with more income and appreciating the yuan to make imports cheaper would increase the share of consumption in GDP and in turn reduce the trade surplus. U.S. Treasury Secretary Tim Geithner repeated the exchange-rate trope during his most recent trip to Beijing last week.
What many critics don't appreciate is that for three decades China has been undergoing a major structural transformation from an agrarian to an industrial economy. Thirty years ago, China's population was 80% rural with agriculture accounting for more than one-third of GDP. Today the rural-urban population split is 50-50, while agriculture makes up less than 10% of GDP.
Workers have moved from less productive agriculture where labor's share of the value of production is almost 90%, to more capital-intensive industry where labor's share is only 50%. This transformation accounts for about 80 % of the decline in the share of household income in GDP over the past decade, equivalent to about six percentage points with repressed interest rates accounting for about 1.5 percentage points or about 20%, even as the absolute value of personal incomes has been increasing at an impressive 8% to 9% per year.
By itself, however, the decline in the share of household income to GDP does not fully explain the decline in the share of consumption. The other reason - although less significant - has been the surge in urban household savings rates. Many factors have been cited for contributing to this increase, including weak social programs, an aging population, saving for housing purchases. But the most important reason has been largely overlooked: domestic migration.
Savings rates of migrant workers are much higher than those of established residents, as much as twice as high in some cities. Without formal residency rights (called "hukou") that provide access to public services, migrants have more incentive to hoard for their rainy days, and hence less to consume. These migrants now account for around half of the labor force in many coastal cities, explaining their impact on the country's personal savings rate.
Overall, the structural transformation of China accounts for about 70% of the decline in consumption relative to GDP over the past decade, given its impact on the decline of household income coupled with the increase in urban savings rates. Financial repression and other factors are responsible to some extent, but only for the remaining 30%.
Macro imbalances may be becoming more extreme, yet on the whole this has been good news as workers shift to more productive activities. It's only in the eyes of the West that this is bad news since the steady decline in the consumption to GDP ratio is mirrored in the large trade deficits the U.S. runs against China.
This difference in perception affects Western policies designed to moderate China's trade imbalances. Most of the debate has focused on exchange and interest rates as it is easier to key in on headline-grabbing numbers instead of the complexities of a structural transformation. But with China projected to become 60% to 70% urban by 2020, the transformation can't be ignored. No matter what the changes in exchange and interest rates, China's consumption-to-GDP ratio is unlikely to turn sharply upward anytime soon.
If policy makers want to soften the impact of this structural change, they should stop recommending changes in the yuan or in the financial system and instead focus on the nuances of urbanization. The National Bureau of Statistics announced recently that China's urban population exceeded its rural one for the first time in history last year. Policy makers can't reverse urbanization, but they can accelerate it. If migrants had hukou or residence rights in the urban areas they worked in, they would automatically have the security to save less and consume more.
The alternative—appreciating the yuan to make its own exports less competitive—isn't attractive for China, and it wouldn't do much to reduce the U.S. trade deficit. Instead Western policy makers should help Beijing to better manage its internal migration to the cities. This could single-handedly turn China's trade account with the U.S. and Europe from surplus to deficit and thus remove a major thorn in relations.
This article was originally published in the Wall Street Journal.