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Alternative Blog Arrangements

November 24, 2010

Dear readers:

Good evening from Hong Kong. Our blog has been inaccessible from the mainland for about three weeks, and we are in the process of creating a new one. We hope to send out a link to a new site soon, along with some updates about how to understand the latest bout of inflation in the context of long delayed relative price adjustments, the re-planning of the socialist market economy and other big themes for the next year.

More to follow.


Putting October PMI into Context

November 2, 2010

The big news so far this week – the increase of China’s purchasing managers’ index (PMI) to 54.7 from 53.6 – may not be quite as big as many are making it out to be. It is, to be sure, an important indicator of future economic activity, but one that needs to be taken in context. Putting this number into the bigger picture – one that includes expectations for inflation and interest rates – the Chinese economy looks softer than this uptick would suggest. It is also important to keep in mind that China’s PMI is based on a sample of firms (fewer than 800 and generally large ones) that is relatively small for an economy as large and diverse as China’s. Looking back at historical leads and lags, PMI thus looks to be a better predictor of things to come when broader underlying trends are strengthening than it is as things slow down.


The knee-jerk reaction of many that have commented on this indicator has been to predict additional interest rate increases by the People’s Bank of China (PBOC) during the coming quarter. We believe that such a move by China’s central bank is possible, but not because the producer side of the economy is on the verge of overheating: if anything supply side inflation data suggests moderation is underway. The PBOC, like other regulators are intent on getting back to a policy course that can be considered more ‘normal’, despite the increasing abnormality of external monetary conditions. That means restoring real interest rates to a course more consistent with this historical band around 3% or so, most importantly as a means of better balancing incentives for investment as China prepares to embark on a new 5-Year Plan that will certainly be investment heavy. With respect to the resistance of asset prices to ‘macro controls’, stronger administrative measures, rather than a punitive cycle of interest rate increases are far more important.


Additional forward looking indicators signal a sustained slowdown to China’s economy, one that we expect accelerate during the coming months. Although the economy was stronger than expected through the third quarter of 2010, it is widely expected that the cumulative effect of controls on money and credit growth, as well as a moderation to inventory driven growth in the US, will be a Q4 growth number of around 9%.

We have consistently noted the decline in the cumulative number of new projects starts by enterprises in China during the first three quarters of the year, and more recent reports indicate a similar slowdown in the real estate sector. Relatively, and somewhat unexpectedly, strong external demand thus seems to contrast with gently sloping slowdown to broad measures of economic activity connoted in the chart above. The pace of this moderation clearly decelerated during the August-September period, but in this broader context the most recent PMI figure does not seem to warrant a reversal of expectations.

One illustration as to why we think the utility of monthly PMI figures declines during the tail end of the economic cycle in China is that it is out of step with fundamental indicators such as electricity production. Growth to monthly electricity output, seen on both a year-on-year (Y/Y) or month-on-month (M/M) basis slowed at the same time that headline PMI has rose. This indicator measures the economy in general, whereas PMI is limited by the shallowness of its sample.


We are expecting the moderation to growth mentioned above to extend into the first quarter of 2011, with industrial activity rebounding with potential vigor starting in 2Q 2011 once new industrial policies and bank lending quotas kick in. As noted in earlier posts, pending industrial policies in China may amount to massive stimulus in the coming years to the extent that plans may have to be scaled back if the economic response to the 12th Five-Year Plan is too enthusiastic. If this is the case it will surely be evident in PMI numbers, but until these policies kick in we are trying to take a broader view of where regulators would likely to tighten things up ahead of efforts at structural changes to the economy.

Planning for a New Industrial World Order

October 27, 2010

 China has recently released the outlines of the most coherent blueprint for state capitalism in recent memory. Presently, there is a general awareness in much of the west about the ideological differences between state capitalism and more market-based systems. In the future, however, foreign governments and capital goods producers alike may be in for a rude awakening when they eventually confront more direct competition from Chinese firms.


Additionally, the release of the proposed “Strategic Emerging Industries Development Plan” (SEIDP) component of the 12th Five-Year Plan (FYP) comes at a time when leaders in advanced economies are looking to expand exports of capital goods to high-growth markets like China, all at the same time. For its part the Chinese government appears intent to reduce its trade surplus to a “sustainable level”, and this will probably include government-supported trade missions to the US and struggling European countries, and possibly even a quantitative target.  Nevertheless, the next generation of Chinese exports is intended to come from “a large group of internationally influential firms” that will meet mature foreign competitors in global markets with cheap export financing and China’s brand of commercial diplomacy behind them.


Initial reports cite “more than RMB 4 trillion” as the amount of fiscal support that the central government is prepared to provide for the SEIDP during the next five-years. Based on the recent experience of the combined financial crisis response by central and provincial-level authorities, it is easy to imagine that once fiscal supports for industrial plans at all levels of government are tallied this figure could easily exceed RMB 10 trillion during the next FYP.  If this is the case, the RMB 2 trillion per year of investment and related spending could contribute up 1.5 percentage points to annual GDP growth. At its core, the SEIDP is intended to guide an economic transition in China towards a more sustainable and domestically driven growth model. Previous attempts have been unsuccessful, partly because a lack of decisiveness and cohesion among the agencies of government involved. This time around, the fiscal resources behind the rhetoric of the SEIDP signal a high level of commitment to what is being taken as an urgent task.


We stop short of identifying the SEIDP as part of the so-called “Beijing consensus”, mostly because this approach to policy making is more utilitarian than normative. At the heart of it, however, and to borrow Ian Bremmer’s definition of state capitalism, is the use of the power of markets for political gain. That is not to imply that China’s leaders are inattentive to social needs, and in fact the opposite is true. Nevertheless, the framework for the SEIDP confirms that the circular relationship between the control of economic resources, socio-economic development, and the preservation of the existing political order will continue through at least 2020.


Historically, government efforts to mobilize resources in support of output growth targets in China have been highly successful. This success has, however, come at a high price:  a highly skewed distribution of national income and excess industrial capacity. With this in mind it is noteworthy that ahead of the SEIDP the State Council is leading another round of forced industrial consolidations in areas where overinvestment threatens “healthy development”, including the automotive, steel and cement sectors. Previous attempts have achieved mixed results. Looking ahead to the SEIDP, central government regulators are poised to make best efforts at preventing overly ambitious and redundant provincial-level economic plans from blowing out the economies of scale that they hope to achieve. They will also be looking to prevent a recurrence of domestic imbalances that have turned economic achievements into social risks.


As noted below, in 2020 economic planners would like to see 15% of China’s GDP come from the pillar industries included in the SEIDP. This figure does not, however, include mention of likely output multipliers that will take place as supportive firms and sectors grow up around planned industrial clusters. The authors of the Plan seem to have this in when they call for the development of a vibrant SME sector to complement the large-scale multinational firms they would like to cultivate, but do not cite a figure for the total proportion of output and employment that may directly and indirectly depend on government guidance.


We would be remiss if we did not mention the topic of innovation: the term appears more than 30 times in the State Council resolution. The push for ‘indigenous innovation’ has received a lot of attention in recent years, partly for the methods behind it and partly for its relative lack of success. As mention in ‘Industrial Policy in China and the 12th Five-Year Plan (2011-2015)‘, the central government hopes to promote an ‘experimental economy’, where research and risk taking ultimately result in new technologies that can be commercialized. Still, the general approach seems to be that if adequate levels of investment are achieved that inevitably some innovation has to occur. China does not lack human resources and engineering talent, but the systemic balance of incentives still appears to be working against government goals. Potentially worrying for foreign firms on this topic is the call in the State Council resolution to “strengthen abilities to attract practices and technologies from abroad, digest them, and re-innovate…”


Limiting Old Risks along a New Course


The concept that President Hu Jintao has reportedly pushed for inclusion in the 12th Five-Year Plan is “inclusive growth”, referring to the need to counter the imbalances of China’s growth model of the past decade. Much of the first 30-years of economic reform in China were driven by the geographic strategy to allow some regions of the country “to get rich first”. The initial hope was that the gains from rapid growth would eventually trickle down the economic ladder socio-economically as well as geographically. What recent years of industrial development in China have shown is that concentrations of resources on both a geographic and sector basis can be self-reinforcing.  The big get bigger, and the rich get richer. This is a common system of state-led industrial plans, and also one that that will be difficult to reverse in China, especially when the SEIDP itself calls for concentrations of output.


Our recent research on the extent of inter-regional convergence in China has shown that regional development initiatives and a shift from a geographic to an industry-focused system of preferences have begun to reverse years of widening disparities. At the same time, however, imbalances related to the distribution of national income have intensified: the proportion of national income accruing to households has fallen and the inequitable distribution of household income has worsened. Where industrial firms are concerned, a range of indicators make clear that the size and market share of those firms owned by or closely associated with government in China have increased at the expense of greater room for private entrepreneurial activity.


As is clear from the translated passages of the State Council’s statement on the SEIDP below, an operative principle for the next round of China’s industrial development is that ‘government leads, and enterprises follow’. Given the tendency for rent seeking and the concentration of economic resources around administrative monopolies in China, questions remain as to how well the central government will be able to prevent the recurrence of the imbalances that it wants to grow out of. It is not a popular position to take in Beijing these days, but bolder academic commentators have begun warning about the need for stronger countermeasures to prevent the SEIDP from acting as an overly powerful magnet for  resources.


Competition under the SEIDP


Domestic media reports are using some interestingly vague phraseology to describe the future relationship between government and markets under the 12th Five-Year Plan.  The term most often occurring is 少操心, which literally means to worry less about something. This can be read two ways: it could imply that the government will leave the market outcomes to the results of open competition; it could also imply that economic planners take demand as a given and are confident that a crop of chosen producers will rise to meet it. We expect that the arrangements outlined in the SEIDP tend towards the latter option, and managed competition will prevail.


This issue harkens back to the debate that occurred around the time of the passage of China’s anti-monopoly law regarding the exclusion of large segments of the economy, including the power generation and transmission and telecommunications sectors, for example, from its reach. The rationale for doing so was rooted in national economic security, and it is unclear to what extent the same exalted status will be granted to these strategic emerging sectors. A potential worst case outcome for some domestic and foreign firms in China would be a tacit quota system for the allowable market share ceded to firms outside of the SEIDP’s guidance.  These are, of course, industries where economies of scale are essential and entry barriers are high, but for a continental economy with four times the population of the US, attempting to restrict industrial development to a handful of industry clusters would seem to limit inevitably the role of competition in market outcomes.  The State Council resolution on the SEIDP specifically cites the size of China’s domestic market as a “great advantage”, and this is one that regulators will hesitate to cede too much of to mature foreign competitors.



It is important to note, however, that the kind of organizational arrangements described above – what we call “upstream monopolies and downstream markets” – can also lead to hypercompetition. For example, China has forced several consolidations of the airline industry, and has effectively banned the formation of new regional and private airlines. At the same time, however, the remaining state-owned carriers continue to compete bitterly on price and service, to the extent that regulators have to step in from time to time to limit fare discounting practices that they know will eventually necessitate government recapitalizations. Consumers benefit from cheap fares, and competing firms battle with each other knowing, or expecting anyway, that when they need government support it will be forthcoming.


To what extent this logic will be evident in strategic industrial sectors once they are up and running remains to be seen, but this kind of competition is already evident in a number of pillar industries that the government has ring-fenced from ordinary regulation. Such an approach is by no means unique to China, but its absolute size and ability to coordinate institutional arrangements spanning, policy, geography, finance and market design could impact the global industrial order far more deeply than ascendant Japan and Korea did in the past, or Brazil and India may in the future.


So what will it mean to “worry less about markets” in the context of the SEIDP? At this point all that is clear is that the government is intent on preventing excessive competition. What remains unknown is the extent to which various levels of government will protect their investments in new industries. For outside participants, domestic and foreign alike, this could mean reduced market access.


It would be easy for some to identify an industrial blueprint like the SEIDP as a blow to globalization, but from China’s perspective its goals for domestic industrial development are, first and foremost, an element of national economic security. This perspective contrasts strongly with the view from more market based systems, where over time corporations have redistributed production and supply chains to reflect shifting geographic realities, and the term “market access” has something of a moral ring to it. Chinese firms in these sectors are, on the other hand, just “emerging”, and the use of this term may put corresponding industrial policies in the category of issues to be treated in a manner consistent with China as a developing country, rather than as an industrial power. If this is the case, the Chinese government will address potential disagreements with foreign firms and governments over the SEIDP in a far different way than it would efforts to reform the international financial architecture, for example. This could well be a manifestation of what we call “face changing diplomacy”: sometimes you meet strong China, sometimes you meet weak China, and who you meet determines the dimensions of the box for negotiations.


It is by no means guaranteed that China’s growth model will be as successful in the coming thirty-years as it has been in the past thirty. Assuming that the SEIDP is, however, the clash between China’s brand of state capitalism and the operative principles of more market based economies could fundamentally alter the role and relevance of the current set of multilateral institutions that have thus far helped to mitigate systemic frictions.













The G20 Communiqué, QE and Currency Conundrums

October 25, 2010

Regardless of the domestic intentions of quantitative easing (QE) in the US and UK, the result on the external side of the equation has to be a weakening of the relative value of their respective currencies. This reality, along with expectations that during the first week of November the US Federal Reserve will begin a new round of QE (and that the UK will implement its own plan the day after the Fed plan kicks in), would seem to make the G20 communiqué irresolute at best.  If anything, the next round of QE will only increase incentives for ‘currency wars’ via intervention, however conventional such actions may be.

Be that as it may, where it comes to the global rebalancing of demand that needs to take place, RMB rates relative to the euro and currencies in Asia may be more important than the much publicized level and trend of the USD-RMB pairing.

As we have written elsewhere, when China effectively re-pegged the RMB to the US dollar in 2008, this was a message to trading partners in Asia that the US dollar was “their currency, and mostly your problem”. We use the term ‘mostly’, because the value of China’s US dollar assets has obviously suffered as the US dollar index has fallen. Where it comes to export competitiveness, however, China, as the region’s strongest economy, allowed itself a US dollar-led devaluation. Additionally, with a closed capital account, China is also able to deflect a large proportion of so-called hot money flows that inevitably accompany ultra-loose monetary policy in the US and lesser liquidity centers to more open regional economies. If China had more developed capital markets and was able to absorb a proportion of such funds befitting the world’s second largest economy, the impact on asset prices and currencies around the region would arguably be smaller. China does not get a free pass, however, as the RMB regime means that domestic liquidity still increases in response to monetary easing by the US Fed. China has allowed some limited appreciation of its currency in recent weeks, but this token gesture does little to alter inter-regional demand and monetary relationships.

Taken together, the effects of a relatively cheap RMB and a closed capital account mean that China is passing on a proportion of the costs associated with a global rebalancing of demand onto other regional and large producer economies. This, along with the fact that as the upstream supplier of excess global liquidity the US is returning to a policy mix similar to “our currency, your problem”, implies that currency and trade related tensions may be little altered by the G20 communiqué. For all of its external financial strength and its rank as the world’s second largest economy China has yet to enunciate much of any vision for a reordered and rebalanced global economy.  For all of its external financial weakness and rank as the world’s largest economy, neither has the US.  The current menu of options include only preventing one interpretation of the mistakes of the past (i.e. The Plaza Accord) or eventually inflating away the excesses of the most recent decade (i.e. QE).

Some have suggested that a short-term dollar rally may soon be upon us, as rising uncertainty lowers the attractiveness of emerging market currencies and assets in favor of ‘safe haven’ assets such as the yen and the dollar. As resistance to structural changes increases globally, the meaning of ‘safe’ has to change as well. If QE causes an adequate amount of backlash, which it well could, the safest thing about the US dollar might becomes its role as a funding currency for carry trades long Asia. As we have said before, inadequate or otherwise faulty assumptions were key contributors to the recent financial crisis, and similar failures of imagination could lead certain bilateral trade and financial relationships into ever more dangerous circumstances.

Don’t Be Afraid of September Inflation Data

October 21, 2010

The growth and inflation data released today shows that the PBOC was targeting asset prices, not consumer prices with its interest rate increase yesterday. With that in mind the data released today makes the PBOC’s warning shot to investors in residential real estate look a bit timid.

If controlling domestic inflation was a big worry, then the central bank should have raised rates in March and not have waited until October to do so. Remarks from PBOC monetary committee member Li Daokui published by Xinhua, that “worries about soaring prices overwhelmed fears about economic growth”, appear to be simply out of step with the trends evident in the data. That is unless Mr. Li knows more than he is saying and is available to pedestrian economic analysts, and he almost certainly does (we hope).

This is the essential question: if growth is slowing down and controls on the growth to money and credit remain in place, why worry about inflation, or rising inflationary expectations?

The data released today by the NBS puts Q3 GDP growth at 9.6% y/y, slightly higher than expected, but consistent with the moderating trend and with policy intentions. The corresponding growth rate for the first 9-months of the year came in at 10.6%. China’s consumer price index (CPI) was up by 2.9% y/y for the third-quarter, with the corresponding rate for September up by 3.6% y/y.

If we were to look at the charts below outside of the context of the interest rate increase by the PBOC yesterday, it would look like an economy that is yes, running hot, but is past its cyclical peak. The slowdown to growth is the product of credit controls and administrative tightening measures that will remain in place, and the economy appears to be gliding towards a soft-landing. So what is all of the fuss about inflation? Asset price inflation and inflation in the real economy are different animals, and the former does not appear to be driving the latter based on the most recent data.

At the risk of sounding redundant there has been a lot of misguided alarm about inflation. If the economy is slowing down, inflation will probably peak soon, and non-food inflation already has. Expectations for the future are more important than the recent past, and if households are expecting a slowdown to growth (e.g. wage growth) and potential regulatory actions that will dent property prices, these expectations are probably pretty well anchored.

Non-food inflation has not increased in 5-months, and could actually fall. The reason is pretty obvious: if producers of consumer goods did not have much pricing power when the economy was really strong, they are going to have even less as the economy slows given levels of accumulated capacity.

On the supply side of the economy, one would expect to see moderating PPI measures as output and investment growth slows. New project starts by enterprises are down, inventory building is slowing, and overall it looks pretty clear that increases to rates of growth to producer prices are past the cyclical peak.


This leaves continuing increases to real estate prices as the counter-cyclical trend. Recent data on bank deposits does not indicate a major draw down and new loan growth figures look reasonably tame. Thinking back to the US housing bubble, which was fueled by non-monetary credit, or in other words financial innovation, is there a chance that backdoor financial innovation in China is one of the factors stoking residential property prices? We don’t have an answer to that today, but it is something well worth looking into.  With this and the charts above in mind, when the real estate cycle breaks, or more meaningful brakes are applied, it is reasonable to expect that moderating trends in non-food CPI and PPI will pick up.

Signals from the PBOC’s Rate Increase

October 20, 2010

Most analysis of the 25 bp rate increase on both loan and deposit rates by the PBOC that we have seen starts off with something about controlling inflation or housing prices. These conventional arguments do not explain much in our view, as there has historically been an inconsistent relationship between the level of interest rates and core inflation in China. The same has generally been the case for property prices.  With that in mind we interpret this move by the central bank as first and foremost a signal to the supply side of the Chinese economy, with secondary signaling value to the US and the rest of the world.


The first question that we think needs to be answered in understanding this move by the PBOC is who did the central bank want to tax with this rate increase? Our quick answers: no, not households; yes, corporates who may be investing too much in the wrong things at this stage in the economic cycle; yes, local government financing vehicles; no, not currency or stock market speculators; maybe some marginal buyers of residential property.

Rates of output and investment growth remain higher than the PBOC and other would like to see at this point. With the State Council set to implement its “Strategic Emerging Industries Development Plan” in 2011 as an important component of the 12th Five-Year Plan, central economic authorities want to send a clear message to producers and regional governments that they should be prepared to heed warnings on “blind investment” in excess capacity. A 25 basis point rate increase alone will not exactly send shivers down the spines of China’s biggest borrowers, and administrative measures are sure to follow in the coming months as part of efforts to get important economic actors in line ahead of the Plan. Interest rates in China are an important political variable as well as a market one.

Where real estate markets are concerned, this rate increase is probably targeted more at companies who continue to drive up land prices by raising their cost of carry (or funding costs for trust companies who have been funding developers) more so than buyers of residential properties with a mortgage.  It is worth noting that during previous tightening efforts by the PBOC commercial banks did not increase mortgage rates by the whole margin of the increase to base lending rates. That may or may not turn out to be the case this time.  After this rate hike the monthly payment on a RMB 1 million, 20-year mortgage would increase by about RMB 116 depending on the terms. This is not a huge margin for households, even on the margins of affordability. This move follows additional signals from the government that further administrative measures to control property price increase are in the works.

A possible secondary message to the US (and others ahead of the next meetings of the G20): don’t push too hard on the exchange rate and trade measures because when we act suddenly and counter to market expectations it roils markets everywhere. The US stock market dropped along with commodity prices overnight following the announcement by the PBOC. An unintended consequence? Probably, for the most part, but it is not hard to imagine that some in the bureaucracy in Beijing took some degree of delight in the global market response to the PBOC’s announcement. 

The message to the world: the real economy in China has decoupled from other majors, and policy makers are prepared to move according to China’s own needs. This is nothing new really, but authorities in China are more unapologetic than they used to be about such things. This includes the exchange rate. Although these two policy variables are adjusted according to slightly different calculations, China probably wants to demonstrate policy independence from outside pressure.

Does this change the outlook for growth in the coming year? Probably for Q4 and the opening quarter of 2011, but not much for full-year 2011 and the medium-term. Stronger than originally expected growth for Q3 would give regulators more room to step up production curbs in energy intensive and polluting industries for the remaining months of the year. However, the start of the new year will mean fresh lending quotas for commercial banks, so 1Q 2011 may well show a seasonal firming up of output growth.  Although controls on credit growth are expected to extend through the end of 2010 and an additional rate increase before the end of the year cannot be ruled out, this does not mean that economic regulators’ comfort zone for GDP growth consistent with a soft-landing has shifted. For its part the PBOC would like to see a stronger relationship between interest rates and risk, as well as more efficient allocation of bank credit, but determinations as to the politically acceptable pace of growth remain questions for the Party leadership.


Will additional ‘hot money’ flows in response to the rate hike complicate economic policy management? Possibly, but additional measures to control the property market – property tax trials for example – and other avenues for speculation will be a splash of cold water on speculative inflows. China’s foreign exchange regulator can make life very difficult for shorter-term capital flows, and increasing regulatory risks will help to balance out expectations for combined yields on RMB assets. Capital flows are a reality they will have to get used to if China really aspires to be home to an international capital market, which it does. The hot money phobia that pervades the domestic media in China is a bit of melodrama in our view, as the domestic equivalent to hot money has to be the bigger fear.  Nevertheless, efforts to tighten up the leaks in China’s capital controls are reportedly in the works.

The argument that asset price inflation will eventually show up in consumer prices is a bit of a stretch, in our opinion. Prices in financial markets and the real economy are simply different animals. Indexes for some non-food consumer goods have remain within a comfortable range – viewed on either a month-on-month or year-on-year horizon – despite continued growth in property prices, and have always moved in accordance with market supply conditions rather than in step with producer or asset price increases. When China’s stock market crashed a few years ago it had little discernible impact on consumer prices, and the same appears to be true as other asset prices rise. China’s stock markets have hardly been swept away by ‘irrational exuberance’ during the past year, so it is unlikely that this rate move was targeted at domestic bourses.

12th FYP GDP Growth Target: “Above 7, below 8”

October 18, 2010

The GDP growth target for the next 5 years most often cited in domestic reports is 7-8% per annum. Given the additional goal of doubling per capita GDP from around US$ 4,000 to $8,000-$10,000 by the end of 2020, a slightly lower target rate of growth is assumed for longer-term forecasting (as well as RMB appreciation). This number has to be evaluated in perspective: the target for the 10th FYP was 7%, but the actual average number came in at 9.5%, with the 7.5% target set for the 11th FYP having turned into average annual growth of 10%. Policy makers always like to set targets that they can exceed with relative ease, but this time around there is good reason to believe that they are sincere in their efforts to rein in excessive industrial capacity and inefficient investment by provincial governments. There are, of course, significant institutional barriers to doing so, but the opening salvo of forced industrial consolidations begun by the State Council in September looks like a promising start.

As mentioned above better distributing national income to increase the household share and reduce various measures of income inequality will be priorities under the 12th FYP. This will take the form of doubling down on regional development initiatives to reduce inter-regional economic disparities, such as the Great Western Development Project and Revitalization of the Northeastern Industrial Rustbelt (both of which have been in place for about 10 years), and the Rise of Central China. Provinces included in these schemes are expected to grow at 10%-12% annual rates given the probably scale of  government-led investment initiatives. As mentioned earlier, the central government may spend “more than RMB 4 trillion” on its new and emerging industry agenda, a figure which could easily balloon to RMB 10-15 trillion once regional governments nationwide spend whatever they can. If central government efforts to control industrial capacity growth in favored sectors at the provincial-level are unsuccessful, annual GDP growth rates could easily surpass targets. We have not heard much (yet) about possible money and credit growth targets for the 12th FYP period, and these will be important inputs for expectations for fixed asset investment growth.

Another dimension will be to reduce the rural-urban income gap: according to official figures, which are wildly inaccurate, urban per capita disposable income was 9,757 RMB for 2009, compared to just 3,078 RMB for rural per capita cash income. This gap has been widening because of the relatively faster pace of price increases in rural areas for a range of reasons. According to great research by Wang Xiaolu with China’s National Economic Research Institute,once “grey income” is factored into this equation, the actual gap is probably well over 20x, compared with the 3.2x based on the official figures.

This inevitably means taxes. According to our analysis the bulk of this burden is going to fall on state-owned enterprises (SOE) and other companies, rather than households. Yes, a property tax of some form is likely, but in general the government does not want to reduce household spending power any more than it has to at a time when it wants to encourage consumption. A larger share of the mountain of retained earnings on SOE balance sheets will be paid out annually to the Ministry of Finance in the form of dividends, and companies will probably have to expand some contributions to social welfare and retirement programs in the form of payroll taxes.

All in all, economic planners would like to see private consumption account for 55% of GDP by 2015. Greater planned investment in social services, such as efforts to make basic medical services universally accessible, may help to increase household confidence. However, with so much uncertainty about the actual level and distribution of household income – even within semi-official circles – a policy gambit closer to “Friedman’s helicopter” might be more effective.

One last target worth mentioning is that for research and development (R&D) spending. As part of efforts to create an “experimental economy”, policy makers would like to increase the current level of R&D spending economy wide from the current level of around 1.5% of GDP to 2%-2.5% by 2015. For “new and emerging industries”, reports indicate that they would like to see this figure come in at around 5%-6% of total industry sales. If output growth averages 8% during the next 5 years, then this would mean that in 2015 overall R&D spending could top RMB 1 trillion.