Increasing the role of domestic consumption is one of the key objectives of China's 11th Five-Year Plan (2006-10). China's impressive overall economic development in recent decades has been accompanied by some imbalances. A relatively low and declining role of consumption has been one of the key imbalances, together with increasing income inequality, intense use of resources and impact on the environment, and a rising trade surplus. The imbalances are largely an outcome of China's capital-intensive, industry-led pattern of growth. The 11th Five-Year Plan aims at redressing the imbalances, in large part by adjusting the pattern of growth.

Consumption has actually grown briskly in China in the last decade. Overall consumption (private plus public) rose by 7.8 percent per year on average since 2003, in real terms. The imbalances that the government is trying to address have arisen because consumption and services have lagged investment and industry for a long period. Real investment grew 11.9 percent per year on average in this period.

When the global crisis broke out, China's senior leaders stressed that, with the outlook for exports more subdued in the "new normal", rebalancing and getting more growth out of the domestic economy has become even more important.

China's short-term policy response to the crisis has mainly focused on investment, but it also helped in keeping up consumption growth. The $586 billion stimulus plan largely fueled infrastructure investment. But some policy measures have helped consumption directly, such as subsidies for rural consumption, lower taxes, and higher pensions. And the government has been increasing its role in financing health, education, and social safety, which makes people feel less restrained to consume. The stimulus and its impact have also helped to contain the decline in consumer confidence during the global crisis.

But more is needed to boost the role of consumption in China's economy on a sustained basis. With the economic recovery now consolidated, there is room to switch the policy focus from short-term stimulus to structural reforms to rebalance the pattern of growth and get more growth out of the domestic economy. What is the best approach to achieve this?

In my view, increasing the role of consumption should be part of the overall rebalancing of the pattern of growth, toward less emphasis on industry and investment and more on services and consumption. Such a shift would result in more labor-intensive growth, with more urban job creation as well as more pressure on wages from the higher demand for labor. By boosting the share of wages and household income in GDP, this would increase the role of consumption in an economically sustainable way By rebalancing the relationship between the expansion of production capacity and consumption capacity, it would also reduce the external imbalance (the trade surplus). More labor-intensive urban growth would help to reduce surplus labor in agriculture as well, thus raising rural per capita income and therefore the capacity to consume in the countryside. Rebalancing would also make growth less intensive in energy and resources and be less detrimental to the environment.

What kind of policies are most suited?

Building on the substantial progress made in recent years, there is further room to increase the government's role in financing health, education, and social safety. In addition, structural reforms in two areas are crucial.

One important area of reform is the measure to ensure that, as China's growth needs to be led more by services and less by industry, new resources are channeled to the growth sectors. This calls for making service sector production more attractive, compared to industrial production. This means removing the subsidies to industry by raising currently underpriced rates of inputs into industry such as land, energy, water, electricity, the environment, and capital. It also means increasing private sector participation and removing entry barriers in several service industries.

In the financial sector, further reform can improve access to finance for small and medium-sized enterprises and service sector firms. Further SOE dividend reform can help channel corporate earnings more efficiently, to either government consumption or investment in a growth industry. Removing the cap on deposit rates would support household income and consumption as well as efficiency (by raising the cost of capital).

The second main area of reform is supporting more successful, permanent migration to the cities, to foster more labor-intensive, service sector-oriented, and consumption-based growth there. China's traditional migration pattern has meant that family members have often stayed in the rural areas, with migrants saving most of their income and sending it back to the countryside. This pattern served well the traditional growth pattern centered on export-oriented manufacturing. However, a rebalanced pattern of growth requires adjustment to the migration pattern.

If migrants are able to take their families with them to the cities and their children able to go to normal urban schools, they will start to spend more of their income in the cities. This will set in motion powerful "feedback" effects boosting urban service sector activity, employment, and consumption. Much of the service sector activity generated this way will not be high brow.

However, given the still very large gap between urban and rural productivity, such additional urban employment will boost overall growth. By improving the quality of education of children of migrants, such a migration pattern will also be good for long-term productivity growth.

More successful, permanent migration calls for further liberaliza-tion of the hukou system (for registration of residence) and, relatedly, reform of the inter-governmental fiscal system that gives local governments the means and incentives to fund the necessary public services. More rule-based transfers from richer to poorer areas would probably need to be part of this. But, allowing municipalities to benefit financially from migration, for instance, via property taxes, would also help. Further land reform would both increase the mobility of migrants and, by facilitating land consolidation and mechanization, boost incomes and consumption in the countryside.

The author is a senior economist at the World Bank Office in Beijing.

(China Daily 12/01/2009 page9)