Liberalization and Wealth Inequality in China

When there are more opportunities for fundamental societal changes, there is more volatility, and correspondingly, more exciting prospects for investments. That’s why I find China and developing economies, which are becoming more “open,” more intriguing than the relatively mature economies of the US and Europe.

One of the next big-money macro plays in the next coming decade or so will be leveraging the thesis that a correction of trade and economic imbalance will occur as the US and China dynamic evolves towards a more mutualistic relationship. As Paolo Pelligrini said in a recent Bloomberg interview, “There are going to be huge shifts in wealth around the globe … I want to invest in that.” Wealth is certainly shifting in the world as China continues to implement more market-based policies, the shift exacerbated by wealth destruction in the West; however, there is a dark-side—growing and rampant wealth inequality. It is my belief that this inequality will have to be adequately addressed in order for this particular wealth-shift to play out nicely, and for that above thesis to hold. I do think that this will happen, and I think answering the question of how it will be addressed will be of primary importance from an investing standpoint.

The positive societal effects of China’s liberalization since 1978, stemming from Xiaoping’s “Four Modernizations,” have been astounding. Below are a couple examples of these positive effects:

• China has had the fastest-growing major economy for the past 30 years, with an average annual GDP growth rate above 10%. According to Paul Solman, Economics Correspondent for the NewsHour with Jim Lehrer on PBSToday, the average Chinese have some ten times the purchasing power they had just a quarter century ago. Mr. Solman also commented that China now boasts 47 cities with at least 1 million people, while the U.S., using the same measure, has nine.

• Li Qiang, a sociologist at Tsinghua University, said, "Studies of social structure have shown that an olive-shaped society with the middle stratum becoming the backbone is always more stable than a pyramid-shaped society with wealth polarization …that's because the middle stratum, generally speaking, is the most important stabilizing force in any society." In China’s case, the middle stratum is also where the wealth is concentrated. According to a McKinsey study, on average, wealthy consumers in China are 20 years younger than those in the United States and Japan. Some 80 percent are under 45, compared with 30 percent in the United States and 19 percent in Japan. China’s wealthy consumers are disproportionately younger than other leading economies.

• With regards to education, the percentage of China's college-age population in higher education has increased from 1.4% in 1978 to roughly 20% in 2005. The UNESCO world higher education report of June 2003 pointed out that the student population of China's schools of higher learning had doubled in a very short period of time, and was the world's largest. In 2002, the literacy rate in China was 90.8%; 95.1% of males and 86.5% of females. Deng Xiaoping reportedly wrote Mao Zedong in 1975 that university graduates were "not even capable of reading a book" in their own fields when they left the university. Many social observers have commented that China’s education system is already more market-oriented than the States, and the untapped intellectual and human capital in the 80% of college-aged population not in higher education leaves a lot of societal potential.

Taken the above at face value without further analysis, and reading the proliferating China rah-rah commentary online, one may start to conclude that “the adoption of liberal and market-oriented policies in the last thirty years have caused overwhelmingly positive societal trends to take place in China.” Yes, that is true, but nothing is ever one-sided. The real question is, to what extent have these policies acted as the tide that causes all boats to rise? The answer is a bit unsettling, and remnants of Old China aggravate the problems that exist. Below are some examples of China’s growing problem of wealth inequality:

• According to Wikipedia, the Gini coefficient is a measure of inequality of a distribution. The Gini coefficient in China has been trending upwards in the past 30 years. It is defined as a ratio with values between 0 and 1. (Interestingly, the US and China’s Gini Coefficient have mirrored each other during this same time-frame; however, a point worth noting is that The World Bank has pointed out the Coefficient is not strictly comparable across places because the underlying household surveys differ in terms of method and type of data collected). According to a 2008 report by Chen Jiandong at Southwestern University of Finance and Economics in Sichuan, China’s Gini coefficient in 2004 was 0.438, rising from 0.302 as the Communist Party began to open the economy to market forces in 1978.

• According to UN estimates in 2007, around 130 million people in China - mostly in rural areas of the lagging inland provinces - still lived in poverty, on consumption of less than $1 a day. About 35% of the Chinese population lives under $2 a day. The China Human Development Report (CHDR) 2005 points out, "if public housing subsidies, private housing imputed rent, pension, free medical care, and educational subsidies were included, the actual per capita income of urban residents in 2002 would increase by 3,600 to 3,900 yuan, bringing the urban-rural income ratio to about four-fold instead of the 3.2-fold acknowledged by official figures." This four-fold number would place China’s urban-rural income ratio amongst the highest in the world.

• Examining the geographic distribution of production shows that the East coast accounts for about 60% of the national industrial output, and Shanghai by itself accounts for about 8–10% of China's gross value of industrial output. This uneven distribution has, in part, been exacerbated by (Old China remnants as mentioned above) setting up preferential tax treatment and creating investment incentives in coastal areas while keeping the inland closed off.

Many are increasingly looking to the East to pick up the pieces after the recent macroeconomic crisis (which certainly, may still be playing out). Because of this, the consequences of not properly addressing the issue of wealth inequality in China could prove to be disastrous, not only for China, but for the global economy. Increasing wealth inequality will ultimately lead to capping potential growth in China, and hindering worldwide macroeconomic recovery.

Can a stable society emerge with such income and wealth disparities? Fundamentally, these disparities are an outgrowth of opportunity disparities, which are the highest in the rural and Western regions. In the coming years, as an investor, it will be important to note whether the Chinese Government places primacy on closing the wealth inequality gap by closing the opportunity gap. I do think this will happen, and is happening right now to some extent. This is where a significant amount of money will be made, as China attempts to close the opportunity gap, what industries will be the primary benefactors?

Related, David Dollar, of the World Bank’s mission in China writes, “Some rise in inequality was inevitable as China introduced a market system, but inequality may have been exacerbated rather than mitigated by a number of social features.” Will these social features, remnants of “Old China,” fall to the wayside, or will they remain, and what industries will be impacted the most?

Answering those two questions correctly will put you in a positive place.

Comments

[Tony Petroski:]

Mr. Mezzadri has written an interesting article. A few things to consider:

From the article:

"As Paolo Pelligrini said in a recent Bloomberg interview, “There are going to be huge shifts in wealth around the globe … I want to invest in that.'"

As a libertarian influenced by Hayek, I suggest you re-read some of your Hayek and I also suggest reading "Wealth and Poverty" by George Gilder. You seem to be caught up in the idea, an idea pushed endlessly in academia and the culture, that there is a "distribution" of wealth from some source, presumably the central government, and therefore, if this distribution is unequitable, it's just to "redistribute" or "spread the wealth around."

Hence the "shifts in wealth" from your article as if a fixed pie is distributed by central governments and then a mad scramble is on to get your share of the pie. If an American who is wealthy, say one who owns a lot of Coca Cola stock, sees his wealth rise 5% due to increased consumption of Coca Cola in China, and a wealthy Chinese, say a distributor of Coca Cola, sees his wealth rise 35%, in what sense has the wealth "shifted"? The rising wealth of free Chinese also enhances the wealth of Americans and others.

I would think a central question for investors and sociologists to ask is: When does the rising middle class in China (there is a large and rising middle class) ask themselves "Why do we have to be slaves to a corrupt communist oligarchy?" "New cars and clean apartments are great, but when do we get our freedom?" It's on that day that the Coca Cola distributorship, awarded to the man who was the brother of the local commissar, will be endangered as will your investment in it.

Read the "Road to Surfdom" again and pay attention to the emphasis on the rule of law that Hayek so brilliantly outlines.

Keep going Mr. Mezzadri.

Oct 29 09:15 AM

[John Galt:]

"growing and rampant wealth inequality"

Is it better for everybody to just stay poor? If some people are going to stay poor, and some are going to make money and live a better life, why is that bad?

Net Wealth:
Person A: 0,0,0,0,1,1,1,1,1,2,2,2,2
Person B: 0,1,2,3,4,5,6,7,8,9,10,11

So why is this whole "income inequality" such a bad thing as millions of Chinese citizens climb out of poverty? Bill Gates becoming a Billionare didn't make you lose any money. He didn't take anything away from you, and in fact he probably made your life better because chances are you use windows on your computer.

Oct 29 10:27 AM

[James Lewis:]

Nice comment Tony...

I think one of the tenents of globalisation is that a larger global system contains a larger amount of nominal value (may it be money, resources etc). A further tenent would be that a larger global system may create substantial innovation and further expand productivity and wealth output. So as one country develops within the global system, there is not normally a shift in net wealth. Coca Cola shareholder nominal net value will increase as well as the Chinese distributor. Of course the shift occurs when the shift in the shareholder is grosly under that of the Chinese distributor.

This of course is what everyone is so annoyed at, as China's policies crowd out the benefit of developing the size of the global economy at the expense of other countries (USA from rich side, Pakistan/Thailand/Viet... from poor side.

On a more micro-level, there is a very serious crowding out on who is benefiting from China's rise on the local level. I do see the economic value and growth of the country as a fixed pie. The government, banks, powerful business people do in effect decide what chunk goes to who. After all it is the government who is keeping wages low to increase export competitiveness. This is a very direct policy and clearly concentrates wealth at the top.

I do not agree the middle class is slave to the corrupt communist oligarchy. It is the lower class and fast becoming the lower middle class. Which accounts for a huge % of the population. Rebellion here is where the issue is. Please also note the relationship between the ethnic minorities and the lower class and also the concentrations of lower class in the west of the country. There is a very clear definitive pattern. For now this can be mitigated.

It is if the lower-higher middle class divide widens substantially that there will be problems. After all these people are educated, know how to use computers, know how to organise themselves and know that they are not being given the same chances as the 'others'. To stop this from occuring, I hope the Chinese government will raise wages, build more low-cost homes, distribute wealth more evenly by reducing corruption. And start to form a proper anti-corruption bureau that does not answer directly to the government. A court system that is not run by the government.

Of course this will take time, but is China moving in the right direction?

Oct 29 10:34 AM

[tripleblack:]

[quote] I would think a central question for investors and sociologists to ask is: When does the rising middle class in China (there is a large and rising middle class) ask themselves "Why do we have to be slaves to a corrupt communist oligarchy?" "New cars and clean apartments are great, but when do we get our freedom?" It's on that day that the Coca Cola distributorship, awarded to the man who was the brother of the local commissar, will be endangered as will your investment in it. [quote]

Precisely correct.

China's problem in all this is that very danger, and we who would invest in China would do well to keep this in mind.

At what point does the totalitarian control of the Party oligarchy run out of flexibility - and at what point does that increasingly powerful and educated middle class INSIST on more flexibility?

There are large landmines buried in the road China has chosen, and it is still uncertain who is most likely to step on them, but I would think that foreign investors would be among the FIRST to find out.

Oct 29 10:35 AM

[huangthomas:]

Is "income inequality" a problem in China? The answer is "yes and no". The Gini coefficient for China is 0.46 and the nominal figure for the US is 0.40. These are data provided by the governments to UN and World Bank. American CIA knows rich American have wealth and income in tax heavens. CIA data shows that it is 0.45 for the US, which may not have statistically significant difference from 0.46 for China. The problem with China is low per capita GDP, 4.4% of that of the US (without correction for PPP). The low per capita GDP sinks large number of the rural residents into poverty.

I don't agree with the notion that Chinese government is intentionally keep the wages low to stimulate export. The low wages can be
attributable to the policy of Mao, who tripled Chinese population from 400 million to 1.3 billion during his 30-year rule. When large number of people searching for finite number of jobs, the wages will naturally go down. This year the job market in China is tight, but the college graduates increased substantially. The college graduates are competing with migrant workers, only 2% have high school diploma, for a $240 a month jobs. It is market economy at work.

Oct 29 01:00 PM

[steveninbei...:]

Huangthomas, please learn business 101 before you say it

Nov 01 02:15 PM

[Mike Mezzadri:]

Thanks for the commentary guys, much appreciated. I'll respond to a couple of points.

//"As Paolo Pelligrini said in a recent Bloomberg interview, “There are going to be huge shifts in wealth around the globe … I want to invest in that.//

I think maybe there might be a misinterpretation. I was referring more to capital and investment inflows.

//Read the "Road to Surfdom" again and pay attention to the emphasis on the rule of law that Hayek so brilliantly outlines.//

I'll admit, it's been years since I've read it, and I'll have to check out that other book you suggested. I put it on my Amazon wishlist.

//When does the rising middle class in China (there is a large and rising middle class) ask themselves "Why do we have to be slaves to a corrupt communist oligarchy?" "New cars and clean apartments are great, but when do we get our freedom?"//

This is an "if" - what I mean by that is if the people will not ask themselves that question if they are being provided for (biting the hand that feeds); however, obviously the government taking this sort of role is not feasible in the long-term. Sooner or later, you run out of other peoples' money to spend. It will be interesting to keep on eye on Asian v Western debt ratings in the next couple of years.

//On a more micro-level, there is a very serious crowding out on who is benefiting from China's rise on the local level. I do see the economic value and growth of the country as a fixed pie. The government, banks, powerful business people do in effect decide what chunk goes to who. After all it is the government who is keeping wages low to increase export competitiveness. This is a very direct policy and clearly concentrates wealth at the top.//

I definitely agree with this!

//CIA data shows that it is 0.45 for the US, which may not have statistically significant difference from 0.46 for China. //

You can't compare Gini Coefficients across different Countries, it's apples to oranges because of data collection methodologies. That is one of the noted downfalls of this statistic. It becomes useful when used intra-Country, and when combined with other quantitative measures of inequality.

//When large number of people searching for finite number of jobs, the wages will naturally go down.//

This statement is basd on a large amount of unfounded assumptions and can't just be taken as fact. When population increases, job creation increases as well, efficiencies go up, scales are realized, technology develops - it's not as simple as how you portend.

//Huangthomas, please learn business 101 before you say it//

I also definitely agree with this.

Nov 04 02:53 PM

[Mike Mezzadri:]

I was looking for a particular quote and finally found it; it's from Huxley's Brave New World Revisted.

[The cry of "Give me television and hamburgers, but don't bother me with the re sponsibilities of liberty," may give place, under altered circumstances, to the cry of "Give me liberty or give me death." ]

www.huxley.net/bnw-rev...


On Oct 29 09:15 AM Tony Petroski wrote:

> Mr. Mezzadri has written an interesting article. A few things to
> consider:
>
> From the article:
>
> "As Paolo Pelligrini said in a recent Bloomberg interview, “There
> are going to be huge shifts in wealth around the globe … I want to
> invest in that.'"
>
> As a libertarian influenced by Hayek, I suggest you re-read some
> of your Hayek and I also suggest reading "Wealth and Poverty" by
> George Gilder. You seem to be caught up in the idea, an idea pushed
> endlessly in academia and the culture, that there is a "distribution"
> of wealth from some source, presumably the central government, and
> therefore, if this distribution is unequitable, it's just to "redistribute"
> or "spread the wealth around."
>
> Hence the "shifts in wealth" from your article as if a fixed pie
> is distributed by central governments and then a mad scramble is
> on to get your share of the pie. If an American who is wealthy,
> say one who owns a lot of Coca Cola stock, sees his wealth rise 5%
> due to increased consumption of Coca Cola in China, and a wealthy
> Chinese, say a distributor of Coca Cola, sees his wealth rise 35%,
> in what sense has the wealth "shifted"? The rising wealth of free
> Chinese also enhances the wealth of Americans and others.
>
> I would think a central question for investors and sociologists to
> ask is: When does the rising middle class in China (there is a large
> and rising middle class) ask themselves "Why do we have to be slaves
> to a corrupt communist oligarchy?" "New cars and clean apartments
> are great, but when do we get our freedom?" It's on that day that
> the Coca Cola distributorship, awarded to the man who was the brother
> of the local commissar, will be endangered as will your investment
> in it.
>
> Read the "Road to Surfdom" again and pay attention to the emphasis
> on the rule of law that Hayek so brilliantly outlines.
>
> Keep going Mr. Mezzadri.

Nov 04 05:24 PM