China: one country - three economies

http://www.morganstanley.com/views/gef/archive/2009/20090529-Fri.html#anchorf302c4b3-4c46-11de-96f6-3f25a44c9933

One Country, Three Economies

There is large economic disparity among the regions in China. At the broadest level, China consists of three economies: the eastern area, which accounts for 64% of the national economy and consists of 11 provinces (including Beijing, Tianjin, Hebei, Liaoning, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong, Guangdong and Hainan); the central area, which accounts for 26% of national economy and consists of eight provinces (including Shanxi, Jilin, Heilongjiang, Anhui, Jiangxi, Henan, Hubei and Hunan); and the western area, which accounts for 19% of national GDP and consists of 12 provinces (Inner Mongolia, Guangxi, Chongqing, Sichuan, Guizhou, Yunnan, Tibet, Shaanxi, Gansu, Qinghai, Ningxia and Xinjiang).

The income level among the three areas is quite uneven. In 2008, while GDP per capita in the eastern area was US$4,790, central and western areas were US$2,820 (or about 60% of the eastern area level) and US$2,500 (or about 50% of the eastern area level), respectively. The large regional disparity in income level becomes even more pronounced when the comparison is made at a provincial level. For example, Shanghai has the highest level of GDP per capita of US$10,440, or more than eight times of that in Guizhou province.

In fact, the regional income disparity in China is larger than both that among the states in the US and the country disparity in the Euro-zone. Specifically, the coefficient of variation (COV) - as a normalized measure of dispersion of a distribution - of provincial GDP per capita in China is 0.64. This is much higher than the COV of state GDP in the US of 0.39, and even higher than the country GDP per capita in the Euro-zone of 0.49.

The regional income disparity reflects several fundamental structural factors. First, urbanization tends to be much higher in the eastern area than in the central and western areas. Provinces with the highest urbanization such as Guangdong, Liaoning, Zhejiang and Jiangsu are concentrated in the eastern area, while the provinces with lowest urbanization such as Yunan, Gansu, Tibet and Guizhou are in the western area. Second, openness to external trade tends to be much higher in the eastern area than in central and western areas. Measured by exports as a percentage of GDP, eastern provinces such as Guangdong, Jiangsu and Zhejiang are 15-25 times as exposed to foreign demand as central and western provinces such as Qinghai, Gansu, Inner Mongolia and Henan.

When the Chinese economy was stricken by the global financial turmoil and economic recession, the shock impact varied significantly on different regions, depending on each region's initial conditions such as its economic structure in general and exposure to foreign demand in particular. We compared the growth rates of industrial value-added between 1Q09 and 1Q08 and used the difference as a gauge of the underlying shock impact from the crisis. It turns out that two types of provinces - which have either large direct exposure to foreign demand (e.g., Shanghai, Zhejiang and Fujian) or are major producers of natural resource commodities (Shanxi, Ningxia and Qinghai) - were most severely affected. While the impact on the former reflected a sharp contraction of external demand, the impact on the latter had largely to do with the collapse of commodity prices. On the other hand, the impact on regions that are less exposed to external demand or commodity-producing industries (e.g., Hunan, Guizhou and Anhui) has been substantially milder.

Three Economies, One Policy Stance

The crisis's impact on different regional economies in China varies. Mitigating the impact of the most serious crisis since the Great Depression in 1929-33 has entailed an unprecedentedly strong policy response. Ideally, the larger the negative impact on a region, the stronger the policy response should be. In another words, the policy response to the eastern provinces should be in principle stronger and more aggressive than that applied to the western provinces.

However, an equally strong and aggressive policy stance appears to have been applied across the regions in practice, independent of the shock impact of the crisis. As part of the Rmb4 trillion stimulus package, each provincial government is allowed to issue local government bonds. The proceeds from the bond issuances are to be used as ‘seed money' to help raise more funds - primarily in the form of bank loans - to finance investment projects undertaken under the stimulus plan. Therefore, the amount of local government bonds should be a good proxy for the strength of the local policy response, be it fiscal or monetary, to help the local economy, in our view.

In theory, there should be a positive correlation between the amount of local bond issuance and the magnitude of the negative impact each province suffers; however, such a relationship simply does not exist in practice. This pattern reflects the particular nature of the central-local government relationship in China, in our view. Compared to many other countries in the world, local governments in China traditionally have a much stronger interest in developing their local economies. In fact, academic literature considers this unique incentive structure as a key - albeit unorthodox - contributing factor to the success of China's economic reform. We think that the seemingly egalitarian approach in determining the size of policy support in coping with the crisis is a result of competition among provincial governments and intense bargaining between local and central governments, as every local government wants to seize this opportunity afforded by the global turmoil to give its own economy a boost through policy stimulus.

In this context, a one-size-fits-all policy approach becomes an inevitable outcome: while the strength of Chinese authorities' anti-crisis policy responses is determined with respect to the adverse situation in those regions that have been hardest hit by the ongoing crisis (e.g., Pearl River Delta and Yangtze River Delta), the regions will likely benefit from a policy response applied equally across them. In another words, despite de facto three economies there is only one policy stance, meaning that the policy boost is appropriately supportive for some regions but super-accommodative for others.

Diverging Regional Growth Trends

Different regions in China will likely demonstrate a pronounced divergence in growth trends during this global economic recession. The impact of global economic recession on different regions inside China is quite uneven, reflecting each region's initial conditions such as its economic structure in general and exposure to foreign demand in particular. At the same time, the policy responses will be largely non-discriminative across regions, with the stance being determined by the adverse situation of the regions hardest hit by the crisis. In this context, the policy support received by those regions that have been less affected by the global recession may more than offset the negative impact of external demand shocks such that their regional economy could do substantially better than China's macroeconomic situation would suggest.

We rank China's 30 provinces by their potential economic performance amid the current global recession by factoring in not only the initial negative impact of the external shocks on the local economies but also the policy support received by each region. Eastern provinces such as Fujian, Zhejiang, Shandong and Guangdong will likely be among the regions that would be most negatively affected by the current global recession, while Guizhou, Hainan, Jilin and Sichuan will likely be among the least affected regions, by our estimate.

Our ranking of economic performance by region seems broadly consistent with the recent passenger car sales, which is a useful proxy for households' purchasing power and consumer confidence, and cement consumption, which is a good proxy of local construction activity.

Looking ahead, with potentially diverging regional growth trends, the firms that have disproportionally large business exposures to a region will likely find their performance critically tied to the performance of the local, instead of national, economy. Identifying those firms that are well positioned to benefit from the regional economies expected to substantially outperform the national economy will likely become an important investment theme, especially when uncertainty surrounding the overall macroeconomic outlook diminishes.

Beyond the near term, the current global economic turmoil and the Chinese authorities' policy response should serve to help narrow the regional economic disparities that have widened in the past decade, and thus are a source of considerable tension in China's economic and social development; this bodes well for a more integrated nationwide market and balanced growth in the long run.