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Part 5:
The future of China’s rural sector

By* Philip Saunders - Co-Head of Multi-Asset Growth,
Sahil Mahtani - Multi-Asset Strategist,
Professor Robert Ash - SOAS, China Institute, University of London

In Part 5 of our deep dive into China’s rural economy, we address ‘The future of China’s rural sector’.

Key points 

  • We believe China’s reform momentum on rural revitalisation is stronger than perceived by most outsiders
  • The rise of rural e-commerce is a catalyst for economic development
  • The prospects for income growth in rural areas depends squarely on Chinese reform momentum. There are three possible outcomes of China’s rural reform efforts:
    • In an ‘optimistic’ best-case scenario, rural incomes will benefit from institutional reform, sustained agricultural productivity improvements, high school and university enrolment, nutritional improvements, the growing use of e-commerce, and rural tourism. This will cut the urban-rural income divide.
    • In the ‘pessimistic’ worst-case scenario, these reforms will happen slowly, if at all, and the income gap between China’s rural and urban areas will continue to grow.
    • In our ‘realistic’ base case scenario, the income gap continues to grow, but peaks within a generation and begins to fall.

Will reform momentum carry the day?

If we haven’t brought prosperity to our villages – and especially if we haven’t brought it to impoverished parts of the countryside – then we can’t claim to have established a prosperous society.” — Xi Jinping, 2012

Anyone trying to generate future scenarios for China should keep in mind David Shambaugh’s salutary observation that “... the Sinological landscape is littered with China watchers’ wrong predictions”. If speculating about the future is always inherently hazardous, trying to predict China’s future demands an especially high-risk premium.

Few would deny that the Chinese government and its supporting bureaucracy possess the necessary expertise to set rational economic and social goals, including those for the rural sector. China’s record since 1978 also offers ample evidence of planners formulating coherent and consistent policies to fulfil these goals. Nor is there any reason to doubt the determination of Xi Jinping and his colleagues to pursue rural revitalisation.

China’s record since 1978 offers ample evidence of planners formulating coherent and consistent policies

However, on several occasions since 1978 China has found itself at what seems a tipping point only for the hoped-for consequences of new policies to fail to materialise. A particularly relevant example for the rural sector was the moment in the mid-2000s when the Chinese leadership for the first time acknowledged the costs of more than two decades of growth-maximising policies. From this emerged a fundamental change in its mindset and a new orthodoxy, which showed a willingness to trade slower economic growth for greater social inclusiveness and environmental harmony. Here indeed was a rational re-ordering of development priorities.

Yet in the years that followed, progress towards economic and social rebalancing was barely visible. Even today most of the problems that in 2000-05 led the government to change its mindset are still at the heart of its policy agenda. Between 2010 and 2018 urban per capita disposable income growth averaged 7.1% per annum; the corresponding rural figure was 8.5%. The outcome was a doubling of the urban-rural disposable income gap to $6,939 in purchasing power parity (PPP) terms in 2018.

Nevertheless, we are optimistic that there is enough momentum now to address this growing gap. China’s reform momentum on rural revitalisation is stronger than perceived by most outsiders, and the rise of rural e-commerce a welcome catalyst for economic development. If both trends can be allowed to play out, then rural wages can rise.

We are optimistic there is enough momentum now to address this growing gap

Rural growth is key to China’s economic transformation because China is now firmly established on a slowing growth trajectory. The OECD’s most recent long-term baseline projections suggest that annual growth will trend downwards from 4% during the 2020s to 1.4% in the 2050s.1

If these figures prove correct, China’s GDP growth between 2020 and 2060 will average 2.3% per year, compared with China’s official estimate of around 9.5% in the four decades after 1978. To ensure the transition is not a rough one, growth in rural China is the low hanging fruit of China’s next phase of growth and will therefore become only more important as an engine of China’s continued economic transformation.

How will reform impact rural wages?

We modelled the impact of three reform scenarios on rural wages, using an economic identity that measures the input to nominal wages from drivers that are highly linked to the reform agenda. In this identity, the %Δ in nominal hourly wages = %Δ in labour share of output + % Δ in prices + %Δ in labour productivity. What this means is that real wages are necessarily a function of two components: the share of GDP going to wages, and labour productivity. For real wage growth to accelerate, productivity has to rise and/or labour share of GDP has to rise – both of which are a function of the Chinese reform agenda.

If China succeeds in boosting crop yields, land consolidation, educational attainment, and nutritional and health outcomes, among other things, that will boost productivity. If China succeeds in redirecting savings away from corporate actors and back towards households, that will boost wage share of GDP. Combined, both would boost wages.

We assume rural inflation will trend upwards to 3% from 2% today in all scenarios, in order to keep the focus on the economic drivers of wage growth.2

The mechanics of this model are designed to be simple and transparent rather than complex and more realistic. In reality, productivity growth spurts tend to be pro-cyclical rather than peaking early and then declining steadily through time. What the scenario analysis does indicate, however, is the wide distribution of outcomes possible with even small changes in productivity growth and labour share growth – both of which are strongly impacted by China’s reform agenda.

The table and chart below summarises the assumptions and results of our scenario analysis. The numbers are rooted in current statistical releases, but the projections are for illustrative purposes only.

Figure 1: Rural-urban income gap

Figure 1: Rural-urban income gap

Source: National Bureau of Statistics, Investec Asset Management.
*($USD purchasing power parity)
**Absolute urban-rural disposable income gap

If China succeeds in boosting crop yields, land consolidation, educational attainment, and nutritional and health outcomes, among other things, that will boost productivity
  Optimistic Base case Pessimistic
  2020 2040 2020 2040 2020 2040
Rural productivity growth 12% 6% 11% 5% 11% 6%
Rural labour share of GDP 49% 56.5% 49% 55% 49% 56%
Rural inflation 2% 3% 2% 3% 2% 3%
Urban disposable income growth 6% 5% 6% 5% 6% 5%
Rural disposable income growth 11.5% 7.5% 9.8% 7.1% 8.4% 5.1%
Urban disposable income* 12,412 36,973 12,412 36,973 12,412 36,973
Rural disposable income* 5,100 33,814 4,955 26,517 4,825 19,109
Absolute gap** 7,313 3,159 7,457 10,457 7,587 17,865
Gap peak year 2037 2027 ?

Source: National Bureau of Statistics, Investec Asset Management.
*($USD purchasing power parity)
**Absolute urban-rural disposable income gap

Our optimistic and pessimistic scenarios

In the optimistic scenario, the coming years would see the benefits of buoyant and sustained rural economic growth shared by all those in the countryside. In this best case scenario, the urban-rural disposable income gap peaks in 2027, at around $8,004, before trending lower towards 2040.

Institutional reform and technological innovation could enable land consolidation and sustained yield growth to continue. Allied to appropriate sown area adjustments, these initiatives help to ensure that China’s core agricultural goal – that of securing its food security – is fulfilled. Agricultural modernisation could then see increasing numbers of farmers engaging in processing and other post-harvest activities, as well as mere production. The potential to develop high-value, high-income niche activities, such as organic farming, would then also strengthen.

Educational initiatives and nutritional improvements help to strengthen the rural sector’s human capital base through increasing high-school and university enrolments, maximising the returns from information and technology advances, thereby accelerating rural digitalisation. Meanwhile, more diversified sources of income emerge not only through wider use of e-commerce, but also through economic diversification. Recent years have seen the rapid development of rural tourism, which generated revenue of 1.4 trillion yuan in 2017. This promises to be a focus of accelerated expansion in the coming years, with beneficial knock-on effects for farmers and others engaged in a wide range of rural activities (hotels, restaurants, transport, handicrafts, and so on).

In our pessimistic case, the reforms happen only slowly, if at all, and the income gap between China’s rural and urban areas will continue to grow. In the pessimistic case, the urban-rural disposable income gap never really begins to close and grows wider and wider across the period of the scenario analysis.

In the best-case scenario, the coming years would see the benefits of buoyant and sustained rural economic growth shared by all those in the countryside

Our base-case scenario

In 2018 the urban-rural disposable income gap in PPP terms was $6,939. In the base case scenario, based on growth ranging between 7-10%, urban per-capita disposable income would rise from $7,457 in 2020 to $10,457 in 2040. This figure may be compared with the equivalent figure for rural disposable income growth, which would rise to $26,500 in 2040 from $5,000 in 2020. In such a case, the absolute urban-rural disposable income gap would peak at $10,585 in 2037.

Here, we assume growth in rural productivity starting at 11% per year and trending down to 6% by 2040. Overall labour productivity in China between 2012 and 2017 averaged around 7.5%, while agricultural productivity has averaged around 10%.4 We estimate rural productivity to be higher than agricultural productivity because since at least the 1980s, as Township and Village Enterprises (TVEs) took off in China, productivity growth in the non-agricultural rural sector grew significantly faster than in agriculture ‘proper’. This will have been underlined by the growth in rural e-commerce in recent years. In the optimistic scenario, rural productivity jumps to 12% and trends down to 6%, while in the pessimistic scenario, those figures are slightly lower from 11% to 5%.

Meanwhile, in the base case, we estimate rural labour share of output will trend upwards to 56% from 49% in the same period.4 5 Considering China appears to have passed its Lewis Turning Point, given continuing urbanization, demographic aging – which will at the margin reduce labour oversupply – and the general policy push towards boosting household incomes, we estimate that labour shares will continue to rise in rural China over the coming two decades. As a result, our base case assumes the rural labour share of GDP will trend up to 56% by 2040 from 49% today. The optimistic case pushes that up to 56.5%, while the pessimistic case sees that decline to 55%.

We estimate labour shares will continue to rise in rural China over the coming two decades

Why it matters

Successful rural revitalisation impacts the big questions in Chinese equity and fixed income. For equities, it means a longer growth period for China’s consumer companies, faster consumption growth in the years ahead, and, of course, a tailwind behind companies attuned to the needs of rural consumers. In fixed income, all things being equal, it means a higher sustainable rate of Chinese economic growth; a higher rate of productivity growth, a lower rate of inflation and a stronger currency.

Successful rural revitalisation impacts the big questions in Chinese equity and fixed income

In the past, the way to convert the impressive Chinese macroeconomic story into returns has been to focus not on Chinese assets but the assets of suppliers to China. These included resource companies, resource-producing economies or exporters of capital and consumer goods. The creation of a vast, consumption-led domestic Chinese economy means the opportunity for domestic assets is where the opportunities now lie. To judge by current Chinese equity valuations, that change is not yet reflected in prices. We have explored the change in asset allocation towards China that global investors must make in our summer 2019 paper, Dig the Well Before You're Thirsty. In that paper, we suggest that based on China's size, growth trajectory and distinctive characteristics, a separate allocation to the country may now be appropriate. The country already possesses the second-largest equity market and the secondlargest bond market. It is by far the largest single-country contributor to global growth and, within the next decade, the Chinese economy is forecast to outsize that of the US. Given the country’s longstanding lack of representation in global benchmarks, even those maintaining their current allocation framework will be making a significant active call on China, one way or the other.

If successful, China's internal transformation, starting with its rural reforms, promises to reshape the world order in ways the West has only just begun to appreciate.

The level of representation of Chinese assets in most conventional indices and global portfolios is wholly inadequate

*Other contributing authors
Greg Kuhnert, Co-Head of 4Factor | Mark Evans, China Analyst | Mike Hugman, Portfolio Manager, Emerging Market Fixed Income

1 "Economic Outlook No. 103--Long-term baseline projections," Organisation for Economic and Co-operation and Development, July 2018.
2 Rural inflation averaged 1.7% between 2013 and 2018 according to the National Bureau of Statistics, and we assume a modest uplift in the years ahead. In this scenario, as in all the three scenarios, urban disposable income growth trends down to 5% in 2040 from 6% in 2020. We hold the urban figures constant to focus on the transformation in rural incomes, though in reality shifts in productivity and labour share that drive rural incomes are unlikely to occur independents of trends in China’s cities.
3 Communication from Prof. Bob Ash with reference to Fan, S., Regional Productivity Growth in China’s Agriculture, CRC Press, 11 July 2019.
4 Estimating this figure for rural areas is complicated, and economists tend to use the agriculture labour share in GDP as a proxy for this. Nevertheless, the figures for China using the OECD Input-Output tables suggests that the labour share of agriculture value-added is close to 95%. When Bai and Qian investigated the matter in 2010, they found that China’s agricultural share of output was far higher than that for other economies, and more than 10% greater than that of the next country in the calculation. The wide variation between China and the rest of the world is mainly due to China’s national accounting method, which treats mixed income—or income accruing to an entity that is both capital and labour—as labour income by the National Bureau of Statistics. Most economies have adopted the UN system of National Accounts, which reports mixed income separately or treats mixed income as capital income. Consequently, China has a distinguishingly high labour share in agriculture. As a result, for the purposes of this scenario exercise, we use the national labour share of output as a starting point. In 2018 it was 49% of output.56
5 Bai, C., and Qian, Z., “The factor income distribution in China: 1978-2007,” China Economic Review, 21 (2010) 650-670.

Important information
This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contain statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein.
All rights reserved. Issued by Investec Asset Management, October 2019.

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