Bolstered by a $586 billion government stimulus program and a surge in lending by state-owned banks, China may be the first major economy to bounce back from the global recession. But the composition of China’s growth remains unbalanced. Aggressive increases in government spending and investment by state-owned enterprises has cushioned the impact of weak exports. But those gains have not been matched by comparable increases in private consumption. Spending by Chinese households as a percentage of GDP is roughly half the US consumption ratio and remains significantly below private spending levels in Europe and Japan. And despite rising sales of items such as automobiles and household appliances, the ratio of private spending to GDP in China today has actually fallen relative to Chinese spending levels of a decade ago.

Why do Chinese consumers spend so little relative to counterparts in other nations? What can be done to change that? Is boosting private consumption in China’s national interest? How would that contribute to global growth? In this interview, conducted by McKinsey director Jonathan Woetzel in June 2009 in Shanghai, four distinguished members of the McKinsey China Council of Business Economists¹ explore these questions. Watch the video, or read the transcript below.

Jonathan Woetzel: Private consumption accounts for only about 36 percent of China’s GDP. That’s about half of what it is in the United States. It’s almost two-thirds of what it is in Europe. Is that too low? Why is it that low?

Wang Xiaolu: It seems to me there are several reasons. One is that China doesn’t have a complete social-security system. By 2007, only one-third of the urban population was covered by the social-security system. And for rural residents, most of them don’t have social security. And also in past years, the cost for education, for medication, for housing has increased quite rapidly—much more rapidly than GDP growth and income growth.

Jonathan Woetzel: What’s a proper, or normal, consumption level for China?

Cao Yuanzheng: According to the historical levels [for China], the consumption share in terms of GDP is over 50 percent. So if we set this as a standard, we can see there is a gap by 15 percent and more. So we have to make some policies to try to narrow this gap.

Jonathan Woetzel: What kind of policies? What could you do? If you were in the Chinese government’s position, what would you do to narrow the gap?

Li Xiaoxi: Income allocation has a significant impact on consumption. The government needs to make some adjustments to reallocate income distribution—how much goes to citizens, how much to governments, and how much to enterprises. This is a macroeconomic adjustment that can be achieved with new fiscal policies, including changes in tax policy.

Bai Chong’en: I think it is very important to increase the income share of households. Without income, no matter what happens, households just don’t have the means to consume.

Jonathan Woetzel: What’s the relationship between the social safety net and consumption?

Bai Chong’en: I actually think that the relationship is not as simple as a lot of people think. And it’s not necessarily that when we increase spending on social security, private consumption will increase. I think the answer depends on how social security is financed.

We did a study on rural healthcare. Rural health insurance is subsidized by the government. So there is no crowding out. The rural residents don’t need to spend a lot to purchase insurance. In that case, we found that, indeed, consumption is increased. But I’m not so sure about urban social security, because social security is mainly financed by payroll tax. And the tax rate is too high. We have five different insurances. And if you add them together, the tax on labor income is around 40 percent.

Forty percent tax on labor income is a lot. That kind of tax crowds out private consumption. And I believe the government should force the state-owned enterprises—especially those with monopoly power—to pay dividends to the government, and use those proceeds to finance social security.

Jonathan Woetzel: What are some of the very short-term policies—things that you could do in the next six months—that would move us toward higher consumption?

Li Xiaoxi: In the short term, we’ve already implemented many measures. For example, we tried to boost sales of home appliances and other durable goods in rural areas by offering them at discount prices subsidized by the government. We hope, by doing so, those items will be more affordable to farmers. Another short-term measure is consumer credit policy, which has been loosened to encourage consumption.

Cao Yuanzheng: Since China is a developing country, that means most of the population is concentrated in the countryside. So how to increase this part of the economy is very important. Long-term and short-term policies have to concentrate on this side.

Wang Xiaolu: It seems to me that the more basic problem is widening income disparity. We know that high-income people have a much higher savings rate compared with low-income people.

Bai Chong’en: In order to have urbanization and industrialization, we need to create more nonagricultural jobs. And on this front, we are not doing so well. And employment growth in the industrial sector lags far behind GDP growth. When you have 40 percent payroll tax on labor income, that suppresses employment.

Li Xiaoxi: The global financial crisis has made our unemployment situation even worse with factory closures and bankruptcy in the southeast coastal area. Many migrant workers who used to work in the Yangtze River Delta and Pearl River Delta had to return home to the midwest. Helping them to find new jobs is critical for boosting domestic consumption.

Wang Xiaolu: Currently, there are something around 140 million migrant workers coming from rural areas to work in urban areas. But they are just temporary workers. They can’t find good accommodation to house their family, to settle down in urban areas. And also, the current education system makes some trouble for their children to be educated in urban areas because they have to pay. Therefore, to accelerate urbanization, you need some policy adjustments to provide a better living environment for migrant workers.

Jonathan Woetzel: It seems we’re talking about a lot of measures to spend money on workers, to reduce payroll taxes. Can the Chinese government afford to increase consumption?

Bai Chong’en: You ask a very good question: where does the money come from? One source is the profit of state-owned enterprises, especially those with monopoly power. When we talk about savings, actually the largest share of savings increase is in the corporate sector. And these savings were not controlled. They were invested in low-efficiency projects. So if the government forces these firms to pay higher dividends, it’s actually one stone that kills two birds. One, you use the money to finance the social-security system. Therefore, you have room to reduce payroll tax. Second, you strip the money away from the state-owned enterprises so that their ability to invest is mitigated.

Jonathan Woetzel: Is this a good time for China to be increasing consumption?

Cao Yuanzheng: You know, we have to. Because there’s no way out. We have to enhance domestic consumption. I think everyone now understands that.

Bai Chong’en: Right. I totally agree with Dr. Cao that that’s the only way. You cannot increase net export that rapidly anymore. And you cannot increase investment that rapidly anymore. So that only leaves consumption.

Li Xiaoxi: We have reached a consensus on the need to boost domestic consumption, but the path we are taking is a zigzag. To cope with the crisis, we have to start with increasing investment. About 30 percent of the investment will eventually end up in consumption. But between consumption and investment expansion, the government is more skilled at increasing investment to stimulate the economy. Therefore, it is a zigzag route rather than a one-leap jump.

Wang Xiaolu: I think in the short term, investment projects are necessary because consumption increases may take a long time. But I think we need to consider more about how to balance consumption and investment.

Bai Chong’en: Normally, there is a saying that when per capita income goes beyond $3,000, then consumption will pick up rapidly. China is moving toward that threshold. However, this conventional wisdom may not give us so much optimism, because usually, the consumption increase comes from housing and comes from automobiles. And in both of these fronts, we cannot follow the Western model, especially the US model. Recently, automobile sales have been increasing very rapidly—to everybody’s surprise. I don’t think that’s a very good sign. We just don’t have so much oil available to let every Chinese household have a private car and drive on gasoline.

Jonathan Woetzel: Let’s say China does decide to increase consumption, what does that mean for the rest of the world? How does China affect the global economy?

Bai Chong’en: I think the world faces a big challenge. The world expects Chinese consumers to pick up and to fill the void left behind by the US and European consumers. That’s not very realistic. Also, Chinese consumption will have to be different from American consumption and European consumption.

Li Xiaoxi: China’s consumption should increase incrementally, not drastically. A dramatic jump in Chinese consumption is not necessarily a good thing, as the global economy is so interdependent. Some people suggest that if China consumes all the goods, there will be nothing left for export.

If China doesn’t export that much, it won’t have much cash to buy T-bonds from the US. Some people seem to assume that China can consume more and at the same time keep buying US bonds. It’s difficult to have your cake and eat it too. In the interdependent global economy, we should keep cool-headed.

Jonathan Woetzel: I guess building on that, does more Chinese consumption mean more Chinese imports?

Bai Chong’en: I don’t think it’s appropriate to say what is the right level of consumption in China. You never know. Different nations have different cultures, and the demographics are also different. The Chinese population is rapidly aging. That makes it necessary for us to save. So my view is that as long as we get rid of some of the structural failures or institutional problems that suppress consumption, then we are OK.

Wang Xiaolu: I think in the coming 10 or 20 years, urbanization will still play a crucial role in China’s economic development. In the past period, [we had] basically a one percentage-point increase each year in the urbanization ratio. And currently the urbanization rate is only 45 percent. [China could] achieve 70 percent of people living in urban areas. We still have a long way to go.

Jonathan Woetzel: What should companies do—companies that target the Chinese consumer? Is now the time to invest, or should they be waiting to see what happens?

Li Xiaoxi: If I’m a business consultant, I would advocate “Green Consumption.” I don’t know if there is such a term in English, but I believe this will become a very critical term in the future. This is one of the areas where China and the US can do a lot together, and there is great room for global cooperation as well.

Bai Chong’en: The old consumption pattern cannot be sustained any more. The main idea now is how to create consumption for all these consumers—from China, India, and from other countries—given our resource constraints, given our environmental constraints. That’s the biggest challenge to the world.

Jonathan Woetzel: Gentlemen, thank you very much.