May 13, 2016

China: Dealing with the End of the Growth Era

Crew members of China Eastern Airlines pose for a group photo with a plane which is painted with Disney figures in Beijing, capital of China, April 26, 2016.
Crew members of China Eastern Airlines pose for a group photo with a plane which is painted with Disney figures in Beijing, capital of China, April 26, 2016.

Both the European Union and the United States can encourage China to carry out transition reforms for future generations.

Since the opening-up of China in the late 1970s, the Middle Kingdom has grown at an exponential rate. Today it is the world’s second-largest economy. The policies of the Chinese leadership have lifted more people out of poverty than any other governing group in human history. However, after 35 years of economic growth China is now facing the pain of transition. Sustained growth on the same scale as the last three decades is improbable. This is something that China, the EU and the US are going to have to struggle with. There is, for instance, going to be no linear ascent of China by which it overtakes the United States. More significantly, however, reduced growth from the levels of the golden years, and the Chinese Communist Party’s response to such reduced growth, is likely to generate greater internal and external instability.
The rise of China from the chaos of the Cultural Revolution to the transformation of the country as the world’s second-largest economy is one of the most amazing transformations in modern times. In 1974, when Deng Xiaoping was due to visit New York, his officials found that, with no banks in China, they could only locate $38,000 to fund the trip. China’s GDP in 1979, at the real beginning of the Chinese economic opening, amounted to only 176 billion dollars. However, 35 years of economic growth at rates for most of that time of over 10% have delivered a GDP of almost 11 trillion dollars. Not only have these growth rates seen China’s economy become second only to that of the US, they have also provided the means to lift more than half a billion people out of poverty and have created the world’s largest middle class. No governing group in history has delivered so much material success to its own people in such a short space of time.
There is, however, a real danger that this genuine and substantial success clouds the views both of analysts who focus on China and of the leadership of the Communist Party as to the prospects of future success. Whilst the CPC was tremendously successful at negotiating its way out of the Cultural Revolution, keeping the country and party together while healing the wounds of the past and opening up the economy, it had unique and one-off advantages in play. Most significantly, China had huge supplies of under-employed labour in its rural communities, very low income levels and (given no healthcare or pensions) a huge propensity to save, wherever the population could do so. A potentially huge market, vast labour resources, low income levels and large savings on which to draw provided the basis for the supercharged economic growth of the last three decades.
That rate of economic growth is now coming to an end. As pools of rural labour have dwindled, income levels have risen so significantly in the country’s major exporting regions that China is losing its competitive labour advantage against both rival middle-income countries and some developed countries. In addition, the other major ingredient which supercharged economic growth—capital investment—is now far less effective at stimulating growth, as most of the infrastructure that will generate worthwhile economic returns has already been built.
China needs to develop a different economic model to advance. This would principally focus on encouraging consumption, a broader services economy and high-value-added services and technology. However, this is far easier said than done. Switching to a consumption-based economy requires Chinese savers to stop saving and start spending. Although the government has started to roll out some healthcare and pension provision, it remains minimal. Trade restrictions make it hard for Western services companies to enter the Chinese economy, and without those entrants it will be a difficult and lengthy process to develop a deep functioning services economy. Furthermore, a high-value-added economy relies upon the free flow of information and the rule of law, to ensure and protect intellectual property rights. The rule of law and, particularly, secure intellectual property rights remain, despite official rhetoric, limited.
Although the current Chinese leadership under President Xi has made efforts to undertake further economic reform with its new free trade zones and commitments to reform state-owned enterprises (SOEs), there has been no major attempt at a further economic transformation. The major change from President Xi has focused on anti-corruption campaigns, restricting Western influence and strengthening the control of the CPC. The most significant economic development has been the direction of yet more capital from the state banks to the SOEs and private companies to build yet more infrastructure, increase productive capacity and acquire yet more assets abroad. The latter direction has resulted in a wave of foreign investment, which in the first quarter of 2016 resulted in more than 100 billion dollars of Western acquisitions.
This strategy, however, is fraught with danger. It loads more and more debt on the books of the state banks, other state financial institutions and the shadow banking sector. Increasingly, less economic return on the debt is being created. Already the debt-to-GDP ratio is over 230%.
These policies are also likely to create trade disputes with the rest of the world. In order to stave off recession and maintain employment, the Chinese party-state is directing its banks to increase the productive capacity of its SOEs and private companies. As a result, the rest of the world is facing a glut of, first, steel production, and, further down the road, chemicals from China’s chemicals companies and coal producers. (As growth slows further, even coal will begin to be exported—potentially wrecking EU climate change policies.) This export of the fruits of state-directed, state-financed increases in productive capacity is increasingly likely to be resisted by the rest of the world as an illegitimate act by the Chinese state and not the operation of a free and open market.
A further source of conflict is likely to flow from the increased export of Chinese capital rather than goods. At one level, economically stressed Western countries may take the view that any Chinese investment is to be welcomed. However, on closer examination it is difficult to be so uncritical of such investment. One issue that a recipient of Chinese investment has to recognise is that it brings an expectation that core Chinese interests will be respected—be it on Tibet, human rights, or Chinese interests in South-East Asia. The second factor focuses upon the security concerns discussed by the US authorities in their foreign investment review process, centred on the Committee on Foreign Investment in the US (CFIUS). These concerns are largely focused on acquisitions by Chinese companies of key infrastructure, high technology, telecommunications and security-related infrastructure. The view taken by the US government is that a non-trivial risk to US security flows from state-owned or state-connected companies having access to key infrastructure and technology companies. As China seeks to export more capital abroad, these security concerns will also arise in Western capitals other than Washington.
A third factor is, even absent any security concerns, the prospect that China will seek to acquire businesses with high technology and/or valuable intellectual property rights. The fear is that the acquiring Chinese company—with assistance from the state—will close the Chinese market to Western competitors of the acquired company, allowing it to grow thick margins in the immense Chinese market. In other words, acquisition becomes a market-restriction and trade-protection strategy which allows China over time to rig global markets in its favour. As Chinese investment in the West continues to expand, all three factors will generate additional sources of conflict.
Over the last three decades, the world and China have got used to Chinese growth; fuel and commodity markets relied upon it; Western businesses exporting to China relied upon it; Germany relied upon it (almost half of EU exports to China are from Germany); and the global economy relied upon China as a guaranteed source of economic growth. And, above all, the CPC relied upon the economy to deliver growth to maintain its legitimacy and political power. Certainly the levels of growth of the golden era are now past.
The difficulty for China, and the world as a whole, is that the desired economic transition may well be unstable and troubled, and ultimately may not happen. The CPC’s default behaviour when faced with trouble over the past 35 years has been to deploy more capital and watch the economy roar away again. However, most of the infrastructure which would generate good returns has already been built. Equally, China (and the world) does not need any more capacity in steel, chemicals or coal. Nor is there the cheap labour available to provide the old core component of Chinese competitiveness. The CPC needs to adjust its policy prescriptions for the world in which it is now living, rather than the world that used to exist. To be fair to the politburo, undertaking reform is never easy. Over three decades, huge vested interests have become entrenched and benefit from the existing model, SOE executives, and networks of state banks, regional governments and local elites. However, unless the nettle of reform is grasped, there is likely to be internal instability as the old economic model finally exhausts itself amid mountains of debt and even lower growth rates. Externally, China is likely to face mounting and universal criticism from other producers of basic industrial products. China could face almost complete opposition from its trade partners.
It is to be hoped that President Xi and the CPC adapt, as Deng Xiaoping and the party did in his day. The obstacles are great, and time is short, but the prize of a high-income China at peace with itself and the rest of the world is great. Both the EU and the US can assist by encouraging the Chinese government to develop the transition policies which will allow China to transform successfully for another generation.


This article was published in ICDS Diplomaatia magazine.

Filed under: CommentaryTagged with:

No comment yet, add your voice below!

Add a Comment