CHINA
25 September 2016
China’s conundrums
The Chinese economy of today is riddled with conundrums, writes John West.
The Chinese economy of today is riddled with conundrums. The government would like to open up the economy to more market forces, but at the first sign of inevitable volatility, its knee-jerk reaction is to impose anti-market controls. It would also innovation to become the new driver of economic growth, but repression of voices of dissent, who are often the most innovative, has been ramped up under President Xi Jinping. Very few other countries have benefited from the post-war system of multilateral cooperation, but China is now regularly flouting and challenging this system.
China’s conundrums are the inevitable consequence of its particular development model. The Chinese Communist government gradually opened up its state-owned and centrally planned economy from 1978. The main elements were opening up to foreign investment and trade, permitting private enterprise, and privatizing many state-owned enterprises (SOEs). China thus stunned the world with three decades of 10% growth rates.
There has been much debate over the role of these SOEs, especially how independent that might be of government control. Their relative share in the economy has declined in tandem with the development of the private sector, and they lag the private sector in terms of productivity and efficiency. But their importance and links to the Chinese government have only grown President Xi Jinping leadership.
Overall, China is not at all an open market economy, as evident by the OECD’s research which highlights stringent state controls on the economy and barriers to trade and investment, which have only been getting worse. And while private entrepreneurship is vibrant in China, when firms become large and successful, they are used co-opted into the government’s sphere of influence. The Chinese Communist Party does not relish the development of other sources of power. “The Communist Party” operates like a mafia organisation,” I was once told in Beijing.
One important instrument of industry protection through much of China’s development was exchange rate manipulation. The value of the Renminbi (RMB) was kept artificially low to help exports and discourage imports. This generated balance of payments surpluses, and resulted in a massive accumulation of foreign exchange reserves. This reserve accumulation was very costly to Chinese citizens who were deprived of imports. It also meant that there less pressure on Chinese industry to become more competitive and productive. But these reserves, which today are still over $3 trillion, provide the Chinese government with financial firepower for international diplomacy (like the Asian Infrastructure Investment Bank) and international investment.
When the US was struck down by financial crisis in 2008, triumphalism was the reaction of Chinese leaders. They interpreted this as a sign of the decline of the US, and the ascendancy of Asia. This period also saw the beginning of a new Chinese assertiveness in international relations and against America and Japan, in particular.
But the Chinese government also panicked. The Chinese economy had long been dependent on exports to the US and other Western markets, and there was fear of the adverse impact on the economy. So the Chinese government launched a massive stimulus package, by pushing state-owned banks to lend money to SOEs and local governments. And all the strictures of state-owned bank dominated financial system, paved the way for a boom in China's shadow banking.
As a result, China's total debt rose from $7 trillion in 2007 to $28 trillion by mid-2014. Representing 282% of GDP, China’s debt is now even larger than that of America (269%) or Germany (258%). China’s rapid debt buildup is about double that in the US before the global financial crisis or in Korea before the Asian financial crisis. If the current pace of debt buildup continues, China's debt would reach 400% of GDP by 2018.
Much of China’s debt is in the SOE sector, with corporate debt representing 125% of GDP. Many of China’s SOEs are zombie companies which are de facto bankrupt. China's government debt of 55% of GDP could jump quickly if the government were obliged to bailout SOEs or to recapitalise financial institutions. Many local government infrastructure projects are not capable of generating financial returns to enable debt repayment. And nearly half of China's total debt is directly or indirectly related to the volatile real estate sector.
Another consequence of the stimulus package is industrial overcapacity which has reached astronomical proportions across a wide range of industries like steel, aluminium, cement, chemicals, refining, flat glass, shipbuilding, and paper and paperboard. For example, China’s steel production “has become completely untethered from real market demand, and is now more than double the combined production of the four next leading producers: Japan, India, the US and Russia”.
Today, the Chinese economy has reached a major turning point, as reflected in its current slowdown. The economy is probably growing in the 2-4% range, not the 6-7% recorded in the country's dodgy statistics. It may have the world’s biggest GDP in purchasing power parity terms, but its GDP per capita is only one-quarter of that of the US. While poverty has been slashed from 89% of the population in 1990 to 27% in 2010 (based on a poverty line of $3.10 a day), only 20% of the population live on more than $10 a day. And China still does not have even one company on Forbes’ list of “The World's Most Valuable Brands”, while Japan has six and Korea has two.
The only way that China can continue to climb the development ladder and global value chain, and become an advanced economy is by reigniting its productivity genie. Since 2007, China's productivity growth has been on a sharp downward trend, and has been hovering around zero in the past couple of years, after having been a key driver of economic growth during much of the reform period. This is all the more worrying now that China's labor force has also been falling these past few years, the result of the sharp decline in the country's fertility rate. With less and less workers, China must lift its productivity. China’s labour productivity is only 15-30% of the level in OECD countries.
As the European Chamber of Commerce has argued "China is not yet an open and domestic market, but rather a patchwork of regional markets, each with its own unique trade and investment barriers”. Indeed, local protectionism is widespread. Local governments promote favoured firms. SOEs have access to subsidized credit, energy and other inputs. They are often tasked with political objectives like maintaining employment. Corporate bankruptcies are avoided by banks rolling over company loans and using local subsidies.
The World Economic Forum has highlighted the structural weaknesses of China’s financial sector. This is dominated by large state-owned banks, which lend mostly to SOEs or large corporations with connections. It is not surprising that they have accumulated many non-performing loans. Small and medium enterprises which could provide new dynamism to the economy struggle to obtain finance.
China’s lack of capacity to innovate has also become a growing concern in recent years. Evolving from a manufacturing-based economy to an innovation powerhouse requires a holistic approach to the innovation ecosystem, including nurturing talent and technological readiness. It is a lot more than spending money on R&D, as China has been doing. It also requires an open society with freedom of speech and academic freedom, which is less and less the case in China today.
As a number of analysts have noted, there is a yawning gap between China’s WTO commitments and practices:
“China’s economic and trade policies increasingly contravene fundamental principles of global trade, including national treatment, non-discrimination, and rules-governed, market-based trade in accordance with the theory of comparative advantage. And, if anything, China’s aggressive embrace of innovation mercantilism -- policies such as forced technology transfer, export and production subsidies, or currency manipulation that seek to advantage domestic enterprises at the expense of foreign competitors -- have only grown stronger in recent years.”
Clearly the government is concerned about social stability risks due to job losses that might result from reform in light of growing labor and other social unrest. It is also struggling with local government and SOE vested interests who might lose from reform. Many SOE managers are also members of the Communist Party’s Central Committee.
It also seems that the Chinese Communist Party is still in the midst of a power struggle on the reform agenda and other issues. Moreover, surrendering control of the economy to market forces is anathema to the “control-freak” nature of the Chinese Communist Party.
There is also a political agenda which is overriding economic imperatives. The government is attached to its goal of “building a moderately prosperous society in all respects and double the 2010 GDP and per capita personal income by 2020”. Thus, it wants economic growth at all costs by employing monetary and fiscal stimulus, and adding further to debt, rather than structural reform. The government is also already eyeing the 2021 celebrations of the centenary of the founding of the Communist Party.
Perhaps the most important political event on the agenda is the 19th National Congress of the Communist Party of China which will be held in the autumn of 2017. While President Xi Jinping will rule for another five year term, this event is very important and sensitive in that it is the occasion to the promote the next generation of leaders to the Politburo Standing Committee. And with different factions jockeying for position, it is of crucial importance for President Xi to have economic stability at this time -- all the more so given that he is angling for a third term. He may be constitutionally limited to two terms as President, but for the offices where real power reside – the General Secretary, and the Chairman of the Central Military Commission – terms are not limited.
In short, China has been able to transform economic weight into economic and political power, even though its GDP per capita, and level of economic and technological sophistication are modest. But neverthelss, China will remain a fragile superpower until it modernises its economy, society and politics. Indeed, Chinese President Xi Jinping should not be surprised that China is very weak in terms of soft power. No country aspires to the Chinese economic or political model. And China has extremely few friends, in contrast to the widespread alliances and partnerships of the US.
China’s conundrums are the inevitable consequence of its particular development model. The Chinese Communist government gradually opened up its state-owned and centrally planned economy from 1978. The main elements were opening up to foreign investment and trade, permitting private enterprise, and privatizing many state-owned enterprises (SOEs). China thus stunned the world with three decades of 10% growth rates.
Role of SOEs
At the same time, the government kept an important stable of SOEs, especially in the energy, telecommunications and banking sectors. These SOEs benefit from government protection and assistance, some of which is designed to help China improve its technological capacity. These SOEs also act as agents of the Chinese state through their foreign investment activities, and through stimulating the domestic economy.There has been much debate over the role of these SOEs, especially how independent that might be of government control. Their relative share in the economy has declined in tandem with the development of the private sector, and they lag the private sector in terms of productivity and efficiency. But their importance and links to the Chinese government have only grown President Xi Jinping leadership.
Overall, China is not at all an open market economy, as evident by the OECD’s research which highlights stringent state controls on the economy and barriers to trade and investment, which have only been getting worse. And while private entrepreneurship is vibrant in China, when firms become large and successful, they are used co-opted into the government’s sphere of influence. The Chinese Communist Party does not relish the development of other sources of power. “The Communist Party” operates like a mafia organisation,” I was once told in Beijing.
One important instrument of industry protection through much of China’s development was exchange rate manipulation. The value of the Renminbi (RMB) was kept artificially low to help exports and discourage imports. This generated balance of payments surpluses, and resulted in a massive accumulation of foreign exchange reserves. This reserve accumulation was very costly to Chinese citizens who were deprived of imports. It also meant that there less pressure on Chinese industry to become more competitive and productive. But these reserves, which today are still over $3 trillion, provide the Chinese government with financial firepower for international diplomacy (like the Asian Infrastructure Investment Bank) and international investment.
China's unbalanced, unstable, uncoordinated, and unsustainable economy
As early as 2007, Premier Wen Jiabao warned that the Chinese economy may have looked extremely strong, but was increasingly, “unbalanced, unstable, uncoordinated, and unsustainable” (the “four uns”). In particular, the environmental cost of China’s development has been massive.When the US was struck down by financial crisis in 2008, triumphalism was the reaction of Chinese leaders. They interpreted this as a sign of the decline of the US, and the ascendancy of Asia. This period also saw the beginning of a new Chinese assertiveness in international relations and against America and Japan, in particular.
But the Chinese government also panicked. The Chinese economy had long been dependent on exports to the US and other Western markets, and there was fear of the adverse impact on the economy. So the Chinese government launched a massive stimulus package, by pushing state-owned banks to lend money to SOEs and local governments. And all the strictures of state-owned bank dominated financial system, paved the way for a boom in China's shadow banking.
As a result, China's total debt rose from $7 trillion in 2007 to $28 trillion by mid-2014. Representing 282% of GDP, China’s debt is now even larger than that of America (269%) or Germany (258%). China’s rapid debt buildup is about double that in the US before the global financial crisis or in Korea before the Asian financial crisis. If the current pace of debt buildup continues, China's debt would reach 400% of GDP by 2018.
Much of China’s debt is in the SOE sector, with corporate debt representing 125% of GDP. Many of China’s SOEs are zombie companies which are de facto bankrupt. China's government debt of 55% of GDP could jump quickly if the government were obliged to bailout SOEs or to recapitalise financial institutions. Many local government infrastructure projects are not capable of generating financial returns to enable debt repayment. And nearly half of China's total debt is directly or indirectly related to the volatile real estate sector.
Another consequence of the stimulus package is industrial overcapacity which has reached astronomical proportions across a wide range of industries like steel, aluminium, cement, chemicals, refining, flat glass, shipbuilding, and paper and paperboard. For example, China’s steel production “has become completely untethered from real market demand, and is now more than double the combined production of the four next leading producers: Japan, India, the US and Russia”.
Need for market forces to play a decisive role
The Third Plenum of November 2013 announced a new phase of widespread reforms, with market forces set to play a "decisive role" in the economy. The goal is to wean the Chinese economy off its investment- and export-led growth model towards one based on domestic consumption and services.Today, the Chinese economy has reached a major turning point, as reflected in its current slowdown. The economy is probably growing in the 2-4% range, not the 6-7% recorded in the country's dodgy statistics. It may have the world’s biggest GDP in purchasing power parity terms, but its GDP per capita is only one-quarter of that of the US. While poverty has been slashed from 89% of the population in 1990 to 27% in 2010 (based on a poverty line of $3.10 a day), only 20% of the population live on more than $10 a day. And China still does not have even one company on Forbes’ list of “The World's Most Valuable Brands”, while Japan has six and Korea has two.
The only way that China can continue to climb the development ladder and global value chain, and become an advanced economy is by reigniting its productivity genie. Since 2007, China's productivity growth has been on a sharp downward trend, and has been hovering around zero in the past couple of years, after having been a key driver of economic growth during much of the reform period. This is all the more worrying now that China's labor force has also been falling these past few years, the result of the sharp decline in the country's fertility rate. With less and less workers, China must lift its productivity. China’s labour productivity is only 15-30% of the level in OECD countries.
China's productivity challenge
To meet its productivity challenge, China must remove more of the shackles of central planning and communism, and become an open market economy, which it is not at all today.As the European Chamber of Commerce has argued "China is not yet an open and domestic market, but rather a patchwork of regional markets, each with its own unique trade and investment barriers”. Indeed, local protectionism is widespread. Local governments promote favoured firms. SOEs have access to subsidized credit, energy and other inputs. They are often tasked with political objectives like maintaining employment. Corporate bankruptcies are avoided by banks rolling over company loans and using local subsidies.
The World Economic Forum has highlighted the structural weaknesses of China’s financial sector. This is dominated by large state-owned banks, which lend mostly to SOEs or large corporations with connections. It is not surprising that they have accumulated many non-performing loans. Small and medium enterprises which could provide new dynamism to the economy struggle to obtain finance.
China’s lack of capacity to innovate has also become a growing concern in recent years. Evolving from a manufacturing-based economy to an innovation powerhouse requires a holistic approach to the innovation ecosystem, including nurturing talent and technological readiness. It is a lot more than spending money on R&D, as China has been doing. It also requires an open society with freedom of speech and academic freedom, which is less and less the case in China today.
As a number of analysts have noted, there is a yawning gap between China’s WTO commitments and practices:
“China’s economic and trade policies increasingly contravene fundamental principles of global trade, including national treatment, non-discrimination, and rules-governed, market-based trade in accordance with the theory of comparative advantage. And, if anything, China’s aggressive embrace of innovation mercantilism -- policies such as forced technology transfer, export and production subsidies, or currency manipulation that seek to advantage domestic enterprises at the expense of foreign competitors -- have only grown stronger in recent years.”
China's reform paralysis
Despite the manifest need to give market forces a “decisive role” in the economy and to reignite the productivity genie, at this stage the Chinese government lacks the courage to do. Little real reform has actually occurred, apart from stuttering reforms to financial markets. The greatest efforts have been employed on prestige projects, like having the RMB included in the IMF’s Special Drawing Rights, rather than substantial projects.Clearly the government is concerned about social stability risks due to job losses that might result from reform in light of growing labor and other social unrest. It is also struggling with local government and SOE vested interests who might lose from reform. Many SOE managers are also members of the Communist Party’s Central Committee.
It also seems that the Chinese Communist Party is still in the midst of a power struggle on the reform agenda and other issues. Moreover, surrendering control of the economy to market forces is anathema to the “control-freak” nature of the Chinese Communist Party.
There is also a political agenda which is overriding economic imperatives. The government is attached to its goal of “building a moderately prosperous society in all respects and double the 2010 GDP and per capita personal income by 2020”. Thus, it wants economic growth at all costs by employing monetary and fiscal stimulus, and adding further to debt, rather than structural reform. The government is also already eyeing the 2021 celebrations of the centenary of the founding of the Communist Party.
Perhaps the most important political event on the agenda is the 19th National Congress of the Communist Party of China which will be held in the autumn of 2017. While President Xi Jinping will rule for another five year term, this event is very important and sensitive in that it is the occasion to the promote the next generation of leaders to the Politburo Standing Committee. And with different factions jockeying for position, it is of crucial importance for President Xi to have economic stability at this time -- all the more so given that he is angling for a third term. He may be constitutionally limited to two terms as President, but for the offices where real power reside – the General Secretary, and the Chairman of the Central Military Commission – terms are not limited.
Economic size means political power
Despite China’s economic travails, its economic size does matter. China’s large market is a magnet for other countries, which makes many foreign governments and enterprises cave into many Chinese demands. Its enormous foreign exchange reserves also matter greatly. Chinese investment funds a widely sought after, especially for infrastructure projects, even though China’s own infrastructure is still very much wanting. China is also openly buying political influence in countries like the US and Australia, and has been able to make massive investments in its military.In short, China has been able to transform economic weight into economic and political power, even though its GDP per capita, and level of economic and technological sophistication are modest. But neverthelss, China will remain a fragile superpower until it modernises its economy, society and politics. Indeed, Chinese President Xi Jinping should not be surprised that China is very weak in terms of soft power. No country aspires to the Chinese economic or political model. And China has extremely few friends, in contrast to the widespread alliances and partnerships of the US.