Critical Issues Confronting China Summary–China's Economy: Does Growth Have a Future?

October 17, 2016
Arthur R. Kroeber, Head of Research, Gavekal; Founder, Gavekal Dragonomics; Editor, China Economic Quarterly

Today China is the biggest trading country in the world and the second largest provider of foreign direct investment (FDI) to other countries, only after the U.S. Its GDP is projected to over take the U.S. in about 15 years. How did China transform itself from an economically unimportant country as late as the end of the 1970s into the second largest economy in the world, surpassing Japan in 2010? What are the challenges China's economy confronts now? And what should we expect in the coming decade or so? Arthur R. Kroeber, Head of Research of Gavekal, Founder of Gavekal Dragonomics and Editor of the China Economic Quarterly, addresses these questions in turn during his talk.

China's economic success story resembles the East Asian development model–which Japan, South Korea and Taiwan all shared–in three ways. First, China's agricultural reform in the 1980s was very effective in motivating farmers with the right incentives and increasing their productivity. Like other East Asian countries, China had relatively even land distribution among farmers so that no big land owners could oppose large-scale industrialization. Second, through financial repression, the state mobilized the excess capital accumulated from agricultural improvement for industrial and educational development. Third, China's economy quickly became export-oriented in the 1980s. This orientation, instead of import substitution or domestic consumption, brought China advanced foreign technology and scarce foreign capital. It forced Chinese manufacturing industries to become competitive in world markets and to upgrade themselves technologically.

China differs from other economically successful East Asian countries in two respects. China's growth has relied on FDI and state owned enterprises (SOEs) more heavily than others did. More reliance on FDI meant that the Chinese economy was more open to foreign technology transfer than other countries in the same development stage. More reliance on SOEs meant that China did not engage in large-scale privatization of state owned assets until mid and late 1990s when smaller SOEs were let go. China's initial success relied more on market liberalization of prices and encouragement of competition from private enterprises rather than privatization. Reliance on SOEs also meant more effective execution of government's economic policies and directives, such as rapid infrastructure construction throughout China. In short, China represents the most successful transition from a planned economy to a market economy, while maintaining its own political system.

Now China's economy faces at least two constraints. One is the domestic tension between the government's economic growth agenda and its ultimate objective of maintaining the Chinese Community Party’s (CCP) one-party control. One plausible reason that the CCP has defied many foreigners' forecast of its demise amid a dynamic economy increasingly driven by the private sector's growth is the CCP's long view of its power. From time to time, it gives up some control in order to foster economic growth because it believes that healthy economic growth will in turn enhance its legitimacy and prolong its power. The other constraint has to do with international relations. Japan, South Korea and Taiwan have all been U.S. allies politically and militarily, whereas China is not. With the political trust of the U.S., these East Asian countries had an easier time with integrating their economies into the world economy. In comparison, China had to pay a higher price for market access and technology transfer. The Americans are still ambivalent about China's political system.

Two more economic challenges confronting China are inefficient use of capital by SOEs and a rapid aging population. As the need for more infrastructure in China declines, the advantage of SOEs in construction diminishes. The average return on assets for SOEs (three percent), is only one-third of that of private Chinese enterprises (nine percent); while the SOEs are twice as indebted as private Chinese enterprises on the whole. This implies that a re-allocation of resources from inefficient SOEs toward the private sector is urgently needed. In addition, the ratio of China's working age population(15-64 year olds) to retirees is projected to decline from 6:1 today to 2:1 in 25 years. How to enhance productivity increase and technological upgrade becomes critical in light of these headwinds.

How will all these factors play out in the coming decade? Kroeber thinks that China's high debt level is unlikely to trigger another round of an Asian financial crisis because its debt is mostly domestically financed. As long as China keeps its high savings rate and banks have steady inflows of deposits, a high level of debt can be re-financed. He thinks that it is also unlikely that China will follow the Singapore model of essentially one-party control with a conservative reform agenda and a steady middle-level growth rate simply because China is too large and diverse. A more likely scenario, according to Kroeber, is that China will resemble Japan in the 1990s, when a long-term deflation set in, but the country still kept getting richer albeit at a much slower rate, and the original system kept going more or less intact.

On the positive side, the income growth in Chinese households has been very positive; there are still many low-hanging fruits in the system to harness. Kroeber concludes that as long as the Chinese government can get its act together or get out of the way of the private sector, there is still much potential for further economic growth. But if the government lets its political control agenda supersede its growth agenda or postpones crucial reforms due to vested interests and lets time slip away, that will be cause for concern.