Can China pull it off?
A couple of weeks ago, the IMF told the world that China was essentially doing all right. It is “transitioning to a new normal,” the IMF said in its regular economic assessment, toward “slower but safer and more sustainable growth.” The main risk, it said, was that the Chinese government’s push for economic reform might prove “insufficient.”
It seems this is a pretty big risk.
Illustration: Tania Chou
Financial markets were shaken by China’s decision to abruptly devalue its currency on Aug. 11, days ahead of the publication of the IMF report.
For all the IMF’s assurances that this was a minor adjustment after a sharp appreciation of the currency until then, a welcome step that “should allow market forces to have a greater role in setting the exchange rate,” investors seem to have taken it as an unsettling signal that the Chinese authorities are desperate.
“The stumbling economy desperately needs a weaker currency,” wrote Diana Choyleva of Lombard Street Research. “Is this the start of a more flexible currency regime or an old-style devaluation?”
Nobody believes China’s official statistics anyway. What if the country’s economy is slowing faster than anybody knows? Developing countries — already reeling from the collapse of China’s demand for their raw materials — could feel the screws tighten further. And if China resorted to further devaluations to bolster exports and work itself out of an economic morass, it would undercut growth worldwide.
On Tuesday, after a 22 percent drop in Shanghai’s main stock market over three days, the Chinese government unleashed a new volley of measures to try to stop the slide, including cutting interest rates and reducing the reserve requirement on banks to stimulate lending again. This added to a rash of less orthodox interventions over the last few weeks, from encouraging borrowing to buy stocks to pledging billions to state-controlled banks to lend to favored projects.
The aggressive actions by the Chinese authorities signal their growing concern over the country’s declining stock market and weakening economy. However, these sorts of moves are not quite what the IMF means when it calls on China to transition from a single-minded export machine into a more complex market economy powered by consumers.
And this brings up a deep, lingering mistrust about Chinese economic governance: There is scant evidence from history that an authoritarian, undemocratic regime like China’s could actually pull off the kind of transformation that it is being called on to make.
“On average, autocratic nations grow faster than democratic ones up to around where China is now, but successful cases democratize at around this level of income per capita,” said David Dollar, a former China expert at the World Bank and emissary to China at the US Department of the Treasury who is now at the Brookings Institution.
Here is how that sounds in Beijing: Further economic change will inevitably lead to political instability — not exactly the strongest incentive for government reform.
A totalitarian regime might be good at deploying capital and labor to deliver raw economic growth. Yet, autocracies are not good at fostering innovation and creativity, which rarely flourish where there is no freedom of thought or speech. While “make the economy grow and don’t have demonstrations” might have worked in the past, a bureaucratic command and control structure will have a hard time handling the more complex demands of citizens in countries that reach middle-income status.
“It must rely more on innovation and provide more services to urban migrants,” Brookings Institution expert on China Kenneth Lieberthal said. “It also has environmental constraints and a demographic profile that is shifting dramatically, with a rising proportion of dependents and a shrinking proportion of workers.”
It is easy to get things wrong. Spending in rural areas on health and education has been dismal. For all the progress of urban schools, the low quality of rural education suggests China might face an acute shortage of skilled labor as it moves up the development ladder.
China’s succession of five-year plans has given local government officials a single goal: grow. This set them off on a binge of borrowing to build everything from roads to industrial parks, often generating lucrative kickbacks for local officials and their families.
“Local governments have been very successful at generating investment and growth, contributing to China’s extraordinary growth performance,” Dollar wrote. “On the other hand, they have not put as much effort into public goods such as environmental protection or social services.”
To understand China’s predicament, Dollar compared its experience with some of the best known stories of successful economic development of the last half-century: Japan, which reached China’s income level per capita in the early 1970s; Taiwan, which passed this threshold in the early 1980s; and South Korea, which hit it in the 1990s.
What is most striking is not how all three countries followed quite similar paths, but how China’s trajectory has diverged from the others’.
Household spending was always the main source of demand in all three, declining gradually to about 50 percent of GDP when they were about as rich as China is today. Investment rates, which rose sharply in the early stages of their development, peaked at that time at about 35 percent of GDP.
By these metrics, China’s economy is upside down: Consumer spending by households is only 35 percent of the nation’s GDP — one of the lowest levels in the world. Its investment rate — nearly 50 percent of GDP — is extraordinarily high. And the productivity of this investment is dismal.
To a large extent, its authoritarian command and control economic governance is to blame. Limits on legal migration to cities promoted an underclass of illegal urban workers toiling for meager wages, slowing consumer spending and hindering urban development. State-owned monopolies plowed profits back into investment rather than into government spending on social welfare. Near-zero interest rates on deposit accounts provided cheap loans to businesses, but penalized savers.
And this means the Chinese transition will be much more complicated. Unlike Taiwan, Japan and South Korea — which went into their transitions with substantial trade deficits, which swung into surplus to pick up the slack when investment rates declined — China has been running a hefty surplus for years. A still-fragile world economy is in no position to absorb even more Chinese imports.
And then there is the democratic deficit. The changes China needs today will require enriching — and empowering — its own citizens. Perhaps that is why despite repeated pledges from top Chinese authorities to reform and “rebalance” its lopsided economy, not much has happened. As the IMF report said, in most areas China’s progress “has just succeeded in slowing the pace at which vulnerabilities rise.”
Perhaps that is why financial markets are spooked.
“The Chinese, too, think it is unclear where their economy and society will be 10 years from now,” Lieberthal said.
If China does not know, how can we?
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