China's economic policy is grossly misguided. On the one hand, too much hope is being placed upon export growth to follow on its past successes as did the former "miracle" economies. On the other hand, authorities in Beijing have hoped that public sector deficit spending would stimulate growth and halt deflation.
Chinese export activities are impressive. However, exports make up about a fifth of China's GDP, far less than in most other Asian nations. With mounting competition and possibilities of slowing growth in demand in foreign markets, exports cannot serve as a reliable growth engine.
Deficit spending is the wrong tool because it is essentially a cyclical tool. Of China's outstanding foreign debt, most of it has accrued over the past five years. China's slowing growth and falling prices reflect structural defects in the economy that will be unaffected by temporary public sector spending. An increasingly larger proportion of Beijing's tax revenue will be necessary just to service debt.
Like Japan, billions of dollars have been pumped into state-sponsored infrastructure projects. However, it is evident in both countries that public works cannot provide the level of growth required. In all events, much of the spending was meant to offset continued lack of consumer demand and the steep price deflation that affects prices of most manufactured goods.
In hopes of boosting domestic spending, interest rates have been cut while consumer credit was also loosened while taxes were imposed on bank interest earnings. Additional bank lending was made available while purchasing shares on the stock market was declared to be a patriotic duty. This latter step was taken in hopes of generating a "wealth effect" by rising portfolio values which would induce shareholders to spend more as asset values climb.
Yet taking the notion of a "wealth effect" seriously when it comes to China requires a leap of fantasy of cosmic proportions. More than 100 million workers in the state sector who do not spend because of concerns about job losses swamp China's nearly 34 million retail shareholders. Consequently, most additional income has been saved rather than spent, and that ratio has been rising.
The good news is that Beijing has promised to encourage private investment and open the economy to private companies. Plans have been announced to provide a higher priority to private industry in order to boost China's growth. This would lead to an end to discriminatory tax and land-use policies against private companies. Private enterprises would also be allowed to be on the same footing as state-run businesses for stock offerings.
However, this is not the beginning of creating a laissez faire economy. China does not have clear and transparent commercial law or the non-arbitrary adjudication to settle contract disputes that support sustainable growth in a private enterprise economy.
It appears that old habits die-hard. Officials in Beijing expect to guide investment and disallow private ownership in industries that affect national security. And "strategic" state monopolies will also be excluded. At the same time, old style intervention also is evident in the continuing habit of establishing official growth targets which are announced at the annual meetings of the National People's Congress.
Beijing raised the salaries of some workers under its employ, especially in urban areas, to stimulate spending. It also expects to bolster its social welfare programs and cut taxes to encourage households to spend more. Such steps will certainly lead to growing public sector deficits and a greater burden of debt.
It has also ordered a moratorium on the production of some types of goods to reduce current inventories while more money is to be spent on roads, bridges and other projects in hopes of creating jobs. This overlooks an important lesson of modern economics. Government spending cannot create permanent jobs, only private sector spending can.
Efforts to stimulate demand are unlikely to halt China's deflationary cycle. This is because its factories are simply producing too many goods. In order to reduce this overcapacity, inefficient plants must be shut down.
Yet downsizing is a tough choice. This is because China's work force increases by about 10 million new workers a year. Therefore, economic growth must be nearly 8 percent just to create jobs for the newcomers. Higher growth is necessary to absorb workers displaced by rationalizing industry.
During the worst of the financial crisis that swept East Asia, Beijing was able to escape financial meltdown. Unfortunately, whatever benefits might be had when hiding behind capital controls have been squandered. Now resolute steps must be taken to establish a modern financial architecture that is responsive to market forces.
Until China moves to a capital market guided by profits instead of party politics and ideology, it cannot pretend to have a world-class financial center. This requires privatizing banks and state-owned enterprises as well as removing barriers that inhibit foreign ownership and restrain competition.
Christopher Lingle is Professor of Economics at Universidad Francisco Marroquin in Guatemala and Global Strategist for eConoLytics.com.
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