Welcome to the Dragonbeat blog. Today, everyone with a serious interest in global issues needs to know about China. This blog expands the analysis of the Chinese economy previously found in the fortnightly column written by the China Economic Quarterly (CEQ) for FT.com. Dragonbeat’s principal writers are Arthur Kroeber, managing director of Dragonomics Research & Advisory, the parent company of CEQ, and CEQ managing editor Tom Miller. By moving to a blog format where you can expect a weekly post from us every Monday, we hope to provide a space where readers everywhere can share their views on China’s economy and its impact on the world. Our first blog post, written by Arthur Kroeber, is below:
The global financial crisis poses two challenges for China: one of domestic economic management and another of international economic diplomacy. How it addresses these two challenges will in large measure determine whether China takes up what it considers to be its rightful place as one of the world’s leaders, or subsides instead into a Japan-like irrelevance despite the size of its economy.
The domestic challenge is straightforward: China must find a new engine of productivity and employment growth to replace a long-running export engine that is likely to be out of commission for several years.
Make no mistake: the global economic conditions of the next decade are likely to differ fundamentally from the conditions that have prevailed during most of the history of China’s economic reform experiment. The formulas that worked in the past will not work in the future.
After it began its programme of “reform and opening” in 1978, many things changed in China but one thing did not: exports rose every single year. Sometimes they rose a little (for instance after the 1989 political crisis, or the 1998 Asian financial crisis); sometimes a lot. But they always went up, never down. In 1978, exports were less than 5 per cent of GDP; by 2001, before China’s accession to the WTO, they were 20 per cent; last year they were 33 per cent. China’s current account surplus, fairly negligible until 2004, peaked at 11 per cent of GDP in 2007.
It is a bit too simple to say that China is an “export driven economy”: as a continent-sized country, it has also generated a lot of growth from domestic market reforms, the privatisation of vast swathes of industry, and the investment required to support the biggest transfer of population from countryside to city the world has ever seen. But the export economy played a crucial role as a vector of new technology and a provider of employment.
All that is on hold now. This year, for the first time since its economic reforms began three decades ago, Chinese exports will fall. Moreover it is quite possible that several years will pass before the export peak of 2007 is recovered. This is because the principal mechanism that enabled China’s export expansion – debt-driven consumption in the US – is broken.
Between 1982 and 2007, US household debt rose from 48 per cent to 97 per cent of GDP, with more than half of that rise coming in the last decade. This huge debt expansion disguised the fact that real wages barely rose in the past 15 years. Over the next several years, US household debt will need to fall back to a more sustainable level, whatever that turns out to be. And after that, US consumption is likely to rise in line with real incomes – i.e., far more slowly than it has over the past quarter century.
Thus one of the principal background conditions of the global economy since the early 1980s – global trade growth nearly double the rate of global GDP growth – has disappeared. China needs to find a way for its economy to grow in a completely new environment.
Contrary to some of the more dire forecasts, China’s economy will continue to grow this year, mainly because the relatively strong position of the treasury and the banking system permit the government to pump huge amounts of money into the economy through fiscal and monetary channels.
But the structure of that growth is unlikely to be sustainable for more than a year or two. Most of the stimulus money is going into investment – and official data show that in 2008, investment’s share of GDP was already almost 44 per cent, substantially higher than the peak share reached in Japan and South Korea during their industrialisation. After two more years of investment-heavy growth, capital formation could approach half of GDP. At that level, the return on investment is likely to fall perilously close to zero, and economic growth will grind slower.
For the past few years, Chinese policy makers have tried to steer the economy onto a path where consumption plays a bigger role – mainly by massively increasing the budget for social services such as education and health care, in the hope that a more secure social safety net would encourage households to spend more of their income. But their efforts in this direction were tentative – in part because they imagined they had a decade or so to manage the transition to a more consumption oriented economy.
It is now clear that such a leisurely approach is inadequate. China needs another round of bold reforms – similar to the privatisation of the housing market and the drastic pruning of the inefficient state-enterprise sector in the late 1990s – in order to create a domestic source of productivity and employment growth to substitute for what has been lost in the export sector.
A good place to start would be the sclerotic service sector – in particular, retail, wholesale, distribution and logistics. In these sectors (except for retail) the state role remains large, and barriers to investment by domestic and foreign private firms are high. Unit distribution costs for consumer goods in China are about double, relative to final sales prices, what they are in the US.
In addition to spurring growth in productivity and employment, reform of these industries would aid the drive to boost consumption, by giving tens of millions of households in smaller cities and towns access to a far wider range of goods.
This is just one reform option – others are equally plausible. Yet there is scant evidence that the government is considering any of them. It appears to believe that a stable basis for economic growth can be created by pouring vast amounts of money into construction projects and waiting for the global good times to return. This is fantasy.
A similar failure of imagination characterises China’s response so far to the second challenge: defining its role in global economic governance. As the world’s third-biggest economy, China desperately desires, and certainly deserves, a “place at the table” where the world’s big economic decisions are taken.
Yet the sad fact is that China brings nothing to that table, other than its desire to sit at it, and a fat wallet. Its leaders have articulated no useful view of how regulation of the global economy and payments system could be improved – and indeed it could be argued that they have no strong interest in changing the rules of the game.
There are a variety of reasons for this. One is simply lack of experience: China has been integrated into the global economy for only a short time, and until four or five years ago Chinese economic policy makers could quite justifiably ignore the rest of the world and focus their energies on the domestic scene, because the level of integration was low. So the number of senior officials with any real understanding of how the global economy functions is very small.
This is perfectly understandable, and time will take care of it. But a more baleful factor is China’s unwillingness to face up to its complicity in the excesses of the past decade. In recent weeks Premier Wen Jiabao has taken to lecturing the Americans on the vices of debt and excessive consumption. One can hardly begrudge him a few sermons, after all the hectoring he has had to endure from ignorant and arrogant Americans about the superiority of their wondrous financial system.
But the hard fact is that China’s US$296bn trade surplus, and its US$2,000bn foreign exchange reserve wallet, are creatures of the same debt-fuelled consumption that Premier Wen denounces. The fallacy of conceiving of international economics as a morality play is that it is impossible for everyone to run a surplus. The supposedly virtuous thrift of savers is made possible only by the profligacy of spenders. A “virtue” that cannot exist without the “vice” of others is no virtue: it is simply one side of a trade.
China’s unwillingness to face up to this fact means that it actually has a strong interest in preventing a serious discussion of a reorganised global economic system. This is because any such discussion would probably have to consider – as a counterpart to measures constraining the ability of the US to abuse its reserve-currency privilege – some variant of a sensible proposal that John Maynard Keynes made during the Bretton Woods discussions of 1944-45: a tax on countries that insist on running big current account surpluses.
So both because it lacks technical tools, and because it has a strong interest in preventing a crucial point from being raised, China is unlikely to make a substantive contribution to the reorganisation of the world’s economic system. Its strategy will be to pony up a bit of cash and score a few political points, but otherwise sit back and hope that order can be restored so that it can continue selling its goods, and stretch out the painful transition to a more domestically-driven and consumption-oriented economy over as long a period as possible.
This is quite a natural position for a developing country with a lot of problems. But it is not the stance of a would-be leader of the world economic order.