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Why China May Stumble

Author: Steven Dunaway
October 13, 2009

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It is commonly predicted that some time in the next two decades China will overtake the United States to become the world's largest economy (although it is acknowledged that it will take considerably more time after that for China to achieve a comparable level of per capita income). These predictions generally are based on simple extrapolations of recent trends in GDP growth in China and the United States. On this basis, the results are not surprising. If China's gross domestic product (GDP) were to continue to grow at a rate more than three times faster than that of the United States, it would easily become the world's number one economy in the time frame envisaged.

But is such extrapolation sensible? There are serious questions as to whether China will be able to maintain a rapid enough rate of growth to vindicate the prognosticators.

There are at least three reasons why China may stumble in the period ahead. First, time appears to be running out on the investment-driven, export-led model of economic growth that China has used to develop its economy. With the slow growth in external demand that is likely to prevail over the next decade or so, continued adherence to this model will result in slower growth in China. Second, the rule of law remains underdeveloped; without it, China will find sustainable growth and development difficult to achieve over the long run. The lack of adequate means to enforce contracts and protect property will have an increasingly detrimental impact on growth over time. Third, political arrangements in China may make it difficult to establish the economic conditions needed for the country to maintain rapid growth. Only if China can deal effectively with these challenges will it be able to live up to its economic potential.

The End of Investment-Driven, Export-Led Growth

Since the mid-1980s, China's economic development has been driven by investment growth. Distortions in basic prices (such as low costs for capital, land, energy, other utilities, and pollution abatement), incentives, and institutional arrangements have strongly favored investment over consumption. In turn, because investment has created new productive capacity that has consistently outstripped domestic demand, exports and the substitution of domestic production for imported goods have been relied on to employ the excess productive capacity created. Reliance on exports and import substitution to lead China's economic growth has been supported by China's policy of maintaining what has become an increasingly undervalued exchange rate.

Up to now, China's growth model has delivered impressive results. But time is running out because of the model's success in making China one of the world's major economies. Further heavy reliance on investment to drive output growth will add to productive capacity and require continued strong export growth. However, mustering such export growth, especially given prospects for slower demand growth in the advanced economies in the period ahead, will be a difficult task. To be able to maintain relatively rapid export growth, China--which is already the leading trading nation in the world--will have to take an ever-increasing share of world trade. To do that, China's producers will have to significantly lower their export prices to overcome the stiff competitive pressures that will exist in world markets.

Rapid economic growth and development in China cannot be sustained for much longer with the current investment-driven, export-led growth model.

Profitability would decline, and Chinese firms would be expected to cut investment over time if they are operating on a commercial basis. In these circumstances, Chinese banks too, if they are operating on a commercial basis, should be increasingly reluctant to finance investment. Consequently, economic growth will slow. The government could step in (as it has in 2009) and prop up growth with fiscal and monetary policy, but such actions will be successful for only a short period of time, while creating additional problems that will at some point have to be dealt with (a lesson the Chinese authorities should have learned from their efforts to hold up economic growth in the early 1990s). Thus, rapid economic growth and development in China cannot be sustained for much longer with the current investment-driven, export-led growth model. Moreover, the situation facing China could be even worse if its attempts to maintain export growth were to invite retaliation from its major trading partners.

Lack of the Rule of Law Will Trip Up China

The rule of law is fundamental for sustaining economic growth and development. Individuals and firms need predictability in economic arrangements and assurances that contracts and property rights can and will be effectively enforced. In the initial phases of development, ad hoc arrangements--which tend to be based on relationships with a country's political authorities--might be adequate substitutes for the lack of a strong rule of law. Initially, high returns on investment might offset the risks associated with the potential unpredictability of such arrangements. But these ad hoc arrangements are not durable as an economy grows and becomes more complicated, returns on investment decline, and centers of political power and influence shift. As a consequence, increasing uncertainty in economic arrangements inevitably will lead to lower investment and slower economic growth.

The current economic and financial crisis is creating additional uncertainty regarding economic arrangements in China. The authorities are drawing the wrong lessons from the crisis.

The current economic and financial crisis is creating additional uncertainty regarding economic arrangements in China. The authorities are drawing the wrong lessons from the crisis. The problems that emerged in the financial systems of the advanced countries are being taken as justification for a continued heavy-handed government presence in the financial system. As a result, further reform of China's highly inefficient banking system and undeveloped financial markets appears likely to be sidetracked. Accordingly, the ability of the economy to sustain rapid growth will be undermined. It is further undermined by the authorities' recent efforts to promote consolidation in some major industries, with China's largest state-owned enterprises tapped to take leading roles. As a result, the government is likely to emerge with a greater direct role in the economy. This would be a major step backward. It will call into question the arrangements under which many existing firms operate and adversely affect the confidence of foreign and domestic private firms in investing in China.

Political Arrangements Could Constrain Growth

To sustain rapid economic growth, China's economy will have to be rebalanced away from its heavy reliance on investment and exports toward consumption. But to do so will entail a dramatic departure from the current growth model and the implementation of major economic reforms. It is not readily apparent that the authorities are up to the task. The current leadership is relatively weak and an instinct toward caution is deeply ingrained. Major economic policy decisions are made by consensus among the members of the State Council (consisting of roughly fifty people, including government ministers and senior members of the Chinese Communist Party), and it has proven difficult to reach a consensus on major economic reform issues among such a large group given their varied interests. There is a strong tendency to cling to the status quo and to favor policy strategies that involve taking only small steps to change the economy.

Moreover, it is not clear whether development of a more market-oriented economy is compatible with the views of the Chinese Communist Party regarding how it wishes to maintain control over the country. Other countries in East Asia controlled by single-party governments for long periods of time (including Malaysia, Korea, Singapore, and Taiwan) have successfully sustained rapid economic growth and development. But these countries have been willing and able to separate economic from political control. In China, the party appears reluctant to relinquish economic control. Its philosophy since the onset of economic reforms in 1978 has been that the government should control "the commanding heights of the economy." Clinging to this philosophy could severely limit the development of a more market-oriented economy and undermine China's ability to maintain rapid growth.

The reluctance to concede economic control is also reflected in macroeconomic policies. There continues to be heavy reliance on direct intervention in the economy instead of relying on indirect instruments of macroeconomic control. This is particularly evident with monetary policy, where government decisions on credit policy continue to play an important role. It also is reflected in the ongoing heavy management of the exchange rate.

A G-20 Opportunity

Contrary to popular belief, China's rise to becoming the world's largest economy is not inevitable. The country could stumble badly in the years to come, if current policies are largely maintained. It is in the best interest of the United States and the rest of the world to encourage and support policy changes in China so that rapid growth can be maintained. The emergence of the Group of 20, which includes China, as the world's leading forum for economic coordination of leading industrial states offers some new prospects for these changes. The agreement at the recent G-20 meeting in Pittsburgh on establishing and monitoring implementation plans to rebalance and improve prospects for growth in the major world economies creates an important opportunity to provide external pressure to help promote policy change in China.

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