Monday, September 1, 2014

China Grows Down

HONG KONG – For more than three decades, China’s GDP has grown by an average of more than 10% annually. But former Premier Wen Jiabao rightly described this impressive growth performance as “unstable, unbalanced, uncoordinated, and unsustainable,” highlighting the many economic, social, and environmental costs and challenges that have accompanied it. Now China must choose between the export-based, investment-driven growth model of the past and a new, more viable economic order.

Cheap credit and perverse incentives – such as promotions for officials who contribute most to GDP growth – have led to massive but redundant investment, which, in turn, has contributed to excess capacity in manufacturing and infrastructure. This model is not only inefficient; channeling government resources to support investment also undermines China’s social development.

Given this, China’s leaders have decided to stop using GDP growth as the primary criterion for evaluating officials’ performance. Indeed, the 12th Five-Year Plan, which extends until 2015, aims to shift China’s economy to a new, more sustainable growth model based on quality and innovation, and accepts that annual GDP growth will likely fall to 7% during the transition.

Most discussion of growth models nowadays is based on work by the Nobel laureate Robert Solow. For Solow, GDP growth is determined by the factor inputs of land, labor, and capital, together with the economy’s total factor productivity (TFP, or the change in output not accounted for by changes in the volume of inputs, but by factors like technological innovation and institutional reform).

Since 1978, China, by implementing major reforms, has achieved three periods of high TFP growth, each lasting 5-7 years. First, in the early 1980’s, following the introduction of the rural household-responsibility system, which boosted agricultural productivity and released a large amount of unskilled labor to work in the higher-productivity urban and industrial sectors, annual TFP growth accelerated to 3-4%.

The second such period followed Deng Xiaoping’s southern tour in 1992, during which he emphasized the need to shift to a market-based – albeit state-controlled – system by opening China’s economy to foreign direct investment and establishing special economic zones to help develop export-oriented industries. This time, TFP growth soared to 5-6%, partly owing to the “catching up” process facilitated by China’s adoption of foreign technology and know-how.

Finally, after major reforms of state-owned enterprises (SOEs) and the tax system, China acceded to the World Trade Organization in 2001. With the country fully integrated into global supply chains, TFP growth hit 4%, where it remained until 2007. Since then, however, the TFP growth rate has fallen by almost half.

Indeed, China’s economy has experienced a significant – and ongoing – growth slowdown in the wake of the global economic crisis that erupted five years ago. By 2012, human capital’s contribution to China’s GDP growth fell almost to zero, with fixed-capital accumulation accounting for roughly 60% of total growth. Large-scale, debt-funded capital investments have raised the country’s credit/GDP ratio to nearly 200%, increasing the financial system’s vulnerability – a development reflected in the recent spike in interbank interest rates.

In order to achieve more balanced and sustainable GDP growth, China’s leaders must implement a set of deep, comprehensive, and long-lasting institutional reforms aimed at boosting TFP. In particular, the reforms should be designed to facilitate China’s transition from its traditional supply-based growth model, which assumes that building hard infrastructure leads automatically to demand growth.

In fact, GDP growth may be slowing precisely because existing investment in manufacturing and infrastructure, undertaken largely by local governments and SOEs, does not match the pattern of domestic demand. As a result, China now faces the problem of short-term excess capacity.

Improving the quality of GDP growth will depend on Chinese leaders’ willingness to enact market-oriented reforms. Rather than directly driving investment, the state must emphasize its regulatory and enforcement functions, including setting and overseeing standards, building an effective property-rights infrastructure, and managing macroeconomic conditions. At the same time, the state must improve the quality and delivery of education, health care, and security, while minimizing corruption and administrative abuses.

In short, China must shift its focus from meeting GDP growth targets to creating an environment that fosters innovation and competition, thereby enabling market forces to set prices and allocate resources more effectively. The state would thus become an intermediary agent, facilitating the development of a sustainable economic order in which less is more – that is, a system in which less intervention creates more opportunities for creativity.

SOEs undoubtedly played an important role in China’s previous growth model, delivering the infrastructure and services that were deemed necessary for the global manufacturing supply chain to function. But access to cheap credit from state-controlled banks creates an incentive for SOEs to generate surplus capacity, which increases systemic risk in the economy. To correct China’s excess-capacity problem would require the relevant enterprises, whether SOEs or private firms, to exit the market.

Unless China’s leaders implement major structural reforms aimed at establishing a market-based growth model, they will be unable to avoid the “middle-income trap” that has prevented so many developing economies from attaining advanced-country status. The deceleration in GDP growth that such reforms would cause would be more than offset by increased market dynamism and overall economic stability.

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  1. CommentedWim Roffel

    What frightens me is the urbanization program. I see it as an effort to keep the real estate bubble going on - at a terrible social and economic price.

  2. Commentedde Lafayette

    It's damn easy telling China what it should do. Damn difficult in actually doing it.

    The size of the task is enormous given the length and breadth and population of the country. Besides, China is a country that for a millenium has been directed from the top.

    Do the Chinese know how to actually compete in a free-market system, which such a system has never existed except for exports?

    No, the transformation will be long and arduous because the "learning process" will be long and arduous. There is no road-map and many will be lost in the confusion.

    So, they will look to the center (Beijing) for "guidance" - as they always have done. Besides, with the dynastic hold on business held by the Communist Billionaires, they to are likely to be a sticking point.

    Undoing their "economic empires" will be much to ask of them, now that they are sitting pretty.

    In fact, it could take not just years but decades - and perhaps even some internal strife ...

  3. CommentedJonathan Lam

    Gamesmith94134: the Instability of Inequality

    “Any economic model that does not properly address inequality will eventually face a crisis of legitimacy.” Each economic model failed respectively on the macro economical system since the scale of supply and demand has been altered by the regulations or manipulation after the globalization. Macroeconomic and microeconomic had took a cakewalk whenever the competition appears, because each applications have a contradiction as shifts in the scale from the market and state; as just as you descript in, “The increase in private- and public-sector leverage and the related asset and credit bubbles are partly the result of inequality. “

    Perhaps, you may have mixed with the atmospherically force on an explosion and implosion of a balloon that micro economical strategies became irrelevance that supply and demand does not react to each other like America. When it met its macroeconomics in the price structures, the emerging market nations created another price structure that made the balloon collapsed under the pressure of competition and its market shrinks by its aggregated demand even after the quantities easing I & II.

    First, Mediocre income growth for everyone but the rich in the last few decades opened a gap between incomes and spending aspirations. It concurs with a lack of economic dynamism that led to sclerotic growth then and the euro zone’s sovereign-debt crisis now. Secondly, price structure collapsed, and deflationary to adjust became the catalyst to its implosion since America or the Anglo-Saxon countries, the response was to democratize credit that were not fully financed by taxes, fueling public deficits and debt. In both cases, debt levels eventually became unsustainable.

    In the part of China or India, low currency exchange rate and low labor cost may not made the best of the product available in its contest of quality; but the aggregated demand from China, India and US combined make the combustion on price that inflation is changing the status of the currency exchange rate and labor cost to rise. In addition, the high rise of price create hardship for those are below the rising living standard since they live on salary; and which polarized the rich and the poor more. With the pressure of the macroeconomic on surplus and workforce, they must face the inequality of the middle class is driving the inflation to eyelevel of its governments that price control and more regulation is put in the situation to halt its price system to synchronize with the developed nations. Its price structure exploded of its price limits after the democratized credits is put into contest with its economical developments. Besides, the aggregated demand rose significantly above the level of supply. Living standard elevates that created the short fall for the poor.

    In turn of atmospheric pressures in the free market system, we complete with state and private development. When the sovereignty confronts each other like photosynthesis in global warming. The escalating the O2 turn O3 and became the sunscreen even the sun ray is not coming through----it is just a mere reflection and it is how stable we are now that rule and regulations are kites floating in the sky and it became instability even for economists who cannot take their breath in O3. In facing the reality of growth, we must guess how the macro-economic alter the anemic or micro-economics take an effect on disinflation. Inasmuch, how much rubber is in the balloon is required to the skin of the balloon when it blasts or collapses? As the power of the middle class if you attempt to restore, you must know which side of the rubber you are taking.

    May the Buddha bless you?

  4. Portrait of Pingfan Hong

    CommentedPingfan Hong

    "Most discussion of growth models nowadays is based on work by the Nobel laureate Robert Solow": Solow has long been replaced by "endogenous model" since the 1990s.

  5. CommentedJoshua Ioji Konov

    The change from Economic Growth to Market Development (i.e. Joshua Ioji Konov Research) is a great achievement by the Chinese economics: it will have profound effect of long term success, however if the EME's role in the overall market (i.e. economy) expand proportionatly.