The Soft Underbelly of China’s Growth

China’s explosive economic growth hinges on the rest of the world, radically changing the global production chain and challenging the global trading system. If China maintains its growth momentum over the next two decades, the global system will face huge challenges. Indeed, the question is not so much whether the global system will endure the imbalances spawned by China, but how severe those imbalances will prove to be.

Much of the concern over the past few years has centered on America’s yawning current account and fiscal deficits, and its effort to get China to let the yuan float more freely against the dollar. China, by contrast, sees its growth as tied to a stable currency, and may not want to introduce a more flexible exchange-rate regime, even after the 2.1% revaluation in July, pending alleviation of structural problems for which it is extremely difficult to set a timetable.

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In fact, even as China’s economy has boomed over the past decade, structural adjustment in its domestic sectors slowed, mainly owing to political constraints. The banking system remains unhealthy and fragile; capital markets are dying.

The private sector’s growth is hemmed in by its inability to invest in economic sectors that the government still monopolizes. Mounting regional disparities, as well as the widening urban-rural divide, impede household consumption growth, increasing the economy’s dependence on exports and foreign investment.

For years, as optimists see it, China has been the world’s cheap assembly shop for shoes, clothing, and microwave ovens. Now, it is laying the groundwork to become a global power in more sophisticated, technology-intensive industries. Billions of dollars are flowing into auto, steel, chemical, and high-tech electronics plants, setting the stage for China to be a major exporter of high-end products.

While this argument suggests that the global trading system must make more room for a rising China (and India), it overlooks the need to address the enormous structural problems in China’s domestic sectors if export-led growth is to become sustainable. For these sectors, rapid investment-driven growth in the past decade has produced a mountain of excess capacity, reflected in stagnant prices and the banking sector’s soaring volume of bad loans, as price wars squeeze profitability and stimulate real-estate speculation.

Postponing structural reforms eventually constrains any economy’s performance, as we saw in Japan in the 1980’s and 1990’s. China has similar problems, with the investment-growth nexus threatening macroeconomic stability – witness the overheating that occurred in 2003 and 2004.

Indeed, China faces tremendous challenges in maintaining macroeconomic stability under conditions of export-led growth, with huge repercussions for the rest of the world. Given China’s size and its rising share in the global market, macroeconomic instability there fuels volatility in global prices for basic commodities and raw materials.

But the political reality is that China’s government favors rapid growth in the short run over the structural reforms needed to sustain long-term economic performance. Fiscal consolidation and the abrupt closure and restructuring of inefficient banks and state enterprises would, after all, constitute a powerful brake on short-term growth, threatening social peace and political stability.

This may explain the growing efforts of Chinese businesses in recent years to go global themselves. Globalization is increasingly viewed as an alternative to domestic structural complexity.

This strategy will exact a heavy price, just as it did in Japan twenty years ago. The main lesson of Japan’s approach is that launching an aggressive buying spree overseas merely upsets established international balances of interests – thus generating greater tensions with the rest of the world – while hiding the seriousness of structural problems at home.

China has much to gain by avoiding such a strategy. Focusing squarely on structural reforms would allay some of the fears that China’s rise has inspired in the rest of the world, while winning praise from the international business community. Rather than scaring global corporations and their home states, China would retain strong political support abroad – and the financing that it needs for its continued development.

In economic terms, China has no choice: it must remove the structural obstacles that stand in the way of rapid growth over the next decade or two. Above all, truly secure and sustainable economic development requires that it build a large consumer base at home.

Of course, the global imbalances associated with China’s economic rise can take longer to adjust than they otherwise would, simply because the US welcomes it as being in America’s own interest. But China’s long-term interest, and that of the world, requires that it get serious about domestic structural reform.