Saturday, November 29, 2014

Why China Can’t Adjust

CLAREMONT, CALIFORNIA – China’s current economic slowdown has no shortage of causes: Europe’s financial turmoil, sputtering recovery in the United States, and weak domestic investment growth, to name the most commonly cited factors. Since exports and investment account, respectively, for 30% and 40% of China’s GDP growth, its economy is particularly vulnerable to weakening external demand and accumulation of non-performing loans caused by excessive and wasteful spending on fixed assets.

But China’s vulnerability to these factors, as serious as they are, is symptomatic of deeper institutional problems. Until these underlying constraints are addressed, talk of a new consumption-based growth model for China, reflected in the government’s recently approved 12th Five-Year Plan, can be no more than lip service.

After all, China’s major trading partners, international financial institutions such as the World Bank and the International Monetary Fund, and senior Chinese officials themselves have long recognized the structural vulnerabilities caused by excessive investment and low household consumption. And, for nearly a decade, China has been urged to undertake reforms to redress these economic patterns, which have undermined the welfare of ordinary Chinese and strained the global trading system.

The best-known feature of China’s macroeconomic imbalances is heavy dependence on exports for growth, which is typically attributed to weak domestic demand: as a middle-income country, China lacks the purchasing power to consume the goods that it produces. With nearly unlimited access to advanced-country markets, China can tap into global external demand and raise its GDP growth potential, as it has done for the past two decades.

If this view is right, the solution is straightforward: China can correct its imbalances by increasing its citizens’ incomes (by cutting taxes, raising wages, or increasing social spending), so that they can consume more, thereby reducing the economy’s dependence on exports. Indeed, nearly all mainstream economists prescribe this approach for China.

But there is another explanation for China’s excessive export dependence, one that has more to do with the country’s poor political and economic institutions. Specifically, export dependence partly reflects the high degree of difficulty of doing business in China. Official corruption, insecure property rights, stifling regulatory restraints, weak payment discipline, poor logistics and distribution, widespread counterfeiting, and vulnerability to other forms of intellectual-property theft: all of these obstacles increase transaction costs and make it difficult for entrepreneurs to thrive in domestic markets.

By contrast, if China’s private firms sell to Western multinationals, such as Wal-Mart, Target, or Home Depot, they do not have to worry about getting paid. They can avoid all of the headaches that they would have encountered at home, because well-established economic institutions and business practices in their export markets protect their interests and greatly reduce transaction costs.

The Chinese economy’s institutional weakness is reflected in international survey data. The World Bank publishes an annual review of “the ease of doing business” for 183 countries and sub-national units. In its June 2011 survey, China was ranked 91st, behind Mongolia, Albania, and Belarus. It is particularly difficult to start a business in China (151st), pay taxes (122nd), obtain construction permits (179th), and get electricity (115th).

Faced with such a hostile environment, Chinese private entrepreneurs have been forced to engage in “institutional arbitrage” – taking advantage of efficient Western economic institutions to expand their business (most export-oriented businesses are owned by private entrepreneurs and foreign firms).

Unfortunately, as China has already claimed a large share of the world’s merchandise exports (10.4% in 2010) and economic stagnation in the West is constraining external demand, this strategy can no longer work. But reorienting their businesses toward the Chinese domestic market requires far more than government policies that put more money in consumers' pockets.

In order to enjoy the same low transaction costs that they have in exporting, China’s entrepreneurs need a much better business environment: an effective legal system, a sound regulatory framework, a government that protects their brands by fighting intellectual-property theft, dependable logistics and distribution networks, and a graft-resistant bureaucracy.

China cannot create such an environment quickly. In essence, the Chinese government must transform a predatory state into a nurturing one, and treat private entrepreneurs as creators of wealth rather than targets of extraction. In nearly all other countries, such a transformation was accomplished by establishing the rule of law and/or moving from autocracy to democracy.

The impossibility of sustaining growth in the absence of the rule of law and political accountability presents the Chinese Communist Party with an existential dilemma. Ever since it crushed the pro-democracy movement in Tiananmen Square in 1989, the party has vowed not to surrender its political monopoly. The investment boom and the globalization dividend of the last two decades allowed the Party to have its cake and eat it – maintaining its rule on the basis of economic prosperity, while failing to establish the institutions critical to sustaining such prosperity. Today, this is no longer possible.

So in a sense, the Chinese bubble – as much an intellectual and political bubble as an economic one – has burst. As China’s economic deceleration exposes its structural vulnerabilities and flawed policies, the much-hyped notion of “Chinese exceptionalism” – that China can continue to grow without the rule of law and the other essential institutions that a modern market economy presupposes – is proving to be nothing but a delusion.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (4)

    Please login or register to post a comment

    1. CommentedLeo Arouet

      La debilidad de la economía china es evidente: altos costos ambientales, excesiva producción, aumento de la desigualdad y el incremento de la brecha entre pobres y ricos. El sueño chino está lejos de hacerse realidad.

    2. CommentedDaniel Gomes

      China's economic model is its last strides due to many different reasons:

      1. Energy costs: For a low cost export based economy all production and transportation costs are critical.
      Take energy costs for example, besides the amounts required to keep factories running, the amount required dor transportation of goods all the way to europe and U.S is far from negligible.

      And as we've seen in 2008, the oil prices will sky rocket as soon as the western economies start growing again. This will give a major advantage to local production and too countries (e.g. EU members) which have learner not to rely on cheap energy.

      2. Inflation and income gap: China's currency policy and lack of any kind of social protection in particular for the armies of migrant workers which keep factories running, generates a continuously widening gap between purchasing power of the masses and the general cost of living since early 2000s.
      The government has started to tackle this but its too little too late, over the past 10 years basic salaries in south china factories stagnated in around $300 US dollars where as a small flat costs around $200.000 US.
      Migrant workers are making barely enough to sustain their families in the countryside.
      Only a small minority of the native city dwellers is seeing some of the benefits from the China's growth, but even these are being eroded by inflation.

      3. On the other hand the government is simply not able to allow the hordes of migrant workers to further increase to sustain manufacturing expansion and therefore abandoning the country side and food production, without seriously endangering food safety, and again, as we all seen in 2008 with rice and pork prices going haywire and china producers preferring to sell to other countries to maximize their profit instead of selling at government fixed prices to their own citizens, we can all see how easy it would be for basic laws of supply and demand to cause a serious uprise.

      4. With an internal market with no relevant aggregate demand other than essential products plus cars and status products there is little incentive for the continuous large scale investments in china, in fact most of the manufacturing industry which could have been transferred to China has already happened and other countries like Vietnam are presenting themselves as more economical alternatives.

      6. China is a demographic time bomb, in Asia due to the lack of social security (or the low coverage incipient ones like in china) the older generations depend on direct cash handouts from the younger generations and the current generation in their 30s will have to sustain 2 or even 6 elders with their own income.

    3. CommentedDennis Argall

      While keenly awaiting the comments of others, let me offer this link:

      as illustration of how human perspectives contribute to the general need of which I wrote thus:

      "...Construction of collaborative connections with China by the US, Japan and others including Australia, is of the utmost importance for global security. We will all do better if we shift from zero sum gaming, make room."

      Hostility and pessimism, in my view, breed hostile and pessimistic outcomes.

    4. CommentedDennis Argall

      Prof Pei has spoken of China's government as a statistical outlier in its longevity among autocracies. China is also an outlier for its population size and consequent governance issues, its poverty and the historically unique rate of revolutionary change and its climb from poverty since 1978.

      There are problems with generalisations for the whole country. I was saying to people in the 1980s that the Chinese coastal strip contained at least four equivalents of post-war Japan, not like the 'little tigers' of Taiwan, South Korea, Hong Kong and Singapore, but on the scale of Japan itself; same picture more dramatic now. While other parts of China are less developed.

      The discussion in Prof Pei's later paragraphs about problems of accountability might be put in context of the way things have gone in western economies in recent times. There has not been much on offer for China as exemplary (or successful) political or commercial conduct in the US or EU or Russia, or India in the reform era from 1978.

      I have argued elsewhere
      that Chinese leaders work with more freedom, plan with more freedom than currently evident in many western democratic systems or academic institutions.

      I am not aware of any thread of political desire in this generation (or the next, the graduates mentioned) to break up this unprecedentedly large country, apart from some elements in minority populations.

      If we say there are problems for the rich and productive in China in getting more deeply into the markets of less developed parts of China, compare the EU dilemma, Germany needing to sustain and build its poorer and 'less well governed' fellow EU members if it is not to lose its own wealth.

      Mind you, I worry about my country's 20% GDP dependence on exports
      ... while having more confidence in China's government to address big new issues than I have in the capacities of my own country's political system, let alone those of the US. We need to think about ourselves when doing this too-common rough-up of China.

      Yes, there are dinosaurs in the Chinese system, I recognise them because they are familiar locally. But there needs to be something more than this kind of statistical chartism, some more refined political examination, to really claim that China is on the verge of collapse.

      I am concerned not least because arguing in the United States about China in this way has for decades fed adversarial ways of thinking about China, which do nothing to lead towards positive outcomes. Feeding the kind of thinking that still imagines Reagan brought down the Soviet Union. Construction of collaborative connections with China by the US, Japan and others including Australia, is of the utmost importance for global security. We will all do better if we shift from zero sum gaming, make room.