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Economics

China’s Stunted Transformation

Jun 30, 2023 Andrew Sheng and Xiao Geng

China has run into major road blocks as it has attempted to implement its "dual circulation" growth strategy. Its success in managing the challenges it faces could be the difference between a global recovery and a global recession.

HONG KONG – China’s growth model is undergoing fundamental change. After decades of relying primarily on external demand to drive growth, the government has embraced a “dual circulation” model, driven by both internal and external demand. The goal is to make China’s economy more resilient and less vulnerable to external shocks, but the structural transformation has run up against major roadblocks.

When Deng Xiaoping launched his “reform and opening up” in 1978, China pursued a development strategy modeled after successful East Asian economies like Japan and South Korea: welcome foreign direct investment, expand cross-border trade linkages, leverage low labor costs to bolster the manufacturing sector, and take advantage of external demand to drive growth. Over the last four decades, FDI flows – about two-thirds of which came through Hong Kong – enabled China to transform Guangdong and other coastal provinces into global supply-chain hubs.

As industrialization progressed, incomes and wealth increased, and Chinese workers became consumers of both goods and services. As a result, the foreign-trade-to-GDP ratio declined, from a peak of 67% in 2006 to around 35% today, though China still relies on the jobs provided by its export industries.

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Andrew Sheng

Writing for PS since 2011
143 Commentaries

Andrew Sheng is a distinguished fellow at the Asia Global Institute at the University of Hong Kong.

Xiao Geng

Writing for PS since 2012
133 Commentaries

Xiao Geng, Chairman of the Hong Kong Institution for International Finance, is a professor and Director of the Institute of Policy and Practice at the Shenzhen Finance Institute at The Chinese University of Hong Kong, Shenzhen.

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0 Comments on this paragraph, 13 Comments on this article

vic lai Jul 5, 2023

The conclusion from the paper "Japan’s Lost Decade Revisited: Total Factor Productivity and Economic Growth" by Jeong Yeon Lee (2011), should be relevant for today's China :
---
"The estimates of Japan’s TFP growth based on the Malmquist index approach tends to
confirm the picture painted by TFP residuals from growth accounting.
The country’s respectable TFP growth with an annual average of 2 percent or more in the 1980s fell to virtual stagnation in the 1990s.
The findings also show that Japan’s productivity growth rate in the 1990s is not only historically low but also lags considerably behind the contemporaneous growth rates in other OECD nations.
-
From the perspective of growth theory, a fall in TFP leads to a reduction in the steady state returns on capital and a slowdown of economic growth.
Therefore, the neoclassical growth framework suggests that it was the fall in TFP that was largely behind the great recession that lasted in Japan for a decade, even though any developments in the demand side observed during the 1990s may have been relevant for the country’s business cycles.
-
The Japanese experience bears important lessons for the countries that have tried hard to stop the economic slump following the global financial crisis from developing into a long-running recession.
Any amount of government efforts targeted at the demand side is likely to fail to carry their economies to a sustainable path of growth unless they are accompanied by
a meaningful improvement in TFP.
Subsequently, the fiscal stimulus packages full of “shovel-ready” projects may prop up the economy just for a short period, but would never be effective measures for preempting possible “double-dips” or “triple-dips”.
-
Against the backdrop of ever-widening recent sovereign debt crisis, it is time to
completely overhaul the fiscal stimulus packages that have been hastily assembled in many parts of the world since the start of financial crisis.
In both developed and developing nations, the governments need to design its spending more wisely with a high priority given to structural transformation that will improve the economy’s TFP."
---
A new reply to this comment has been posted.
vic lai Jul 1, 2023

President Xi's economic advisors should pay close attention to two Chinese news articles published in recent days in China, because they provide the sorely needed ultimate guides to the effective solutions of many of the major economic problems facing today's growth-declining China.
---
徐高：需要纠偏对我国债务的认知（万字长文）
https://finance.sina.com.cn/zl/china/2023-06-28/zl-imyyvafw9686121.shtml
---
陆挺：如何抓住稳经济的牛鼻子
https://finance.sina.com.cn/zl/china/2023-06-29/zl-imyyxwap1855310.shtml
---
The first article implies that China's underdeveloped central government treasury market (especially relative to that in Japan, the US, and the EU countries) can provide another sorely-needed safety asset to China's growing and wealthier middle class, so that those people no longer rely too much on the country's Ponzi-scheme-like and hence unsustainable booming urban real-estate market as their main source of safety financial assets in the future years.
---
The second article shows that, China's metropolitanization and city-group urbanization strive, which should have been enacted as early as a decade ago in 2013 when Xi first became the new President in China, should and can still be actively pursued in today's China, to sustainably prop up China's internal aggregate demand, to replenish China's current weakening external demand and to help maintain the country's relatively high real growth rate in the coming decades.
---
A new reply to this comment has been posted.
vic lai Jul 1, 2023

President Xi's economic advisors should pay close attention to two Chinese news articles published in recent days in China, because they provide the sorely needed ultimate guides to the effective solutions of many of the major economic problems facing today's growth-declining China.
---
徐高：需要纠偏对我国债务的认知（万字长文）
https://finance.sina.com.cn/zl/china/2023-06-28/zl-imyyvafw9686121.shtml
---
陆挺：如何抓住稳经济的牛鼻子
https://finance.sina.com.cn/zl/china/2023-06-29/zl-imyyxwap1855310.shtml
---
The first article implies that China's underdeveloped central government treasury market (especially relative to that in Japan, the US, and the EU countries) can provide another sorely-needed safety asset to China's growing and wealthier middle class, so that those people no longer rely too much on the country's Ponzi-scheme-like and hence unsustainable booming urban real-estate market as their main source of safety financial assets in the future years.
---
The second article shows that, China's metropolitanization and city-group urbanization strive, which should have been enacted as early as a decade ago in 2013 when Xi first became the new President in China, should and can still be actively pursued in today's China, to sustainably prop up China's internal aggregate demand, to replenish China's current weakening external demand and to help maintain the country's relatively high real growth rate in the coming decades.
---
- vic lai Jul 2, 2023
  
  To me, simply speaking, many of China's current aggravating major internal economic problems can be traced back to one major economic "mistake" committed by then Primier Wen Jiabao exactly 2 decades ago.
  ---
  China's current central government in Beijing is now expected to pass a new economic stimulus package to deal with the country's ongoing worsening problems of disinflation, growing unemployment (especially that of the young people), and laggard economic growth, but the nature, size and composition of the coming non-trivial stimulus package, if any, is still not clear today.
  The composition of the coming new economic stimulus package is now really of vital importance to the future economic development of not only China but also the rest of the world.
  ---
  In identifying China's current genuine main economic problems, we shouldn't be distracted by
  (i) the Global Financial Crisis of 2008 and the subsequent secular drop in foreign demand for China's exports,
  (ii) China's usual up-and-down business cycles in the past decades,
  (iii) the Covid pandemic and its aftermath (like China's almost-3-year-long economic-suicide-like strict pandemic lockdowns),
  (iv) Trump's trade restrictions and Biden's sanctions of all kinds imposed on China,
  (v) US-induced deglobalization-cum-deChinarization warm-war-like global movement,
  (vi) the US's latest runaway inflation and her Fed's ongoing rate-hiking cycle.
  ---
  This is because, many of the China's current main domestic economic problems have mostly been structural in nature, and so mainly a result of the economic policies chosen and pursued by Beijing's central governments in the past 2 decades, which could be traced all the way back to the year 2003.
  The year 2003 was the year when Wen Jiabao started his 10-year tenure (from 16 March 2003 to 15 March 2013) as the new Premier of the PRC.
  ---
  - vic lai Jul 2, 2023
    
    China's current economic situation is nothing new ------ it's been quite similar to Japan's in the early 1970s.
    The crux of a country's economic development is how to raise (further) the country's total factor productivity (or her labor's average skills), a factor which hadn't been very important in the years of China's early economic development, but has become more and more important nowadays, especially if China is to successfully circumvent the Middle Income Trap.
    ---
    In the 1960s, Japan’s economic growth rate was as high as 10% or more, thanks to the rise in productivity as a result of the country’s urbanization strive --- a large amount of Japanese workers were moving from the (village) area with low productivity to the big cities where the productivity was much higher.
    ---
    Later, Japan’s productivity dropped significantly, because the then Japanese government started to enact the policy of evenly developing the whole country’s land area.
    Kakuei Tanaka’s “On the Transformation of the Japanese Archipelago” (日本列岛改造论) started in 1972, with the core idea that massive infrastructure construction were enacted to create more employment opportunities in each part of the country.
    According to a Japanese scholar, this was the most inefficient economic policy in the island country, and was one important reason leading to the sharp fall in Japan’s growth rate after 1974.
    ---
    At that time, many people were distracted by the first global oil crisis which broke out in the early 1970s, and so they wrongly attributed Japan's quickly declining economic growth rates thereafter to that oil crisis.
    ---
    - vic lai Jul 2, 2023
      
      There's nothing new under the Milky Way.
      Many people also think the Global Economic Crisis of 2008 had mainly contributed to China's rather fast falling growth rates in the following years.
      But the main reason, like the situations in Japan in the early 1970s, was actually a serious policy "mistake" dating back to the year 2003.
      As always, China should learn from Japan’s past economic mistakes.
      ---
      Premier Wen (and President Xi in the past ruling decade) had always thought China was always different from other countries, and so they assumed mistakenly that one of the country's most important factor markets --- the land market in both the urban and the rural parts of the country --- the development of which could be manipulated by egalitarian top-down administrative directives, rather than effectively guided by free-market price signals.
      ---
      In the Animal Farm, all animals there should be equal, or so the Beijing leaders in the past 2 decades thought.
      So, in the name of equality, precious urban land development quotas had to be sacrificed and diverted from the eastern richer cities to the poorer cities in the more remote parts of the country.
      The restriction of new property development mainly in the eastern richer cities imposed by the leaders had forced many domestic property developers to leave the eastern part and went to the more backward parts of the country.
      ---
      Hence the propping up of many ghost cities in the western and remote parts of China (together with many non-self-liquidating real malinvestment infrastructure projects), and the relative lack of new supply of residential land and flats available in the eastern and coastal parts of the country.
      The problem in the higher-tier cities had also been made worse by the government's imposition of buying quotas in their first-hand residential property markets, because this had discouraged the incumbent property owners there to increase the supply of second-hand flats in those cities.
      ---
      The problem was also made worse by the fierce "GDP Competition" between the local governments and regions of the country, in which a large amount of precious land in the city was allocated as very cheap industrial land to the FDI and other local investors, thereby further suppressing the availability of residential and commercial land which could have been developed in those cities, which in turn had "contributed" to the "Land Finance" of the local governments.
      ---
      - vic lai Jul 2, 2023
        
        Trying to suppress the fast rise in land and housing prices (and rents) in the major cities, China's local governments, like the Hong Kong city government, have mostly chosen to suppress the demand for housing in one way or another, rather than to increase the supply of land and housing to mitigate the steaming housing markets there.
        The usual demand-supply adjustments of the free market has been replaced by governmental administrative restrictions.
        ---
        Up until 2016, the area of construction land in China's first-tier cities was 1.69 times that of 2003, compared with 2.17 times in the second-tier cities and 2.20 times in the third-tier cities.
        But in the past years, the growth of population in the first-tier cities exceeded 30%, much larger than that in the other cities.
        The relative lack of land and house supply in the major cities is the main reason of "house inflation" in those cities ------ too much (safety-asset-seeking) money is chasing too few residential houses there.
        ---
        The quick rise in house prices, and the commensurate fast rise in new bank credits collateralized by the mortgaged new houses, have been mutually reinforcing each other, contributing to the quick rise in M2 relative to the GDP of the country, meaning that the country's booming housing markets, and hence the local government's Land Finance, have inadvertently been the main source of newly created bank credits and hence one of the main channels through which the effects of the expansionary monetary policies enacted by the PBOC (China's central bank) have been transmitting to the country's real (and virtual) economy.
        ---
        The above argument is indirectly confirmed by the almost unique non-bubbling housing market in Chongqing, a megacity in southwest China.
        There, a typical newly built residential house has been maintained at an average price which is about the total income obtained by the house buyer who keeps working for a total of only 6 to 7 years, thanks mainly to the famous land-coupon system being practised in that city.
        This means, in China's coming re-urbanization strive, much more construction land quotas must be allocated to the metropolitan cities or city groups.
        ---
        
        vic lai Jul 2, 2023
        
        Due to Wen's egalitarian land-allocation policy, data showed that China's total factor productivity started to decline after 2003, but this decade-long secular structural problem had been eclipsed by the country's fast economic growth propelled mainly by the buoyant international economies before the breakout of the Global Financial Crisis of 2007-09.
        The 4-trillion-yuan investment binge enacted by Wen after the GFC was a massive set of expansionary fiscal-cum-monetary policies without paying attention to, or correcting, the structural problem just mentioned.
        ---
        Hence the problems of
        (i) "over-investment" as often claimed by the rebalance economists, which actually had been more a problem of mal-investments than over-investments (or under-consumption),
        (ii) quickly rising remaining debts of the local governments as a ratio of their own GDPs (more than 80 per cent of the Local Government Financing Vehicles involved were from western provinces, whose economies are less developed than those of the coastal provinces. Guizhou province had the most LGFV credit incidents among all Chinese provinces, forming half of the total in 2018 and 2019),
        (iii) the propping up of the commercial banks' bad debts,
        which, when combined together, had resulted in the widespread but misleading demonization of the 4-trillion-yuan expansionary fiscal policies enacted by Wen after the GFC.
        ---
        
        vic lai Jul 2, 2023
        
        When Xi became the new President in China in March 2013, Wen's mistaken urbanization legacy was unfortunately not corrected, perhaps mainly because, according to the Beijing leaders, China's social stability in the urban cities (controlled population growth there) should trump the importance of efficient urbanization and hence faster economic and productivity growth.
        Note that today, with every one out of 5 young Chinese people being out of work, the ensuing potential social instability problems in China may pose a much bigger challenge to the current Beijng leaders than otherwise should have been the case.
        ---
        Given Trump's trade wars and Biden's economc sanctions, the trend of deglobalization and de-Chinarization, the current pandemic, and the recent falling GDP growth rates, today's China should quickly shift to economic growth which is more propelled by internal demand, and this requires the central government not only to deficit-spend en masse, but also to deficit-spend wisely, to correct the (local governments') mal-investment problems caused by the structural problem first created by Wen.
        ---
        Like Japan in the last century, the recent popping of China's massive housing bubble seems to have been plunging China into a similar balance-sheet (repairing) recession, which requires China's central government to use expansionary fiscal policies to replenish the country's quickly diminishing internal aggregate demand.
        China's coming re-expansionary fiscal policies, if any, should be guided by the "correct" re-urbanization strive.
        Much more residential (commercial, and industrial) land quotas should therefore be allocated to the main metropolitan cities or city groups of China, to accelerate the country's unfinished urbanization strive, enabling the lagging-behind urbanization runner (a major part of the country's internal aggregate demand) to catch up with the far-leading industrialization runner (a major part of the country's aggregate supply) ------ the two Marathon runners should normally be running in-sync.
        Today, it's still not too late for China to do so (even though, strictly speaking, it should already have been started 2 decades ago).
        ---
        
        vic lai Jul 2, 2023
        
        Many China watchers (including Richard Koo, the originator of the balance-sheet-recession model) have been misled by the Lewis-Turning-Point development model.
        There are at least two non-trivial problems when this model is being applied to today's China.
        ---
        (i) No hukou restriction exists in this model, so that rural farmers are always free to move to work and settle in the cities of their choice.
        But in today's China, due to the hukou restrictions, this is certainly not the case.
        ---
        (ii) It's only a static model.
        What's actually been happening in a typical successful country is a dynamic constantly-readjusting economy, during which the more industrialized or technologically advanced or service oriented the main cities have become, and the more advanced farming techniques are being invented and applied in the rural villages, the more surplus rural workers the country will generate who (together with their children) mostly want to seek higher-paying jobs in the urban cities.
        ---
        It's not that a certain so-called static "Lewis Turning Point" exists, and that has been reached or surpassed, such that the mission of urbanization in the country has mostly been completed.
        ---
        
        vic lai Jul 2, 2023
        
        While China's diminishing population dividend in recent years has led to the quickly rising real labor wages especially in the eastern cities of the country, her quickly rising labor costs has also been caused not by the more healthy reason of quickly rising labor productivity, but by the quickly rising property prices, rents, and costs of living in those big cities, which in turn have been part of the results of the same old structural problem first developed by Premier Wen and subsequently also pursued by President Xi.
        ---
        Together with the imposition of the New Labour Contract Law and her quickly rising minimum wages in the cities, China's quickly rising average labour cost relative to the average rise in her labour productivity has partly contributed to the overvaluation of the yuan's Real Effective Exchange Rate (REER) measured against unit labour cost in recent years, and has also induced many labor-intensive FDI investments to leave China and go to other lower-cost nearby countries.
        ---
        The phenomenon of quickly rising wages in the country's big cities has in turn also misled many Chinese and foreign economists into making the conclusion that China has already reached or passed the Lewis Turning Point.
        One result of this is that many enterprises in the country's main cities have resorted to automation or the widespread use of robots to replace the manual labor from the villages, and so further hindering the country's not-yet-complete urbanization strive.
        ---
        
        A new reply to this comment has been posted.
        
        vic lai Jul 2, 2023
        
        While China's diminishing population dividend in recent years has led to the quickly rising real labor wages especially in the eastern cities of the country, her quickly rising labor costs has also been caused not by the more healthy reason of quickly rising labor productivity, but by the quickly rising property prices, rents, and costs of living in those big cities, which in turn have been part of the results of the same old structural problem first developed by Premier Wen and subsequently also pursued by President Xi.
        ---
        Together with the imposition of the New Labour Contract Law and her quickly rising minimum wages in the cities, China's quickly rising average labour cost relative to the average rise in her labour productivity has partly contributed to the overvaluation of the yuan's Real Effective Exchange Rate (REER) measured against unit labour cost in recent years, and has also induced many labor-intensive FDI investments to leave China and go to other lower-cost nearby countries.
        ---
        The phenomenon of quickly rising wages in the country's big cities has in turn also misled many Chinese and foreign economists into making the conclusion that China has already reached or passed the Lewis Turning Point.
        One result of this is that many enterprises in the country's main cities have resorted to automation or the widespread use of robots to replace the manual labor from the villages, and so further hindering the country's not-yet-complete urbanization strive.
        ---
        
        vic lai Jul 3, 2023
        
        In a competitive chess game, only one wrong move and that player of the game is doomed to lose at the end.
        Hong Kong's premature deindustrialization in the 1980s (and "too many" university graduates after 1997) had ultimately contributed to the political turmoil of the city in 2019.
        ---
        If the above analysis is not too far from the truth, China should obviously study in great detail all the past economic mistakes made by Japan and strive not to make any similar mistakes in the future.
        This is one of the advantages enjoyed by a late-comer.
        As in a tennis match, or like an individual's stock investments, it's usually that player who has made the least amount of mistakes that will usually become the final winner of the game.
        ---
        Simply speaking, the composition of China's coming new economic stimulus package, if any, should
        (i) in the short run, cater mainly to the consumption needs of the country's households and the cash needs of the (private) small and medium enterprises,
        (ii) in the medium and long run, finance the really useful real investment projects, whether new or old infrastructure projects or housing projects, that should all be united and appropriately guided by the "correct" re-urbanization strive.
        ---
        
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