Friday, July 21, 2017
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But the current bout of exchange-rate anxiety is really just a symptom of the fact that China’s transition from an export-led growth strategy to one propelled by domestic consumption is proceeding far less smoothly than hoped.

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The China Delusion

NEW YORK – China’s management of its exchange-rate peg continues to rattle global financial markets. Ongoing uncertainty about renminbi devaluation is fueling fears that deflationary forces will sweep through emerging markets and deliver a body blow to developed economies, where interest rates are at or near zero (and thus cannot be lowered to defend against imported deflation). Fiscal gridlock in both Europe and the United States is heightening the angst.

But the current bout of exchange-rate anxiety is really just a symptom of the fact that China’s transition from an export-led growth strategy to one propelled by domestic consumption is proceeding far less smoothly than hoped.

For some people, visions of the wonders of capitalism with Chinese characteristics remain undiminished. They are certain that, after more than three decades of state-directed growth, China’s leaders know what to do to turn their slumping economy around.

The optimists’ unreality is rivaled by that of supply-siders, who would apply shock therapy to China’s slumping state sector and immediately integrate the country’s underdeveloped capital markets into today’s turbulent global financial system. That is a profoundly dangerous prescription. The power of the market to transform China will not be unleashed in a stagnant economy, where such measures would aggravate deflationary forces and produce a calamity.

The persistent downward pressure on the renminbi reflects a growing fear that Chinese policymakers have no coherent solution to the dilemmas they face. Floating the renminbi, for example, is a dangerous option. After all, with the Chinese economy undergoing wholesale economic transformation, estimating a long-term equilibrium exchange rate that will anchor speculation is virtually impossible, particularly given persistent doubts about data quality, disclosure, and opaque policymaking processes.

But if the current exchange-rate peg to a basket of currencies fails to anchor the renminbi and prevent sharp depreciation, the deflationary consequences for the world economy will be profound. Moreover, they will feed back on the Chinese export sector, thus dampening the stimulative impact of a weakened currency.

The key to stabilizing the exchange rate lies in creating a credible development policy. Only then will the pressure on the renminbi, and on China’s foreign-exchange reserves, subside, because investors both within and outside the country will see a clear way forward.

Establishing policy credibility will require diminishing the muddled microeconomic incentives of state control and guarantees. It will also require reinvigorating aggregate demand by targeting fiscal policy to support the emerging economic sectors that will underpin the new growth model.

But, as usual with China, such a strategy is riddled with contradictions. For example, reducing the size of the state-enterprise sector is necessary, yet would be certain to depress aggregate demand at a time when demand is already soft. Likewise, cutting fiscal support (via government-directed bank lending) to zombie firms would free up fiscal capacity and enable resources to be redirected to new sectors that facilitate services and urban employment; but this would exacerbate – at least at first – today’s demand shortfall.

Slashing the state sector abruptly and expecting to achieve transformation through austerity is not the way forward. Economic historians, notably Michael A. Bernstein in his study of the Great Depression in the United States, have convincingly shown that an economy in transition requires strong aggregate demand to pull resources into new sectors. If both the old and new sectors of an economy are in a slump, capital formation will sputter, investment in upgrading human capital will decline, and structural adjustment will stall. Robust aggregate demand is always essential to successful transformation.

An equally large obstacle to China’s economic transition – the problem that almost dare not speak its name – is the widespread worship of China’s hybrid market economy. Simply put, today’s muddled market incentives impede transformation by favoring state-owned enterprises.

In early 2012, when the Chinese leadership moved toward stronger private ownership, stocks in the private-sector sub-index outperformed the state-owned sector sub-index on both the Shanghai and Hong Kong stock exchanges. But since the spring of 2014, this trend has reversed, and the state-owned sector sub-index has outperformed the private-sector sub-index. As the Chinese economy slows and default risk grows, the value of state guarantees rises, directing capital away from private-sector growth.

This hybrid system clearly impedes credit allocation from catalyzing development, while creating and sustaining vested interests opposed to reform. This holding pattern is particularly harmful because profound transformation will surely depend on financing from a sound sovereign bond market, which cannot function properly until uncertainty related to the government’s contingent liabilities – all those implicit guarantees – has been resolved.

China has it within its power to stabilize its exchange rate via credible reforms, particularly policies that redirect resources to invigorate domestic demand and pull resources toward the newer high-value sectors. The reforms China needs cannot be accomplished in a slump, or by a large exchange-rate depreciation that deflates the world in a vain effort to turn back the clock to an era of export-led growth that stagnant demand in the West has rendered nonviable.


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If China is to avoid economic decline, it will have to overhaul its governance system – and the philosophy that underpins it – without triggering excessive social instability.

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Overhauling China

LONDON – Pessimism about China has become pervasive in recent months, with fear of a “China meltdown” sending shock waves through stock markets worldwide since the beginning of the year. And practically everyone, it seems, is going short on the country.

There is certainly plenty of reason for concern. GDP growth has slowed sharply; corporate-debt ratios are unprecedentedly high; the currency is sliding; equity markets are exceptionally volatile; and capital is flowing out of the country at an alarming pace. The question is why this is happening, and whether China’s authorities can fix it, before it is too late.

The popular – and official – view is that China is undergoing a transition to a “new normal” of slower GDP growth, underpinned by domestic consumption, rather than exports. And, as usual, a handful of economic studies have been found to justify the concept. But this interpretation, while convenient, can provide only false comfort.

China’s problem is not that it is “in transition.” It is that the state sector is choking the private sector. Cheap land, cheap capital, and preferential treatment for state-owned enterprises weakens the competitiveness of private firms, which face high borrowing costs and often must rely on family and friends for financing. As a result, many private firms have turned away from their core business to speculate in the equities and property markets.

Chinese households are also squeezed. In just 15 years, household income has fallen from 70% of GDP to 60%. Unless Chinese households are able to reap their fair share of the benefits of economic growth, it is difficult to imagine how a consumption boom is supposed to happen. Clearly, China must take bold steps to unleash the dynamism of the private sector and boost household demand.

China has proved its capacity to implement radical reforms that eliminate major distortions, thereby boosting growth and absorbing excess debt. In the late 1980s, falling GDP growth (the annual per capita rate reached a low of 2% in 1989) and a rising volume of non-performing loans (NPLs) fueled expectations of an economic implosion.

It never came. Instead, the Chinese government launched a raft of radical reforms, including large-scale privatization of industry and elimination of price controls and protectionist policies and regulations. As the state’s share of non-agricultural employment fell – from 30% in the mid-1990s to 13% by 2007 – private-sector productivity rose at an average annual rate of 3.7% from 1998 to 2007. State-sector productivity grew even faster, at 5.5% per year. This productivity growth contributed about one-third of China’s total GDP growth – which accelerated to double-digit rates – over this period. China’s entry into the World Trade Organization in 2001 – another bold step – was a major factor in this success.

China gdp growth

This time around, however, the task facing China’s government is complicated by political and social constraints. The economic reforms China needs now presuppose political reform; but those reforms are hampered by fears of the social repercussions. If China is to avoid economic decline, it will have to overhaul its governance system – and the philosophy that underpins it – without triggering excessive social instability.

The good news is that China has a promising track record on this front. After all, it was a fundamental ideological shift that enabled China’s 35-year-long economic boom. That shift emphasized economic development above all else, with the champions of growth being protected, promoted, and, if necessary, pardoned.

A similar ideological shift is needed today, only this time the focus must be on institutional development. Sustainable long-term growth – based on efficiency improvements, productivity gains, and innovation – is possible only with an effective institutional framework, and that requires fundamental changes to the political and regulatory systems. Only by overcoming vested interests and building a more efficient bureaucracy, bound firmly by the rule of law, can the reforms China needs be pushed through.

Complicating matters further are mounting social conflicts, such as between urban and rural populations, among industries, and between the private and state sectors. The potential for mass protests and civil unrest is now hampering the government’s determination to create change. But with a concerted effort to create a level playing field that gives more people a bigger piece of the economic pie, not to mention more transparent governance and a stronger social safety net, China’s government could reinforce its legitimacy and credibility. That, in turn, would strengthen the authorities’ capacity to ensure stability.

China’s experience in the 1990s suggests that the country can bounce back from its current struggles. With major reforms only half-complete, there are significant opportunities for stable growth based on efficiency and productivity gains, rather than merely on consumption. Once key distortions are eliminated and resources – including labor, capital, and talent – are being allocated more efficiently, China will be able to continue its march toward high-income status.

China’s government may struggle at first; after all, performing surgery on oneself is difficult to initiate and even more difficult to get right. But if economic conditions worsen, as seems plausible, action will become unavoidable. Good times may breed crises in the West; in China, it is crises that bring better times.


Questioning Capitalism with Chinese Characteristics

Read Comments (3)
  1. Comment Commented

    To restore its high growth rate, China has to undergo its second phase of economic reforms which will be based on productivity gains and indigenous technological innovation rather than on borrowed technology and licensed production. Read more

  2. Comment Commented

    Fully agree with the Author. China has to increase its domestic consumption which is abysmally low 35% of GDP compared to other economies like Brazil, India, Russia ( in the range of 57 to 60%) Read more

  3. Comment Commented

    It is strange that a 6,5 growth of the biggest world economy has driven so much media skepticism about its future. Looking at the arguments china weaknesses looks more like an exerciese of wishfull thinking than as a reality. I mean with a eurozone near colapse and USA with debts over its head (mostly to China) it is strange to question Chinise capitalism. Read more