Until the onset of the industrial revolution a little more than two centuries ago, China was world’s largest economy. The debate as to why the industrial revolution took place in Western Europe rather than a commercially more advanced China remains a matter of debate (Pomeranz 2000). Domestic and international turmoil during the first half of the 20th century, followed by disastrous economic policies during the first three decades of the PRC’s existence, led China to fall behind even further. China’s share of global GDP is estimated to have collapsed from historically 1/3 to a mere 4% during the height of the Cultural Revolution in the late 1960s (Maddison). Today it is back at around ¼ (in Geary-Khamis dollar terms). In the late seventies, China finally emerged from the political and economic turmoil caused by the Cultural Revolution (1966-76) under the pragmatically-minded leadership of Deng Xiaoping, who famously stated that it didn’t matter if the cat was black or white as long as it caught mice. Various types of liberalising reforms, notably the reform of township and village enterprises (TVEs) in the late seventies and the establishment of special economic zones (SEZs) in the eighties, brought about fundamental economic change and set free a stunning economic dynamism lasting to this day (Naughton 2007).
The Chinese economy has registered annual economic growth of more than 10% since the late seventies. No other economy has managed to grow that fast for such an extended period of time. Japan and Korea, for instance, experienced real GDP growth 6-8% a year during their respective, shorter-lived high-growth phases. China’s achievement looks somewhat less exceptional if one accounts for the difference in terms of per capita incomes between the most advanced economies and the respective catch-up economy. Chinese per capita income as a share of US income in the late seventies was lower than Japanese of Korean incomes relative to the US in the fifties and seventies. China has therefore been able to sustain higher growth for longer. Chinese per capita income was a little more than USD 9,000 in 2012. US per capita stood at USD 50,000, or more than five times as large as China’s (World Bank 2013). China’s per capita income today is comparable to Albania’s. Due its large population, however, China is today the world’s second largest economy – whether measured at market exchange rates or in power purchasing terms. China’s is also the world’s largest goods exporter, the largest trade, the largest commodity importer as well as the largest producer of industrial goods.
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| Source: IMF |
China has pursued an export-oriented industrialisation strategy relying on high domestic savings and investments characteristic of so-called ‘late developers’ (Gershenkron). Views as to whether the success of the Asian tiger economies was due to essentially liberal policies or the existence of a developmental state continue to diverge (Johnson 1982, Wade 1990, World Bank 1993). Some analysts see China’s economic policies as constituting a set of policies, dubbed the Beijing as opposed to the Washington consensus, instrumental in generating high economic growth (Cooper Ramos 2004; Halper 2010). In this vision, a competitive currency supports rapid export growth; a closed capital account helps keep domestic interest rates low; high savings and investment help build a high-quality infrastructure and finance large investment in export-oriented manufacturing sectors, facilitating export-oriented industrialisation. Meanwhile, an authoritarian regime with a fair degree of policy autonomy and an approach to economic policy characterised by gradualism rather than shock therapy are also essential elements of the so-called Beijing consensus. China’s economic strategy is often compared to that of its East Asian peers, Korea and Japan. Significant differences exist, however (Koerber 2012). Unlike Japan and Korea, China opened up early to allow FDI and as a result its export sector continues to be dominated by foreign firms. Chinese state-owned enterprises continue to represent a significant share of GDP. While the relationship between the developmental state and the corporate sector was close in both Japan and Korea, state ownership was significantly more limited in both cases.
China, like the other late developers, is perhaps best described as an economy pursuing competitive-conforming strategies (Yifu 2012). This contrasts sharply with countries that pursued comparative-advantage defying strategies such as often occurred in the case of import-substitution policies in Latin America. Even here, the extent to which these policies were failures remains a matter of debate (Rodrik 2008). After all, the larger Latin American economies did succeed in creating an industrial base, while wrong-headed macro-policies eventually led to economic crisis and policy change. It is nonetheless clear that in practice East Asia has been far more successful than countries that pursued an import-substitution industrialisation strategy in terms of generating economic growth, raising per capita incomes and creating economic stability. Competitive-conforming economic development strategies seek to take advantage of cheap, abundant and relatively skilled labour by building up a light manufacturing base while tapping into abundant and stable foreign demand. The resulting acceleration in economic growth allows for a rise in domestic savings and a rise in investment, allowing the economy to upgrade its technological and human capital base over time. Gradually, the manufacturing base is upgraded and economies from exporting light manufacturing to more sophisticated, higher value-added exports. Economically, it is far more difficult to build a high-tech industry from scratch (e.g. Indonesia’s aircraft industry).
The question today is how much longer China will be able to sustain high real growth rates. The pessimists point towards an unbalanced growth model, signs of over-investment and asset bubbles and the rapidly approaching the co-called middle-income trap (Eichengreen et al 2013) as well as increasing demographic drag. The optimists, by contrast, point to continued urbanization, policy changes aiming to re-balance growth away from investment towards greater consumption, while raising productivity growth, and a still significant catch-up potential relative to the technological leader. Capital controls and a strong external position provide the government with ample policy space to support economic growth over the short- to medium term. The capital stock per capita is quite low, and there is plenty of scope to raise the stock of physical and human capital. If China manages to raise the efficiency of investment, there is plenty of catch-up potential left to tap. It would be a mistake to attribute Chinese growth over the past few decades primarily to extensive as opposed to intensive growth. Intensive growth is reflected in the increase in total factor productivity. Extensive growth is generated due to rising labour or capital inputs. China has undoubtedly witnessed a rapid increase of its capital stock, while labour force growth has contributed relatively. However, China also has generated very significant total factor productivity growth.
Governments often do play an important role during economic take-off through supporting infrastructure, state-directed investment and financial repression. But these policies need to be tuned to the stage of economic development. As the economy becomes more sophisticated and complex, the state, not matter how efficient, will find it increasing difficult to support growth by way of direct ownership and direct intervention. Funnelling low-interest loans to strategically important sectors or taking advantage of financial repression to offer cheap loans to the economy may work very well for a while. Over time, government bureaucracy will find it difficult to identify so-called winners, while the development of more developed financial system will make it harder to deal with potential negative side effects of financial repression (e.g. off-balance sheet bank lending, housing bubbles). Sooner or later, financial liberalisation and greater efficiency of capital allocation will become necessary (Shih 2008). In order to maintain high growth, more and more credit needs to be extended, which raises the risk of over-indebtedness and risks being unsustainable. The continued availability of cheap capital may limit innovation. More problematically, a less efficient SOE sector receives relatively greater and cheaper funding than the more efficient and innovative private sector given the greater incentives of the state-dominated financial system to lend to quasi-government borrowers. Making way for greater private-sector expansion will almost inevitably require less state and less influence, but a well-though-out and intelligent regulatory and competition framework. Korea, Japan and Taiwan successfully transitioned from state-supported to private-sector led economic growth in their time. Interestingly, preparing for this sort of transition is exactly what the new Chinese leadership is professing it wants aim for.
Received economic opinion is that China should reduce its over-reliance on investment and shift growth towards greater consumption, in part by allowing for more market. On the other hand, the capital stock is still comparatively small. Maintaining high investment does not appear to be a mistaken policy as such, but if, as currently seems to be the case, incremental investment generates less and less growth and increases the debt burden to potentially destabilising levels, policy change is needed. Raising the economic returns on investment will likely require creating more of a level playing field for private companies and state-owned enterprises (SOEs). Initially catch-up economic growth is easy and can largely be directed by the government. Over time, the emergence of rent-seeking interest groups and simply the complexity of an increasingly advanced technological economy make it harder for the government control economic development, while economically the catch-up potential diminishes.
Economically, China will soon be confronting the so-called “middle income trap” that postulates that economic growth experiences a marked downward shift once GDP per capita (in 2005 dollars) reached USD 10-12,000 or so. One may quarrel about the specific level at which the slowdown occurs and the magnitude of the slowdown. But it is clear that as economies gradually approach the technological frontier, it becomes harder to sustain high growth rates. In the case of China, sustaining growth will likely require less state or at the very least a more efficient state, and more private sector.
Politically, partial economic reform may have led to the emergence of a “mixed” state-centred system that perpetuates the privileges of the ruling elite (Pei 2009). This system allows the elite to reap the gains from limited reforms to sustain the unreconstructed core of the old command economy, thereby ensuring its continued political supremacy. According to the view, China finds itself in a “trapped transition,” where the ruling groups have little incentive to pursue further reform. Absent economic reform, however, economic growth is bound to decline. There certainly is a risk that vested interests to grow too powerful (Olson 1982). Interest-based coalitions emerge that oppose growth-enhancing reforms that would diminish the rents they derive from the present set-up (e.g. SOEs and state-owned banks benefitting from controlled interest rates).
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| Source; IMF |
Politically, partial economic reform may have led to the emergence of a “mixed” state-centred system that perpetuates the privileges of the ruling elite (Pei 2009). This system allows the elite to reap the gains from limited reforms to sustain the unreconstructed core of the old command economy, thereby ensuring its continued political supremacy. According to the view, China finds itself in a “trapped transition,” where the ruling groups have little incentive to pursue further reform. Absent economic reform, however, economic growth is bound to decline. There certainly is a risk that vested interests to grow too powerful (Olson 1982). Interest-based coalitions emerge that oppose growth-enhancing reforms that would diminish the rents they derive from the present set-up (e.g. SOEs and state-owned banks benefitting from controlled interest rates).
However, other late developers successfully adjusted their approach to economic growth and development policies and thus to sustained relatively high growth (Korea), at least until they started to catch up with the lead economy (Japan). China has thus far also proven its ability to relatively successfully deal with various economic challenges. The key challenge is to pursue the kind of policies that allows China to take advantage of the remaining untouched potential. The new leadership seems to recognise that need for broader economic reform. It has also refrained from opting for the easy way of implementing a large economic stimulus. The government committed itself to a whole range of reforms at last year’s Third Plenum.
In the political-economy terms, the government has an interest in sustaining economic growth in order to maintain popular support. Headline economic is different from rising household income. The reduction in household income, if measured as a share of GDP, may well be the reason for China’s high savings and investment rates, but they nonetheless allowed for a rapid rise in absolute consumption and per capita income levels. In spite of massive investment in capital-intensive industries, China managed to create sufficient jobs to absorb excess rural labour and maintain political stability. Creating employment remains important concern for the government, as unemployment is seen as potentially threatening political stability. In addition to meeting societal expectations of rising incomes, it will be increasingly important to tackle the quality of economic growth (ecological consequences, food safety etc.). In this sense, the leadership’s acceptance of a lower economic growth rate and a commitment to boosting household income and consumption is not only economically realistic, but also politically desirable. The new leadership has also demonstrated its willingness to remove political opponents to necessary reforms (e.g. arrest of several SOE executives).
The Third Plenum reforms, if successfully implemented, will transform China’s economic model fundamentally. Chinese economic reform has long been characterised by gradualism. This gradualism has also been evident in the case of RMB internationalisation. In fact, the government will be even more hesitant to push these reforms aggressively, for rapid liberalisation carries the risk of destabilising economic-financial shocks. Moreover, financial internationalisation will reduce the government’s control over the economy, for RMB internationalisation requires the effective dismantling of the main pillars underpinning China’s economic development strategy: (1) capital controls, (2) domestic financial repression, (3) state-directed credit allocation, a (4) non-market-determined exchange rate and (5) export-led industrialisation. In short, complete RMB internationalisation would spell the demise of the Chinese development model.
The central role government has played hitherto diminish, as the market is allowed to play a “decisive” role. This will be a gradual process. Interest rate deregulation, the opening of the capital account and a more flexible exchange rate will require significant reform in order to make the domestic banking system capable of operating under conditions of more or less deregulated interest rates, the end of financial repression (and loss of captive depositor base) and greater exchange rate variability. This includes directed lending, window guidance, control over capital in- and outflows as well as value of the currency and, indirectly, export competitiveness. Most importantly, the liberalisation of capital outflows would expose banks and would likely raise the cost of capital. In short, such changes would undermine a system that channels cheap capital to state-owned companies that take advantage of an undervalued exchange rate. In short, such changes would largely dismantle central elements of the Beijing consensus. Equally important, lots of legwork needs to be done before financial and capital account liberalisation can be implemented with acceptable risks to macro-stability. Reform is not going to happen overnight and will necessarily be piecemeal.
China’s medium-term economic ascent is unlikely to be derailed. In the seventies, many analysts predicted that the USSR was going to overtake the US in the eighties, only for it to fall apart, quite literally, at the beginning of the nineties. In the late seventies, Japan was dubbed to become ‘number one’ (Vogel 1979), only for it to experience a major financial crisis and the lost decade of nineties. China is different. It is not a closed command economy, shut off from foreign technology and competition. It is not a country that is even close to catching up with the US in terms of capita. China does face some challenges that resemble problems faces by Japan and even the Soviet such as a weak financial system and adverse demographic prospects and not very productive state sector. But China has sufficient flexibility to deal with these problems in part precisely because of its far greater medium-term growth potential. Unlike the USSR, it does not need to fundamentally transform its economic system, simply gradually reform it. Unlike Japan, China is, and has proven to be, more aggressive in terms of financial sector restructuring. China is very unlikely to return to 10% real GDP growth rates, but at much easier to achieve medium-term 6-7% (the 2013 government target is 7.5%), its growth will prove more sustainable and its ascent steady.
Last but not least, other countries demonstrated that economic development is possible and China can draw on their experience as well the experience of the countries encountered severe economic difficulties. While only very few economies have succeeded in catching up, more or less, with the most advanced economies in terms of per capita income, partial income convergence is achievable and is all China needs to achieve in order to become the world’s largest economy. Its population is about four times as large as the US population. China is set to overtake the US in terms of GDP (measured at PPP exchange rates) as early as 2016, according to IMF projections. Some analysts even project Chinese GDP to reach twice the level of US GDP by 2050 (Keidel 2008). Long-term projections are fraught with problems. Nonetheless, if this scenario were to materialise, it would still leave Chinese per capita income at only a little more than ½ of US income. In spite of the uncertainty, not a completely implausible scenario, if one takes Korea and Taiwan as approximate bases for comparison. The economic rise of China is as pivotal as it appears quasi-inevitable.