One intriguing phenomenon in recent history is our perverse habit of slapping the label “miracle” or “model” on fast-growing economies right before they lapse into stagnation or implode. In the 1980s, Japan’s economic achievement gave rise to the notion of a “Japanese model,” shortly before its real-estate and stock-market bubbles burst. A few years ago, our obsession with China’s rise led many to believe that the Chinese had also found a secret path to enduring economic success. The idea of a “Chinese model,” loosely defined as a mix of state capitalism and authoritarian rule, gained popularity, both in China and the West.
In retrospect, it seems that countries should avoid being labeled “miracle” or “model” at all costs because such recognition is a sure indicator of imminent economic catastrophe. Twenty years ago, Japan experienced the humiliation of going from world economic champ to chump within a few years of its financial meltdown. Today it seems to be China’s turn.
Recent data from Beijing indeed show a very rough patch ahead for the world’s second-largest economy. Industrial production, which roughly accounts for half of China’s GDP growth, rose only 9.3 and 9.6 percent in April and May respectively, far below the average annual rate of nearly 15 percent for the last decade, and about 25 percent below the pace for the last 12 months. The growth of electricity consumption, a more reliable indicator of economic activity, slumped to 3.7 percent in April, half of its usual rate. The June numbers were hardly better. China’s manufacturing activity, based on the official Purchasing Managers’ Index, showed the slowest growth since last November.
Foreign trade, one of the twin engines of Chinese growth (the other is fixed-asset investment), presented a mixed picture. While the trade data for April showed virtual stagnation, with exports growing at only 4 percent and imports grinding to a halt, May must have brought much-needed relief to Beijing, as exports grew 15 percent, far exceeding lowered expectations.
The only relatively bright spot in this dismal landscape is domestic consumption. China’s retail sales grew at an average of 14 percent in April and May. But since household consumption accounts for less than 40 percent of the GDP, the impact of rising retail sales on growth is modest at best.
The precipitous slowdown of the Chinese economy, caused by economic woes in Europe (China’s largest trading partner) and weak domestic demand attributed to stagnant growth in investment, has led the World Bank to reduce its forecast for Chinese growth to 8.2 percent for 2012 (China grew 9.2 percent last year) and forecast 8.6 percent for next year. Credit Suisse, the investment bank, has cut the Chinese growth rate even further, to 7.7 percent for 2012 and 8.2 percent for next year.
Obviously, struggling developed economies would do anything to have China’s growth rates. But for a country accustomed to double-digit growth for three decades, a transition to high single-digit growth presages not only the potential for political and social turmoil, but also a difficult period of structural economic change.
To put it differently, if not starkly, the recent deceleration means the end of the so-called Chinese economic miracle. The era of rapid economic growth driven by investments and exports is over for China.
To many veteran China watchers, China’s economic slow-down is all but inevitable. For the past decade, liberal economists, international financial institutions like the World Bank and the IMF, and China’s major trading partners have been urging China to change its state-led development model that has relied excessively on fixed- asset investment and export for growth, at the expense of household consumption. They have repeatedly warned that channeling resources to projects favored by the state would crowd out the private sector and waste precious capital, while squeezing the income for average households and reducing their capacity for consumption. In addition, such a strategy was almost certain to raise trade tensions with the West since rapid growth in investment, by creating industrial overcapacity, would force Chinese companies to dump their excess production on the global markets.
Sadly, for many years, such warnings fell on deaf ears in Beijing. Giddy with the apparent success of the much-touted “Chinese model” and unwilling to undertake the reforms that would make growth more balanced and sustainable, Chinese leaders paid mostly lip-service to rebalancing the Chinese economy. Macroeconomic indicators for the past decade show worsening domestic imbalances, with investment rates consistently in excess of 40 percent of GDP since 2004 and household consumption falling to around 35 percent of GDP in the same period, the lowest for a major economy (by comparison, household consumption accounts for 70 percent of GDP in the U.S.). In the meantime, China’s external imbalances, reflected mainly in huge trade surpluses, have grown as well. In 2007 and 2008, China’s trade surpluses reached an astonishing 8 to 9 percent of GDP. In the last three years, as Western demand for Chinese goods fell and labor and material costs rose, China’s trade surpluses have dropped below 2 percent of GDP.
The deterioration in growth could not have come at a worse time for Beijing. The ruling Chinese Communist Party is in the middle of a leadership transition. Contrary to the popular perception of a decisive leadership, the jockeying for power inside this political oligarchy typically paralyzes policymaking. Outgoing leaders may want to revive economic growth at any cost in order to strengthen their hands in picking successors and save their reputations. But incoming leaders fear that their predecessors’ policy may lead to wasteful investments and a build-up of bad loans in the banking sector, a financial mess they do not want to inherit.
A significant part of the problem with the Chinese economy today originated in Beijing’s outsized stimulus package in 2009–2010. In response to the global financial crisis in late 2008, the Chinese government stimulated the economy with 4 trillion yuan ($600 billion) in fiscal spending and about 12 trillion yuan ($1.9 trillion) in new bank lending. Altogether, the injection of 16 trillion yuan into the economy, equivalent to 35 percent of GDP over two years, lifted the Chinese economy and earned Beijing plaudits around the world at the time. But most of the money went into fixed- asset investments and real estate, fueling a property bubble, causing inflation, and creating a mountain of bad loans in the banks. In the meantime, Chinese households did not benefit. Their consumption level has barely budged.
Because of the botched stimulus package four years ago, China today faces an excruciating choice. It can certainly make the same mistake again by using a combination of fiscal spending and government-directed loans to inflate growth through more investments. Such a strategy would provide enormous relief to state-owned enterprises (SOEs), local governments, and well-connected real-estate developers sitting on unsold property. SOEs can use the free money from Beijing to expand their empires, local governments can build more white elephants, and real-estate developers can roll over old debts and avoid liquidation. The costs of this option are obvious. While growth in the short term can be raised artificially, it is bound to crash again. Worse still, China’s financial system will be saddled with even more nonperforming loans. At present, the government’s total debts, both explicit and implicit, are estimated to be around 70 to 80 percent of GDP. As a middle-income country with a per capita of $5,000 but a rapidly aging population, China does not have much room to take on more sovereign debt.
Another option is to risk more bold and market-friendly measures. Instead of funneling capital into SOEs and local governments, Beijing can launch programs that put money directly into the pockets of consumers. Giving low-income households vouchers for food, rent, health care, and other necessities can boost consumption instantly. Cutting taxes will also raise the real income of Chinese citizens. Better still, Beijing can kill two birds with one stone by forcing over-leveraged real-estate developers into bankruptcy, taking over their unsold apartments, and selling them at a steep discount to low-income or middle-class families. Such a move would let the air out of the real-estate bubble and provide low-cost housing to urban residents priced out of the frothy real-estate market.
Which path will Beijing take ? The first option is economically calamitous but politically sensible since it will benefit the ruling elites and their constituencies at the expense of China’s long-term economic prosperity. The second option is economically sensible but politically infeasible since it essentially asks the party to share its wealth with the people. The slogan in front of the party’s headquarters in Beijing may still claim “Serve the people,” but everyone knows that the party serves itself first and foremost.
Even if Beijing somehow manages to muddle through the current growth slowdown with a stimulus package full of compromises, the long-term prospects for China are not encouraging.
First, the favorable factors responsible for the “Chinese Miracle” have disappeared or are disappearing. Its population, which used to be very young and provided abundant cheap labor, is aging fast. The costs of health care and pensions, for which China has not made meaningful financial provisions, are expected to explode in the coming decades. Its export growth, averaging 20 percent per annum for over a decade, has powered its economic engine. But with rising labor costs, anemic demand overseas, and political backlash from its trading partners, China cannot count on exports to lift its growth in the future. Neglect of the environment, which has given China an artificial competitive advantage, has created an ecological catastrophe that must be addressed immediately—and at great cost.
Second, the Chinese growth model, which relies on investments and exports (collectively accounting for 70 percent of GDP growth), has lost its magic. State-directed investments such as modern airports and high-speed trains may have impressed Westerners, but most of them are either too costly, inappropriate, or wasteful. Such investments also come at the expense of private consumption since the government has to tax households heavily in order to fund them. Using undervalued currency and cheap labor to increase exports has become less viable, both diplomatically and economically.
The only strategy that can help China maintain growth and avoid long-term stagnation is to reject state capitalism and return to pro-market reforms. The substance of such a strategy is well-known : privatizing SOEs, breaking up government monopolies, liberalizing interest rates, freeing up the private sector, raising household income to make domestic consumption the primary engine of growth, building a social safety net, and ending mercantilist trade policies.
The real hurdle for China in embracing this new model of growth is not economic. The country has ample financial and human resources to make the transition. The obstacle is political : the ruling party will have to give up many of its privileges and alienate its core constituencies (the bureaucracy, SOEs, local governments, and personal cronies) if it decides to embark on China’s Third Revolution.
At the moment, no one knows what Beijing’s new leaders will do. But one thing is certain, if they stay the current course, they will most likely bear witness not just to the ignominious end of the Chinese economic miracle, but also the fall of their party from power.
This essay was originally published on the Daily Beast.
