Is the end of "cheap China" imminent?

It was at the very outset of China’s world-changing program to enter the global market that Ross Garnaut was first briefed on Beijing’s plans.

In the three and a half decades since, the eminent Australian economist has been consistently upbeat about China’s chances of making it.

Only when the army massacred students in Tiananmen Square in 1989, prompting the leadership to question its entire strategy, did Garnaut hesitate.

But, of course, Beijing soon resumed its trajectory from a closed, rigid communist economy to an open, flexible market one.

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China has been in and out of fashion many times with the financial markets over the decades since. Its irresistible rise confounded armies of analysts and swarms of savants, wrecking reputations across the Western world.

For instance, the author of the 2001 book The Coming Collapse of China, an American, Gordon Chang, predicted it had five years, 10 at the most. He’s since taken to writing annual explanations of why he’s not wrong, just premature.

But Garnaut, economic adviser to Bob Hawke and one-time Australian ambassador to Beijing, followed China’s transformation intimately and stayed positive throughout.

Until now. China, the world’s second-biggest economy, is now just a couple of years from eclipsing the US. On the current path, it will soon reclaim the title it lost in 1840 of being the biggest economy on earth.

But can it stay on that path? Garnaut says that apart from the Tiananmen moment, it’s “the first time in 35 years I’ve been worried about China’s outlook.”

Why?

His concern isn’t the one that the galah in every economic petshop has been squawking about for the past year or two, the slowdown in the growth rate from 10 per cent a year to a little over 7.

It’s the nature of China’s growth, not so much its speed, that troubles him.

For the past decade and a half, China’s economic growth has been based on the government’s response to two big economic disasters.

First was the Asian financial crisis of 1997-98; second was the global financial crisis of 2007-08.

Both times, China’s authorities overcame the effects by unleashing enormous stimulus programs.

“Those two big and brilliantly executed stimulus programs did what they were supposed to do – they kept growth going in China and its trading partners,” says Garnaut.

“China experienced extraordinary investment-led growth from the start of this century to 2011 – it was the strongest period of growth ever, in any significant economy.”

And because investment favoured enormous infrastructure projects that are greedy for energy and metals, “it was also the most metals-intensive and energy-intensive growth burst the world has ever seen".

“That’s where Australia got its mining boom,” supplying those Chinese needs, says Garnaut.

In the middle of this burst of government-engineered growth, wages in China started to grow faster than productivity and labour shortages appeared for the first time.

The country whose great global advantage had been endless supplies of cheap labour suddenly ran out of it from about 2008.

In his book The End of Cheap China, the American Shaun Rein begins by recounting that 20 years ago he had to deflect legions of “gorgeous young prostitutes” whenever he stayed in a Chinese hotel.

Today, says Rein, prostitutes no longer pursue hotel guests and the only ones in evidence are as old and paunchy as their clients. This is his opening indicator of rising demand and rising wages for workers in China.

He reports that labour shortages are the biggest single problem for most major foreign firms doing business there.

China’s leadership achieved important things in this phase of growth, says Garnaut in setting out his latest view this month to the inaugural seminar of the Centre for Contemporary China Studies at the University of Melbourne.

Not only did it make China a great economic power, it addressed two of the nastiest symptoms of its breakneck growth. One, rising real wages and better rural services halted the widening of the gap between rich and poor, one of the most extreme in the world.

Two, the government started to address some of the more shocking environmental disasters. The intensity of coal-burning in making electricity, for instance, is being reduced.

The bad news?

“The downside is that the big stimulus cut across the market sector and reinforced the role of the state in the economy,” Garnaut concludes.

In other words, China’s progress from a state-dominated economy to a flexible market-dominated one halted, and went backward.

“It cuts across the good intentions of deepening the role of markets in allocating resources,” says Garnaut.

Investment now equals about half of China’s annual output, the biggest proportion in recorded economic history, with the exception of a brief period in Singapore, says Garnaut.

Investment itself is not a bad thing; unproductive investment that stiffens the state sector at the expense of the market is.

Garnaut fears that China’s current slowdown might panic the government into yet another big wave of stimulus. That might hold up the growth rate, but “with the emphasis again on indiscriminate state-connected expansion”, reinforcing the problem with the structure.

“The leadership under Xi Jinping has the right reform agenda, but it’s easier said than done” as powerful interests resist restructuring.

The ferocity of the anti-corruption campaign illustrates the power struggle that’s under way, as well as the government’s determination to deliver.

“This doesn’t necessarily mean that China will fail; it is a worrying sign that we need to keep an eye on. We won’t know for a while whether China can overcome it.”

If it can’t, Gordon Chang and all the legions of doomsayers will indeed be shown not to be wrong but just premature.

Peter Hartcher is the international editor.

Illustration: michaelmucci.com

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