Saturday, March 24, 2012

Can China change its growth model?

How many countries with nearly two decades of double-digit growth under their belt would look in the mirror and say: ‘It’s just not working anymore’?

I daresay, not many. But that is precisely what some Chinese leaders appear to be doing — a point most recently underlined in a new report, China 2030, published by the World Bank and China’s Development Research Center (DRC).

China’s leaders clearly recognise that their growth model, which depends disproportionately on exports and investment in fixed assets, is not sustainable. And they appear to be self-reflective enough to weigh how (and how deeply) to change it.

One of the report’s most important conclusions is that private enterprise needs more space to thrive. Industrial, financial and political resources are heavily skewed toward state-owned enterprises in China. So the major banks, for example, give household depositors a negative return on their savings while bankrolling industrial policies through state-backed firms. This is one of many reasons for deeper financial reform in China, a case made quite trenchantly by former US treasury secretary Henry Paulson in a recent speech. But more broadly, China is clearly at an economic crossroads. The newly published report shows why, and several earlier studies, including one that I led at Eurasia Group, titled China’s Great Rebalancing Act, outline some of the problems Beijing will need to overcome in making this transition.

All of these reports make one common argument in particular: that China’s growth model is no longer sustainable and the country’s savvy leaders know it. Beijing is committed, at least in principle, to rebalancing China’s economy because its capital-intensive, export-oriented approach is delivering diminishing returns and threatens to become a major political vulnerability for the government.

But making these changes will be incredibly difficult, and China’s leaders will have to make serious and deep reforms to everything from subsidies to financial policy. This will prove impossible unless they can overcome inertia and ‘reform fatigue’, fight powerful constituencies among state-owned enterprises and entrenched financial interests, introduce a more market-based approach to energy policy, roll back subsidies (for example on land and energy), reform financial markets to free up capital for entrepreneurs and private business, and boost domestic consumption, among other challenges. In short, they will have to alter the underlying structure of China’s political economy.

I am among those who have been sceptical of China’s ability to undertake such deep reforms, arguing in the Eurasia Group report that Beijing would ultimately ‘lack the political stomach and sense of the moment to implement a comprehensive and ambitious rebalancing agenda’. Thus the release of China 2030 makes this an especially good time to re-examine that proposition.

Eurasia Group’s 2011 report outlined some of the problems Beijing will need to overcome if it hopes to eventually alter its growth model.

First, China’s economy is overly dependent on fixed-asset investment and exports. Consumption represents only about 35 per cent of GDP, a figure well below those of developing countries such as India. The perpetuation of a production-intensive economic model owes much to inefficient capital allocation. This condition is buttressed by an illiberal and politicised financial system, as well as distorted input costs including subsidised energy and land prices.

Second, one of the more troubling consequences of China’s capital-intensive growth model is that companies (and the government) have captured much of the enormous wealth generated in the last three decades at the expense of Chinese households.

This dynamic is not only exacerbating an already yawning gap between the government and business elite on the one hand and the average Chinese citizen on the other; it is also repressing consumption. A broken social welfare system, which cannot adequately deliver public goods such as pensions and healthcare, constrains consumption and encourages saving further. And that is why the fate of ongoing reforms will be so important.

Third, China’s vast regional disparities in living standards and average incomes are often likened to the contrast between different centuries. Policy makers in Beijing face the unique problem of having to deal with issues typical of both 21st-century middle-income countries and 20th-century developing countries. And these inequalities play out across a continent-sized economy: the wealthy coast contrasts starkly with the continental hinterlands, which comprise poor western provinces and regions populated by ethnic minorities. While China’s efforts to reduce poverty have been impressive, barriers to urban residency and the lack of progress on land reform have exacerbated regional inequality.

Fourth, capital-intensive growth has exacted steep environmental and resource costs.

Subsidised energy and land prices have encouraged companies to exploit China’s natural resources and ignore debilitating energy inefficiencies. Beijing sought to industrialise in a compressed timeframe, but, in its haste to catch up to the advanced industrial economies, the country has found itself on an increasingly unsustainable trajectory from both an environmental-degradation and a natural resource-security perspective.

So, the question facing China’s leaders is largely a political one, not an intellectual one: even if China’s leaders know they must implement necessary reforms, can they overcome the entrenched constituencies that will fight hard to block them? It is encouraging, therefore, that some political and economic elites in China have taken ownership of the China 2030 study. As the report’s foreword lays out: ‘the research was organized jointly by China’s Ministry of Finance (MOF), the Development Research Center of the State Council (DRC), and the World Bank’. The DRC’s president, Li Wei — whose prior career includes stints at such pillars of the entrenched establishment as the State-Owned Assets Supervision and Administration Commission, which oversees China’s 120-odd central state-owned enterprises — co-signed the foreword with the World Bank’s president, Robert Zoellick.

The reaction to the new DRC and World Bank report among Chinese elites should offer some interesting hints. But the real test will come next year once China’s political transition is settled and China’s leaders refocus on underlying economic structural challenges. Put bluntly, their choices will shape China’s next decade and beyond.
By Evan A. Feigenbaum Adjunct Senior Fellow for East, Central and South Asia at the Council on Foreign Relations.A version of this article was first published on the Council on Foreign Relations Asia Unbound blog.East Asia Forum

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