Abstract and Keywords
Few countries get the public’s attention to the extent that China does. And few generate such diverging views concerning its economic, social, and political evolution. This chapter sets the context by noting China’s impressive economic achievements as well as current financial difficulties. Markets are questioning whether China can survive the threat of looming debt and property-market bubbles, while the general public is more concerned with the country’s political stability and security as Beijing becomes more aggressive in its claims over neighboring islands. How does one explain such extreme variation in views? Many factors are involved, which makes it difficult to be ideologically neutral regarding this emerging great power. If the diagnosis is wrong, then likely so are the policy prescriptions.
Few countries command the public’s attention to the extent that China does. And few generate such widely varying views on its economic and political prospects. This book is about why there are such differences and why the conventional wisdom is so often wrong.
That China warrants so much attention is not surprising. Its remarkable economic performance is challenging the world’s geopolitical balance of power and triggering debates on the virtues of state-led versus market-led capitalism. China’s rise is seen positively in uplifting hundreds of millions out of poverty, but many also see it as a threat to the established international order and Western democratic traditions. All this is occurring at a time when populist pressures are raising concerns about the economic benefits of globalization and the capacity of institutions to deal with its social and political consequences. Against this background, the intentions of presidents Donald Trump and Xi Jinping to elevate the profiles of their respective nations and to champion differing views on globalization will increase tensions in the coming years.
Why perceptions about China’s economy are so often wrong is not as easy to decipher. For China specialists, these differences stem from the lack of an agreed-upon analytical framework. For the public more generally, there are also challenges in drawing the appropriate conclusions about a country that is so big and regionally diverse in the distribution of its natural resources and economic activity.
For the economists and financial community covering China, the lack of an agreed-upon analytical framework makes it difficult for views to coalesce. Decades ago in the heyday of the Soviet Union and centrally planned Eastern European economies, universities routinely taught courses on socialist systems or “transitional” economies as an academic discipline. With the demise of the former Soviet Union and its economic links with Eastern Europe, this body of analysis faded away as a popular field of inquiry. The consequence is that many of the market-based principles used for analyzing the behavior of firms and (p.2) macroeconomic aggregates for a typical developing country often fare poorly when applied to China. And because China’s financial, fiscal, trade, and social welfare systems are more closely linked than those in market-based economies, it can be difficult to identify the fault lines when problems do emerge.
Unlike Russia’s rapid economic transformation, China’s reform process was more gradual in its systemic shifts. While market forces play a significant role in shaping China’s economic outcomes, state-driven mandates often matter more. Western textbooks see competition as being driven by firms, but China’s provinces and local administrative units also play a unique role in creating pressures for change. This phenomenon has no counterpart among other developing economies or the historical experiences in Eastern Europe.
And because China is a continental economy, regional and spatial factors shape economic outcomes in ways that traditional macroeconomic indicators do not easily capture. This creates a tendency for observers to simplify when a more holistic approach would be more appropriate. Moreover, sentiments are almost always clouded by emotionally tinged differences in ideology and culture between the West and China. Thus, aspects of China’s growth process and structural transformation are easily misinterpreted, resulting in misguided policy prescriptions.
China’s Rise Generates Conflicting Views
Usually, economic trends are a concern confined to financial institutions or academics. For China, even routine announcements such as last quarter’s industrial production, a decline in imports or a modest 2 percent exchange rate adjustment, as occurred in August 2015, can end up as front-page news or grist in US presidential campaign debates.
Despite so much scrutiny, China is an abnormal economic power whose rise has mystified almost everyone. Over the years, one was as likely to read about the middle kingdom dominating the international economy as about a possible imminent collapse. Similarly, some observers see China’s authoritarian system as its Achilles heel, while others see it as a major contributor to its impressive achievements.
Nobel Laureate Joseph Stiglitz writes about this being “the Chinese Century.”1 At the same time, predictions of China’s demise can come from established economists such as Harvard Professor and former International Monetary Fund (IMF) chief economist Kenneth Rogoff, who has been warning for years of an impending debt crisis.2 Among the more skeptical in the financial community is former UBS chief economist George Magnus, who has cautioned against China’s rise being seen as inevitable given its weak institutions, aging population, (p.3) and environmental degradation.3 But Stephen Roach, the former chairman of Morgan Stanley Asia, continues to express confidence that China will be able to manage its economic challenges.4 Many now see China’s slowdown as a sign of a diminishing global influence, but given its size and still relatively high growth rate, others note that its role will only increase.5
Over the past decade, there have been a flood of media reports and in-depth studies establishing what has become the conventional wisdom about China’s economic performance and prospects. Among the many popular beliefs are the following:
• “It is impossible for American firms to compete with China because its wages are so low.” (Yet China’s wages are now five times what they once were in the mid-1990s, and its $600 billion trade surplus in 2015 was six times that of a decade ago.)
• “American companies invest a lot in China and this is why jobs are being lost.” (Yet only around 2 percent of America’s foreign investment actually goes to China.)
• “Corruption has negative consequences for China’s growth.” (Yet spreading corruption has actually promoted rather than impeded growth.)
Typical of the economic arguments made in recent years are statements like these:
• “China’s surging debt levels mean that a financial crisis is inevitable.”
• “An over sixfold increase in property prices is a clear sign of a bubble.”
• “China needs to rebalance its growth away from repressed consumption and excessive investment to escape the ‘middle-income trap.’ ”
• “Official statistics are manipulated to give politically acceptable results.”
The problem with these, and other, widely shared sentiments is that they are either misleading or wrong. If the analysis is off, then likely so are the policies that are being advocated.
China’s Unique Economic Track Record
The context for this book is that China is at an inflection point in moving from its historic double-digit growth rates to a slower path whose dimensions are still to be determined. At the height of the Global Financial Crisis (GFC), China accounted for an astounding 50 percent of the world’s economic expansion, yet today its slowdown is wreaking havoc on economies that previously benefited (p.4) the most from its rise. Judgments about China’s economic prospects have become more pessimistic, and this is also triggering concerns about its future political evolution. Markets are now questioning whether China can survive the threat of looming debt and property-market bubbles.
Much of the variance in perceptions stems from how one interprets China’s remarkable economic history. China’s economic performance after Deng Xiaoping opened up the economy in 1980 led to three decades of double-digit GDP (gross domestic product) growth, lifting some six hundred million from poverty—more than the entire population of Africa.
How exceptional is this performance when measured against other countries? As seen in Figure 1.1, China’s growth rate over the two decades from 1991 to 2010 puts it in a class by itself. No other country comes even close. More recently, China’s economic slowdown has generated widespread concerns about its prospects. Taking the average of the recent four-year period (2010–14) for which cross-country data are available (see Figure 1.1), China’s growth rate of around 8 percent is still much better than all but a handful of countries and compares quite favorably with the global average of 3.4 percent.
China’s exceptional economic performance is the result of a series of pragmatic reforms that encouraged more competition, made use of the country’s advantages, and were sequenced to reflect evolving institutional capabilities and market opportunities. Its economy underwent three major transformations in the course of these reforms: from an agrarian to an industrial and services-driven economy, from a closed economy to a relatively open one, and from a totally state-dominated economy to one of mixed ownership.
What was different was the process that China used to reform its economy rather than the policies themselves, since the reforms broadly adhered to (p.5) mainstream prescriptions including liberalizing markets, diversifying ownership, and maintaining stable macroeconomic conditions. By pursuing reforms in a gradual, experimental way—often with second-best but practical approaches—and providing incentives for local authorities, the leadership was able to develop workable transitional institutions at each stage of development. These reforms made China’s firms globally competitive without the need to embrace the mass privatization initiatives that took place in the former Soviet Union. China also grew rapidly because it was partially insulated from the swings in global economic cycles due to its capital controls and command over investment decisions.
For much of the period from 1980 to the early 2000s, China’s performance was more of an academic curiosity regarding a growth experience that did not fit the usual norms. But that all changed after China gained membership in the World Trade Organization (WTO) in 2001. Its export prowess altered global trade patterns and ultimately geopolitical relations. China’s trade surpluses soared to nearly 10 percent of GDP by 2007, unprecedented for such a large economy. Its surpluses were seen as globally destabilizing, contributing to the large trade deficits in the West, especially for the United States. After suffering through decades of financial weakness and shortages of foreign exchange, China’s external reserves expanded twentyfold from less than $0.2 trillion in 2000 to nearly $4 trillion in 2014, before falling back more recently.
For most of this period, China’s economic rise was largely seen as a positive outcome that buoyed up exports from commodity-producing nations in South America and Africa as well as Asian economies that specialized in high-tech components to be assembled in China for European and American markets. China became the major source of lower cost consumer goods for the world and helped support a protracted period of global economic expansion in the new millennium. For the most part, its success was seen by its neighbors as an economic opportunity and the process as harmonious regarding its impact on foreign relations.
But in response to the GFC in 2008, China’s position both economically and geopolitically changed dramatically. China’s policies to counter the financial crisis initially appeared to be a major success in keeping growth going at home when the economies in the West fell into recession. But subsequent cycles of credit expansion generated rapid debt buildup and excessive property construction. This has now raised widespread concerns that China would succumb to its own financial crisis. The combination of having to deal with mounting debt levels coupled with a maturation of its economy has led to a prolonged slowdown which as of early 2017 had yet to bottom out.
This contraction has generated worldwide concerns, because China still accounts for about a quarter of the increase in global output. The consequences have disproportionately impacted metal and energy prices, with ripple effects (p.6) on financial markets. Commodity-exporting countries have felt this especially keenly, and prospects seem dampened for many formerly dynamic economies in East Asia.
Nevertheless, market watchers and the media have exaggerated the negative aspects of China’s economic problems. Many of the uber-bears now point to China’s recent problems as evidence of a flawed growth model or a precursor to a debt-driven collapse. Yet common sense tells us that no economy can grow at 10 percent annually forever, doubling in size every seven years. Cross-country experiences indicate that as an economy matures, growth moderates, just as it did for the other successful developing economies over the past half century. And while China’s debt surge has gone on for too long and needs a more disciplined approach, it is still manageable.
China’s GDP growth rate of 6.7 percent in 2016 hit a twenty-five-year low, yet it was still higher than any other major economy aside from India. And over the past decade and a half covering both the Asian Financial Crisis (AFC) and the GFC periods, China’s growth record stands out in being more stable and robust than other major emerging market economies in East Asia or elsewhere (see Figure 1.2).
On the foreign policy front, China shifted from what had been seen as a largely passive stance on global and regional issues to increasing assertiveness regarding territorial claims in the South China Sea and similar frictions with Japan in neighboring waters. This has ratcheted up regional tensions and brought China into a more adversarial position with the United States, whose much-publicized (p.7) “rebalancing or pivot” back to Asia is viewed by Beijing as a containment strategy. These days, security concerns in Asia are focused on the possibility of a conflict between a rising great power and the dominant one.
At the same time that China’s external relations have become strained, its economic achievements at home are being compromised by widening income disparities, surging corruption, and worsening environmental conditions. The rapid shifts in China’s prospects have spawned a growing debate about China’s economic and political evolution and its domestic and foreign implications.
Differing Global Views of China
Differing perceptions of China begin with views about its position in the global economy. For many years, the majority of Americans and Europeans believed that China was already the leading economic power, yet the rest of the world—especially China’s immediate Asian neighbors as well as China itself—felt strongly that the United States was still on top. Why is there such a dichotomy between the views of the developed and developing countries, which at first glance appears to be the reverse of what one might have expected? The answer lies in misunderstanding the importance of trade balances in determining a country’s economic might (see Chapter 2).
Going beyond economic concerns, negative feelings about China have hit all-time highs in the United States. The same is true in Europe, although the depth of such sentiments varies considerably across nations. Many instinctively would guess that public opinions about China might be most negative in the United Kingdom, given tensions over Hong Kong, and more positive in Germany, given its strong economic and political relationships with China. Yet the reality is the opposite. Not recognizing and understanding the nature of such patterns makes it even harder to form effective foreign policy responses.
For the more ideologically inclined, China raises many red flags. Its economic ascendancy threatens the tenants of Western political liberalism—grounded in free markets, democracy, and the sanctity of human rights. China’s impressive achievements challenge these principles. These concerns often surface as a debate between the roles of the state versus the market, or the priority to be accorded to individual liberties versus collective action. The debate has been caricatured as a battle between two systems, although the two may have more in common than differences regarding the problems that need to be addressed. This has nurtured sentiments that are likely to be harsher than the reality in judging China’s economic situation.
The debate over whether a market- or state-led system is more growth enhancing became more serious after the AFC in the late 1990s, when China’s growth soared. It intensified further during the GFC in 2008 when the major Western economies stumbled badly while China for a while seemed to be insulated. Many believed that China would suffer in the aftermath of the AFC, even if it was not among the most severely affected. They did not foresee the impact of three powerful drivers of growth that emerged with the new millennium: the dynamism of an expanding private sector, a construction boom, and the emergence of an Asian production-sharing network centered on China. These forces, along with market liberalization, drove a surge in investment rates and rapid GDP growth over the subsequent decade and a half (see Chapter 3).
Some of the hotly debated issues that emerged during this period found support among both critics and believers in China’s growth process. One such theme is that China’s growth model is excessively unbalanced as measured by its extremely low share of personal consumption relative to the size of its economy, with a commensurately high share of investment. This was seen as the major reason for China’s huge trade surpluses and a risk to its longer-term growth prospects. This led to many experts and institutions to recommend that for China to escape the so-called middle-income trap it needed to have a more consumption driven growth process.6 This view, however, is misguided. Unbalanced growth is largely a consequence of a successful growth process driven by urbanization and regional differences rather than a weakness—even if these imbalances have been pushed too far in recent years. Moreover, contrary to expectations, China’s trade surpluses moderated even as its consumption-investment imbalance widened (see Chapter 4).
Part of the confusion comes from mixing up what economists call “supply” or productivity-related factors that shape a country’s medium- to long-term growth process with the near-term cyclical problem of inadequate “demand” to absorb what is being produced currently—which if unresolved would dampen growth prospects. Thus most observers look to increasing household consumption as the solution for inadequate demand caused by depressed global trade and declining investment needs at home. Few realize that given the nature of China’s economic system, the problem can only be solved by increased government expenditures largely in the form of social services to supplement personal consumption as the source of more demand in the future.
Since the GFC, China watchers have been fixated on the surge in China’s debt-to-GDP ratios and a looming property bubble. The doubling of equity prices from 2014 to 2015, followed by a 40 percent collapse, have added to such (p.9) worries. Experts have warned that all economies that have incurred similar bubbles have experienced a financial crisis and there is no reason why China should be any different.
Yet China is different—not because it is immune to financial pressures, but because the structure of and interactions within its economic system are not the same as others. Most of China’s debt is public rather than private, and sourced domestically rather than externally. China also did not have a significant private property market a decade ago, so that most of the recent surge in property prices is the consequence of market forces trying to establish appropriate values for land—whose value was previously hidden in a socialist system. China’s equity bubble also differs in the sense that it was not driven by economic fundamentals but by flawed government policies (see Chapter 5).
The debt crisis has led most market analysts to focus on what they see as serious weaknesses in China’s financial system as evidenced in the arguments that were being made after the GFC that China’s interest rates were too low and that its banks needed to be better managed to moderate the surge in nonperforming loans. Yet the reality is that its interest rates have been too high rather than too low, and soaring debt levels are being driven more by weaknesses in its budgetary system than its banks. But there is a moral hazard problem since China’s ambitious growth targets lead to excessive lending because the firms and banks involved can pass the costs of poor decisions on to the state. These concerns require attention, but the prospects of a near-term economic collapse are exaggerated. The solution lies in increasing productivity and overhauling China’s fiscal system while strengthening accountability (see Chapter 5).
Differing Socioeconomic and Political Concerns
For many China watchers, worsening social tensions rather than the economy per se is the real risk. Income inequality has increased more rapidly in China over the past several decades than in any other major economy, and many see this as potentially destabilizing the system. Yet in one generation China has spawned hundreds of millions of new jobs for those leaving low-productivity agriculture, and growth in real wages has been multiples higher than in other countries. This paradox is explained by the spatial nature of China’s growth process which can be characterized as a race to the top with urban incomes increasing faster than rural incomes (see Chapter 6).
On a more general level, the commonly accepted view is that economic and political liberalization go hand in hand and a market-driven form of capitalism is better than China’s state-led version. Yet while the pace of economic liberalization in China has been impressive, political liberalization by the usual markers (p.10) has been caught in a time warp. China also seems to be trapped in a spiral of ever-increasing corruption. Many assume that President Xi Jinping’s highly publicized campaign against corruption, if successful, will lead to more rapid growth and a stronger role for the Communist Party, even though the opposite is likely to result (see Chapter 6).
Differing Views on China’s Global Economic Relations
For the United States, trade tensions have dominated its economic agenda with China for much of the past decade. Most Americans believe that their country’s huge trade deficits are closely linked with China’s similarly large trade surpluses and that an undervalued renminbi is the reason. Yet the reality is that there is no direct causal relationship between China’s surpluses and America’s deficits, and much of the rhetoric surrounding the alleged manipulation of China’s exchange rate and promoting more manufacturing jobs in the United States is similarly misplaced (see Chapter 7).
For those focused on global power shifts, a related issue of internationalizing China’s currency is seen as signaling Beijing’s desire to increase its stature in the world economy, possibly at the expense of the United States. Yet few understand that the economic rationale for internationalizing the renminbi is intrinsically weak and, given the structure of China’s economy, the likelihood of this happening is very low. But this objective can play the role of a Trojan horse in supporting China’s economic reforms and broader national security objectives.
The general public believes that American firms are investing heavily in China, leading to loss of American jobs. Yet contrary to popular perceptions, flows of foreign direct investment (FDI) between the United States and China are abnormally low. The standard view is that rich countries have excessive capital and invest in poorer countries that lack the necessary savings. Yet the United States and China illustrate the opposite situation, with China now investing more in the United States than the United States is investing in China. The nature of trade relations partly explains why this is the case, but political and security concerns also explain why the European Union’s investment relations with China are so much stronger than America’s (see Chapter 8).
Currently, the United States and European Union are both negotiating bilateral investment treaties (BITs) with China. Interwoven into the sensitivities of the discussion are concerns about technology transfer and intellectual property rights (IPR) theft as China’s production process becomes increasingly more sophisticated and a direct competitor with the West. China has been pouring money into innovation, with surging levels of support for research and development, higher education, and strategic industries. Many in the United States (p.11) see China as a potential threat as it moves up the value chain in production. Yet China is not really more innovative and technologically advanced for a country at its income level. Moreover given historical experiences, IPR theft is unlikely to be curtailed at this stage in China’s development (see Chapter 8).
China’s trade and foreign investment flows underpin President Xi Jinping’s strategy to elevate China’s regional presence and to gain more friends by strengthening links with Europe through his “One Road, One Belt” initiative, while the US “pivot to Asia” is an attempt to reassert itself in the region. The potential for conflict has increased because of the island disputes in Asian waters. These have also made it next to impossible for China to nurture warmer feelings with its neighbors. President Trump may take a harder position regarding these disputes even if the affected Southeast Asian nations seek options to lower tensions.
While China’s economic reforms have nudged it to becoming a more “normal” market-driven economy, tensions are exacerbated because China has become an “abnormal” great power. It is the first great power that is a developing rather than a developed country, the first to get old before it gets rich. Its weak institutions and historical legacies mean that it has more insecurities than would be expected of a great power. Whether the result turns out to be destructive relations between China and its neighbors and the United States or a more conciliatory process that allows the region to remain stable and prosper is uncertain (see Chapter 9).
Explaining Why Conventional Wisdom Is So Often Wrong
How does one explain why there is such extreme variation in views and why conventional wisdom is so often misguided? The answer is that observers see China through multiple lenses (see Chapter 10). Geopolitical differences in values and inadequate analytical frameworks are part of the explanation, making it difficult or nearly impossible for both pundits and academics to approach issues in an intellectually validated or ideologically neutral way.
Policymakers in Beijing often complain that the Western media tends to “demonize” China and that judgments are impaired by unwarranted and ideological biases. But the more dispassionate observers will remind their friends in China that its discriminatory trade and investment practices and restrictions on the international media create the climate for stinging criticisms, as exemplified in the 2016 annual report of the bipartisan Congressional-Executive Commission on China which took a particularly harsh position on the government’s human rights record.7
The issue is not whether one should be positive or negative about China’s economy and its political and foreign policy implications but instead about (p.12) fitting China into a framework that leads to a better understanding of the reality. Many experts inappropriately use the experiences of other countries to assess developments in China and in doing so their conclusions are often wrong. Some have argued that China does not follow the same economic and financial principles that apply to others—but while the principles might be correct, the assumptions might not fit China’s mixed economy.
The problem is compounded by the opacity of China’s economic and political system. Everyone thinks that China manipulates its statistics to give excessively positive outcomes, but the mystery lies in how such indicators are constructed and the implications of the rapidly changing structure of China’s economy. Ironically, China’s GDP growth rate measured over the long term has been under rather than overstated.
The media is under considerable pressure to convey an easily digestible message to the general public that is in line with accepted values and norms. The result often fails to take into consideration China’s size and geographic diversity, as well as the peculiarities of its governance structures and growth path.
Among the more analytically inclined, differing perceptions reflect how one views the many distortions in China’s economy that result from blending market-based principles into a still centrally controlled system, leaving many of its economic institutions caught in a no man’s land. The consequence is that analysis of what economists call “market distortions” in a transitional economy like China is more tenuous. The more pessimistic China watchers see these distortions as signs of a possible economic collapse. The more optimistic see potential for improved outcomes with reforms. Purists seek ambitious market-based solutions that might yield a hypothetical “best” outcome. The more pragmatic see the logic in pursuing “second-best” approaches and the merits of a more gradual path to get around vested interests.
More often than not, the China debate reflects a misreading of the role of the state in influencing economic decision making in China. The Western concept of an economy is based on competition among firms in open and free markets. Unique to China, local governments are also part of the competitive economic environment. Beijing sets the broad parameters, and policies are calibrated in ways that defy traditional thinking. Competition in China is not just the result of pressures generated by markets and firms but can also come from local government entities. Not incorporating these factors into the analysis leads to a misunderstanding of what has been happening in China.
At the geopolitical level, views are driven by the tensions that come from a rising power seen as threatening the position of the dominant power and rewriting the principles upon which the existing global order was established. Economic differences between nations can and do raise concerns, but ultimately their resolution does not have to be a zero-sum game but one from (p.13) which both sides can benefit. A realignment of global power relations, however, is usually a zero-sum game that is more likely to distort perceptions and foster conflicts.
This book takes a critical look at China’s economy through many perspectives. Chapter 2 covers global public perceptions of China’s economy and the contrasting views shaped by economic and political considerations. Chapter 3 explains how Deng Xiaoping’s opening up of the economy more than three decades ago laid the basis for China’s growth model which underpins the current debate about its economic challenges. Chapters 4 and 5 delve more deeply into China’s growth process, focusing respectively on its unbalanced nature and more recent concerns relating to its debt and property problems. Chapter 6 elaborates on the social and political conflicts facing China and their relationship to economic developments. Chapters 7–9 discuss how China’s trade and capital flows and foreign policies have impacted the global economy, particularly the United States and Europe. Chapter 10 provides an overview of China’s current economic prospects and a framework for helping the reader crack the China conundrum.
(1.) Joseph Stiglitz, “The Chinese Century,” Vanity Fair, January 2015.
(2.) See the commentary on Professor Rogoff’s views in Andrew Ross Sirkin, “A Warning on China Seems Prescient,” International New York Times, August 24, 2015.
(3.) George Magnus, Uprising: Will Emerging Markets Shake or Shape the World Economy (West Sussex, UK: John Wiley, 2010).
(4.) See, for example, Stephen Roach, “False Alarm on China,” Project Syndicate, January 26, 2016.
(5.) See Danny Quah, “Chinese Lessons: Singapore’s Epic Regression to the Mean,” World Bank Future Development Blog, November 10, 2014.
(6.) The concept of a “middle-income trap” was developed by Indermit Gill and Homi Kharas, An East Asian Renaissance: Ideas for Economic Growth (Washington DC: World Bank, 2007). The concept is that developing countries have been relatively successful in moving from low- to middle-income levels, but for a variety of reasons—notably the inability to shift to higher-valued production—only a few middle-income countries have been able to move up to high-income levels.
(7.) Congressional-Executive Commission on China, “2016 Annual Report,” October 6, 2016.