Bill Emmott - International Author & Adviser

Article

The coming change in China
Voice - January 2008

The momentum behind China’s economic and political rise is impressive. It brings to mind the phrase "shock and awe" that was commonly used by American military thinkers in connection with the invasion of Iraq in 2003—before things went so badly wrong there. In China’s case too, the frequent expressions of shock and awe by foreigners visiting and observing that country are liable to be misleading.

A big change looks as if it is on the way. It is a change that will alter China’s economic structure and character in a profound manner. That does not necessarily mean that China’s economy is going to collapse or that it is going to become a lot weaker. But it is going to change, and probably slow down, and the change will be a disruptive one. During great disruptions the consequences in politics, financial markets, corporations and social behaviour are always unpredictable.

There are many people inside and outside China who are predicting a big change, or even a collapse. But many of them are using the wrong argument for why change is on its way, they are looking in the wrong direction. Typically, the direction in which they are looking is towards the Olympic Games that will be held in Beijing in August 2008. The argument is that when the Olympics take place, a huge investment boom will come to an end, as the effort to build the stadiums, the roads, and the other infrastructure for the Games will also come to an end. When that investment ceases, the economy will slow down and perhaps even go into reverse.

The trouble is that this is an emotional argument rather than one based on analysis of the facts. The emotional idea is that the Olympics are an event of great national importance for China, so the investment and other spending for the Olympics must also be of great national importance. But that just isn’t true.

China is a large country with a very large economy. The Games will be very important in Beijing, and Beijing is a very important city in political terms. But it is not very important in economic terms. The Beijing metropolitan area accounts for merely 1.1% of China’s total population and it produces just 3% of China’s GDP, according to the chief Asia economist of UBS Securities, one of the world’s top investment banks.

Beijing’s share of China’s GDP is the lowest ratio between the Olympic city and the host country’s GDP for any Olympic Games in the past 30 years, and probably throughout the period since the modern Games were begun in 1896. In 2004, when the Games were held in Athens, the host city accounted for more than one-third of Greece’s population and an even higher share of its GDP. Yet the Greek economy did not collapse when the Games were over.

Why, then, should China’s collapse after the Olympics? Yes, there has been a lot of investment in new infrastructure for the Games. But that investment has been tiny compared with what has been going on all over the country. China’s annual GDP is now worth $3.3 trillion (that compares with $4.3 trillion in Japan). Total investment, by private firms and by the public sector has soared to 45% of that figure: an amazing $1.5 trillion each year. Spending on the Olympics and on Beijing as a whole is only a small part of that figure.

So, by the way, is investment by foreign companies, which is something people often get far too excited about: at $60 billion-70 billion a year, foreign direct investment is less than 5% of total investment in China. Even if it were to disappear altogether (which it won’t) the loss would barely be noticed. Foreign direct investment has been important as a way for China to import foreign technology and management skills, but has been insignificant as a source of capital.

Of course, if foreign investors were to withdraw from China, such an event would be symbolically important. It would not be important because of its direct effects, nor because it would cause any real shortage of capital or of new investment. It would be an important symbol because it is almost certain that anything that scares away foreign investors will also scare away the much larger and more significant domestic investors. It would be a sign that something dramatic had changed in the Chinese economy, something which was now going to reduce investment of all sorts. But how likely is that to happen?

Learning from Japan in the 1970s

Despite all the efforts by economists to do so, we cannot in fact forecast the future. Economic forecasts consist of extrapolations, or continuations, of recent major trends, with minor adjustments made to account for new events. Economists find it virtually impossible—well, perhaps, actually impossible—to forecast true turning points in the economy. All their data and the equations in their mathematical models are derived from the past. They cannot be derived from anywhere else. So it is impossible to make a mathematically-based forecast saying that the future is going to be radically different from the past.

Instead, we have to rely on history, on subjective judgment, and on instinct. These are not and cannot be scientific, but they are all we have. In the case of China, some of the most enthusiastic promoters of the country like to claim that its growth and its success are unique; that never in history has a country grown as fast, for so long, and by Chinese methods. Japanese readers, however, should know that this is wrong.

China’s growth since 1978 has been unique in only one respect: the fact that its starting point was the Communist central planning system built (with disastrous results) by Mao Zedong. In other respects, however, it has followed the model that was pioneered by Japan, first after the Meiji restoration and then again in the 1950s and 1960s. That model was also used by South Korea, Taiwan, Singapore and Hong Kong during the 1970s, and by some other South-East Asian nations during the 1980s and 1990s.

Although the exact formula used by each country has differed, the East Asian growth models have shared some important common aspects: openness to trade, especially of manufactured goods and components; rising domestic savings to finance a high and rising level of investment; some guiding role for government, but amid highly competitive domestic markets; political and social stability; an emphasis on education; and, for long periods, a currency system that maintained a cheap exchange rate which helped exports to grow.

If you look at China today, in fact, it is hard to avoid seeing clear similarities to the way in which Japan evolved during the 1960s. It is even, of course, true that Japan hosted the Olympic Games in Tokyo in 1964, just as Beijing will do this year. The data concerning the Chinese economy look more like Japan in the late 1960s than in that period around the Tokyo Olympics of 1964.

In all of the East Asian success stories, investment has played a vital role: the building of new factories, roads, railways, ports, airports, houses, offices and much more besides. In Japan during the 1960s, investment climbed and climbed to reach 40% of GDP in 1969-70. In those days, the yen enjoyed an exchange rate that was fixed against the dollar and other currencies under the "Bretton Woods" system of fixed rates that had been agreed in 1944-47 (the system was named after the town of Bretton Woods, in New Hampshire, in which the American and European allies agreed to set it up, along with the International Monetary Fund and the World Bank).

By the time of the 1960s, that yen exchange rate looked much too cheap. Japanese exports were soaring, building up a big trade surplus. Capital had been very scarce in Japan during the 1950s, but by the 1960s it was much more abundant, which is why investment was able to rise so high. There was another important consequence of rapid growth and high investment: pollution. In Japanese cities, the air became heavily polluted, and the same was true of rivers and lakes.

Does that sound familiar? It should do, because the same sort of trends can be seen in China today: a currency that is too cheap, a rising trade surplus, abundant capital, high and rising investment, big environmental problems.

Here are two excerpts from books written by Americans, one about Japan and the other about China. They are worth comparing, because they essentially say the same thing. The first is from a book published in 1975 by Frank Gibney, a journalist and publisher, though he was writing mainly about Japan in the late 1960s:

…Most of the beautifully scenic Inland Sea was hopelessly polluted by the so-called red tides of polluted waters from the factories on its shores. Smog warnings became regular and asthma sufferers began trekking to the hospitals. Regional complaints and petitions about pollution, about 20,000 five years ago, had risen to 76,000 as this decade began. In the south, hundreds of people fell ill from eating the local fish. Many died. Similar problems occurred in the north, with mercury-filled drainage from one factory and where a painful bone disease was caused by cadmium…

And the second is from a book published in 2007 by Susan L. Shirk, a former State Department official under the Clinton administration, but who is mainly a scholar specialising in China:

For two decades, the government treated environmental protection as a distraction from economic growth…Breakneck industrialisation produced some of the worst air and water pollution in the world. According to environmental officials, acid rain is falling on one-third of the country, half of the water in its seven largest rivers is "completely useless"…one-third of the urban population is breathing polluted air. More than 70% of the rivers and lakes are polluted, and ground water in 90% of the cities is tainted.

The final interesting thing is that the two books had very similar titles. Gibney’s book was called "Japan: The Fragile Superpower". Shirk’s recent book was called "China: Fragile Superpower". Perhaps in American eyes all Asian superpowers look fragile?

How China may change

The parallels are important, though the stories of how Japan changed and how China changes will inevitably be different in many ways. What happened to Japan is a story involving Richard Nixon, the Arab oil embargo, and democratic politics. China has none of those three elements, at least not directly.

Richard Nixon was important for Japan because in 1971 America’s then president decided unilaterally to abandon the Bretton Woods system of fixed exchange rates. America’s trade deficit was rising, its inflation was getting worse, and investors were fleeing the country. During the next few years, all major currencies were forced to float freely on international markets. As a result, the value of the yen rose abruptly, not as the result of a Japanese decision to revalue the rate but because of President Nixon.

The Arab oil embargo was important because in 1973 it led to a sudden rise in oil prices, which raised the costs of Japanese industry and which caused the general inflation rate to soar in Japan. The combination of a revalued yen, higher oil prices and general inflation produced a crisis for Japanese industry. They had to reorganise, improve their energy efficiency, cut costs, and move upmarket to more sophisticated, higher-value goods—or else die.

Democratic politics were important for Japan because of the protests against environmental pollution that were mentioned in the excerpt from Frank Gibney’s book. The figure of 76,000 petitions and complaints came from 1971. As a result, the LDP decided that it had to enact environmental laws for Japan, which it did in 1972, and enforce them strongly, or else risk losing power.

To repeat and expand the point, China today has many of the same features that Japan had in the late 1960s and early 1970s. It is a lot poorer, in terms of income per head, than Japan was then, but its economic structure is similar. And if you compare the incomes and living standards of the Chinese who live in the richer coastal cities of Beijing, Shanghai, Guangzhou, Xiamen, Hangzhou, Dalian and others with Japan in the early 1970s, the living standards are much closer.

The surplus of the current account of China’s balance of payments is now more than 10% of GDP, which is larger than Japan’s current-account surplus has ever achieved. Investment is 45% of GDP, driving annual rates of GDP growth of more than 11.5%. But that investment has become less and less efficient: if it were truly productive, then such a high level of investment ought probably to be generating GDP growth closer to 15% every year. A lot of investment is being wasted.

Inflation is starting to rise in China. The official target for consumer-price inflation is 3% per year, but in August the figure exceeded 6%. Government officials claim that the only reason for that higher inflation rate is a shortage of pork, as a pig disease has reduced supply of one of China’s most widely consumed meats. Once farmers manage to breed more pigs, the price will fall.

But this seems too complacent. Other factors are also driving costs higher for Chinese consumers and for companies. The money supply has been allowed to expand at 20-25% a year, much faster than GDP growth, because banks have been lending to boost that investment and because the central bank’s attempts to prevent the currency from appreciating have added to the amount of money in circulation. House prices are rising by more than 10% a year. The Shanghai stockmarket shows all the signs of an inflationary asset-price bubble: it has risen by more than 100% in 2007.

Meanwhile, wages are rising. The main source of cheap workers for Chinese export industries have been young people migrating from the countryside. But thanks to the "one-child" policy of population control that China introduced in the late 1970s, the numbers of young people have begun to decline. China has a huge population, which is much younger overall than Japan’s. But it has already begun to age.

The result is that there are fewer young people able and willing to migrate to the factories, so they are having to be paid higher wages to persuade them to do so. In manufacturing industry, productivity has also been rising, helping industry to control its costs. But wage rises have now begun to outpace productivity. And productivity outside manufacturing, especially in services and construction, has not been rising so fast.

Finally, as Susan Shirk’s book excerpt said, China’s environmental problems are growing. Smog in the cities, dirty water and toxic waste are all producing more and more protests by Chinese citizens, and they are also proving dangerous in many places. In 2007, China overtook the United States to become the world’s biggest producer of the greenhouse gases that cause global warming. As a result, pressure on China to reduce emissions and clean up its industry is going to grow.

For all these reasons, China faces a change that will be comparable to the sort of change Japan went through during the 1970s. It will have different causes: China controls its own currency and so there is no Nixon figure to shock the Chinese into a revaluation; it has no democracy, and so the pressure on the environment will not produce the same sort of political reaction as it did in Japan.

Yet change is going to come. The rising inflation rate is the main reason to be confident about this point. As long as the Chinese currency is kept artificially cheap, the central bank will be unable to control domestic inflation. Rising inflation will bring the risk of protests by ordinary workers and consumers, of the sort that led to the Tiananmen Square massacre in 1989. The Communist Party will be determined to avoid a repeat of that. So as soon as it becomes convinced that inflation is a serious, structural problem rather than just a result of pig disease, the Party (ie, the government) will change its economic policy.

To control inflation, China needs to allow its currency to be revalued. That would also have the effect of putting pressure on Chinese companies to raise their productivity, to invest in better technology, and to produce more sophisticated goods and services—which is exactly what Japanese companies did during the 1970s.

A revaluation, combined with a new central bank monetary policy aimed at controlling inflation, would have the effect of reducing investment. If less money is invested in heavy industry and construction, the problem of pollution will also be reduced. But in addition to that, the government will need to make reforms in order to enforce its environmental laws much more rigorously, if it is to avoid facing more and more public protests about pollution.

This could occur in a smooth, gradual manner. If it does, the result will be a slowing of China’s growth rate, from the current level of 10-12% a year to a level closer to 6-8%: still impressive, but no longer quite so spectacular. However, when a change of this sort takes place, there is no guarantee that it will be smooth.

A big risk is posed by the asset-price bubble, in the stockmarket and in real estate. A costlier currency and higher interest rates would both hit shares and property prices. The bubble might burst, bringing big losses for ordinary investors. Another risk is that while the change is taking place, protests about inflation and the environment start to grow, encouraging more political criticism and unrest.

China is always changing. But it is never likely to do so in a truly stable manner. China now has to copy Japan, by going through the sort of changes that Japan went through in the 1970s. Japan had a democracy to help keep it stable. China does not.


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