At every stage during China’s remarkable three decades of economic growth, as the country shook off the dead hand of Maoist central planning, outsiders have scratched their heads and wondered whether Chinese growth was really sustainable. They had only to list all the problems China faced, and compare them with the ability of a small group of then-inexperienced economic policy-makers to handle them, and their pessimism could look amply justified. But only twice during those three decades have they been right: in the late 1980s, when China suffered high inflation and then a recession, both precursors to the Tiananmen Square protests; and again 10 years later when a similar cycle occurred and was concealed by official statisticians. Then, and on other occasions when outsiders turned wrongly pessimistic, the Chinese authorities eventually succeeded in working out solutions to the country’s problems.
Now, the same sort of thing looks like happening again, albeit in a different form. The Chinese economy is not suffering from inflation, at least not directly. But it does look as if its current form of economic development is going to have to change. And there are two ways in which that could take place: in a gradual manner, helped along by the economic policy-makers; or after some sort of crash and recession. Given the Chinese authorities successful record, a gradual, managed change looks the likelier bet. But a crash cannot entirely be ruled out. How this occurs will matter hugely to the rest of the world, for China has become the globe’s third largest trader, after Germany and the United States.
The economic model China has been following looks in some ways as if it is unreal, and yet it has been highly successful as has been shown by its maintenance of annual GDP growth rates in excess of 10%. The cost of capital for Chinese companies seems to be zero, thanks to stockmarket public offerings, cheap loans and the financial reserves companies have built up from their own profits. There is a seemingly unlimited supply of cheap labour, in the form of migrant workers from rural areas. For exporters, the exchange rate between the Chinese renminbi and other currencies has been managed in order to keep export prices low.
As a result, the surplus on the current account of China’s balance-of-payments has ballooned from about 1% of GDP in 2001 to nearly 10%, which is the largest ever recorded by a big economy. China’s central bank has built up the world’s largest foreign-exchange reserves, worth $1.2 trillion, for it has to keep buying foreign currency in order to stop the renminbi rising. It then has to work hard to prevent those financial inflows from fuelling inflation inside China, by mopping up liquidity by selling bonds and by forcing commercial banks to hold larger and larger reserves.
This looks extraordinary, and in the scale of what is occurring truly does fit that word. But in fact the pattern of China’s development is really quite ordinary, by East Asian standards. Its economic model has been fairly similar to that followed in the 1960s by Japan and in the 1980s by South Korea. This means that there are good precedents for what may happen next, and to guide the Chinese policy-makers’ response.
The difficulty, though, is that China is simultaneously showing symptoms that were seen in Japan in the early 1970s and other seen in the late 1980s. The first, and most important, parallel concerns the role of investment in China’s economic growth. Japan’s high-growth years in the 1960s were characterised by a high and rising level of investment. By 1971, investment had grown to a level of nearly 40% of GDP; to understand how extraordinarily high that was, it is worth noting that the level in America today is about 15% and in Japan about 24%. After that peak in 1971, however, investment gradually declined in Japan.
China now has an even higher level of investment than Japan did in 1971. As a share of GDP, investment has risen to about 43%. Since China’s overall growth rate has stayed at about 10-11% per year, this means that Chinese investment has become less efficient, for it is requiring more and more investment to generate the same rate of economic growth. China is experiencing what economists call “the law of diminishing returns”: as you add more capital investment, so the reward from each extra bit of investment diminishes.
Japan was successful during the 1970s in weaning its economy off its dependence on exports, largely through a mixture of fiscal policy, a sharp revaluation of the Japanese yen, and a vigorous industrial restructuring to deal with the inflationary impact of the 1973 oil shock. Those policy changes bought Japan a further 20 years of growth, until its failure adequately to liberalise the economy brought about a financial bubble that eventually burst in 1990.
China’s problem is that not only does it need to emulate Japan’s adjustment during the 1970s, but it also needs to deal with the sort of financial bubble Japan faced in the late 1980s. Consumer price inflation is low, but asset prices are soaring, thanks to abundant liquidity. That is why companies are acting as if capital is costless. So are ordinary Chinese households, who are rushing in their millions to buy shares: last year, the Shanghai stockmarket index rose by more than 160%; so far this year it has risen by more than 40%. By any measure, that means that a bubble is inflating.
The good news is that the Chinese leadership know very well that the model must change. The Chinese premier, Wen Jiabao, said in March this year, at a press conference, that “There are structural problems in China’s economy which cause unsteady, unbalanced, unco-ordinated and unsustainable development.” The bad news is that the leadership is finding it hard to do anything about it.
What it knows that it should be doing is a mixture of three things, all of which echo the Japanese response in the 1970s: increasing public spending on health, education and social services, in order to boost domestic consumption and improve people’s lives; raising the cost of capital, in order to discourage excessive investment and to prevent inflation; and upvaluing the Chinese currency, in order to help control inflation and to reduce the trade surplus.
The Chinese leadership is, however, facing a lot of opposition to these measures. Powerful interest groups, especially in business and local government, do not want investment to be reduced, as they are profiting hugely from it. Local governments also prefer to spend public money on investment, from which they can make money themselves through corruption, rather than on health and education. Exporters do not want the currency to be upvalued. And no one wants the Shanghai or Shenzhen stockmarkets to collapse, as that would anger ordinary Chinese and produce an awkward image to the world during China’s Olympics year of 2008.
Later this year, the Chinese Communist Party will be holding its 17th party congress. During that meeting, there will be a fierce argument about whether and when to introduce these new policies. Meanwhile, inflation is beginning to appear: the wages of rural migrant workers are rising by 15% per year. The bubble in share prices on the Shanghai stockmarket is still growing, drawing in more and more ordinary Chinese investors.
The current Chinese economic model could end with a crash, as Japan’s bubble did in 1990. Or it may be gradually changed, as Japan succeeded in doing during the 1970s, through a change of policies. The fight in this autumn’s 17th party congress could determine the outcome.