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Presentation to Apgood, February 27 2008

By Guy de Jonquières*

To call China’s economic development breathtaking is an understatement. In less than a generation, it has transformed itself from an impoverished agrarian society into the world’s fourth largest economy in nominal dollar terms, its third biggest international trader, its second largest manufacturer and home to its biggest current account surplus and foreign exchange reserves. Last year, China contributed 17 per cent of global growth, the same as the US. China has lifted some 400m people out of poverty, according to the World Bank, and raised literacy levels to more than 90 per cent, from only10 per cent in 1950. Over that period, life expectancy has almost doubled, while infant mortality rates have plummeted.

I would like to sketch briefly the history of how this has been achieved, before turning to some of the main future challenges that China faces.

Central to China’s rise was the determined, but highly pragmatic, pursuit of sweeping economic reforms. These were aimed, not at loosening the Communist party’s grip on power, but the reverse: strengthening it by associating the party with modernisation and prosperity. However, in implementing reforms, the party was prepared to abandon ideological idées fixes and experiment. Deng Xiaoping, China’s supreme leader and the reforms’ architect, called this “crossing the river by feeling the stones”.

I would highlight four sets of reforms, in particular:

First, starting in the early 1980s, replacement of Mao-era communal farms with smallholdings, and the freeing of agricultural prices. The results were strong increases in farm output, productivity and rural incomes, though these have tailed off in recent years.

Second, starting in the early 1990s, wholesale demolition of import and inward investment barriers at a speed and on a scale without precedent in any country. This process, which culminated in China’s WTO entry in 2001, unleashed ferocious domestic competition and by promoting inward FDI, gave access to modern knowhow, technology and production methods.

Third, the ruthless weeding out of and mass closure of failing state-owned enterprises in the 1990s, with the loss of 30m to 40m jobs.

Fourth, the tolerance, if not active encouragement, of private enterprise, which today accounts roughly a fifth of domestic Chinese companies’ industrial output.

The second ingredient has been massive fixed-asset investment in physical infrastructure and plant, equalling more than 40 per cent of GDP. This, rather than exports, has been the main growth driver for most of the past 20 years. Coupled with better management, it has enabled China to raise manufacturing productivity by 20 per cent annually for well over a decade, more than three times the rate in the west. Rapid productivity gains, not cheap labour or an undervalued currency, are the bedrock of China’s industrial competitiveness.

High rates of investment have been financed by a high domestic savings rate, artificially low interest rates and, latterly, large retained earnings from corporate profits, all of which have created a vast pool of cheap capital.

So far, so positive. But while China’s dash for growth has promoted rapid development, it has been achieved at huge costs, both social and economic. It has also created vast and complex policy challenges for the future.

First, it has been hugely wasteful, in terms of capital and resources. As my former FT colleague Martin Wolf has pointed out, any economy with an investment rate as extraordinarily high as China’s should have been growing very much faster.

Second, excessive reliance on manufacturing investment to drive growth has created severe and worsening environmental problems. According to the World Bank, 20 of the world’s 30 most polluted cities are in China, and water pollution, in both rural and urban areas, is becoming both a source of public discontent and a barrier to sustainable future development.

Third, China’s fixation with manufacturing – 36 per cent of economic output - has produced serious distortions and imbalances. Much-needed spending on social infrastructure such as schools and medical care, both of which have steadily deteriorated in quality, has been neglected, while pensions arrangements are almost non-existent. At 0.8 per cent of GDP, government health spending is lower than in the 1980s. These factors have induced still higher precautionary household savings, necessarily depressing consumption and hence living standards. Though consumption has grown, its share of GDP has been falling for years.

Fourth, income inequality is growing rapidly. There are many reasons for this trend, which seriously worries a regime terrified by of social instability. Among them are, first: uneven regional development, with the fastest growth concentrated in the coastal areas; second, the high proportion of GDP going to, until recently, untaxed corporate profits; and third, that manufacturing, while paying relatively high wages, has been a rather inefficient job creator. By most estimates Chinese industry employs no more people today than before the mass state-owned industry closures of the 1990s.

Fifth, China’s financial system remains primitive, and both fiscal and monetary policies are still extremely crude. Inefficient pricing of capital leads to its misallocation, encouraging excessive flows into property and equity markets and repeatedly creating serious risks of asset bubbles. These problems have been exacerbated by China’s tight management of its exchange rate through market intervention, which has swollen domestic liquidity.

Sixth, China’s increasing reliance since 2005 on exports to drive growth has contributed to an explosion of its current account surplus and worsening global financial imbalances. At a time when growth in much of the west is weakening, these trends, if unchecked, risk inciting a protectionist backlash.

China’s leadership is not stupid: it is well aware of the dangers. Since Hu Jintao became president four years ago, Beijing has sought to shift the emphasis from all-out growth to a wider range of priorities. Frantic efforts have been made to damp down fixed asset investment, while more attention and money is being focused on objectives such as cleaning up the environment, improving social programmes and narrowing income inequality. At the same time, improving economic and political governance through internal reforms of the party has become a key goal of the leadership, at least rhetorically.

These changes have been dictated at least as much by Beijing’s concern with political survival as by economic calculations. Shorn of any ideological convictions, China’s Communist party is acutely aware that its legitimacy hinges on delivering material improvements in living standards to the mass of the people. For most of the past 20 years, it has sought to do so by maximising headline growth. But increasingly, the Chinese people are starting to demand a better distribution of the fruits of growth in ways that not only raise their spending power but improve their overall quality of life. Though few are demanding western-style democracy, they are increasingly pressing for better protection of their rights, especially property rights, which have been much trampled on by greedy and corrupt party officials.

So far, the results have been at best mixed. But it is clear, at the least, that the new approach will need time and iron determination to succeed. Many initiatives, such as creating universal pensions coverage, will take decades to achieve, and implementation is dogged by severe skills and management shortages. Enforcement mechanisms needed, for instance, to impose environmental rules are weak and easily evaded by strong-willed provincial and city governments still preoccupied with promoting growth above all else. It will also be a huge challenge to eradicate deeply-ingrained corruption and instil greater efficacy in a government system that is based on top-down control and relies heavily for control on the power of patronage.

Furthermore, whatever Beijing says about moderating the dash for growth, it knows it must keep output expanding fast enough to create millions of new jobs every year - or face the threat of social instability. That task will be made no easier by the recent weakening of the global economy, the crippling legacy of the recent snowstorms, rising price inflation and the short-term impact of the growing pressures to allow faster appreciation of the renminbi.

On the other hand, three powerful secular trends argue in favour of a change in China’s development model. The first is that its reliance on fixed asset investment as the prime growth driver will eventually become unsustainable, because the sheer amount of capital needed to fund it will simply become too great to be affordable.

The second is the environment. The most pressing issue is water. Not only is it in increasingly short supply much of the country, but much of what is available is contaminated by large-scale industrial pollution. That will have political, as well as economic, consequences.

The third is demographics. The long-tail effects of the “one-child” policy imposed in the 1960s will soon be felt with a vengeance. China’s population is set to peak by or before 2030 – and the working population well before then. When that happens, the question may no longer be whether China’s growth miracle will continue, but whether the country can avoid growing old before it grows rich.

Finally, a few comments on the impact of China’s rise on the rest of – and particularly the developing - world. First, China’s success has clearly had a powerful demonstration effect elsewhere. In India, China’s example, and has helped energise attitudes to growth. In politically less free countries, notably in Africa, China’s model appeals to ruling elites because it suggests that economies can prosper under authoritarian and non-democratic regimes. Whether those regimes are ready to undertake the same radical market reforms as China remains an open question, however.

Second, one way of looking at China is as a machine that has pushed up prices for raw materials and then turned them into low-cost consumer products for the world. Whether that is positive or negative depends on your standpoint. For resource-rich countries in Africa, higher commodities prices have clearly been a bonus – though whether it will be spent is another matter. However, many of those countries are much less happy about the impact of Chinese competition on their own exporters of products such as textiles and footwear. Growing criticisms are also voiced of Chinese business practices, especially in countries with weak labour and worker protection laws.

The picture in east Asia is rather different. Many countries in the region feared initially that competition from China would cost them lost exports and inward investment. To date, those concerns appear exaggerated. For many east Asian countries, China is now their biggest source of external demand and most run bilateral trade surpluses with it. There is also no firm evidence that China has captured FDI at other countries’ expense

One reason is that China is still, to a large extent, a final assembler of parts and sub-assemblies made elsewhere, notably in Asia. That is particularly true in electronics, where expansion of China’s industrial capacity has been matched by steadily rising component imports from the rest of the region. So recent growth has been largely complementary, based on changes in the division of labour.

However, there are two qualifications. First, the final markets for many, indeed most, of China’s exports are still in the west. So east Asian economies – especially those with high export dependence – would be hit by any serious downturn in the OECD area – though China’s low level of local value-added means it should escape relatively lightly. Second, in the longer term, China aims to bring on-shore production of many inputs that it currently imports, as it has already been doing in steel and vehicle manufacturing. That trend, however, could ultimately be beneficial for its neighbours if it induces them to move up-market into technologically more advanced products and services.

So the picture of China’s impact is continuously evolving and far from clear-cut. Overall, attitudes in other developing countries to China’s rise remain ambivalent. While welcoming the short-term benefits it has brought, many also wonder how long they will last and whether they, as well as China, will remain winners in the future.

* Senior Fellow at Chatham House and The European Centre for International Political Economy, formerly The Financial Times’ Asia Columnist and Commentator