This week’s social unrest in Athens, strikes in London and worries over the United States’ debt ceiling may well turn out to be harbingers of a second wave in the global crisis rather than secondary effects of its first chapter.
By all accounts, the global crisis is not over. Beyond the unrest on display in Europe, the US economy faces the possibility of a lost decade of low growth and high unemployment, and the future of the eurozone – and the European project itself – is more uncertain than ever. Equally if not more important, some of the major emerging economies – most notably China – may not yet have come out of the crisis.
In this article, I will first discuss why global imbalances pose a threat to the world economy. I will then address China's role in dealing with this threat, as well as the downside risk and difficulties that China itself faces in rebalancing its growth model. To do so, I will discuss both short run and long run constraints on China's continued growth performance. Finally, I will link China's political economy to some important recent findings on the determinants of long run economic convergence in income per capita between developing and developed economies and highlight the difficulties China will face in implementing needed policy and institutional reforms.
A tale of debtors and creditors
The fundamental destabilizing force in the world economy today is the massive public and private debt overhang in developed economies. This overhang causes a “contained depression” in which households and banks are scrambling to fix their balance sheets while their governments face increasing pressure to reduce their own budget deficits and debt burden in order to continue to have access to markets for funding. In addition, some Western economies, notably Greece and Portugal, must fill a huge competitiveness gap after a decade of unsustainable surges in wages above productivity growth.
This debt overhang also creates all sorts of economic pressures and social tensions, of which the protests in Spain and Greece and the strikes in the UK are but the most recent example. There is a simple yet fundamental reason for these tensions: as sound as the goal of “big-push," across the board austerity and deleveraging may seem, in practice (as well as in theory), it is infeasible.
Martin Wolf makes the point forcefully in his Financial Times editorial this week, in which he explains that the deleveraging process cannot occur across the board. Given that large current account surpluses in China and Germany are structural, it is not possible for (i) households, (ii) businesses and (iii) governments in “deleveraging” countries such as the US, the UK and much of Europe to simultaneously strengthen their balance sheets.
For these countries to reduce deficits at the same time as households and businesses deleverage, Wolf argues that “an offsetting reduction in business sector financial surpluses” must take place. And “that can happen in two ways: a surge in business investment or a reduction in retained earnings.”
With the former option unlikely in times of austerity and slow growth and the latter being self-defeating, since a fall in profits would reduce growth and thus real incomes, Wolf concludes that "it is impossible to eliminate structural fiscal deficits until either the private sector structural adjustment is complete or we see big shifts in the external balances. It is impossible, finally, for this external adjustment to occur without big changes in the surplus economies."
China’s role in rebalancing the growth path of the world economy
The latter point is absolutely key for the future of the world economy. And it is all the more important since the biggest surplus economy of all, China, may be headed for some turbulence.
Before analyzing the seriousness of the downside risk for the Chinese economy in the coming years, let us take a step back to understand where China is today and how far it has come.
According to some forecasts, China will become the largest economy in the world by 2020. According to a study by Arvind Subramanian at the Peterson Institute for International Economics, it already is the largest economy in the world when GDP is measured using appropriate purchasing power adjustments.
On the political front, China's expansion was based on Deng Xiaoping's strategy, starting in the early 1980s, of "playing two hands hard." The first hand was to keep the Party in power no matter what. The second hand was to achieve economic growth by any and all means possible and available. This strategy remains central to Chinese policymakers' thinking.
China’s performance over the past three decades, and especially over the past decade, has been staggering. According to the IMF's April 2011 World Economic Outlook, in real terms China's GDP grew by 10% per year on average between 1980 and 2010 (bearing in mind that these data are subject to caution, given that official Chinese data are not entirely reliable). Yet there is no guarantee that China will be able to continue on this trajectory. The possibility of economic decline, be it relative or absolute, cannot be discarded.
Two major challenges: short and long run
China must address two major challenges to its continued growth performance. The first, which is the binding constraint for growth in the short run, is a rebalancing of the sources of output growth away from investment and towards private consumption. The second, which is the binding constraint for growth in the long run, is the opening up of its political and social order.
Both challenges correspond to a shift in growth models. As Jean-Michel Severino and Martin Wolf stressed in a recent conference on global imbalances at LSE, China must make the transition from an export-oriented to a domestic-oriented economy, meaning it must rely less on exports and more on domestic consumption for growth.
There are three reasons for this. First, there is significant evidence that China has misallocated capital, via investment, on a spectacular scale. The result is, on the one hand, artificially inflated nominal GDP numbers and inadequately adjusted real GDP figures, and, on the other hand, a significant increase in debt.
Second, the external-growth model upon which China has relied will be much more difficult to exploit in the coming decade, as China moves up the global supply chain and overindebted consumers in developed countries cut back on consumption of China’s exports.
Third, if wages continue to grow more slowly than productivity, and if a strong middle class fails to emerge relatively soon in spite of the material expectations of many Chinese citizens, the legitimacy of the Party's tight grip on the political system could be severely undermined and widespread social unrest could ensue. Conversely, if a large cohort of China's richer coastal population reaches an average per capita income level well in the middle-income country range (say, around $8000), the pressures for an increase in political liberlization and an opening up of the social order could become particuarly strong.
The weakness of China’s investment strategy is clear. As bad investments (e.g., an unneeded chemical plant or an umpteenth apartment building) show up now as increases in GDP but will produce negative externalities (e.g., air and water pollution) later on, there is cause for concern as to the validity of China’s growth numbers and the strength of its potential future growth.
Michael Pettis, a professor of finance at Peking University, draws a parallel to the misallocation of investments in the build-up to the crises in Japan in the 1990s and in the US in the 1920s.
The first challenge if China is to avoid a major slowdown in growth, or possibly a large negative shock to growth and crisis, is thus a transformation in its growth model. Crucially, such a transformation will also reduce China’s current account surplus, thereby helping rebalance global growth and indirectly aiding the deleveraging efforts under way in developed economies.
There are nevertheless major short- and long-run obstacles to such a growth model transition.
Cronyism vs. social learning
An important obstacle to reform is that the large distortions imposed by Chinese policymakers, because they have lasted for a long time, have entrenched special interests and made them powerful and extremely resistant to a change in the country’s growth model and the Party's investment strategies. This argument regarding powerful interest groups' influence on the direction of policy and institutional reform was made by Jeffrey Frieden in his classic analysis of the political economy of the 1980s Latin American debt crisis, Debt, Development, and Democracy.
Victor Shih, a Chinese-born political economist at Northwestern University, provides an interesting nutshell description of China. He views the country as a “mix of socialism, state capitalism, and crony capitalism.” "China," he says, "has the socialist legacy of state ownership of strategic firms and the entire financial sector (except for underground banks and trust products)."
Shih notes that “Because these SOEs [state owned enterprises] face competition within China and in the global market, some of us call this phenomenon state capitalism.” “Of course,” he says, “China endowed itself with capitalist competition by deliberately opening its market in many sectors to global competition, which set it apart from autarkies like North Korea. Increasingly, however, we see interest groups with strong state connections trying to influence state policies in order to obtain private gains. Crony-influenced state policies tax the households, as in the case of forced evictions, create oligopolies, as in the case of oil companies in China, and stall further reform in various sectors." More generally, China's sustained high levels of investment increase debt and hold down personal consumption growth.
Under this angle, China and Germany, which lead the group of surplus countries with Japan, can be seen as having so far avoided structural adjustment. A housing bubble may exist in China, and this could cause a brutal landing for the Chinese economy. Low cost of capital is typically associated with the emergence of asset bubbles, and real estate could have part-taken in such a bubble. To the extent that the central government can take housing units off the market by compulsion, however, the housing bubble, even if it exists, could probably be deflated relatively gradually.
The story of the crisis so far is that deficit countries such as the US and – for different reasons – Greece have been forced to adjust following the financial crisis while surplus countries have been able to delay this adjustment. But this does not imply that surplus countries will not need to adjust, eventually.
In order to sustain growth in the long run, China must arguably become politically more open, so that entrepreneurs and innovation can thrive. Recent research by Dani Rodrik suggests that getting into the "right industries" may in fact be the key for developing countries to achieve long-run economic convergence with developed economies. Unconditional convergence is typically opposed to conditional convergence. Conditional convergence means that a country is converging to its own "steady-state" level of income per capita. Unconditional -- or absolute -- convergence means that all countries converge to the same per capita income. Rodrik argues that "the reason that unconditional convergence fails at the country level seems to be that not all industries (agriculture?, informality?, many services?) are equally adept at absorbing technologies from abroad." The crucial implication is that "the trick seems to be moving labor into the manufcaturing (and other) industries where there is automatic convergence to the global productivity frontier." Precisely, there is much uncertainty as to whether China's forceful directed investment growth strategy will allow it to correctly identify these key industries and let them flourish.
In an apt summary of the political-economic dynamics of the UK’s and the US’ economic development, Shih argues that “In the case of England, [the institutional arrangement that underpinned rapid economic development] might have been some form of state capitalism, as [in the case of] the US. However, in both cases, institutions eventually developed to allow different interest groups to influence policies in a more transparent way. Powerful interest groups still drive policies in both of these countries, but the media and the public provide some (I emphasize 'some' here) checks against crony capitalist tendencies. Eventually, some institutions (not necessarily a constitution) develop to protect the property rights of ordinary citizens.”
Shih goes on to provide sobering words on China, however. His assessment of the future is far from optimistic: “In China, leaders with regime-wide influence used to check against cronyist tendencies. Today, I see less clear stance against powerful interest groups, and more inaction dressed up as reform. I would agree with the assessment that institutional development is lagging.”
Indeed, if accurate this description of China’s political economy clashes with some of the key determinants of long-run economic convergence (that is, the convergence in per capita income between developing and advanced economies). Rodrik argues in his book One Economics, Many Recipes (2007, p.112) that successful industrial policy involves “social learning—discovering where the information and coordination externalities lie and therefore what the objectives of industrial policy ought to be and how it is to be targeted.”
Rodrik adds that “what is needed (…) is a more flexible form of strategic collaboration between public and private sectors, designed to elicit information about objectives, distribute responsibilities for solutions, and evaluate outcomes as they appear.” It is hard to imagine how a crony (state-)capitalistic system, as seems to currently exist in China, can provide such opportunities for social learning.
An example of the lack of flexibility that may hamper China in the near future is the very low real and nominal interest rate. As banks overwhelmingly dominate China’s financial system, low interest rates transfer resources from savers to borrowers and fuel investment booms at the cost of domestic consumption (which, incidentally, is of course less easily controlled by the Party than public investment decisions). At the moment, some reformers are seeking to recapitalize the country's "Big Four" state-owned banks. These are highly leveraged and prone to instability as the loans from the recent lending boom, which was characterized by low credit standards, come due. The political economy of these recapitalizations is complicated, however, as beneficiaries of the big four banks' easy credit -- the SOEs and local governments, principally -- will no doubt make this needed reform difficult to achieve.
Michael Pettis points out that these borrowers are mostly capital intensive companies that deal in real estate, construction and government. Pettis describes this process as monetary growth being “channeled not into household demand but rather into production of more goods,” with the inflationary impact of monetary expansion remaining muted. Pettis calls this financial repression and pits it against currency appreciation and inflation as a way to deal with rapid productivity growth in the tradable goods sector.
Finally, the fact that China's public debt has recently been revised upward, partly due to the non-performance of its local government investment vehicles, is consistent with the idea that China’s investment-based growth model is generating large amounts of debt which threaten its future growth. On a twenty year horizon, in addition to the challenge posed by popular demand for political liberalization, China will face a severe demographic test as the effects of its one-child policy finally kick in full force and the share of its working age population shrinks.
The way forward
Policy solutions going forward will inevitably have different impacts on different sectors within the Chinese economy. Letting the renminbi appreciate will favor Chinese consumers but will put pressure on the tradable goods export sector. Increasing interest rates, which are currently very low, will benefit savers but will be costly to local and municipal governments and SOEs, which are highly leveraged. Raising wages above productivity growth will be costly to employers. And strengthening the social safety net could induce Chinese consumers to consume more and save less (e.g., for retirement), yet this would presumably have to be financed to a large extent by the state, adding to the strain on public finances.
In the longer run, reformers pushing institutional reforms needed to sustain growth will undoubtedly face a barrage of resistance from powerful elements in the Party, both at the national and local level. Other constituents who benefit from the status quo will add to this resistance and make institutional change all the more difficult to achieve. A case in point is the increase in interest rates, which despite giving a leg up to a majority of households (which are net savers) would be extremely costly to many SOEs and real estate companies, whose managers are typically close to local and national Party leaders. Such powerful vested interests will remain a major obstacle to institutional change.
Despite the challenges ahead for China’s economy and political system, the country has thus far defied the West by producing tremendous growth and poverty alleviation whilst ignoring many if not most of the orthodox recipes for successful economic development. In Dani Rodrik’s words, China has shown that “’development’ is working while ‘development policy’ is not.” Let us hope it can also show the world that convergence works while convergence policy does not.