End of the affair: a fading Chinese economic miracle and the need to deviate from it

All economic indicators, ranging from export to investment to manufacturing to financial, are pointing in one direction – south. Apart from that, the continuous decline in house prices and the skyrocketing credit boom are raising fears of a bubble-burst in both real estate and bank lending. Surely something has gone wrong for the so-called Chinese miracle, the export-led model that led to astonishing economic growth in the last few decades. 

For the casual observer, the reason for China’s troubles is that it depends largely on exports as its engine of growth. Hence, the main culprit is the recent European fiscal woes combined with the slowdown in the US economy.

But in-depth analysis shows that the Chinese slowdown is not caused by global downturn alone, but also by domestic adjustment programmes aimed at ensuring China’s survival in the longer run. 

For a greater understanding of this, we must first clarify the “Chinese miracle”. 

It is widely perceived that Chinese miracle comprised export-led growth created by cheap labour. That is partially correct. Another important ingredient often left unspoken is the cheap domestic capital that derived from a high saving rate of around 50 per cent of GDP (in the US it’s around 4 per cent). This high saving rate means that China has an abundant source of internal capital to fund domestic investments. 

And invest they do. Contrary to general belief, the main engine of the Chinese economy is not exports (net exports contributed nothing to the economy), but domestic investment, which accounted for around 48 per cent of GDP. Sadly, much of this investment is made rather inefficiently by state-owned enterprises (SOEs) and local governments, where cronyism involving executives and project bidders is the norm. Signs of bad investment are visible countrywide. Empty residential buildings in rural cities, a giant resort the size of Dubai’s Palm Island in the south, and the bullet-train collision that reeked of corruption in China’s railways are examples of dubious and inefficient use of funds.

This flaw in China’s system remains embedded because of the country’s authoritarian nature. The interest rate is capped by state, and all major Chinese banks are state-owned. Hence, SOEs and local authorities can receive cheap money from banks, while private entrepreneurs, especially small ones without political ties, have to depend for capital on a shadow banking system with sky-high interest rates. This is the central systemic flaw of the Chinese economic model, since it deprives private investment – especially start-ups – and the innovation that comes with it. 

But that very flaw also gives China an advantage, in terms of financial resiliency. The high saving rate, much more than investment (no matter how poor it is), gives China an ample cushion should the loans ever turn sour. 

Nevertheless, apart from its fundamental flaw, the Chinese model also threatens a “middle-income trap”, or the problem of economic stagnation due to the inability to switch from a labour-intensive to a sophisticated, technology-driven producer. In the case of China, this threat is intensified by labour-market saturation as a result of the one-child policy (the workforce is expected to start shrinking in 2014).

In short, despite its past success, the Chinese miracle based on cheap labour and cheap capital (two main production factors) under an authoritarian regime is not sustainable in the long run. The threat of a middle-income trap and bad investment are the result of inefficient use of both production factors. Moreover, the recent Chinese export slowdown implies that country’s export dependency is vulnerable to external shock.

Chinese authorities realise this, and change in macroeconomic policy towards sustainable development is being formulated. This is being done on four fronts. The first and easiest part is to increase the minimum wage to move production up the value chain and hence up productivity (increasing the cost of labour encourages employers to switch to machines, which give higher productivity per one unit of labour). 

The second policy front is financial liberalisation to allow commercial banks’ interest rate to deviate from the government’s and encourage the launch of new private banks. Competition between banks will benefit society since savers will receive higher rates on their deposits while entrepreneurs will get alternative sources of loans. 

While the first two policies are practical and being implemented, the latter two are still on policymakers’ wish list. These are 1) to push SOEs and local government towards transparency, since doing so will lead to more efficient use of funds, and 2) to promote public welfare, especially for rural and unemployed people. The minimum-wage rise will bring more layoffs, and without a safety net of unemployment benefit and education to increase worker skills, political turmoil is inevitable. 

The harsh truth is that the need for change comes at a bad time. Global slowdown and the risk of another round of financial crisis is knocking at China’s door, while the urgent need for reform at home is increasing day by day. To move from one development stage to the next, China needs to move out of its comfort zone. Doing so will not be easy, due to several foreseeable threats. However, if it sticks with the status quo, the damage will be worse in the long run. 

 

Piyasak Manason is vice president for research and planning at Kiatnakin Bank.