What’s Next for the Chinese Economy?

Since China began its economic reforms in 1978, its economy has grown substantially. GDP growth after inflation has averaged nearly 9% per year, a remarkable record by all accounts. Within just one generation, China has transformed itself from an economically impoverished and politically unstable country to the second-largest economy in the world. It has lifted more than 500 million people above the absolute poverty level, along with other notable but lesser-known achievements: China is the only developing country to have participated in the Human Genome Project and the first developing country to complete a manned space program.

But China now faces monumental challenges, both economic and political, in the years ahead. One thing we know about economic growth is that it typically slows down after a period of robust performance. Part of the reason for this slowdown is entirely benign: It is much more difficult for a country to grow at a sustainably fast pace when the per capita GDP is high than when per capita GDP is low. The consequences of a slowdown that occurs for that reason are as benign as its cause. Ultimately, it is a country’s level of development, not its growth rate, that matters for the welfare of its people. Rich countries — in other words, countries that have high per capita GDP — generally have higher standards of living, longer life expectancies and healthier populations than poorer but fast-growing countries. If China slows down due to the fact that it has become rich, this is cause for celebration rather than concern.

But herein lies the problem: The reasons behind China’s likely slowdown are not only because it has become a richer country. Other factors likely to impede China’s growth include the highly unbalanced structure of the Chinese economy and low levels of efficiency; despite more than three decades of reforms, China is still substantially statist in its basic orientation. As a result, for each percentage point of GDP growth, China requires more and more energy and investments, with very worrisome implications for its environment and for the health of its population.

A consensus view among China scholars is that China has achieved rapid growth by relying heavily on exports, investments in fixed assets and infrastructure, and its vast, low-cost labor force, rather than on technology and innovations. That growth formula made sense for the country in the 1980s and 1990s, when China began its reform program and its effort to catch up with Western economies. But there is increasing evidence that China is hitting the wall of diminishing returns with this growth model. Export growth is unlikely to be a major growth driver when Western economies are growing slowly, and Chinese investments in fixed assets have already reached an amount equivalent to almost half of the country’s GDP. No other country remotely matches this level of investment intensity. As a result, there will not be much bang for each additional buck invested.

Concerns About Slower Growth

There are already some emergent concerns about the implications of a Chinese slowdown. The Chinese press has reported that several Chinese cities have begun to experience a substantial repricing of their real estate assets. For example, the city of Hangzhou, which had a red-hot real estate market only two to three years ago, has recently experienced substantial real estate price declines.

The investment-intensive nature of Chinese GDP growth has a lot to do with the country’s excessive and unhealthy reliance on real estate investment as a driver of growth. A massive repricing of Chinese real estate assets would likely strain the balance sheet of Chinese banks, resulting in more nonperforming loans and bad loan assets. Optimists about the Chinese economy argue that banks in China are state-owned, which means two things: first, that the banks have strong implicit guarantees from the government; and second, that they are not under pressure to mark their asset values to market on a real-time basis. The opacity of the Chinese banking system reinforces the guarantees by the government, which should preclude the kind of sudden loss of confidence that precipitated the financial crisis in the U.S. economy in 2008. Optimists about China could also point to other crisis-resistant features of the Chinese system. For example, its nonconvertible capital account prevents what is known in economics as a “sudden stop,” that is, a sudden stoppage of capital inflows coupled with significant outflows of capital.

China optimists are correct on technicalities. However, the notion that China could grow merrily as if bad loans had no consequences is naive. Bad debt leads to economic crises in some cases and slowdowns in others. Japan, for example, averted an explicit crisis, but it could not escape economic stagnation.

China may follow Japan in the way its bad debt eventually gets resolved. That does not mean that China will slow down to Japan’s growth rate; with vibrant entrepreneurship and a decent human-capital base, China has the potential to grow at a high rate for many years to come. But say China’s economic growth rate were to fall to 4% annually. At China’s current comparatively low per capita income, that would represent a waste of China’s potential. Even during the Cultural Revolution, China was able to grow its economy 2% to 3% annually. A Lehman-style implosion is just one of many unpleasant outcomes of bad economic management, but it’s by no means the only one. Growth stagnation is another scenario, and there is nothing to cheer about a country such as China stagnating at its current level of GDP per capita.

Escaping the “Middle-Income Trap”

The longer-term cause behind China’s economic slowdown is social and political in nature. Academic research shows that fast growth at an extremely low income level is relatively easy, although not every low-income country is able to grow. What is harder is being able to grow after the country has attained what is known as “middle-income status.” Middle income is roughly defined as between $6,000 and $8,000 per capita, a level that China has attained or is very close to attaining. Historically, only a few economies have been able to break out of the “middle-income trap.”1 In East Asia, these economies include Japan, Korea and Taiwan.

Can China break the trap that has bedeviled so many other developing countries? Not if it adheres to its current economic and political system in its rigid form. Research by Scott Rozelle at Stanford shows that all economies that have grown beyond middle-income status have had one thing in common — a high level of income equality.2 Measured by the Gini coefficient, income inequality ranges from 0 (absolute equality) to 1 (absolute inequality). The countries that have successfully grown beyond middle-income status have averaged 0.33, with none higher than 0.40. A number of estimates of China’s current Gini coefficient are in the 0.45-0.50 range, and one estimate even puts China’s Gini at around 0.60. If that latter estimate is correct, China has one of the highest levels of income inequality in the world.

Why does income inequality impede growth? There is a widespread view in many countries including China that capitalism leads to rising income inequality. Capitalism in its extreme form no doubt does lead to inequality, as the French economist Thomas Piketty explains in his book Capital in the Twenty-First Century.3 But it’s important to note that central planning — or its close cousin, state capitalism — is also a cause for inequality. There is a fundamental difference, though, between the situation depicted by Piketty and the conditions in China. In the developed West, capitalism in its extreme form has impeded social mobility. In the United States, for example, low tax rates on unearned income contribute to a widening income gap — and that income gap, in turn, enables the wealthiest individuals to manipulate the political system in their favor.

And herein lies the difference with China. In the 1970s, China had an extraordinarily high level of inequality. The state taxed 80% of the population — the peasantry — in order to subsidize the 20% in urban China. The urban few were showered with subsidized food prices, health insurance, free education and guaranteed employment. In this context, a move toward capitalism led at first to a leveling of income in China.

Today, the truly private capital owners in China are first-generation entrepreneurs. Their entire income is “earned” in the sense that it is derived from deployment of their knowledge of the market and of business operations. What’s more, first-generation private entrepreneurs in China tend to come from humble and rural backgrounds. The reason for this is somewhat complicated. In essence, central planning has achieved two things. First, it largely killed off entrepreneurship in the urban areas but not in the rural areas. Second, it impoverished precisely the segment of the population with a stronger entrepreneurial orientation — China’s peasantry.4

Yet, in the minds of some Chinese leaders and the general public, curbing inequality requires rebuking the capitalist system and rolling back reforms. Former Chinese Politburo member Bo Xilai famously railed against the market economy — even arresting and jailing private entrepreneurs — as a way to appeal to the masses of China’s poor and downtrodden. This flawed understanding may lend support to more state ownership and a stronger role of the state in the economy. A reversion to state ownership would be harmful to China’s growth in the long run. Most dangerously, perhaps, it would allow populist figures espousing views similar to Bo’s to gain increasing status in China if income inequality and corruption persist.

A country with income inequality is also more likely to be politically unstable, which may undermine growth. The linkage between inequality and political instability is somewhat complicated. For example, systematic and large-scale survey research by Harvard University sociologist Martin K. Whyte shows that the Chinese people are not unduly concerned about rising inequality. Whyte says that it is a myth that inequality has created a “social volcano” in China. However, it’s worth noting that this finding was generated when the Chinese economy was growing robustly, and that the political and economic consequences of inequality are “contingent” (that is, their effects depend on a host of other factors that are well beyond the purview of Whyte’s survey project). Therefore, it is entirely possible that the consequences of inequality may be benign when growth is fast but may become more harmful when growth becomes moderate.

When GDP grows quickly, there is some political tolerance of corruption and inequity on the part of the Chinese people; after all, corruption and inequality mainly reduce the size of the potential economic gains for the Chinese people. However, when growth falters, the political implications of corruption and inequity are far more disruptive. In an environment of low growth, corruption and inequity have to be “funded” by an absolute reduction of living standards. There is a material difference — in terms of politics and psychological dynamics — between giving up potential gains of income and giving up actual income.

Harvard economist Benjamin M. Friedman argues, mostly referring to the United States, that economic growth is a vital source of elements of a good society (such as political tolerance and openness).5 Growth stagnation, on the other hand, contributes to a deterioration of these qualities in a society. If this is true for a country at a high income level and with a relatively developed social safety net, the social and political effects of growth are probably a magnitude larger in a country such as China. Think of the contrast between Indonesia and South Korea. Both countries were hit by an external financial crisis in 1998, but in the case of Indonesia, a country with a high level of extant income inequality and corruption, the financial crisis led to the crumbling of the governing Suharto regime. South Korea, on the other hand, not only survived the financial crisis intact but also implemented proactive political and economic reforms with minimal political and social instability.

Finding a New Growth Formula

Can China avoid the middle-income trap and grow at a sustained rate for another decade or more? The answer is yes, but only if the country undertakes significant reforms, especially political reforms. Bear in mind that the factors that drive a country to grow when its GDP per capita is $700 are quite different from the growth drivers when a country has a per capita GDP that is approaching $7,000, as China’s current per capita GDP is. At $700 per capita GDP, China could simply copy and transplant the technology and production methods of other countries. To grow quickly, China did not need to come up with its own innovations and technologies. To date, what can be considered as “premium” features of a country’s political system, such as rule of law, intellectual property rights, labor rights and democracy, have not been important factors in China. Indeed, Chinese leaders have seen them as a hindrance to growth; rule of law and strong intellectual property rights may impede the pace of copying and reduce the speed of transplantation of Western technologies to China.

As a country becomes more prosperous, the growth formula necessarily changes. Innovations, technology and productivity improvements become increasingly important and necessary. There is also a greater need for domestic entrepreneurs and innovators. The issue is not that China does not value science and technology. There is no shortage of technocratic ideas and expertise in China, and many Chinese leaders are engineers by training. Over the past two decades, China has invested heavily in R&D, and its R&D expenditures are now close to 2% of GDP, a level attained by only a few fairly wealthy countries.

But the payoffs from such massive investments are at best uncertain. Ongoing research that I have been conducting with my colleague Fiona Murray suggests that these technological investments have much less impact than might be expected, given the scale of the R&D investments. One explanation is that Chinese R&D takes place in an environment that is a “republic of government” rather than a “republic of science.” China’s universities are tightly controlled by the government, and Chinese university presidents and deans are far more powerful than faculty. Unlike their counterparts in the United States, who are fiercely independent, Chinese professors are more like company employees. Research projects are often managed from the top down instead of being initiated by professors and researchers. Data sharing across bureaucracies is difficult, and dissemination of research findings — especially in areas that have implications for policy — is subject to the political imperative of maintaining “stability” through suppression of information.

Chinese leaders understandably want China to rebalance and to grow on the back of technology- and science-based innovations. This is both a laudable goal and an imperative need. China’s current growth is dangerously unbalanced. The environmental costs are extremely high; resources are wasted on a massive scale; and debt levels may have reached an unsustainable level. Moreover, labor exploitation is increasingly costly from a political perspective, as Chinese workers today are more conscious of their rights and are demanding a bigger share of the economic pie. In the past, China relied on the huge export markets in Europe and in the United States as a ready outlet for the Chinese economy. But it is unlikely that Western economies will be able to resume the kind of growth that would absorb the massive capacity China has built up.

A technology-driven growth model is not merely an extension of China’s current approach to growth with added emphasis on R&D. China has already been investing heavily in R&D, as noted, but that hasn’t altered the fundamental nature of the country’s growth. The reason is that much of Chinese R&D investment is not market driven but heavily state directed. Despite China’s high level of investment overall, private-sector companies invest very little in R&D. To truly take advantage of its R&D investments, China needs to transition to a stronger market-based economic system, a political system that is more open and democratic, and a legal system that is rule-based and offers strong protection for intellectual property. There should be more freedom to think and to challenge authority and limitations on the reach and power of government. In other words, China needs political reforms as well as economic reforms to enter the next stage of its growth model.

Political reforms would ensure that the dividends of China’s future growth are broadly distributed, which would widen the base of growth and reduce dependency on the whims and actions of the economic and political elites. Expanding the economic base will put Chinese growth on a surer and more sustainable footing. As Daron Acemoglu and James Robinson argue in their book Why Nations Fail, economies that bestow the fruits of growth on a concentrated group of elites inevitably fail in the long run, even while some of them enjoy short periods of rapid growth.6 There is no reason to believe that China is an exception to this rule. In fact, many of China’s serious problems, such as low consumption relative to GDP and corruption, can be ultimately traced to the high levels of economic and political inequality that are prevalent today.

China needs both economic and political reforms to move to the next stage of its development. It should focus more on the drivers and the consequences of its growth and less on the growth rates per se. A lower annual growth rate — in the neighborhood of 5% to 7% versus the recent historical norms of 9% — can be the new norm as long as the drivers are not energy and investment intensive but activities that rely on technological and managerial innovation. This type of growth would be more beneficial because the fruits would be broadly shared and would accrue to a wide segment of the population. Growth driven by productivity and innovations would also likely produce less smog and pollution — thus enhancing the quality of the environment and the true living standard of the Chinese population.