For roughly 30 years, China’s “economic miracle” has catapulted the once-impoverished country from relative backwater to global economic juggernaut. Driven by export-led growth and massive state investments in manufacturing and infrastructure, China had enjoyed a period of scorching GDP growth at an average of 10 percent a year. However, that growth has now stuttered to roughly seven percent and, as the country’s upward trajectory flattens, wide gaps have begun to emerge in the Chinese economic model.
These gaps derive from a deep inefficiency at the core of China’s model. Namely, a reliance on economic controls and enormous state-led stimulus, which has shackled Beijing to the success of bloated state-owned enterprises (SOE). As Director of the Project on Chinese Business and Political Economy at CSIS, Scott Kennedy, writes: “[Chinese] efficiency of manufacturing has improved and they have excellent logistics, but capital in China is wasted in monumental proportions.”
China’s giant pile of public and corporate debt presents an excellent example of this inefficiency. By some estimates, it now requires six dollars of debt to produce just one dollar of GDP growth, and corporate debt stands at nearly 170 percent of the country’s GDP. Meanwhile, total public debt in China tops 260 percent of GDP, an increase of 110 percentage points over the past decade alone.
The reason for this grand accumulation of debt over the past decade is relatively benign. Following the 2008/9 financial crisis, Beijing opted for economic stimulus and loose lending over austerity and belt-tightening, a policy that maintained growth and helped prevent the kind of disinflation and anemic growth seen in many developed economies. However, the country has failed to turn off the flow of easy money. Over the past two years, the Chinese economy has taken on new debt at roughly the same pace as it did just after 2008, and today, almost a third of that new debt is used to pay the interest on old debt.
Of course, this problem is not only the result of a loose credit policy. Until recently, the lynchpin of China’s dramatic growth has been its ability to manufacture and export goods to the rest of the world, especially developed countries, at a cut-rate price due to a combination of low-wage labor and government-subsidized investment. However, as China develops, the wage differential for labor has inevitably closed, and slowing global growth since 2008 has reduced demand for Chinese goods. Both of these trends cut deeply into the profits of Chinese firms.
This conundrum provides an opportunity for President Xi Jinping’s government to try to redirect investment away from low-cost manufacturing, and according to Kennedy, “they are attempting to rebalance the economy…towards services, innovation, advanced manufacturing, a more efficient financial system, etc.” However, “Beijing is still doing these reforms in a way that involves the heavy hand of the state.” This sort of economic central planning from the government has its advantages, but it has also resulted in overinvestment in inefficient SOEs and created artificial growth and overproduction in entire sectors like steel manufacturing.
This overinvestment has, in turn, pulled Beijing into a confounding political trap. Although President Xi appears to understand China’s desperate need for economic reform, the specter of widespread unemployment in a country of 1.36 billion terrifies his government. Beijing knows that it needs to whip its bloated SOEs into shape and halt the giant infrastructure projects and property investments that have led developers to build so-called “ghost cities” and fueled a nascent bubble in the real estate market, but the fear of putting millions out of work has encouraged policymakers to keep the credit lines open for such boondoggles.
Ironically, writes former special assistant to the President and Senior Director for East Asian Affairs in the George W. Bush Administration, Dennis Wilder, the “shift to a service-oriented economy away from a dependence on industrial production is clearly a key to solving China’s job creation problem.” But, “[Xi’s] options for generating growth are politically riskier than those pursued by his predecessors.” Beijing is not only afraid of stoking political unrest by creating temporary unemployment through reform, it is also loath to loosen its tight grip on the economy by winding down SOEs, cutting regulations, and encouraging more competitive and efficient private businesses to develop.
According to Wilder, Xi will look to further tighten his control over Chinese society before pursuing necessary economic reforms. If that is the plan, China does have a comfortable cushion on which to ride out this transitional period. The country has an extremely high savings rate, over three trillion dollars in foreign exchange reserves, and the government enjoys close control over currency and capital flows in and out of the country.
However, dangerous bubbles do exist in places like the real estate market and China’s growing financial sector. Similarly, increased government spending in reaction to a perceived crisis – like China’s mini stock market crash last year – could produce the same effect as a bubble pop by fueling inflation, cutting savings, and undermining the value of Chinese assets.
Even if the country does manage to sidestep these crises and rebalance the economy, it is likely to do so in the way that it is accustomed, by overinvesting and spending in new priority areas chosen by Xi and the central government. Although this scenario would be far less disruptive to the global economy as a whole, the result could be that rampant Chinese overproduction wipes out more efficient foreign competitors in entire new sectors like clean energy or tech.
As Timothy Heath, Senior Defense Research Analyst at the RAND Corporation, notes, “Like most other countries that have experienced rapid development, China is struggling to transition from a highly successful but unsustainable economic model.” However, unlike most other countries, the results of China’s transition will have deep and immediate repercussions for the rest of the world. China, says Kennedy, is unique in that it “socializes its risk to everybody else…China’s size gives it special power, it also gives it special responsibilities.”
Fritz Lodge is an international producer at The Cipher Brief. Follow him on Twitter @FritzLodge.
