Understanding the way China’s economy works

Author: Peter Drysdale, Editor, East Asia Forum

There are many views about which model provides the best understanding of Chinese economic growth and, more immediately, what the prospects are for maintaining a high growth rate in the face of the palpable structural, environmental and social challenges that China confronts today.

Construction workers walk past high-rise commercial buildings in Beijing 9 March 2008. If the economy is to continue to grow, even at a more moderate rate, it has to graduate from simple manufacturing production, relying on the mobilisation of labour, to growth led by industrial upgrading, driven by high rates of human capital formation and research and innovation. (Photo: AAP)

Yu Yongding has recently and famously described the Chinese economy as being trapped in a ‘Groundhog Day’ pattern of growth. What he reckons is that ‘even since the global financial crisis, the Chinese economy has followed the familiar cyclical pattern of (of growth that it has over) the past two decades: high investment supported by expansionary policy drives growth; inflation follows after lag; policy is tightened; growth drops away, but inflation is still high; more tightening; inflation falls at last, but growth falls away more than desired at the same time; policy is shifted from tight to expansionary; again, led by investment, growth rebounds. And a new economic cycle starts — Groundhog Day for Chinese growth’. He believes that the Chinese economy will probably continue to grow at a rate higher than 8 per cent this year. But growth is likely to be achieved at the expense of structural adjustment and the discovery of a new, more sustainable growth pattern. The real challenge for the Chinese government will come later.

Ligang Song identifies over-reliance on state intervention and the stranglehold of state-owned enterprises (SOEs) as the Chinese economy’s Achilles heel. ‘If China wants to take economic development to its next stage’, Song argues, ‘it will have to nurture the market-based economy and establish a more robust and adaptable regulatory framework, providing fair access for both SOEs and private companies to capital and technology and creating a social culture that builds entrepreneurial capabilities and extends respect to the contribution that entrepreneurship makes’.

Over the past three decades, the Chinese business landscape has changed remarkably. Reform of ownership in the state sector, the growth of private enterprise and the entrenchment of market incentives have laid the foundation for China’s rapid economic growth. Reform has favoured entrepreneurship that has powered the Chinese economy. The private sector has contributed an increasing share of national output.

Were that reform to stall, the engine of Chinese economic success and its higher-than-average growth rate would falter. Among the unfinished tasks are the need to: fix the relationship between the state and SOEs; deal with state monopoly of key sectors of the economy; improve corporate governance; reform the financial market so that private business has fair and equitable access to capital for investment; and improve the regulation of enterprise and China’s legal system as it affects the way the market functions. Chinese institutions are not yet sufficiently compatible with allocating resources efficiently via a well-functioning market economy to guarantee continuing high economic growth. If the economy is to continue to grow, even at a more moderate rate, and avoid the ‘middle income trap’, it has to graduate from simple manufacturing production, relying on the mobilisation of labour, to growth led by industrial upgrading, driven by high rates of human capital formation and research and innovation. As entrepreneurial-driven growth has to overtake factor-driven growth if the pace of growth is to be sustained, the urgency of finishing these reforms will be more pressing.

It is clear that Song’s unfinished business of Chinese reform is deeply political in character.

In this week’s lead essay Yiping Huang takes the contrarian view that the Chinese economy is already in the middle of the transition toward a more sustainable new growth model with slower GDP growth and a more balanced economic structure, a view that he observes is not common among either China watchers or market participants. Policymakers in China have accepted that the economy is settling back to a new and lower potential rate of growth, and that (not leadership transition) accounts for why they were reluctant to stimulate recovery last year.

‘The downward shift of the potential rate of growth’, Huang argues, ‘is most clearly evidenced by China’s demographic change. The Chinese government used to be obsessed about attaining a minimum of 8 per cent GDP growth. The key rationale was that an 8 per cent growth rate was seen as necessary to support full employment and maintain social stability. However, in the late 1990s when the 8 per cent growth target was initially proposed, China’s working-age population was increasing by more than 10 million people a year. In 2012, China’s working-age population declined by 3.5 million people’.

The new growth model that Huang identifies has one common cause: emerging labour shortages and rapid wage increases. China has well and truly reached what economists call the Lewis turning point where a country runs out of unlimited surplus labour in the rural sector and wages (and living standards) start to rise rapidly.

Huang argues, as he has previously argued, that a primary feature of China’s reform is asymmetric liberalisation — that is, the complete freeing of product markets but heavy distortions in factor markets. ‘The generally depressed costs of production have the effect of subsidies for the corporate sector but taxes on households. This was the key mechanism that contributed to both strong economic growth and growing structural imbalances during China’s reform period’. This has changed in recent years as rising wages redistribute income from the corporate sector to households and boost consumption as the share of household income in GDP increases.

The irony, says Huang, is that the new growth model is not primarily driven by government policy but a consequence of endogenous forces in the labour market. Huang warns that the next round of shocks — from rising costs in the capital and energy markets — could precipitate recession in the heavy industrial sector.

Peter Drysdale is Editor of the East Asia Forum.

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