Lessons from the East: Why Structural Reform Matters

The future of China’s economy has always been ambiguous, and consequently, debatable. In the last week itself, opposing prognoses have emerged: Bloomberg argues that ‘China has it’s economy’s back’, CCTV asserts that ‘the economic slowdown will avoid a steep fall’; simultaneously, the Financial Times prophesies ‘gloom spreading and a hard landing’, and Daily Reckoning describes the ‘Chinese Economic Death Spiral’.

Yet, with China contributing to over 15 per cent of global output, and over 30 per cent of global Gross Domestic Product (GDP) last year, the ‘Empire of the Dragon’ stands central to worldwide growth. However, to maintain this stature, structural reform is pertinent.

The Story So Far

For the past few years, China has been at a crossroads facing trade-offs between the strict government controls imposed by the Chinese Communist Party’s philosophy, and the economic growth drivers demanded by a more open and liberal society.

From 1978-2014, the government managed to keep the productivity engine, and thereby the economy ticking through various politically acceptable reforms and policy changes. It started with successful reforms in the agricultural and industrial sectors and moved towards stressing innovation and the invention of products, services, and business models in the last decade.

While the reversal of financial reforms from 1990 dampened this rise, the opening up of more sectors to private and foreign enterprises, along with China’s accession to the WTO in 2001 facilitated an export-led growth from 2001-14. The Chinese government countered the 2008 global financial crisis with massive investment in housing and infrastructure (physical and social).

However, this has not been an unmixed blessing. Opposite views could argue that the Chinese government has also created several challenges, such as corruption, pollution and inefficiency in allocating economic resources, all of which hinder growth.

The Chinese leaders have recognised some of the weaknesses in their governance and today’s President Xi Jinping has called for further modernising China’s governing systems. Although the economy is facing critical problems due to the tentacles of state control, it is unlikely to experience a downfall or a crisis anytime soon.

Nonetheless, in 2015, particularly after the confused devaluation of its currency, China is faced with a situation wherein the obstructing effects of state control are beginning to strain the development strategies exercised so far. The question then arises, what will China need to do to sustain its high growth rates?

Macroeconomic Imbalances

China is both the ‘culprit and victim of its macroeconomic imbalances’ and will have to stabilise and reprioritise its economic policies skillfully. For example, China is trying to clean up the debt mess left over by the stimulus of 2009, which has reached more than 250 per cent of GDP. Its residency controls have stymied the free flow of people, thus under-using its abundant labour resources.

The stock market has undergone large speculative changes, rising sharply in 2014, peaking in 2015, and then collapsing soon after in the same year. Even though these dynamics have marginally impacted aggregate economic growth, they are reflective of the need for a transition from government and party control to a market-based tactic, though with rigorous and effective regulations.

China’s economy is open in some parts and closed in others, pooling to form a nebulous whole. It has moved from central planning to what might be called a ‘commanding heights economy’, which albeit laudable, is far from completing its transition to a market economy.

The monopoly rights, preferential access to capital, and export tax rebates enjoyed by State Owned Enterprises (SOEs) have resulted in frauds and inequality in addition to economic distortion. Allowing private enterprises to compete equitably with state firms will induce entrepreneurial confidence, improve the distribution of resources, and increase the varieties of consumer goods and services, thereby directly impacting the standard of living.

Concomitantly, China needs measured, and smart regulatory changes in its financial system: robust and effective stock market regulation, independent functioning of the Central Bank, and the selling of government shares in state-run firms to prepare for global capital flows.

Currently, Chinese savings are invested in low-yielding assets abroad. Allowing domestic investment in foreign assets will certainly aid in bridging the savings-investment gap, and favouring household consumption over production would further overall growth. An emphasis on easing the state’s grip on research, the Internet, and education will also be constructive, enabling creativity through a free flow of ideas.

Harnessing Comparative Advantages

The Solow growth model states that a permanent rise in growth can only come from an increase in total factor productivity (TFP).

Those who view China’s economy as the glass half full are optimistic about China’s future as they see the rise in TFP coming from the country’s booming technological sector. With several Chinese innovations of the past decade such as Alibaba, Xiaomi, and WeChat competing with multinational brands, China has gained a comparative advantage in sectors other than apparel and traditional electronics.

China has the potential to be the next ‘technological dynasty’ due to its large domestic market. There are also some new sectors, such as green technology, which are important for China’s sustainable development. With foresight, China will be able to use its economies of scale to gradually shift from absorbing the existing technology to becoming an indigenous innovator of new technology for driving its growth.

Thus, although China lost its scientific and technological edge from the 15th century onwards by becoming culturally insular, shunning exploration of the wider world and remaining suspicious of importing outside ideas and influences, the exploitation of its advantage of backwardness has allowed China to emerge as the world’s workshop. Today, that stance is morphing into an innovation hub.

In 2008, China’s per capita income had reached only 20 per cent of US per capita income, measured in purchasing power parity, allowing considerable scope for further progress.

All in all, to maintain high growth rates, China will need to find a balance between providing transitory protections to nonviable firms to maintain stability and liberalising entry into sectors in which the country has a comparative advantage.

The Road Ahead

A well-functioning market is a precondition for developing an economy’s industries, because only with such a market can relative prices reflect the relative scarcities of factors of production in the economy.

Through appropriate functions of competitive markets and a proactive, facilitating state, a developing country can tap the potential of its backwardness and achieve dynamic growth.

China appears to be rebalancing its economy away from rapid growth that is driven by high fixed investment, exports, and heavy industry, to a more consumption-based economy with greater emphasis on services, welfare, and innovation. For some, China’s slower economic growth rates are a positive development.

However, as the Chinese government continues to emphasise the role of the state in the economy, it is unclear whether it is willing to implement the type of comprehensive economic reforms that are needed to ensure healthy economic growth.

The major focal points are the need for rebalancing capital and current accounts by giving an increasing importance to consumption over investments and production, tapering the rural-urban divide, and kerbing monopoly power of state enterprises in the context of a greying population, and the imperatives of expanding education to spur creativity.

As a Chinese proverb goes, everything is ready except the east wind, namely, that which is crucial. Thus, the dragon must learn to distinguish real from imagined perils, and to trust, in order to consolidate its empire.