China’s Great Stagnation

China’s Great Stagnation

China’s economy is stalling. The most likely economic scenario over the course of the next decade is not high growth or an economic collapse, but stagnation. American policymakers need to pay attention.

The government reports the number of working-age people started to inch downward in 2012 and has fallen progressively more sharply each year through 2015. These numbers may not be entirely accurate, but the work force will certainly shrink before this decade ends and continue to shrink throughout the next decade. The contribution of labor to growth will fade until labor actually detracts from growth, as it does in Japan and parts of Europe. Older countries tend to stagnate.

In addition, growth based on natural resources has disappeared. In the 1980s, farm productivity soared, permitting those who had become unnecessary farmers to become manufacturing workers and helping create the world’s new factory. Land and natural resources will not spur economic growth again for the foreseeable future because the PRC has significantly depleted its resource endowment.

Illustrations of this range from arable land to zinc deposits, but the clearest is water. The World Bank cites water stress starting at 1,000 cubic meters of water per person per year; northern China offers one-fifth of that. Three-fifths of monitored national groundwater sites are rated by Beijing as unfit for drinking. Just as hefty payments are due on financial debt, they are also due on environmental debt, making growth even more difficult.

Weakness in other sources of growth means increasing reliance on something that is hard to measure: innovation. The PRC has successfully imported foreign technology, legally and through the theft of intellectual property. As countries climb the technological ladder, however, they no longer benefit greatly from merely absorbing what others offer, and innovation becomes more challenging.

The government’s response is exactly wrong. Sustained, broad innovation that drives growth must be bottom-up while the infamous indigenous innovation program is top-down. It is highly unlikely the government will be able to anticipate years of change in computing, telecom, energy, and elsewhere. Moreover, intellectual property is still not well protected, reducing the incentive to innovate. Continued regulatory protection of SOEs means the private sector cannot succeed beyond a certain point in the two dozen industries that SOEs dominate, sharply curbing innovation in those industries.

Reform Prospects Dim:

State action brought China to this point. More state action—such as credit provision or infrastructure spending—cannot reverse it. A return to a healthy economic trajectory will require resuming pro-market reform. The party seemed to recognize this under Xi Jinping when the November 2013 plenary meetings promised to give the market a “decisive” role. Premier Li Keqiang has said reforms will be as painful as cutting one’s own flesh. This was certainly better than the public investment boom inaugurating the Hu Jintao government. However, the reform restart praised by many was badly designed from the outset.

Greater labor mobility could mitigate aging by letting workers move freely to desired jobs. The PRC still discourages mobility by denying pension and other benefits to those working in the “wrong” area. Pledged changes keep the most popular urban centers cordoned off and retain most barriers between rural and urban areas at least until 2020—important lost years. If this is due to continued fear of migration breeding social instability, the party will restrict workers indefinitely.

Reform could also sharply increase the value of natural resources, along the lines of the American shale boom. This would require China to mimic at least parts of the American model, featuring private ownership of rural land, open competition among energy firms, and legal protection of innovators. The policy platform and actions to date show no progress in any of these areas. Notably, outright environmental damage is being reduced. But this means less harm to future growth, not a boost.

Finance has seen reform, most importantly in bank licenses for private entities. While interest rate liberalization wins headlines, it has little value when the vast bulk of the financial system must follow party orders. What is needed is the commercial—not political—lending, which can only come from independent institutions. The private licenses will bolster the return on capital, and thus growth, eventually. But it could take decades for private banks to substantially erode the state’s 90+ percent share of banking assets, even while unsound lending adds to the debt pile. Much more radical steps are needed.

The best solution is to fix the SOEs that state banks are required to lend to. Regrettably, there has been no pro-market reform in the state sector—quite the opposite. The party’s original pledges went the wrong direction:  rather than shrinking SOEs to make space for private competition, they call for private cooperation with the state. This is essentially an attempt at private bailout of public-sector errors. Further, rather than being sold or allowed to fail, SOEs are being merged to become even bigger.

This also affects innovation. Beijing sees super-large SOEs winning global competitions, but faced with no competition at home, these firms have considerably less reason to innovate. Chinese consumers will continue to be offered inferior products, and many state giants will eventually lose ground overseas, no matter their size. Only private firms, forced to compete at home and overseas, can succeed fully.

Global Economic Implications:

Absent powerful pro-market reform that is nowhere in sight, true economic growth will halt by the end of this decade, no matter what the government claims. The most important implication concerns the dollar: the RMB will fall well short of challenging the dollar, and the future of the world’s reserve currency will depend almost entirely on American choices.

Otherwise, for the US in particular, a stalled China will be primarily a lost economic opportunity. Financial exposure to the PRC is minor in comparison with the size of the American financial system. The PRC’s trade role as a gigantic low-margin manufacturer has brought benefits but is certainly not a necessity; other countries played this role before and will again. China’s economy will still have nearly bottomless needs for elderly care and environmental technology, for example, but the enormous opportunities that many American companies anticipated will not materialize.

Other economies, though, are not as large or as self-sufficient and thus more vulnerable to Chinese weakness. Energy and metals exporters from Brazil to Zimbabwe already have suffered greatly. Chinese weakness will more subtly continue to affect key trade partners such as South Korea, exerting downward pressure on their growth. On the more positive side, stagnation may already be inducing heavier Chinese outward investment. Fewer opportunities at home push Chinese firms to seek greener pastures elsewhere, at least benefiting foreign asset holders.

A central question is where to find global growth going forward. A rebalancing PRC was supposed to be a boon, as rapidly rising Chinese consumption would mean far more imports (ex-commodities). It is not reasonable to expect an economy with the PRC’s debt trajectory to be an important and durable source of net global growth. Indeed, there are intensifying complaints that Beijing is attempting to finesse its debt situation by dumping excess production overseas and stealing its partners’ growth.

Japan previously succumbed to debt-induced paralysis, Europe may be in the process of succumbing, and the US faces an attenuated version of the problem that will intensify as entitlement spending expands next decade. India is not large enough, much less reliable enough, as a source of global expansion at this point. In this context, Chinese stagnation is especially unwelcome. In addition to its direct impacts, it raises the likelihood that the world as a whole faces a period of economic weakness.

A stagnant China will still be large and important. It will certainly be one of the world’s very top manufacturers and traders, and quite possibly the leader in absolute size in these areas. It will be a major global investor. At home, it will offer huge markets for real estate and public health, among other things. While the PRC’s growth is vanishing, its size and economic stability remain. There are important security implications of all these characteristics.

The Politics of Stagnation:

Xi Jinping inherited a debt-plagued economy that had abandoned reform. If that wasn’t enough, Xi also had to contend with the exposure of high-level CCP corruption prompted by the Bo Xilai case. Bo was a charismatic party leader of Chongqing province who built his reputation as being “tough on crime and corruption” and his legacy as the son of a prominent Mao contemporary. But his family’s corruption was exposed when his wife was arrested for the murder of a British fixer, who had helped the family launder money. Bo’s public fall from grace not only raised uncomfortable questions among ordinary people about the magnitude of the corruption among the CCP elite, it exposed a rift in the upper echelons of the CCP over who would succeed Hu Jintao.

As a result, Xi’s first order of business was to gain control over a fractious party leadership. To consolidate control, he has pursued a threefold political strategy. First, he has largely tossed out Deng’s post-Mao model of consensus-driven leadership. To the extent possible under a dictatorship, Deng had put in place decision-making checks and balances and a relatively stable succession process. Deng was trying to ensure both that Maoist-style totalitarians would not reemerge and that his ambitious reform plans would be enacted.