Looming Stagnation
FORECASTERS OF the fortunes of nations are no different from Wall Street analysts: they all rely on the past to predict the future. So it is no surprise that China’s rapid economic growth in the last thirty years has led many to believe that the country will be able to continue to grow at this astounding rate for another two to three decades. Optimism about China’s future is justified by the state’s apparently strong economic fundamentals—such as a high savings rate, a large and increasingly integrated domestic market, urbanization and deep integration into the global trading system. More important, China has achieved its stunning performance in spite of the many daunting economic, social and political difficulties that doomsayers have pointed to as insurmountable obstacles to sustainable growth in the past. With such a record of effective problem solving, it is hard to believe that China will not continue its economic rise.
Yet, while China may sustain its growth for another two to three decades and vindicate the optimists, there are equally strong odds that its growth will fizzle. China’s economic performance could be undermined by the persistent flaws in its economic institutions and structure that are the result of half-finished and misguided government policies. A vicious circle exists in which the Communist Party’s survival is predicated on the neglect of fundamental aspects of society’s welfare in favor of short-term economic growth. And many of the same social, economic and political risk factors the government has thus far sidestepped—heavily subsidized industries, growing inequality, poor use of labor—remain. Some are becoming worse.
Because the party relies on growth for legitimacy, Beijing invests in tangible signs of progress—factories, industrial parks and the like. This emphasis on “visible” gains has in turn led to huge social deficits. By focusing on short-term growth instead of long-term sustainability, health care, education and environmental protection have all been neglected. Not a cause for optimism.
The end result is a state built on weak political, economic and societal foundations with a potentially unhappy and restless people. Reducing these economic and social deficits will require both additional financial resources and politically difficult institutional changes. Allowing such deficits to accumulate is simply not viable.
Worse, China’s difficulties will be compounded by the future deterioration of some of what have thus far been structural and political strengths—a large, young population; underpriced natural and environmental resources; and a public consensus in support of economic growth. With fewer people entering the workforce, a rapidly aging population and ongoing environmental damage, China faces the choice between stagnation, even disaster, or fundamental change. The fact that all of these risk factors have not derailed China’s growth in the past does not preclude the possibility that they could do so in the future, especially if the Chinese government fails to make major policy adjustments.
Of course, these challenges—rebalancing China’s economic growth, addressing social deficits and rebuilding a political consensus that supports growth—are manageable if the Chinese government can implement effective economic and political reforms and remove the underlying causes. But will Beijing do so? Does the Chinese political system possess the flexibility and inner strength to overcome the opposition of entrenched interests? Is the ruling Communist Party willing to take the risks of adopting reforms and disrupting a carefully balanced coalition of political and economic interests?
As the world is engulfed in a global economic crisis and China’s growth engine starts to lose steam, it is time to reexamine the risk factors that lie ahead and rethink our complacent assumptions about China’s future.
HIGH RATES of economic growth tend to conceal serious structural, institutional and policy flaws because, as the Chinese saying goes, “one mark of beauty can hide a hundred spots of ugliness.” All too often, high growth rates themselves are taken as prima facie evidence of superior institutions and wise policies. Our obsessive focus on the speed of economic development often blinds us to the underlying weaknesses of the country. Over time, such myopia leads to complacency and, worse, a dismissive attitude toward warning signs of trouble.
In China, four factors were crucial to the state’s economic performance over the past thirty years: high domestic savings (which allowed for investment in industry), the demographic dividend (which provided a large potential workforce), the globalization dividend (which enabled integration into the world market) and considerable efficiency gains from the liberalization of an enormously inefficient planned economy. However, while these fundamentals have contributed to rapid economic growth since the 1980s, they unfortunately also allowed the Chinese government to avoid undertaking effective measures that would further liberalize the economy, establish robust regulatory institutions and dramatically reduce the role of the state in the economy. This does not mean that Beijing has not taken important reform measures. It has—but it did so, almost without exception, only when compelled by a serious economic crisis (as was the case with mass bankruptcies of state-owned enterprises at the end of the 1990s).
Such behavior is costly because it ignores the fact that benefits from investment in capital, demographic advantages and growing trade neither solve all problems nor remain static. Today, as China’s export growth plummets and domestic consumption remains anemic, it is quite evident that economic and societal imbalances have not only undermined China’s sustainable growth but also have weakened its ability to weather the current economic crisis. To be sure, these imbalances have been building up since the early 1990s. Their principal symptoms consist of excessively high investment in fixed assets (i.e., capital-intensive industries) and low household consumption, rising dependence on exports as a growth driver and the underdevelopment of the service sector. For example, from 1992 to 2005, investment rose from 36.6 to 42.6 percent of GDP while household consumption declined from 47.2 to 38 percent of GDP. In 2007, household consumption fell to 35 percent of GDP, a historical low. Consequently, export growth assumed increasing importance as a key driver of GDP growth. By 2007, export growth contributed roughly 25 percent of GDP growth.
Because the bulk of China’s investment goes into the manufacturing sector, particularly capital-intensive heavy industries, persistently high investment has exacerbated the imbalance between too much manufacturing and too little growth in the service sector. Compared with its developing-country peers, China stands out for having an underdeveloped service sector.
Besides creating excessive dependence on exports and industry, too much investment in fixed assets has begun to yield decreasing economic benefits. Between 1991 and 1995, RMB 100 million in additional investment yielded RMB 66.2 million in additional GDP, 400 new jobs and RMB 10.4 million in additional wages. Between 2001 and 2005, the same amount of extra investment yielded only RMB 28.6 million in additional GDP, 170 new jobs and RMB 3.7 million in additional wages.
Such structural imbalances threaten growth sustainability because they create massive economic distortions, subjecting the Chinese economy to chronic excess capacity, low consumer welfare, rising trade frictions and poor utilization of its comparative advantage—people—because these imbalances lead to growing capital intensity and decreasing labor intensity.
OF COURSE, these structural imbalances are symptoms of both unreformed economic institutions and the continuation of bad policies. Despite thirty years of reform, the Chinese state maintains a decisive influence on the economy through both its direct presence (state-owned or - controlled enterprises) and its policies. For example, state-owned enterprises (SOEs) account for about 35 percent of GDP today, but the government’s role in the economy is much more substantial than even this figure indicates. The state maintains a monopoly or near monopoly on the so-called strategic sectors, such as banking, financial services, natural resources, energy production, telecom services and most heavy industries. Nearly all of China’s largest companies are owned or controlled by the state.
In addition, key input prices, such as those of energy, land and capital, are set by the government. Because of the government’s bias in favor of investment and manufacturing, such key prices are set at artificially low levels as subsidies. For example, the primary market for land is almost nonexistent. Local governments often seize land from powerless and voiceless peasants and sell the land-use rights to developers and/or use it for infrastructure projects—all for a fraction of its market value. As for the cost of capital, the Chinese government has been skillfully wielding financial repression to use household savings as a way to subsidize the investment of Chinese state-owned firms. Until recently, SOEs could borrow from banks without worrying about repayment. Even though household deposits are nominally protected by the state, Chinese taxpayers are responsible for bailing out banks that are drowning in massive nonperforming loans.
Obviously, such wasteful use of China’s scarcest resources—energy, land and capital—to maintain an unbalanced growth model cannot be sustained indefinitely. For the past three decades, China’s strong economic fundamentals enabled its government to continue these distortions with impunity. But many of these fundamentals are either weakening or expected to disappear within the next two decades, thus making it impossible to achieve high growth with the same flawed policies.
Of the deteriorating fundamentals, two deserve special mention—demographics and savings—because they have in the past been among the principal drivers of China’s growth. China is expected to lose its demographic dividend in the middle of the next decade. The median age of the population will rise from 32.5 years in 2005 to 37.9 years in 2020. The percentage of the population 60 and over will increase from 11 percent in 2005 to 17.1 percent in 2020. By 2030, according to the Chinese minister of labor and social welfare, 351 million Chinese, or 23 percent of the population, will be over 60, and the elderly-dependency ratio will increase from 5.2 to 1 in 2006 to 2.2 to 1 in 2030. The worker-to-retiree ratio will fall from 3 to 1 in 2006 to 2 to 1 in 2030. The rapid aging of the Chinese population will unavoidably increase health-care, pension and labor costs, eroding China’s competitive advantage. More important, this will also cause China’s savings rate to fall. One World Bank estimate suggests that old-age dependency could depress private savings by six percentage points of GDP by 2025. Another study of demographic change, without population-policy adjustment, estimates that per capita income growth would fall from 5.3 percent a year in 2000 to 2.9 percent a year by 2020.
This means the government will be unable to continue its practice of subsidizing industrial growth with private wealth. When coupled with an aging, increasingly dependent society and poor social services, stagnation and, eventually, abysmal failure loom.
IF SEVERAL years ago few would concede that China’s rapid economic growth was achieved at very high social cost, such as deteriorating social services, potentially catastrophic environmental degradation and rising income inequality, today this is no longer a disputed fact. Even the Chinese government has admitted that its economic growth is socially costly.
The accumulation of social deficits since the early 1990s was the unavoidable outcome of government policies that deliberately shift resources away from providing socially beneficial services (education, health care and environmental protection) to projects and activities that could produce immediate and visible signs of progress (infrastructure, commercial development in cities and industrial parks). Such policies were perfectly aligned with the imperative of regime survival and the incentives of individual government officials. For the Communist Party, policies that could generate rapid short-term economic growth even at the expense of long-term social costs were preferable because of the party’s dependency on growth as a source of legitimacy. For government officials whose promotion critically depends on their ability to deliver visible and measurable signs of growth, diverting scarce resources away from social services to investment projects offers a guaranteed ticket to higher offices and greater power.
As a result, these policies have worked wonders for both the party and its members, but their social costs have been horrific.
Official data indicate that the government’s relative share of health-care and education spending began to decline in the 1990s. In 1986, for example, the state paid close to 39 percent of all health-care expenditures while individuals paid 26 percent. By 2005, the state’s share of health-care spending fell to 18 percent, and the share of individuals’ spending rose to 52 percent. This dramatic shift in cost has placed significant burden on household budgets and consequently reduced access to health care. Per capita health-care expenditures as a share of consumption more than tripled in urban areas from 1990 to 2006 (from 2 percent to 7.1 percent) and increased 30 percent in the countryside. Unable to pay for health care, about half of the people who are sick choose not to see a doctor, based on a survey conducted by the Ministry of Health in 2003. The same shift has occurred in education spending. In 1991, the government paid 84.5 percent of total education spending. In 2004, it paid only 61.7 percent. During the same period, tuition and fees (costs borne by individuals) rose significantly. In 1991, they accounted for 4.4 percent of spending. By 2004, they contributed about 19 percent. One key indicator that reduced government spending has restricted access to education is the percentage of middle-school graduates who go on to enroll in high school (since students have to pay for high-school education). In 1980, almost 25 percent of the middle-school graduates in the countryside went on to high school. In 2003, only 9 percent did. In the cities, the percentage of middle-school graduates who enrolled in high school fell from 86 to 56 percent in the same period.
On the natural-resources front, the extent of China’s environmental degradation is now fairly well-known. Although estimates of the cost of pollution vary, they all suggest that environmental degradation is exacting a huge toll on Chinese society. The most recent study, a joint effort by the World Bank and the Chinese government, shows that the aggregate cost of pollution in China in 2004 was roughly 5.8 percent of GDP. Another study undertaken by two Chinese government agencies and released in 2004 estimates that the amount of underinvestment in environmental protection is roughly 1.8 percent of GDP a year. To fully treat all pollutants discharged in 2004 alone, China would need a one-time expenditure of 6.8 percent of its 2004 GDP—RMB 1.086 trillion, or $158 billion. The Chinese government’s poor stewardship of the environment has added huge stresses to the country’s fragile ecological system. Although a continental-sized country, China is resource scarce on a per capita basis. In particular, it suffers from serious water scarcity and uneven distribution of water resources: the per capita water availability is only 30 percent of the world average, and the area north of the Yangtze River, which accounts for 64 percent of China’s land surface, has only 19 percent of the country’s water resources. Truly alarming is the Chinese government’s growth-at-all-costs strategy that has devastated the country’s already-scarce water resources. The 2004 joint study reports, “About 25,000 kilometers of Chinese rivers failed to meet the water quality standards for aquatic life and about 90 percent of the sections of rivers around urban areas were seriously polluted.” Without prompt and effective measures, environmental degradation will not only pose an insurmountable hurdle for future economic growth, but also precipitate large-scale social unrest and political conflict.
Then there is rising inequality—a mainstay of many countries experiencing rapid economic development and social change. Although the causes are complex, government policies that fail to ameliorate the effects of economic-growth inequality can further exacerbate the trends. In China, the government has consistently undercut social services to the general public, and left the poor bearing the brunt of the deterioration in the provision of public goods. Additionally but inexplicably, Beijing has failed to counter rising inequality by instituting a relatively progressive tax system. China has no capital-gains tax, property tax or inheritance tax. Its income tax is so ineffectively enforced that it generates only a very small portion of government revenues. At present, income inequality in China has reached a level close to that of Latin America. The overall level of income inequality from 1985 to 2006 rose 39 percent (averaging a 1.8 percent increase per year). Although “within” (intraurban and intrarural) income inequality remains lower than national inequality, it has also risen significantly. In fact, the rate of increase in urban income inequality from 1985 to 2006 was twice that of rural income inequality (63 percent compared with 27 percent). The distribution of wealth in China is even more unequal than income. Household surveys and academic research show that the Gini coefficient of wealth rose from 0.40 in 1995 to 0.55 in 2002 (the higher the Gini coefficient, the more unequal the distribution of wealth or income). The distribution of financial assets is particularly skewed. In 1995, the Gini coefficient for financial assets was 0.67; it rose to 0.74 in 2002. These trends do not bode well for China. If they are not reversed by effective policy, China will likely suffer a rising crime rate and increasing social conflict closely associated with frustrations and tensions generated by inequality and high perceptions of social injustice.
THE COMBINATION of accumulated economic imbalances, misguided growth strategies, deteriorating fundamentals and social deficits makes it difficult to imagine that China will be able to maintain its current rate of economic growth without significant policy changes and reforms. Even with effective policy adjustments, China is unlikely to keep growing at a high single-digit rate for the next two decades. As we have seen, such high growth in the past has been obtained through artificial means. It is inflated, not just by creative accounting, but by discounting and excluding consumer welfare, social costs and environmental damage.
If China does not make the necessary changes, it will face something far worse than low single-digit growth—the delicate coalition among the ruling elites will unravel, the legitimacy of the Communist Party will erode and social unrest will rise. If it does make adjustments, we will merely see lower rates of growth.
But neither Beijing nor the outside world should worry about China’s reduced rate of growth in the coming decades because, to the extent that the Chinese government has improved the quality of growth at the cost of speed, it will be able to sustain a respectable rate of growth while addressing the economic and social problems caused by past policy mistakes.
Incidentally, this is what the current Hu Jintao government has pledged to do. However, based on the modest achievements of Beijing’s efforts to rebalance its growth strategy so far, it is becoming increasingly clear that the current growth strategy is rooted in the existing political system. It would take much more than rhetorical exhortation to reverse course. As long as Chinese government officials are assessed and promoted based on their ability to deliver economic growth, often within the two-and-a-half-year tenure of a party chief, the short-term obsession with the rate of growth will continue. In addition, so long as Chinese officials are accountable to their superiors, but not to the general public, they will have little incentive to pursue policies that would benefit their constituents. State monopolies on key sectors and the distortion of factor prices (such as energy, land and capital) will continue as long as the Communist Party believes that further withdrawal from these sectors and price liberalization will undermine its ability to influence the economy and maintain an expansive patronage system which benefits its supporters. Finally, good governance, measured in terms of adequate delivery of public goods and sound environmental stewardship, will be difficult to achieve without greater participation by China’s embryonic civil society and major social groups.
So a major course change would suspiciously lead to something akin to political liberalization—something the Communist Party has tried very hard to prevent since 1989. It is doubtful whether Beijing has the political courage to gamble the party’s future on it.