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China’s Economic Reforms Have Hit a Wall

China's economic model is not sustainable to growth in shipments of export cargo and import cargo in international trade.

China’s Economic Reforms Have Hit a Wall

By almost any measure,‭ ‬China’s economic performance over the past four decades is as impressive as the Great Wall is long.‭ ‬Since the late‭ ‬1970s,‭ ‬the People’s Republic of China has grown faster for longer than any country in history—ever.‭

But just as the Great Wall wasn’t as effective as popularly imagined,‭ ‬the foundation of China’s economy is weak.‭ ‬Because of China’s sheer size and its integration into global production networks,‭ ‬one thing is for certain:‭ ‬as China’s economy goes,‭ ‬so goes the world’s.‭ ‬Furthermore,‭ ‬the dangers of an malfunctioning Chinese economy are monumental,‭ ‬not just for China but for the United States and everyone else.

An Unsustainable Model
From the late‭ ‬1970s until‭ ‬2010‭ ‬China averaged more than nine percent real growth,‭ ‬but growth has fallen considerably since,‭ ‬coming in at‭ ‬6.7‭ ‬percent for all of‭ ‬2016.‭ ‬More troubling than the country’s dive in growth is its collapse in productivity.‭ ‬All of China’s growth now is achieved through mobilizing more money and labor,‭ ‬not improvements in human capital or technology.‭ ‬It now takes three times as much capital to generate a single unit of economic growth as it did in‭ ‬2008.‭ ‬The result is an explosion of debt that now accounts for at least‭ ‬280‭ ‬percent of GDP,‭ ‬and could break through the‭ ‬300‭ ‬percent mark by year’s end.

China has three strategies to arrest this trend.‭ ‬The first is to shrink the size of the old economy by reducing capacity in heavy industrial sectors dominated by lethargic state-owned enterprises,‭ ‬including steel and aluminum.‭ ‬The second is to expand the new economy by supporting high value-added services and advanced technologies.‭ ‬And the third is to reform local government fiscal systems while tightening regulation of new financial instruments such as wealth management products.‭ ‬The headline figures do reflect economic restructuring‭; ‬services now count for more than half of the economy,‭ ‬high-tech manufacturing is expanding rapidly,‭ ‬and the issuance of new credit is slowing.‭ ‬But despite these efforts,‭ ‬productivity is still flagging.

The culprit is massive state intervention.‭ ‬In‭ ‬2013,‭ ‬Chinese President Xi Jinping promised that the market would play a decisive role in the allocation of resources.‭ ‬In fact,‭ ‬Communist Party and government bureaucrats have increased,‭ ‬not decreased,‭ ‬their role in the economy via industrial policy and mercantilism,‭ ‬and factory closures and production cuts are now the purview of policymakers rather than businesspeople.‭ ‬Under the Made in China‭ ‬2025‭ ‬plan and other similar initiatives,‭ ‬billions,‭ ‬if not trillions,‭ ‬are being thrown at strategic industries from semiconductors to artificial intelligence.‭ ‬That is why,‭ ‬for example,‭ ‬almost two dozen Chinese provinces are investing simultaneously in fabrication facilities to pump out memory chips.‭ ‬Companies and research institutes are filing worthless patents in record numbers because they receive a fee from bureaucrats for doing so.‭ ‬And state-backed credit is still flowing freely to high-priority projects around the country,‭ ‬which is why the economy grew at‭ ‬6.9‭ ‬percent in the first quarter of‭ ‬2017‭ ‬despite tepid private-sector enthusiasm.

The era of economic reform and openness that Deng Xiaoping launched in‭ ‬1978‭ ‬was built on a foundation of gradual liberalization at home and greater openness to the outside world,‭ ‬albeit with the caveat that the Communist Party’s monopoly hold on power would not be threatened.‭ ‬Under President Jiang Zemin and Premier Zhu Rongji China entered the World Trade Organization in late‭ ‬2001‭ ‬with the aim of using globalization to liberalize China’s economy and make it more efficient.‭ ‬That commitment waned under the next leader,‭ ‬President Hu Jintao,‭ ‬but he was weak and was pushed and pulled by conservative and liberal forces,‭ ‬leading to policy that bounced between various goals and tactics.

An Unlikely Liberal‭?
Xi Jinping not only does not believe in markets,‭ ‬but he is also far more powerful than his predecessors.‭ ‬Despite the promises of reform he made in‭ ‬2013,‭ ‬he was always a fair-weather liberalizer,‭ ‬and as soon as clouds formed over the housing sector in‭ ‬2014,‭ ‬Xi quickly resorted to intervention to shift money into the stock market the following year.‭ ‬The sudden fall of the Shanghai and Shenzhen bourses that summer was met with ham-fisted measures that beget additional intervention.‭ ‬Reform now means not marketization but strengthening the state.

Some elements of foreign industry are benefiting from Beijing’s state capitalist approach.‭ ‬American companies selling consumer durables and services,‭ ‬transport goods,‭ ‬and construction equipment are doing quite well in China,‭ ‬thank you.‭ ‬But a growing number of foreign producers—particularly those at the high end of the value-added chain—now find targets on their backs placed there by China’s industrial policy dons.‭ ‬Survey after survey shows foreign companies feeling less welcome.‭ ‬Although even obtaining a small slice of the massive Chinese cake brings substantial income,‭ ‬China’s claim that it supports win-win outcomes with the world is now wryly understood to mean‭ “‬China wins,‭ ‬China wins.‭”

However,‭ ‬if China,‭ ‬Inc.‭ ‬continues to compete and win unfairly,‭ ‬all will end up losing,‭ ‬especially China.‭ ‬Its economy can’t continue to run on a fattening diet of industrial policy stimulus.‭ ‬The global competitive landscape and business models of industries,‭ ‬even when operating far beyond China’s borders,‭ ‬also will be harder to sustain in the face of bottomless financing from Chinese sources.‭ ‬And all of this could translate into macroeconomic instability and volatility around the world.

There are several ways this trajectory could be reversed,‭ ‬but none are highly likely.‭ ‬Some believe that Xi may be intentionally acting as a conservative nationalist for now so that he can consolidate his power and unleash a program of liberalization at a later time,‭ ‬perhaps after this year’s‭ ‬19th Party Congress.‭ ‬This is probably little more than wishful thinking,‭ ‬however,‭ ‬and the Xi we see is likely the Xi we will have to live with.‭ ‬He is more likely to double down on state intervention in his second term than to reveal himself as a true liberal.

An economic crisis might also present Xi with a stark choice,‭ ‬but China has many ways to avoid a full-blown meltdown‭; ‬it boasts a huge pool of savings and holds very little foreign debt.‭ ‬Even if a crisis emerged,‭ ‬perhaps as the result of a chain reaction involving the collapse of housing prices and defaults on bonds and other financial instruments,‭ ‬it isn’t clear how Xi would respond.‭ ‬The‭ ‬1998‭ ‬Asian financial crisis is instructive.‭ ‬Kim Dae-jung of South Korea broke up several of the country’s leading conglomerates and banks and opened up the economy.‭ ‬By contrast,‭ ‬Malaysian Prime Minister Mahathir Mohamad inserted capital controls and strengthened state involvement in the economy.‭ ‬Xi clearly more closely resembles the latter figure.

Wrongheaded Protectionism
This leaves foreign influence as the last way to encourage economic liberalization and a more balanced relationship with the rest of the world.‭ ‬Unfortunately,‭ ‬the Trump administration threw away the best tool to incentivize China to change when it abandoned the Trans-Pacific Partnership,‭ ‬an agreement that would have lowered barriers for trade in goods,‭ ‬agriculture,‭ ‬and services,‭ ‬and would have created entirely new rules to govern the behavior of state-owned enterprises,‭ ‬e-commerce,‭ ‬investment,‭ ‬and government procurement.‭ ‬With China on the outside looking in,‭ ‬it would have had to reform on the world’s terms to avoid being shunted from the superhighway of the global economy into a cul-de-sac.‭ ‬It is unlikely that similar bilateral agreements between the United States and individual TPP states would be nearly as effective,‭ ‬and although other multilateral and regional deals are under negotiation—such as the WTO’s Environmental Goods Agreement and the Asia-based Regional Comprehensive Economic Partnership—Beijing has enough leverage to ensure that such pacts produce limited concessions.

With little domestic pressure and no substantial multilateral or regional tools,‭ ‬the entire burden appears to be on the shoulders of high-stakes U.S.-China negotiations.‭ ‬President Trump talked a mean game during the campaign but has moderated his tone since,‭ ‬including refraining from labeling China a currency manipulator.‭ ‬At the Mar-a-Lago summit in April,‭ ‬Trump and Xi agreed to a‭ ‬100-day negotiating period in pursuit of initial progress in rebalancing the relationship between the two powers.‭ ‬Chinese officials believe they have tamed Trump and can avoid major penalties by taking token steps to shrink the trade surplus—perhaps by buying more American beef,‭ ‬fossil fuels,‭ ‬and Boeing jets.‭ ‬Given the need for China’s help on North Korea,‭ ‬it is possible Trump may take the easy deal.‭ ‬However,‭ ‬because of his longtime complaints about unfair trade and the arrival of U.S.‭ ‬Trade Representative Robert Lighthizer,‭ ‬it is just as likely that Washington will insist China demonstrate a real commitment to constraining its industrial policy machine.

Enlightened decision-making appears to be in short supply on both sides of the Pacific these days,‭ ‬and a failure by China to return to a reformist path could do irreparable harm not only to its own economy but to the liberal international order,‭ ‬and set the two superpowers on the path toward a trade war.

Scott Kennedy is deputy director of the Freeman Chair in China Studies and director of the Project on Chinese Business and Political Economy at the Center for Strategic and International Studies.

Central bank governor says China's move to advanced manufacturing could yield shipments of export cargo and import cargo in international trade.

Not Your Average Zhou

Zhou Xiaochuan, the urbane governor of China’s central bank for the past 13 years, gave a lengthy interview recently to media outlet Caixin. This represents Zhou’s first public comments on China’s economy in almost five months, the last time being when he attended a meeting of G-20 finance ministers and central bankers in Ankara, Turkey, in September. In the intervening time China’s stock market and currency, the renminbi (RMB), have continued to display substantial volatility despite (or perhaps because of) extensive government intervention. Market confidence in China has declined precipitously, with some questioning the basic capacity of Chinese authorities to govern their economy. The purpose of Zhou’s interview was to reassure Chinese and global markets.

Q1: What did Zhou say?

On the one hand, a lot! This interview ran to almost 13,000 characters, or 16 pages in Chinese, and 13 pages in the translated English version). On the other hand, not much. His comments went only slightly beyond what other Chinese leaders and the official media have said. But he made some important clarifications. Several substantive comments stand out.

Most important were his remarks about the RMB. He reaffirmed the official policy of maintaining a relatively stable exchange rate and not permitting a large devaluation. Breaking somewhat new ground, he said that currently the RMB is not precisely pegged to either the U.S. dollar or a basket of currencies. Since December authorities have more clearly referenced the 13-currency basket when setting the initial daily rate and intervening, but they have not rigorously tried to maintain a peg. He said the goal was to move to a more rigorous peg but gave no timeline.

He defended the current exchange rate and argued against devaluation by noting that China has had higher growth and lower inflation than the United States and other major economies, as well as a large trade surplus, all of which suggests a stable or even appreciating currency over the long term. He turned away the argument that a devaluation is justified to stem capital flight. He no less than 20 times used the terms “speculate” and “speculators” to criticize those who are irresponsibly betting against the RMB, and by implication, shorting China, and said China would fight against these efforts. He also blamed the U.S. Federal Reserve for exiting quantitative easing and its December 0.25 percent rate hike for generating greater capital outflow pressures on China.

Second, he explained why he believes China still has strong growth prospects. He stressed: (1) China’s high savings rate, which translates into a high investment rate; (2) Likely continued growth in exports, particularly as China moves to higher value-added manufacturing; (3) Room for growth in services, which has surpassed 50 percent of GDP last year; and (4) Further steps to open up investment opportunities for private capital (he specifically did not say “foreign capital”). Noteworthy is that the first two elements are indicative of China’s traditional growth strategy; the governor did not directly emphasize the potential contributions to growth through improvements in efficiency or total factor productivity.

Third, he dismissed the notion that China’s slowdown was causing a fall in global commodity prices. The volume of imports of commodities, such as oil, rose in 2015, but since prices have dropped so much, the total value of imported commodities has shrunk.

Fourth, he suggested that the rise in capital outflows from China was not “hot money” looking to escape but rather the result of a rise in outward investment and efforts by domestic borrowers of foreign funds to repay those debts early in expectation of a weakening RMB. He sees the early repayment steps as healthy “autonomous” actions of Chinese businesses and a one-time adjustment, after which the pace of outflows should slow.

Finally, Governor Zhou talked at length in the last section of the interview about the central bank’s strong interest in developing a digital currency for the country. He gave no timetable but said that previous efforts to modify its paper currency had each taken about 10 years. Given China’s size and the complexity of the transition, “a digital currency will coexist with cash for quite a long time before it finally replaces cash.”

Q2: Did Governor Zhou provide a specific defense of the current exchange rate level?

As noted above, he primarily made the argument in relative terms. He made what appears to be a circular argument about how to determine when a currency is in equilibrium:

“Our aim is to have the exchange rate ‘broadly stable at an adaptive and equilibrium level,’ and there are interactions between the two. Although the equilibrium level defies an accurate assessment, a broadly stable exchange rate level can only be achieved when it is around the equilibrium level. Stability is impossible when the exchange rate is at a wrong level or in disequilibrium. Meanwhile, the pursuit of an equilibrium level can only be facilitated by the presence of general stability. Few will heed fundamentals or equilibrium analysis in times of turbulence and turmoil.”

Q3: Will his comments reassure the business community?

Given his strong reputation, some inherently trust Governor Zhou and may reassess their concerns or at least the sense of alarm that seems to have taken hold in some quarters. But many are so spooked by China’s policy volatility, rising debt, and slowing growth that these comments will not make much of a difference. Many in the business community are looking for unambiguous signals that China is committed to liberal economic reforms, not only in the future, but in the near term. Using that criteria, Zhou did not deliver. He counseled patience with the current approach and specifically said that economic reforms would not follow a “straight line” in order to avoid “transition traps” and “reform fatigue.”

Q4: Did he explain the central bank’s approach to communication, or why he hasn’t spoken publicly in so long?

The governor suggested that he has refrained from speaking sooner because speaking to markets in and of itself would not solve China’s economic problems or reduce the inherent uncertainty in global markets. “The central bank is not God nor [a] magician that could just wipe the uncertainties out,” he said. In a sense, he seemed to be rejecting the notion that part of his job description is to explain China’s economic situation and reassure markets. This defense is not entirely unreasonable, but it does not explain why he has been quiet for so long. There are rumors that Governor Zhou disagreed with the massive intervention in the stock market last summer and has kept quiet to show his dissatisfaction and let others take the blame. Conversely, given the problems with the renminbi in the wake of reforms that he strongly pushed for in order to prepare the RMB to join the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) basket, his standing internally may have suffered as well. In this second interpretation, the leadership may have determined that it was necessary for Zhou to finally speak because of his international standing.

Q5: Why did he speak to markets through an interview with Caixin?

Caixin has a strong reputation as an advocate of liberal economic reforms due to the leadership of its founder Hu Shuli, who reportedly has close ties to economic technocrats, including Zhou. Speaking through China’s official state media would have been viewed less favorably by international markets, and giving an interview to a foreign media organization, such as the Wall Street Journal or Bloomberg, would have been looked down upon by China’s political establishment.

Q6: Is this the start of an effort to speak to markets more regularly?

Markets should not expect a more regular schedule of statements from Governor Zhou. He is unlikely to start speaking as often as his counterparts in the United States, the European Union, and other advanced industrialized economies. In between his comments, observers will need to pay attention to the statements of the central bank’s vice governors, reports on their website, and comments from China’s other officials, including Finance Minister Lou Jiwei; Liu He, head of the party’s Leading Small Group on Economics and Finance; and Premier Li Keqiang. However, far more important than all of them is President Xi Jinping, the only person in the country who can speak absolutely authoritatively about the country’s economic direction and policies.

Scott Kennedy is deputy director of the Freeman Chair in China Studies and director of the Project on Chinese Business and Political Economy at CSIS. This piece was originally posted here.

Another consequence of China's slower economic growth has been the decline in the shipments of export cargo and import in international trade.

Economic Consequences of China’s Slowdown

Perhaps the most popular term used among strategic analysts in the past year is Thucydides Trap—the notion that a rising power and the incumbent power are destined for war—because of the growing rivalry between the United States and China.

The worry is that as China’s economy continues to grow, China will gain the means and confidence to challenge American military primacy and influence in Asia. From this perspective, China’s recent economic slowdown is viewed as helpful in putting off the day of reckoning.

The empirical evidence about strategic rivalry is actually much more ambiguous than some prognosticators insist. And in the Chinese case, although anxieties have risen because of tensions over China’s irredentist ambitions in the South China Sea and cyber, open warfare over these issues seems highly unlikely or necessary. Even more important, the negative consequences to the world—which must include both China and other countries—from its economic weakness are not just hypothetical; they are already visible and could become more damaging if not addressed soon.

China avoided the worst of the global financial crisis with a four-trillion renminbi stimulus package. But that binge in infrastructure spending has been followed by a hangover of debt and overcapacity. Domestic demand for electricity, steel, cement, copper, and glass has all fallen off, as have imports and exports. The only thing keeping the country out of recession is resilient employment and consumption data, accompanied by a gradual transition toward services, which is less dependent on infrastructure growth.

Concern about China’s poor economic performance is not only the result of built-up debt, but recent policy swings. Xi Jinping came into power advertising a comprehensive reform package. He started with a range of reforms in finance, utility prices, fiscal affairs, and free trade zones, but in the past year, we’ve seen a string of policy moves that are decidedly more statist. The government intervened to slow a stock market collapse last summer, suspending trading of many stocks, ordering shareholders not to sell, and reportedly using $500 billion to soak up unwanted shares.

The stock market fiasco was followed by the poorly managed liberalization of the renminbi, with the market expecting further depreciation. While authorities spent billions to maintain the RMB’s strength, Chinese citizens shipped their dollars out of the country, leading to a decline in foreign exchange holdings.

The mistakes of the summer were accompanied by cheap-calorie stimulus, with several cuts in lending rates, ramped-up fiscal spending, and a 3.6 trillion renminbi debt-swap program involving local government bonds.

Slower growth and greater volatility in the short term mean a rise in debt and corporate losses, which may very well translate into higher unemployment and a slowdown in household consumption. And given the unpredictable mix of market and state in recent policies, doubts are growing about the leadership’s basic competence to govern the economy, which had always been the Communist Party’s strong suit.

From the perspective of the United States and others, slower Chinese growth means less demand for their goods. Commodity prices have fallen off, hurting Australia, Brazil, and the Middle East.

Exports to China of manufactured intermediate goods and final products from the United States, Europe, and other industrialized economies have all dropped. A slower growing pie could also translate into greater protectionism, a trend already visible in high-tech goods such as semiconductors and telecommunications.

But the most important emerging negative externalities from China’s economic troubles are volatility in global securities markets and greater pressure on macroeconomic policies for the United States and others. China’s economy is now large enough and its capital markets open enough that problems there spread elsewhere at the speed of light, as investors everywhere move their funds with just the click of a button.

The most pressing challenge is not faster growth, but more unambiguously market-oriented economic policies that are also more clearly articulated and explained. It is in China’s self-interest to calm markets and restore the confidence of investors, domestic and global. Even if further stimulus is warranted, accompanying it with greater liberalization and market access, for example in services, would be an important signal that Xi Jinping is not just a fair-weather reformer.

The United States can emphasize even further the benefits to China of pursuing an unambiguous reform policy agenda. The conclusion and implementation of the Trans-Pacific Partnership (TPP) would also serve as bright directional arrows pointing China to further open its economy, as remaining outside TPP would put China’s economy at a strategic disadvantage precisely in those high-value-added sectors in which it is hoping to develop greater capacity.

China’s hosting of the G-20 process in 2016 provides another opportunity to strengthen coordination of macroeconomic policies and further hone strategies toward healthier and broadbased growth strategies. Generating better economic performance in China should be welcomed, not feared. A Thucydides Trap is hypothetical, whereas the negative consequences from China falling into a “middle-income trap” are real and potentially upon us.

Scott Kennedy is deputy director of the Freeman Chair in China Studies and director of the Project on Chinese Business and Political Economy at the Center for Strategic and International Studies (CSIS) in Washington, D.C.

China’s Currency Devaluation: Short-Term Fix or Long-Term Reform?

The Center for Strategic and International Studies provided Global Trade with the following Q&A on China’s currency situation, with Scott Kennedy, director of the Project on Chinese Business and Political Economy.

 

Q: What policy steps did China take yesterday?

A: On Tuesday morning China’s central bank announced a two-part adjustment in its exchange rate policy. First, it stated although the central bank would continue to keep the daily maximum trading band for the Renminbi (RMB) at two percent in either direction, going forward the initial rate each day would be set in a more market-friendly manner. Instead of the central bank making the decision unilaterally in reference to the previous day’s opening rate, the central bank would consult with “the market” (most likely a small group of banks) when setting the initial rate in reference to the previous day’s closing rate. Consistent with that approach, the central bank on Tuesday morning announced a new reference rate for the Renminbi that was 1.9 percent lower than where it closed on Monday, from 6.1162 to the U.S. dollar to 6.2298 to the U.S. dollar.

Although the People’s Bank of China (PBOC) has not moved from a managed peg to a free-float, it is signaling that the long-term peg to the U.S. dollar is no longer sacrosanct and that the central bank will accept a degree of volatility never permitted before. In the short-term, given the flagging economy, the likelihood is for this liberalization to lead to a modest depreciation. In foreign exchange markets in Asia outside China on Tuesday the RMB’s value fell even further than the two percent band, suggesting a further fall in its value. [Editor’s note: The RMB opened 1.8 percent lower on European markets on Wednesday.]

 

Q: Did China’s leadership do this to promote sagging exports or push forward economic reform?

A: The leadership hopes to kill at least two birds with this stone. It is likely motivated by both short-term and long-term goals. In the short term, they are responding to declining exports, which is partly the product of the RMB’s effective appreciation over time as the U.S. dollar has strengthened against a wide swath of currencies. In addition, depreciation may generate desired capital inflows in a period when there appears to have been capital outflows as a result of the country’s economic troubles as well as the ongoing stock market volatility. But the policy adjustment is also aimed at liberalizing the exchange rate mechanism, which is necessary to achieve greater international usage of the RMB and is necessary as part of China’s effort to have the RMB included in the International Monetary Fund‘s special drawing rights (SDR) basket of currencies.

It is unlikely that this policy adjustment will lead to a huge boost in China’s exports on its own because Chinese goods are already priced competitively, and much of China’s exports are made from imported components, and this depreciation makes those components more expensive. In addition, foreign demand is likely to be relatively limited because global demand is not growing quickly. However, this may at least give a psychological boost to Chinese exporters, which may raise Xi Jinping’s domestic popularity.

 

Q: Why does it appear that overseas markets, including in the United States, reacted negatively?

A: There is likely concern of a substantial capital flow toward the RMB and China, which would mean less demand, for example, for U.S. stocks and bonds, which may explain part of the falloff in U.S. markets. There may also be concern that other countries could follow China, resulting in competitive devaluations. My view is that while we see short-term capital movements as a result of this step, these concerns are likely overstated in the grand scheme of things given the size of U.S. capital markets.

 

Q: Does this signal that broader economic reforms are back on track after government intervention in the stock market?

A: We will have to wait and see. If the RMB moves in either direction that generates either too much currency inflows (hot money) or outflows (capital flight), the key question is whether the central bank will resist the urge to intervene. If it can maintain self-discipline, this is a potentially positive sign for other reforms, including greater liberalization of the capital account and market access in sectors currently dominated by state-owned enterprises (SOEs). But if they re-intervene in a ham-fisted way, akin to what has been done in the stock market, then we will know that this was primarily about short-term stimulus and growth, and that the commitment to broader reform has waned. In that regard, this modest move has potential big implications.

 

Scott Kennedy is deputy director of the Freeman Chair in China Studies and director of the Project on Chinese Business and Political Economy at the Center for Strategic and International Studies (CSIS) in Washington, D.C.