The China Skeptic’s Talking Points Memo

Little more than three decades since the opening of China’s economy under the leadership of Deng Xiaoping, the country has emerged as the greatest force reshaping the global economy and, with it, the global balance of power.[i] On the basis of purchasing power parity, Chinese gross domestic product (GDP) now exceeds $11 trillion, making it the world’s second largest national economy, just behind the United States, which it is expected to surpass by all estimates within the next two decades.[ii] On a per capita basis, however, China remains very much a developing country, ranking 120^th in the world. If China’s development to date and future prospects are unrivaled in scale, so are the multifaceted challenges that threaten further progress. Chief among these challenges are China’s aging and increasingly unhealthy population, a polluted environment already pushing the limits of sustainability, and multiple economic and institutional obstacles.     

As China prepares to undergo its one-per-decade leadership transition in November, the chorus of observers in and outside of the country calling for reform again crescendos to its most hopeful peak, this time tempered by the dissonance of disappointment from the past ten years. China’s breakneck growth over the past decade belies its tepid political stasis, condemned by some even within the Communist Party itself. A recent essay attributed to a leading editor of a newspaper run by the Party’s central school is stunning in its forcefulness, writing that country’s current leaders of having “created more problems than achievements” and suffer from a “crisis over the legitimacy of its rule.”[iii] China’s next generation of leaders do not have the luxury of governing on auto-pilot: they must undertake credible efforts to address the mounting distortions that pervade Chinese society or risk condemning China to the middle income trap with uncertain implications for political stability.

Demographic Challenges

Begin first with China’s population. The skeptic’s typical refrain is that China will “grow old before it grows rich.” Within the past five years, the proportion of China’s working population has reached a peak and will begin declining rapidly as the share of the elderly increases—a consequence of China’s infamous “one-child” policy. There have been occasional reports of a potential reversal of this policy—already two single-children who marry may have two children of their own—but no reversal will challenge the demographic tidal wave already set in motion. The end of the demographic dividend means that China’s great comparative advantage—cheap labor—is disappearing at the same time it is racing to make the leap to the next stage in economic development.

As China progresses from simple to more advanced manufacturing, there is a demand for more skilled workers.  A stream of media reports has highlighted labor shortages in cities throughout China, which is already putting upward pressure on wages. [iv] Wages of urban workers in private enterprises surged 18% in 2011 to an average level of ¥24,500 ($3,900) per year, an acceleration from 2010 when they rose 14.1%.[v]  Reports of protests by workers indicate, too, that expectations of pay and working conditions are much higher amongst the second generation of workers under China’s opening than amongst the first.[vi] Changing conditions in the Chinese interior, long the source of the country’s laborers, are also complicating matters. As UC San Diego professor Barry Naughton has observed, because there is little landlessness in China, factors “pushing” migrants into the city are weak, despite the pull of urban wages. As China seeks to develop cities in its interior, this too absorbs labor that otherwise would have gone to the coasts. The result is that the next stage of higher value added manufacturing in the coasts might be undercut by first-stage development in the interior.

But it is no given that China’s transition to higher-value added sources of growth will be inherently successful. Higher wages are already prompting some manufacturers to look elsewhere in Asia. As labor costs make China less competitive relative to Asian peers on the low-end, greater US competiveness means China will face pressure on both ends of the market. According to a survey of US manufacturing executives at companies with sales greater than $1 billion by Boston Consulting Group, more than one third are planning or considering bringing production back to the United States from China. The leading factors driving their decisions are labor costs—which have remained stagnant in the US for nearly a generation, boosting relative competitiveness—product quality, and ease of doing business. In a separate report, BCG predicts that up to 30 percent of current US imports from China could move back to the US.[vii] But this is not necessarily bothersome to China’s leadership, which is seeking to promote more advanced manufacturing and has a still fast growing domestic market to absorb export losses.

With the old comes the sick.[viii] Despite being a middle-income country, China is increasingly suffering from costly first world diseases. One example: China is estimated to have an incidence of diabetes of nearly ten percent; the United States, five times wealthier, has a diabetes incidence of eleven percent. In China, the total number of smokers is equivalent to the entire US population. All told, a 2011 Chinese report estimates that about 13% of China’s GDP activity is lost to disease.

If the proportions are worrisome, the sheer scale of the sick will be like nothing the world has ever seen. They will challenge an underdeveloped healthcare system toward which the government has only begun to seriously direct resources. In 2000, the World Health Organization ranked China, then the world’s sixth-largest economy, 144^th out of 191 countries in terms of the quality of its health-care system.

Following the dismantling of the “iron rice bowl” of benefits Chinese citizens enjoyed as part of their employment in state-owned enterprises, individual Chinese were forced to burden a significantly higher proportion of health care costs—one reason behind the country’s high savings rate. Government spending as a share of health expenditures fell from 39% in 1986 to 16% in 2002. However, following the embarrassment the government suffered in its handling of the SARS crisis, the state has once again started to invest substantial amounts in its healthcare system. It has launched new rural programs and in January 2009, announced plans to invest what would become $173 billion by 2011. As a result, the government’s share of health spending rebounded to 24% in 2010.

The Chinese government’s ability to manage its health challenges will be the critical factor in determining whether or not the millions lifted out of poverty will suffer a reversal in their fortunes as they age. As China’s decades-long comparative advantage in abundantly cheap labor is diminishing, whether or not the engine of the Chinese economy is sufficiently capable of shifting gears to the next stage of economic growth remains subject to debate.

Environmental Challenges[ix]

Considering the Chinese environment presents the country at its most contradictory—the leading producer of solar panels and wind turbines is also the world’s largest emitter of carbon dioxide.

China’s population has long confronted the challenges of unforgiving natural resources: the country’s per capita water reserves are only slightly more than one-quarter of the world average.[x] Its hilly terrain allow about one-tenth of a hectare in arable land per capita, or one sixth the levels present in the United States.[xi] Already scarce, China’s land and water is increasingly, and, perhaps irreversibly, polluted, presenting a potentially significant break on economic development.

Despite reducing the amount of carbon equivalents emitted per unit of GDP, or the energy intensity, by half from 1993 to 2009, China is still twice as inefficient as Japan and a third more inefficient than Korea and the US. With a heavy dependence on coal, sixteen of the world’s twenty most polluted cities are in China. An estimated 750,000 people die prematurely every year due to air pollution in large cities. According to Yanzhong Huang, a senior fellow at the Council on Foreign Relations, “environmental pollution is also believed to have significantly increased the infertility rate for couples from three percent in 1990 to 12.5-15% today.”[xii] According to China Daily, birth defects have risen by 70% between 1996 and 2010 and are now the second-leading cause of death among infants in China.[xiii]

According to Elizabeth Economy, also a senior fellow at the Council on Foreign Relations, up to 10% of China’s farmland is currently polluted. Water is far worse: two-thirds of China’s cities have less water than they need. Two-thirds of the Yellow River, which supports 150 million people and 15 percent of China’s agricultural land, is considered unsafe for human use.

Despite China’s commitment to more efficient growth, it is a feeble match against projected demands of an ever-wealthier population for increased consumption—from meat to electricity to gasoline for cars. And these human pressures are nothing quite like the threat posed by climate change: China’s government, which has been reluctant in international fora to support a comprehensive global agreement, has forecast it is at risk of a 37% decline in the country’s agricultural output due to climate change in the second half of the century. Shanghai is at significant risk from rising sea levels.

The estimated cost of the environmental damage totals 8-12% of Chinese GDP annually.[xiv] Without dramatic reform and serious lifestyle compromises, China is rapidly stealing from its future for illusory gains today. The Chinese government committed to generating 15% of its energy from renewable resources by 2020. It has promised to reduce its energy intensity by an additional 16% by 2015 after reportedly being on track to achieve a 20% decline by 2010.[xv] Despite these ambitious goals, it remains unanswered whether China’s leaders—particularly on the local level—are willing to restrain short-term growth in the interest of long-term environmental sustainability.

Economic Challenges

China is on the path of a critical economic transition that will determine whether it will successfully enter the ranks of developed nations or fall victim to the middle-income trap in which the growth cycle stalls.[xvi] Key to this challenge is whether China can successfully create a strong environment for the next phase of growth, by educating its citizens for the knowledge economy and supporting a stable policy environment that supports efficiency and entrepreneurship. To do so would require overcoming the substantial policy-driven distortions and inefficiencies that currently undermine China’s economy. The longer these distortions are left unaddressed, the more costly they become to proactively unwind.

It is easy to accept the Western misperception of exports primarily driving China’s economic growth. But it is not; instead the economy is dominated by investment, which accounts for nearly half of China’s GDP, enabled by the country’s high savings rate or, in other words, the suppression of consumption.[xvii] As Simon Cox summarizes, an undervalued currency inhibits imports; a weak safety net requires substantial saving in its own right; and capped interest rates and sheltered markets reward industry profits at the expense of consumers. Where exports and investment have powered China’s growth to date, its future is dependent on supporting consumption and services.

The rate of investment exceeds that of any other major economy including Japan and South Korea at their peaks, attracting many China skeptics such as hedge-fund manager Jim Chanos who points to the most notorious examples of irrational investment and writes off China as “Dubai times 1,000.” Most analyses emphasize that China is more likely misallocating rather than overinvesting more resources than its economy can handle. At an estimated capital stock per person 8% of that of the US and 17% of South Korea, China still has room to run. And relative to its economy, a capital stock of 2.5 times GDP is in line with comparable countries. This does not, however, diminish the concerns about potential misallocation of resources, which nonetheless could trip up growth.

State-owned enterprises are central to the economy’s misallocation of resources. Despite being substantially downsized and restructured in the 1990s, state-owned enterprises (SOEs) remain a significant portion of the Chinese economy—and highly inefficient ones at that. SOEs control a third of assets in the industrial and service sectors of the economy and benefit from preferential financing, land, electricity, and other input subsidies. Unirule, a Beijing think-tank, calculates that without their generous subsidies, state-owned companies between 2001 and 2009 delivered an average real return on equity of -1.47%.[xviii] Research by several economists suggest that had private enterprise been able to channel more investment relative to the SOEs, China could have achieved the same rate of growth at nearly half the current level of investment. Continued reform of the state sector of the economy is essential to achieving efficient and sustainable growth; but their replacement with highly political involvement in nominally “private” sectors of the economy, with accompanying large subsidies, is little improvement on the distortions that lead to suboptimal investment. 

In the short-term, significant risk is intertwined in the fiscal position of the local governments, the strength of the banking system, and the country’s real-estate markets. In 1994, the central government, alarmed by its declining share of tax receipts relative to GDP, implemented a sweeping reform of the country’s tax system. While the reform was very positive for the subsequent increase in efficiency, it sharply cut revenues to local governments. Over the past two decades, China has held its local governments increasingly accountable for substantial amounts of new public spending while restraining their ability to generate revenue through taxes.[xix] Limited in their ability to tax or issue debt to support their spending, local governments involved themselves quite heavily in their economies, by taking stakes in large numbers of joint ventures, many of them in real estate, whose value has soared throughout the country. It is estimated that local governments now have more than $1.4 trillion in off-balance sheet financing vehicles, a substantial amount of which is believed to be seriously underperforming, due to investment in uneconomic projects.[xx]

This poses a major threat to the Chinese banking system, a banking system that the government used as a key lever in its response to the 2008 global financial crisis by directing it to inject large amounts of debt into the economy to sustain growth. Lending surged from 122% of GDP in 2008 to 171% of GDP in 2010.[xxi] As the bills come due for this debt, analysts have expressed increasing concern that the Chinese banking sector may be vulnerable to a substantial blow.

The real extent of losses are obscured by the fact that banks are simply rolling-over debt that realistically can’t be repaid, delaying the inevitable. Indeed, in February, The Financial Times reported that the government had instructed banks to rollover their loans to local governments.[xxii]The banks, which are already undercapitalized relative to other emerging market economies, with an equity to asset ratio of 6%, suffer impairment on 10% of assets to wipe out the banking system’s profits and more than a third of its equity.[xxiii] Nonperforming loans are currently stated at 1%, but private estimates range easily into the double digits.

While the central government has more than enough resources to absorb any blow to the financial system caused by a provincial financial hangover or banks directly, the turmoil would nonetheless be bad. Most vulnerable to a credit tightening would be small and medium-sized enterprises—which receive less generous financing than the large national champions or provincial favorites—which are reportedly increasingly dependent on non-bank financing at large interest rates.[xxiv] Belatedly recognizing a key part of China’s debt troubles are linked to restrictions on provinces’ fiscal authority, the central government has recently tested the waters by allowing some local governments to issue debt.[xxv]

If a hangover is currently being felt in China’s economy, it is centered on the floor of the Shanghai Stock Exchange: since reaching its all-time high in the fall of 2007, the Shanghai composite has fallen by more than 50% and languished for more than three years.

Longer term, China’s greatest risk is that its economy fails to shift to more advanced, knowledge-based industry and services that generate more value-added. To do so, it needs to reorient its education system away from its traditional emphasis on rote instruction to one that fosters critical thinking and do more to support intellectual property and entrepreneurialism. That only two Chinese universities comprise the global top 100 as ranked by the Times Higher Education survey—the highest ranked only 49^th —gives some suggestion of the challenge ahead.

The government, as it has elsewhere, has responded robustly with a web of policies designed to promote “indigenous innovation.”[xxvi] The government has articulated a plan to increase research and development (R&D) investment to 2.5% of GDP, up from 1.3% in 2005; raise the contribution made by technological advances to economic growth above 60%; limit dependence on imported technology; and become one of the world’s most-patented and cited researching nations. China has supported its effort to date through direct R&D spending and subsidies; discriminatory government procurement; and support of proprietary national technology standards–with the eventual desire to make them global–that favor domestic companies. Since 1995, Chinese patent filings have surged thirty-fold to 307,293 in 2010.[xxvii] China’s investment in innovation continues to grow, increasing 21.9% in 2011 over 2010 and now comprises 1.8% of China’s GDP.[xxviii]

All developing nations depend on technology transfers from more developed nations to kickstart their own growth and China has been successful in attracting research arms of major multinational corporations. But rampant infringement of intellectual property and coercive policies has shaken foreign confidence in China. Treasury Secretary Tim Geithner has gone so far as to characterize the situation as “systematic” theft. The most egregious exemplar of China’s desperation to transition to an advanced economy may be found in an US intelligence estimate that accuses China of stealing American companies’ intellectual property over the Internet as a matter of national policy.[xxix] Going forward, the clearest indication of whether China is succeeding in its mission to transition to a high-tech economy is likely not to be found in statistics over the amount of patents filed or engineers graduated, but whether the intensity of its industrial espionage activity diminishes—and if China itself becomes a target.

Institutional Challenges

Yet beyond demographic, environmental, and economic challenges facing China, one must consider the institutional shortcomings of China’s communist, state-driven development model. The Party’s unwillingness to accept any growth that threatens its status as the country’s power center, endemic corruption and weak rule of law are all significant threats to further progress.

As Richard McGregor writes in his survey of the Chinese Communist Party,[xxx] the principal dilemma China’s leaders face with respect to economic development is ensuring that economic prosperity does not produce wealth-driven power centers outside of the Party control. The continued ownership and existence of party committees effectively more powerful than company Board of Directors are the current means by which the Party maintains its control of the country’s largest corporations, particularly with respect to their leadership.

Its relationship with entrepreneurs is more mixed, and ultimately the bigger test of the Party’s commitment to economic growth. On one hand, it has worked aggressively to cultivate the support of entrepreneurs and integrate them into the Party power structure. On the other, preferential financial and other forms of support for state companies are constant impediments to developing an innovative private sector that will drive the next phase of Chinese growth.[xxxi] Confronted with the choice of growth, that it cannot channel to its own enrichment, and maintaining power, the Party will choose the latter.

Closely related to the dominance of the Communist Party are the pervasiveness of corruption and a weak rule of law. Indeed, the central bank admitted as much in 2011 when it reported that up to 18,000 officials had fled China between 1995 and 2007 with more than 800 billion yuan in stolen assets.[xxxii] Corruption has a very tangible effect on economic growth. Three of the top ten business challenges cited by American businesses in China are directly are directly associated with corruption and rule of law concerns.[xxxiii]  Pak Hung Mo of the Hong Kong Baptist University finds that a 1% increase in corruption levels reduces growth rates by .72%, attributing heightened political instability as mostly responsible. Podobnik, et al. find that a one unit increase in a country’s Corruption Perceptions Index rating (meaning an improvement as published by Transparency International) leads to a 1.7% increase in per capita growth rate.[xxxiv] Since 2007, China’s corruption perceptions score has increased by one tenth of a point to 3.6, with 10 being least corrupt, while its ranking has fallen slightly from 72 to 75^th most corrupt.[xxxv]

The more important story for China’s future is less outright corruption but the risk that those who have already overwhelmingly benefitted from reform will actively impede any needed further reform that threatens to undermine their relative power. China’s devolution to a crony capitalist state would seriously undermine its growth trajectory.

Finally, one must consider China’s institutional strength, including not only its ability to regulate its economy, but all supporting aspects, including education, health care, infrastructure, the environment, and orderly systems, rules, and policies. By this measure, China’s progress has been mixed, with generally high levels of literacy and ambitious further plans for its education system, a respectable life expectancy rate, and world-beating signature infrastructure projects; but as previous sections of this paper have illustrated, its management of issues such as the implications of its impending demographic revolution and the environment are less stellar. A continuing impulse to regulate will also be challenged by the country’s growing size and complexity: it is easy to regulate a small economy, it is far less so to regulate a more complex one—and with much greater consequences when mistakes are made or market failures left unaddressed. Much rests on the competence of China’s emerging generation of leaders, which the Communist Party has long held a monopoly on for lack of opportunities elsewhere. But as Chinese and multinational companies aggressively pursue Chinese talent, the state itself may find its talent pool and regulatory capacity challenged.[xxxvi]

Departures

China’s leaders recognize all of the major problems it faces, albeit some more publicly than others—and so do the Chinese people, who are increasingly vocal about very real injustices committed in the name of development. In the past three decades, average Chinese have benefited from an extraordinary opening of new possibilities. In many areas, the state government has retreated significantly into the background of daily life, though brooking no surrender in its ultimate political control. The implicit social contract underlining the Communist Party’s legitimacy is the economy’s growth. The Chinese leadership’s aggressive stimulus efforts at any sign of economic slowdown are indicative of their own fear of the precariousness of their rule.

One cannot deny—and indeed one must applaud—the nearly half-billion persons delivered from poverty attributable to China’s economic development. The risk, however, that this progress should falter—or simply fail to meet the country’s heightened expectations—could result in a painful readjustment of uncertain political volatility.

What may be even more troubling to the Chinese leadership may be the results of a 2011 poll that reported more than half of China’s millionaires were in the process of or considering emigrating, with the United States and Canada as their most preferred destination. When those who have most benefitted and stand to further benefit from China’s progress are hedging their bets, it calls into question the very integrity of that progress.[xxxvii]  A more morbid variation on the same theme: nearly 300,000 Chinese commit suicide each year, a rate that is among the highest globally.[xxxviii] In an economy growing wealthier faster than any the world has ever seen, 300,000 Chinese each year are giving the clearest possible vote of no confidence.

American businessmen, in particular, have long been guilty of the hypocrisy of decrying government intervention of any kind in America while simultaneously praising the Chinese government for its management of their economy. While there is nuance in any comparison of such scale between America and China, this hypocrisy is a contradiction that eventually must be reconciled: markets, not governments, create prosperity and China is no exception. It has succeeded where its government has let the market thrive and taken a supporting role, not because of the government. China must fully embrace this reality and let the market deliver prosperity commensurate to China’s promise or suffer the consequence of stalled progress.