Will the bamboo bend?

Unlike many times earlier, the Communist leadership may not have a policy fix for China’s economic troubles this time. This has serious repercussions for the country and the world.

Neelkanth Mishra | 16 August 2023

This was published in the Times of India on 16 August 2023 (link).

This is not the first time that Chinese economic policymakers have faced serious challenges. To many the last 45 years might appear as a continuous period of rapid growth, but nearly every decade, radical shifts in policy were necessitated by previous reforms either running out of steam or causing distortions.

Adapting to change and capitalising

The “reform and opening up” of 1978 was itself a response to the economic damage wrought by the Cultural Revolution and the need to keep up with neighbors like Japan, which were growing rapidly. By the mid-1980s, acceleration in growth of newly unshackled town and rural enterprises and in agricultural output, together with price-decontrol, pushed up inflation, which reached 28% in February 1989, a catalyst for the Tiananmen Square protests. Reforms then focused on encouraging private sector growth (the Shanghai Stock Exchange reopened in 1990, Corporation Law passed in 1993, the renminbi was devalued suddenly). This helped growth, but also exposed the bloat in the public sector, and triggered large layoffs, taking away the “iron rice bowl”.

In the early 2000s, large loan write-downs, recapitalization of China’s public-sector banks and China joining the World Trade Organization then set the stage for the next phase of growth. In 2009, as the financial crisis questioned the sustainability of goods demand in the west, China launched a massive fiscal stimulus, focused on infrastructure and real-estate.

Throughout this period, China’s embrace of foreign firms that brought capital, expertise, and global value-chain linkages, helped sustain growth as well as China’s dominance of global manufacturing. In 2005, nearly 60% of China’s exports came from foreign firms manufacturing in China. Even today, nearly a third of China’s goods exports (more than a trillion dollars) are by foreign firms operating in China.

Over time, as the Chinese economy grew, the state became more powerful, improving its ability to intervene with hard resources, making its industrial policy much more potent, like for example in its near-complete domination of the renewable energy and energy storage ecosystems.

So, even as we digest the worrying new signs last week that the Chinese economic miracle may be ending – deflation (which is dangerous in an economy with record levels of debt), a sharp fall in exports, and a large real estate developer missing payment deadlines (reigniting concerns on China’s excess housing supply), can we expect the Chinese government to engineer course correction?

New era, new problems

There are reasons to believe that “this time is different.”

The most important shift has been in the “principal contradiction”, resolving which is the primary objective of policymaking in Marxist regimes. In 1981 it was amended to “the ever-growing material… needs of the people versus backward social production”, in other words, prioritizing economic growth, even it came at the cost of state control. But in 2017 this was changed to the “contradiction between unbalanced and inadequate development and the people’s ever-growing needs for a better life”, eschewing growth at all costs and making “common prosperity” a policy priority.

There are other differences too. An economy’s growth can be split into three parts: Labor input, Capital input, and Total Factor Productivity (TFP); like for a factory, output can grow by increasing the number of workers (labor), buying more machines (capital), or changing processes (TFP). China’s labor supply is now shrinking, and TFP fell in the five years pre-Covid, as resource-allocation shifted from private firms to public sector firms. Capital formation is slowing too: It had dominated China’s growth over the past decade, but is hurt by a slowing housing market, global manufacturers diversifying away from China, and local-government debt problems exposing the overbuild in infrastructure.

In addition, China is hitting the limits of “supply-side economics” (improving supply through investments and cost reduction), which dominated policymaking over the past four decades. Demand, on the other hand, is constrained by a rapidly ageing population, which lacks a strong social safety net – pension assets in China relative to the size of its GDP are even smaller than that of India – and is likely to reduce spending as it nears retirement. Consumption growth had been falling even before Covid. Given how large real-estate is for household wealth, a weak housing market further dents consumer confidence.

Dilemma for the current regime

It is well understood that the government needs to give a consumption stimulus, but such a measure appears unlikely. Not only is the regime ideologically opposed to handouts lest they “make people lazy”, but it is also wary of inflationary pressures and economic and social volatility they can cause.

Further, whereas the damage wrought by changing rules of engagement between the private sector and the state has received much attention, the relationships between central, provincial, and local governments are perhaps as important for the future of China. Mao believed in decentralization and delegated power to local governments – an important shift away from Stalinism, and a major driver of the growth acceleration in the past half century. These dynamics may have shifted recently, too.

The magnitude of change, like the potency of medicine, often depends on the severity of the malaise – things may worsen further before material changes are undertaken. Even then not all changes are successful. The government would attempt new shifts in policy, but given the changing context, there are no easy solutions. Even before 1978, periodic shifts in government policy were common, like the adoption of Stalinism in 1950, which had to be undone later that decade, or the Great Leap Forward and the Cultural Revolution, which did not meet desired objectives.

A growth rebound thus appears unlikely, which is bad news for the global economy: Of the US$25 trillion of GDP added globally over the last ten years, China contributed US$10 trillion (40%).