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China’s New Normal: An Indispensable Locomotive of Global Growth

Mar 07 , 2016

Following the ongoing turmoil in China’s stock exchange market, pundits have concluded that China’s “soft landing” in single digit growth is the end of an era that positioned the Middle Kingdom as a magnet for investors and producers worldwide. Some have even framed the world’s largest economy (in PPP terms) “a giant with fragile legs” facing an imminent economic apocalypse. At the same time, populists who seek to connect the economic disharmony in China with president Xi’s authoritarian governance have even argued that the “Chinese model” has failed to deliver and the Chinese Communist Party (CPC) will soon face social backlash over its statist policies. Contrary, however, to mainstream reporting, omens for the economic future of China are far from ominous. China’s economy is transitioning into a “new normal” of lower growth, yet China continues to add to global product, each year, a GDP as big as Turkey’s. Such an enormous contribution attests China’s official position that the world’s most populous nation remains an indispensable locomotive of the global economy with many lucrative investment opportunities attracting capital.

To address the misconceptions of China’s economy, it is necessary to be guided by the core growth factors that the rich literature of development economics offers: 1). diminishing returns; 2). population dynamics; 3). trade growth; 4). innovation / Schumpeterian dynamics.

Relevant to these overarching themes is the diversification of the production base from manufacturing to services, the migration from rural to urban areas, and the long-term formation of human capital—the core pillar of disruptive innovation.

China is undoubtedly experiencing the inalienable effects of diminishing returns for its production base has expanded substantially. It is also gradually losing the “population dividend,” as Chinese demographics have stagnated. Nonetheless China is also quickly progressing in innovation and grassroots entrepreneurship. On the trade dimension, China is transitioning from exploiting its low wage labor (Post-2001 WTO entry) and free-riding in the intellectual property system, to being a more responsible stakeholder and climbing up the value ladder.

As the source of export growth has dried up, China is moving decisively to increase its innovative capacity through spending on R&D (China will surpass both the EU and the United States combined by 2030), lawful acquisition of foreign firms that transfer technology and the build up of a central strategy to transition its economy from the “population dividend” to the human capital dividend; from labor quantity to labor quality.

If Chinese actions in the recent global environmental summit in Paris is a case to study, it is a promising signal that China shows commitment to promote painful internal reforms during an already difficult time of world economic recovery knowing that it’s economy will experience significant exogenous shocks.

The Inescapable Law of Diminishing Returns and the New Silk Road

As apples cannot defy gravity similarly economies cannot defy the law of diminishing returns, unless they introduce modern “Prometheus,” or technological innovation to form new economic possibilities of production—also called endogenous growth in economic jargon.

Going back to the intellectual foundations of modern economics, reverent fathers like Adam Smith and David Riccardo realized that there has always been an inalienable empirical relationship between production and production factors. Simply put, adding more workers to a field will inescapably lead to an increase in the output produced, yet the increase will after a certain point, diminish. In its modern macroeconomic expression the law of diminishing returns is reflected in higher growth (on average) for developing economies and lower growth (on average) for developed economies.

Thus a China of GDP per capita of $10,000 will grow much slower than a China with a $5,000 GDP per capita. While this has already been attributed–at least partly–to a problem of “overcapacity,” Chinese policy makers have sought higher returns by investing outside of China (particularly through the OBOR initiative).

The United States faced a similar economic puzzle at the end of WWII. The massive public investments and the wartime hyper-patriotic frenzy of the American economy had to transition to a new model and explore the global market – a strategy that the Marshal plan strategically promoted.

The end of the “population dividend”

Another crucial factor contributing to economic growth is population. Once a country establishes the basic institutions to produce human capital, manage taxation and the economic distribution of resource, population growth adds to economic growth and conversely, population decline hinders aggregate economic growth. It has indeed been a cliché that China will grow old before growing rich and this is also a relevant factor contributing to lower growth. As Chinese population has recently been only marginally growing its impact on Chinese growth has not been as strong as it used to be. As an extreme example Japan (certainly much richer than China) is experiencing continued recession due to extremely adverse demographics. Chinese regulators have taken into consideration the economic dimension of population control and for the first time in 30 years the one child policy has been eased to a “2 child” policy.

It is too early to foresee the exact impact of population trends in the aggregate size of the Chinese economy under the new rule, yet the impact of population trends is very relevant to the current soft landing of the Chinese economy as the pool of poor rural workers moving to China’s megacities is inexorably drying up. This is a clear case in the richer areas of the Chinese coastline, however in China’s second and third-tier Western cities, poor, rural populations remain substantial. Empowered by the increased trade dynamics that the Silk Road promises to release in Western China these populations could become one of the pillars of Chinese growth—at least in the midterm. This hope is evidenced in increased government investments in Western Chinese megacities such as Chengdu, Chongqing, and Xi’an.

The political economy of China: The state and the individual entrepreneur

China is a peculiar “animal” with an all-powerful “Leninist” party and a hybrid flourishing private economy. While state behemoths like Sinopec and State grid hold trillions in assets, private companies like Ali Baba, Tencent and Xiaomi expand at an impressive rate. Perhaps this exceptional endogenous entrepreneurial ability of the Chinese society to create innovative high-tech companies with unprecedented business success is an indicator that many “Cassandrian” prophets have under-assessed.

As Tsinghua’s Professor Ying Lowrey has marvelously described in her latest book the technological and entrepreneurial revolution in China is rapidly transforming once geographically remote and impoverished villages, turning them into vibrant communities connected to the domestic and world economy. This unique Chinese breed of “Innopreneurship,” or the confluence of innovation and entrepreneurship, which according to professor Lowrey constitutes the “Alibaba model,” is only the first page of a book that will rewrite the laws of business for a globalizing economy, as it empowers small-scale yet increasingly efficient production. Other companies like Haier have already invested in disruptive technologies like 3D printing and the Internet of things and the Chinese state has promoted bilateral agreements with Germany to attract significant German knowhow to upgrade the Chinese industrial base for the 21st century.

The rise of China’s new economy proves that the country has not only benefited by a “latecomers advantage” but is leading the technology revolution in some sectors. Not surprisingly the Chinese leadership seems to have understood the significant impact of innovation and entrepreneurship in Chinese economic ecosystem and has boosted the “Innopreneurship” concept. Last year, Premier Li Keqiang visited Zhonguancun area in Beijing – China’s silicon valley located next to Tsinghua and Peking University, as a high profile public diplomatic visit to boost the societal interest in grassroots innovation and start-ups. This is certainly an area with much promise for China; experts assessing long-term trends of Chinese economic variables need to pay more attention to this.

The “Human Capital Dividend”

Last but not least is China’s impressive accumulation of human capital. Perhaps next to the United States, China remains the only “big elephant in the room” increasing its size of its advanced human capital. Human capital, a concept already present in Chinese classical literature, has been the driver of growth. A country’s ability to educate or attract (by migration) human talent is a core variable enhancing growth. Succinctly, Michio Kaku – a famous futurist – has named the H1B Visa as America’s top secret weapon; for it is the foreign born scientists and managers holding that very Visa that produce America’s disruptive innovations and win Nobel prizes.

The impact of the Anti-corruption Campaign

Part of the peculiarity of the Chinese political economy is the recent massive anti-corruption campaign led by president Xi Jinping. The massive scale of the anti-corruption drive has affected China’s non-tradable sector and has significantly limited economic activity in conspicuous consumption and to a certain extent frivolous public procurement. While no published econometric research has assessed the economic impact of the anti-corruption campaign on Chinese GDP growth, the author would be surprised if this is not significant. In the short to midterm, the campaign will adversely impact GDP growth, however in the long term the returns will be strictly positive, as China will economize resources and the distribution of output will become more efficient.

Geo-economic and residual factors

Presenting a short, comprehensive assessment of the Chinese economy must leave many factors unexamined and perhaps simplify many others. For instance it is also relevant for the future of China that the prices of commodities are at a historic low (partly but not solely because of China’s lower growth). To the extent that this trend will continue, the Chinese economy can economize on resources and enjoy higher returns on infrastructure investments.

In addition the current geo-economic game between the United States and China, each pursuing a strategically competing trade strategy with regional agreements will also affect Chinese trade and growth. Many neocons in the United States are pushing for stronger emphasis to the “containment” factor of the U.S. hedging “contain and engage” strategy toward China arguing that slower Chinese economic growth will weaken Beijing regional assertiveness. The politicization of Sino-U.S. economic relations however will be a detrimental factor for the strategic engagement between Washington and Beijing and needs to remain a fringe agenda.

The peculiarity of the Chinese system and the very size of China tend to encourage overly simplistic analyses of the Chinese economy. China is not melting, nor will it ever return to double-digit growth. And while rightfully many advisors have urged Chinese regulators to improve the efficiency of price signal and structurally reform the economy from investments to consumption, what matters perhaps more pressingly for both the Chinese economy and global economic stability is sustainable multilateral coordination for harmonious economic governance. This includes key dialogues on the importance of industrial policies (UN industrial unit), green energy, monetary and financial stability (Basel Committee on Banking Supervision) and the creation of truly neutral institutions that coordinate national economic policies to normalize global economic cycles.

It is a grave mistake to politicize economic reforms and look to the world as a zero sum game. As Larry Summers – a heavyweight of strategic economic intelligence put it in his latest assessment of USA’s global economic statecraft, American and Chinese producers are competing, yet aggregately, China and the United States are net beneficiaries of their economic exchanges and of global economic growth. This should be the overarching imperative influencing discussion on the future of China’s economic reforms instead of the current focus on Xi’s internal political initiatives and both Xi and Obama should utilize their forthcoming meeting in Washington’s Nuclear Summit to set the key agenda of the summer 2016 U.S.-China strategic economic dialogue.

To be sure, internally and in the near term, the Chinese economy will of course face transitional difficulties harmonizing Keynesianism with SOE’s reform and the internationalization of its financial system. In the longer term China will be a winner. Because of the size of its market and as far as the CPC endorses liberal globalization, European and American economic agents will continue to engage with China. The current hype about China’s stock exchange bubble is a failure to understand that China is simply maturing towards a “new normal” and will continue to drive global growth. It is in the cards as well as the crystal ball.

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