Yeqing's bookshelf

China’s meteoric economic rise has created its share of admirers and its share of detractors, not to mention an equal measure of fear that Beijing may either succeed or fail. Can China harness the strengths of its economy for the good or will its deep societal ills rise to the surface? Pei argues that the effects of severe environmental degradation, an unruly populace and a diseased infrastructure cannot be underestimated. Anderson believes China’s GDP juggernaut will continue going strong. It may even break world records.

Looming Stagnation by Minxin Pei  

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.

Beijing’s Exceptionalism by Jonathan Anderson 

IS CHINA’S rise inevitable? Well, as we’ve learned to our great chagrin over the past twelve months, there’s nothing inevitable about continued rapid economic expansion or the near-term success of any economic model, and past performance is most emphatically not a guarantee of future returns. And, as with any lower-income developing country, there are plenty of visible and unforeseen pitfalls that could hurt China’s growth prospects over the coming years and decades.

However, as author and newspaperman Damon Runyon famously remarked, “The race is not always to the swift nor the battle to the strong—but that’s the way to bet.” And when taking odds on the potential of today’s emerging markets to mature into wealthier and more powerful states, you had best be betting on China.

The mainland is already getting there faster than any major economy before it. And, the risks of an outright economic derailing over the next ten to twenty years are much lower than commonly believed.

IN A debate often dominated by conjecture and assertion it helps to focus on hard data, and at the macroeconomic level, here are the hardest numbers we have: in the three decades between 1978 and 2007 the official Chinese GDP grew at an average real pace of 9.9 percent. Of course, the quality of historical growth figures has generated an intense academic debate, and many researchers conclude that real growth has been overstated for a variety of reasons (such as under-measurement of inflation and other distortions in the traditional socialist statistical system); however, even the most skeptical analysts still come out with numbers of 9 percent year over year (y/y) or above for the postreform era.

How does an average growth rate of 9 or 9.9 percent compare with other major historical cases? As it turns out, whether we take the top or the bottom end of the range, China is a world-record holder. Over its peak thirty-year growth period Japan grew “only” at an average real rate of nearly 8 percent, and between 1960 and 1995 the high-growth Asian “tigers” expanded at paces of 7.8 percent in Hong Kong, 8.3 percent in South Korea, 8.4 percent in Singapore and 8.9 percent (the previous record) in Taiwan. This is not all; with the sharp slowdown in mainland birthrates since the 1970s, China’s outperformance in terms of per capita income growth is higher still.

The next set of figures concerns the sources of that growth. Remember from first-year economics that in the most basic formulation there are three ways for countries to grow: (i) by adding more labor, (ii) by adding more capital, and (iii) by combining capital and labor in better and more productive ways. The latter is so-called “total factor productivity” (TFP) growth, and is in many ways the best single measure of long-term economic success because it gauges the “quality” rather than just the quantity of growth.¹ Here, as well, researchers have carried out detailed studies of China’s growth composition. Estimates of historical-factor-productivity growth tend to run from 2 percent y/y to 4 percent y/y, with the broad bulk centered around 3 percent. That is, as best we can measure, just under one-third of China’s growth is coming from rising productivity.

How does this compare with other parts of the world? Once again China posted a record performance. For much of the postwar era, the industrialized West saw annual TFP growth rates of up to 2 percent; the average for Japan and other high-growth Asian countries was around 2.5 percent—with no other region coming even close to these numbers. So productivity growth of 3 percent or thereabouts puts the mainland economy at the very high end of global experience.

And this brings us to our final set of hard numbers. In 1990, average Chinese national income in prevailing U.S.-dollar terms was $350 per head. By 2000, that figure had risen threefold to $1,000 per head, and, as of the end of 2008, per capita income had tripled again to $3,000. If China continues to grow at 8 percent y/y or above in real terms for the next two decades, then in present-dollar terms, per capita income could easily reach $8,500 by 2020 and $20,000 by 2030. This puts average mainland incomes above where Taiwan and Korea are now—i.e., solidly middle class and eligible for OECD membership—and also puts the total size of the Chinese economy above the combined level of the United States and the European Union today.

Let me summarize here for emphasis: in strict macroeconomic terms, so far China is unambiguously the most successful emerging economy of the postwar era. And at the current pace of development, China’s “rise” is not some hazy prospect shimmering on the distant horizon, but a concrete reality only twenty years down the road. Most important of all, as laid out above, the mainland doesn’t need to grow at a breakneck pace of 10 percent per year to attain developed-country status by 2030; 8 percent will do nicely, and even if trend growth drops to 6 percent or 7 percent, this simply pushes back the arrival date by a few years.

In other words, if you want to argue for China’s failure, it’s not enough to say that the economy will slow. Instead, you need a massive disturbance or outright crisis that derails growth for a long, long spell—and you need it fairly soon.

In today’s public debate there are plenty of potential hazards to point to, including bubbles bursting, global depression, social tensions, loss-making state enterprises, an inefficient socialist model and the lack of political freedom. And as I stated at the outset, there’s no guarantee whatsoever that one or more of these elements won’t suddenly overwhelm China’s growth prospects and drag the economy down. However, an objective look at risk factors shows that they are moderate, with little to suggest that the economy faces a looming crisis anytime soon. With apologies for the brevity imposed by space constraints, let me at least give a broad outline of the main arguments here.

FIRST UP is perhaps the most obvious and pressing concern, which is China’s fate in the current global recession. Export volume contracted outright in the fourth quarter of 2008, and the turnaround in local stock and property markets has sent domestic construction and industrial spending down sharply as well. With the prospect of much-slower growth and rising unemployment this year, it’s natural to wonder if this is the shock that could send the mainland over the edge.

However, by any measure China is one of the least export-exposed economies in the Asian region; only around 8 percent of the mainland workforce is employed in export industries, and light-export manufacturing, such as toys, textiles and electronics processing, accounts for a smaller share still of total Chinese investment spending. Even at the very peak of the recent trade expansion, net exports drove no more than one-sixth of overall GDP growth. This helps explain why China was able to keep right on growing during previous sharp export recessions, such as the global IT bust in 2001–02, and why it will take much more than falling exports to seriously impair medium-term-growth prospects today.

Turning to the domestic economy, China’s local stock market shot up nearly sixfold between 2005 and 2007 before suffering an equally dizzying fall in the past fifteen months, raising concerns of a Japan-style “postbubble malaise.” On the other hand, this is nothing new; for the past two decades Chinese stock prices have inflated wildly every five years or so followed by equally abrupt declines. The important fact is that even today equities account for a very small part of household and corporate balance sheets, that is to say, in real economic terms China’s stock market is still little more than a sideshow.

Housing and property markets are a different issue. As we have seen in the United States, property recessions can wreak significant havoc—but the key here is that China looks nothing like the United States. Consumer mortgage debt is tiny, average loan-to-value ratios are extremely low as well, nationwide home prices have actually declined relative to incomes for the past decade and absolute inventory levels haven’t budged since 2004. So while Chinese sales and construction volumes fell sharply last year and home prices are now contracting on a nationwide basis, there’s little in the data to suggest that the current property woes are anything more than a painful cyclical correction.

NEXT TO address in the debate over China’s rise is the persistent idea that since the country is nominally socialist, the economy must have muddled through so far due to the efforts of central planners who ignore free-market principles and allocate resources against all economic rationality—and just like the Soviet Union before it, China is threatened with a nasty shock if and when market forces finally prevail. A lighter version is that China is overdependent on the “extensive” growth model, i.e., planners are good at throwing capital and labor at a problem but bad at getting returns on investment; once the economy starts to run out of resources the entire system could falter.

According to the data, however, neither of these is a real concern. The single-best indicator of the quality of overall resource allocation in any economy is one already discussed—total-factor-productivity growth. For the Soviet Union, the figures were simply awful. On standard measures, the Soviet economy actually saw TFP levels fall by nearly 1 percent per year in the final two decades of its existence, the worst performance of any major region in the world and an accurate reflection of the hugely distorted nature of the economy.

Meanwhile, as we saw above, China not only had positive TFP growth for the last three decades, but one of the absolute-best productivity performances on record. This is mirrored in financial data such as industrial profitability, corporate returns on equity or returns on invested capital. Regardless of the measure you choose, China has seen consistent improvements over the past fifteen years, and, even in today’s global slump, margins and capital returns have remained near record-high levels.

Nor is there any indication that the “extensive” part of mainland growth is in danger anytime soon. Much has been made of the looming demographic downturn, but this almost completely misses the point; if we look at China’s historical growth pattern, only perhaps one-sixth came from labor expansion, with another third from factor productivity—and the rest was due to new capital creation. In other words, just as in China’s Asian neighbors, the real heavy lifting in trend growth was done by savings and investment.

How likely is it that China will run out of savings to invest, or profitable destinations for its capital? Rising productivity and respectable corporate returns tell us that the latter issue is not a concern, as China still has plenty of areas for profitable investment at home. And on the former front, remember that the mainland currently exports around 10 percent of its GDP in excesssavings to the rest of the world, by far the highest level of any major economy.

ACCORDING TO current statistics, roughly 25 percent of Chinese GDP is generated by state-owned enterprises, or SOEs. To most readers this brings up a specific set of connotations: state enterprises generally do not run on market principles, depend on government for resource allocation and economic decision making, suck resources and subsidies from the “good” part of the economy, hide behind protectionist walls and often destroy value outright—causing outputs to be worth less than the cost of producing them. So even if the private sector is buoyant and profitable, having a “dead weight” of this magnitude risks pulling the rest of the economy down with it.

The trouble is that none of those characteristics really hold true in China. Industrial statistics show that mainland SOEs are more profitable on average than the private sector, and even when we adjust for sectoral differences there is almost no visible difference between state-owned and private profit performance. With the exception of recent short-lived fuel subsidies, the government does not hand cash to state companies; quite the opposite, SOEs pay far more in net taxes to the government than their private counterparts. And sectoral data suggest that overall productivity and margin growth have been a good bit faster in heavy-industrial state sectors than, say, in foreign-funded light-manufacturing export firms over the past fifteen years.

Many may ask how this is possible. The answer is that there’s not much “state” left in China’s state-owned enterprises. In most emerging markets you will find, say, one large, state-owned telecom company, one automaker, one airline and so on down the line—usually companies that are heavily protected and often loss making. By contrast, the mainland has dozens of major automakers and airlines, hundreds of steel companies, a good handful of major telcos, power producers and the rest. Most of these firms may be state owned, but they compete aggressively with one another; entry barriers are very low even by Asian standards, with many sectors highly open to private and foreign investment.

Moreover, only the very largest SOEs have any guarantee of existence at all, as they discovered in the late 1990s when then-Premier Zhu Rongji mercilessly shut down tens of thousands of state-run companies because they were neither profitable enough nor large enough to be worth saving, thereby putting more than 25 million state workers on the street. Major SOEs still enjoy preferred access to commercial-bank resources, but this access is fading rapidly as banks are under strong pressure to hone their focus on profits and cash flow. And the state now has almost no direct say in corporate investment and production decisions, having dismantled the (largely rubber-stamp) government-investment-approvals process a number of years back.

THEN THERE is the question of how China can grow without democracy. The idea that economic success puts the rising aspirations of the middle class on a collision course with China’s authoritarian regime is a cherished tenet, and the recent wave of rising social unrest is often touted as proof that a painful clash is imminent. However, while there’s little doubt that China will face growing political frictions and some painful choices over the next decades, there’s also little to suggest that the country faces a looming crisis.

In fact, when it comes to Asia, the better question may be: how can you grow with democracy? After all, every one of the region’s economic success stories over the past thirty years—Japan, South Korea, Taiwan, Hong Kong, Singapore, Malaysia—happened in what was effectively a one-party state, and some had governments as authoritarian as China’s. By contrast, countries with consistent or intermittent periods of democratic rule, such as the Philippines, India, Bangladesh, Pakistan and Thailand, came in toward the bottom of the growth list. Clearly the lack of contested elections was not a hindrance to growth in Asia; indeed, it was one of the best predictors of success.

This is because Asia’s economic winners may not have had democracy but they did have capitalism. All of the high-growth countries had a strong market orientation and a commitment to globalization; they generally also had strong governance institutions with some measure of social accountability. In effect, there was an unwritten contract with the populace that as long as governments delivered the goods in terms of growth, the citizenry would hold off on democratic aspirations until the economy reached a stable, middle-class income plateau.

Is China different, and could the political order fall apart well before incomes reach more developed levels? To make this claim, there are two possible lines of argument. The first is that the mainland simply isn’t as “capitalist” as the Asian tigers were, with less market orientation and more state distortions and problems. I’ve already disputed this idea for China itself, but I should also stress how well the mainland holds up in a comparative sense.

At one-quarter of GDP, China’s state-owned economy today is largely comparable in size to the historical role of Japan’s keiretsu and South Korea’s chaebol in their own economies, with the crucial difference that mainland SOEs are a good bit more exposed to market forces. Foreign direct investment plays a far bigger role in nearly every industrial sector in China than in Japan and South Korea even today, not to mention in the 1970s and 1980s. By any measure, China has much greater domestic competition within industries than its north-Asian neighbors, and large Japanese and South Korean firms arguably received more effective support and subsidization from their “main bank” relationships than mainland SOEs do from Chinese state banks today.

The second argument is that the Chinese state is more rigid and less responsive—and that a rising wave of social unrest is already threatening political stability. Even by the government’s own statistics there has been a marked increase in public or “mass” disturbances since the beginning of the decade, and reports of unruly demonstrations and violence are common in the foreign press.

But, there’s just one caveat. Very few of these disturbances involve higher-income urban residents, or for that matter urbanites at all; instead, the vast majority come from farmers and rural migrants. In other words, this is not the aspiring middle class “rising up” against authoritarian rule, but rather the poorest segments of the population chafing against their plight. And, as it turns out, their gripes are founded in economic issues, not political ones.

Let me explain what I mean. As China pursued enterprise reforms during the 1990s, one of the consequences was a collapse of budgetary finances; at the lowest point, general government revenue had dropped to less than 10 percent of GDP, more reminiscent of an African nation than a nominally socialist state. This left the authorities with barely enough funds to maintain civil-service employment, forcing sharp cutbacks in education, housing and medical services. And by far the worst affected were county and village governments, which were left to fend for themselves by exploiting their own base: levying taxes on farmers and expropriating land.

The other problem was rural incomes. Local farm prices were flat or falling from the mid-1990s through the early part of this decade, and Chinese farmers saw very little income growth at a time when their urban counterparts were gaining wealth at a record pace. With flat earnings, rising taxes and fees, village governments selling off farmland at minimal compensation and migrant wages stagnant as well, it’s little wonder the mainland saw growing rural disturbances.

But now look what has happened over the past half-decade. To begin with, budgetary revenue has rebounded steadily as a share of GDP, reaching 20 percent in 2007, and suddenly the center is flush with cash. This has meant rising transfers to local governments, increased spending on health and education, and the removal of all agricultural taxes in the last few years. Second, the authorities have undertaken significant changes in land-tenure policy, including better guarantees of a farmer’s claim to a specific piece of land, a more transparent sales and transfer regime, and more avenues for legal recourse. These leave less scope for local corruption and more gains to farmers from future land transactions.

Third, since 2004 there has been a large trend rise in domestic food prices, driven by rising urban consumption and the natural decrease in supply due to past land sales. And over the past three years real farm-income growth at last caught up with and even exceeded the urban pace of wage increases. Finally, rural migrant wages have also jumped over the same period as a result of tighter labor markets caused by fewer young, mobile workers.

The bottom line is that China has seen considerable structural and largely market-driven changes that are already fundamentally altering the rural income balance, and should go a long way toward addressing the economic problems leading to the recent unrest. This year and the next will be tough, to be sure, as weak export markets and, especially, falling construction demand take a toll on migrant employment—but as I argued above, these are cyclical issues that are unlikely to prevent a return to trend growth in the near future and over the long term.

Pei Responds: 

DEBATING TOP-NOTCH economists, especially a highly respected and knowledgeable one like Jonathan Anderson, apparently borders on intellectual masochism for a political scientist. But because most economists are handicapped by an intellectual tunnel-vision problem—they tend to use economic growth as the only mark of social progress and ignore the overall context in which economic development takes place—this contest is not only winnable, but also can be intellectually fulfilling.

Jonathan starts out by using what he calls “hard data” to argue two points. First, on the economic front, he points out that China’s economic growth for the past thirty years has been driven by productivity growth (hence, it is of high quality), and that its state-owned enterprises have become market oriented and more profitable, on average, than private-sector firms. Second, Jonathan sees the risk factors that could derail China’s growth as “moderate”; he believes that social tensions in China are driven primarily by economic factors that will be easily fixed with China’s continued growth (poor social services in cities and low income growth in the countryside); and, that the lack of democracy rather than being a real danger is instead “one of the best predictors of success” in Asia.

Unfortunately, Jonathan makes three mistakes that undermine his optimistic forecast of China’s rosy economic future. First, the data he cites as “hard” are actually quite subjective. At best, they paint an ambiguous picture of China’s economic performance. Second, he understates the degree to which the Chinese state is entrenched in the economy and overstates the level of performance by the SOEs. Finally, in typical economist fashion, he ignores the so-called elephant-in-the-room risk factors—environmental degradation, high socioeconomic inequality and corruption—and downplays the future impact of an aging population and the potential for social conflict. It is not just the economic fundamentals that he has misjudged but also, perhaps more importantly, China’s societal and political weaknesses.

MEASURING ECONOMIC performance is hard, even for economists. One of the best yardsticks is, as Jonathan points out, total-factor-productivity growth. Unfortunately, estimates of China’s TFP growth are highly contestable. Based on research by leading American and Chinese economists, China’s TFP growth rate has been declining in the past decade, so using the average TFP growth data for the past three decades is not a reliable way to forecast China’s future growth. It merely spreads the gains out over time, thereby masking the recent downturn.

Further, it is probably too generous and truly unrealistic to use TFP data alone to assess China’s economic performance. TFP marks productivity gains, but what if such gains do not accrue to the average Chinese citizen? What if rapid GDP growth is not accompanied by commensurate growth in household income and consumption? This is where China comes up short. While its GDP growth for the last three decades approached 10 percent a year, the growth of household income was lower (the weighted household income rose at about half of the per capita GDP growth rate in rural areas and at roughly 75 percent of the per capita GDP growth rate in the cities). Simply put, an average Chinese does not have the money to buy Chinese products (especially since he must also save for health care, education and retirement due to a tattered social safety net). This has led to a level of consumption that has shrunk to a historical low in recent years. Such evidence suggests that China may have a large economic output, but it has not been fully translated into increased individual welfare, hindering the growth of domestic demand and the overall health of the economy.

When it comes to Jonathan’s assertions about the state’s role in the economy, he again looks to data rather than nuance. The influence of the Chinese state in the economy vastly exceeds the direct output of SOEs. Jonathan argues this number runs to about 25 percent of GDP. In actuality, SOEs account for a much-higher percentage of the economy; my debating partner has not included many companies in which the state has a controlling interest. Even more so because the Chinese government controls the price of capital and land, and limits entry to strategic sectors of the economy, its influence in the marketplace is far more extensive and potent than most people realize. Chinese SOEs are also not as productive as Jonathan tries to show through his data. Their profitability comes from their monopoly status, not from their competitiveness. In fact, 80 percent of SOEs’ profits come from a handful of giant state monopolies, such as China Mobile, China National Petroleum Corporation (CNPC) and Sinopec. Research shows that, in terms of marginal capital output, SOEs are about half as efficient as private and foreign firms operating in China.

Finally, Jonathan should have taken into account the impact of environmental degradation and rising social injustice (compounded by inequality and official corruption) on China’s economic future. Given the extent of environmental pollution and the costs of mitigation and protection required to make China a country in which people can breathe, drink and eat without getting poisoned, no economic forecast of China’s future will be persuasive if it downplays or overlooks the environmental risk factor. And above all, while the normal ebbs and flows of an economic cycle may help explain social grievances, they are not the sole cause and it would be wrong to ignore other factors. In fact, in many recent large-scale riots, economic factors were conspicuously missing. What is important is that when a fast-growing society is perceived by its people as unjust, as China is today, its rulers are sitting on a ticking time bomb.

That is why Chinese leaders are calling for a “harmonious society.” Regrettably, even the best economists have missed the political warning signs.

Anderson Responds: 

LET ME start by repeating my conclusion from the main article: to argue against China’s eventual rise it’s not enough to point to vaguely perceived imbalances or assert that the economy can’t go on exactly the way it was before. We need more than a little grit in the wheels to slow the country down—instead, we need a definitive, fundamental crisis that pushes China off the growth path for a long time to come. And we need it soon, ideally within five to ten years.

Now, as an avid follower of Minxin’s work, it’s a pleasure to have a chance to comment on his views, and he clearly provides an engaging review of long-term challenges for the mainland economy. But has he made the case for a looming crisis? Unfortunately, the answer is no—and on most counts the arguments fall very wide of the mark indeed.

One of Minxin’s main propositions is that the state’s role in the economy is unhealthy and out of proportion, that Beijing created a false sense of economic well-being and a flawed set of economic structures. He asserts that the government creates massive economic distortion by manipulating key input prices such as those of energy, capital and land. Yet to start, I must ask, what energy mispricing? For the past two decades Chinese fuel prices have been set more or less at world levels, with the exception of the short-lived 2007–08 subsidies as a response to global crude price spikes, and, as I write, Chinese consumers are paying more for fuel than their U.S. counterparts. There is no “world price” for electricity, which makes comparisons harder here, but while China regulates prices, it does not subsidize electricity production or distribution.

He talks too about the government’s heavy hand in the corporate sector. But here again, where are the chronic subsidies Minxin mentions? With the exception of the 2007–08 payments to oil refiners, China has not given cash handouts to industrial state firms for a very long time. As I noted, quite the opposite is true; SOEs today face a much-larger tax burden than the private sector and are the largest provider of funds to the government.

The government does provide an implicit subsidy to banks by putting a ceiling on deposit rates and a floor on lending rates. But while this artificially depresses the return to Chinese savers, it also imposes an artificially high cost of funds on corporate borrowers. In other words, China is not subsidizing capital; if anything, it is taxing it.

Minxin is correct that there was a time when SOEs were not expected to repay loans, but as a macroeconomic phenomenon this era effectively ended in the mid-1990s when the government began to shut down debtors and impose hard budget constraints on banks and firms. As a result, the vast majority of China’s “massive” nonperforming loans (NPLs) were extended before 1997—and, following a subsequent extensive cleanup, mainland state banks now have very low NPL ratios by emerging-market standards.

As for the argument that China is getting a decreasing return on investment, Minxin is not so much wrong as misguided. One of the very definitions of long-term economic development is the accumulation of capital, which in turn automatically means falling returns on new investment; if RMB 100 of new capital spending yields less new output than before, this is more likely a measure of success than failure in a rapidly growing economy.

How can we know for sure? For serious economists, the answer is to look at the returns to labor as well. If labor efficiency is rising faster than capital returns are falling, the economy is healthy; if not, then there is a stronger case that growth is imbalanced and distorted. The one numerical indicator that captures both capital and labor efficiency—and thus the single best measure of long-term economic success—is total factor productivity, and as I discussed earlier nearly every available study done on this basis finds very high rates of TFP growth in China.

Most important of all, if we look at bottom-up measures of corporate returns for any given sector, it’s difficult to find even one industry where net margins, return on equity or return on invested capital failed to rise on average over the past decade, i.e., precisely the period during which Minxin claims China should have been careening into hopeless overcapacity.

Minxin also cites demographics as a potential source of economic stress. However, although there’s no question that China faces an eventual decline in labor-force availability, this is a profoundly long-term process, particularly when we consider that China still has another 75 million or so underemployed rural workers waiting to come into industry and services. And remember that labor growth contributed only around two percentage points to trend growth in the first place; the majority was explained by capital investment and rising efficiency. So while demographics can slow the mainland down at the margins, this is hardly a revolutionary turning point.

Minxin is also correct that aging societies generally save less, and I have little argument with his estimate of 5 percent of GDP for eventual household-savings losses—but this can hardly matter for China today, which exports a full 10 percent of GDP in excess savings to the rest of the world. By any reasonable calculation the economy could lose three times Minxin’s figure in terms of lower savings and still grow very comfortably at 8 percent or above.

In addition to economic factors, Minxin also addresses what he sees as deep societal fissures, from inequality to the environment. As a long-term resident of China, I have no interest in downplaying the considerable environmental problems plaguing the country. However, it’s one thing to point to bad air and bad water and quite another to argue that this will lead to economic crisis. If we accept that water availability is the most serious potential issue, then the math becomes surprisingly simple: by far the biggest user in China is the agricultural sector, and we will know that water is becoming a meaningful economic constraint when we see food production under pressure. And it may surprise many readers to discover that China is still a sizable net agricultural exporter, with no sign whatsoever to date of this trend reversing.

And now we come to what I believe are the most serious issues, where I agree with Minxin that the trends of the last decade—falling social expenditures and rising inequality—if left unchecked, could lead to grave trouble. And the figures he quotes are a broadly accurate reflection of reality . . . up to, say, 2003. As I discussed in the main article, these two problems were not failings of governance so much as adverse economic shocks (the late-twentieth-century collapse in government revenue and falling rural incomes). Over the past five years the underlying momentum has already changed dramatically. Again, Chinese government revenues have skyrocketed since the near-starvation days of the late 1990s and are now back on a par with most emerging markets, allowing for a significant ongoing expansion in social spending and transfer payments. And rural income growth between 2004 and 2008 was the best in nearly fifteen years, reflecting the economic impact of demographic changes and urbanization as well as greater government support. If the present renaissance continues, then what looked like an intractable dilemma five years ago could well become a distant memory in another five years’ time.

In sum, China is a good deal more market oriented than Minxin assumes in his writings—and the market is already sorting out China’s most pressing remaining problems.

Minxin Pei is a senior associate in the China Program at the Carnegie Endowment for International Peace. His most recent book is China’s Trapped Transition: The Limits of Developmental Autocracy (Harvard University Press, 2006).

Jonathan Anderson is a senior global emerging economist at UBS.

¹ Think, for example, of India and the Soviet Union. In the 1970s and 1980s both grew at exactly the same annual pace (4.2 percent)—but while the Soviet Union got there by artificially depressing consumption and throwing ever-greater amounts of capital into investment, India enjoyed high consumption rates and much lower capital-investment needs. To capture the difference between these two cases we have to measure TFP growth (which was positive in India and negative in the Soviet Union).