Fixing the Chinese economy – how to do it

china-economy4Amid feverish speculation about the trajectory of the Chinese economy, Hong Kong-based economist Kui-Wai Li traces the decade-by-decade history of economic reforms in China and maps the way ahead for creating a principle-based system to revive and sustain China’s economic growth.

China’s economic reform began in 1978 after the late Premier Deng Xiaoping had seen the hi-technology industries in his visit to both Japan and the United States. The motto “it does not matter whether it is a black cat or a white cat so long as the cat can catch mouse” opened up the drive to modernisation in China. Pragmatisation, liberalisation, marketisation and privatisation are the major features of economic reform. The “household responsibility system” introduced around 1979 that allowed agricultural surplus to be sold in the non-state market soon led to “million yuan households”. The establishment of a number of “special economic zones” along the coastal areas, which attracted the inflow of capital initially from overseas Chinese, had aided economic development and produced labor-intensive manufactured goods for exports.

Reforms: From 1980s to 2000

The reform in the 1980s began with a revitalisation of the four state-owned banks. However, the rise in income resulted in excess demand for household manufactured goods. Premier Zhao Zhiyang introduced industrial reforms that aimed at redirecting production resources from the Soviet-type heavy industry to light manufacturing industries. The economy soon had to grapple with industrial bottlenecks as the structure of heavy industrial production became outdated. Speculations and hoarding of raw materials appeared in 1987, and the excess demand for household goods soon resulted in large imports and rapid price inflation. The “foreign exchange certificate” (FEC) created at the beginning of the reform served as the “superior” currency as imports could only be obtained using FEC, while black market existed in the trading of the Renminbi. China’s first economic crisis emerged when there were divergent views between the reformists and the hardliners, resulting in the political turmoil in June 1989.

Economic reform was reinvigorated in 1992, but the turning point came in 1994 when Premier Zhu Rongji introduced the Austerity Plan that removed the FEC and devaluated the Renminbi by 30%, restricted loans to unproductive areas and at the same time encouraged investment in the more remote regions in western China. The 1995 bank reform formalised the central bank, encouraged state-owned banks to be more profit-oriented, and permitted other banks and financial institutions to operate in the market. The two stock markets in Shanghai and Shenzhen prospered, and increasingly Chinese corporations used Hong Kong’s stock market for their capital acquisition. The state-owned enterprises (SOEs) reforms in 1997 further promoted non-state businesses, but many large corporations have close relationship with either the provincial or central government. One can argue that the re-introduction of economics was the theme of the 1980s, but the drive to economic productivity could correctly summarise the activities of the 1990s. ‘

2000-10: China joins WTO

The key issue at the turn of the century in China has been the accession to the World Trade Organisation in 2001, which has taken over a decade of negotiation in the Sino-US trade agreement. The key obstacles had been the issues of intellectual property rights (IPR), trade openness, trade in services and finance. Over the years, China has made attempts to reduce tariffs and non-trade barriers and introduced IPR laws, but the effectiveness in the implementation and execution of the various laws has been questioned. Reinforced by the much-trumpeted Beijing Olympics in 2008 and the World Expo in Shanghai in 2010, the Chinese economy has performed massively in the first decade of the new century. Industrial export has been surging, making China the “factory of the world”, and the second largest world economy, surpassing Japan.

The rise in world status shows an external dimension, but numerous economic problems have cumulated over the years in China. Despite the anti-corruption call by various chairmen, premiers and party leaders, there is “more thunder than rain”, as a lack of effective implementation and the cohesive nature of the party and government officials served like a cartel. Although a large number of workers laid off from the 1997 SOEs reform has led to a steady growth in small and medium-sized enterprises (SMEs), the social welfare provisions for the elderly, public housing and health support have not been matched, resulting in social grievances. The rapid rise in earnings of many party and government officials has spawned numerous potential economic pitfalls. In addition, China for years managed to garner the largest trade surplus and foreign exchange reserve. China also attracted the largest quantum of foreign direct investment. Together with the continuous large money supply and capital raised from the stock markets, China is now experiencing a “cash rich” status. The continuous pressure on the revaluation of the Renminbi has led Chinese enterprises to invest overseas, mainly in areas that can secure energy, agriculture and raw material supplies from other developing countries.

Global Financial Crisis

The 2008 global financial crisis has brought new external problems to bear on the Chinese economy. The weak world economy has reduced China’s export and inward investment, and then Premier Wen Jiabao had to rescue the economy with more austerity plans, ending with massive amount of subsidies to households. There have been calls on expansion of domestic demand to boost local consumption and the promotion of local economy, but the lack of reliability on domestic output and the inadequate welfare protection have dampened domestic consumption considerably. Some would argue that 2008 was the turning point in the continued growth of the China economy, and attention would be given more to domestic issues, such as corruption and embezzlement of funds, the production of fake and toxic products and capital flight as the currency becomes more acceptable internationally. The roster of grievances is also growing by the day – the system on land use allocation has been distorted, widening inequality gap whereby the rich are spending with a vengeance, while the poor are facing crises and natural disasters that required mass assistance and subsidy.

Besides, rapid urbanisation has piled up pressure on the adequate supply of agriculture output, and the rising income has whetted demand for imported food. The one-child policy has been under pressure for further reform. It is well-known that the families of political leaders have exploited their positions and enriched themselves through personality and political influences.

New Leadership, New Challenges

The new leadership in 2013 under Chairman Xi Jinping and Premier Li Keqiang will have no easy task in bolstering the Chinese economy. The good news is that Premier Li has been trained as an economist. The economic challenges facing the new leaderships are two-folded. Externally, China’s economic might has led to new concerns internationally. How would China play a more responsible role in the world, or whether China would become a new “imperialist” in its use of economic power, especially to the less developed neighbouring countries? To the advanced countries, the concern obviously is that as a big economic power, China holds a different political ideology from other world powers. Domestically, the concern is how the leaders could bring China to a new stage of economic growth, and foster greater economic harmony between regions, and between state and non-state organisations and businesses. Although the Chinese economy has gone far in the last three decades, there are signs of full economic and industrial capacity.  What is needed is systemic reform that would install a fair and equitable economic system so as to eliminate personality and political influences. A reformed system is sorely needed which enabled individuals to show and maximise their own abilities and comparative advantages. In other words, a full-fledged and reliable system would become the agent or intermediary that stands between the individual and the government.

Next Steps

Based on the fundamentals of a market economy, one can suggest that the Chinese economy could proceed in the following steps. On the issue of human capital, there should be a greater improvement in vocational training and education to train middle management employees. In addition, business-related subjects, especially ethical issues, should be given greater focus in education. Social ethical behaviour could be promoted, improved and developed along with urbanisation and education in schools. There should be greater focus on bridging the gap between the development of eastern and western provinces. Similarly, the effort should be on plugging the gap between urban and rural areas, industries and agriculture production, and between different income groups and ethnic groups. The ultimate aim is to create new economic opportunities to benefit more common people.

China’s fiscal policy has been in deficit for years, due largely to the subsidy given to provincial and local governments, industries, infrastructure provision and households. No government can maintain a deficit for a long time without cumulating debts. Similarly, the monetary policy has been regarded as loose with large money supply and continuous growth in bank loans. The new leaders will need to tackle the financial and monetary economy to avoid potential crises by giving appropriate consideration to interest rate policy and exchange rate policy. The policy choice would be a decision between using more market instruments or adhering to central control, thought there has been a saying in China that things could be out of control without government instructions. But this is exactly what is needed: to institute a workable system that would replace government directives by systemic guidelines and rules as the problem, more often than not, has been the enforcement rather than the lack of appropriate rules and guidelines.

With a more advanced Chinese economy, further reform will involve a multi-tasking situation with multiple demands and the exercise of multi-level decision making. While coordination work requires some degree of effective control, the institution of an orderly, disciplined and a principle-based system would eventually bring confidence and sustainability to the China economy.

(Dr. Kui-Wai Li is Associate Professor, Department of Economics and Finance, City University of Hong Kong. This article has been written exclusively for India Writes, It is part of the ‘China Connect’ initiative of India Writes and The Global Insights India (TGII), which seeks to provide insights into key developments impacting the world’s second largest economy.)