The world has grown accustomed to China being one of the most powerful engines of the global economy. It has maintained a growth rate of more than 10% for five consecutive years while keeping inflation relatively low. Gross domestic product (GDP) increased to Rmb2466bn ($347.79bn) last year, bringing China ever closer to overtaking Germany as the world’s third largest economy. Exports grew by 25% in 2007, imports by 20.8% and foreign direct investment rose 13.6%. Profits at industrial companies rose almost 40% in 2007, the growth in fixed asset investment was up by 24.8% on 2006.
In the political and cultural realm, it has become clear that China – outside of party ideologues and within the constraints of its authoritarian system – has quietly developed a lively and broad-thinking intelligentsia. This hidden world of think-tanks is engaged in passionate debate about the future, pitching economic models against each other and drawing on a wide range of development ideas.
More surprising still, such concepts are increasingly being absorbed into the political process and are being used by the Communist Party of China to test the waters for ideas and increase the options available to decision makers. Intellectuals are now routinely asked to brief the politburo, and their reports feed into the party’s five-year plans. If China has already proved that authoritarian regimes can deliver economic growth, some observers wonder if, in the future, this emerging model of “deliberative dictatorship” could prove that one-party states can deliver social and political reform.
Miracles and mischief
If all this feeds the notion of the Chinese economic miracle, and greater cultural and intellectual freedom, then there is an accompanying list of problems that many believe could derail China’s economic juggernaut. For one thing, inflation is rising. Keeping a lid on it while the exchange rate is not free floating is difficult, but policy makers fear floating the renminbi because it will hit exporters. Likewise, the economy is unbalanced: it needs to move from export and investment towards public and private consumption, and from huge current account surpluses and reserve accumulations towards a more balanced external position.
There is widespread unease about China’s trade surpluses. There are backlashes against the rise of substandard goods and corporate China’s disregard for intellectual property rights and patent law.
More broadly, rampant growth has led to massive environmental degradation, which local authorities have done little to stem despite environmental protection policies issued in Beijing. Corruption and lack of rule of law are endemic. Debilitating power crises are seen as indicative of deeper problems, and nobody knows how much the repair bill will be for recent snow storms that devastated huge areas of the country. Disease has decimated crucial pig stocks, causing huge shortages and a rapid rise in the consumer price index. Despite a reduction in absolute poverty, there is growing inequality between the rich and the poor – in health and education, as well as in earnings – which has lasting implications for future development.
All of these trends have led to a steady increase in the number of protests and disputes: in 2005, the last year for which there are complete figures, there were 87,000 incidences of officially reported social unrest. Unofficial figures suggest this already outlandish number is growing.
In isolation, many of China’s challenges may be manageable, short-term or at least not disastrous. But what if all its problems come home to roost at the same time, just when the global economy slows down and its key export markets shrink? China proved remarkably resilient to the Asian crisis of 1997-98 and the global recession of 2001, and expectations are high that it will prove to be so again. But will its economic miracle stay the course?
Are we all wrong about China?
The inflation problem
Inflation is an immediate problem. As The Banker went to press, Chinese inflation was at an 11-year high. The consumer price index had risen to 8.7% in March (up from 4.4% in June 2007), driven by a 49% rise in meat and poultry prices. Meanwhile, surging crude oil prices had pushed up the producer price index by 6.6% in February 2008.
“We are entering dangerous territory,“ says Gene Ma, president and chief economist at CEB Monitor Group in Beijing. “Historically, the government has shown it can manage inflation spikes of around 5% [such as in 2004], but when inflation gets to 10% and more, as it did in previous inflationary episodes in the mid-1980s and early-1990s, they were unable to engineer a soft landing for the economy.”
While the diagnosis is straightforward, the treatment is more sensitive. Dealing with domestic inflation means addressing a broader range of issues, including the value of the renminbi and China’s trade imbalances with the rest of the world, and these are very touchy political issues, indeed.
Despite growing international pressure to reduce its trade surpluses, driven by an undervalued renminbi that has fed cheap exports, Beijing has so far refused to float the currency for fear that it would cripple the export sector and slow the economy too drastically. Instead, it has championed a process of slow currency appreciation.
To support the currency, the government has sterilised incoming foreign capital flows by issuing local currency bills to take the funds out of circulation. This excess liquidity has led to a massive expansion of the money supply, adding to inflationary pressure. And with US interest rates falling and Chinese rates rising, that policy is becoming more expensive for the People’s Bank of China (PBC) to follow. According to figures released by Goldman Sachs at the end of February, sterilisation operations are now costing China about $4bn a month.
Monetary policy not working
Instead of a significant exchange rate revaluation, China has relied almost exclusively on monetary tightening, raising interest rates and reserve requirements on bank deposits. Most believe that these are unlikely to work. First, there is already asset price inflation and extensive debt-financed speculative investment, so Beijing is constrained from meaningful tightening for fear of triggering a financial collapse. Second, raising reserve requirements on bank deposits lowers the return on deposits and makes them less attractive, which further encourages depositors to invest in property or stock markets, and spurs yet more asset price inflation. And third, the continued undervaluation of the renminbi results in continuing trade surpluses and large FDI inflows, which leads to more monetary expansion in China.
Traditional transmission mechanisms have so far proved ineffective. In 2007, the PBC raised one-year lending rates six times and banking reserve requirements 10 times – as well as imposing administrative measures dealing with bank lending and price subsidies – to little effect. This indicates that problems stem from the present exchange rate regime.
Revaluation would free the central bank from its monetary straitjacket to hike real interest rates into positive territory. It would cool the economy and help to rebalance the trade books, and help to reduce the impact of global commodity price inflation by lowering their domestic price in renminbi.
It may not be the kiss of death to exports that Beijing fears. Nick Lardy, senior fellow at the Peterson Institute for International Economics in Washington, says that Beijing’s “static” view on the impact of an exchange rate rise on the export sector’s profitability is out of date and not supported by the evidence. “Through the end of February, on a bilateral basis with the dollar, the renminbi had appreciated by 15% [since July 2005], and yet the trade surplus will be in the neighbourhood of $380bn – or more than 11% of GDP – when we get full-year 2007 figures,” he says.
“You have to ask: if the export sector is as fragile as Beijing makes out, how has it managed to absorb that much currency appreciation – as well as double-digit wage inflation – yet still grow its export sector and keep price rises down to around 1%? There must also have been some robust productivity growth in the tradeable goods sector, and I think Beijing underestimates this,” says Mr Lardy.
There are signs, however, that the government’s view is changing. “The understanding of inflation in China has changed a lot in the past few months,” says CEB Monitor’s Mr Ma. “When the PBC released its monetary policy report in February [for Q4 2007], it said expressly that a stronger renminbi can help China to correct its trade imbalances and rein in inflation. The latter is new, and acknowledgement of this is very encouraging. The problem is how fast the government will allow the renminbi to appreciate.”
In any event, Mr Ma says that there is clear evidence that the PBC will continue to tighten its monetary policy; the question, he asks, is whether it can, or will, tighten enough. “Last year, the PBC raised rates six times and reserve requirements 10 times. That is unprecedented. But the problem is that it is like running after a moving train. The PBC is running fast, but the train is moving faster because there is so much liquidity,” he says
Asset bubbles
Rampant asset price inflation looks increasingly like a bubble ready to burst. Since bottoming out in the summer of 2005, the Shanghai stock market had gained 295% from trough to peak, before beginning to correct in October 2007. Although it is no more than a drop in the bucket of previous gains, the market is on the way down; at the end of February, it had dropped by 24% from its highs last summer.
The key explanation for asset inflation lies in the distortions in the banking system. Households earn about 71 basis points on demand deposits, while headline inflation is currently 7.1%. Such negative returns have pushed more and more money into property and the stock market.
“There is no relationship between share price and the economic performance of domestic listed companies,” says Mr Lardy. “I’m not sure if there is a bubble but if there isn’t one, China has created all the conditions that would lead to the creation of a bubble.”
In the property market, the biggest threat lies in the southern cities of Shenzhen and Guangzhou. There, property markets have made huge gains in the past several years but are now cooling rapidly, at least partly in response to action taken by Beijing, which recently increased the minimum down payments on property to 40% from 30%.
The nation’s largest publicly traded developer, Shenzhen-based China Vanke, sold property worth Rmb4.23bn in November, 18% less than in October. According to ABN AMRO in Hong Kong, sales of new homes in Shenzhen have slowed to fewer than 20 units per day from 200 units in the recent past. There is now a glut of homes, and China’s real estate boom is beginning to look scarily similar to the US’s, which came to a crashing halt in 2006.
According to a report from ratings agency Moody’s, Chinese developers are among the most vulnerable of any group in Asia to downgrades because a slowdown in home sales would deplete cash. In December, Standard & Poor’s cut the credit ratings of Greentown China Holdings, the largest builder in Zhejiang province, by one level to BB-.
What would happen if, or when, the bubbles burst? Just one illustration of the scale of the problem is the size of the country’s retail investor population: by the end of 2007 it had exploded to 136 million, 10 times the number in 2006.
Many analysts argue that a collapse would have a limited impact on the real economy, but even if this were the case, a market crash would have far-reaching political consequences. Many publicly listed companies are state-owned, and the government has been an active promoter of the stock market. A massive sell-off would severely hit household net worth, and so tens of millions of individual investors would direct their anger at the government; they may even assume that the state is liable for the collapse of their share prices. If solid economic growth and a booming stock market have helped to legitimise the Communist Party, an equity market collapse would seriously damage the leadership’s credibility as competent technocrats.
If past behaviour is anything to go by, large-scale public protests are likely. In May 2007, thousands of furious investors demonstrated outside the headquarters of the ministry of finance just because it had increased trading tax by 0.2%; it precipitated an instant sell-off. The government is therefore unlikely to emerge unscathed from a market crash.
Growing civil unrest
Social unrest is already a persistent and growing problem for Beijing. The most recent official figures are for 2005, which revealed 87,000 reported incidences of public unrest (disturbances involving 15 or more people); this had risen from 8700 12 years earlier. Unofficial figures suggest that such incidences are still growing.
| Albert Keidel, senior associate at the Carnegie Endowment for International Peace, believes that the country’s recent problems may trigger another wave of instability. Mr Keidel says that until about 2005, taxes, fees and tolls caused the most protest; these were subsequently overtaken in 2005-06 by poorly compensated farmland seizures. “Now, rising inflation, environmental degradation and growing inequality are increasing causes of social unrest,” he says. |
Mr Keidel is not alone in fearing trouble. In a government webcast in January, Wang Zhikun, deputy head of China’s ministry of civil affairs, tried to head-off inflation-related dissent by vowing that the government would step in to help the poorest communities hit by the rising cost of food. Government-imposed price controls have failed to tame the surge in food prices since last year, which have already led to stampedes, injuries and deaths at shops selling discounted cooking oil, rice and eggs. Mr Wang promised that the government would do more. “If prices remain high, or get higher still, the money that central government spends in helping low income urban and rural dwellers will rise, and by a large degree,” he said.
Environmental degradation is a mounting cause of social ills and scandal. In May last year, thousands of protestors took to the streets of Xiamen following a text-message campaign, leading to the suspension of a petrochemical plant’s operations. In July, a chemical spill in Jiangsu halted the water supply to 200,000 residents.
In the same month, the head of China’s State Environmental Protection Administration (SEPA), Zhou Shengxian, admitted that the rising number of riots, demonstrations and petitions across the country was related to growing public anger at pollution. Mr Zhou called for a “struggle” against polluters.
The cost of degradation
The public has good reason for disquiet. Massive environmental problems have followed hot on the heels of rapid economic growth. In 2006, China consumed more coal than the US, Japan and the UK combined, and the environmental price is high: 16 of the world’s 20 most polluted cities are in China, four of them in the coal-rich north-east province of Shanxi.
The country is experiencing widespread deforestation and heavy pollution; a World Bank report says that air and water pollution kills about 500,000 people a year. China is already one quarter desert, which is expanding at a rate of 1300 square miles annually. Increasing water scarcity is spreading throughout the north and west of the country: the availability of water per capita in the northern plains, including Beijing, is only one eighth of the global average. The SEPA has admitted that many of the country’s main river systems are so polluted that the water is unfit for human contact.
Notwithstanding the need to quell growing public anger, there is a clear and mounting economic cost to environmental problems. The SEPA has previously stated that degradation and pollution cost the Chinese economy the equivalent of 10% of GDP annually.
| Elizabeth Economy, senior fellow and director for Asia Studies at the Council for Foreign Relations, cites figures such as $36bn in lost industrial output from a lack of water to run factories, and $13bn from the health impact of acid rain. |
“The evidence shows that local economies have been severely affected,” says Ms Economy. “For example, desertification is drying up opportunities for agriculture and animal husbandry, and creating millions of environmental refugees. Along the eastern seaboard, [the size of] the prawn catch in the Bo Hai sea has fallen by 90% since 1990, decimating that part of the fishing industry. Moreover, tainted food products are also harmful to China’s trade efforts.”
Beijing versus the provinces
Much of the blame for environmental problems is laid at the door of heavily polluting companies that flout environmental guidelines. A recent inspection of 529 firms along the Yellow River, Yangtze and other major waterways found that 44% had violated environmental laws; nearly half of the 75 waste water treatment facilities underperformed or did not work.
In his comments last year, the SEPA’s Mr Zhou called for local officials to stand up to violators. Unwittingly or not, he identified a key problem and one of Beijing‘s biggest weaknesses: the disconnection between agenda setting by the government and enforcement at a local level. Local officials ignore environmental mandates in favour of attracting investment, jobs and bribes. And because the problems are seen by the public to emanate from government, most cases of unrest are directed towards local authorities and officials.
This highlights what may prove to be a more pervasive political problem for Beijing. Whether it is repressive or arbitrary local taxes, land grabs by officials, non-enforcement of environmental laws, or the use of local thugs to demand compliance to damaging development, people have begun to connect the political regime with the hardships that the general populace faces.
Overcoming public disquiet, and ensuring that local authorities follow Beijing’s rule, may require revolutionary bottom-up political and economic reforms, says Ms Economy. “The lack of transparency, rule of law and official accountability mean that data cannot be trusted, corruption is rampant, and there is little recourse for environmental redress through the legal system,” she says.
“China’s environmental problems stem as much from its corrupt and undemocratic political system as from Beijing’s continued focus on economic growth. Improving the environment is not simply a matter of mandating pollution-control technologies; it is also a matter of reforming the country’s political culture.”
Beijing may be forced into action, because from greater economic freedom has followed higher expectations, and a citizenry is emerging that is increasingly defiant of the authoritarian apparatus. Where once it was militant students or the landless and the poor who agitated, now even the newly rich middle classes, who rarely take to the streets, are joining in. The most recent incident came in January this year, when well-heeled protesters staged a ‘stroll’ in the financial district of Shanghai over fears that the magnetic levitation railway emits radiation. Peaceful it may have been, but it was also an unmistakable act of defiance by a previously compliant segment of the populace.
More responsive government
There are signs that Beijing is reacting in terms of meaningful policies and administrative change. For example, leaks about ministry changes ahead of the party congress last month, showed that Beijing is responding to environmental problems and is putting in place a structure that will enable Beijing to enforce its directives at the local level.
“There has been a substantive change in Beijing. Many of the problems have become too big to ignore and there is a lot of public pressure,” says Mr Ma. “It was leaked at the end of February that when the congress convenes in March [previously it was a sub-ministry]. This is very important as it will give SEPA the same status as local government and the power to enforce environmental standards.”
Beijing has made other changes that signal its growing sensitivity to the problems faced by its citizens and its determination to rein in local government corruption. On the eve of the Lunar New Year, the government issued ‘No 1 Central Document’, a landmark edict on land rights for the country’s 700 million rural population.
Although land laws have been passed since the 1990s, local implementation has resulted in land rights being illegally readjusted or reassigned to outside developers, and land taken by cadres and sold for enormous profit, with woeful compensation for farmers. Thus, little of the wealth created by China’s reforms in the past 30 years has made it to the countryside.
The 2008 edict is extensive, and forcefully spells out a new framework. For the first time, Beijing calls for the establishment of a rural land rights registration system and says that land rights certificates must be issued to every farm household; it spells out that local governments and cadres must implement rules strictly; it states that no land expropriations will be approved until all safeguards are satisfied, and compensation is deemed adequate and has been delivered to farmers.
The government still has much to do to put teeth into the policy, but many people in China believe this is a turning point in land reform. In an article in the South China Morning Post, Li Ping, head of the Beijing Representative Office and a staff attorney at the Seattle-based Rural Development Institute, which contributed to the recent Cato Institute policy paper ‘Securing Land Rights for Chinese Farmers’, wrote: “The clear implication of this powerful new document is that Beijing finally means business on securing land rights in farmers’ hands.”
New, improved one-party state
Political discourse, too, has entered a new phase. In his recent book, What does China think?, based on three years of discussion with Chinese thinkers inside and outside of the Communist Party, Mark Leonard, executive director of the European Council on Foreign Relations, unveils a far more contemplative intellectual class than many may imagine exists inside China’s one-party state.
Mr Leonard argues that economic growth is no longer seen as the overriding goal for the Chinese state; that there is more talk about the introduction of a welfare state, and promises of an increase in the funds available for pensions, unemployment benefit, health insurance and maternity leave. Rural China is not only promised an end to arbitrary taxes, but also improved health and education. The template for a new Chinese model blends the idea that markets will drive economic growth, but expresses concern about inequality and the environment, and a quest for new institutions that can marry competition with co-operation.
Although China’s idea of democracy is not the same as that in the West, Mr Leonard reveals that experimentation with aspects of democracy abound. Ideas such as the use of elections only at the margins, but making public consultations, expert committees and surveys a central part of decision-making. Even if there will always be the same leadership – the Communist Party – there will be more choice about the policies it implements, he argues.
For example, in Chongqing, the local government has made all significant rulings subject to public hearings, in person, on television and on the internet. Hearings on ticket prices for the light railway resulted in fares being reduced from Rmb15 to Rmb2 (about 28 US cents). This experiment is being emulated in other cities around China.
In another example, the small township of Zeguo in Wenling City is using “deliberative polling” to make major spending decisions. Following a process of consultation, a random sample of the population votes on issues. Zeguo used this technique to allocate its Rmb40m public works budget. In discussion with Mr Leonard, Chinese political scientist He Baogang suggested that one-off experiments with this type of “deliberative democracy” could become a template for political reform.
Less ideological drive
Carnegie’s Mr Keidel agrees that China is less ideologically driven than many people think, and argues that it is easy for an outsider’s view of China to be distorted by their own preconceptions. “Beijing is not bound by Communist ideology. It draws more and more on standards from a distant past about what it is to be good government. It looks to great thinkers from its history to ask questions about a government’s moral obligations,” he says.
Although he is realistic about the scale of the problems faced in China, Mr Keidel (who served as deputy director for the Office of East Asian Nations at the US Department of the Treasury, and before that was a senior economist at the World Bank in Beijing) says that he thinks China will be able to navigate its way through them. “It is easy for an observer to say that China’s government is incompetent, without a full understanding of the massive and complex issues that it is dealing with.
“Which government could smoothly transition through an economic restructuring that meant making 50 million or more people redundant, for example? Beijing jumps on each new problem – for example, eliminating agricultural taxes rather than instituting subsidies. It has shown that it makes practical decisions based on the issues at hand; this tells me that problems will be solved,” he says.
Can leopards change their spots?
Other observers are not as sanguine as Mr Keidel, and fear that Beijing is too quick to fall back on old habits. The Peterson Institute’s Mr Lardy says that he is concerned about policy backtracking. He fears that recent responses, such as the introduction of price controls and restrictive labour laws, may not bode well if there are even tougher times ahead.
“There has already been some retrogression in terms of market reforms; the key question is whether this is a temporary response to market conditions or more long term. There are still some in Beijing who believe that if there are problems, you resort to tried and tested methods,” says Mr Lardy.
And this is just the latest symptom of a much more serious disease. Another example is fuel price distortions. “Beijing has not passed on rising energy prices, and this now represents a subsidy to consumers equal to 1% of GDP. It is an example that the courageous moves of the 1990s are gradually being erased,” says Mr Lardy. “It becomes even more critical when you consider the scale of migration to China of a lot of energy-hungry industries. This is not just a question of temporary food pricing, but of some much more fundamental pricing distortions indicative of Beijing‘s fundamental approach.”
The scale of the challenges faced by China may seem overwhelming; its problems may seem too many and too big to be solved. In a less benign global economy, pessimists might suspect that China’s economic miracle will end in a stock market and real estate crash, and that its boundless appetite will finish in environmental disaster. What that would mean for a world that increasingly relies on China as a market for its commodities and that lives on its cheap goods is difficult to estimate.
Optimists, however, point to the great strides that China has made in its 30 years of economic reform, and to the philosophical and cultural shifts that are occurring organically. If the world is lucky, the optimists will be right.
