The China files, Part 2: Brave new economic model

May 10, 2011

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Hugo Dixon

The Chinese government knows it’s time for a change. The old economic model based on cheap exports and eye-popping investment can’t be sustained.

Fortunately, politicians aren’t sitting on their hands. The latest five-year plan, covering 2011-2015, aims to boost internal consumer demand as the main engine of growth. It envisages a bigger share in the economy for services, which are currently only 43 percent of GDP — barely half America’s level. The plan calls for more high-tech industry and for greener, less carbon-intensive growth. There’s also to be a big push into social housing, so the poor can afford somewhere to live.

All this is good on paper — and all these things are already happening to some extent. But to achieve this fully, Beijing is going to have ride roughshod over vested interests and loosen its grip on the economy, society and politics. That’s not going to be easy.

Take the drive into high-technology. Beijing’s approach to date has been to make it hard for foreign companies to sell products such as cars into China unless they set up joint ventures with local partners. The idea is that this helps technology transfer. Until now, foreign companies have been so intoxicated by the opportunity to sell to a market of 1.3 billion people that they have largely gone along with the Faustian pact. But they are becoming more wary: witness this year’s American Chamber of Commerce survey on the business climate in China.

It is, of course, open to China to invent its own technology and certainly large sums are being earmarked for research and development, which is to rise from 1.8 percent of GDP to 2.2 percent of GDP over the course of the five-year plan. But it’s unclear whether the socio-economic system is well structured to encourage invention.

Schools, for example, are often criticized for getting children to mug up facts rather than think for themselves. And even if Chinese companies have technology, they may themselves face barriers to exporting their products. For example, Huawei, the networking giant, has been singly unsuccessful in signing up a big U.S. telecoms operator as a client because of concerns in America that having a Chinese supplier could somehow compromise the security of a vital piece of infrastructure.

Meanwhile, intellectual property rights are poorly protected. That makes it logical for a budding entrepreneur to copy somebody else’s invention rather than invest in research himself — and find that somebody else copies him. This applies not just to manufacturing but to a whole range of services industries especially media and software. Jokers say the acronym “C2C” means “copy to China.”

Equally, further deregulation will be required if the push into services is really going to gather pace. That will mean liberalizing areas dominated by state-owned enterprises, notably media and financial services areas. That could make the authoritarian government feel uncomfortable.

Beijing’s ambition to turn Shanghai into an international financial center is a case in point. This looks an impossible dream unless foreign banks are permitted to have a bigger slice of the market (they currently only have 1.8 percent of total assets), capital controls are removed, the exchange rate is freed up and a proper rule of law instituted (the judges are now subservient to the ruling Communist Party rather than independent). Each of these measures will be hard to push through.

China has an abnormally high savings rate — 54 percent of GDP in 2009 compared with 10 percent for the United States. This is partly the result of the carnage in World War Two at the hands of Japan, the long civil war between the Communists and the Nationalists, the horrific famine in the late 1950s and the Cultural Revolution in 1966-1976.

These memories are fading. But the aging population has new concerns about how to pay for its health care and pensions — especially as the state does very little on this front. The one-child policy exacerbates this because the Chinese people cannot look forward to a large brood of kids taking care of them in their old age. With all their eggs in one basket, it makes sense to save a lot.

To get its new economic model working, Beijing will have to cut saving and boost consumption. That, in turn, means increasing the amount of money in people’s pockets and encouraging them to part with it. There are four main ways to do this — but each is problematic.

First, push up wages. This would give people more money to spend. The snag is that wage inflation is already chipping away at China’s competitiveness — and Beijing is scared about what will happen if the economy can’t create the millions of jobs that are needed each year to absorb new migrants from the villages to the cities.

Second, allow the exchange rate to appreciate. That would keep down inflation, likely to be above 5 percent when official figures are released on May 11, and boost consumers’ purchasing power. But again, it would undermine competitiveness.

Third, give the people a better deal on tax and social security, so that they wouldn’t need to save so much themselves. As part of the latest five-year plan, the government does intend to improve pensions and health care. And, in the short run, it is rich enough to afford to. The country has foreign reserves equivalent to 50 percent of GDP, more than offsetting public sector debt which is 17 percent of GDP. But the fiscal position is not as strong as it looks. Local governments have incurred huge off-balance sheet liabilities to finance their investment splurge. And the problem with making generous promises to an ageing population is that the cost mounts year by year.

Finally, give the people a better deal on their savings. At present, deposit rates are set artificially low so that cheap funds can be funneled via state-owned banks to state-owned enterprises. Banks, meanwhile, are guaranteed a fat fixed margin on lending. Even after the latest hike, the maximum banks are allowed to pay is 3.25 percent for one-year deposits — meaning savers get a negative inflation-adjusted interest rate of around 2 percent.

Effectively, this system acts as another tax on the people. Freeing up interest rates would be good for the masses and encourage consumption, but it would hit two powerful vested interests: the state-owned enterprises which would have to pay more for their capital; and the banks which would see their margins squeezed.

It’s doubtful the leadership has the stomach to do all of this wholeheartedly. As a result, consumption and services won’t grow fast enough to take up the running from exports and investment. That leads to an even trickier question for China’s policymakers: how to keep stability in a political system where insiders gobble up economic goodies and free speech is suppressed?

This is part two of a multi-part series. Part one looks at how fast China can grow. Part three looks at China’s crony capitalism.


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some very interesting points in this article, bravo Hugo

Posted by teu | Report as abusive

I welcome our new Overlords.

Posted by Radis | Report as abusive

Kudos to Dixon for recognizing the possibility of a wage hike in China, as well as its effects on competitiveness. I think what Dixon is somewhat slyly pointing to with both this and his second point (exchange rate appreciation), is that these are keys to how China has taken advantage of the U.S. and other countries, and it would not wish to change them for fear of undermining what has resulted in its vast power-grab up to this point.

Ultimately, changing both of these is unlikely since China seems to prefer its underhanded sniping at other country’s economies so long as they refuse to stand up for themselves, and going off of the assumption that they will remain stupid and unconfrontational for as long as possible.

Furthermore, China needs its minimum wage low to maintain a devalued, impotent lower caste who cannot fight back against its tyranny, just as it needs its strict controls over the media. While it may make a few cosmetic changes like increased public housing to minimize public dissent, do not expect it to do anything that would endanger its grip of control on the people.

Posted by Jzyehoshua | Report as abusive

[…] final installment of a series. Earlier installments discussed China’s crony capitalism, its brave new economic model, and just how much China can continue to grow. « Previous Post Next Post […]

Posted by The China files, postscript: Feisty females | Reuters Breakingviews | Report as abusive

Have to say they are good pointes;

Meanwhile,just want to mention that both economic theory and history realities shows, when a major economy is in trouble, the main course and main improving directions can not be outside factors.

Like when China facing risks, they can not says this is not caused by the actually very powerful force of the printing of green notes, which certainlly have cause global inflation and exchange rated unstable, and hurt all major economies and peoples wealth outside of America.

So does when America Economy melt down due to accumulated factors in many main elements of the economy, it’s not a good balanced view to say it’s because the other nations done, and that in order to improve the situation, the main changes need to be made in other nations economies instead of looking at way to change the infrustucture of America’s own.

After all, America’s GDP is about 25% of globles and it’s influential to other economies are much larger in general than vice verse.

Posted by NewGlobes | Report as abusive


I highly doubt about your comment:

+++ ” … Furthermore, China needs its minimum wage low to maintain a devalued, impotent lower caste who cannot fight back against its tyranny, just as it needs its strict controls over the media. ” +++

Based on what I have eye-witnessed and experienced by myself in China, the truth is really not as what you have described.

My recent trip to China (Beijing) was last month (Feb 2012). Compared it with my last trip there in 2009, I amazingly learnt from my friends that:

1- The minimum wage standard (stipulated by the government) is increased by 57% in 2012 compared with in 2009; (compared with the number in China, the Min. Wage at many places in N.A. have been kept unchanged for quite a few years.)

2- Those above-average-salary guys, such as managers in companies, IT engineers, bankers, got an at least 50% increase in compensation compared with 3 years ago;

3- Low-income groups, such as courier-man, restaurant waiters, baby-sitters … got an wage increase well above 50%, some even doubled; construction workers got an increase of 30-50%;

More interestingly:

1- Some of my businessmen friends complaints to me about the rising labour cost, added that “the local district government officials held seminars for the enterprise owners to educate them about the social meaning and tax benefits of INCREASE THE INCOME OF THEIR EMPLOYEES !”;

2- In the sub-urban of Beijing, the local government leaders publicly call on the farmers to “try all means to leverage the central government’s policies to enhance the income … “.

From above numbers and facts we could see that both the minimum and average salaries (at least nominal salary) there in China has recorded a significant growth in the past 3 years. As for before 2009, we saw the same trend but I don’t have exact numbers readily in my hand now.

Research analysts should base their conclusion on the facts, numbers and logic rather than on air, and be responsible for the clients and audiences.

Posted by JoeAlpha100 | Report as abusive

Let me add something here:

The significant increasement of nominal income was observed in some major cities (not only Beijing) and the country-side areas nearby. It is not everywhere of China, but we could still see the trend.

If we deduct the inflation, the real term income is still a significant increasing. (Chinese official inflation rate indicator CPI, which is about 4-6% in most time of last year, doesn’t include the real estate prices.)

The retired also got pension payments from the government increased in last year. (This group is complex: some of them receive only from government pension programs, some also have a company pension program, while some younger generation holds commercial annuity which is not matured yet.)

Posted by JoeAlpha100 | Report as abusive