China is now the richest nation of the world, according to a recent report by McKinsey & Co, Bloomberg reported. While its numbers showed that global wealth grew by three times in the last 20 years, the report says that China led the way in that growth and surged ahead of the United States to attain the number one spot on the list of the world's richest countries.
But of late, there has been much discussion about the challenges facing the Chinese economy. Some believe that the declining GDP growth rate and the sustained challenges related to debt are indicative of long-standing fragility that is now coming to the fore. Others have argued that the barrage of regulatory actions taken over the past year indicate that the Party under Xi Jinping is turning sharply left, expanding control and suffocating the private sector. Such assessments, unfortunately, miss the woods for the trees. The current upheaval is not a fallout of the inherent weaknesses of the Chinese economic model. Rather, it is a product of a fundamental restructuring that is being engineered by the leadership to address the model’s limitations and stimulate new drivers to achieve high-quality growth. Understanding this direction is critical for foreign investors and policymakers.
Before discussing the different dimensions of the restructuring that is underway, it is useful to address the arguments about collapse. First, from a GDP growth standpoint, it is important to note that the Chinese leadership has increasingly demonstrated greater comfort with accepting lower rates of growth. In fact, through much of the early part of the year, Premier Li Keqiang was engaged in expectation setting, after having set the annual GDP growth target to around 6%. Given the record economic slowdown in 2020 due to the COVID-19 pandemic, this was an extremely modest target, which sent a message to local governments across the country. Therefore, a third-quarter slowdown in GDP growth in 2021 to 4.9 per cent isn’t likely to rankle Beijing.
A Year With a String of Regulatory Actions
Second, this has been a year of tremendous regulatory churn. Ever since the scuttling of Ant Financial’s IPO late last year, there have been a series of actions. These have covered a wide range of areas, including fintech, consumer internet, anti-monopoly action in e-commerce and the gig economy, cybersecurity, education, workers rights, culture and entertainment, etc.
The August 2021 meeting of the Central Committee for Financial and Economic Affairs placed these diverse sets of actions within the broad framework of Common Prosperity. Despite the sudden torrent of regulatory action, the confused early messaging from Beijing and increased investor anxiety, the economic damage has been rather limited. While large private technology enterprises have lost market value, non-financial FDI into China remained strong at $129.3 billion, up 25.2% year-on-year. Also, private-sector employment and fixed asset investment remain robust.
Third, debt and financial risk have been on top of the agenda for the Chinese leadership for the longest time. The challenges in this regard are structural and go to the heart of the Chinese economic model. Responding to the global economic downturn after the 2008 financial crisis, the Chinese government turned to investment as a driver of growth, launching a stimulus package of $586 billion. Supply-side expansion fuelled growth, as enterprises binged on easily available debt.
For instance, China’s debt-to-GDP ratio rose sharply from just under 140% in 2008 to nearly 260% in 2019. While this seemingly was plateauing in 2019, there was a sharp increase following the stimulus package that was announced in May 2020 in response to the COVID-19 pandemic.
Most of these were essentially supply-side measures. But these were also accompanied by a greater willingness by Beijing to allow defaults and failures in order to address the moral hazard that underpins the debt situation.
The insolvency of Baoshang Bank and the management of the Evergrande crisis are indicative of this. In fact, data show that China’s debt-to-GDP ratio has been falling for the past four quarters. Yet, it remains to be seen how far Beijing will go in this regard and what kind of costs it deems acceptable.
From Export & Investment to Consumption & Innovation
So, what exactly is it that the Chinese leadership appears to be doing? As argued earlier, there is a fundamental restructuring of the economic model that is currently under way, and the disruptions that have been evident are a product of this.
There are three broad dimensions of this effort.
First, there is an attempt to shift the drivers of economic growth from exports and investments, particularly the non-productive kind, towards consumption and innovation.
For well over a decade, China’s capital-to-output ratio has been steadily rising, while the total factor productivity has tumbled. For instance, a working paper by the World Bank Group, published in June 2020, explained that China’s aggregate total factor productivity growth slowed from 2.8% in the 10 years before the global financial crisis to merely 0.7% in 2009–18. Consequently, there is an effort to redraw incentives, particularly with regard to unproductive debt, as discussed above, and to promote innovation, direct greater capital flows towards the real economy and SMEs, along with focusing on education and human capital development.
Wealth Gap Impedes Growth
Second, there is a realisation that while the earlier development model enabled rapid growth, it also led to many negative externalities, such as deepening income and wealth inequality and imbalances in access to public services, such as health and education. This situation is increasingly being viewed from a political risk prism. For instance, in an essay in the Party journal Qiushi in October 2021, Xi Jinping argued, “At present, income inequality is a prominent issue around the globe. The rich and the poor in some countries are polarised with the collapse of the middle class. This has led to social disintegration, political polarisation, and rampant populism — indeed, the lessons are profound! Our country must resolutely guard against polarisation, drive common prosperity, and maintain social harmony and stability.”
At the same time, there is a sense that such inequality is impeding the drive towards high-quality growth. For instance, an innovative economy requires a large high-quality or better-educated workforce, which is lacking in China today.
Also, boosting broad-based consumption requires not just a large middle class but also a relatively well-off middle class. This is not necessarily the case in China either. For example, speaking at the National People’s Congress in 2020, Premier Li Keqiang had highlighted this, stating that there were over 600 million Chinese whose monthly income was barely 1,000 yuan (roughly $ 140), which was not enough to rent a room in Chinese cities. Consequently, the Common Prosperity agenda is expressly focussed on expanding pathways for upward social mobility for people.
Finally, undertaking these changes will require painful adjustments and a reassessment of what the critical factors of production are for the new economy. Data, for instance, is one such factor. Consequently, there is a sense that the Party must adopt a much more interventionist role in guiding the traditional factors of production like capital and labour, while also evolving new models of control over new factors like data.
For investors, policymakers and observers abroad, it is important to note that this process will entail much experimentation and, therefore, volatility. Moreover, Beijing is neither prescient nor can it control every actor and outcome. Consequently, one should be prepared for stops and starts, a certain amount of tumult, and greater political risk.
(The author is a Fellow, China Studies at Takshashila Institution. He tweets @theChinaDude. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)