Chinese Checkers

Klemens von Metternich famously said when France sneezes, Europe catches a cold. That was long before the global economy was inextricably interdependent, before China emerged out of its isolation to become an engine of global growth. Today, GDP figures released in Beijing take only minutes to cause tremors in international stock markets. With billions of dollars invested in the China growth story, the world’s stake in the Chinese economy is not very much less than that of its leaders in Zhongnanhai.

 

Reports that China’s manufacturing index contracted for the first time in seven months saw markets tumble. Then a market-friendly speech by China’s new premier Li Keqiang buoyed up spirits. He called for reducing red tape by freeing 33 per cent items from China’s License Raj. He declared, “The market is the creator of social wealth and the wellspring of self-sustaining economic development.” This was music to the ear of investors. The implicit admission is that public-sector investment and export driven growth that had long propelled China has run its course. Is market reform finally coming?

 

The situation today is more urgent than when a booming world economy could happily absorb the gushing torrent of China’s exports. Not only is demand for Chinese products shrinking in a recession-bound Europe and slowly-growing US, China’s domestic factors are less favourable for relying on the old policy. The government controls interest rates and its artificially low exchange rates and energy prices have distorted the economy, resulting in a huge misallocation of capital.


Meanwhile, its greying population and rising wages are now putting downward pressure on exports. Investment in infrastructure and housing do not create the kind of consumer demand needed to replace falling demand overseas.

 

A recent IMF report on China noted that “expanding agriculture and services including investing in healthcare, education and financial services are likely to be more important instead of building more factories to supply steel, cement and appliances for foreign consumers.” The kind of investment that China needs to make, the IMF economists pointed out, “will be possible only through financial sector reform, making liberalisation of this sector an urgent issue.”

 

Li has proposed giving private businesses a larger role in investment decisions and setting prices. He promised to liberalise bank lending policy, to encourage private investment in finance, energy, railways, telecom and other spheres. The government also held out the promise of opening finance, healthcare, logistics and other sectors to foreign investment.

 

China’s growth model has reached a turning point, but reforming it is not just a matter of readjusting the economy. It touches on the fundamentals of a one-party state. It is not surprising that despite incessant talk of the need to rebalance the economy, there has been little progress. Reforms would mean curbing the power and privileges of state-owned enterprises run by China’s Red Princes and families.

 

But the alternative, as outlined by the IMF report, is not attractive either. “If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing constraints due to dwindling land, labour, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles.” Put another way, doing nothing is a sure recipe for popular discontent and instability.

 

Yet, China has a record of biting the bullet and undertaking painful reforms when survival is at stake. Growing discontent over economic disparity, air pollution, concerns about food security and unemployment (7 million students will graduate this month) might just push the government into translating words into action. And even a modest opening to the private sector could energise foreign investment and create a worldwide impact.