In a very uncertain global economy, we’re finally getting some certainty from the world’s two largest economies – at least on the political front. In the U.S., the interminably long election season finally ended with the re-election of President Barack Obama. Meanwhile, halfway around the planet in Beijing, a congress of China’s Communist Party, which begins today (EDS: Thursday), is expected to finally anoint Xi Jinping as the nation’s next leader. The two political processes couldn’t be more different – one politician fought for his job on CNN, the other maneuvered behind tightly sealed doors – but the outcome of each is equally important for the global economy. What happens with growth, jobs and investment around the world will depend to a healthy degree on the decisions taken by these two men.
The common perception is that one of these leaders faces a bigger economic headache than the other. Obama will have to resolve the fractious battle over how to close the government’s yawning budget deficit before the nation falls off the fiscal cliff, bring down stubborn unemployment and recharge American competitiveness. Xi, meanwhile, seems to be sitting pretty. Growth in China has slowed, but to a rate that remains the envy of the world, while Chinese industry continues its march onto the world stage.
But in this case, looks can be deceiving. Sure, Obama has tremendous economic problems to resolve, but Xi’s challenge is just as daunting – perhaps more so. Obama has to dig the U.S. out from the baggage of the last financial crisis, but Xi has to undertake sweeping reforms to ensure China doesn’t fall into a crisis.
When I write about China potentially facing an economic crisis, I often get laughed at or verbally abused. The official People’s Daily accused me of being a “China basher.” This is part of China’s problem. Any attempt to have an open and honest discussion of what is really happening inside the Chinese economy gets shouted down. But that doesn’t solve the underlying flaws in the Chinese economy. It is easy to keep growth rates high when policymakers pump money into the economy to fund the grandiose schemes of state enterprises or to build more infrastructure. But such an investment-led growth model inevitably leads to a debt crisis. Money gets used inefficiently, debt levels rise, excess capacity gets created, and in the end, the system collapses.
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There is no shortage of signs that China is experiencing these very problems. Wind farms have been erected but not connected to the electricity grid. Hundreds of solar cell makers will likely go under. Shopping malls get built where no one shops. HSBC analyst Zhiming Zhang, in a fascinating October study, showed how the problems of the steel industry encapsulate how China’s growth model can be rotting at the core even as it continues to post high rates of growth. Despite record liabilities (of $445 billion for the top 80 mills in the first half of 2012) and massive losses, the industry keeps expanding. Here’s a bit of Zhang’s analysis:
China’s enduring love affair with steel has serious implications for the whole country and beyond…It is also a case study of a fragmented state-owned industry, like others in China, that feels the need to keep expanding even when production and capacity levels are commercially unviable. Indeed, the steel sector is an example of the macro versus micro contradiction at the center of China’s growth model. On the one hand, at the macro level it is positive for GDP growth. On the other, it highlights the overcapacity, overproduction, and debt at the company level in a sector that underpins national fixed-asset growth…State-owned steel companies can fund expansion through bank loans or the bond market; most are rated ‘AA’ or above – remarkable for an industry that is losing so much money…So the message is beware, macro numbers often don’t tell the micro story.
Fixing these issues requires more than a tweak here or there. The reforms that Xi must undertake are no less fundamental than the ones started in 1979 by Deng Xiaoping. Back then, China was a closed, command economy. Deng opened China up to the world, rolled back the state and allowed the rise of private enterprise. Today, Xi needs to drastically alter the nature of the economy again. The state-led, investment-driven growth model is running on empty; the economy needs to become more balanced and more market-driven, with better rule of law. Do not think this is an easy transition. There are many powerful players benefiting from the current system – from SOEs to the bureaucracy – that will attempt to thwart such changes. Xi will need to show a ton of political will to push through the necessary reforms.
And what are those reforms? Here’s my must-do list for Xi:
Scale back state enterprises. Much of China’s growth story has been a private sector story as Deng’s reforms unleashed the entrepreneurial spirit of the country’s massive populace. But in recent years, that trend has been somewhat reversed. State enterprises have gained in influence, especially since the massive stimulus program instituted by the government after the 2008 financial crisis. SOEs gobble up a large share of the available bank credit; they also receive subsidized land, energy and other inputs. The problem is that they are far less efficient than the private sector. Studies routinely show that SOEs are not as profitable as private companies. Take away their subsidies and their profits evaporate, one influential study proclaimed. That means the nation’s resources are being consumed by an inefficient part of the economy. This situation can’t continue. Xi is going to have to roll back the power of the SOEs and force them to become better performers. That means opening up more of the domestic economy to real competition.
Encourage the country’s consumers. Though China is still a developing nation that requires a ton more infrastructure and apartment buildings, the economy as it stands right now is far too dependent on investment. Xi has to “rebalance” the economy to give it more engines of growth. That means finding ways of encouraging the nation’s consumers to play a bigger role in the country’s economy. To do that, the government has to provide a stronger social safety net – better healthcare, a more reliable pension system – to convince consumers that they don’t need to save as much for the future. Policymakers also must liberalize interest rates. Right now, interest rates are controlled in ways that subsidize industrial investment but offer poor returns to the average saver. Freeing up interest rates would simultaneously make investment more rational and provide more disposable income for households.
Develop a real financial sector. Liberalizing interest rates, however, will also put pressure on China’s banks. Right now, rates are set in a way that allows the banks an automatic profit. Ending that system would force the banks to compete and become more commercially oriented. That’s good for the economy over the long term, but it will be destabilizing in the short run. Chinese banks are still not strong enough in credit analysis and still too directed by bureaucrats to operate soundly in a more open financial environment. If China wants to move forward, policymakers have to strengthen its banks and other financial institutions and better prepare them for a more competitive, more liberalized market. This will also help to ensure credit gets allocated more intelligently and alleviate the problem of excess capacity.
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Strengthen rule of law. Chinese officials like to say that China is a “country of rules.” There are a ton of regulations and rules to follow even on the simplest of matters. But having a lot of rules is very different from having rule of law. The fact is that bureaucratic decisions are erratic and inconsistent. Rules are not applied equally or fairly. Many regulations are left purposely vague to give bureaucrats more power. Officials pressure companies to follow government preferences that aren’t actual rules on the books. The court system is a joke. This creates a level of uncertainty that hampers investment and gives the politically connected an advantage. All economies eventually fail on a lack of rule of law. China must fix this problem by fostering an environment in which regulations are clear and applied fairly.
Will any of these reforms actually happen? The hope is that Xi Jinping will be more reform-minded that his predecessor, outgoing President Hu Jintao. But the fact is that we know very little about Xi’s true opinions on major economic issues (or, for that matter, on any significant issues). Xi has risen to the top by a process of consensus within the Communist Party, which means he has had to appeal to both its more liberal and more conservative elements. Yet the truth is that Xi must be a reformer. If not, the Chinese economy could be headed for something ugly. That’s not good for Xi, China, or the world.