- China has decisively shifted from a growth-maximising model to a growth-quality model. This shift involves a ‘creative destruction’ process that is inherently contractionary. At the same time, it conflicts with Beijing’s goal to double per-capita income by 2035, which requires an average GDP growth rate of 5% a year over the next 10 years. This is the paradox the country faces.
- Beijing’s focus on re-industrialisation to create a high-tech economy at the expense of consumption risks damaging growth before the country reaps the benefits of economic restructuring. Externally, such a policy could worsen trade and geopolitical tensions, especially with the US.
- China’s economic reform model is based on the strategic use of market forces to change the economy under state guidance. However, many investors have assumed that the market is the driver of such changes. The difference in view has important policy and investment implications.
Beijing’s ‘hesitant’ policy easing since the Covid pandemic has puzzled many investors. It has even prompted some to doubt if China is still investible. Arguably, a large part of the problem of weak growth is cyclical (see “Is China Investible – a Macroeconomic Perspective”), meaning it could easily be resolved by strong reflation policies. However, Beijing has not done this, leading to questions ranging from whether China is fragile and on the brink of collapse, to whether it is still a rising power on the cusp of global dominance.
These conflicting questions are not new, but they have been amplified by the Covid-19 pandemic. They reflect China’s current economic paradox: that its deflationary structural reform policy is clashing with its reflationary growth objective to double per-capita GDP by 2035 under the ‘common prosperity’ framework.
An economic paradox
The Xi administration wants to focus on ‘high-quality development’ and ‘new quality productive forces’, retreating from the old economy of polluting industries, infrastructure and property investment. While the latter helped lift China from poverty to middle-income status, the new policy direction aims to push China to rich-income status via a structural rebalancing towards a high-tech economy.
A revolutionary change…
President Xi is determined to pursue structural reforms. What is new is the change in the political and economic incentives that had governed China for over four decades.
From Mr. Xi’s perspective, there is a link between leadership power and reform implementation. His vision for the future is not to reduce state intervention but to refine the role of the state in the economy. The new economic model is a strategic mix of the state driving changes and market forces being used as a tool to make them.
The new reform tactics
In 2020, Beijing made a tactical shift in its ‘dual circulation’ policy to tackle intensifying domestic and geopolitical challenges, in particular Sino-US competition (see “Regulatory Tightening Explained”). To achieve ‘common prosperity’, China has reiterated its policy of increasing the private sector’s role in the economy. High value-added manufacturing and innovation driven by small and medium-sized enterprises are to serve as the engines for raising China’s productivity.
Technology is a ‘new quality productive force’ (in addition to the classical ones of labour and capital) for generating disruptive breakthroughs. The new generation of industrial policies focus on ‘future industries’ that are nascent or do not yet exist.
China’s leaders are willing to tolerate inefficiency and waste as long as the effort produces champions in the end. Local governments are doing everything they can to foster emerging industries, from combining venture capital with public investment to attracting scientific talent that feels threatened by America’s scrutiny of Chinese scientists.
Risks to China
The problem with the new strategy is that the old and new economies are deeply intertwined. If the old economy falters too quickly, it will likely hinder the rise of the new one. This can already be seen in the battered property market, which has wiped out jobs and destroyed household wealth and public confidence, significantly damaging private sector spending.
Compounding this problem is insufficient policy easing, as seen in the lack of a sustained recovery in China’s credit impulse to ease the restructuring pains (Exhibit 1). This deflationary policy mode runs the risk of overestimating the economy’s resilience to negative shocks and deprives it of recovery momentum (see “PBOC Needs to Ease More Aggressively and for Longer”). But Beijing wants to quit the old, debt-fuelled supply-expansion growth model and is willing to tolerate the slower growth resulting from structural reforms and debt reduction.
Without a robust economy, the transition risks ‘killing the goose that lays the golden egg’. China is accelerating its shift to cutting-edge technologies as its economy loses growth momentum and local governments run into debt problems. This backdrop makes the structural transformation risky.
Beijing’s single-minded focus on producing advanced-technology products has driven local authorities to over-invest in sectors that Mr. Xi favours, notably electric vehicles (EVs) and solar panels. Excess capacity is forcing producers to export goods, exacerbating trade and geopolitical tensions, especially with the US.
Risks to the world
The failure to recognise China’s economic paradox creates risks. Some who focus only on China’s economic problems worry the country may make aggressive military moves (like attacking Taiwan) as its power wanes, a view that could lead to mutual antagonism and geopolitical risk.
The country does face strong headwinds amid its structural rebalancing process, but predictions of China imploding and becoming uninvestible seem overblown at this point. China is moving towards a high-tech and green economy. GDP growth of 4%-5% a year is still significant for a country of its size and China remains the world’s second largest consumer market after the US. But as the rate of growth of private consumption and investment declines, investors and trade partners must adapt to a new reality and diversify their risks.
