Trapped in a state-led economy

Ahn Dong-hyun
The author is a professor of economics at Seoul National University.

Skepticism about the world’s second largest economy is brewing in Wall Street and elsewhere. Most of the data from China — growth rate, unemployment rate, domestic demand, investment and exports — are red flags. The Chinese economy grew 2.24 percent in 2020, the first year of the Covid-19 pandemic, 8.45 percent in 2021 and 2.99 percent last year. It was expected to rebound at around 5 percent after the reopening, but is still under the government-set threshold of 6 percent.

While most parts of the world are struggling with high inflation, China is faced with deflation with the consumer price index and producer price index retreating 0.3 percent and 4.4 percent on year to reflect the sluggishness in domestic demand. Youth unemployment hovers above 20 percent, while investment gained just 3.4 percent. Exports fell by a whopping 14.5 percent in July against the same period a year ago. The once mighty economy that fueled global growth is in a colossal crisis.

The Chinese economy started to pick up from 1978 under Deng Xiaoping through the state-led growth model. While Americans’ consumption of China’s low-priced factory products from cheap labor fueled growth for China, the United States could rein in inflation. The practical exchange added traction to China’s economic growth.

The momentum was kept alive even after Deng’s death in 1997. But it changed from 2010. Growth began to stagnate when China entered the middle-income rank when its per capita GDP reached nearly $8,000.

Projections for China differ based on whether the sluggishness is deemed just a temporary outcome from Beijing’s strict Covid-related restrictions or a structural problem of the Chinese economy. The consensus puts heavier weight on the latter. There are two views on the causes of China’s crisis: economic reasons and political ones.

The first view, or the economic factor, is shared by mainstream economists like Michael Pettis and Paul Krugman, who argue that China’s growth model based on state-led investment has hit its limits. To reinvigorate the engine, the government must turn to a new growth model based on strongly boosting domestic demand.

Deng and other Communist Party leaders are believed to have studied and borrowed the Korean development model of the Park Chung Hee era in the 1960s and 70s aimed at pushing economic growth through investment from the capital accumulated from savings and constrained consumption. Under a similar strategy, Beijing made aggressive investments in fixed assets, amounting to 40 percent of GDP. The public investment-push model can accelerate growth when the economy is running high, as investment returns can exceed the fund-raising cost.

But when investment returns fall below the financing cost due to an economic slowdown, over-investment can impair growth. As a result of over-investment, Korea did suffer a liquidity crisis in 1997. China faces a similar situation.

In 1996, just a year before the Asian financial crisis, Korea’s per capita GDP was $13,400, close to China’s $12,700 today. The watershed calls for a shift in growth engine from investment to consumption. In the transition, China can benefit from its huge population, as seen in Beijing’s earlier decision to drive growth by boosting domestic demand.

But the problem is that despite the rhetoric, China’s policy transition has stalled. Beijing’s interest rate policy is one example. The Chinese central bank has been resorting to “financial repression,” which refers to arbitrarily lowering market rates to increase fiscal spending and spur corporate investment. According to Chen Zhiwu, a professor of finance at the University of Hong Kong, China has been artificially keeping the interest rate more than 5 percentage point below the balanced level. The issue of over-investment can hardly be resolved due to the borrowing rates artificially kept low in defiance of market rules.

The biggest beneficiaries of the low interest rate are local governments and state-owned enterprises. Chinese provincial governments are grappling with the fallout from their reckless spending. The demolition of a 190-foot-tall (58-meter-tall) statue of Chinese war god Guan Yu in Jingzhou city of Hubei Province after spending more than 300 million yuan ($46 million) to build represents an elephantine squandering by local governments. State enterprises also benefitted from the low rate policy. According to Chen, the wealth transfer to state enterprises thanks to cheap rates reached 1.2 trillion yuan in 2016 alone, while the benefit for private companies stopped at 800 billion yuan. Distortion in wealth distribution only worsened as more benefits went to public corporations with low productivity than private companies.

Domestic demand-driven growth policy is nothing new, as it was actually launched by President Xi Jinping in 2015, two years after he took power. Mortgage loans surged from 2015. According to Prof Chen, the benefit for borrowers of mortgage loans from low lending rate, which averaged at 200 billion yuan in 2014, shot up to 500 billion yuan in 2015 and 1.3 trillion yuan in 2021.

The cheap rates to boost domestic consumption went to real estate speculation instead of stimulating consumption. As private consumption did not increase much, it upset Beijing’s strategy to outpace the U.S. economy through a consumption-driven growth.

The other view, or the political factor, is shared by economists like Adam Posen, president of the Peterson Institute for International Economics. They argue that China can hardly ensure additional growth due to political instability. The collective leadership maintained until after Deng’s death ended with the emergence of strongman Xi Jinping. Xi — a member of the Princelings — pursued rigid fundamentalist communism unlike the accommodative model led by Deng. Under the imperialistic rule of Xi, autocracy and surveillance over companies strengthened through the recent enactment of anti-spy laws. State control over new industries like ICT and regulations also have toughened.

Prof. Posen claims that China is suffering from “economic long Covid,” in which the low confidence in the private-sector from government intervention, even before the pandemic, is further weakened from the draconian government intervention during the pandemic. As a result, the stimuli measures are not effective as companies continue to cut back on investment and households opt for security by keeping their money in savings.

The two views behind the crisis — over-investment and political insecurity — may look contradictory but reflect the conundrums of a country stuck in the middle-income trap. To address over-investment, growth should be led by consumption. But since the demand for precautionary savings increases in the face of future insecurity, political stability is essential to prevent a contraction in consumption.

As the uncertainty is heightened by the authoritarian government, it casts a shadow over the Chinese economy. When economic and political wings are both unstable, the government finds an external enemy to divert people’s attention. This explains Beijing’s hard-line stance against the United States. On its part, the United States cannot but contain China as it has been blamed for grooming a tiger over the last 40 years.

The rivalry between the two superpowers cannot be resolved over a short period of time. China’s economic future depends on how the government addresses over-investment and political instability during the transition from a state-led growth model to a market-driven growth model.

Translation by the Korea JoongAng Daily staff.