When snakes and ladders meet financial leverage

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frederic matteucci's picture

When snakes and ladders meet financial leverage

The governance challenges facing China’s new leadership involve policy decisions whose aims are to transform China into a high-income society. The transition from middle to high income is the path China finds itself on currently. Just as the game of snakes and ladders, it is fraught with traps in which previously high-growth countries, in Latin America for instance, fell. The successful transition will have occurred after several decades if the following five challenges are resolved: (1) reforming the growth model in a rising labour cost environment, (2) rebalancing economic activity from exports and investments towards domestic consumption, (3) restructuring the social safety net particularly for the migrant population, (4) tackling income inequality and corruption harmful to a harmonious society, (5) adopting global responsibilities on systemically important issues such as climate change, and the direction of the world economy.

Few models can be followed. Only two large countries, Korea and Japan have managed that transition, Korea being the more recent and instructive example. Yet both are comparatively homogenous countries unlike China. Essentially China is composed of three distinct economies each with different levels of income and development: the rural provinces geared towards agriculture which supply the rest of the country with cheap abundant labour; the export-driven coastal provinces which have led growth since 1978; and an emerging innovation-based economy characterised by productivity improvements whose role is to lead the transition to high-income status. The policy decisions have to balance the dissimilar needs of these distinct economies in terms of exchange rate and wage levels for instance.

China’s size is another distinctive feature which determines its interaction with the global economy. The growth model is very similar to that of the Asian Tigers of earlier decades but its exchange rate and current account surpluses have greater global implications since China is now the second largest economy. Put simply, China has become systemically important even though it is still a developing country. China’s impact on carbon emissions and commodity prices at present implies that it cannot follow the development strategy used by today’s high-income countries. Low-carbon growth has become inevitable rather than optional. Furthermore there are not enough natural resources to allow China a different type of growth. Unprecedented in history, China must execute the transition to a high-income country whilst dealing with the responsibilities and obligations that befit its position as an economic superpower. Nowhere is this clearer than at the G20 summit of April 2009 in which China plays a key role in the post-crisis recovery of the world economy.

It ought to be said that the 12th five-year plan (FYP) acknowledges the aforementioned challenges. In fact the necessity for different growth model was recognised as early as the 9th FYP. Recognizing challenges is easier than surmounting them. Many of the structural reforms invoked in previous plans have not been implemented as the situation would have required. Rising income inequality, corruption scandals, food safety scares in recent times speak to that.

Middle-income challenges for China

Should China fall in the middle income trap, the scenario of a “perfect storm” cannot be ruled out. The combination of unsuitable macroeconomic policies, financial sector implosion coupled with insufficient supervision, military conflict in the South-China Sea, food shortages, natural calamities, and feeble governance could seriously hinder China’s transition and cause uprisings.

Consequently policy decisions should be seen with the objectives of limiting the risks to growth and mitigating negative impacts on the welfare of the population. In that sense, policy decisions are about designing and implementing a framework that decreases distortions and puts in place the pre-conditions for the rise of a prosperous middle-class whilst enabling the emergence of innovations in a knowledge-based economy.

In practice this implies a reform of the hukou system so that migrant workers in urban areas have access to services just like the registered resident population when it comes to social housing, education, social safety-net provisions, and healthcare. The avowed goal is to raise the contribution of consumption to economic growth and therefore diminish the need for precautionary excess savings that arise as a result of a dearth of social services.

The inability to bring about a prosperous middle class is one of the explanations put forward to clarify why it is that countries are not able to make the transition from middle-income to high-income societies. Brazil and Argentina in the 1980s and 1990s are cases in point. At the other end of the spectrum, Korea navigated that transition successfully by making the transition to a knowledge-based economy during the same period. Korea is the closest comparable country for China’s transition in so far as its policies regarding university education and foreign-direct investment (FDI) policies. The key element in my opinion is that the growth of high-tech sectors occurred alongside an improvement of the overall education levels of the workforce both across different levels of occupation and across all the industrial sectors.

A commonly-held view is that significant slower growth would cause social and political unrest. Whilst it is true that unemployment has disruptive effects from a social standpoint, this view does not really capture the link between household income, GDP, and consumption. I would venture to say that for the household sector in China it is not the reported GDP growth that matters but rather the rise in the disposable income of the said households. The consequence of this is that appropriate policy measures should be based on median household income levels. In fact, economic rebalancing on the global stage will not occur with more investment-led growth in China but rather with more net-demand. The corollary to that is the unwinding of fixed-asset investment-led imbalances and a new policy based on a modified central-local government fiscal transfer mechanism.

Unwinding existing imbalances

Currently, China’s economy is characterised by an unusually high investment to GDP ratio. Investments are necessary for the transition to a high-income nation but serious problems occur when the rate of capital allocated to investment is too high. There comes a point when the debt increase necessary to finance fixed-asset investment is running ahead of the ability to service that debt. There are anecdotal evidences that “white elephant” projects in the property sector as a result of the 2008-2010 fiscal stimulus will not generate enough cash flows to reimburse the lenders. This problem is further compounded by overcapacity in certain industrial sectors such as steel, and cement.

The very worrying thing is that China as of February 2013 is still expanding credit at a very high rate to fund all the investment growth but it does not have a positive financial account which indicates that FDI linked to investment for the export sector has in a way fallen by the wayside to leave mainly investments driven by political considerations that might do very little to increase the ability of the economy as a whole to improve the ability to repay either existing or future debts.


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