Is the Chinese Economy Really ‘Bottoming Out’?

Despite optimism over the recent data released, the Chinese economy is unlikely to return to the days of double-digit growth.
Data released in mid-October showed that China’s third-quarter GDP grew by 7.4%. This was expected but also below the 7.5% target set by Chinese Premier Wen Jiabao in March. On the other hand, retail sales and industrial output performed far better than expected, prompting many observers to say that the Chinese economy is on its way to recovery. Nonetheless, because the country’s economic problem is structural in nature, the Chinese economy is unlikely to return to the days of double-digit growth, even if it stabilizes with reforms.In order to understand the Chinese economy’s structural problem, one must first understand how China has been able to achieve such rapid growth in the past thirty years. China has essentially followed the same growth model that Japan and South Korea, to name a couple of examples, have followed. All these countries shared similar characteristics.After the devastation wrought by World War II, they were left with little to no capital but highly dense populations, which became the basis for extraordinarily cheap labor. Once they began to bring in and inject a massive amount of capital into their labor pools, their export-driven economies began to take off rapidly. Because the Japanese and the South Koreans were initially very poor, they had relatively high savings, which were used to pump more capital into their economies. It is also important to note that governments guided the allocation of resources, not the market, in order pump in as many resources as possible into industrialization. China was able to follow the same path after Deng Xiaoping opened the Chinese economy to the world and foreign capital began to pour in, leading to extraordinarily high growth for the past thirty years.The problem with this model of growth has to do with the fact that the allocation of resources is guided by the state, not by the market, which causes massive inefficiencies. In accordance with the law of diminishing return, more and more resources must be pumped into the economy to achieve the same rate of growth. In the short term, state capitalism, by artificially pouring in a large amount of resources, provides countries with a massive amount of return, which can be used to pay back the capital-providers while still having left-over revenue as profits.Over time, however, the law of diminishing return catches up very quickly with state capitalism’s inefficiencies, and profit margin eventually evaporates due to decreasing revenue and increasing debt. Factoring in the bubbles created by overly optimistic expectations, the economic model based on state capitalism eventually runs into a serious economic crisis, such as those experienced by Japan in the early 1990s and South Korea in 1997. The fact that China’s growth engine today is sputtering indicates that the country has reached the point where the law of diminishing return is finally catching up with the inefficiencies of its economy.If history is to serve as a guide, the Chinese economy will probably not return to the days of double-digit growth. Since the early 1990s, the Japanese economy has been stagnating due to failure at reforms, while the South Korean economy, despite swallowing difficult reforms, has yet to return to the days of its miraculous growth. The dismal state of the global economy magnifies China’s structural problem by continuing to plague China’s export industry.The eurozone crisis in Europe and the economic crisis in the United States have led to two of China’s largest customers purchasing far less Chinese goods, while a whole new set of economic trouble seems to be emerging in East Asia. In addition, China’s demographic profile, which shows that China’s working population will begin to decline in the next few years, means that the country will no longer enjoy the advantage of cheap labor in the future, while having to support a massive and still growing class of retirees.In order to maintain a moderately high level of growth as South Korea has experienced since 1997, China will first need to work towards transforming its economy based on the model of state capitalism to one based on market capitalism in which allocation of resources is decided by the market rather than by the state. Doing so will require the Chinese state to further loosen its grip on the economy and work towards greater privatization and decentralization. Moreover, China will need to create an environment in which innovation can flourish. Doing so will require political and legal reforms, which many Chinese leaders are wary of supporting.The fact of the matter is that, despite all the optimism, it is still too early to tell whether the Chinese economy is recovering or not. At best, the Chinese economy could stabilize at a growth rate somewhere between 7% and 9%, which would still be high. At worst, it could crash and burn, resulting in massive social unrest and probably the fall of the Communist Party in power. The actual outcome could fall somewhere between these two extremes. Still, given all the variables involved, what really happens from now on is truly anybody’s guess.

Photo courtesy of mckaysavage via Flickr.