Understanding China's Economic Challenge and Why It Matters

Chinese leaders must slow their country's growth and transform how their economy functions.

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Chinese officials attend the inauguration ceremony of a new thousand-foot skyscraper tower in Huaxi / Reuters

How many countries with nearly two decades of double-digit growth under their belt would look in the mirror and say, "hey, it's just not working anymore?"

I daresay, not many.

But that is precisely what some Chinese leaders appear to be doing.

Last summer, I wrote a lot for this blog about a report from Eurasia Group called China's Great Rebalancing Act. I wrote the report with my colleagues Nicholas Consonery, Damien Ma, Michal Meidan, and Henry Hoyle, and our punchline was simple: China's growth model is no longer sustainable and the country's savvy leaders know it. And, we argued, they are committed in principle to rebalancing China's economy because their capital-intensive, export-oriented approach is delivering diminishing returns and threatens to become a major political vulnerability for the government.

But, we continued, making these changes will be incredibly difficult. To do so, China's leaders will have to make serious and deep reforms to many elements of their country's political economy. They will have to overcome inertia and "reform fatigue," fight through the opposition of powerful constituencies among state-owned enterprises and entrenched financial interests, introduce a more market-based approach to energy policy, roll back subsidies (for example on land and energy), reform financial markets to free up capital for entrepreneurs and private business, boost domestic consumption, and so on. In short, they will have to alter the underlying structure of China's political economy.

The operative word here is "political" economy. Do such reforms sound daunting? They should--and mostly for political reasons.

Nick, Damien, Michal, Henry, and I were skeptical of China's ability to undertake such deep reforms. Put bluntly, we argued that Beijing ultimately would "lack the political stomach and sense of the moment to implement a comprehensive and ambitious rebalancing agenda."

So the release of an important new World Bank report, China 2030, makes this an especially good time to reexamine these propositions.

Let's go back to my point about Chinese leaders looking at their country in the mirror. China 2030, echoes some of the themes we touched on in China's Great Rebalancing Act. But it does so at greater depth and in a more prescriptive, not simply analytical, way. And, very interestingly, it does so with the apparent buy-in of China's leaders. The Wall Street Journal reported last week that some of China's incoming crop of top leaders has been loosely or indirectly associated with the report.

The China 2030 project emerged from a proposal to China's leaders from the World Bank's president, Robert Zoellick, who suggested a joint study on China's medium-term development challenges. As the report's preface lays out, "the research was organized jointly by China's Ministry of Finance, the Development Research Center of the State Council (DRC), and the World Bank. The report was written and produced by a joint team from DRC and the World Bank who worked together as equal partners."

So, some political and economic elites in China have taken ownership of this study.

The DRC's president, Li Wei--whose prior career includes stints at such pillars of the entrenched establishment as the State-Owned Assets Supervision and Administration Commission (SASAC), which oversees China's 120-odd central state-owned enterprises--co-signed the foreword with Zoellick. But the Journal reports that his deputy, Liu He, may be the key figure, not least because he helped to author China's 12th Five Year Plan, which runs from 2011-15, and which many (including our report) argue offers a blueprint--at least on paper--for many aspects of the rebalancing agenda.

Not surprisingly, then, the World Bank's important new report is getting a lot of headlines. China's leaders clearly recognize that their growth model, which depends disproportionately on exports and investment in fixed assets, isn't sustainable. And they appear to be self-reflective enough to weigh how (and how deeply) to change it.

You can read the World Bank report here, along with supporting data and technical studies.

And you can watch a video of Zoellick introducing the report here.

One of the Bank's most important conclusions is that private enterprise needs more space to thrive. Industrial, financial, and political resources are heavily skewed toward state-owned enterprises in China. So the major banks, for example, give household depositors a negative return on their savings while bankrolling industrial policies through state-backed firms. This is one of many reasons for deeper financial reform in China.

But more broadly, it's clear that China is, therefore, at an economic crossroads. And the Bank's report shows why.

In our own study last year, my colleagues and I outlined some of the problems Beijing will need to overcome:

Producing too much and consuming too little

China's economy is overly dependent on fixed asset investment and exports. Consumption is about 35% of GDP, a figure well below those of developing countries such as India. And the perpetuation of a production-intensive economic model owes much to inefficient capital allocation. This condition is buttressed by an illiberal and politicized financial system, as well as distorted input costs including subsidized energy and land prices.

The rich are getting richer

One of the more troubling consequences of China's capital-intensive growth model has been that companies (and the government) have captured much of the enormous wealth generated in the last three decades at the expense of Chinese households. This dynamic is not only exacerbating an already yawning gap between the government and business elite on the one hand and average Chinese citizens on the other, it is also repressing consumption. A broken social welfare system, which cannot adequately deliver public goods such as pensions and healthcare, constrains consumption and encourages saving further.

The developed/developing country paradox

China's vast regional disparities in living standards and average incomes--from booming Shanghai to impoverished Ningxia--are often likened to the contrast between different centuries. Policymakers in Beijing face the unique problem of having to deal with issues typical of both 21st-century middle-income countries and 20th-century developing countries. And these inequalities play out across a continent-sized economy: the wealthy coast contrasts starkly with the continental hinterlands, which comprise poor western provinces and regions populated by ethnic minorities. While China's efforts to reduce poverty have been impressive, barriers to urban residency and the lack of progress on land reform have exacerbated regional inequality.

Inefficient and excessive energy use

Capital-intensive growth has exacted steep environmental and resource costs. Subsidized energy and land prices have encouraged companies to exploit China's natural resources and ignore debilitating energy inefficiencies. Beijing sought to industrialize in a compressed timeframe, but in China's haste to catch up to the advanced industrial economies, the country has found itself on an increasingly unsustainable trajectory from both an environmental degradation and a natural resource-security perspective.

The question, then, is largely a political one, not principally an intellectual one: Even if China's leaders know they must implement necessary reforms, can they overcome the entrenched constituencies that will fight hard to block them?

The reaction to the World Bank's new report should offer some interesting hints. But the real tests will come next year once China's political transition is settled and China's leaders refocus on underlying economic structural challenges. Their choices will shape China's next decade and beyond.

This article originally appeared at CFR.org, an Atlantic partner site.