With China’s post-COVID economy slow-to-attain takeoff velocity, Western detractors have been quick to pour scorn on China’s near and longer-term growth prospects.
Much like the overstated growth prospects of 1950s Soviet Union and 1980s Japan, China’s prospects have been greatly exaggerated. As China’s excess capital investment-driven growth model hits a wall, the economy will inevitably regress to a mean of 2-3% medium-term growth. For others, a prolonged economic slowdown in combination with a collapsing real estate sector raises the specter of a Japan-style slide into deflationary stagnation and a ‘lost decade’ of growth. Far from surpassing the U.S. economy by the end of this decade or the early part of the next, China’s economy may never surpass the U.S. economy in aggregate size.
These derisive projections are off the mark.
China is not 1980s Japan. At the time, Japan's economy was already advanced and urbanized, with a per capita income nearing that of the U.S. Moreover, the overvaluation and subsequent dramatic decline in its equity and real estate markets were on a much larger scale. By contrast, China has just begun to turn the corner towards becoming an advanced economy. Its per capita income is a fifth of the U.S.’ suggesting a vast scope for productivity-led growth, and its urbanization rate is a good 15 percentage points below that of 1980s Japan, with 200 million rural Chinese expected to migrate to second and third-tier cities in search of a better life, and its asset price declines barely denting Chinese households’ wealth (although it has awakened citizens to realize that housing markets are no longer a one-way bet).
The operative comparison of China’s economy should instead be with 1990s South Korea.
In the late 1980s/early 1990s, South Korea’s per capita income as a percentage of the U.S.’ was close to where China’s is today, and the South Korean economy – like China’s economy today – was excess investment-driven, aggregate demand deficient, and structurally imbalanced. Over the next three decades as Seoul transitioned to a more productivity-led and consumption and services-oriented growth model, the economy recorded an average gross domestic product growth rate of roughly 4.5%. As a result, South Korea’s per capita income, measured in current U.S. dollars, is about half of the U.S.’ today (US$70,219 v. US$35,142 per capita in 2021, https://data.worldbank.org/). Should the productivity level of Chinese workers over the next quarter century achieve that of South Korean workers today - a foreseeable prospect– the Chinese economy will be twice the size of the United States’.
China’s demographic dividend may have approached the point of exhaustion but there is still ample pent-up growth potential awaiting release in its ongoing transitions from state to market and from rural to urban. The country continues, furthermore, to grow at a rate that is somewhere between two to three times that of the United States (averaged over a five-year time horizon), which is just beneath the norm that has held for much of the past three decades of reform and opening up.
Be that as it may, Beijing must not bank on South Korea’s past becoming China’s future. It must strive to do better, prioritizing the structural transformation of its growth and development model as well as its fiscal framework and inter-governmental (center-local) relations.
China’s fixed asset-heavy overinvestment model must yield faster to a more consumption-centered and services-driven one, consistent with internal economic rebalancing and aggregate demand management. The experience of past East Asian transitional economies, Japan and South Korea notably, is not altogether positive. Even as the services sector’s share of growth and domestic employment reached 70%, the low productivity growth in the sector constrained aggregate wages shrank labor’s share of national income, exacerbated inequality, and stymied investment-consumption rebalancing. The gap in aggregate demand was typically bridged via credit or asset price bubbles – a by-product of the financial liberalizations launched at the time.
China must avoid this predicament. It must lower barriers to entry into its service industries, many of which are dominated by state-owned oligopolies, while simultaneously guarding against over-regulation. It must progressively lift hukou (household registration/ residency card) restrictions fully, such that hukou becomes just a registration of residence rather than a determinant of access to public services. It must build out a unified and portable social security net while at the same time reforming its pension system to gradually raise the presently low retirement age, and thereby add millions of ‘additional’ workers to the labor force. Foremost, China must untie household consumption from housing. A structural slowdown in residential real estate construction paired with a shift in the relative burden of taxation from labor income to property and capital gains, will go a long way toward pivoting the macroeconomy to a more balanced, sustainable, and consumption-centered one.
In time, the upheaval in the property market will come to be seen as a blessing in disguise, incentivizing new growth drivers and accomplishing a consumption-centered growth that no amount of intonating that “housing is for living in, not for speculating on” could achieve. Indeed, the day China serves as the final consumption market for Asia’s dynamic vertically integrated trade and production networks, the renminbi will also bump the dollar from its pedestal as the region’s currency of choice.
As for reform of its fiscal framework and inter-governmental (center-local) relations, the taxation structure of the Chinese state must shift away from revenues derived from investment-led growth – given that the underlying growth model is hitting up against its limits. Besides, with industry being the primary source of revenues, the incentive to foster an economy that is services-driven or responsive to consumers’ interests is correspondingly diminished. The composition of taxes must shift from indirect to direct taxes (as is the case in advanced economies), the tax base must expand, and the state’s fiscal functions must be separated from the credit allocation system.
The structural revenue deficits that have pushed local governments to raise funding from opaque, off-budget mechanisms must be plugged too. The local government debt problem is essentially one of commercial debts incurred by these governments routed through their investment vehicles. The coverage of China’s Budget Law does not extend to commercial debts incurred by the state (local governments, in this case), yet such debts enjoy implicit state guarantees judging by the absence of any defaults on municipal corporate bonds to date. Moreover, since such debt is accounted for as corporate debt and hence not included in local budgets and final accounts, they escape scrutiny at the local level too. This deception must end. These debts must be brought onto the government’s books, transparently accounted for, and ultimately worked out via a comprehensive central-local debt resolution program.
Alongside, local governments must be allowed to enjoy predictable tax-sharing revenues, the authority to raise own-source revenues such as a recurrent property tax, and their access to credit to fund expenditure responsibilities broadened. The current land-based model of finance for urban development must unequivocally give way to a municipal bond-based financed one.
In time, the upheaval in local government debt markets will be seen as a blessing in disguise, both incentivizing and compelling the Chinese state to draw up a fresh blueprint of intergovernmental fiscal reform. Much like the 1994 center-local fiscal compact - the Tax Sharing System (TSS) Reform - did away with the perverse incentives of the 1980s-era fiscal contracting system and ushered in three decades of robust investment-led growth, reform of the fiscal framework and intergovernmental relations today will spark a quarter-century of consumption-centered growth. Reform of local government finances will also defeat the root causes of local protectionism and facilitate the creation of a more unified national market.
China enjoys ample scope to work its way out of its property and local government debt-linked headwinds, which have placed a dampener on consumer confidence, and renewed its high-quality development model. With the Party’s Third Plenum, typically an economic reform-focused agenda-setting gathering, expected to follow later this year, this opportunity should be comprehensively grasped.
