The Strategist

China: Is It Jump Back or Forth?

10/06/2015 - 13:18

Obviously, China has fallen on hard times. The communist revolution in October 1949, which put the country's supreme leader, Mao Zedong, on the throne, is celebrating its 66th anniversary. However, there is one big problem threatening to spoil the party. August 24, the "Black Monday", stock exchanges of the country collapsed – it was the most significant falling of the financial markets since the days of the dotcom bubble in 2001 - and they were followed by other global stock exchanges.

Bad news preceded the collapse: the gradual slowdown in the economy and the devaluation of the Chinese currency, the yuan, what brought losses in the US $ 5 trillion to global stock markets. Since 2012, China has been trying to change its own model of growth that are dependent on public investment and exports. The slogan of the communist regime is now calling to expand the domestic consumer market so that the country would turn into a shopping mall from the world's factory. Panic spread in the financial markets is a sign of anxiety and uncertainty about the innovations, reigning in the world. Whether the shakes at the market will be followed by a further fall in the Chinese economy? In what direction the country is moving? And to where China, the share of which in 2014 accounted for 12% of world growth, could pull the world?
China is not yet going through a crisis. In spite of the turmoil caused by the global economy, the fall in the Chinese stock exchanges is in fact nothing more than a classic speculative bubble rupture. Over the past two years, the Chinese government has encouraged investment on the Chinese stock exchanges. Millions of Chinese have moved their money out of property shares. Until June this year, there were discovered more than 10 million new operations accounts in the stock market, more than the total for 2012 and 2013. The profile of new investors, however, looks quite boldly. About two-thirds of them left school at the age of 15 years. Nearly 10% are illiterate. More than 60% are planning to triple its revenues in a few months. Worse more, many are investing in stocks on borrowed money at very low interest rates, supported by the government.

The strategy of the Chinese government is to encourage consumption and to turn high Chinese savings (currently 51.5% of GDP) in investments in Chinese companies. All this have been stimulated by the five-year plan presented in March 2012 by the Central Committee of the Communist Party of China. It is referred to a change, seen as a result of the global economic crisis of 2008. Thereat, China entrenched status of world factory, and it had been approaching to status of the world's largest trading power. However, the global crisis has rocked the Chinese economy. In 2009, industrial production, with the exception of the construction sector, had fallen sharply. Forecasts of growth declined. It was a shock to the then-successful Chinese economic model, focused on the export production, cheap labor force, the undervalued exchange rate and large public investment in industry and infrastructure, for example, in the construction of roads and airports. Since then, the Chinese CP has decided to move from the economics of public investment and industrial production to the economy of domestic consumption and services.

At present, China is at the middle of the crossing. It is not an easy task to maneuver the second largest liner of the global economy; there are showers and storms waiting in the way. Any sigh of China, the second largest economy in the world, echoes on others, especially on Brazil, which in recent years has acquired dependence on China. Therefore, the entire global economy closely monitors the measures, taken by the Chinese leaders, - largely because some of them seem to be unstable. "The party wants and needs to make state enterprises more efficient, yet they should not be subjected to full competition. The Chinese government would like to give more freedom to the yuan, however, it is concerned that the weakening of the currency will trigger capital flight, - says an economist David Li, a professor at Tsinghua University in China. - All of this raises concerns that the Chinese would have changed their plans for the economy based on consumption, and turn back to the export model. "
Features of the Chinese regime cannot afford to dispel the concern. Even the most eminent Sinologists are difficult to predict what will happen in China because of the lack of transparency. It is difficult to worm out the plans and wishes of the Chinese leaders, firmly entrenched in the Politburo of the Chinese Communist Party. "What lies behind the devaluation of the yuan? - asks Daniel H. Rosen, the founder of the consulting agency RHG and former adviser to President George W. Bush on China and Asia. - Was that part of Beijing’s bet on pushing its economic reform? Or was it an antireform to hold declining export performance of China? No one knows".

When the Chinese strategists skeletonized their five-year plan and pondered economic changes, they probably did not consider the real problems. To implement this new phase of Chinese capitalism, reducing the weight of the economy’s industrial sector should be offset by a proportional increase in the services sector. Only that, this transition is not so simple and requires serious reforms. Many services, such as financial, are still controlled by the state, and private entrepreneurs, taking them up, face resistance from the state bureaucracy, which does not want to lose its privileges. Also, there are no developed market institutions such as the Commission on Securities and Exchange Commission (SEC), the sheriff of the US equity markets.

Another problem in China is the so-called middle-income trap. In recent decades, economists have observed behavior of dozens of poor countries that have migrated to the economy of the middle-income. China and Brazil are included in this group of countries where GDP per capita ranges from 3 to 16 thousand dollars. These are countries, which economies has witnessed rapid growth in the transition from an agrarian to an industrial matrix. Meanwhile, with the main industry having reached maturity, they cannot grow as fast and as a result, may even experience stagnation. The countries have become too expensive to compete in the commodities market with the poor countries, and, at the same time, have not reached yet a sufficient technological development to be measured by the more innovative industries in rich countries. The trap occurs just at the end of the road, when GDP per capita reaches 11-13 thousand dollars: the Chinese income level nowadays.   

According to economists who study the phenomenon in order to avoid the middle-income trap, extricating from the difficulties requires investments in the advanced technological infrastructure, higher education, and financing of the local industry’s internationalization. With regard to the first two factors, China is doing a lot of work compared to other emerging economies, such as Brazil. The challenge of internationalization is difficult. In view of the gigantic domestic market, major Chinese companies, especially in technology, are more concerned about local competition rather than going beyond the country's borders. Thus, many Chinese companies suffer from what economists call the "Galapagos syndrome". They are able to grow there, where they were born, but "die" when they make attempts to fight for market share in other countries. This is mainly obliged to the complexity of creating products at a price that can compete with the prices in the countries - leaders in technological innovation.
South Korea may be an inspiring example for China. Korean GDP per capita amounted to about the level of Brazilia in 1970 - about 5 thousand dollars. Today, when the figure reached more than 32 thousand US dollars, it has become one of the few countries to get rid of traps. Today’s China and yesterday’s South Korea have a number of common features: interventionist state, significant investments in infrastructure and education, as well as supporting the internationalization of large economic groups. South Korea is encouraging so-called ‘chaebols’, which are global brands such as Samsung and Hyundai. The secret of South Korea’s success was the fact that the state has reduced its intervention in the economy, strengthened the private banks and has delegated investment in research and development to enterprises. This is what China has not done yet. However, if the Chinese take to copy Koreans, they will face the problem of scale. All of South Korea's population is 50 million people, which is about equal to the population of only two Chinese cities of Beijing and Shanghai. The internationalization was a matter of survival for Korean companies. For the Chinese, this business is about expansion of the market, which already has hundreds of millions of consumers.
Despite the shake-up, China seems to be on the right track. Even with the dubious statistics, showing the 7-percent GDP growth a year, China's economy has a number of sustainable performance. Salary increases about 10% per year. The growing share of household income now goes to consumption, entertainment and travel. Over the past three years, the services sector was the main engine of China's growth. "Even if China's financial crisis happens, it will not be a crisis of the Chinese economy’s fundamentals - says Nicholas Lardy of the Peterson Institute for International Economics, deputy chairman of the National Committee on US-China Relations. - On the contrary, the crisis could strengthen the basement of the new Chinese economy, promoting it forward on the reform path." The world, affected by changes in Chinese attitudes, longs to that would happen.

Original by Rodrigo Turrer and Bruno Ferrari, Epoca