The Chinese economy has been growing at breakneck pace in recent years. Annual increases in gross domestic product in the 9-11 percent range mean its economy is now nudging up against Germany for the position of the world’s third largest, having overtaken the UK and France.
That extraordinary economic boom has lifted millions of Chinese citizens out of poverty, inspired economic reform and competition from other countries, and driven global flows of trade, capital and talent.
Western companies that used to see China as little more than a low-cost manufacturing base now see it is an important market in its own right. Many are clamouring to sell their products and services to its burgeoning middles classes. The number of affluent people in three major cities in China with personal annual income exceeding $26,000 will more than triple from 1.1 million in 2005 to 3.9 million in 2015, bankers HSBC predict. MasterCard says the amount of discretionary spending by affluent households in the country’s three largest cities could rise from about $18bn in 2005 to $117bn by 2015.
All this means that the health of the Chinese economy is more important than ever to the economic health of the wider world. Which is why some of the latest trends coming out of the country are causing concern. Two recent surveys from the Chinese central bank show a worrying downturn in economic confidence among the country’s bankers and business people. They fear that rapid economic growth may tip over into dangerous overheating.
In the first survey, 14 percent of companies felt the economy, which has hit its highest point since the first quarter in 1994, was growing too fast. In this year’s first quarter, only 7.9 percent of respondents thought the mainland’s economy was overheating. Those worries pushed a measure called the entrepreneurs’ confidence index down to down to 83.4 percent for the second quarter of the year – the lowest level in two years.
Bankers meanwhile are even more worried about the way things are going, according to the second survey. This showed that the industry’s confidence index plunged to 37 percent in the second quarter – that’s the lowest level ever. At the start of the year it stood at 61 percent. More than two thirds of bankers believe the economy is overheating, compared to just under half who took that view at the back end of last year.
Are these concerns justified? The World Economic Forum warned recently that Chinese industry is at a turning point. Wage pressures, while still mild at the macroeconomic level, are changing costs for many firms. Profits are also shrinking from the revenue side, as domestic competition in the manufacturing sector becomes ever more intense.
Structural factors contribute to the problem, said the report, Global Growth@Risk. With few companies ever declared bankrupt, struggling firms have continuing access to credit and jump into competitor’s product lines or new ventures, rather than innovate to exit the marketplace. It is also easy for new companies to enter a market by ripping off existing products, as intellectual property protection is weak. Again, this leads to increased competition and thin margins, leaving very little capital for investment in research and development and new product lines.
The WEF report calls this a vicious circle, one which the growth of the domestic consumer market can help to break. “As investors begin to take more of an interest in Chinese consumers than in cheap Chinese labour, many have begun to fund the development of local design capabilities,” it says.
Dependence
China’s dependence on the consumption habits of US and EU consumers is probably its biggest economic vulnerability, according to the WEF. The domestic market is growing – the retail sector is growing at 13 percent and will probably accelerate to keep pace with urbanisation. But the big question is whether the market will grow fast enough to offset any downturn in export markets. If not, then when a downturn does hit the US or EU, “China will be left with huge overcapacity and a cyclical downturn of its own,” the WEF warned.
There are also big institutional constraints to continued growth. China has surprised many western observers with its ability to generate free market-led growth without the types of political institutions generally associated with market activity, says the WEF report. This ‘institutional underdevelopment’ will need to be addressed lest it constrain growth in the near future. One major concern is the judicial and legal system, which still struggles with corruption. Low pay and local appointment and accountability for judges may need to be reviewed. A system of national appointments and rotating jurisdictional assignments could mitigate the possibility of corruption becoming locally entrenched. A freer press would help.
On the political risk side, Chinese growth is also threatened by the rise of protectionism in the West. Seeing the rapid growth of the Chinese economy, and forecasts for future growth that they find frankly alarming, some in the West are calling for action now to stop the potential Chinese domination of the world economy.
China has some levers that it can pull to reduce this risk, such as gradual currency reform and support for imports, “but the most important factors may be the diplomatic capabilities of future US governments and the flexibility of the US economy,” says the WEF report. “The latter will help absorb the effects of globalisation, and the former will help prevent amplification of any backlash.”
Interestingly, and perhaps naively, China does not see itself as expansionist, but as the WEF notes, with amusing understatement: “The rise of a great economic, and potentially military, power cannot help but reshape the attitudes of other countries towards China.”
Another risk to China’s continued economic growth is that the country will fall victim to its own success. The most important social issue in China is rising inequality. The boom may have created a wealthy middle class, but what about everyone else? “If rapid growth creates ‘two Chinas’ it will almost certainly prove unsustainable,” says the WEF.
The risk of growing inequality is something that the country’s leaders have publicly acknowledged, with words, at least. President Hu Jintao, for example, has called for “harmonious growth”.
Demographic changes are important here. People in China can currently retire at as young as 50, and the WEF says the number of working age people in China will peak within the next 10 years. Whether or not this becomes a drag on Chinese growth may depend on how successfully the country sustains growth up to that point. Unlike those in most Western countries, the Chinese government does not hold any retirement-related liabilities. With growth rates still high, however, concern for social welfare and stability has led the government to begin considering national retirement benefits, says the WEF.
The population is moving, too. As many as 400 million Chinese will move to cities in the next 20 years. This migration and urbanisation of the rural Chinese population has the potential to boost productivity and strengthen the development of consumer markets. So far, China has avoided the kid of mega-slums that blight much of the developing world, “but the risk may get worse if urbanisation rates accelerate,” the WEF report warns.
It will be difficult to provide the services and infrastructure required by this growing urban population, but the biggest challenge will be dealing with the environmental impact. Media coverage of the environmental damage wrought by China’s rapid growth has done little to enhance the country’s international reputation, especially ahead of next year’s Beijing Olympics. But environmental damage is also hampering further growth. The WEF report quotes Xinghai Fang, Deputy Director of the Office for Financial Services in Shanghai. “Tai Lake near Shanghai is now completely contaminated and local people can no longer drink the water,” he said. “Air pollution, soil contamination – these are all constraints. Fast growth is important, but environmental challenges are too large for the economy not to slow down.”
Innovation
In the long term, if China is to secure its economic gains it needs to become an ‘innovation-oriented’ economy. The government knows this, and has made it a goal to achieve by 2020. But if the country is to reach that status, it needs a better return on its fast-rising investments in research and development (R&D) and higher education, according to a new OECD report.
In its first review of China’s innovation system, the OECD said China still had a long way to go to build a modern, high-performance national innovation system. R&D spending had increased at an annual rate of 19 percent since 1995 to reach $30bn in 2005, the sixth highest worldwide. “China has made impressive investments in R&D, human resources and R&D infrastructure to date, at the same time, China has still a long way to go to build a full-fledged and mature national innovation system,” the report said.
Much of China’s investment has focused on the high-technology sector, updating equipment and facilities, and experimental research for new products rather than on basic research, which is the foundation of long-term innovation. The OECD called for more investment in sectors such as services, energy, environmental technology and basic research.
To encourage domestic firms to innovate and benefit more from closer ties with the R&D centres of foreign companies, the government should enforce intellectual property rights (IPRs) more effectively and strengthen competition, said the OECD, echoing the WEF’s comments.
China should improve its governance of science and innovation policy, the report said. Its ability to allocate public resources to support government priorities has played a key role in closing the technological gap between China and the rest of the world. But the design, management and evaluation of programmes could be improved and made more market-oriented.
The central government should also consider creating a mechanism to co-ordinate initiatives more effectively across government departments at the national level and set guidelines to avoid duplication in regional and national science and innovation programmes, the OECD said. Creating an independent agency to monitor and evaluate the success of programmes would also help.
Universities play a key role in China’s innovation system. They run more than one in 10 Chinese science and technology firms, account for one in five patents granted each year and provide venture capital to promising start-ups. Further reform of these public research organisations would help increase the quality and efficiency of researchers: “this is important because current demand for talented managers or highly qualified researchers exceeds supply,” the OECD said.
It warned that, looking ahead, China could also face a shortage of skilled workers in science and technology, despite currently having more researchers than any other country except the US. In recent years, undergraduate degrees in science have even fallen in absolute terms. “China should improve the quality of science education to attract more students, with more emphasis on managerial expertise and entrepreneurship,” the OECD said.
China is already suffering from a chronic brain drain, a trend confirmed by a recent study from the Chinese Academy of Social Sciences, one of the major research and think tank institutes used by the Beijing government. Seven out of 10 Chinese who go to study abroad do not return, it found. Instead of coming home, they take post-graduate courses, get married, take jobs or change citizenship.
The report said this brain drain is a major reason why China still lacks research pioneers who can create an innovative society and economy. Earlier this year the government tried to start reversing the trend by offering a package of incentives to returnees, such as allowing them to earn more than the highly structured scale of salaries permits. But the number of Chinese studying abroad keeps increasing and is expected to be 200,000 a year by 2010. A separate survey showed that 30 percent of high school students in Shanghai and 50 percent of middle school students want to change their nationalities.
And this is a big problem. Booming China is, it seems, a seductive lure to everyone except educated Chinese. While Western businesses see China’s economic boom as an opportunity to enter an enormous new market, many of the brightest people in that market see it as an opportunity to leave. For the boom to be sustainable, that needs to change.
