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‘Dream Team’ nightmares

by Kevin Rafferty

Special To The Japan Times

President Xi Jinping and Premier Li Keqiang have now been confirmed in China’s top jobs and are now all set to steer the country to overtake the United States as the world’s biggest economy by the middle of the decade, a great dream for the so-called Xi-Li “Dream Team.”

China has raced from strength to strength with unprecedented real growth rates never seen before in the world, not for one year but for 30. China’s 9 percent growth in per capita terms between 1982 and 2011 far outstrips Japan’s record of 6.3 percent growth in 1951-1980.

Moreover, China is still ticking ahead at 7.5 to 8 percent, while developed countries are languishing, and are crippled with heavy debts. So the Dream Team should be able to dream about a great future. However, Xi and Li were warned last month by their own colleagues that the country needs reforms or the dream economic growth could easily turn into nightmares.

Xi and Li still have plenty of cheerleaders. Surprisingly, in late March, the Organization for Economic Cooperation and Development, the club of rich industrial nations, issued a report far more bullish than any China bulls. It predicted that China’s growth will be 8.5 percent this year, rising to 8.9 percent next year and will average 8 percent for the decade.

The OECD is more optimistic than Beijing itself, which aims for 7.5 percent growth this year and 7 percent in the five years to 2015. Angel Gurria, the former Mexican minister who heads the OECD, commented that China “is the one country that always lowballs their growth (targets). At the OECD, we always say we’re going to grow half a percent more, one percent more than we actually do.” Surely this is far too flippant a remark for a serious comment on a serious subject by a serious organization.

Richard Herd, chief of the OEDC China desk, was not concerned about the high levels and high dependence on investment, which has largely driven China’s recent growth. “The level of investment in the private sector is well-founded by the rates of return, and in infrastructure, we still think there are tremendous needs,” Herd said in Beijing. “We’re positive on investment in the sense that we see rates of return remaining quite high.”

Similarly, the OECD report played down concerns about heavily indebted local governments and the rise of a dark shadow banking system. It pointed out that the Chinese government has big cash reserves as well as fiscal flexibility, which allow it to deal with potential trouble and prevent a crisis. The report did suggest that China needs a series of economic, financial and regulatory reforms, but also noted that many have already been set in motion.

China’s own leaders are not so complacent. Deputy Premier Zhang Gaoli, who is also a member of the Politburo Standing Committee, warned just after the OECD report that failure to make sweeping reforms, including a reduction in state control, would consign the economy to years of low growth.

“There are increasing downward economic pressures, and the problem of excess capacity is worsening,” Zhang said.

He singled out government institutions, the household registration system and environmental protection as leading areas for action. Without action, Zhang warned, “Even if our absolute economic size gets bigger, our economy, our growth standards, will still be at the mid to low end.”

Zhang was echoing fears of Zhu Min, former deputy head of China’s central bank, who is deputy managing director of the International Monetary Fund. Zhu called on China to create jobs and boost wages in an effort to raise consumption and move away from its unhealthily high levels of investment. He warned that the heralded headline growth figures could be misleading and that China needed to look at the quality of its growth not just the quantity. “The key issue for China is not growth. … It is the quality of growth and reform,” he said.

He added: “China should discourage investment. Currently loans are cheap and the factor price is so low — energy, transportation, water, power. Those things all encourage the expansion of investment.” So much of China’s resources are going into investment that it has “squashed people’s income levels.”

Zhu’s prescription was that money should be pushed to ordinary Chinese and that the country’s hitherto neglected services sector should be developed as a twin growth track with manufacturing. He said that over-concentration on investment meant that only 60 percent of China’s industrial capacity is being used.

For a ready antidote to the rosy economic predictions, professor Michael Pettis of Peking University is persuasive and fluent. He quickly summarizes China with the new leadership in place: “Not surprisingly, there were few surprises. The leadership is saying all the right things, but they have been saying the right things for quite a while — nearly two years in the case of Li Keqiang.

“The constraints they face, however, have neither changed nor been addressed. First, any real rebalancing means much slower growth than Beijing seems willing to tolerate. Second, the groups (“vested interests”) that have benefited from the old growth model are very reluctant to allow any erosion of the benefits they have accrued.” Pettis is pessimistic about China’s dependence on investment claiming that “an increasing share of investment is being wasted on factories, bridges, real estate, airports and other projects that have little or no economic value.”

China needs to rebalance and encourage greater consumption, which has fallen to about 35 percent of gross domestic product, against the mid-50s, which would be expected from a burgeoning new power. But this is a complex and complicated process with wide-ranging implications, some of them uncomfortable for politically well-connected interests.

Pettis contends that China’s economic development model is not new. The grandfather of the model was the first U.S. Treasury secretary, Alexander Hamilton. Pettis thinks of China’s growth model “as merely a more muscular version of the Japanese or East Asian growth model, which is itself partly based on the American experience. The model has three elements: infant industry tariffs; internal improvements, including infrastructure; and a sound system of national finance.

The fledgling U.S.-imposed tariffs and other measures raised costs to foreign manufacturers to allow American industrialists to compete in their home market. “In addition,” Perris notes, “Americans had to acquire as much British technological expertise as possible (which usually happened in the form of intellectual property theft).” There is little new under the economic sun.

But, Pettis argues, China risks losing its way because it is developing powerful state-owned enterprises as national champions; instead, it should encourage “brutal domestic competition. Beijing should also eliminate subsidies to production, the most important being cheap and unlimited credit, because senior managers of Chinese companies rationally spend more time on increasing access to these subsidies than on innovation, a subject on which, in spite of the most absurd hype of recent years, China fares very, very poorly.”

The lessons of America’s experience, and of England before, are that industrial revolutions are not driven just by scientific developments, but by the commercial application of scientific developments, backed by a robust financing system.

In China’s case, the financial system is stable and unlikely to fail, given government support for banks, in stark contrast to America in the 19th century when the banks were, to quote Pettis, “chaotic, prone to crisis, mismanaged and often fraudulent, and yet the U.S. grew very rapidly during that time.”

But America, then as now, “has been very good at providing money to risky new ventures.” But in China, the banks “favor large, well-connected, and often inefficient giants at the expense of risk-takers.”

Kevin Rafferty is the editor in chief of PlainWords Media.