Reinventing China, Again

Note: This article is an abridged version of an in-depth country study produced as part of the Prosperity Index project of the Legatum Institute. Complete versions of all 12 are available on the Institute website.

For much of the five centuries in which China has showed its face to the West, foreigners have been preoccupied with how to make money in the Middle Kingdom. The dream seems especially vivid right now, as China hints that it is reinventing itself as a consumer economy.

But that transition won’t be easy. First, to move the economy into the big leagues, it will need to build supporting institutions ranging from comprehensive pension and health care systems to far more sophisticated financial markets.  Second, China will need to change from a dazzlingly successful export machine to a balanced economy that both meets the needs of domestic consumers and plays a stabilizing role in the global economy. Third, it must manage its growing geopolitical power and hunger for raw materials carefully in order to preserve the benefits of global economic integration.

FIRST PHASE: 1978 – 1989

Post-revolutionary China first strayed from its ideological redoubt in 1978 — the year Deng Xiaoping cautiously led his impoverished nation away from 29 years of central economic planning and state ownership. Back then, state enterprises made up 78 percent of the China’s productive capacity, and collectives owned the rest. One billion Chinese lived (and sometimes starved) on collective farms. Per capita income was around $500 a year in today’s purchasing power.

First, farmers were permitted to choose which crops to plant; later they were paid for what they grew on their own plots. And they were paid more generously, reversing a strategy developed by Lenin to extract every last crumb from agriculture in order to feed heavy industry. Agricultural production doubled in a decade, even as underemployed farm workers streamed to the cities.

Industrial reforms followed agricultural. Deng created special export zones that welcomed foreign investors and by 1984, they were thriving in 14 coastal cities. Deng had put the country on a path to a mixed socialist-capitalist economy without sacrificing any political control.

Contemporary China’s first phase of development ended with a bang at Tiananmen Square on June 4.  Foreign investors paused after the United States and other nations imposed sanctions on China. But not for long — which brings us to the period in which China became the factory to the world.

SECOND PHASE: 1990 – 2008

Foreign direct investment took off, rising from $5 billion in 1990 to close to $100 billion annually by late in the last decade. Beijing (correctly) viewed foreign business as the key to transferring the management techniques and advanced technology needed to leapfrog a long period of industrial trial and error. What’s more, it needed to find jobs for tens of millions displaced by the agricultural reforms.

So foreign companies got tax breaks and land, conveniently cleared of villagers. They also got cheap wages and few restrictions on pollution or working conditions. All they had to do was turbo-charge China’s climb up the production ladder from simple labor-intensive goods (apparel and toys), to consumer electronics, to machinery demanding complex industrial organization, long supply chains and sophisticated process technology (cars and commercial aircraft).

By the end of this second phase, China was the world’s second-largest economy. In three decades, China had lifted 600 million people out of poverty and peasants who lived most of their lives at subsistence had children who routinely earned close to $5,000 annually.

THIRD PHASE: 2008 – ?

From 1980 to 2008, per capita income, measured in terms of purchasing power, rose eleven-fold!  But growth is no longer the only objective for Chinese political leaders. Nor, for that matter, is it clear that the Chinese economy could keep growing at anywhere near that pace without fundamental structural change.

China faces both developmental and demographic challenges. The former is what’s been dubbed the "middle-income trap": the vast majority of developing countries — more than 85 percent in the postwar era, according to the World Bank — get stuck in middle-income territory ($4,000-$12,000 in today’s purchasing power).

Can Beijing beat the odds? One glaring weakness is the immaturity and lack of independence of the banking system. Though nominally privatized, the handful of huge banks are regularly asked to perform government functions — for example, lending billions to local governments to fund infrastructure projects with little prospect of repayment.

The government has in the past bailed out banks that have marched off fiscal cliffs to Beijing’s tune — and it certainly has the resources to prevent their collapse in the future. But, lacking independence and free-market incentives, the banks have failed to develop the skills to allocate capital to its most productive uses. A "shadow banking" sector has mushroomed to serve private enterprise largely ignored by the government-chartered banks. It is virtually unregulated, though, and would constitute a real danger to China’s financial stability in the event of a serious economic downturn.    

Equally to the point, China must manage modernization even as its population grows old. The ratio of those over 65 to the working-age population will double in two decades. This demographic shift is happening all over the world — but in China, the pace will be unprecedented thanks to the government’s draconian effort to contain population growth since the 1980s.

China’s baby boomers start retiring in a few years, putting immense pressure on health care and other dependents’ services. When Deng set loose the collective farmers, he also abandoned socialized medicine in the countryside. The government acknowledges the vacuum it created, as well as the reality that modern health care systems require major inputs from the public sector. And Beijing has been working on an ambitious reform model of universal private health care bolstered by heavily subsidized, government-run health insurance. But it’s decades away from meeting the goal of providing first-rate care to all Chinese.

Actually, more is at stake here for China than the risk of getting caught in the middle-income trap. The sharp decline in Chinese exports during the global financial crisis brought home the urgency of China’s need to move beyond the status of factory to the world.  China will continue to make computers and furniture and auto parts for Westerners to buy. But Beijing wants to refocus its increasingly sophisticated productive capacity on the domestic market.

In theory, that should be easy. All Beijing must do is to convince the Chinese to spend their money instead of saving nearly half of it. To that end (among others), many cities have raised minimum wages by double digits since 2008. But lacking a safety net, older Chinese households will be hard to persuade.

There’s another reason China is determined to move past its phase-two policy of growth at any cost. The Chinese are complaining more. They complain about corrupt party officials stealing their land and selling it to real estate developers. They complain that three decades of insider deals and backs turned to abuse of the environment have left the air dangerous to breathe and the water sometimes deadly to drink.

As part of its defense of the legitimacy of one-party rule, Beijing is becoming more responsive to their wishes. In several demonstrations this year, regional officials have sided with rioters instead of corrupt local officials — something once unthinkable.

Younger Chinese have very different attitudes than their parents. Chinese who lived during the turmoil of Mao’s rule are less willing to risk the unknown and more willing, as the Chinese saying goes, to "eat bitterness." But those who have mostly grown up in one-child families in a period in which GDP was doubling every eight years, have higher material aspirations.

One paradox here: Even as modern China makes the pivot to production for domestic markets, the economy is becoming more closely connected with the rest of the world. Production and marketing chains, for example, reach across multiple continents. But this amounts to interdependence, not dependence — China doesn’t need the outside world as much today as a source of managerial skills and process technology.

Two trends — one in manufacturing, one military — are bringing China and the world closer together economically, but pushing them apart politically. Consider manufacturing, where raw materials went in one end of the assembly and finished goods came out the other.  No longer.  Take something as seemingly simple as a shirt with buttons down the front.

Fabric woven by a factory in Korea or India may be shipped to Vietnam or Cambodia, where other workers cut out the panels of the shirt, which are stitched together in yet another factory. Then the half-finished shirt goes to China, where workers attach buttons (imported from Japan). Chinese workers sew on the label and attach a price tag before shipping the finished product to Walmart or Brooks Brothers.

Or consider the iPod. The brains (software) were created by a team of engineers at an Indian company. The liquid crystal screens come from Japan, the flash memory chips from Korea. Those get shipped to mainland China — to huge factory complexes owned by the Taiwanese sub-contractors that make what Apple sells.

Today, lots of companies are like Apple: they either no longer make what they sell, or no longer sell what they make. This change in manufacturing dynamics has changed global trade patterns, and that in turn is changing geopolitics. Nations all across Asia that used to rely on the United States as their biggest trading partner are now equally dependent on China.

Japanese companies make the high-tech electronics for computers, but rely on China to assemble them. Australia avoided recession after the global financial crisis by turning itself into China’s mine shaft. Today, Australia trades more than twice as much with China as it does with the United States.

Hence the bifurcation.  Asia-Pacific’s middle- and high-income countries are bound to China in economic terms — ties that only grew tighter during the global recession when China’s demand for imports never flagged. But they remain dependent on the United States in military terms.

China has begun using its new economic leverage to squeeze its neighbors. For instance, when the Philippines objected to its fishing boats entering disputed waters, Chinese travel agents boycotted the Philippines and Chinese port inspectors allowed fruit imported from the Philippines to rot on the dock.

And back in 2010, after Japan arrested the captain of a Chinese fishing boat in waters both countries claim, China briefly banned exports of rare earth minerals that Japanese companies needed to make their most sophisticated products — including the high-end electronics components that Japanese companies mostly ship to China for assembly.  Meanwhile, the looming source  of friction is oil and gas deposits in the South China Sea, where China, Malaysia, Vietnam, Taiwan, Brunei and the Philippines all have competing claims.

Nor is China depending entirely on its economic muscle to make its geopolitical points. It is also building up its military capacity, including its first blue-water navy in 500 years.  By no coincidence, the Pentagon announced it would deploy 60 percent of U.S. warships in Asia-Pacific theater, instead of half.

China may be ever more closely connected with the rest of the world by globalization, but as China moves deeper into stage three of development, it’s political leaders are choosing their own path. And there is no guarantee that China’s preferred way forward will dovetail neatly with the interests of the rest of the world.