The Secret to Making China’s Economy Grow Forever

Forget the euro — in the next five years, the most important story in the global economy will be the pace and success of China’s economic reforms. Earlier this month, at the opening of the National People’s Congress, Premier Li Keqiang reiterated the main points of the plan his government introduced last year and set economic targets for the future. In doing so, he took an enormous risk: If the reforms don’t come, the targets will almost certainly remain out of reach, and his government will be a failure.

Li’s speech was remarkable, if for nothing else, for its frank and straightforward portrayal of China’s economic situation. Lower demand from overseas consumers has depressed domestic investment. Higher costs and lower prices have eroded growth in manufacturing. A path to entrepreneurship can help solve the employment gap for new graduates. To hear an American politician — or his speechwriters — conveying these notions in such plain and intelligible terms would be, shall we say, refreshing.

But there was one area where Li’s economics took a more intriguing turn. He suggested that China should maintain a growth rate similar to its current target of 7 percent for many years to come, raising incomes all the while. If this sounds like unicorns and rainbows, well, it would be for most advanced economies. Maintaining such a high growth rate while boosting incomes is virtually impossible unless an economy is constantly transforming itself to become more entrepreneurial and competitive. Otherwise, as incomes rise, the rate of growth will almost certainly fall.

The logic behind this phenomenon is simple — so simple it’s embedded in Li’s own observations. Eventually, an economy that sticks with the same fundamental institutions and technologies will experience diminishing returns. You can keep investing and giving workers access to more capital, making them incrementally more productive, but their living standards will only improve up to a point — a sort of mathematical limit. Moreover, as their incomes rise, the rate of economic growth will decline. This has happened in the United States, Japan, and Korea.

It will happen in China, too — in fact, it may already be happening, as China’s economic growth rate has fallen fairly steadily, from 14.2 percent to 7.4 percent, in the past seven years. The only way to maintain a growth rate around Li’s target of 7 percent while allowing incomes to rise is to avoid those diminishing returns. And to avoid diminishing returns, China needs to change, constantly.

It’s hardly the recipe we’d expect from a calcified, entrenched technocracy. To fulfill Li’s ambition, China will have to work every year to push up the mathematical limit of its living standards. Every reform that makes its business climate more innovative, entrepreneurial, and free will essentially give its economy a new lease on life — a new target for living standards. And Li appears to understand this, too. As he wrote:

“Our country is in a crucial period during which challenges need to be overcome and problems need to be resolved. Systemic, institutional, and structural problems have become ‘tigers in the road’ holding up development. Without deepening reform and making economic structural adjustments, we will have a difficult time sustaining steady and sound development.”

He called this period of adjustment and reform a “new normal”, but it’s hardly normal at all. It’s not a new status quo, but rather a new phase of growth in which China will have to be more dynamic than ever, altering its economic architecture all the time, like a building that’s never finished.

This is quite a different situation from that of the United States or Japan. The fundamental institutions of the American and Japanese economies — the legal, tax, and regulatory systems, and the markets they govern — have remained more or less unchanged for years. In the absence of deep changes, the limits of American and Japanese living standards rely mostly on marginal advances in technology. Japan had chances to liberalize its economy and become more entrepreneurial, notably under the leadership of Junichiro Koizumi in the early 2000s, but it stayed set in its ways: favoring big corporations, maintaining trade barriers, and generally being skeptical of competition both at home and abroad.

No politician in the United States or Japan is foolish enough to pledge economic growth of 7 percent per year. It’s a huge challenge even for a developing country, yet Li and his boss, Xi Jinping, have essentially bet the future of their government on it. Fortunately for them, China’s reform program has the potential to shift the goalposts. The specifics Li gave were numerous: liberalizing financial markets and reducing the cost of capital; slimming down state-owned enterprises and opening more industries to private markets; further opening foreign trade while reducing restrictions on foreign investment; discarding price controls but implementing efficient pricing of energy and other environmentally-sensitive goods; increasing research and development while promoting small enterprise; relaxing controls on internal migration and encouraging more urbanization; bolstering health and education along with infrastructure for energy and information; containing overinvestment by local governments but giving them more regulatory freedom.

All of these reforms could help China to grow faster for many years to come, but none among them is a sure thing. Concerns have already begun to spread that the restructuring of state-owned enterprises will still leave much of the economy under government control. Specifics on arguably the most important reforms — of the legal system — were clouded by political rhetoric when released last month. And in every single initiative, China’s government will have to deal with vested interests that have profited under the old system.

But the reforms could hardly be more important to the global economy. By 2019, according to the International Monetary Fund’s forecasts, China’s economy will be almost as big as that of the current eurozone. But depending on the progress of China’s reform program, its growth might vary much more than that of the eurozone. In all likelihood, the world can expect the eurozone to grow by somewhere between 0 and 2 percent per year, adjusted for inflation, in the next five years. For China, the range may be more like 5 to 10 percent.

In other words, much more is at stake in the East than in the West. Even if the eurozone manages to alleviate its current headaches, it won’t necessarily become the leading engine of the global economy. But if China succeeds, lifting tens of millions more people out of poverty and bringing greater demand for goods and services to the rest of the world, it will be a boon for everyone — not least Li and his cronies, who might just get to keep their jobs.

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