Reference no: EM131737648

Case Scenario: GROWTH IN CHINA: MIRACLE OR MIRAGE?

The end of communism in the Soviet Union led to a tremendous decline in economic activity in that region, with real GDP falling as much as 50%.1 The gradual movement away from communism in China occurred under an entirely different scenario, with real GDP reportedly rising an average of 8% per year. We are skeptical of any figures from communist countries; but while growth in China appears to have been quite rapid for several years, it probably slowed down to about 3% starting in 1998, even though the government ministers continued to insist that real GDP kept rising more than 7% per year. China accomplished its impressive growth spurt by implementing the following measures:

1. Attracting capital from overseas. In many cases, the funds came from ethnic Chinese who saw great growth opportunities in China. However, many US firms also invested heavily in the country.

2. Foreign exchange has been earned through a huge trade surplus with the US. In 2001, Chinese exports to the US rose to $100 billion, while US exports to China increased only to $16 billion. No other country or region has this great a trade disparity. That huge imbalance is accomplished in part by keeping the Chinese yuan undervalued.

3. China has generated internal saving by creating ‘‘capitalist zones'' which permit rapid growth of free enterprise; most of the funds are then poured back into further investment.

4. While the Chinese government still rules much of the country with an iron hand and does not tolerate political dissidents, it has permitted some free market economics to operate without the dead hand of excessive bureaucracy.

5. Many foreign firms have been unable to generate profits in China. This is not because their Chinese ventures are poorly managed. Instead, many firms are required to buy raw materials and parts from the Chinese at prices set by the government. These prices are set so high that most of the profit ends up accruing to the government rather than foreign investors. While that generates increased saving in the short run, it may be counterproductive in the longer run. Recently, the Chinese have shown signs of reversing these policies. Considering that the Chinese economy is still in the early stages of emerging from the shackles of communism, perhaps its leaders have done an outstanding job in boosting productivity and real growth. However, it is not difficult to be skeptical about many of the announced results. Foreign tourists and investors see the great progress being made in the coastal cities; they do not see the peasantry continuing to labor under conditions of near-starvation.

For every new multimillionaire, there are thousands of lowly workers whose standard of living has not risen at all. That is often the case in the emerging stages of capitalism, but Chinese political officials will have to moderate their economic power to move to the next stage of economic development. It remains to be seen whether they will choose to act in that direction. The inconvertible currency, the enormous trade imbalance with the US, and the disappearance of profit margins for foreign investors are all danger signs for the future. It is unlikely that China will be able to continue its recent growth rate without taking much bolder steps toward a capitalist economy. Recent evidence suggests, however, that they are intensifying their efforts to attract more foreign capital. In 1998, a book by He Qinglan entitled China's Pitfall revealed for the first time the degree to which China was mired in corruption and cronyism; it was almost as severe as the much better-known situation in Russia.

The review of this book by Liu Binyan and Perry Link, which was published in the New York Review of Books under the title ‘‘A Great Leap Backward,'' stated in part that: The urban ‘‘reform'' amounted to a process in which power-holders and their hangerson plundered public wealth. The primary target of their plunder was state property that had been accumulated from forty years of the people's sweat, and their primary means of plunder was political power. Only about 10 percent of GDP comes from urban private enterprise. During 1997 and 1998 average personal income growth has fallen off sharply, and for large portions of both urban and rural poor it has reversed. There is much more in this remarkable book that establishes how much of the so-called Chinese prosperity reported in the western press is the Oriental version of a Potemkin village. At first glance, comments of this sort call into question the viability of investing in China. It appears that total GDP is not much above $1.2 trillion, or about $1,000 per person, compared to roughly $10 trillion and over $35,000 in the US. More to the point, if He Qinglan's estimate is correct, and only 10% of GDP comes from urban private enterprise, that would be about $120 billion, which is barely more than the $100 billion exported to the US each year. Based on these figures, it would appear that the private sector of the Chinese economy that serves domestic consumers is minuscule. It also seems likely that Chinese exports to the US cannot continue to grow exponentially indefinitely. The information in this book strongly suggests that the initial burst of real growth, fueled primarily by imports of capital from overseas Chinese and the surge of exports to the US, foundered because the communist infrastructure was unable to support the next round of development. Labor costs in China are unquestionably very low, but they are even lower on the Indian subcontinent.

Without further massive injections of foreign investment - this time from investors generally, not just overseas Chinese - and a rule of law that permits corporations to earn and repatriate profits, the outlook for the Chinese economy would not appear to be favorable. Yet one puzzling aspect remains: why was this book published? Suppose that the top Chinese leaders surreptitiously arranged for China's Pitfall to be published and leaked to select members of the western Press in order to signal to the bureaucracy that major changes were critically needed. The reason for assuming that might be the case is that in September 2002, the New York Review of Books - which is apparently the preferred publication for leaks - summarized a rather remarkable document: an internal memorandum prepared by the current top leaders to identify and select the next generation of leadership. The purpose of making such a document available was presumably to convince investors that unlike Russia and other formerly communist countries, the mantle of leadership in China had now progressed to the point where an orderly transition could be assured, indicating that the rule of law was becoming more relevant and important - and not so incidentally, that China was now ready to welcome foreign investors on a permanent basis. If China can establish its credentials and assure foreign investors they will be able to earn a normal profit and repatriate those earnings, the picture of stagnation and decrepitude so vividly painted in China's Pitfall could quickly be reversed.