Grit in the growth machine

With the United States struggling to curb overheating and Europe shocked by war, more economic trouble in China comes at a bad time for all. COVID lockdowns may be the immediate cause, but mask a bigger question: is the Chinese “economic miracle” fading? And do China’s policy-makers know how to react?

When the worlds biggest port isnt working, that sends a shiver down the spine of international trade. In recent years China has accounted for up to 40 per cent of global growth, as not only the worlds biggest exporter but also its second-biggest importer. Now, after a rebound from COVID in early 2021, China is flagging, already undershooting its growth target for 2022, and has loosened bank reserve ratio requirements despite fears about the strength of its financial system.

Most attention from outside China has been fastened on the impact of its lockdown policies, as the authorities chase Omicron through city after city, notably of course Shanghai. Domestic and international supply lines were interrupted yet again by the closure of its port in April, and by the shortage of workers to clear it even as it reopens. Other major Chinese ports - such as Shenzhen and Ningbo - have suffered similarly.

Beijing, now under the spotlight, is seen as the ultimate test of China’s “zero-COVID” policy, and the difficulty of abandoning an approach so clearly led by President Xi Jinping - as well as the associated difficulty of ramping up an alternative vaccination strategy at sufficient speed. The social and economic impact has been considerable.  Working their way through China’s current difficulties without a financial crisis is going to be a severe test for its fiscal and monetary policy-makers.

As many inside and outside have noted (e.g., China’s Economic Growth in Retrospect, Yang Yeo, Brookings 2019), China’s economic resurgence wasn’t an inexplicable “miracle”: rather, an extraordinarily successful delivery of the tenets of classical economics. Growth, you’ll recall from those old textbooks, is driven by labour, capital formation and technological progress. And in the key period (1978 to 2018) in China, the savings rate topped 50 per cent, and the working-age proportion of the population peaked at 75 per cent. Together labour and capital powered a growth rate that averaged over 9 per cent a year. QED, as they say in the (classical) West.

This “miracle” was underpinned by two sets of government actions: first of all, the one-child policy, applied in 1980 to check population growth.  Whatever other issues this raised, it helped to deliver a huge pool of mobile workers to manufacturing cities, leaving their (few) children to grandparent care.   There was a short-run “demographic dividend” that has been estimated to have accounted for as much as a quarter of the economic growth in China in that period.

Second, there was the decision to open up the economy to trade, even in a highly mercantilist fashion.  This brought technological progress through competition and acquisition (one way or another) of western intellectual property. But whatever Western voters like to think, the benefits didn’t all flow China’s way: importing nations enjoyed falling manufactured goods prices, for so long that they had almost forgotten what inflation was like. Until, of course, this year…

In China, the benefits lasted through the first efforts to shift policy away from over-dependence on goods exports towards services. The “demographic dividend” tapered only slowly. The savings rate continued to be high, to a degree not entirely easy to explain (although Income inequality certainly played a part). The current account surplus was matched by a rapid build-up of overseas assets. But at the same time, loss-making state-owned enterprises required restructuring and the banking system felt the strain. And now China is facing into new headwinds.

The first, of course, continues to be viral. It’s hard for China to accept that the West’s current approach to “living with COVID” looks both more successful and more humane. The big story, it’s fair to say, isn’t over: a more lethal or vaccine-proof variant of COVID could still upend the West’s success by swamping its health systems.  But the stream of smaller stories from lockdown cities aren’t doing China any good.

The second headwind comes from overseas, with a harsher international climate, economically and politically, than in the balmy days that followed China’s entry into the World Trade Organisation in 2001. A tightening of policy in the United States, China’s biggest trading partner, bodes ill for China’s export growth; so does weakness in Europe, and particularly Germany (China’s biggest non-Pacific market).  But of course that’s not all: on top of long-running political concerns, China’s friendship with Russia, even after the Ukraine invasion, has raised the noise level in US talk of trade retaliation.

Whatever gets applause on the hustings, mutual interest remains a powerful restraint. Most observers have concluded that the sanctions on Russia couldn’t be replicated against China without severe self-harm to the United States and risk to the global financial system. The Rubicon of interdependence between the world’s two biggest economies was passed some years ago.  All the same, alarm at supply chain breakages has driven more than a mood swing against globalisation: it has already led, for example, to a ramping-up of chip manufacture in the United States.

But the most daunting headwinds are blowing from China’s own hinterland. To begin with, the population is ageing. The baby boomers of the 1960s are reaching retirement; the next generations are thinner on the ground. If the one-child policy has gone, there’s no sign of the birth rate recovering to replacement levels. China is facing its own, historically-distorted version of the demographic challenges with which the West has been struggling for decades. Ultimately, growth potential depends heavily on demographics (which those Western countries hoping to square immigration bans with low birth rates, rising incomes and longer lives might care to remember). China’s is beginning to shrink.

And even in the short term, the gap between China’s economic growth target and independent forecasters’ expectations is widening.  The stocks of some of China’s most famous tech behemoths have taken a battering; high-profile debt defaults have unsettled the stockmarket; the Shanghai and Shenzhen indices have fallen sharply since the beginning of the year. 

Still, it’s easy to be too pessimistic. China could tweak it its lockdown operations to recalibrate the health and economic risks without any openly-declared change of policy.  And that’s what already seems to be happening in China's ultra-sensitive capital city, at least to some extent. Schools and cultural institutions may be closed, complete lockdowns have been more narrowly targeted. This may be exacerbating anger in China about inequality - one rule for the Beijing elite, another for the rest of us - but could also point to a way forward for other cities. A more effective vaccination programme isn’t rocket science, it only requires honesty about the evidence, better decision-making and organisation - and could be game-changing for China’s prospects.

Most of the international institutions are still forecasting a growth rate that would be more than respectable by developed economy standards. Chinese manufacturing is still a terrific cash machine, as the continuing flow of inward investment testifies. With internal migration still pouring into cities, it doesn’t make much general sense to talk of an overheated labour market. And if the Chinese authorities are unsettled by a decline in the yuan, it still hasn’t reversed all of its rise last year, when they were equally worried by its strength.

So what about economic policy? If China is talking of yet another boost to infrastructure spending, its traditional way of bridging the gap between forecast and target, is that so different from the actions so many Western governments are taking to build back better” after the pandemic? Well, maybe not, except in scale. But the accumulated burden of non-productive investment in China, financed by the public and corporate sectors, already hangs heavy on the financial system, while another lifeline to the construction industry wont prevent more bankruptcies.

All of which suggests that repeated reliance on its default policy to shove growth up to target would not be the best sign that China’s official machine fully understands its changing world. The shift to sustainable domestic-led growth requires a more complex set of reforms, and a reset of more than COVID policy.

Facing headwinds requires balance and flexibility, effective and consistent regulation rather than a hunt for the on-off switch. This doesn’t come easily to a system of policy-making that militates against transparency, mobility and adaptability, whether in health, social or financial policy..

Few governments of any kind like losing face, but democracies can sometimes rip off the sticking-plasters, and force honesty (or U-turns) upon governments before it is too late. Whether China’s system of government can successfully internalise this painful but necessary process of adjustment to a changing world is the big question that lurks behind its COVID troubles.

Guest Author: Baroness Sarah Hogg, Former Frontier Economics Chairman