Chinese Economy – A Reality Check

The workshop of the world has successfully conquered the global manufacturing turf by churning out low-cost, quality goods, catering to consumers across the globe. China’s growing influence on manufacturing is being seen as a threat by many experts and nations. According to critics, however, there is more myth than reality about China’s miraculous growth story. Look at China’s claim of its stupendous growth and attempts to reveal the reality behind…

During the last two decades, China’s economy witnessed a remarkable transition. Chinese economy, home to 1.3 billion people has been expanding at the rate of more than 8% annually since 1980. This ‘workshop’ of the world has conquered the global manufacturing turf by churning out low-cost quality goods, catering to consumers across the globe. Over a quarter century ago, it was largely an agricultural nation, but today, it is rapidly transforming itself into an industrial nation and thereby raising its populations’ living standards. China’s annual GDP growth has been way ahead of the world economy consistently since the commencement of its reforms in 1979.

During the 1990s, foreign direct investment (FDI) has flowed into China. In 2002, it became the first country to attract more FDI in a year than the US, bringing in $53.2 billion, whereas in the case of US, it was $52.7 billion. It’s no surprise that in spite of global economic and financial market turmoil in the past, China’s strong economic performance has made its mark. This robust growth is attributed by the interrelated drivers that include the move to a market economy, rapid penetration into global export markets, rapid progress of privatization, labor market deregulation, rapid urbanization, the application of new technology, and massive foreign capital inflows, boosted productivity and fueled consumer demand. One important thing about the Chinese economy is that it is an economy built around the individual and small and medium enterprises, unlike Korea and Japan. Domestic demand will be the principal driver in the world’s sixth largest economy, China, where 22% of the world population is living.

After the US, now China is the powerful engine of the world economy. The Bank Credit Analyst, a Canadian research firm, estimates that the US accounted for only 20% of global growth in 1995-2002, while China’s share was 25%. Since 1995, its imports have grown twice that of Uncle Sam’s. It is also an important consumer of commodities. According to a research by Germany-based Deutsche Bank, in the year 2002, China consumed 21% of the world’s traded aluminium, 24% zinc, 28% iron ore, 17% of copper and 23% of stainless steel. Going by an annual GDP of more than $1,000 billion, it is obvious that China’s rise has a dramatic impact on the world economy.

Over the years, the Chinese economy has not only grown but has also risen steadily up the value chain. For instance, in 1990, it led the world in production of only cotton textiles and televisions. However, by 2002, it had added to the list desktop PCs, cameras, refrigerators, motorbikes, DVD players, bicycles, cellular phones, cigarette lighters, etc. In fact, there are very few products in the global marketplace that aren’t made in China. Going by this, many manufacturers feel that they must either produce in China or expand their purchases from China.

A recent report on the global investment situation by the United Nations Conference on Trade and Development (UNCTAD), reveals that at present nearly 400 of the Fortune 500 enterprises have invested in more than 2,000 projects in China. Unlike in the past, most of these projects are not labor-intensive industries, but capital-intensive industries. Even R&D facilities are being relocated to China. Besides, taking advantage of China’s low labor costs to inexpensively produced goods for exports, foreign companies are also targeting the Chinese domestic market. Also, in line with the China’s WTO commitment, it is now opening up its service industries, including the banking sector, to foreign investors.

In the Asian region, China is increasingly looked upon as the next economic superpower, especially when compared to the troubled Japan. Beyond this region, it’s the only bright spot in the world economy, as the major economies are not witnessing sound fundamentals. If we go by the present global economic conditions, certainly the prospects for Chinese economy are rosy because no other economy is expected to report anything near 7-8% of growth. In fact, the Chinese boast that the 21st century would be the Chinese century, when China will become the economic superpower, first in Asia and then in the world. According to the US-based investment bank, Lehman Brothers, “China can sustain an average annual economic growth rate of 6% and dislodge Japan as the world’s second largest economy in less than three decades. If this growth is sustained, China’s economy, by 2030, will be bigger than each of the major European economies and could conceivably displace Japan to become the largest economy in Asia, and the world’s second largest after the US.”

Despite all the sunny predictions, as China moves towards modern industrialization and globalization, there are also unavoidable social and economic effects. These include widespread corruption, widening of income gap and rising unemployment (there are 380 million people without a regular job in China.) Providing jobs or economic support for this number of people will be a daunting task. Beyond this, according to China’s National Bureau of Statistics, 90% of the domestic goods manufactured are in oversupply. This massive oversupply would lead to factory closures, creating more unemployment and social instability. China’s growth rate largely centered on the huge jump in fixed-asset investment in the first nine months of 2003, up 30.5%, compared with an increase of 16.1% in the year 2002. In short, growth is a function of investment in the economy.

As China is attracting the largest foreign investment in the world, there is more money coming into a market already awash with liquidity. Consequently, there is too much easy money flooding around. All these developments will add on to banking sector which is already plagued by increasing non-performing loans. Officially, these constitute about 20% of all loans. However, external observers like Standard & Poor’s put this figure at 45% and classify China’s banking system as the weakest among all big economies. However, Deutsche Bank Research observes that bad debt has not posed an immediate threat to China’s financial sector. According to the Deutsche Bank Research unless domestic banks are successfully restructured before the restrictions on foreign banks’ businesses are removed, they could face a potential liquidity crisis. Moreover, an undervalued currency and low interest rates have now resulted in a massive fiscal deficit as well i.e., $37.36 billion or 3% of GDP, an internationally recognized alarm level.

Economists as well as the Chinese authorities are expressing concerns that the Chinese economy is overheating due to the booming pace of real estate, steel, automobile investment and production, and a rapid expansion in money supply. Excessive investment in these sectors prompts oversupply, thus driving prices lower. A major surge in investment, bank lending, construction and car manufacturing has put the Chinese economy at risk. As consumer purchases drop on expectations that prices will continue to fall, factories are forced to ratchet up output to combat decreasing revenues as sales slide. The vicious cycle leads to default on bank loans and eventual economic collapse.

Sustainability of China’s growth rate is the key issue now. Infrastructure bottlenecks pose a threat to future growth. Investments in transport, telecommunications, and energy have lagged behind, resulting in chronic shortages of transport services and increased urban congestion. 

Gordon G Chang, author of Coming Collapse of China, predicts that the present growth is unsustainable. He further says, “Growth these days is essentially dependent on three factors: fiscal stimulus, FDI and exports. Chinese record budget deficits mean that government pump-priming must end soon. The economy is now hooked on ever-increasing infusions of Central Government cash, and that flow of funds is not sustainable in the long run. China could face a financial crisis in the next half decade.” Beyond this, as long as China depends on low wage levels to compete in international markets, it can at best be a ‘factor of the world’ rather than an ‘industrial power’ that would rule over such high value-added areas as product standards, brand names and core technologies.

Going by the above adverse threats, to keep the economy on track, the Chinese authorities are taking various steps, such as mopping up excess liquidity through bill and bond issues, tightening supervision of bank lending, particularly to sectors of concern, and tightening reserve requirements for financial institutions. Besides, it has declared that it will work towards a more market-oriented exchange rate arrangement in the longer term. Despite calls from some trading partners for faster action, the country has made it clear that it will not rapidly move to adopt a flexible exchange rate.

In order to keep the reform process on track and to keep the economy under control, China has to sustain a stronger GDP of more than 7% per annum. Even with the growth rate of 7-8% during the past few years, unemployment has been rising. Thus sustaining and even accelerating growth without compromising on stability is crucial for the economy. Without strong growth to absorb the displaced and new labor market entrants, there could be an increasing social unrest leading to resistance to structural reforms. China will have to delay structural reforms to avoid social and political instability, which in turn, would reduce sustainable long-term growth and result in a vicious cycle of weakening economic activity and increasing social hardship.

Hong Kong-based Royal Danish Consulate is optimistic about the future of the Chinese economy. It says that China’s ongoing reform program and its accession to the WTO are likely to support strong medium-term economic performance and help boost China’s share of world trade over the next decade, delivering significant gains in living standards for China and economic gains to its major trading partners. WTO membership will increase demand for foreign imports and open the services sector to greater foreign investment and competition. However, it warns that in addition to implementing its WTO accession commitments fully and in a timely manner, China faces a set of substantial domestic economic policy challenges – notably in finance, social welfare, SOEs and agriculture – that will require considerable further efforts on the part of the Chinese authorities to ensure continued economic success over the medium term.

Regarding the future of the Chinese economy, Deutsche Bank Research is very bullish, going by its booming exports, which have been becoming major contributors to GDP. It believes that China is expected to maintain a growth rate that, over the next ten years, will probably be high enough to allow the authorities to advance structural adjustment. Through efficiency gains from these reforms, China should then be able to achieve high growth for another decade, moving its GDP above that of many industrialized countries.

China plays an important role as an export market and low-cost supplier for other major economies and their companies and of course, as the financier of the US trade deficit. Any slowing down in its current growth could have important implications for Asian countries that are increasingly becoming Chinese-dependent trading partners. If the boom busts, the end result could be disastrous.

Jany, Lead Economist