China’s economy, following the general path of the East Asian Developmental State model, was able to rapidly transition from a peripheral economy to an industrialized nation. To increase productivity, land ownership was divided into family-owned plots and small farms were incentivized to maximize their output and create an income surplus. China was then able to use this surplus to mobilize state-directed investments such as education, infrastructure, and heavy industry. The focus on export manufacturing encouraged competition and innovation, and a heavy reliance on FDI and SOEs allowed China to become perhaps the most successful post-Communist transition economy. The CPC moved from a centrally planned socialist economy to a market-based transition economy without privatizing most enterprises, as party officials saw relinquishing control over SOEs as a weakening of the power of the central authority. China’s unique combination of formal centralization and effective decentralization has allowed the government to mobilize huge amounts of resources through the centralized authority while simultaneously allowing room for entrepreneurial activity at the local level.
Arthur Kroeber outlined China’s key domestic and international tensions that inform current policy choices. Maintaining the party’s monopoly over power must be balanced with maximizing economic growth, at times requiring tradeoffs between growth and political control objectives. President Xi has particularly emphasizing the power of the central authority, and the nation has asserted itself as a fully independent geopolitical actor. The ambivalence of whether China is to be a “rule taker” or a “rule maker” in the Asia-Pacific region has been a source of friction between China and the US.
China faces several key challenges in the coming decade in maintaining economic growth and an effective governance system. Since 1980, China has focused on maximizing investment and installing the capital stock for a modern economy, with dirigisme and SOEs playing a significant role. Over time, however, the extremely high rate of growth eventually comes to a halt. Investment in areas such as infrastructure is no longer as effective, and as the source of that growth is reduced, the dependency on productivity increases. Once the infrastructure has been built, the structure for productivity is in place, and continued investment has diminished returns; the focus then shifts to making existing projects efficient. Thus, China’s primary job is now to maximize the return on their investments, which ultimately requires a larger role for free markets. According to a CEIC, NBS, Gavekal Data/Macrobond model based on gross residential completions, China’s demand for new housing is peaking and set to decline, signaling the end of the housing boom. Additionally, China faces the economic challenges associated with the transition from a young to an old society. China’s dependency ratio, which halved from 1975-2010, is expected to rise by 50% over the next three decades. China is at the end of its demographic dividend, as the workforce that propelled it to economic success is now retired and using government programs such as healthcare and pensions. Kroeber noted that China must also look to successfully transition from a less inclusive to more inclusive governance. A complex society with a market-driven economy requires more participatory decision-making, and Kroeber stressed the necessity of shifting more resources to the private sector. SOE productivity has stagnated, widening the gap with private firms, and China’s private-sector debt ratio is now higher than most countries.
Kroeber presented three potential scenarios of how China’s economy may look in the coming years. Most appealing to the CPC is the pathway of becoming a rich, technologically advanced nation while maintaining its one-party system. If economic reforms succeed and China can secure growth at 5% by 2020 with stable leverage, China may be able to become what Kroeber calls “Singapore on Steroids.” This may coincide with the marginal easing of political controls after the 2017 Party Congress. Alternatively, a failure to effectively enact economic reform may lead to bank failures and a financial crisis. However, given that China still has a strong deposit base, there is not much funding risk and it is very unlikely that a financial crisis will occur. A third scenario with a much higher likelihood than a crisis, on the other hand, is that entrenched political economy bargains may impede reforms, and China may become stuck in a low-growth, high-debt trap. If debt is financing less productive projects and the state becomes more concerned with social stability, China may retreat from foreign adventurism and focus on domestic welfare and social reform.
While there was an established playbook for responding to a Clinton administration, Trump’s volatility and contradictory statements make his next steps difficult to predict. Xi Jinping was declared a “core leader” after the 6th Plenum, implying that he is not linked to any leadership generation and his rule is thus not necessarily time-limited. The 19th Party Congress in 2017 looks to be a decisive moment in Xi’s consolidation of his ruling mandate, and party officials have stated that the customary age in top party posts is “flexible.” Kroeber predicted that from a strategic standpoint, US-China relations point in China’s favor. The likely failure of the Trans-Pacific Partnership reflects China’s opportunity to set its own terms for regional economic integration, particularly through initiatives such as One Belt One Road. From a tactical perspective, a US reflation trade may put further downward pressure on the RMB and increase incentives for capital outflows. China may be subject to trade sanctions, in which case we may expect a protectionist global environment.
Trump may respond to China with a tariff on all Chinese imports, but Kroeber noted that this is unlikely given that it will harm US firms and raise prices for the constituency that elected him. A more likely response is the implementation of targeted duties on specific sectors under Section 301, as this would bring attention to rustbelt industries such as steel. However, the Chinese government realizes that foreign companies need the Chinese market more than China needs these companies, and any sanctions the US places on China may be self-defeating. Trump may also declare China to be a currency manipulator, a symbolic move with limited practical impact given the main consequence would be the denial of Chinese firms gaining access to US government procurement contracts. China may respond to these gestures with retaliatory tariffs on US imports, a reduction of procurement of US products (notably Boeing aircraft), and perhaps most dangerously an imposition of informal regulatory constraints on US firms. Although it is too early to determine the nuances of the Trump-Xi relationship, it appears to be following a tense and contentious path.