The Chinese Economic Model Muddle
What, actually, is the Chinese Economic Model ? A short journey through Chaos, Reform and then 23 years of muddling through.
Slow Motion Train Wreck
Much ink has been spilled in recently describing the halt to China’s previously dramatic economic growth.
What is puzzling is that there has been so little criticism of China’s economic decisions for more than twenty years.
Economic problems have been significant well before the current growth slowdown, but even while GDP growth numbers were high, and impressive high speed rail was whizzing goods and people across the country, the economic trajectory has for years been unsustainable and its output inefficient - the wrong things produced and produced inefficiently.1
China’s leaders love to boast about “The Chinese Economic Model” without being specific about what it actually is or why it might be better than conventional economics.
Let’s look at what actually works, then what China actually did….
What Is The Conventional Economic Model ?
After World War Two, countries around the world tried various means to rebuild their economies. Some like Britain and France tried high levels of government ownership. Some like Scandinavia tried high taxes and generous welfare. By the 1980’s it had become clear what worked, and what didn’t.
In the 1980’s, there emerged a consensus that nations can achieve reasonable levels of material prosperity with the following basic policies:
Don’t have price controls. Otherwise you get shortages.
Avoid subsidies. Subsidies mean society has more of what it wants less, and less of what it wants more, due to taxing one thing to subsidise another.
Keep government from owning commercial businesses. They run them in their interests of politicians and managers, not in the interests of consumers or investors.
Encourage private sector growth: Create certainty and facilitate competition. This might mean deregulation, but as mistakes in the banking sector (eg 2008 sub prime crisis) show, enforcing appropriate regulation is vital for stability and certainty for the private sector.
Governments should focus on things that only government can do. This includes welfare, health and education. Making sure infrastructure is built is important, subject to ensuring the economic case for projects is sound. Government ownership is not necessarily required to provide infrastructure2.
Embrace (re)globalisation3. Reducing import protection facilitates specialising in what your country is good at. Encouraging a level playing field for foreign investment creates competition and innovation. The cost of decoupling, de-risking or what in China is labelled “de-sinicisation” is higher prices for customers and lower profits for investors. Unfortunately free trade only works when politics and military strategy don’t get in the way. Peace was profitable.
Intellectual Property Protection. Investors will not invest in creating or introducing new technology if they cannot make money for a reasonable period from it. A fair and efficient legal system and efficient protection of Intellectual property will encourage more investment and growth.
Currency Pricing. If you can, float your currency. Otherwise price your currency according to the market (ie a pegged system). Once you have a suitable buffer there is no point in building up surplus foreign cash and distorting your local money supply management. Price money right.
What Actually Is The Chinese Economic Model ?
Chinese government spokesfolk often argue that many countries can benefit from China’s experience and emulate its model.
The model is a product of the political institutions that manage it.
Four Phases of CCP Economic Management:
Considering the period of Chinese Communist Party management of the Chinese economy, four main phases of economic policy direction are evident. In order to understand the current one, we should consider how it evolved…..
Phase 1: “Everything under heaven is in utter chaos; the situation is excellent.”(Mao)
1949- 1962: “Liberation” and the “Great Leap Forward”
Close the stock market.
Nationalise all businesses
Minimise international trade
Impose price controls
Impose top down economic plans (eg five year plans)
Force farmers into communes and destroy agriculture, creating mass starvation
Pursue ambitious steel manufacturing plans with backyard furnaces
While doing everything else wrong, divert scarce resources to make technological achievements in military fields, eg atomic and hydrogen bombs, and ballistic missiles.
Urge the populace to create extremely large families.
Phase 2: “To Rebel is Justified, Smash the Four Olds”
1962 to 1977: The Cultural Revolution.
Foment a personality cult
Close schools and universities
Divide the nation into factions that literally fight each other.
Build a heavy industrial base in locations far away from ports where they would otherwise have had cheap access to imported inputs or lower transport cost for export.
Phase 3: “Whoops We Screwed Up” ….
Let’s ….“Reform and Open Up” (改革开放-gǎi gé kāi fàng)
From the death of Mao in 1976 when reform tentatively began, until 2003 when economic reformer Premier Zhu Rong Ji stepped down, major and helpful reforms took place.
In the beginning:
End of Cultural revolution, return to social stability
One Child policy (seemed like a good idea at the time)4
Removal of price controls
Legalisation of small private enterprises
Agricultural reform - farmers permitted to keep what they grow and even sell some crops for cash.
Rural Hukou5 holders permitted to work in urban areas but without social security or education for their children. Released a seemingly unlimited supply of desperate workers from the country to power the urban economy.
All quickly led to economic growth.
Then through the 90’s further improvements were made:
Export focused special economic zones, eg Shenzhen
End of dual currency which (at that time) had overvalued the Yuan
Privatisation of smaller and medium sized enterprises, especially those owned by provincial and township authorities
Creation of private residential property market
Large government funded infrastructure projects
Performance of Government officials judged by economic results.
Tax reform financially strengthening the central government, weakening local government, and leading to reliance on selling property to developers.
Most of these were good reforms or at least pointing in the right direction.
Phase 4: 国进民退 (gúo jìn mín tùi)
The State Advances, The Private Sector Retreats
After 2003, sensible reform had stalled and the latest China Economic Model started to consolidate.
The Current Chinese Economic Model Key Features:
Growth in inefficient state enterprises parasitically subsidised by the private sector.
SOE’s get privileged access to loans from state banks, have party cells meddling in management, have subsidies and advantaged access to government contracts, but still manage to make returns on assets at only about ⅓ the level of more efficient private companies. 100 % government ownership is not viable because the state sector needs the private sector to directly or indirectly subsidise it.
Party influence on managerial decisions.
Companies that are mainly or even fully private must have party cells on the payroll, meddling in management decisions. In addition to “studying” or attending to party work during company time, they meddle in the strategic direction of the firm. Under the guise of carrying out the “main theme” of the latest CPC meeting or a top down generated Five Year Plan, they inhibit competition and entrench the power of the established social order.
Tech Crackdown:
Anyone not obsequiously praising the CCP is an enemy, so when Jack Ma (马云 mǎ yún) expresses the truth about the state owned banking system and pitches his own solution, he “disappears” from view, to emerge poorer and quieter, months later.
Not only did Chinese shareholders lose wealth, the potential for world beating fintech innovation and a chance to leapfrog from China’s current banking system, to a futuristic digitised and more efficient financial system, has been slowed down - hopefully not lost.
Punishment of individuals as cover for failure of the system:
How many “corrupt” officials and business people can one country have ?
The Wall Street Journal listed fourteen dead or missing billionaires, and Min Xin Pei points out that it’s the political, administrative and legal system that creates the incentives and opportunities to build wealth in ways that involve misbehaviour and high risk.
SOE bailouts, repeatedly
In 2003 and 2005 Huarong and other asset management companies bailed out loss making state enterprises. Instead of fixing the boat, they just keep bailing out the water. In 2017 Huarong itself was in financial trouble and it’s former boss Lai Xiao Min executed for graft, financial and personal misdemeanours.
Cart-Before-Horse Infrastructure Strategy:
In the 1980’s and 90’s travellers found the arrival into Hong Kong’s Kai Tak airport frankly frightening. The case for a new airport was well justified by consumer demand. The private sector and local consumption had grown since Mao’s excesses had populated the territory with refugees from Communism and the territory had a vibrant economy based on free markets and rule of law, enabling the refugees to build their own future. Infrastructure was built when it was actually needed, with money Hong Kong already had or could afford.
China puts the cart before the horse.
Instead of growing infrastructure to support requirements, infrastructure spending is seen as a way of forcing the economy to grow. At the early stages of economic reform, empty roads or airports didn’t matter. As the economy grew, thanks to the private sector, they eventually got used. This has not worked in the 21st century the way it (sort of) worked in the 1990s, because the economic case is often not justified.
Debt funded low return infrastructure to create jobs instead of facilitate growth, has imperilled the finances of provincial and municipal governments.
Belt and Road “Initiative”:
BRI involves lending to developing countries to get them to buy exports of services (engineering and construction).
Chinese State Banks lend money to projects the IMF and international banks wouldn’t touch with a barge pole.
If / when it all falls over, China tries to get the IMF, World Bank or foreign commercial banks to take a haircut on their loans to the indebted country, or take possession of the asset, although even this may entail losing money.
Since 2017 BRI projects have substantially decreased by number of projects and overall value. From 2018 onward many BRI related loans needed “renegotiation” imposing further losses on China’s banking system.
Property Market Over Reliance:
The Chinese property market has been booming with the occasional brief pause since its creation in 1998. The restrictions on investing outside China, and the poor liquidity and dominance of state sector controlled enterprises in the Chinese stock markets have made it hard for the average Chinese middle class investor to find good investments to park savings.
Investment in residential housing was popular for years, while the economy boomed. Today around 70 % of Chinese household wealth is invested in property.
The first ghost cities emerged in 2006 and the most well known mass destruction of unused housing was in Yunnan in the 2020s.
To get rich in property development you needed connections at government (ie party) level, to get access to land and resources, and to get access to finance from state owned party directed banks.
As the “model” developed, it became possible to get buyers to prepay ie (lend), to sell bonds to investors, and gain finance from “shadow bankers”, mainly wealth management trusts that are not effectively regulated or monitored. Evergrande took this a step further by creating their own wealth management arm, that could steer investment from small investors, into their property enterprise. Recently Evergrande had 8 cents of equity and 92 cents of debt for every dollar of assets, so a modest fall in asset values could easily result in negative equity.
Property Market Reform Conundrum:
The model traps decision makers with difficult choices:
If they weaken the property sector it lowers apparent wealth of consumers and consumer confidence. It also leaves municipal governments with less financial firepower through reduction in land sales revenue.
If they pump up the market with more liquidity, they are kicking the can down the road again, and each time the “Coming Collapse of China”6 doesn’t come, the chance it will happen, later, worse, increases.
Ironically this phenomenon of short term decisions that make the future worse is often associated with democracies that have regular elections, and a government with no expiry date should be able to make decisions that consider the long term.
Clearly the claims of dictatorship supporters, are wrong. The Leninist Political model is still swayed by short-termism, and the interests of the political elites.
Wrong response to 2008 financial crisis:
After the 2008 financial crisis, Chinese officials boasted that the USA had failed and China’s model was superior. They then took actions seemingly designed to prove themselves wrong.
Chinese authorities maintained high economic growth by creating their own debt fuelled bubble. Worse. The political system skewed a massive credit injection into loss making and underperforming state and state connected firms, and excessive infrastructure.
Closed Financial Market
Chinese citizens cannot easily invest outside China. This means returns are reduced, and they are dependent on the performance of the local stock market.
Most companies on the Chinese stock markets are mainly majority government owned and perform poorly due to pursuit of non profit objectives. Government meddling in the share markets, eg restrictions on large stock sales, government directed fund buying to support the market, restrictions on data availability, all serve in the long run to deter local investment.
Foreign investors face capital controls, and are both limited in what they can do, and nervous about increasing exposure in the current political environment.
Non-Convertible Currency.
Despite China being the world’s largest exporter, a major importer and a significant destination for FDI and source of outward investment, its currency is not convertible and this has distorted investment decisions and currency valuation.
Currency suppression phase to boost exports
From 1949 to the late 1970’s, the Chinese currency was priced artificially highly and China was not open to world trade.
In the 1980’s, China attempted to price the currency properly, but by the 2000’s it had a sustained period of dramatic undervaluation, skewing production toward exports, and inhibiting growth of local consumption, creating an imbalance now hard to rectify.
HuKou Apartheid
Rural Hukou holders have now long been permitted to work in urban areas but without social security or education for their children. Economically this is analogous to the South African apartheid that ended by the early 1990s. Like apartheid, working away from your hometown was better than staying in your dilapidated home province, but your status was dramatically unequal in the city. Hukou restrictions are now gradually being unwound, but the legacy is that the children of the poorest people have been denied parental contact, health care and education at city level and are not skilled for the 21st century.
Demographic cliff
The One Child policy ended in 2016, but now the idea of only having one child is entrenched, further reinforced by difficult economic circumstances. Many other countries have this problem without a one child policy, but it’s a part of the Chinese model no national economic strategist would want to emulate.
Intellectual property theft:
China’s infamous efforts at Intellectual property theft assumed there would be no retaliation from other countries. It’s hard to quantify what technologies were not applied to the Chinese market due to fear of simply being appropriated, but now foreign companies and governments are taking it seriously and putting up barriers to technology access.
Ignore The Environment:
Up until the 2010’s, only output mattered. Until it reached a crisis point of poisoned soil, air and water, the damage to the environment by heavy industry was barely taken into account. Anyone who complained, suffered the force of the law to suppress them. Environmental damage is a real, tangible cost, measured in lost future production, worse health outcomes, and often irreversible damage to ecosystems.
So Many Muddles, So Little Time:
So many of these headings could be chapter headings, in a huge book, and there are so many more aspects to the China model that deserve coverage.
We are just scratching the surface here.
Where Now ?
China’s positive economic performance only begins after the death of Mao, anything would have been better, including Nationalist rule.
The current model is hopefully a step along the way towards a better system. To improve, it would need a modern political system7, as a one party state defends the interests of those at the top, not the populace at large.
Decisions about production, consumption, investment, environmental management are skewed when the incentives are to serve a self selecting, entrenched elite and not the citizens themselves.
The Chinese model is a muddle, stumbling blindly, unable to let the Chinese people achieve their full potential because of stale dogma and the need to protect the party from the people.
It is not something for other nations to emulate.
Allocative inefficiency - producing the wrong things. Production inefficiency, producing with waste and high cost. If you build a new apartment building under budget - that is production efficiency, but if no one lives in it, that is allocative inefficiency.
Some would argue health and education can be left to the private sector, but in practice most countries give government a significant role in ensuring minimum levels of healthcare and education are available.
Globalisation from the 1980’s onward was not new, nor the first or second time in history that free trade had spread rapidly.
There was of course, no open debate or discussion about the one child policy. Expert demographers, may well have disagreed at the time, if it had been safe to do so.
户口 Hukou - registered permanent residence.
Much ridiculed book by Gordon C Chang 2001. “The Coming Collapse of China” outlined seemingly intractable debt problems relating to state enterprises that could trigger China’s economic collapse. We’d have to say he was wrong, but the systemic issues he identified have not been dealt with. He might argue the collapse is still coming, later, bigger.