Dec 1, 2017  |  JUSTIN YIFU LIN

With the age of Western global dominance coming to an end, it is China’s time to shine. The potential is certainly there, but to realize it, President Xi Jinping will have to confront serious challenges, from domestic supply-side reforms to expanding international responsibilities.

BEIJING – In his opening speech at October’s 19th National Congress of the Communist Party of China, President Xi Jinping argued that China had “crossed the threshold into a new era.” He then pledged to build a “great modern socialist country” that is prosperous, strong, democratic, culturally advanced, harmonious, and beautiful by mid-century, led by an empowered CPC, but open to the world.

These are bold aspirations, though if anyone is in a position to deliver them, it is Xi, now widely regarded as the most powerful Chinese leader since Mao Zedong. But the specifics of Xi’s plan remain unclear. What will it take for China to modernize effectively in this new era?

OUT WITH THE OLD?

The era may be new, but one of the trends that will define it is already well underway: China’s dual-track transition from a planned to a market economy. Continued progress on this front is vital to boost stability, capitalize on China’s comparative advantages, and spur rapid socioeconomic development, thereby paving the way for deep institutional reform.

Since the transition began in 1978, China has taken important steps, including to liberalize employment-generating industries like manufacturing and to implement rural reforms. Yet, given that China’s leaders have always placed a high priority on stability, they have taken an incremental approach, while maintaining many of the interventionist policies typical of a planned economy, including protecting and subsidizing large state-owned enterprises.

In the early years of the transition, the capital-intensive SOEs that China’s government was propping up defied the country’s comparative advantages, and would not have been able to survive in a competitive open market. But, thanks to China’s rapid growth and accumulation of capital, many of those SOEs have now become viable. The time has come to eliminate distorting subsidies and protections. Only with such a change, alongside deep and ongoing institutional reforms, can Xi reach his stated goal of allowing markets to play a “decisive role” in resource allocation – critical to the modern economy he aims to build

THE NEVER-ENDING GROWTH STORY

In many ways, China is already on a strong footing. Over the last 38 years, the country’s GDP has grown at a rate of 9.6% – an unprecedented feat. And the economy still has considerable growth potential. As it stands, there is a wide gap between per capita income in China, an upper-middle-income country, and in the developed economies. This gap represents the difference in labor productivity, and thus points to opportunities for growth-enhancing technological innovation and industrial upgrading.

Already, China is at the global frontier in some industries, such as high-speed rail, renewable energy, and household appliances. Securing a leading position in other advanced industries – such as e-commerce and mobile devices, which have short product cycles and require substantial human capital – will be vital to enable the country to continue to thrive. Fortunately, China faces no shortage of local talent, and it boasts a massive domestic market for new products.

So far, China has not managed to capitalize fully on these assets, and continues to lag far behind the West in terms of the quality – and, thus, the price – of the products it manufactures. Yet, if China can close this gap, it has the potential to achieve 8% annual economic growth.

Other economies have shown that it can be done. China’s per capita GDP (in purchasing power parity, or PPP, terms) in 2008 was 21% that of the US – the same ratio registered by Japan in 1951, Singapore in 1967, Taiwan in 1975, and Korea in 1977. All of those economies maintained an 8-9% growth for another 20 years after that point, and they didn’t even have the option, as China does, to take advantage of human-capital-intensive industries with short production cycles.

Some have argued that the blind pursuit of GDP growth is a risky game, claiming that the challenges China now faces are the result of its prolonged and rapid economic expansion. Yet India has been growing more slowly than China for decades, and faces more severe pollution, income inequality, and corruption. In short, as long as potential allows, it makes little sense for developing countries not to pursue a high growth rate.

THE REFORM TIGHTROPE

Of course, this does not mean that China should be reckless. Turning potential into reality requires the right conditions on both the supply and demand sides. If China is to fulfill its potential in a sustainable way, supply-side innovation policies should be complemented by demand-side efforts.

Growth can be supported on the demand side through exports, investment, and consumption. At a time of plummeting annual export growth – from 16.5%, on average, from 1978 to 2014 to below zero in 2015-2016 – many are pointing to consumption as the next key driver of Chinese growth, arguing that it is more sustainable than investment.

But higher consumption hinges on higher incomes, which depend on higher labor productivity. And higher labor productivity demands constant technical innovation and industrial upgrading. Without investment, there can be no innovation or upgrading, much less income or consumption growth.

Given this, China should be focusing not on replacing investment with consumption, but on improving the efficiency of investment, so that it supports the productivity growth, job creation, and wage gains needed to sustain domestic consumption. This will require, among other things, that China address supply-side imbalances, including excessive leverage and overcapacity.  At the same time, China’s leaders must pay close attention to the needs and expectations of the emerging middle class. Xi has made it clear that his vision is to be carried out by a powerful CPC, which should “resolutely oppose all statements and actions that undermine, distort, or negate” its leadership or the Chinese socialist system. If the CPC is to maintain the popular legitimacy needed to underpin its authority, reform efforts must be people-oriented, focused on meeting the public’s rising expectations regarding living standards, environmental quality, transparency, governance, and freedom of speech.

CLOUDS BEYOND THE BORDERS

Of course, China is not reforming its economy in a vacuum. And there is no shortage of challenges confronting the global economy. Twenty-six years after its economic bubble burst, Japan is still struggling to secure strong growth or escape deflation fully. The European Union seems finally to be emerging from its own slump, which began with the 2008 economic crisis, but the recovery remains fragile, with GDP growing at about 1%, on average, and unemployment still high. While the US is doing somewhat better, its GDP is growing at just 2% per year, and neither the International Monetary Fund nor the World Bank expects it to reach 3% before 2020.

A key reason for this state of affairs is that developed countries have consistently failed to pursue difficult but necessary structural reforms. Politicians know that structural reforms are necessary to enhance long-term competitiveness; but they fear the political repercussions of the short-term impact on investment, employment, and consumption. In times of slow growth and mounting unemployment, however, such reforms only become more difficult.

In Japan, Prime Minister Shinzo Abe established structural reforms as the third “arrow” of Abenomics (the first two being fiscal stimulus and monetary easing). Yet, after five years, the third arrow remains in the quiver, and annual GDP growth stands at just 1%. I fear that long-term sluggishness like what Japan is experiencing might afflict a larger number of developed countries.

None of this will be good for political stability. In the United Kingdom, the vote for Brexit was followed, a year later, by an unexpected loss for the Conservative Party in a snap election. Donald Trump’s victory in the 2016 US presidential election shocked the world. German Chancellor Angela Merkel is struggling mightily to form a coalition government.

Faced with an anemic recovery, mounting unemployment, and rising inequality, electorates in developed countries will naturally vote for change. China needs to gird for it – and for the uncertainties that follow. What it must not do is panic. Staying calm and pursuing smart, forward-looking policies is the best way to ensure that China does not get caught in the crossfire of international upheaval.

PUTTING AMERICA FIRST

This is particularly true with respect to the US, which, despite its ongoing retreat from global leadership, remains the single biggest international player – and China’s single most important economic partner. If China is to achieve the “great rejuvenation” of the Chinese nation that Xi seeks, its leaders will need to avoid conflicts – including trade disputes – with the US, by leveraging economic complementarity.

In China, per capita income is about one-fourth that of the US in PPP terms, and about one-seventh nominally, while average labor productivity is low. This makes it less likely that the US and China will compete directly in, say, high-value-added, high-tech, and capital-intensive industries. So, unlike the European Union and Japan, China is seldom locked in international competition with the US, because Chinese exports to the US are mainly low value-added goods (a point that US President Donald Trump seems unable to understand).

In fact, not only do the comparative advantages of the US and China rule out direct competition; the market of one actually enables the other to make the most of its own strengths. For US companies, China’s market – the world’s largest, in PPP terms, contributing over 30% of the global market’s annual expansion – is too lucrative to pass up. Given that America’s largest firms are often the biggest donors in US elections, US policymakers have a strong incentive to maintain – and deepen – economic ties with China.

It will not be all smooth sailing for the bilateral relationship – far from it. The US has lately been feeling threatened by China, whose international influence is expanding in lockstep with its economy. But whatever geopolitical rivalries emerge should not be allowed to undermine the mutually beneficial bilateral trade relationship. This makes it all the more critical for China to continue to upgrade its economy and realize its growth potential. Only by ensuring that it is indispensable to American business can China remain on friendly economic terms with the US, even as political challenges – including those rooted in the continued growth of China’s geopolitical clout – inevitably emerge.

A GLOBAL GOVERNANCE RESET

Make no mistake: China is right to seek and assume a larger global role. It is by far the world’s largest economy by PPP, and it will become the largest economy in nominal terms before 2030. It is only reasonable that China’s growing economic clout should be accompanied by greater influence over global governance.

The current international order has contributed to relative peace and stability since it was created at the end of World War II. Yet it has been dominated by the Western countries that created it. It has not only served these countries’ interests before all others; it has also championed their approaches to development and governance.

Very few developing countries have succeeded within this system. In 1960, there were 101 middle-income economies; by 2008, only 13 of them had reached high-income status. Worse, since 1945, only two of the world’s 200-odd developing economies – Taiwan and South Korea – have ascended from low-income to high-income status. (If all goes according to plan, China will become the third by 2025.)

No developing economy – except perhaps one that is economically and geographically close to Western Europe – can succeed by adhering to the advanced economies’ development prescriptions. That is why a new kind of development thinking is needed, one that takes into account the lessons of those – from the four “Asian Tigers” to China itself – that have succeeded precisely by ignoring the development strategies pushed by the West.

In the 1950s and 1960s, developing countries were told repeatedly that, to raise incomes and labor productivity to the level of the developed world, they needed to achieve the same level of industrialization. So, rather than continuing to export agricultural produce and minerals, and import modern manufactured goods, many dove head first into the deep water of automobile, steel, and equipment manufacturing. Some never resurfaced.

In the 1980s, when that import-substitution strategy had proved a failure, developing countries were told that the problem lay in the fact that they were not full market economies. They must, according to the neoliberal logic of the so-called Washington Consensus, immediately roll back government intervention, and pursue privatization, deregulation, and trade liberalization.

But the most successful developing economies are those that rejected these prescriptions. Japan and the four Asian Tigers pursued labor-intensive, small-scale traditional manufacturing, instead of import substitution. China adopted its gradual, dual-track approach to the transition from planned to market economy. Vietnam and Cambodia – two more Asian countries that have achieved stable development – also resisted the conventional neoliberal wisdom.

A similar trend can be seen in Eastern Europe. In Poland and Slovenia, large, non-privatized SOEs contribute nearly 30% of GDP – no lower than the ratio in China. Uzbekistan and Belarus, the best economic performers among the ex-Soviet countries (aside from the three Baltic states), also rely on non-privatized firms.

There is no one-size-fits-all development strategy. Successful countries think about what they can do well with what they have, and create conditions to scale up those industries. That is what China has done – and what it, as an increasingly central player on the international stage, must help enable other developing countries to do, too.

Xi’s Belt and Road Initiative, which promises massive infrastructure development in Eurasia and Africa, is an ideal vehicle for this. And, beyond the BRI, China can use its engagement in countries all over the world to spread a new and viable set of development and governance ideas. China has a clear interest in their success: bringing about prosperity in the developing world would be the best way for Xi to achieve what he – and now the CPC – call the “Chinese Dream” of individual achievement and national greatness.