Is China’s Slower Growth Inevitable?

A new study by a leading economist concludes that policy choices were responsible for the economic slowdown.

The State Strikes Back: The End of Economic Reform in China? By Nicholas R. Lardy. Peterson Institute for International Economics, 2019. 200 pages.

China’s slowing economy is not a big worry only for Taiwan. Much of the rest of the world has grown increasingly dependent on the Chinese playing a key role powering global growth.

Some economists say that China’s booming growth over the past four decades was bound to end eventually – and that’s what we’re seeing now. But Nicholas R. Lardy, one of the world’s leading experts on China’s economy, argues in his compelling new book that the country’s recent woes are largely self-inflicted.

Lardy, a senior fellow at the Peterson Institute for International Economics in Washington, D.C., says China is making a serious mistake by veering away from its market reform policies of the 1990s and wasting too many resources propping up money-losing state enterprises that are dragging down the economy. More than two-fifths of state firms persistently lose money, he says.

The current policy has stifled the competitive forces that once stoked the rapid growth, Lardy writes in The State Strikes Back: The End of Economic Reform in China?

With a well-designed economic reform program, China’s economy could return to the days of growing an average of 8% or more for a couple more decades – well above the pace of recent years, Lardy says.

Many have long argued that the Communist Party viewed economic growth as the key factor to remaining in power. As long as the party kept delivering impressive GDP figures, the people would tolerate one-party rule.

Author Nicholas R. Lardy, senior fellow at the Peterson Institute for International Eco-nomics in Washington, D.C., is a leading expert on the Chinese economy. Photo: PIIE

But Lardy suggests the party has had a change in attitude in recent years.  What’s most important now is maintaining a tight grip on power – not delivering stronger economic growth. “China’s leadership seems to have willingly accepted reduced profitability, slower growth and the greater financial risk associated with high leverage to be able to exercise more economic and political control,” Lardy says.

China’s last big push on economic reform was in the late 1990s, led by Premier Zhu Rongji who oversaw a major initiative to downsize and restructure state companies. The bold, risky reform effort led to the layoffs of tens of millions of workers at rusty state-owned factories. But it paved the way for China entering the World Trade Organization in 2001.

During the decade-long rule of President Hu Jintao and Premier Wen Jiabao, China’s economic reforms became much less ambitious, and the leadership began turning away from Zhu’s policy of opening up. When the global financial crisis hit, the government responded with a massive credit-finance stimulus program, not a renewed effort at economic reform.

The tide really turned in favor of state firms after the rise of Xi Jinping, who has doubled down on the state industrial policy at the expense of market-oriented reforms. Xi has promoted state-owned enterprises as a major source of economic growth.

Lardy spends some time considering other theories explaining China’s cooling economy. He is skeptical of the “convergence hypothesis, also known as the “latecomer’s advantage.” It holds that poor countries can grow faster than rich ones by borrowing and adapting advanced technologies from the wealthier economies. As the less-advanced economy catches up, it begins to slow because it must start developing its own technology, and that can be an arduous process.

Lardy also considers the view that China’s period of “super rapid” growth was bound to slow and that the inevitable is finally happening. Indeed, the country’s economic boom from 1977 to 2010 has been amazing – perhaps the only instance of such growth in the history of mankind.

He notes that Taiwan was one of the only other countries that has come close to maintaining a boom that long, with 6.8% average annual growth for the 32 years between 1962 and 1994. Korea also had an impressive growth streak, with 7% on average for the 29 years from 1962 to 1991. Both economies have come down to Earth quite a bit in recent years.

Lardy marshals a great deal of economic data as he picks apart these other explanations of what’s happening in China. The discussion gets technical – far too complex to summarize in a book review – and left me wishing that I had taken more economics courses when I was in college.

His policy prescriptions for getting China’s economy back on the fast track include reducing the barriers to entry for more productive private firms, especially those in service industries such as banking and logistics. Lardy says that more bottom-up, market-oriented mergers and acquisitions should be encouraged. More private firms should be allowed to take over underperforming state assets.

The reform program should also force into bankruptcy “zombie firms” – perennial money losers that limp along by borrowing additional funds to pay interest on prior outstanding debt. Lardy points to an International Monetary Fund study that says about 28,000 enterprise bankruptcy cases were filed in the U.S. in 2014, compared with about 3,700 in China. The U.S. had 4.6 times the number of company bankruptcies as China.

But shutting down the zombie firms involves risk for party officials who fear that layoffs will cause social instability. Downsizing the state sector will involve cutting millions of jobs. Lardy says the party also views the companies to be essential to maintaining its control and achieving strategic objectives such as the Made in China 2025 industrial plan.

Another obstacle to far-reaching reform is the opposition of vested interests, such as bureaucrats, leaders of large state-owned enterprises, and political officials.

Despite these formidable challenges, Lardy finds reasons to be optimistic that the leadership can pull off bold reforms again. He says that ensuring rising income levels is still extremely important to the party’s legitimacy. Slowing economic growth undermines this goal – especially at a time when the government needs to spend more to clean up the environment, improve food safety, expand the social safety net, and deliver on other things crucial to realizing Xi’s “Chinese Dream.”

Bilateral trade frictions with the U.S. might also slow the economic momentum and get the leadership to adjust its statist approach. Lardy also says that Xi’s support of state-driven growth contradicts the Chinese leader’s repeated public pledges to further open China’s economy and promote globalization. But I doubt Xi cares about being consistent. On many other occasions, the party has been perfectly comfortable saying one thing and doing another.

At times, Lardy’s book was overwhelmingly technical for this eager student of economics. His approach is heavy with macroeconomic data. Don’t expect many insights from interviews with investors, business leaders, and policy makers in the industrial trenches of China. But he presents a strong argument that makes The State Strikes Back worth reading for those seeking to better understand the Chinese economy’s structural challenges.

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