Arthur Kroeber

China’s economy is at a transition point, where the breakneck growth of the past 30 years is no longer sustainable. Chinese leaders have talked instead about a move to a “new normal,” where growth is driven by consumption, innovation, and services rather than reliant on exports and government investment. Outside observers, however, are split as to whether China can manage this transition. Arthur Kroeber, managing director of independent global economic research firm Gavekal Dragonomics and editor of China Economic Quarterly, provided some much-needed perspective in his recent book China’s Economy: What Everyone Needs to Know. Kroeber talked with The Diplomat about the state of the Chinese economy – its challenges and assets – and where conventional narratives go wrong in describing the complex issues at stake.

Right now there’s a lot of debate over whether China should be granted “market economy” status at the World Trade Organization. Putting aside the politics involved in that question, what’s your take on the economics – is China a “market economy”?

It’s impossible to put aside the politics, since the determination of market economy status under the WTO is a political, not a narrowly economic, issue. There is no neat, technical way of declaring that China—or any other country—is a “market” or a “non-market” economy. Every advanced economy consists of a blend of markets and state intervention; none is pure. In China’s case, over 95 percent of prices are set by the market, approximately three-quarters of output is produced by privately-owned firms, and the remaining quarter comes from state-owned firms that almost never enjoy a monopoly position but are subject to considerable competition. These are clearly market features. At the same time, China’s state sector is twice as big, relative to GDP, as any other major economy’s state sector. And the government uses a wide range of formal and informal mechanisms to channel more resources to state firms than they would be able to get in a fully competitive system. These are non-market features. But they are not unique to China. Other countries—including major economies that enjoy market economy status under the WTO, such as India and Brazil—have large state sectors and employ similar mechanisms to favor them, though perhaps not to the same degree.

The point at issue in the market economy status debate is a practical one. If a country refuses to acknowledge China as a market economy, then it is easier for it to impose anti-dumping duties on Chinese imports. Right now a few major industries in other countries, notably steel, are at risk of disappearing because of competition from cheap Chinese imports. Some countries may decide that it’s in their national interest to protect key industries by denying market economy status to China in whole or in part. (The EU, for instance, is considering a compromise by giving China market status, but creating an exception for steel.) These decisions can be justified on political or national security grounds, and economic nitpicking has nothing to do with them.  

One of the main arguments of your book is that China’s economy is not on the brink of collapse, but it’s also not particularly healthy. In other word, the long-term prognosis is not good unless China drastically changes its economic model. The leaders in Beijing are well aware of the problems, as well. How successful do you think they’ve been in leaving behind an economy based on government investment and exports in favor of a service- and consumption-based model?

China today faces the same problem that every fast-growing developing country must face at some point. In the early stages of growth, the main job is to accumulate physical capital: infrastructure, basic industries, and housing. Later on, growth has to come not from accumulating capital, but by generating a higher return from the capital that’s already in place. This transition is hard and always takes a long time. China has made decent progress so far. Export reliance is way down from the peak: the current account surplus has fallen to 3 percent of GDP, from nearly 10 percent in 2007. The investment rate has started to fall, and consumer spending now accounts for about half of GDP growth. But much more needs to be done. The economy still relies too much on investment in housing and infrastructure. The government needs to be more active in deregulating service industries to spur private investment, and clean up the financial sector so that less capital goes to unproductive state firms and more of it goes to productive private firms. It needs to accept that the current rate of growth is unsustainable. A 5 percent average growth rate over the next decade would be a terrific achievement, and more than enough to ensure healthy growth in jobs and wages.

There’s been some speculation that China’s rapidly rising debt levels could cause a major crisis. You argue that imminent collapse isn’t particularly likely, but also point out the issues caused by China’s debt. How do you see debt impacting China’s economy going forward?

China’s gross debt—the combined debt of corporations, households and the government—is now 250 percent of GDP, up from 150 percent seven years ago. The level is high and the rate of increase is concerning. But financial crisis is not triggered by high debt: it is triggered by an inability to fund the debt. China has a high national saving rate—over 45 percent of GDP—and does not borrow from foreigners. Almost all China’s debt is fully backed by bank deposits. This is in stark contrast to the United States on the eve of its financial crisis in 2008, when there were less than 30 cents of bank deposits for every dollar of debt.  So there is very little risk that China’s banks will run into a crisis because of an inability to fund the loans they issue.

The real problem is less dramatic, but more insidious. An increasing share of debt in China consists of loans to companies that are making completely unproductive investments, in infrastructure or excess-capacity industries. Because more and more capital is going into projects that have a lower and lower return, the country’s economic growth rate is being dragged down. As the economic growth rate slows, companies have more trouble repaying their debts. Banks don’t want to write these loans off, so they extend more credit to these unproductive firms. It’s a vicious cycle. If these practices continue unchecked for another several years, China in the 2020s might come to resemble Japan in the 1990s: high debt, low growth, entrenched deflation, and no way out. There’s still plenty of time to orchestrate a financial cleanup that will avert this outcome, but the next five years will be crucial. 

There’s a lot of hand-wringing about China’s slowing growth and its ability to continue to provide employment and upward mobility for its citizens. On the other hand, most economies the size of China’s would be thrilled to have over 6 percent GDP growth a year. How worried does China need to be about the slowdown?

China has big problems but it also has enormous vitality and many assets. The biggest asset is a fast-growing class of affluent consumers. Today there are about 80 million households—240 million people—with a household income of at least $20,000 a year. These consumers are driving double-digit growth in e-commerce, healthcare services, financial products such as mutual funds and life insurance, overseas tourism, and high-end brands. Their complex and changing demands are spurring innovation among a rising group of dynamic private firms, including the internet giants Tencent, Alibaba, and Baidu. And this group of consumers is expanding rapidly. Even if GDP growth slows to 4 percent over the next decade, by 2025 there will be at least 160 million of these affluent households—double today’s number. The crucial question is whether the government will ease up on its urge to control everything, and let these consumer-driven sectors flourish. Beijing doesn’t really have to do anything to stimulate consumer demand—it just needs to get out of the way.

Your book has been praised as a welcome counter to the “conventional wisdom” on China’s economy. What’s the single biggest misconception that you see repeated about the Chinese economy?

There are many, but the biggest is probably the idea that there is some kind of existential contradiction between the dynamic economy and the authoritarian one-party state. For decades Westerners have said this combination is unsustainable and that either the economy will stagnate or the Communist Party will collapse. For decades they’ve been proved wrong. The current version of this argument is that China’s “rising middle class” (those affluent consumers I just talked about) will force fundamental political change. There’s little evidence of that: affluent urban Chinese are beneficiaries of the current setup, deeply fear the chaos and instability they think would arise from more open politics, and in the age of Donald Trump see little to admire in Western democracies. The Party is far from perfect, but it runs a much more resilient, pragmatic, and flexible system than the old Soviet Union or the stifling, low-growth autocracies of the Middle East.  As the economy and society become more complex the Party will have an ever harder time maintaining its monopoly on power, but it has a long history of adaptation and will probably succeed. The cost is that, because of the Party’s insistence on strict control of information flows, China will probably not be anywhere near as innovative or creative a society as it could be. But it will still continue to grow.