Will China succeed?

Until very recently I had the idea in the back of my mind that high rates of economic growth in China could be explained largely in terms of expansion of the private sector to meet export demand – with this rapidly growing sector absorbing a large amount of surplus labour from the agricultural sector. I knew that high economic growth in China was associated with substantial disparities in income between the industrial areas along the coast and the rural hinterland, but I imagined that the latter areas would also share in the benefits of growth as surplus labour was drawn out of the agricultural sector.

I must have connected the wrong dots. A recently published book by John Lee, Will China Fail?, points out that 75 percent of China’s growth comes from capital accumulation and over 70 percent of the capital goes to state owned enterprises (SOEs) – which produce less than 30 percent of output (Policy Monograph 77, Centre for Independent Studies, September 2007, p 60). Growth of employment in the non-state sector fell from 6.8 percent per annum in the 1980s to 3.4 percent in the 1990s (p 89). The capital allocation to SOEs apparently has more to do with preserving existing jobs than creating additional ones. So that means that high economic growth has not been doing much to absorb surplus labour from agriculture or to employ over 100 million people who are apparently floating around looking for jobs.

How could this happen? The story John Lee tells is about state banks that are flush with funds (high levels of private savings to fund health and education) which they direct to state owned enterprises, which have powerful friends in politics. This means that increasing amounts of money are being poured into production of goods that are not being consumed. The result for the banks is an increasing proportion of non-performing loans.

It is difficult to obtain independent confirmation that the situation with regard to non-performing loans is currently as bad a Lee claims. A relevant study by the IMF published in 2004 (see here) suggests that there had been some improvement - but the study may be out of date.

Can the Chinese government resolve these economic problems? I am more optimistic than John Lee, but I must admit I don’t have much basis for my optimism. From what I read in the papers, the present crop of Chinese leaders seem at least to acknowledge that they have problems and to be announcing policies to address them. They might manage to reform the system to a sufficient extent to enable economic growth and some degree of social harmony to be sustained.

What would it mean for us if China fails? There are obvious implications for Australia’s mineral exports. The people who have been saying that the mining boom would not last for ever were always going to be right one day. A weakening in mineral export prices in the next few years now seems to me to be a distinct possibility. It would represent a significant shock to the Australian economy, but not an economic disaster.

The more worrying implication of economic failure in China would be the possibility of a retreat from its peaceful rise policy and adoption of an increasingly belligerent stance in international relations.