China Has Learnt Global Lessons Well

Country moving from old drivers of growth to sources of innovation and services

Stephen Roach

Stephen Roach is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He was formerly chairman of Morgan Stanley Asia and the firm's chief economist. For his 30-year career at Morgan Stanley, he headed up a highly regarded team of economists around the world. He has long been one of Wall Street's most influential economists.

In looking back on its extraordinary accomplishments since 1978, China has much to be proud of in celebrating 40-year milestone on the road to economic development. But as President Xi Jinping implied at the opening of the 19thCPC National Congress in October, 2017, this milestone should be viewed as more of an intermediate stop on a long journey rather than a final destination. In essence, it is a pivotal transition point between the economic take off of a poor nation and the sustained growth of a moderately well-off society that aspires to great power status by 2050.

In keeping with this sense of transition, for the first time in 36 years, the Party has revised the all-important “principal contradiction” facing Chinese society — from the backward social production of a poor nation as stated in 1981 to inadequate and unbalanced economic development as restated in October 2017. This underscores a very different focus for China's basic strategy over the next several decades — moving away from old drivers of manufacturing-led growth and uncovering new sources of innovation- and services-led growth.

But with this shift in strategy also comes an equally daunting reassessment of how China's shifting trajectory fits into the broader world — both from an economic as well as from a geostrategic perspective. Long dependent on external demand as the sustenance for economic growth and development during the early stages of its take-off, China is now playing an increasingly important role in driving and shaping the rest of the world. Fitting the “Next China” into a world that is facing its own set of very daunting problems — ranging from climate change and environmental degradation to mounting inequalities and trade tensions — promises to present China with enormous challenges in the years to come.

A legacy of crises

Experience over the past 20 years underscores that China should not take global risks lightly. That lesson is all the more meaningful in 2018 — a year that not only marks the 40thanniversary of China's reform and opening-up but also the 10thanniversary of the global financial crisis and the 20thanniversary of the Asian financial crisis, two singular events that posed enormous challenges both to China and to the world. While China was adept at dealing with the short-term repercussions of these crises, there are enduring strategic implications that are only now becoming evident.

While the Chinese economy is a good deal less dependent on the vicissitudes of external demand than was the case before the 2008 crisis, exports still account for nearly 20 percent of the nation's GDP, or about half the share going into household consumption. With consumer-led rebalancing still in its very early stages and not yet strong enough to buffer unexpected shocks elsewhere in the economy, any disruption in the global climate could prove quite problematic for China.

In the early days of China's economic development, export-led growth was a powerful antidote to a nation that was afflicted by 20 years of internal instability from the mid-1950s to the mid1970s. It was hardly a coincidence that as the export share of the economy went from 4.5 percent in 1978 to 37 percent in 2006, Chinese GDP growth surged to 10 percent annually on average for three decades. Two factors were at work — an increasingly powerful Chinese export machine and a major acceleration in global trade. It was a most fortuitous combination — coming at just the right point in time to spark China's economic takeoff.

While Chinese reforms were an essential ingredient in the successes of this export-led growth strategy, China's export machine didn't materialize out of thin air. It required massive investments in productive capacity and infrastructure that pushed the fixed investment share of GDP above the 40 percent threshold by the early 2000s. Unlike other developing economies that borrowed heavily from abroad to fund their investment programs, China's boom was largely self-funded — supported by a surge in domestic savings that ultimately breached the once unheard-of threshold of 50 percent of GDP in the pre-crisis 2000s.

Yet as President Xi implied in his report to the 19thNational Congress of the Chinese Communist Party, there is good reason to doubt the staying power of China's externally-focused growth gambit. His warning, of course, was very much in sync with concerns originally expressed by former premier Wen Jiabao. In March 2007, Wen famously cautioned of the “Four Uns” — a Chinese economy that had become increasingly “unstable, unbalanced, uncoordinated and unsustainable” .

Ten years later, Xi's message has sharpened the focus on an“unbalanced and inadequate” system, but the implications of the basic message are very much the same: China can only stay the course if it resolves the contradiction of its imbalances. That underscores the long-standing case for structural rebalancing of the Chinese economy away from exports and external demand toward services, innovation and consumer-led growth.

Like the prescription that followed from the critique of Wen, Xi's reassessment of China's principal contradiction is also shaped importantly by the trials and tribulations of the outside world — a world, as Xi put it, that remains “…in the midst of profound and complex changes.” That gets to the second building block of China's export-led growth miracle — the strength of external demand that supported the all-powerful Chinese export machine.

That support turns out to have been fleeting. The Asian financial crisis of 1997—1998 was a warning of what was to come — a severe and protracted slowdown in global trade that has continued with a vengeance in the aftermath of the global financial crisis of 2008—2009.

It was tempting, of course, to ignore the first of these two external shocks, as Asia and the world bounced back sharply from the crisis of the late 1990s. China was particularly adept in deploying what it called “proactive fiscal policies” in order to sidestep the pan-regional contagion back then.

Meanwhile, with another eye on the opportunities of WTO accession that were about to come China's way, it was hardly a time to doubt the opportunities of export-led growth.

Yet, unfortunately, there was trouble brewing in an increasingly crisis-prone world. The underpinnings of external demand for Chinese exports turned out to be built on quicksand. The bursting of the US subprime mortgage bubble, eventually accompanied by the implosion of global credit and equity bubbles, as well as a virulent European sovereign debt crisis, led to a fullblown collapse on the demand side of the world economy, with lasting repercussions for global trade.

Following the unprecedented 10.5 percent plunge in global trade in 2009, world trade growth since has averaged only 3 percent— literally half the 6 percent pace over the 1980 to 2008 period. China, the world's biggest exporter, could hardly dodge that bullet.

Global healing in the aftermath of such a wrenching crisis has been a long and arduous process. This resonates with Xi's lingering concerns about the persistently fragile state of the world economy.

The toughest global lesson may well be that China needs to look elsewhere to resolve its principal contradiction. Quite simply, it can no longer afford to bet on the once seemingly unstoppable momentum of global trade. Recent populist hints of a “de-globalization” only underscore the perils of the external solution to China's remaining development challenges.

The lessons of Japan

The legacy of these two global crises offers some very important cautionary lessons for China — namely that it cannot take external demand for granted in a crisis-prone world.

But there is another set of important lessons that can be drawn from the rise and fall of the modern Japanese economy — the first Asian economic miracle of the post-World War II era. After 45 years of 7¼ percent GDP growth from 1945 to 1990, the Japanese economy has slowed to just 1 percent average annual growth since 1991.

China has studied the Japanese experience quite carefully and its senior leadership has actively debated the risks of Japanese-like lost decades. In a celebrated interview on the front page of People's Daily in May 2016, a so-called “authoritative person”warned of the overhang of China's debt-intensive growth and the Japan-style quagmire it could lead to. The focus was not just on debt but on the perils of asset bubbles, unsustainable currency policy, banking system perils, and the deadweight of “zombie industries”.

While no two economies are alike, there are three major lessons from Japan that are especially important for China:

First, the currency suppression of a mercantilist growth model is bound to elicit a strong response from the rest of the world —especially if other nations are struggling with their own growth problems. That was the case in the mid-1980s when the Plaza Accord put Japan under major pressure and it is the same case today when the United States raises strong objections to Chinese trading practices.

Second, economies are at great peril if they ignore the interplay between asset bubbles and leverage. Japan's balance sheet recession of the 1990s is an obvious and painful example of the mounting risks to financial and economic stability. Other nations have struggled mightily with the trade-off between growth shortcuts and stability — including the United States and its sub-prime crisis and Europe with its sovereign debt crisis. The stability-growth trade-off is at the core of any system's political economic balancing act. Resisting the temptation for risky growth gambits is the only way out. China's newfound focus on deleveraging and financial stability is a sign that it has learned this important lesson.

Third, zombies sap any economy of its underlying productivity and ultimately strangle economic growth. In the end, subsidized lending to insolvent corporations and condoning bank reluctance to write down bad credits doesn't buy time — it only puts a struggling system in a deeper hole. Keiretsu-like interlocking ownership arrangements are especially insidious in that they magnify cross-company and cross-sector spillovers in the aftermath of distress in asset and credit markets. Until Japan started dealing with its zombies in the late 1990s and early 2000s, the carnage of the first lost decade only worsened. China seems to understand this aspect of the Japanese malaise quite well, with its senior leadership warning explicitly of the zombie-like perils of excess capacity. The challenge will be to transform this into disciplined corporate and banking restructuring.

China is not Japan. It is more pragmatic in adjusting its growth model. It places a much greater emphasis on stability. And it knows full well the benefits of reforms in shaping the opportunities for economic development.

China's biggest global risk

Of course, China's global challenges now entail a new and serious risk — mounting trade frictions with the United States. In his inaugural address in 2017, US President Donald Trump asserted that “… protection will lead to great prosperity and strength”. The Trump administration has now moved from rhetoric to action in its avowed campaign to defend US workers from what the US president calls the “carnage of terrible trade deals”. And China is clearly the target.

Significantly, the Trump administration's narrow fixation on the US' outsized bilateral trade imbalance with China continues to miss the far broader macroeconomic forces that resulted in a US multilateral trade deficit with 102 countries in 2017. Lacking in domestic savings and wanting to consume and grow, the US must import surplus savings from abroad and run massive current-account and multilateral trade deficits to attract foreign capital.

Contrary to tough talk from the Trump administration, there is no winning strategy in a trade war. Of course, there are two sides to every dispute, and mounting economic tension between the United States and China is an obvious case in point. The ongoing structural transformation of the Chinese economy is not without important consequences for its codependent partner, the United States.

As China shifts from surplus savings to savings absorption —drawing down its 45 percent domestic saving rate to fund the safety net of the Chinese people — it will have less savings to loan to the United States and to subsidize the safety net of the American people. Yet with the large and growing budget deficits

of “Trumponomics” likely to require more surplus savings from abroad, China's shift to savings absorption comes at a particularly vulnerable time for the United States.

Consequently, a growing disconnect is increasingly evident between the US and Chinese economies. Resolution of the twin contradictions facing both nations seems increasingly unlikely. America shows little inclination to address its own contradictions — especially, with the Trump administration and Congress willing to exacerbate America's savings dilemma in the years ahead.

China, by contrast, seems determined to tackle the imbalances and strategic challenges of the new era.

In the end, China's powerful economic takeoff was very much a levered play on globalization, global trade, and ultimately the global economy. Yet the lessons of Japan, the Asian financial crisis, and the global financial crisis all underscore the systemic perils of an externally focused growth strategy.

Escalating trade tensions with the United States only reinforce this conclusion. By recognizing the “unbalanced and inadequate” characteristics of China's great successes in the first stage of its development, Xi and the Party leadership seem to understand the pitfalls of staying this course. Following a new course becomes all the more urgent.