Why China Can’t Adjust

by Minxin Pei Minxin Pei is Professor of Government at Claremont McKenna College. 09.07.2012

Introduction

China’s current economic slowdown has no shortage of causes: Europe’s financial turmoil, sputtering recovery in the United States, and weak domestic investment growth, to name the most commonly cited factors. Since exports and investment account, respectively, for 30% and 40% of China’s GDP growth, its economy is particularly vulnerable to weakening external demand and accumulation of non-performing loans caused by excessive and wasteful spending on fixed assets.

But China’s vulnerability to these factors, as serious as they are, is symptomatic of deeper institutional problems. Until these underlying constraints are addressed, talk of a new consumption-based growth model for China, reflected in the government’s recently approved 12th Five-Year Plan, can be no more than lip service.

After all, China’s major trading partners, international financial institutions such as the World Bank and the International Monetary Fund, and senior Chinese officials themselves have long recognized the structural vulnerabilities caused by excessive investment and low household consumption. And, for nearly a decade, China has been urged to undertake reforms to redress these economic patterns, which have undermined the welfare of ordinary Chinese and strained the global trading system.

The best-known feature of China’s macroeconomic imbalances is heavy dependence on exports for growth, which is typically attributed to weak domestic demand: as a middle-income country, China lacks the purchasing power to consume the goods that it produces. With nearly unlimited access to advanced-country markets, China can tap into global external demand and raise its GDP growth potential, as it has done for the past two decades.

If this view is right, the solution is straightforward: China can correct its imbalances by increasing its citizens’ incomes (by cutting taxes, raising wages, or increasing social spending), so that they can consume more, thereby reducing the economy’s dependence on exports. Indeed, nearly all mainstream economists prescribe this approach for China.

But there is another explanation for China’s excessive export dependence, one that has more to do with the country’s poor political and economic institutions. Specifically, export dependence partly reflects the high degree of difficulty of doing business in China. Official corruption, insecure property rights, stifling regulatory restraints, weak payment discipline, poor logistics and distribution, widespread counterfeiting, and vulnerability to other forms of intellectual-property theft: all of these obstacles increase transaction costs and make it difficult for entrepreneurs to thrive in domestic markets.

By contrast, if China’s private firms sell to Western multinationals, such as Wal-Mart, Target, or Home Depot, they do not have to worry about getting paid. They can avoid all of the headaches that they would have encountered at home, because well-established economic institutions and business practices in their export markets protect their interests and greatly reduce transaction costs.......

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