What Should China Do?

by Michael J. Boskin

Michael Boskin, Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution, was Chairman of George H. W. Bush’s Council of Economic Advisers from 1989 to 1993.

STANFORD – The Chinese government’s heavy-handed efforts to contain recent stock-market volatility – the latest move prohibits short selling and sales by major shareholders – have seriously damaged its credibility. But China’s policy failures should come as no surprise. Policymakers there are far from the first to mismanage financial markets, currencies, and trade. Many European governments, for example, suffered humiliating losses defending currencies that were misaligned in the early 1990s.

Still, China’s economy remains a source of significant uncertainty. Indeed, although the performance of China’s stock market and that of its real economy has not been closely correlated, a major slowdown is underway. That is a serious concern, occupying finance ministries, central banks, trading desks, and importers and exporters worldwide.

China’s government believed that it could engineer a soft landing in the transition from torrid double-digit economic growth, fueled by exports and investments, to steady and balanced growth underpinned by domestic consumption, especially of services. And, in fact, it enacted some sensible policies and reforms.

But rapid growth obscured many problems. For example, officials, seeking to secure promotions by achieving short-term economic targets, misallocated resources; basic industries like steel and cement built up vast excess capacity; and bad loans accumulated on the balance sheets of banks and local governments.

Nowhere are the problems with this approach more apparent than in the attempt to plan urbanization, which entailed the construction of large new cities – complete with modern infrastructure and plentiful housing – that have yet to be occupied. In a sense, these “ghost cities” resemble the Russian empire’s Potemkin villages, built to create an impressive illusion for the passing Czarina; but China’s ghost cities are real and were presumably meant to do more than flatter the country’s leaders.

Now that economic growth is flagging – official statistics put the annual rate at 7%, but most observers believe the real number is closer to 5% (or even lower) – China’s governance problems are becoming impossible to ignore. Although China’s growth rate still exceeds that of all but a few economies today, the scale of the slowdown has been wrenching, with short-run dynamics similar to a swing in the United States or Germany from 2% GDP growth to a 3% contraction.

A China beset by serious economic problems is likely to experience considerable social and political instability. As the slowdown threatens to impede job creation, undermining the prospects of the millions of people moving to China’s cities each year in search of a more prosperous life, the Chinese Communist Party will struggle to maintain the legitimacy of its political monopoly. (More broadly, the weight of China’s problems, together with Russia’s collapse and Venezuela’s 60% inflation, has strained the belief of some that state capitalism trumps market economies.)

Given China’s systemic importance to the global economy, instability there could pose major risks far beyond its borders. China is the largest foreign holder of US Treasury securities, a major trade partner for the US, Europe, Latin America, and Australia, and a key facilitator of intra-Asian trade, owing partly to the scale of its processing trade.

The world has a lot at stake in China, and China’s authorities have a lot on their plate. The government must cope with the short-term effects of the slowdown while continuing to implement reforms aimed at smoothing the economy’s shift to a new growth model and expanding the role of markets. Foreign firms are seeking access to China’s rapidly growing middle class, which the McKinsey Global Institute estimates already exceeds 200 million. But that implies a stable business environment, including more transparency in government approvals, and looser capital controls.

With these goals in mind, China’s government recently engineered a modest currency devaluation – about 3% so far. That is probably too small to alter China’s trade balance with Europe or the US significantly. But it signals a shift toward a more market-oriented exchange rate. The risk on the minds of investors, managers, and government officials is that currency markets – or government-managed currencies buffeted by market forces – often develop too much momentum and overshoot fundamental values.

As China’s government uses monetary policy to try to calm markets, micro-level reforms must continue. China must deploy new technologies across industries, while improving workers’ education, training, and health. Moreover, China needs to accelerate its efforts to increase domestic consumption, which, as a share of GDP, is far below that of other countries. That means reducing the unprecedentedly high savings rate, a large share of which accrues to state-owned enterprises. If private firms and households are to replace government-led investment as the economy’s main drivers of growth, the state must reduce its stake in major enterprises and allow more profits to be paid directly to shareholders, while providing more of the profits from its remaining shares to citizens.

The shift away from excessive state control should also include replacing price subsidies and grants to favored industries with targeted support for low-income workers and greater investment in human capital. In addition, China must reduce administrative discretion, introducing sensible, predictable regulation to address natural monopolies and externalities.

Back at the macro level, China needs to reallocate responsibilities and resources among the various levels of government, in order to capitalize on their comparative advantage in providing services and raising revenue. And the country must gradually reduce its total debt load, which now exceeds 250% of GDP.

Fortunately, in facing the difficult adjustment challenges that lie ahead, China’s $3.6 trillion in foreign-currency reserves can serve as a buffer against unavoidable losses. But China must also avoid reverting to greater state control of the economy – a possibility glimpsed in the authorities’ ham-fisted response to the correction in equity prices. That approach needs to be abandoned once and for all, before it does any more damage to China’s quest for long-term stability and prosperity.


Michael J. Boskin, Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution, was Chairman of George H. W. Bush’s Council of Economic Advisers from 1989 to 1993.

Copyright: Project Syndicate, 2015.
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