China's future hinges on Xi's radical economic reforms

China's future hinges on Xi's radical economic reforms

While the debt saga involving China’s second-largest property developer, Evergrande, has grabbed the attention of the global investment community, there is a risk that a far more important storyline concerning the Middle Kingdom’s attempts to overhaul its economic structure may get overlooked. Xi Jinping’s China is undertaking multiple radical reforms that could either put it on a path towards achieving a more sustainable and higher quality economic growth or bring about a premature end to a four decade-long economic miracle that has lifted hundreds of millions out of poverty.

First and foremost, the Chinese leadership is attempting to reduce the economy’s overreliance on cheap credit and debt-fueled investment to drive growth. There is a widespread consensus both within and outside China regarding the need to transition to a domestic consumption-led growth model.

Following the 2007-09 global financial crisis, Chinese authorities were faced with a sharp fall in demand for their exports from their key overseas markets as U.S. and European households focused on deleveraging and improving their balance sheets. China decided to loosen the credit tap and entered a rapid growth period characterized by an extraordinary surge in domestic infrastructure investment and a massive property boom.

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The construction boom allowed China to rapidly recover from the global financial crisis. The spillover effects also caused a global recovery in commodity prices and led to a rapid but brief economic resurgence in emerging markets. But it left China burdened with an increasingly unbalanced economy that was starting to show signs of fragility by 2015.

China’s dangerous reliance on its vast real estate sector to sustain growth and the resultant excesses of the property sector forced the country’s leadership to deal with the growing economic and financial distortions. Chinese authorities introduced the “three red lines” campaign in August 2020 to force deleveraging in the real estate sector.

Evergrande appears to be one of the major casualties of the campaign. The Chinese idiom “kill the chicken to scare the monkey” may explain the reluctance of authorities to bailout Evergrande as they attempt to signal the seriousness of their push to transition to a new growth model. 

A second area of focus for Chinese authorities is centered on generating more widespread prosperity in order to enhance the real spending power of China’s vast and growing middle-class. The famously high-saving Chinese households have so far failed to boost their consumption sufficiently enough to bring about a much-needed transition away from the investment and export-led growth model.

A variety of factors – demographic shifts and gender imbalances, a limited social safety net and the consequent desire for precautionary saving, surging inequality, high property prices, and limited availability of financial instruments and investment opportunities – have been highlighted as explanations for the high saving behavior of households in China.

Chinese authorities are also aggressively (some say too aggressively) tackling the rise in income and wealth inequality. The controversial push to attain “common prosperity” has created considerable uncertainty among China’s entrepreneurial elites. Instead of relying purely on market forces to ensure redistribution or primarily on Western-style progressive taxation and redistribution models, Xi Jinping’s China is pushing for a third alternative. The “common prosperity” approach is more reliant on societal pressure backed up by a regulatory squeeze to force the highly successful and the wealthy to share their good fortunes with broader segments of the society. There is a real danger that authorities might overreach and curtail the innate entrepreneurial vigor of Chinese society and limit the country’s future growth prospects.

Finally, Xi Jinping’s China is aiming to fundamentally alter its economic and financial relationship with the rest of the world by working towards the establishment of a so-called dual circulation economy. As part of the plan, China wants to reduce its reliance on the West, and the U.S. in particular, for its key technology needs. 

Furthermore, the stated goal of transitioning to a domestic consumption-led growth model (one that is enhanced by the establishment of a more open and sophisticated financial system that allows households to access a wide range of domestic and international investment products) is likely to make China an even more crucial trading partner for the rest of the world. The rise of the Chinese middle class has the potential to fundamentally alter the supply and demand calculus for products and services worldwide.

If China also manages to become more financially integrated with the rest of the world, the impact on the international financial system is likely to be quite significant as well. The establishment of a digital Yuan and the push to internationalize the renminbi has the potential in the long run to challenge the U.S. dollar’s status as the pre-eminent global reserve currency.

As Thomas Orlik argues in his excellent book, “China: The Bubble That Never Pops,” it is dangerous to assume that China is headed for an inevitable crash and an economic hard landing. It may be wise not to automatically presume that China is headed for a fate similar to that of Japan. (Following the bursting of its equity and real estate bubbles in the early 1990s, Japan saw its economic power wane rapidly.)

Current (U.S.) and future (India) competitors to China need to carefully evaluate the strength and weakness of China’s unique political and economic structure. There is clearly a greater need for outsiders to become better informed about China as its global significance rises.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.