The Influence of Emerging Giants

In this third phase of the industrial revolution, developing economies are growing at three times the rate of their predecessors, says Nobel Laureate Michael Spence. Their power will matter to all of us or our children.

by Rachel Beck

In 1978, Chinese leader Deng Xiaoping and his advisors began a bold experiment: They permitted farmers to sell surplus production at market prices. It was a radical idea at a time when China's centrally planned economy required farmers to meet quotas and sell at controlled prices. Food and other farm output increased along with farmers' income and prices. Seeing the results, Deng contacted Robert McNamara, then president of the World Bank, not to ask for money but for advice. Advisors from the West followed, sometimes meeting semi-secretly with Chinese leaders on Yangtze River boats, according to Michael Spence, Stanford Graduate School of Business dean emeritus. Spence, who is also a Nobel laureate, was not part of that original group, but he is a trusted advisor to China's national leaders today.

"Deng sat them down and said: You know we are embarking on this new course. It is more promising. To be honest with you, we do not know much about running a market economy and managing it and you are a bank, but we do not think we mainly need money," Spence told Peter Robinson, MBA '90, in an interview for the Hoover Institution.

The restructuring plan worked. The powerhouse that China would become ultimately revolutionized not only its own economy but the world's, too.

Spence is the author of the 2011 book, The Next Convergence: The Future of Economic Growth in a Multispeed World, in which he sheds light on how Chinese leaders think as well as on his own views of the changing global economy. "Once you are a trusted advisor, they are extremely open with you about what they are wrestling with, what they are worried about, and what is going on in the rest of the world," he said in an interview for this magazine.

For the last six years, Spence has worked with the Chinese on their strategies for growth. He helped provide external advice and experience as Chinese leaders developed their Twelfth 5-Year Plan, an economic blueprint that was adopted in March. That plan sets forth another radical change for the Chinese economy because it calls for it to move away from the export- and investment-led structure of the past 30 years toward a pattern of growth in which domestic consumption has a much expanded role.

As China shifts its economic drivers, its leading role on the global stage will only expand. In fact, China and India, which has also seen consistent explosive economic growth in recent decades, are at the forefront of the rapidly changing and increasingly important developing world. Some 13 developing economies have grown by more than 7% for at least 25 years, Spence says, a pace never seen before and one that may continue for another 20 years, with other countries joining the group.

By the middle of this century, Spence forecasts, China and India together will account for 40% or more of global income, a dramatic climb from their 15% share of the $60 trillion in annual global income today. That also will mean a dramatic reversal of economic power for the United States and Europe, which today account for 47% of global income but will account for about 20% — or 10% each — by then.

"Twenty or 30 years from now, we will have China and India, and we won't be dominant any more, but we will be doing fine as long as we educate people, remain innovative, and so on," Spence said during Robinson's interview in June for the Hoover Institution's Uncommon Knowledge web program. "We are going to have two economic giants, and between them, how they interact and how they discharge the responsibilities that go with their size and power will have a great deal to do with how the rest of us do."

World economic power has been shifting for decades, but the recent economic struggles of both the United States and Europe have speeded up the process, Spence says. While the Western world faltered over the last three years, the largest developing nations managed to mostly bypass trouble.

"Right now, the emerging economies that are trading with each other are self-sustaining. They can grow even if major industrial powers just plug along," Spence told Australia's Sydney Morning Herald in August. "If you go back 10 years that wouldn't have been possible. Weak growth in Europe or the United States of 1 or 2% would have dented growth in China and associated emerging nations. But not now. China will become increasingly decoupled as time moves on. Its own emerging middle class will drive its own growth."

The kind of growth seen in the developing world represents, in Spence's view, the third century of the Industrial Revolution. In his book, he lays out how economic growth was negligible worldwide for several hundred years. Being rich typically coincided with being in power, but most people were poor until England began its industrial revolution about 1750. Industry drove incomes higher and, as a result, consumption. National income rose and the rate of gain was sustained. Eventually, the pattern of growth driven by technology in England moved to continental Europe and the European offshoots — Canada, the United States, Australia, and New Zealand. By 1950, Spence says, the average incomes of people living in those countries had risen at least 20 times, from about $500 a year to $10,000 or more.

Over those 200 years, overall economic growth in the industrialized world rose about 2% to 2.5% annually. In today's developing world economies are expanding at a rate three times that, year after year. That is because they have the benefit of importing advanced countries' technology and know-how, he says.

China's role in the global economic transformation didn't come by accident. When it began its market-pricing tests, some 82% of China's population worked in agriculture. That meant the benefits of its experiment were widespread. The timing was right for a country that had been struggling to lift its weak economy from a period of negligible growth and episodes like the Great Leap Forward, where millions of Chinese starved to death. The Communist Party recognized, according to Spence, that it would lose credibility if the poor performance continued.

"They said we have to do something different," he says. "We have to open up. We have to start learning from the rest of the world."

When the Chinese turned to foreign advisors 30 years ago, they sought out well-known economists and had them work with government officials, social scientists, and central bankers. Among the featured presenters were János Kornai, who had studied communist economies, and James Tobin, who taught about managing the demand side of the economy, which was totally new to the Chinese.

Since then, the Chinese have regularly looked to foreign advisors. Spence was connected to the Chinese through Edwin Lim, a former World Bank leader who had done extensive work in China in the 1980s and in 1994 helped set up the China International Capital Corp., China's first international investment bank. Lim began including Spence in meetings with the Chinese six years ago, and Spence worked with Lim on policy issues that the Chinese identified as challenges for them, such as pensions, urbanization, and their role in the global economy. Over time, Spence gained a front-row view of how the Chinese approach their plans for growth. As part of their preparation for the latest 5-Year Plan, Spence and others first wrote papers on such subjects as social policies, income inequality, and interactions with the global economy, and then combined them into one synthesis report.

"For the synthesis report and all the papers, they wanted it published in Chinese so the Chinese could read what they had heard from outside as part of the process of putting this plan together," Spence says. "It is now published in Chinese, and an English version is also on the web."

The plan recognizes China's shift from what economists call a developing economy to middle-income status. That typically happens when a country's per capita income gets in the range of $5,000 to $10,000 a year, and the industries that drive growth in its early stages of expansion become uncompetitive due to rising wages. A country becomes advanced when incomes rise above $20,000 a year. Only Japan, Korea, Taiwan, Singapore, and Hong Kong have sustained their high growth rates going from middle-income to advanced-economy status.

"As a result of 31 years of high-speed growth, China has a per capita income now of $4,000, less than a tenth of ours," Spence says. "But it is a lot better than $400, which is where they started." He believes that the 9% growth rate that China has achieved since the economic reforms 30 years ago is sustainable for at least the next decade, but the Chinese will begin to slow it down on purpose. The Twelfth 5-Year Plan set the future growth target at 7% annually. Spence says the lower forecast gives China "space" to deal with issues such as income inequality and the shift toward domestic consumption. Spence also says that the Chinese want to devote resources to cleaning up environmental problems and developing a lower carbon and less energy-intensive economy.

"They will eventually slow down and become more like us," Spence says.

China's labor-intensive export sectors are losing their competitive edge as wages rise. Largely concentrated around the coastal areas of the country, those sectors must move inland to get cheaper labor. Eventually, the export sectors will decline and move out of China to other parts of Asia. They will be replaced by sectors that rely more on technology and human capital. As domestic demand rises, the Chinese are also producing more for themselves, and sectors that serve the domestic customer are expanding. Services will grow, global brands will start to appear, and the government's ownership will decline. On his visits to China, Spence says, he has seen a boom in businesses targeting the growing middle class, including construction, transportation, and even dry cleaners and hair salons.

India's economy, on the other hand, trails China's development by about 14 years, he says. Economic reform began in the late 1980s, and per capita income is now about a third of China's. About 70% of the population lives in rural areas, but a significant shift to urban areas is expected over 20 years. For that to happen, massive infrastructure needs to be built, including everything from housing and transportation to sewage, water, and energy systems.

While labor-intensive products for export drove China's economic growth, India lacks a strong manufacturing sector. Spence points out that India has invested in education and technology, which has allowed its service sector to flourish, and its trade in services is expanding rapidly in size and scope. India is known as a hub for information technology outsourcing, and more service industries are finding their way there. Expert medical services, film editing for television, and grading exams for teachers in advanced countries are services all being outsourced to India right now, he says.

Population growth is another distinction between the two countries. Right now, China's population is 1.3 billion compared to India's 1.2 billion. But, as Spence notes, over the last five years, India's population grew at 1.4% a year, while China's grew at 0.6%, reflecting the country's one-child policy. He says that the nearly one percentage point difference will have a modest negative impact on India's per capita income growth relative to China's.

As these countries grow, they will have to consider what their billion-strong populations are doing to the environment.

"An interesting and very recent development is a growing recognition in the large emerging economies that the growth paths of their predecessors and the advanced countries won't work because they put too much strain on a broad range of natural resources and the environment," Spence wrote recently in a paper prepared for the International Monetary Fund.

He told the Australian: "At some time in the future, China may face a choice between draconian measures to restrain emissions for the good of the planet and further growth. It may choose to go for growth regardless."

As trusted advisors, Western-trained experts may have some influence on the decisions that this global giant ultimately makes. So far at least, China still relies on outsiders to help educate it on what it should do and how its actions are viewed globally.

"They are coming to realize that they will soon be big enough economically to put pressure on the entire globe's environment," Spence told the Australian. "In a sense, they will become much of the globe."