In late April, Beijing reported first-quarter GDP growth of barely above 7%, far lower than the 10 to 11% rates typical for the last decade. The news prompted business headlines full of stark warnings about a continuing slowdown of the Chinese economy at the precise time when most of the developed world is still struggling to regain pre-crisis growth. But instead of worrying about a slower China's effects on the precarious global ecosystem, maybe we should rejoice. Lower growth in China, it turns out, is part of the world's biggest developing country's shift to a more stable and sustainable pace of development that will have profound and positive effects on the Western economies as well.
That's the view of former GSB dean, current Hoover Fellow, and 2001 Nobel Laureate Michael Spence. And he has reason to know: Not only has Spence researched and written extensively on developing-country economics, but in recent years he has held informal advisory positions in China, working closely with some of Beijing's top planners and economists. Spence spoke to us from Milan, Italy, where he lives. Excerpts:
Why do you say China's slowdown is actually good news for the world economy?
China's turbocharged growth at 10 or 11% of GDP year after year was an abnormal situation. It was a function of a lot of unhealthy imbalances in the world. Before 2009, the advanced economies were growing faster than they should have been, with leverage, asset bubbles, and that sort of thing. One result was abnormally high demand for Chinese products. Then, during the financial crisis, when exports fell off, the Chinese government reacted by opening the spigots of credit and investment, which kept growth going at a very high rate — but the Chinese policymakers knew that this was not a sustainable growth strategy. You just cannot keep growing at that rate once your economy gets to be as large as China's is now. Advanced economies are doing well when they grow around 2.5 to 3%. China is on a trajectory to become an advanced-income country. During that transition, over multiple years and decades, China will inevitably slow down. It was never realistic to think this country could sustain 10 or 11% growth.
So the slowdown is healthy, but why now?
At least three things are happening at once. First, you're seeing a dramatic and complex transition as China's economy shifts from that of a very high-growth early developing country and enters what economists call the "middle-income trap," which I can explain in a little more detail later. Second, you have a crisis in the advanced economies that really slows them down, cutting into the demand for Chinese products. Third, the Chinese government is shifting the emphasis of their policies to deal with social tensions, equity issues, and environmental sustainability. So they have prudently lowered the growth target for the current five-year plan to 7 to 7.5% and seem to be on target.
What are the specific changes in China behind lower growth?
Again, several things are going on simultaneously. Wages are rising fast, especially in the coastal areas, and that is causing major structural changes in the way the economy is put together. Companies oriented toward the most labor-intensive activities in the global supply chain will move to other countries, change their business model, or go out of business. Wage increases are starting to boost household income as a share of the economy, which will shift the composition of demand toward the consumer and the domestic service sectors, where growth also tends to be slower.
We've also seen more reports recently on business bankruptcies and debt defaults, and some economists are warning that China has a dangerous debt bubble that could collapse at any time.
Newspaper reports on debt in China have been misleading. Public sector leverage is well below most other countries. China also happens to be one of the countries where the assets on the state balance sheet are enormous, including $3.5 trillion in reserves, 90% of the shares in state-owned enterprises, a lot of the country's land, plus tax capacity. There are some concerns with corporate debt and with China's version of the shadow banking system, which is a set of complicated and unregulated end runs around the state-owned banking sector. But they are busy getting their arms around that. The question of what's going to happen with the debt is not whether the government has the firepower, but whether mistakes get made managing it. If they pull the plug too fast, the risk might be a collapse in the real-estate sector or other contagion. Then the temptation will be to open the spigots of credit and public investment again, but they know that this is not a sustainable growth strategy.
Are there concrete examples of less leverage and shift to healthier growth — fewer airports in the middle of nowhere or ghost towns built all over China, for example?
Everyone gets worked up about the ghost towns. I think they're mistakes and scary if they go awry, and there are too many of them, but I haven't seen any actual inventory on how big they are relative to overall investment. More critically, local governments have had the instinct to keep building more infrastructure for lack of any better ideas, and that's what Beijing is reining in. What they're now trying to create is a system that screens out the bad investments but keeps the good ones, such as the high-speed train network and interstate highways they've built.
Explain the "middle-income trap" and why so few countries have managed to escape it.
Early-stage developing countries grow because they have access to foreign markets and foreign technology. So they focus on developing exports, and everybody gets it in their head that this is where the underlying growth is. This is a successful formula when income is $800 per capita, but when income rises to $5,000, countries start to get competitors in precisely those areas that generated the growth. So they typically do things that protect those sectors and companies, like subsidize them, control the exchange rate, all those things that never work and slow the economy down. The middle-income transition is difficult precisely because the growth pattern has to change and the policies that support it have to change. Unfortunately, there is a very strong tendency for organizations, including governments, once they find a successful formula, to stick with it beyond its useful life.
Can you give an example of how a country escaped this trap?
The best example, perhaps, is Korea. Before the mid-1980s, Korea was a high-quality manufacturing powerhouse based on low-cost labor. Around that time, people in Korea thought it was terrible that wages were rising. It was perfectly normal for wages to go up as the country grew and became richer, but now, in the mid-1980s, the Koreans had to do something else to drive the growth. Yet in Korea, many critics said no, we have to keep doing what we're doing, wage increases have to stop, this is where the jobs are. If the government had listened to these people, it would have been a disaster.
Instead, the government stopped targeting industries, stopped focusing on export zones and stuff like that, started investing in education and technology and all those things you associate with an advanced economy. It turned over more decision-making to the private market, including letting the old companies die off. But a lot of those companies survived by moving their low-cost activities to even cheaper countries. It wasn't a perfect transition, but it worked. When these companies making decent washing machines got up one morning and said, "We're going to make semiconductors now," people thought they couldn't do that. But that's exactly what they did. What the Korean policymakers understood was that in order for this transition to work, the government needed to back off from deciding which sectors would be favored, and instead let the market and innovation drive the actual structural configuration of the economy.
How does this apply to China?
Most of the things you expect to see, you're starting to see. They've begun to let export businesses struggle, where they either find new business models or die off. Exports, which used to be a primary driver of growth, are growing very slowly now, in part because of slow growth in advanced economies. A good share of demand is now generated inside the country — including a fair amount of horsepower starting to come from private consumption, even if China is in no conceivable way yet a consumption-driven economy. Chinese policymakers are intensely curious about other countries, and they've studied Korea and many other cases. They have a well-articulated game plan that I think is comprehensive, credible, and pretty complete.
The previous Chinese government also announced some bold economic reforms but did not deliver on them. What will be the signs to prove that they are serious about reforms this time?
More businesses failing, or changing their business models in the tradable side of the economy. A higher share of GDP going to household income. Clearer evidence of financial sector reform and regulation, including deeper and broader capital markets for corporate and municipal bonds, venture capital and private equity, more foreign competition. A liberalization of cross-border capital flows, though this would have to be gradual in a world of unusual monetary policies in the West. But again, the most important sign that the reformers are serious is that growth is down to where it is now.
But what about the 300 million additional workers moving from the countryside into the cities? Doesn't China need high GDP growth to provide employment for them?
Ten years ago, the big employment engine was the low-cost export sector. As that manufacturing becomes more capital-intensive and higher value added, it will need less labor. So what's going to replace the old employment engine? If the urban population grows from 50 to 80% of the total population, and cities grow and expand, there are a ton of service jobs that go along with urban life, from subway drivers and dry cleaners to shops and restaurants. That's going to be an important employment engine. In other words, it's not GDP growth we should be looking at, but changes in the composition of the economy to where these new jobs are going to be created.
What does your study of middle-income countries tell you about political change in China?
In most countries, as people get richer and more comfortable materially, they want to have a voice — that is, a political voice — in the way the place is run. In cases like Japan, Korea, and Taiwan, you had dominant single parties kept in power by structures that made it very unlikely that another party would ever get elected. All of these have evolved into genuine multiparty democracies. No one knows what version of this change will occur in China. There is no question that most people think — and I would agree — that economic development is accompanied by the evolution of and change in political and social institutions. Even if that happens in an idiosyncratic Chinese way.
How will China's reforms change the world economy?
China has been a growth engine, and now it's also a huge market. According to McKinsey Global Institute figures, China's middle class is 230 million people now, going to 630 million people in 10 years. This is an economy with an enormous amount of growth in purchasing power. What happens in a middle-income transition is that people get rich enough to buy certain things, like cars, larger homes, appliances. The whole developing world is going to have a big market in China to sell to. It positively affects everybody.
Even if the reforms transition China's economy to slower growth?
What we should probably worry about is not whether it maintains the old rate of growth, but rather whether Chinese growth drops below the country's sustainable rate of 7 to 7.5%. Or whether an accident happens, or they don't complete the reforms, or a group that doesn't want a market-based economy gets the reins of power. A lot of these and other things could happen. But we should not worry excessively about China successfully making a transition to a middle-income country, which is going to come inherently with a less explosive rate of growth.