China Goes for Quality (Stephen S. Roach)

  Stephen S. Roach -- Morgan Stanley Global Economic Forum

  Dec 4, 2006 -- MELBOURNE -- The Chinese are getting serious in shifting the focus of their extraordinary economic development from quantity to quality.  This transition has been actively discussed in China for over three years, but in extensive meetings in Beijing last week, I sensed that the quality debate has finally come to a head.  This could have very important implications for China’s trade policies, commodity demand, environmental considerations, banking reform, and its capital allocation process.  It is a very big deal.

  Western perceptions of the Chinese economy are formed largely on the basis of the quantity dimension of its remarkable transformation.  This is perfectly understandable, as the nation’s GDP per capita has more than quadrupled over the past 15 years -- taking China from the world’s 10th largest economy in 1991 to the fourth largest today.  With a population of 1.3 billion people, a 10 percent growth trajectory puts the scale effects of Chinese economic development in an entirely different league than the world has ever experienced.  Given the daunting transition from state to private ownership, China needed such hyper-growth to offset the massive job losses stemming from the reforms of its state-owned enterprises -- cumulative headcount reductions estimated at more than 60 million workers since 1997, alone.  The Chinese feel they had no choice other than to focus on the quantity of growth in the face of such extraordinary job loss.  The strategy was critical in order to maintain social stability -- by far, the single greatest risk to this first phase of China’s reform experience.

  But now the most disruptive phase of SOE reforms is in the past.  That eases China’s dependence on the quantity imperatives of economic growth and allows reformers the opportunity to focus on the long-neglected quality dimension of its transformation and development.  This shift in the character of economic growth couldn’t come at a better time.  The “negative externalities” of the quantity fixation are starting to loom increasingly formidable.  Long dominated by exceptionally rapid gains in export-led industrial activity, the Chinese growth model has been characterized by open-ended investment spending, undisciplined bank funding, environmental degradation, nearly insatiable demand for oil and other industrial materials, and mounting trade frictions.  With industrial output -- which makes up about 50 percent of Chinese GDP -- accelerating to a roughly 17 percent average annual growth rate over the past four years, those externalities have become increasingly serious.  By shifting its focus from quantity to quality, China is, in effect acknowledging an increasingly urgent need to address the negative repercussions of rapid growth head on. 

  Trade policy is the most immediate item on the quality agenda.  The first meeting of the newly established strategic economic dialog with the United States is now less than two weeks away -- set for Dec. 14-15 in Beijing.  Led by U.S. Treasury Secretary Hank Paulson, a high-level U.S. delegation will not want to go away empty handed when it comes to coping with a large and ever-widening bilateral trade deficit with the China -- estimated at $202 billion in 2005 and at least $225 billion in 2006, and equal to fully 25 percent of America’s record multilateral trade deficit.  Paulson has already set the stage for a very important shift in the US-China bilateral trade discussions -- attempting to broaden out the debate from a single-minded fixation on the currency issue.  That’s not to say the US delegation won’t put pressure on China to accelerate the pace of renminbi revaluation, but it will also push for more Chinese progress on the equally important matters of financial sector reforms and protection of intellectual property rights (IPR).

  What I found last week in Beijing is that the Chinese may well be willing to move more aggressively on the IPR issue than has been the case in the past.  There is a key reason for this shift: Inasmuch as China’s economic prowess has moved rapidly up the value chain in recent years -- from low-value-added items such as toys and textiles to increasingly high-value-added technology products -- there is a growing consensus forming within the Chinese leadership that IPR protection is now in its best interest, as well.  As one senior official put it best to me last week, “Since the China of tomorrow will be more about innovation and knowledge-based breakthroughs, we need to protect our own IPR.”  This speaks of a China that is now putting increasing value on the quality of its intellectual capital rather than on the quantity potential of its mass-production platform.  OECD data underscore how far China has come in investing in the basic research underpinnings of intellectual property: In 2006, it overtook Japan and stood second only to the United States in the global research and development spending sweepstakes.  Little wonder China now wants to protect its own proprietary knowledge base.

  Interestingly enough, I saw a real-time example of what China can do on the IPR front when it puts its mind to the effort.  Like most airports these days, Beijing International Airport has become something of an indoor shopping mall.  Notwithstanding opportunities to make last-minute purchases of Chinese arts and crafts, the crowds were biggest at the Beijing 2008 kiosk, where travelers were fighting over newly minted souvenirs from the upcoming Olympics.  What I found most interesting in these products is that they are all “officially licensed” -- in many cases, complete with a numbered and laser-tagged authentication certificate designed to foil counterfeiting.  The Chinese have long complained how difficult it is to enforce IPR protection in a nation where factories and distribution facilities can spring up overnight.  Try finding official Beijing 2008 souvenirs in China’s fabled open-air markets that contain knock-offs of a wide range of Western products.  Let me assure you -- you can’t.  When the Chinese put themselves to the enforcement task, they can accomplish almost anything.  A recent anti-piracy effort -- the so-called “100-Day Campaign,” running from July 15 to Oct. 25, 2006 -- is a high-profile example of China upping the ante in this area.  There is a great opportunity for a breakthrough on the all-important and long-contentious IPR issue at the upcoming US-China strategic economic dialog -- an outcome that could pull the rug out from under the increasingly vocal protectionists in the US Congress.

  I also found a China more willing to focus on upgrading the quality of its manufacturing technology.  The degradation of the Chinese environment has now reached a serious threshold: Fully seven of the ten most polluted cities in the world are in China, according to World Bank statistics.  Moreover, China leads the world in water pollution by a wide margin -- emitting three times as many organic water pollutants as the number two polluter -- the United States, whose economy is five and a half times the size of China’s.  At the same time, Chinese production is woefully inefficient when it comes to reliance on energy and other raw materials.  For example, China currently requires about twice as much oil per unit of GDP as the rest of the world, according to the International Energy Association.  The recently enacted 11th Five-Year Plan has a stated target of reducing China’s oil per unit of GDP by 4 percent a year, or 20 percent over the 2006-10 period.  At the same time, the government wants to move away from a “commodity-heavy” growth model that gobbles up outsize portions of base metals and other raw materials.  Chinese leaders -- especially those at the National Development and Reform Commission who still guide the national planning process -- feel this can best be accomplished by shifting away from rapidly growing commodity-intensive fixed investment toward more of a “commodity-lite” growth model centered increasingly on private consumption.  Whether it’s curtailing pollution or cutting back a voracious appetite for energy and other industrial materials, I sensed a heightened awareness in official Beijing to tackle this important aspect of the quality problem head-on.

  I noticed a similar approach toward the quality of Chinese bank lending.  Interestingly enough, there is a clear consensus amongst Chinese banking regulators as well as senior banking officials that another round of nonperforming loans is inevitable once the economy slows (see also Wendy Dobson and Anil Kashyap, “The Contradiction in China’s Gradualist Banking Reforms,” prepared for the Brookings Panel on Economic Activity, September 2006).  Both China’s regulators and bankers felt that the excesses of the current investment boom -- with fixed investment climbing toward the unheard of and worrisome 50 percent threshold -- have become a breeding ground for new NPLs.  China very much needs to increase the quality of its capital allocation process.  Reforms, according to the Chinese I met with last week, are the only means to accomplish this -- especially reforms that inject greater discipline into the investment and loan approval process.  The imposition of administrative edicts curtailing fixed investment in a number of overheated sectors is helpful in this regard, as is a new effort aimed at increasing the selectivity of foreign direct investment.  In both cases, however, the administrative policies are only band-aids until the establishment of a robust market-driven system of capital allocation.  Equally encouraging are recent public listings of the large Chinese banks, which should inject market-driven incentives into an increasingly commercialized bank lending business.  In the end, however, the centralization of a still highly fragmented Chinese banking system is essential in order to instill a rigorous, commercially-viable lending culture.  With a China slowdown likely to come sooner rather than later, I sensed a new urgency in Beijing in dealing with this critical aspect of the quality problem.

  Finally, I picked up a subtle, but important, shift in China’s overall attitude toward reform.  Last spring, there were visible signs of a worrisome pushback against one key element of the reform process -- the opportunity for foreign multinational corporations to take strategic stakes in Chinese enterprises.  There was a gathering concern in some quarters that foreigners were buying precious State assets on the cheap -- especially as a surging Chinese stock market was quick to inflate the market value of foreign-acquired stakes.  According to insiders involved in China’s financial sector reforms, those fears have since subsided, as the pro-reform faction in the senior Chinese leadership appears to have recently won out in a struggle with Party conservatives.  A potentially worrisome dilution in the quality of reforms has been avoided as a result.

  In the end, the quality of the growth experience is the ultimate arbiter of its sustainability.  China has elected to go for quantity since the onset of the current reforms back in 1978.  It has had remarkable success in staying the course.  But as China comes of age, it is only natural that such an approach change, with greater attention placed on the quality of the economic growth outcome.  There is, undoubtedly, an important tradeoff between these two dimensions of the growth experience.  A new emphasis on quality probably means that China will have to compromise on the quantity front.  The good news is that as a 10% growth machine -- and recently well in excess of that -- that’s a luxury China can well afford and seems willing to accept.  Contrary to widespread perceptions, China doesn’t need 10-11% economic growth to ensure social stability.  Its newly enacted Five-Year Plan, which is tilted toward meaningful improvement on the quality front, calls for “just” 7.5% average GDP growth through 2010.

 An external shock is the only real stumbling block I see in this potential realignment in the Chinese growth model.  A U.S.-led shortfall of global growth or a politically-inspired outbreak of Washington-led protectionism are the biggest risks in that regard -- the former providing a temporary setback and the latter a more worrisome systemic risk (see my 1 Dec. dispatch, “Unprepared in Beijing”).  But barring those possibilities, the China I saw last week seems more than willing to pay the price of slower growth and opt increasingly for quality over quantity.  That’s outstanding news for China and for the world as a whole.

LINK: Morgan Stanley

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