the rocky road to prosperity - anu press

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Avoiding economic crashes on China’s road

to prosperity13 Wing Thye Woo

Introduction

There is a long tradition of predictions of gloom and doom among Chinaeconomists. For example, in the mid 1990s, Nicholas Lardy (1998) of thePetersonInstituteforInternationalEconomicsstartedhighlightingthedefactoinsolvencyoftheChinesebankingsystemwiththeimplicationthatabankrunleadingtofinancial-sectorruinwasastrongpossibilityinthemediumterm.Thetwenty-firstcenturybeganwiththeclaimbyGordonChang(2001)thatChina’simminentaccessiontotheWorldTradeOrganisation(WTO)wouldcausesuchwidespreadunemploymentwithinChina’salreadyalienatedpopulationthatthecountry’seconomicandpoliticalsystemswouldcollapse.

Thesetwodirepredictionshaveturnedouttobewrong.China,infact,accelerateditsannualgrossdomesticproduct(GDP)growthtodouble-digitratesafter2001.Lardywaswrongbecause,whilethebankswereindeedbankrupt,theChinesegovernmentthatownedthemwasnotbankruptandcouldaffordtobailoutthebankswhennecessary.Thefiscalstrengthofthegovernmentmadeitirrationalfor depositors to contemplate a bank run. Chang was wrong because WTOmembershipquickenedthepaceofjobcreationinChinabygreatlyincreasingthevolumeofforeigndirectinvestment(FDI)inflow.WTOmembershipmadeChinamoreattractivetoFDIbecauseitguaranteedtheaccessofChinesegoodstotheUSmarketbyeliminatingtheneedforChinatoreceivedmost-favourednation(MFN)statusannuallyfromtheUSCongress(McKibbinandWoo2003).

Thefactthatthedoomsayershavebeenwrongsofardoesnotmeanthattheirdirepredictionsareguaranteednot tohappen in the future. It alsodoesnotmean that gloom and doom can be ruled out because the doomsayers couldsimplyhavebeenwrongintheirspecificidentificationsofwheretheywouldcomefrom.Thischapter is,first,anassessmentof someof theobstacles thatChinacouldstumbleintoonitsdevelopmentpath;and,second,aproposalforhowtheseobstaclescouldbeovercome.

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The rocky road to prosperity

ThetraditionofforecastinggloomanddoomforChinaisquitesurprisinggivenChina’seconomicperformanceinthepast30yearsand,indeed,itisbecomingmorecommontohearglowinglyoptimisticassessmentsofChina’sfuturethandismissivelypessimisticones.Forexample,JimO’Neilletal.(2005)ofGoldmanSachshavepredictedthatChina’sGDPwillsurpassthatoftheUnitedStatesin2040evenafterassumingthatChina’sGDPgrowthratewillslowsteadilyfromitsaverageannualrateof10percentduring1979–2005to3.8percentduring2030–40.1

AgoodguidetohowoneshouldregardthenewoptimismandthetraditionalpessimismcanbefoundinthediscussionsoftheSixthPlenumoftheSixteenthCentralCommitteeoftheCommunistPartyofChina(CPC)inOctober2006.ThesixthplenumpassedaresolutiontocommittheCPCtoestablishaharmonioussociety by 2020. The obvious implication is that the present major social,economic and political trends within China might not lead to a harmonioussocietyor,atleast,notrapidlyenough.

Among thedisharmonious featuresmentioned in the ‘resolutionsof theCPCCentral Committee on major issues regarding the building of a harmonioussocialistsociety’wereseriousimbalancesinsocialandeconomicdevelopmentacross (and within each of) China’s 31 provinces; worsening population andenvironmentalproblems;grossly inadequatesocialsafetynetsandhealthcaresystems; and serious corruption. The harmonious socialist society wouldencompassademocraticsocietyundertheruleoflaw;asocietybasedonequalityandjustice;anhonestandcaringsociety;astable,vigorousandorderlysociety;andasocietyinwhichhumansliveinharmonywithnature.

China’seconomyduring thepast threedecadescanbe likened toa speedingcar. The CPC leadership in 2006 saw that the car could crash in the futurebecausetherewereseveralhigh-probabilityfailuresthatmightoccurandcauseeconomiccollapse.Tobespecific,therearethreeclassesoffailuresthatcouldoccur:hardwarefailure,softwarefailureandpowersupplyfailure.

A hardware failure refers to the breakdown of an economic mechanism—adevelopmentthatisanalogoustothecollapseofthechassisofacar.Probablehardwarefailuresincludeabankingcrisisthatcausesacreditcrunch,abudgetcrisis that necessitates reductions in important infrastructure and social

1 ForareviewofthedebateonhowtointerpretChina’shighgrowthin1978–2000andwhyChina—unliketheeconomiesof the formerSovietbloc—didnotexperiencearecessionwhen itmade theswitch fromacentrallyplannedeconomytoamarketeconomy,seeSachsandWoo(2000)andWoo(2001).

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expenditure (and possibly generates high inflation and balance-of-paymentsdifficultiesaswell) anda serious slowdown inproductivitygrowth fromtheaccumulationofmicro-inefficienciescreatedbystateintervention.

Asoftware failurereferstoaflawingovernance thatcreatesfrequentwidespreadsocialdisordersthatdisrupteconomy-wideproductionanddiscourageprivateinvestment. This situation is similar to a car crash that results from a fightamongthepeopleinsidethespeedingcar.Softwarefailurescouldcomefromthepresenthigh-growthstrategycreatingenoughinequalityandcorruptiontogenerateseveresocialunrest,andfromtheStatenotbeingresponsiveenoughtorisingsocialexpectations,hencecausingsocialandeconomicdisorder.

A power supply failure refers to the economy being unable to move forwardbecauseithitseithera natural limit oran externally imposed limit—asituationthatisakintothecarrunningoutoffuel(anaturallimit)orintoaroadblockerectedby foreigners (an externally imposed constraint). Examples ofpowersupplyfailuresareanenvironmentalcollapseandacollapseinChina’sexportsbecauseofatradewar.

There are many events within each type of failure that could make China’shighgrowthunsustainable isbeyond the scopeof this chapter.We limit thediscussionheretothosethatseemmostlikelyinJune2010.

Potential hardware failure

Chinawillfacetwopotentialhardwarefailuresintheaftermathoftheglobalfinancialcrisis:aweakeningofthefiscalpositionandaslowdowninproductivitygrowth.Tosee thesourceofourconcern,wehave to recall,first, thenatureof theglobalfinancial crisis and themanner inwhich it impactedonChina;andsecond,thekindofeconomicmechanismsthatwereusedtogeneratethestunning8.7percentGDPgrowthratein2009.

Theglobalfinancial crisisburstonto theworld sceneon15September2008when investment bank Lehman Brothers filed for bankruptcy. This actionsparked a wholesale flight to liquidity that caused a meltdown of financialmarkets globally. This widening financial crash, in turn, became a negativefeedback loop to the level of aggregate income. GDP growth (year-on-year)turnednegativeinthefourthquarterof2008intheUnitedStates(–1.9percent)andtheUnitedKingdom(–2.1percent).

Thisabruptdecline inGDPof themajoradvancedeconomies translated intoa large, abrupt negative external shock to China that had two components:


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a negative export shock and a negative inward FDI shock.2 This prolongedcontractionary external impulse hit China at a time when its economy wasalreadyslowingfromthetighteningofmonetarypolicythatwasimplementedimmediatelyaftertheconclusionoftheseventeenthCPCcongress inOctober2007.Intherun-uptothepartycongress,easymonetarypolicyhadsteadilyboostedGDPgrowthfrom10.4percentin2005to11.6percentin2006and13percent in2007.GDPgrowth,whichhadbeenbroughtdownbytightermonetarypolicyto10.4percentinthesecondquarterof2008,fellto9.6percentinthefourthquarterof2008,andthenfurtherto6.1percentinthefirstquarterof2009,undertheadditionalsqueezefromthelargedrop-offinexportandforeigninvestment.

TheChinesegovernmentrespondedwithveryaggressivefiscalandmonetarypolicies to offset the external deflationary policies. It announced in earlyNovember2008thatafiscalstimulusofRMB4trillionwouldbeundertakenin2009–10—anannualstimulusofabout7percentofGDP.Monetaryeasinghasbeenevenmoredramatic,withbroadmoney(M2)increasedby28percentin2009.

Whileconsumerpriceindex(CPI)inflationin2009wasreassuringlylowat–0.7per cent, ‘land prices…doubled in 2009 on a nationwide basis’ (‘China tellsbankstorestrictloanstolocalgovernments’,The New York Times,25February2010).Thevalueofresidentialpropertytransactionsin2009was80percenthigher than in 2008 (‘Marketdefies fear of real estatebubble inChina’, The New York Times,4March2010).3Thefirstquarterof2010sawevenmorerapidincreasesinlandprices,especiallyinthemajorcoastalcities.4InmidApril2010,thegovernmentsoughttostabilisepropertypricesbyimposingrestrictionsonmortgageapplicationstobuysecondandthirdhomes.

Theroaringrealestatemarketandtheuseofnon-marketmeans(forexample,bansonpurchases)totameitaresymptomsofsomedeepeconomicproblemsthatChinahastoaddressinordertosustaingrowthoverthelongrun.Specifically,the real estate boom is part of a generalised investment boom unleashed bythe RMB4 trillion stimulus program implemented since November 2008.Thefact that thecentralgovernmentwould fundonlyone-thirdof theproposedexpenditure might prompt one to think of the stimulus program as a workagenda for the government to create the incentives to induce investment to

2 On a year-on-year basis, the growth rate of exports turned abruptly negative (–2.2 per cent) in 2008(11months)andremainednegativethrough2009(11months).ThegrowthrateofFDIalsoturnedabruptlynegative in 2008 (11months)—to–36per cent from35per cent in 2008 (10months); remained negativethrough2009(sevenmonths);andrecoveredtohistoricallylowlevelsin2009(eightmonths)to2010(fourmonths).3 ThearticlealsoreportedthatsomeduplexesinShanghaiweresellingforUS$45millioneach.4 In2009,landpriceshadgoneup200percentinShanghai,400percentinGuangzhouand876percentinWenzhou(‘China:noonehome’,Financial Times,21February2010).


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reachthestatedlevel,butsuchaninterpretationwouldbewrong.Thestimulusshould be properly understood as permission by the central government toallowadditionalinvestmentsuptothestatedlevel.

ThisdifferentunderstandingisbasedontherealitythatalargepartofChina’seconomyisstillstatecontrolled5andthatthissegmentpursuesotherobjectivesbesides the ideal of profit maximisation. Because state-controlled enterprises(SCEs)areusuallybailedoutwhentheirinvestmentsturnouttobebasedonover-optimistic projections or are derailed by bad luck, the outcome is thewell-knowninterest-inelasticphenomenonofa‘thirstforinvestment’bySCEsand localgovernments.The state-appointedSCEmanager is always in favourofexpandingthescaleandrangeoftheoperationoftheSCEbecauseityieldsthreemajorbenefits tohimorher:higher likelihoodofpromotionbasedontheprovenability tohandlebigger things;greaterpatronagepower tobuilda political base; and more resources that could potentially be diverted forpersonalgain.Similarly,localgovernmentleadersalsosharetheenthusiasmofSCEmanagersforeconomicgrowthintheiradministrativeregionsforthesamethreereasons.

Wheneverthestate-controlledbanks(SCBs),whichdominateChina’sfinancialsector,extendloanstoaccommodatethehighdemandforinvestmentloansbySCEs and local governments, a ‘liquidity tango’ is generated.The inevitableoutcome of a protracted liquidity tango is high inflation followed by non-performingloans(NPLs).6Thenotableperiodwhensuchliquiditytangoswererare was 1996–2001 when Zhu Rongji was prepared to punish the managersofSCBs severely for the appearanceofnewNPLs.Thekey is thatwhenevera SCB manager feels they are operating under a soft-budget constraint, theyextendloansreadilybecauseascaling-upoflendingbringsthethreebenefitsmentionedpreviously.

At present, the central government has two lines of institutional defence topreventtheliquiditytangofromgettingoutofhandinChina’spartiallyreformedeconomy.ThefirstlineisthatalllargeprojectsneedtheapprovaloftheNationalDevelopment and Reform Commission (NDRC; formerly, the State PlanningCommission).Thesecondlineisthatallbanksareassignedcreditquotas.

So, when Premier Wen Jiabao approved the stimulus program and coveredonlyone-thirdofitscost,hewasgivingpermission:1)totheSCEsandlocalgovernmentstoinvestmoreinordertooffsetthespendingslumpintheprivate

5 State-controlled firms include state-owned firms and publicly listed firms in which the State and itsintermediariesholdthecontrollingshare.6 SeeWoo (2006) for a more detailed discussion of how the frequent rescue of state firms (also knownas the soft-budget practices of the government) has made the economy inflation prone since economicdecentralisationbeganin1978.


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sector;and2)totheSCBstoextendthenecessaryloanstofundtheapprovedprojects.Hereinliesthemechanismforthesuccessofthestimulusprogram:theuse of capacity-maximising state-controlled production and financial units toboostaggregatedemand.BecausetheSCEsandSCBsareimplementingastate-assignedmission,theirmanagerscannotrightlybeheldresponsibleshouldtheassignedprojectsturnouttobefinancialbustsinthefuture.

Not surprisingly, the public media carries occasional anecdotes about newinvestmentsinindustriesplaguedbyovercapacity(forexample,steel,cementandaluminium), trophy investments (forexample,grandtowncentres,high-speedrailandstatelyadministrativebuildings)andspontaneousprivatisationof project funds (for example, massive purchases of cars by state bodies).7AnothercommonconcernaboutChina’s stimulusprogramwas that theSCBswerechannellingthefloodofliquiditytotheSCEsandneglectingtheincreasedfinancingneedsoftheprivatesectorbroughtonbytheglobalfinancialcrisis.Pressedforworkingcapital,twowell-knownlargeprivatecompanies,Rizhao(asteelfirm)andMengniu(adairy),agreedtobeacquiredbytheirstate-ownedcounterparts.

WhileitisclearthatChina’smassivemacro-stimulusprogramhasbeensuccessfulinwardingoffdeflationfromthenegativeexternalshocks,weseethisprogramascreatingtwopotentialhardwarefailuresinthefuture.

ThefirstisaweakeningofthefuturefiscalpositionoftheState.Manyoftheindustrial and infrastructure investments in 2009 were undertaken by the8000localinvestmentcompaniesestablishedbylocalgovernments.Ithasbeenestimatedthattheloansoftheseinvestmentvehiclesamountedto51percentofGDPin2009.8(Thepresentdebtofthecentralgovernmentamountsto20percentofGDP.)AddinginthelargeloanstotheSCEs,therecentstimulusprogramhasthepotentialofgeneratingahugenumberofNPLs.ItisimportanttoseethatNPLsarenotjustafinancial-sectorproblem;theyareafiscalproblem.TheUSandUKbailoutsoftheirfinancialsystemsin2008–09makethispointmostclearly.

GivenChina’shistoryof liquidity tangos, it is reasonable toworry thatmostofthebankloanstothestimulusprogramwillendupasNPLs.9Theresulting

7 See,forexample,Forsythe(2009);‘China:noonehome’,Financial Times,21February2010;‘Chinaauditfindsmisuseof funds tied to stimulus’,Financial Chronicle,29December2009,<http://www.mydigitalfc.com/news/china-audit-finds-misuse-funds-tied-stimulus-821>; and ‘China boosts auditors’ power asstimuluspackagespendingpromptscorruptionconcerns’,People’s Daily,21February2010,<http://english.peopledaily.com.cn/90001/90776/90785/6898354.html>8 The51percentfigureisfromcombininginformationinShih(2010),whoreportedthedebtofthecentralgovernmenttobe20percentofGDP,withinformationintheFinancial Times (‘Chinawarnedofgrowing“landloan”threat’,28March2010)thatreportedthecombinedfigurewas71percent.9 SomeobservershavepointedoutthattheNPLratiohasstayedlowsincethesecondroundofrecapitalisationin2003and,hence,haveclaimedthattheSCBshaveimprovedtheirinternalincentivesandrisk-assessment


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financialcrisiswouldcauseChinatocrashmuchliketheUnitedStatesandtheUnitedKingdomdidin2009unlesstheChinesegovernmentsteppedinagain—asitdidinthe1998–2003periodtorecapitalisethebanks.Suchalarge-scalerecapitalisationwouldinevitablymeanthatstateexpenditureinothercategorieswouldhavetobereduced.10

Thesecondpotentialhardwarefailurethatcouldresultfromthe2009–10macro-stimulusprogram isa slowdown in theproductivitygrowthof theeconomy.Unlessthe2008–10expansionofthestatesector (sometimesoccurringattheexpenseoftheprivatesector)isbalancedbyalargerexpansionintheprivatesector, the post-1949 economic history of China does not give ground foroptimism thatPremierWen’swayof imparting theneededboost to capacityutilisationduringtheglobalfinancialcrisiswillnotbecomeadragonfutureproductivitygrowth(‘CommunistPartyneedstoloosenitsgriponChina’,The New York Times,2March2010).11

Potential software failure

The satisfactory functioning of a market economy requires a wide arrayof regulatory institutions that ranges from straightforward law-and-orderadministrationtocomplicatedlegaladjudication.China’sstrategyofincrementalreformcombinedwith the fact that institutionbuilding is a time-consumingprocess means that many of its regulatory institutions are either absent orineffective.The resulthasbeengovernance failure onmany fronts,with themostwell-knownrecentonesbeingviolationsofthewelfareofconsumersandworkers.

TherehavebeensignificantregulatoryfailuresinkeepingChina’sfoodsupplyandpharmaceuticalproductssafe.Themisuseofchemicalstolowerproductioncosts has resulted in the addition of poisonous substitutes to toothpaste(‘China investigates contaminated toothpaste’, The New York Times, 22 May2007; ‘China prohibits poisonous industrial solvent in toothpaste’, The New York Times,12July2007),coughmedicine(‘FromChinatoPanama,atrailofpoisonedmedicine’,The New York Times,6May2007)andanimalfeed(‘Fillerinanimal feed isopensecret inChina’,The New York Times,20April2007;‘Anotherchemicalemergesinpetfoodcase’,The New York Times,9May2007);

ability so much that large NPL ratios are a thing of the past.We, however, think that it is premature topronouncevictoryon state-ownedbank (SOB) reformsbecause the2003–09periodhasbeenoneofhighgrowth.10 See Tong and Woo (2006) for an analytical discussion of the undermining of fiscal stability by theconstantrecapitalisationofSCBs.11 This debate over the growth of the state firms at the expense of private ones is conducted over theheadingof‘guojin mintui’(thestatesectoradvances,andtheprivatesectorwithdraws).


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theapplicationofleadpainttochildren’stoys(‘Asmoretoysarerecalled,thetrailendsinChina’,The New York Times,19June2007;‘Trainwreck’,The New York Times,19June2007;‘Fisher-Pricerecalls1.5mChina-madetoys’,Financial Times,2August2007);12andtheoveruseofantifungalsandantibacterialsinfishfarming(‘FDAcurbssaleof5seafoodsfarmedinChina’,The New York Times,29June2007;‘Aslippery,writhingtradedispute’,The New York Times,3July2007).Derelictionofdutybygovernmentofficialsisthefundamentalreasonforsuchgovernancefailures.Themostwell-knownrecentcasewastheconvictionofZhengXiaoyu,theformerdirectorofChina’sfoodanddrugsafetyagency,foracceptingbribes toapproveproduction licences forpharmaceuticalandfoodcompanies(‘Ex-chiefofChinafoodanddrugunitsentencedtodeathforgraft’,The New York Times,30May2007;‘For2children,banofadrugcametoolate’,The New York Times,13July2007).

Therehavealsobeensignificantregulatoryfailuresinthetreatmentoflabour,especiallyintheareasofoccupationalsafetyandwagepayments.Oneofthemostrecenthorrifyingaccounts involved the forced labourofkidnappedchildrenin thebrickkilnsofShanxi andHenanProvinces (‘China to investigate into“slavelabour”incident’,China Daily,16June2007).13TheofficialChina Dailyreportedthat‘asmanyas1,000childrenmayhavebeensoldintoslavelabourincentralChina’ (‘Chinabrickworkslavechildrenmaynumber1,000’,China Daily,15June2007).Aparentvisitingthebrickkilnsinherquesttofindhersonfoundthatthelocalpolicewerenotonlyunwillingtohelpbutdemandedbribes(‘ReportsofforcedlabourunsettleChina’,The New York Times,16June2007).Inonecase,thesonofthevillagepartysecretaryownedthebrickkiln(‘5Chinesearrestedinenslavementcase’,The New York Times,18June2007).

Perhapsthetwomostdismayingrevelationsfromthenewsreportsonthebrickkilnslaveryarethatthissadstateofaffairshasbeengoingonforadecade14—andthe‘forcedlabourandsexualexploitationhaveincreasedasthetrendinhumantraffickinginChinahastakenaturnfortheworst’(‘Moreforcedintoprostitution,labour’,China Daily,27July2007).YinJianzhong,theseniorofficialattheMinistryofPublicSecuritywhoidentifiedtheworseningtrendinhumantrafficking inChina, recognised a reason for thenegativedevelopment tobe‘theloopholesinthelegalandlaboursystems…[Specifically,]theCriminalLawonhumantraffickingprotectswomenandchildrenonlyandleavesoutgrown-upand teenmales. Itdoesn’thaveprovisions forpunishing those trafficking

12 Thefirstarticlealsoreportedtherecallofaghoulishfakeeyeballthatwasfilledwithkeroseneandofaninfant’swristrattlethatpresentedachokinghazard.13 The New York Times (‘Chinaslavescandalbringsresignationcalls’,18June2007)reportedthat‘[t]heworkersenduredprison-likeconfinementwithfiercedogsandbeatings…Releasedworkerswereshownontelevisionwithfesteringwoundsandemaciatedbodies.’14 ThispointwasmadebythepopulartabloidSouthern Metropolis Daily;seeThe New York Times(‘Chinaslavescandalbringsresignationcalls’,18June2007).


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peopleforforcedlabourorprostitution’(‘Moreforcedintoprostitution,labour’,China Daily, 27 July2007).The fact that such legal loopholes exist supportsourcontentionthatthemaincauseofthegovernancefailuresinChinaisthe‘derelictionofdutybygovernmentofficials’.15

Inadequateinstitutionsofgovernancearenot,however,theonlycauseofsocialtensionsinChina.Thepresenteconomicdevelopmentstrategy,despiteitsabilitytogeneratehighgrowth,alsogenerateshighsocialtensionsbecause,inthepast10years,ithasfailedtoreduceextremepovertyandtoimprovesignificantlytherural–urbanandregionalincomedistributions(Wooetal.2004;Démurgeretal.2002).InanAsianDevelopmentBank(ADB2007)studyofincomeinequalityin 22 Asian countries, in 2004, only Nepal had a Gini coefficient (47.3) thatwashigherthanChina’s(47.3).Meanwhile,in2004,China’sincomeratiooftherichest20percenttothepoorest20percent(11.4)ofthepopulationwasthehighestinAsia—significantlyhigherthanthenexthighestincomeratio(9.5forNepal).ChinaisprobablythemostunequalcountryinAsiatoday.

InthefirstphaseofChina’seconomicdevelopment,theprovisionofmorejobswasenoughtolowerpovertysignificantly.Atpresent,however,manyofthepeoplewhoarestillpoorrequiremorethanjustjobopportunities.Theyfirstneed an infusion of assistance (for example, empowering them with humancapitalthrougheducationandhealthinterventions)inordertobeabletotakeupthesejobopportunities.Effectivegovernanceforequitablegrowthhasnowbecomeevenmorechallenging,sotheprobabilityofimprovingsocialharmonyhasbeendiminished.

Furthermore, the present mode of economic development also generatesimmenseopportunities forembezzlementof stateassets, seizureof farmlandsforindustrialdevelopmentandcorruptionbecauseoftheabsenceofeffectivemechanisms to supervise government employees (Woo 2001). These featurescertainlymakesocialharmonyhardtosustain.

The data on social unrest are consistent with the hypothesis of rising socialdisharmony.First,theincidenceofpublicdisorder—labelled‘socialincidents’—hasrisensteadilyfrom8700in1993to32500in1999,andthento74000in2004.Second,theaveragenumberofpeopleinvolvedinmassincidentshasalsorisengreatly—fromeightin1993to50in2004.

15 ThispointwasmadebytheShanxiGovernor,YuYoujun,whosaid:‘Foralongtime,relevantgovernmentdepartmentsdidlittletoregulateruralworkshops,smallcoalminesandsmallfactories,andtheyarebasicallyoutofcontrolandarenotbeingsupervised…Thederelictionofdutybycivilservantsandthecorruptionofindividualshavemadeitpossibleforillegallabourtoexist,particularlytheabductionsofmigrantworkers,andforcedlabourofchildrenandmentallydisabledpeople.’See‘Fearslingeroverchildslavesatkilns’,South China Morning Post,23June2007.


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Clearly, the number of mass incidents would have been lower if China hadbettergovernance.Therewouldhavebeenmorepre-emptiveeffortsatconflictmediationbythegovernmentandlessabuseofpowerbygovernmentofficialsif the government’s actions had been monitored closely by independentmechanisms—andalsoifthegovernmenthadbeenheldmoreaccountableforitsperformance.

Power supply failure

The two most probable power supply failures that China faces are tradeprotectionismandenvironmentalcrises.Whilewethinkthattradeprotectionismisthelikelierofthetwotocausegrowthfailureinthemediumrun,wewilllimitourselvestosomebriefremarksonthistypeofpowersupplyfailurejustbeforeconcludingthechapterbecausewehaveanalysedthisissueatlengthinWooandXiao(2007)andWoo(2008).

ThepresentmodeofeconomicdevelopmenthasgivenChinathedirtiestairintheworld,ispollutingmoreandmoreofitswaterresourcesandis,possibly,changingtheclimatepatternswithinChina.TherealityisthattheCPC’snewobjectiveoflivinginharmonywithnatureisnotachoicebecausetheMaoistadageof ‘manconqueringnature’ is justasunrealisticascreatingprosperitythroughcentralplanning.ThereisnodoubtthatChina’srapidgrowthinthepast twodecadeshasdonesubstantialdamage to theenvironment (Economy2004).

Water shortages appear to pose the most immediate environmental threat toChina’scontinuedhighgrowth.16Presently,Chinauses67–75percentof the800–900billioncubicmetresofwateravailableannually,andpresenttrendsinwaterconsumptionprojecttheusageratein2030tobe78–100percent(‘Topofficialwarnsofloomingwatercrisis’,South China Morning Post,7November2006).Thepresentwatersituationisalreadyfairlycriticalbecauseoftheunevendistributionofwaterandthelowerthanaveragerainfallinthepast15years.Rightnow,about ‘400ofChina’s660cities facewatershortages,with110ofthemseverely short’ (‘Chinamaybe lefthighanddry’,The Straits Times, 3January2004).17

Theextendedperiodofsemi-droughtinnorthernChinacombinedwitheconomicandpopulationgrowthhavecausedmoreandmorewatertobepumpedfrom

16 Airpollutionisalsoaseriousproblem.Ofthe20citiesintheworldidentifiedbytheWorldBankashavingthedirtiestair,16areinChina.Itisshockingthatleadandmercurypoisoningaremorecommonthanexpected;see‘China’seconomicmiraclecontainsmercuricthreat’,Financial Times,18December2004;and‘ApoisonspreadsamidChina’sboom’,The Wall Street Journal,30September2006.17 TheshortageisreportedtobemostacuteinTaiyuaninShanxiandTianjin(Becker2003).


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theaquifers,leadingthewatertabletodrop3–6metresayear(‘Northerncitiessinkingaswatertablefalls’,South China Morning Post,11August2001;Becker2003).AstudyusingmeasurementsfromsatelliteshasestablishedthatthepartofChinanorthof the thirty-sixthparallelhasbeen ‘sinking at the rate of 2mmayear’(‘NorthernChinasinking…asthesouthrises’,The Straits Times,18March2002).18Specifically,‘Shanghai,Tianjin,andTaiyuanaretheworsthitinChina,witheachsinkingmorethantwometres(6.6feet)sincetheearly1990s’(‘Chinesecities,includingOlympichostBeijing,slowlysinking’,Agence France-Presse,23July2004).TheoverallwatersituationinnorthernChinaisreflectedinthefateoftheYellowRiver,‘whichstarteddryingupeveryfewyearsfrom1972,didsoforincreasingperiodsoftimeoverlongerdistancesinthe1990suntil1997,whenitdriedupforalmosttheentireyearoverastretchofseveralhundredkilometres’ (‘Chinamaybe lefthigh anddry’, The Straits Times, 3January2004).

Watershortagesandtheincreasingpollutionofwaterarenottheonlyseriousenvironmental threats to the economy of northern China19. The desert isexpanding(possibly,atanacceleratingpace)andhumansappeartobethechiefculprits.The State Forestry Administration reported that 28 per cent of thecountry’slandmasswasaffectedbydesertificationin1999and37percentwasaffectedbysoilerosion.Thereport identifiedabout65percentofthedesertas having been created by ‘over-cultivation, overgrazing, deforestation andpoor irrigation practices’ (‘Quarter of land now desert—and man mostly toblame’, South China Morning Post, 30 January 2002). One direct upshot is agreat increase in the frequency of major sandstorms20 that play ‘havoc withaviation in northern China for weeks, cripples high-tech manufacturing andworsensrespiratoryproblemsasfardownstreamasJapan,theKoreanpeninsulaandeventhewesternUnitedStates’(‘Billionsoftreesplanted,andnaryadentinthedesert’,The New York Times,11April2004).IntheassessmentofChenLai,Vice-MinisterofWaterResources: ‘Itwill takenearlyhalf a century forChinatocontroltheerodedlandandrehabilitatetheirdamagedecosystemsinaccordancewithChina’spresenterosion-controlcapabilities’(‘Quarteroflandnowdesert—andmanmostlytoblame’,South China Morning Post,30January2002).

18 According to Becker (2003): ‘Some 60 per cent of the land in Tianjin municipality is plagued bysubsistence.’19 Examples of reports about serious water pollution include: ‘Main rivers facing a “pollution crisis”’,South China Morning Post,6June2003;‘Boomingcitiespollutingscarcewatersupplies’,The Straits Times,18September2003;‘Riversrunblack,andChinesedieofcancer’,The New York Times,12September2004;‘“Cancervillages”payheavypriceforeconomicprogress’,South China Morning Post,8May2006;and‘Rulesignored,toxicsludgesinksChinesevillage’,The New York Times,4September2006.20 ThenumberofmajorsandstormsinChinawasfiveintheperiod1950–59,eightin1960–69,13in1970–79,14in1980–89,23in1990–99,14in2000,26in2001,16in2002and11in2003,accordingtoYinPumin(‘Sands of time running out: desertification continues to swallow up “healthy” land at an alarming rate’,Beijing Review,16June2005).


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WhilenorthernChinahasbeengettingdrierandexperiencingdesertification,nature—as if in compensation (or in mockery)—has been dousing southernChinawithheavierrains,causingheavyfloodsthathavebroughtconsiderabledeaths and property damage almost every summer since 1998.21 The sadpossibility is that the northern droughts and southern floods might not beindependenteventsbutacombinationcausedbypollutionthatoriginates inChina.Wewillhavemoretosayaboutthispossibilitylater.

Clearly, without water, growth cannot endure. In response to this, thegovernmentbeganimplementationin2002ofMaoZedong’s1952proposalforthreecanalstobebuilttotakewaterfromthesouthtothenorth:aneasterncoastalcanalfromJiangsutoShandongandTianjin,acentralcanalfromHubeitoBeijing andTianjin, and awestern route fromTibet to thenorth-westernprovinces(‘Ambitiouscanalnetworkaimstomeetgrowingneeds’,South China Morning Post,27November2002).Constructionoftheeasterncanal(tobebuiltonapartoftheexistingGrandCanal)startedin2002andofthecentralcanalin2003.Workonthewesterncanalisscheduledtobeginin2010oncompletionofthefirststageofthecentralcanal.

Thismassiveconstructionprojectwillbenotonlytechnicallychallengingbutextremelysensitivepoliticallyandfraughtwithenvironmentalrisks.ThecentralcanalwillhavetotunnelthroughthefootofthehugedykethatcontainstheelevatedYellowRiverandthewesterncanalwillhavetotransportwaterthroughregionssusceptibletofreezing.ThenumberofpeopledisplacedbytheThreeGorgesDamwas1.1millionandthiswater-transferschemeisabiggerproject.Movingpeopleinvoluntarilyiscertainlypotentiallyexplosivepolitically.Theprojectcouldalsobepoliticallyexplosiveontheinternationalfront.Oneplanforthewesterncanalcallsfor‘dammingtheBrahmaputraRiveranddiverting200billioncubicmetresofwaterannuallytofeedtheageingYellowRiver’—ascenariothatisreportedly‘givingsleeplessnightstotheIndiangovernment’(‘China’sriverplanworriesIndia’,Times of India,23October2006).

Many opponents of the water-transfer project have argued that waterconservationcouldgoalongwaytowardsaddressingChina’swaterproblemsbecausecurrentlyatremendousamountofwateriswasted(‘Alertsoundedoverloomingwatershortage’,The Straits Times,10June2004).Themostimportantreason for this inefficient use of water lies in the fact that ‘China’s farmers,

21 TheNationalDevelopmentandReformCommission(NDRC2007)reported: ‘TheregionaldistributionofprecipitationshowsthatthedecreaseinannualprecipitationwassignificantinmostofnorthernChina,[the]easternpartofthenorth-west,andnorth-easternChina,averaging20–40mm/10a,with[the]decreaseinnorthernChinabeingmostsevere;whileprecipitationsignificantlyincreasedinsouthernChinaandsouth-westernChina,averaging20–60mm/10a…Thefrequencyandintensityofextremeclimate/weathereventsthroughoutChinahaveexperiencedobviouschangesduringthelast50years.Droughtinnorthernandnorth-easternChina,andfloodinthemiddleandlowerreachesoftheYangtzeRiverandsouth-easternChinahavebecomemoresevere.’


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factories and householders enjoy some of the cheapest water in the world’(‘WaterwastagewillsoonleaveChinahighanddry’,South China Morning Post,8 March 2006), even though China’s per capita endowment of water is one-quarteroftheworldaverage(‘Alertsoundedoverloomingwatershortage’,The Straits Times,10June2004).

There is,however, theunhappypossibilitythatneither thepricemechanismnor the three canals can solve China’s water problems, making its growthunsustainableunlessthepresentmodeofeconomicdevelopmentisdrasticallyamended.

A reform agenda for avoiding crashes on the road to prosperity

Dealing with potential hardware problems

We identified two potential hardware problems arising from the large doseof SCE–SCB-based macro-stimulus that Prime Minister, Wen Jiabao, hasadministered to maintain full utilisation of production capacity: NPLs thatcouldcauseeithertheSCBstocollapseorafiscalcrisisfromthebailoutoftheSCBs,andlowerproductivitygrowthinthefuturefromthecrowdingoutoftheprivatesectorbythestatesector.China’sinstrumentsofmacro-stimulushavecreatedatrade-offbetweenmaintenanceoffullcapacityutilisationintheshortrunandsustenanceofahighrateofcapacityexpansioninthelongrun.

Our recommendation is that China eliminates this trade-off by replacing itsmacro-stimuluswiththreenewgrowthdriversthatareinterrelated:1)creationofmorenewentrepreneurs;2)urbanisationaccordingtotheprincipleoffuturehomeownership;and3)developmentofamodernfinancialsysteminwhichtheprivatesectorhasagreatlyenhancedrole.

The State can partly offset the expanded state sector by mobilising inlandmigrant workers laid-off from the coastal provinces into an entrepreneurialforce.Manyofthesemigrantshavesufficientworkexperiencetostarttheirownfactories/workshops to take advantage of the increased cost competitivenessof the inland provinces created by the explosive extension of the nationaltransportationnetworkduringtheglobalfinancialcrisis.Becausetheprimarybarriertotheemergenceofthisgroupofowner-operatorsistheavailabilityofcredit,thegovernmentshouldlegalisesmallandmediumprivatebanks,astheyhavecomparativeadvantageoverthefourlargestatebanksincateringtotheneedsofthesenewentrepreneurs.Thehealthydevelopmentofthenewprivate


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bankswouldrequirethatthesystemofprudentialsupervisionbestrengthenedandthat interestratesbederegulated.Farmlandshouldalsobeprivatisedsothatthenewbusinessescanhavethecollateraltoaccesscreditfromthenewprivate banks. As most of the migrants are from the western provinces, thegovernmentcouldunleashthisfirstdriverofgrowthinthewesternprovincesonanexperimentalbasis.

The creation of a new large group of private entrepreneurs will bring threemajorbenefits

• expenditurebythisnewgroupwillsubstituteforthepresentmacro-stimulusprograminkeepingaggregatedemandhigh

• privatefirmsarelikelytohavehigherproductivitygrowththanSCBs

• thesesmallandmediumprivateenterpriseswillbemore labour intensivethanSCEs.

The second new growth driver is urbanisation based on the principle ofaffordablefuturehomeownership.Thefastgrowthoftherealestatesector—notonlyrecentlybutinthepastdecade—reflectsnotjustspeculativedemandbutgenuinepent-updemandforhousingandgenuineaccommodationtomeetthehighrateofthejointindustrialisation-urbanisationprocess.22Thebulkofthenewarrivalsfromthecountrysidecannotqualifyforbankmortgages,somanyinvestorshavebeenbuyingmultiplehousingunitstorenttonewarrivalswiththeintentionofraisingtherentsovertimeinlinewiththeincomegrowthoftherenters.Inthissense,muchoftherecenthousingdemandhasbeenspeculative.

WeproposethatChinastudiesthelow-costpublichousingschemesinHongKongandSingaporeandestablishesanationalhousingprogramunderwhichthe new arrivals would rent homes for seven years and then have the firstright to buy these units at a price based on construction costs.This ‘futureownership’formofurbanisationwouldpreventtheproblemofemptyhousingheldforspeculativereasonsescalating intoNPLs.Chinacanaffordamassivepublichousingprogrambecausetheexpensivepartofsuchprogramsinothercountries is thecostof landandnot thecostof the structures—and land inChinaismostlyownedbytheState.23

22 Ifspeculativedemandhadbeentheoverwhelminglydominantcauseofthepropertyboom,houserentswould not have risen substantially (because the speculative investors would tend to rent out their extraunits).Instead,rentinBeijinginMarch2010was19.6percentabovethatinMarch2009;see‘Surveyshowshousepricesstill toohigh’,China Daily,12May2010,<http://www.chinadaily.com.cn/metro/2010-05/12/content_9839054.htm>23 Itshouldbenotedthathousingconstructionisrelativelylabourintensiveandthathomedecorationishighlylabourintensive.


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OurproposedformofurbanisationwillsupportChina’sgrowthinthreeways

• through the maintenance of real estate investment to supply the neededhousingandtohelpmaintaintheexistinglevelofaggregatedemand

• throughtheredirectionofbankloanstonewruralmigrants,withthenewhousingagencyastheintermediary,topreventtheappearanceofNPLs

• thishousingschemewillredistributeincometotheruralmigrants(whichhelps in reducing the threat of software failure), with the positive sideeffectthatconsumptionwillrisetohelpoffsettheeliminationofthemacro-stimulusprogram.

Wenotethatthefirstandsecondnewgrowthdriversaremutuallyreinforcing.Thenewenterprisesoftheformerruralmigrantswouldinevitablybelocatedinorneartownsandcitiestotakeadvantageofinfrastructureandpositivespill-oversfromagglomeration.Wenotethatthemaininstitutionaladjustmentsthatmustbemadetoenabletheworkingofthesecondnewgrowthdriverarethesameasthosethatwouldhelpthedevelopmentofthefirstnewgrowthdriver:privatisationoffarmland,terminationofthehouseholdregistrationsystemandliberalisationofthefinancialsystem.

The third interrelatednewgrowthdriver is the true legalisationofprivatelyowned financial institutions.24 The emergence of a strong small–mediumbankingsectorwouldreducethedominanceoftheSCBsandhencemaketheeconomy less vulnerable to their collapse from potential NPLs.The entry ofprivatebanks(domesticandforeign)willreducetheprobabilitythatanyoneofthebigfourstatebankswouldremaintoobigtofail—andhencereducethesoft-budget protection enjoyed by the now monopoly state banking system.TheprivatisationofsomeunitsoftheSCBs,andtheemergenceoflargedomesticprivatebanks,willalsohelpinstrengtheningthebudgetconstraintsperceivedbythemanagersofSCBs.Thedevelopmentofamodernbankingsystemwithamajorrolefortheprivatesectorwillthenceincreasethequalityofbankloansalongwiththeincreaseinthequantityofbankloans—helpingtoreducetheappearance of NPLs along with market-directed investments replacing themacro-stimulusprogram.25

Dealing with potential software problems

The important realisation about hardcore poverty is that, in today’s China,introducing more of the same economic policies will not produce the same

24 Wedonotconsider listedbanks inwhich theStateholds thecontrollingshare (often throughstate-controlledintermediaries—forexample,‘legalpersons’)tobeprivatebanksinthetruesense.25 Themanagementof state assets and the regulationof thefinancial sector shouldalsobe reformed toeliminatethephenomenonofrepeatedrecapitalisationoftheSCBs.


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salubrious results on every front because the development problems havechanged. This was illustrated above with the example that, during the firstphaseofeconomicdevelopment,theprovisionofmorejobs(througheconomicderegulation)wasenoughto lowerpovertysignificantly,whilemorerecentlyjobopportunitiesalonehaveprovedinsufficient.

ComplicatingmattersisthattherehavenotjustbeenrisingexpectationsabouttheperformanceoftheStateinitstraditionalfunctions(forexample,coordinatingwateruse);therearealsonewexpectationsabouttheparticipationoftheStateinsomeadditionalareas(forexample,reducingincomeinequality).Inthisnewsituation, the greater use of democratic procedures, the establishment of anindependent judiciaryandtherestorationofa freepressmightbe inevitableif the CPC is to successfully accommodate the rising social expectations andmediatetheemergingdifferencesinsocialexpectations.

OnemainsourceofrecentsocialunrestinruralChinahasbeentheconversionoffarmlandtoindustrialparkswithoutadequatecompensationforthefarmers.It is interesting therefore that the ‘No. 1 Document’ issued in January 2006jointly by the CPC Central Committee and the State Council pledged to notonly‘stabiliseandregulatethetransferofland-userightsandacceleratelandacquisition reforms’,but ‘expandchannels toexpresspublicopinions in thecountrysideandimprovethemechanismtoresolvesocialconflicts’(‘Newpledgetogivefarmersaloudervoice’,South China Morning Post,30January2007).26

ThedesirebytheHu–Wenleadershiptoimprovetheinstitutionsofgovernanceisalsoborneoutbythe followingreport fromtheSouth China Morning Post aboutwhatPremierWensaidwhenhemetagroupofChinesecitizensinJapaninApril2007:

During30minutesofimprompturemarks,hesaidthekeytopursuingsocialjustice,themainland’smostimportanttask,wasto‘letpeoplebemastersoftheirhousesandmakeeverycadreunderstandthatpowerisinvestedinthembythepeople’…MrWenisknownforbeingcarefulaboutwhathesays,whether inpreparedremarksorspeakingoffthecuff.Thefact thathehighlighted, in thepresenceofHongKongandoverseas journalists, the need for political reform is uncharacteristicand interesting…There have been signs that the leadership underPresidentHuJintaoisunder increasingpressuretoundertakedrasticpoliticalreformstoconsolidatetheparty’sgriponpowerandstampoutwidespreadcorruption.(‘Imprompturemarksrevealtheparty’spressureforreforms’,South China Morning Post,16April2007)

26 TheNo.1Documentdesignationisdesignedtoshowthatthisisthemostimportanttaskinthenewyear.


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WhiletherearereasonablegroundsforananalysttodoubteitherthesincerityofPremierWen’swordsorhisabilitytoactonthem,theanalystcannotdoubtthatPremierWen isat leastaware thatdemocracy isoneway to solvemanyof China’s problems of governance. The embrace of the harmonious societyprogram by the Hu–Wen leadership reveals the CPC’s acknowledgment thatdemocracy,theruleoflaw,areductionincorruption,landreformandimprovedincomedistributionmakeanindivisiblecombinationthatisnecessarytoensurethesocialstabilitythatwillkeeptheeconomyonthehigh-growthpathneededtocatchupwiththeUnitedStates(avisionthatactsasthebedrockoftheCPC’slegitimacytorule).

Warding off software failure is of course much more difficult than wardingoff hardware failure because political reforms lie at the heart of successfulreconfiguration of the software of governance.The modernisation of China’sadministrativesoftwarewillrequiretheadoptionoffreeelections,afreepressandanindependentjudiciary.

Dealing with power supply failure caused by environmental degradation

The general point is that effective policymaking on the environmental frontisaverydifficult taskbecausemuchof thescienceabout theproblemisnotknown.Forexample,thereisnowpersuasiveevidencethatChina’svoluminousemissionsofblackcarbon (particlesof incompletelycombustedcarbon)havecontributedsignificantlytotheshifttoaclimatepatternthatproducesnortherndroughtsandsouthernfloodsofincreasingintensity(Menonetal.2002;Streets2005).The biggest source of what has been called in the popular media the‘Asianbrowncloud’isburningofcoalandbio-fuelsinChinaandIndia.ThislinkbetweenpollutionandwatershortagesfurtherreducesthepossibilitythateitherthepricemechanismorthethreecanalscansolveChina’swaterproblemsunlessthepresentmodeofeconomicdevelopmentisdrasticallyamended.

Chinamustnolongerselectitswaterstrategyanditenergystrategyseparately.Asystemsapproachtopolicymakingisnecessarybecausetheinteractionamongtheoutcomesfromthedifferentsectoralpoliciescangenerateseriousunintendedenvironmentaldamage.IfpartoftheshiftinChina’sclimateisintegraltoglobalclimate change, a sustainable development policy would require a completerethinking of the location of population centres and the types of enhancedinternationalcooperationonglobalenvironmentalmanagement.

The uncomfortable reality for China is that unless ecological balance isrestoredwithinthemediumterm,environmentallimitscouldchokeofffurthereconomicgrowth.And theuncomfortable reality for the restof theworld isthat thenegativeconsequencesof large-scaleenvironmentaldamagewithina


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geographicallylargecountryareseldomconfinedwithinthatcountry’sborders.The continued march of China’s desertification first brought more frequentsandstorms to Beijing and then, beginning in April 2001, sent yellow dustcloudsnotonlyacrosstheseatoJapanandKoreabutacrosstheoceantotheUnited States. China’s environmental management is a concern not only forChina’swelfarebutforglobalwelfare.

Indiscussingtheenvironmentalaspectsofthewater-transferplan,itisimportanttonotethatthereisnowopencontroversyinChinainvolvingakeygovernmentinfrastructureproject—andthiscontroversyisnotlimitedtomembersofthetechnocracy.Theverypublicnatureofthecontroversy—andtheinvolvementofmorethanjustscientists,engineersandeconomistsinit—revealshowveryfarsocialattitudeshaveprogressed.Theimportantpointisthatthischangeinsocial expectationswill require anygovernment inChina to live inharmonywithnature.Anygovernmentwill,however,havegreatdifficultiesindoingsoevenifitwantstobecauseagreengrowthpolicyinvolvesasystemsapproach,andscientificunderstandingofmanyecologicalsubsystemsandthenatureoftheirinteractionsisstillratherincomplete.

TheglobalenvironmentisanimportantareainwhichChinacanhelptobuildaharmoniousworldsystem.27Specifically,ChinashouldbemobilisinginternationalconsensustoformaninternationalresearchconsortiumtodevelopwaystoburncoalcleanlybecauseChinaisnowbuildingapowerstationaweekandhenceisabletofacilitateextensiveexperimentationonprototypeplantstoburncoalcleanly.Furthermore,given thegrowingwater shortages inChina (especiallyinthenorth)andinmanyofitsneighbouringcountries,Chinashouldstartaregional forumonthe jointuseofwater fromtheTibetanPlateaubefore thesituationbecomestoocritical.Chinashouldalsobemobilisinganinternationalscientificresearcheffortonthedesalinationofseawaterfordrinking.Ifglobalcooperationoncleanenergyresearchanddesalinationresearchissuccessful,itwillunleashsustainabledevelopmentinthewholeworld.

Dealing with power supply failure caused by trade protectionism

Finally, we consider briefly how to reduce the probability of the speedingcar (that is, China) crashing into a roadblock that takes the form of tradeprotectionism. There is no denying that international tensions over China’slargechronictradesurpluseshaveincreasedgreatlysince2004,andhavebeenexacerbatedbytheglobalfinancialcrisis.Chinahasbeenaccusedofmisconductonmanyinternationalfronts—forexample,causingtheglobalfinancialcrisisby

27 SeeMcKibbinetal.(2008)foranexampleofanefficientglobalcarbondioxideemissioncompactthatChinaandtherestoftheworldcouldadopt.


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forcingcheaploansonUSconsumers28andengaginginbeggar-thy-neighbourdevaluationsbykeepingafixedrenminbi–USdollarexchangerate(‘WillChinalisten?’,The New York Times,17March2010).

TherootofChina’schroniccurrentaccountsurplusisthatthesumofsavingsbySCEsandtheprivatesectorexceedsthesumoftheirinvestmentexpenditures.This chronic large trade surplus reveals a deep-seated and serious problemin China’s economy: its dysfunctional financial system (Liu and Woo 1994).China generates the current account surplus because of inadequate financialintermediation and the surplus grows over time because the dysfunctionalfinancialsystemfailstopoolriskstoreduceuncertainty-inducedsavingsandfails to provide loans to reduce investment-motivated saving. The optimalsolution to China’s excess saving is to establish an improved intermediationmechanismforcoordinatingprivatesavingsandprivateinvestments.

Itmustbementionedinfairness,however,thatatradeimbalancereflectstheeconomic situation in two countries: China could not have over-saved if theUnitedStateshadnotunder-saved.USprofligacyistobeblamedforthetradetensions just asmuchasChinese thriftiness.Furthermore, asWoo (2008)haspointed out, even if China’s trade balance were zero, the pains of structuraladjustmentandincomeredistributioncausedbytechnologicalinnovationsintheUnitedStates,institutionalchangesintheUnitedStates,globalisationandimmigrationintotheUnitedStateswouldstillbethere—andtheamountofUSworkeranxietygeneratedcollectivelywouldbemuchlargerthantheadditionalworkeranxietygeneratedbythewideningtradedeficit.

ThereductionoftradetensionsbetweentheUnitedStatesandChinawouldbehelpediftheUnitedStatesnowstrengtheneditssocialsafetynetstolowerthecostofchangingjobs.Specifically,theUSCongressshouldspeedupthereductionoffiscalimbalancesandexpandtradeadjustmentprograms—especiallythosethatupgrade the skills ofyoungerworkers.The importantpoint is thatUS–China trade tensions would be lower if both countries undertook correctivepoliciesratherthanifChinaactedalone.

Apart from what the United States and China can each do independently toreduceinternationaltensionsoverthetradeimbalance,theyshouldalsoworktogethertopreventtheGeneralAgreementonTariffsandTrade(GATT)–WTOfree-traderegimefromweakening.Specifically,ChinahasbenefitedimmenselyfromtheWTOsystem,yetithas,uptothispoint,playedaverypassiverole

28 Nicholas Lardy has described China as being in a co-dependent relationship with the United Statesinwhich ‘[t]he UnitedStates is the addict.We are addicted to consumption.China is thedealer.They’resupplyingthecreditthatmakesitpossibleforustoover-consume’(‘WinterInstitute:ChinaandUSjoinedatthehip’,Newsrelease,2March2009,FromconferenceatStCloudStateUniversity,Minnesota,27February2009,<http://www.stcloudstate.edu/news/pressreleases/default.asp?storyID=28126>).


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inpushingtheDohaRoundofnegotiationsforwardtocompletion.Bydefault,Brazil and India have assumed the leadership of the developing economies’camp in the trade negotiations. According to Susan Schwab, the US TradeRepresentativeat theGroupofFour (G4: theUnitedStates,EuropeanUnion,BrazilandIndia)meetinginPotsdaminJune2007,BrazilandIndiaretreatedfromtheirearlierofferstoreducetheirmanufacturingtariffsinreturnforcutsinagriculturalsubsidesbytheindustrialisedeconomiesbecauseof‘theirfearofgrowingChineseimports’(‘SchwabsurprisedbystanceofIndiaandBrazil’and‘China’sshadowloomsoverDohafailure’,Financial Times,22June2007).

WiththeUnitedStatesweakeninginitsresolvetoprotectthemultilateralfree-tradesystem(Woo2008),ChinashouldnowbecomemoreactiveintheDohaRoundnegotiationstoderegulateworldtradefurther.Sucharolewillbeverymuch in China’s interest because Brazil is now bypassing multilateral tradeliberalisationbyenteringintofree-tradenegotiationswiththeEuropeanUnion.ThefactisthatagrowingnumberofnationssuchasBrazil‘areincreasinglywaryofamultilateraldealbecauseitwouldmandatetariffcuts,exposingthemmoredeeplytolow-costcompetitionfromChina.Instead,theyareseekingbilateraldealswith richcountries that are tailored to the twoparties’needs’ (‘Brazil,otherspushoutsideDohafortradepacts’,The Wall Street Journal,5July2007).ItistimeforChinatoshowthatitisaresponsiblestakeholderbyjoininginthestewardshipofthemultilateralfree-tradesystem.SuchaninternationalstancewouldalsoreducethethreatofthistypeofpowersupplyfailuretoChina’sowngrowth.

Conclusions

Ourassessmentisthattheprobabilitiesofeitherasoftwarefailureorapowersupply failure are higher than the probability of a hardware failure becausethefirst twoareharderproblems todealwith.Formosthardwareproblems,Chinacanlearnfromtheexperiencesoftherestoftheworld,especiallythoseoftherichercountriesinEastAsia,aslongasideologicalconstraintsonmethodsof economic management continue to wither. The 1868 insight of the Meijireformists that success in economic catch-up largely involves willingness toadoptandadaptto‘bestinternationalpractices’willcontinuetoapplytoChinauntilitspercapitaGDPconvergeswiththatofJapanandWesternEurope.

Dealingwithsoftwarefailureisharderthandealingwithhardwarefailurefortwo major reasons.The first is that development policymaking in China hasbecome more challenging because popular expectations of administrativeperformancehaverisendramaticallywithincomegrowthand,moreimportantly,with increasingknowledgeof theoutsideworld.AChinesegovernment that


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consistentlyfailstoproduceresultsinlinewiththeriseinsocialexpectationsrunstheincreasingriskofbeingchallengedbyinternalfactionswithintheCPC,culminatinginanopensplit,witheachsideseekingthesupportofnon-partygroups.

The second reason is that successful reconfiguration of the administrativesoftware requires not just highly developed political skills but favourablecircumstances in the domestic political arena and a benign internationalenvironment—bothofwhicharenormallybeyondthereachofmostpoliticianstomanipulate.Whathappens in the futurewilldependonwhether theCPCis sufficientlyconfidentandpolitically skilfulenough to lead thedemocratictransitionandemergeafterwardsasthemostimportantpoliticalforce.Historytells us that the French and British monarchies reacted very differently topopularrequestsforreformoftheadministrativesoftware—andtheoutcomeswereverydifferentineachcase.ThepracticalissueiswhethertheCPCcandoabetterjobinpoliticaltransitionthantheKuomintangdidinTaiwanduringtheperiod1983–88.

Dealingwithpowersupplyproblemsismuchharderthandealingwithhardwareproblemsbecauseitofteninvolvesworkingonissuesofwhichtheworldhasfew(mostly,no)successfulexperiences(forexample,aglobalcarbondioxideemission pact) or it involves working with powerful foreign partners wheredifferentiationbetween culturalmisunderstanding (for example, abombasticnational but nevertheless well-meaning demeanour) and unstated nationalrivalry(forexample,keepingshippinglanesopen)isnoteasy—oritinvolvesworking with both of these difficult conditions. As most solutions to powersupplyfailuresrequireahighdegreeofmobilisationofinternationaleffort—whichChinahashistoricallybeentooweaktoparticipateinmeaningfully—

ChinaandtheothermajorpowerswillneedtoconvergeintheirrethinkingofChina’s responsibilities in theworldeconomybefore there canbe significantcooperationoncommonproblems.29

29 AtimelydiscussionaboutChina’sroleinthefutureworldeconomyisfoundinthecollectionofpapersinGarnautetal.(2009)—forexample,Woo(2009).ThepresentdisputebetweenChinaanditsbiggesttradingpartners over its exchange-rate regime illustrates very well the difficulties of handling a power supplyproblem.Theproposed—andhighlycontentious—solutionofasignificantrenminbiappreciationistypicalofthenarrowlyfocusedsolutionsthathavebeenproposedforpowersupplyfailures(forexample,onlybuildingcanalstotransferwaterfromsouthtonorthwhenChinashouldalsoreduceblackcarbonandconcentrateurbanisationinsouthernChina).Specifically,aneconomicallymoreefficient—andpoliticallymoreamicable—solutiontothetradeimbalanceproblemwouldrequire:1)morethanonepolicyinstrumenttobeusedtoreducethetradeimbalance(thatis,notjustappreciationoftherenminbi,but,atleast,liberalisationoftheChinesegovernment’sprocurementpolicyandexportpromotionbytheUnitedStates);2)morethanonepartytoadjustitspolicieswhenthesituationistheproductofpoliciesinatleasttwocountries(thatis,theUnitedStatesandChinamusttakecorrectivepolicies,notjustChina);and3)morethanthepursuitofasinglepolicytargetbutachievementofarangeofmoredirectwelfareobjectivesaswell(thatis,goingbeyondreductioninthesizeofChina’stradesurplustoincludeobjectivessuchasstrengtheningtheWTOsystemofadjudication,andkeepingGDPgrowthrateshighinallcountries).


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China’s economy has now become an important shaping force of the globaleconomy and, along with it. Chinese civil society has come to possess moreandmoreofthemiddle-classaspirationscommonintheindustrialisedworld.China’scontinuedhighgrowthnownecessitatesanewdevelopmentstrategythat also emphasises the creation of a harmonious society and a harmoniousworld—andthiswillrequireanimprovementinitsadministrativesoftwareandthesustenanceoftheglobalpowersupply.

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