If the country falls back on old bad habits, its chances of reaching high-income status may well be threatened
By putting more barriers in China’s path to US markets and, in the process, risking some short-term damage to the domestic and global economies, US president Donald Trump could exact a heavy long-term cost on the world’s second-largest economy. Indeed, he may even threaten China’s chances of eventually entering the ranks of high-income countries.
Chinese leaders have long known that they need to change their development model if they are to make this difficult transition, powering through the dreaded “ middle-income trap” that’s tripped up so many other developing countries. For two decades, they relied on global markets to provide a crucial tailwind while they pursued reforms at home. But this is changing now that the US is increasing tariffs on Chinese imports and limiting their tech companies’ access to US markets. Also, some US companies have already begun to reorient their supply chains away from the mainland.
With external tailwinds turning into headwinds, China will need to rely far more on domestic demand to generate prosperity. To do so without building up risks in the financial system, Beijing would need to promote far greater household consumption and private investment, rather than relying on the debt-fueled government investment and inefficient state owned enterprises that have helped drive domestic engines of growth for most of the last several decades.
This effort will fail unless the government can overcome three habits that tend to reassert themselves whenever economic and financial insecurities increase in China.
The first is the tendency for households to sock away more money as a form of self-insurance. Especially when they’re uncertain about their economic prospects, Chinese households revert to parking away higher savings to safeguard their future ability to pay for things like hospital bills, education for their family, and retirement.
China’s success in prudently reducing its household saving rates in recent years appears to have stalled in the last 12 months. The latest high-frequency economic data, including this week’s lower-than-consensus expectations for retail sales and industrial output, suggests the problem may get worse before it gets better. China needs to do more to provide households with pooled insurance mechanisms (including improving health insurance, education and pension systems) so that they can feel more confident spending.
The second trend is the tendency for the government to revert to fiscal and monetary stimulus whenever the economy hits a soft patch. Recent evidence suggests that such measures are less effective than they used to be, requiring much more debt per unit of GDP to stabilise growth. This only adds to the risks building up in China’s financial system. Most development economists argue that to avoid the middle-income trap, countries instead must lead with the supply side, securing further productivity gains and diversifying their domestic economic base.
The third is the government’s tendency to fall back on state-owned enterprises to boost GDP. Most available evidence suggests that the efficiency and productivity of these companies is low and declining, while their contributions to China’s debt load and resource misallocations are increasing. China instead should be empowering its more efficient private companies to be responsible for the bulk of jobs and growth in the economy.So far China has resisted following the examples of Canada and Mexico in making concessions to the Trump administration in order to defuse trade tensions and build a more sustainable economic relationship with the US. If it also cannot resist indulging these three habits, its multi-decade record of impressive economic performance, not to mention its future prospects, will be at serious risk. That would only further embolden those US policy makers who, driven by both economic and national security considerations, hope their actions now will dampen China’s ability to challenge America’s global dominance.