China's development -- now for the hard part

China is now beginning the "hard part" of development -- as its growth is slowing, debt is increasing sharply, adverse demographics are biting and the inefficiencies of state capitalism are visible.

Pragmatic policy-making has driven China's rapid development since 1978. But with growth now slowing, debt increasing sharply, demographics now biting, and the inefficiencies of state capitalism increasingly visible, China is now beginning the "hard part" of development.

China's development is well documented. Annual economic growth rates of 10%, before slowing more recently to a new normal of 7%. Poverty, based on a poverty line of $1.25 a day, fell from 84% in 1981 to less than 10% today.

China is the world's second largest economy, and is now arguably the world's largest in purchasing power parity terms. It is also the world's biggest trading nation. The Chinese currency, the renminbi, is internationalizing as it is increasingly used for international trade transactions. In recent years, China's state-dominated economy has seen the rise of successful private companies like Alibaba and Xiaomi.

How did this once poor and isolated country achieve such rapid success?

The government of Deng Xiaoping progressively unleashed the energies of the talented Chinese people. Key to this was removing the shackles of central planning, privatising old state-owned enterprises (SOEs), opening up to international trade and investment, and allowing new economic freedoms. The government has also invested strongly in infrastructure and education.

Despite China's veneer of hyper-capitalism, the government has always intervened in the economy in a multitude of ways. This may have helped Chinese enterprises succeed in the earliest stages of development.

Prior to the 1990s, such intervention included industrial policies like high tariffs, investment incentives, export subsidies and domestic requirements on foreign firms. Some of these policies had to be phased out with membership of the World Trade Organization, although SOEs still have access to subsidized finance, land, energy etc. Over the past decade or more, Chinese companies have benefited more from an undervalued exchange rate.

Even today, there are continual complaints about Chinese government discriminating against foreign companies on the basis of anti-monopoly law, and also state-sponsored intellectual property theft and cyber-espionage. And restrictions on foreign direct investment (FDI) remain widespread. China's FDI policies are the most restrictive of 58 countries surveyed by the OECD in its FDI Regulatory Restrictiveness Index.

The big picture hides a multitude of nuances.

China may well have the world's biggest economy, but its GDP per capita is still only 13% of that of the US. It ranks a lowly 89th in the world for GDP per capita, on a par with Peru or the Maldives.

Much of its importance is due to its enormous population. China may be the world's biggest exporting nation, but half of its exports still comes from foreign-investment enterprises, rather Chinese enterprises, even if the Chinese share is now rising.

China has benefited from a demographic dividend, thanks to its large youthful population. But due to the one-child policy, China's work force has already started declining, and the demographic dividend is passing. In contrast to Japan, China is becoming old before it becomes rich. As evident from rising wages these past years, China can no longer rely on cheap labor as a source of growth. Growth must now be driven by productivity, human capital and innovation.

Chinese company purchases of Western companies with strong brands and good technology is very helpful for industrial upgrading. But the protectionist policies of the past must be unwound in order to develop a more innovative business culture.

China has retained a large number of SOEs and state-owned banks dominate the financial sector. This why China is often said to have a system of "state capitalism", whereby SOEs pursue national political strategies, while also operating as business enterprises. China's SOEs are renowned for the inefficiency and corruption, even if they are improving. Many enjoy monopoly positions in the domestic market thanks to government protection.

Even ostensibly private sector companies like Alibaba have close links to the Chinese Communist Party. The Party always makes great efforts to co-opt emerging sources of power.

Despite growing prosperity, China's citizens have many reasons to be unhappy.

Pollution makes life insufferable in the big cities. A widening income gap between rich and poor, together with deeply entrenched corruption, give rise to a widespread sense of injustice. Children from one-child families are under enormous family pressure to succeed. Rural migrants to large cities like Shanghai do not have access to social benefits like public education or health.

Human rights abuses are legion, and have been increasing over the past couple of years under President Xi Jinping. Minority groups like Tibetans, Uyghurs and Christians suffer in particular.

There are widespread restrictions on freedom of expression and assembly, and access to information. Intellectuals, academics, students, NGOs, trade unions and the media have particularly been targeted by the current government.

The shutdown of Google, Facebook, Twitter and Facebook has many impacts, including inhibiting academic research, as has the increased use of propaganda. And widespread censorship has resulted in painfully slow Internet speeds, in a country which ironically would like the Internet to become a new motor of economic growth.

Cultural freedoms are also greatly restricted. The travails with the authorities of artist Ai Weiwei are just one example among many. In sharp contrast, the immediate post-war economic boom period in Japan was a golden age in Japanese culture thanks to the freedoms that came with the end of Japanese military rule.

Most restrictions on Chinese citizens' lives are due to the Communist Party's fear of social and political unrest, in light of its fragile grip on power. Perhaps the most flagrant evidence of paranoia is the recent official campaign against "Western values" in school education.

Growing numbers of Chinese citizens are leaving, or sending their families to more sympathetic climes like Australia, Canada, New Zealand and the US, and more recently to Europe. Another trend is "birth tourism", whereby Chinese mothers give birth in overseas, including in Hong Kong, so that their child can obtain another nationality. Illicit financial outflows from China have been enormous, and would be $1.3 trillion for the period 2003-2012, according to Global Financial Integrity. And capital flows have reportedly accelerated in recent months.

China's reaction to global financial crisis

Triumphalism was the reaction of Chinese leaders, when the US was struck down by financial crisis in 2008. They interpreted this as a sign of the decline of the US, and the ascendancy of Asia. This period also saw the beginning of a new Chinese assertiveness in international relations and against America and Japan, in particular.

But the Chinese government also panicked. The Chinese economy had long been dependent on exports to the US and other Western markets, and there was fear of the adverse impact on the economy. So the Chinese government launched a massive stimulus package, by pushing state-owned banks to lend money to SOEs and local governments. And all the strictures of state-owned bank dominated financial system, paved the way for a boom in China's shadow banking.

As a result, China's total debt has risen from $7 trillion in 2007 to $28 trillion by mid-2014, according to a recent report by the McKinsey Global Institute. It accounts for more than one-third of the growth in debt globally. Representing 282% of GDP, China’s debt is now even larger than that of America (269%) or Germany (258%).

China’s rapid debt buildup is about double that in the US before the global financial crisis or in Korea before the Asian financial crisis. If the current pace of debt buildup continues, China's debt would reach 400% of GDP by 2018.

China’s debt may be concentrated in the SOE sector, with corporate debt representing 125% of GDP. But China's government debt of 55% of GDP could jump quickly if the government were obliged to bailout SOEs or to recapitalise financial institutions.

Indeed, China’s debt binge has created many vulnerabilities. Unregulated shadow banking accounts for nearly half of new lending since 2008. Some local government infrastructure projects are not capable of generating financial returns to enable debt repayment. And nearly half of China's total debt is directly or indirectly related to the volatile real estate sector, where prices are already falling.

Which way forward?

The Third Plenum of November 2013 announced a new phase of widespread reforms, with market forces set to play a "decisive role" in the economy. The goal is to wean the Chinese economy off its investment- and export-led growth model towards one based on domestic consumption and services. Conscious of Japan's long stagnation, the Chinese government is also keen to promote innovation and entrepreneurship as new growth drivers.

Since the Third Plenum, the government's energies have been marshaled to a massive anti-corruption campaign. This is important for improving the governance of the economy, and for neutralizing anti-reform groups. It is also seen as the last chance to restore faith in the Communist Party by salvaging its reputation.

The anti-corruption campaign has been mainly used to eliminate rivals to President Xi Jinping, and enable him to consolidate his grip on power. There are indeed reports of a sharp increase in suicides. Legal processes stop upon death, enabling families to keep ill-gotten gains.

Very little headway has been made in the reform program. As the economy slows (in part due to the paralyzing effect of the anti-corruption campaign), the government will likely remain hesitant about rapid reform, in light of the creative destruction that it necessarily entails. Indeed, new economic stimulus is exacerbating over-capacity. And while many anti-reform vested interests have been eliminated in the anti-corruption campaign, many still remain to lobby against reform. The National People's Congress in early 2015 struck a more modest tone about China's economic prospects.

Chinese reverberations

We are only just beginning to see the reverberations of China's renaissance after two centuries of absence from the global scene. Napoleon was right when he once warned, “Let China sleep, for when she wakes she will shake the world.”

Analysis today of China today often focuses on its transformation of its economy from central planning towards market-based capitalism. But what is perhaps more important is the transformation of a feudal society and political system to a more prosperous and open system.

It is tempting for Westerners to imagine that China will inevitably democratize. And there are of course demands and pressures for modernization, entailing democracy, rule of law, human rights, freedom of the press, and individualism. But these are presently being resisted by the Communist Party.

As is clear from the anti-corruption campaign, China is still very much subject to the "rule of the Party" rather than the rule of law. There is no role permitted for an independent anti-corruption authority, judiciary, media or NGOs in fighting corruption. Indeed, anti-corruption media and NGOs are arrested for exposing corruption. It is only the Party who can decide who is corrupt.

Another reality is that China is fundamentally, and has always been, an empire, which dominates by force much of its periphery -- Tibet, Inner Mongolia, Xinjiang, Hong Kong. China's long history has been one of ups and downs, expanding and contracting borders, and periodic dynastic change, as each dynasty has lost the mandate from heaven.

Centrifugal forces are strong in China, and the Communist Party is very much aware of its historically fragile grip on power. This is why it spends more on domestic security than the military. In fact, some international commentators, like American academic David Shambaugh, believe that the "endgame of Chinese communist rule has now begun".

China's renaissance is only beginning to reverberate through a world that has been dominated by the West for several centuries. SOEs strut the global economic stage, snapping up bargains everywhere including Greece. Military expenditure is going off the page, sending shock waves through China's East Asian neighbors, as the People's Liberation Army flexes its muscles. Exports of arms have increased by 143% over the past five years, making China the world's third biggest exporter of arms. And China's construction of the "Great Wall of Sand" in the international waters of the South China Sea is a blatantly provocative challenge to international law.

China's creation of the Asian Infrastructure Investment Bank (AIIB) is also a direct challenge to the American-led postwar economic and political order. But while China's construction industry is cheering on the AIIB, the many Chinese citizens who lack for economic and social infrastructure are surely disappointed. As they would also be by China's financial assistance to "allies" like Venezuela and Zimbabwe, which are proving to be troublesome investments.

The Chinese regime is motivated to reassume its traditional role of political domination of East Asia. This is however being resisted by China's neighbors, which are increasing democratic, and do not wish to be dominated by a communist, regional hegemon.

We can only hope that China's takeoff will be completed with a peaceful, prosperous and stable soft landing. But that is not assured -- especially in 2015, the year of the goat, the most unlucky of all in Chinese astrology!