China's Economy - It's the Real Thing

Stephen Roach (Chief Economist, Morgan Stanley, New York)

This essay is based on remarks presented before the United States-China Business Council on February 13 in Washington, originally posted in the February 26, 2003 issue of South China Morning Post in Hong Kong and reproduced here with permission from the publisher.

The world has long been suspicious of the Chinese growth story. That has especially been the case over the past five years. China has survived two critical tests in that period that should have dashed some of the scepticism. It came through the Asian financial crisis of 1997-98 with barely a scratch. And it survived a synchronous global recession in 2001 with a similar Teflon-like resilience.

Yet the sceptics are still worried that China's rapid growth dynamic is not sustainable. Some even warn of an imminent crisis in the Chinese economy. I disagree, and expect the strength of the Chinese economy to continue throughout this year.

There can be little doubt that China is now coming of age. While still a relatively small economy, its growth is now strong enough to have a major impact on the dynamics of the broader global economy. Currently, China accounts for only about 4 per cent of a US$32 trillion (HK$250 trillion) world economy. However, in a weakened global climate, China's growth rate is now strong enough to have accounted for 17.5 per cent of the growth in world gross domestic product (GDP) last year - second only to the growth contribution of the United States.

There are no guarantees that China can stay this course. In my view, the world's most populous nation must overcome three macro challenges to get to the "promised land" of economic prosperity.

First, China must address a fundamental imbalance in the mix of its economic growth - moving away from externally led growth towards increased support from domestic demand. Our estimates suggest that the growth in Chinese domestic demand accounted for only 26 per cent of China's total GDP growth last year - a meagre contribution by any standards. Moreover, this demand has been driven largely by state-sponsored infrastructure investment and foreign direct investment.

China needs to focus increasingly on private consumption as a source of economic growth. That is not easy when massive job shedding of six to eight million workers a year continues in state-owned enterprises.

Arresting deflationary pressures is a second macro challenge that China faces. Chinese consumer inflation has been falling at nearly a 1 per cent annual rate for the past two years. In a sluggish world, China's deflation problems have become the world's deflation problems. As an increasingly open global economy imports ever-rising volumes of low-cost Chinese goods, the world price level moves inexorably lower. In my view, this is not China's fault, as some have maintained. It is more reflective of the excesses of consumption for saving-short nations, such as the US.

The third macro challenge is the need to diversify the geography of its economic base. China's latest five-year plan is notable for its emphasis on the need to develop the western portion of this vast nation.

These efforts can hardly be expected to bear fruit overnight. But the leadership remains critically focused on related issues of social stability and the risks to such stability that could be brought about by widening disparities in incomes between the wealthy coastal region and the considerably poorer inland rural areas. A geographic diversification of China's economic base is ultimately the only viable solution to this growing dilemma.

Like any economy, China faces risks on both the upside and the downside. In my view, the upside is all about China's steadfast commitment to reform - a record that has been most impressive in defying the sceptics.

State-owned enterprise reforms continue apace, as China moves aggressively to embrace and implement its strain of "market-based socialism". Admission to the World Trade Organisation, of course, is the ultimate guarantee of China's reform process - not only binding it to the rules-based system of the world economy, but also opening China to foreign competition on a timetable that is rapid enough to put real heat on inefficient domestic enterprises.

China's steadfast commitment to reforms is what separates it from the pack. That, alone, continues to keep me more optimistic about China than any other economy in the world.

Alas, there is also the downside to contend with. In my view, these risks are primarily cyclical - a by-product of China's externally led growth dynamic.

While exports now make up 26 per cent of the economy, the growth in China's exports accounted for 74 per cent of the total growth in Chinese GDP last year. If history repeats itself and the world economy goes back into recession in the aftermath of the current oil shock, export-dependent economies such as China would be particularly vulnerable. As the drumbeat of war in Iraq grows louder, China must be mindful of that very risk.

Painful as they are, business cycles come and go. The benefits of structural change, by contrast, are everlasting. In that vein, I believe China's transition and development has finally attained a critical mass. That poses the most daunting challenge of all: China must break with 5,000 years of inward-looking traditions and focus increasingly outward to understand the global implications of its extraordinary transformation. In return, the world must begin to put aside a deeply entrenched scepticism of China and take this remarkable success story seriously.

History may well judge the rise of China as one of the most important catalysts in the laboratory of globalisation.