Why does a strong economy lose momentum and fall into secular stagnation? What can emerging economies learn from the experience of advanced economies? How can an effective "prescription" be prescribed for the current economic situation in China? Fundamentally, some people must spend more than they earn for an economy to grow. In his new book, The Caught Up Economy, renowned economist Gu Chaoming argues that if China's economy wants to develop in the current external environment, domestic businesses and consumers must expand.
[Written by Chen Chaoming]
The easy part of China's economic growth story has come to an end
After World War II, the United States decided to open its huge domestic market, which accounts for nearly 30% of global GDP, to the world, and this act changed the rules of the game for the world. The advent of a free trade framework has completely eliminated the notion that territorial expansion is a necessary condition for economic growth and prosperity.
China has also benefited from a free trade system, successfully transforming an extremely poor agricultural country with more than 1 billion people into the world's second-largest economy in just 30 years. In the 30 years since China's reform and opening up in 1978, it may have been the fastest and largest period of economic growth in history, with per capita GDP of more than 1 billion people growing from more than $300 to more than $10,000 in 2019. China's rapid integration into the global economy attracted significant foreign direct investment, starting with Hong Kong and Taiwan, and soon expanding to all advanced economies.
The reason why those investments are attracted is that the free trade system allows companies to sell their products around the world. China has implemented reform and opening up: many bright Chinese students have gone to Western universities to study and Xi, and as China has prospered, a large number of tourists have begun to travel around the world. This is in contrast to the completely closed systems of the USSR and Eastern Europe, where contact with foreigners was strictly controlled. Reform and opening-up prompted China's accession to the WTO in 2001.
Accession to the WTO and access to the global market has led to companies from all over the world setting up factories in China. China's economy is growing rapidly, with exports accounting for as much as 35% of GDP. If it weren't for market supply under a free trade system, it would have taken decades for China to achieve such growth.
Western companies that were able to take advantage of China's cheap and industrious labor saw limitless investment opportunities and invested in China in the same way that capitalists did during the period of urbanization before Lewis's inflection point. These investments have greatly boosted China's economic growth and turned China into the "factory of the world".
But these investments have also exacerbated inequalities within developed countries, just as they had generated during the pre-Lewis inflection point of urbanization. This is partly because foreign firms expanding rapidly in China may reduce their investment in the country, dampening domestic economic and productivity growth. In fact, sluggish productivity growth in advanced economies is the opposite of the rapid growth in productivity and incomes in China and other emerging markets, which may be the result of investment by firms in developed countries. As a result, workers in other parts of Asia and the West have had to compete with Chinese workers and see their own wage levels stagnate, or even fall.
Those in advanced economies who are still wondering where the golden age of fixed asset investment enthusiasm has gone, need only find a window seat on a flight from Hong Kong to Beijing (or vice versa) when the weather is nice. They'll see an endless cluster of factories below, expanding in all directions. Many of these factories were originally founded by foreign capital, because China was left without capitalists by the time of China's reform and opening up in 1978.
Initially, the main source of outbound investment was Taiwan and Hong Kong. In fact, it was these businessmen in the 80s of the 20th century who brought the ideas and methods of managing the market economy. They realized that what was produced in Chinese mainland could be sold all over the world. Their pioneering efforts were followed by others from the West and Japan, who also recognized that China's rate of return on capital was much higher than that of their own country – provided that the goods produced in China could be sold around the world.
China, like other countries, follows the laws of urbanization, industrialization, and globalization. In fact, China has crossed the Lewis inflection point around 2012 and is experiencing rapid wage growth. This means that China is in a golden age of post-Lewis inflection point.
Rising wages in China have led Chinese and foreign companies to relocate factories to low-wage countries such as Vietnam and Bangladesh. Indeed, the globalization and free-trade system that has enabled China to benefit from being the lowest-cost producer is currently facing challenges.
This means that the easy part of China's economic growth story is over. If China wants to sustain economic growth in the face of rising wages, it will need to improve its domestic business environment so that companies choose to continue investing at home, at least in some sectors, even if they find a higher return on capital abroad. Challenges facing Chinese policymakers include a shrinking workforce and competition with the United States.
China's Challenges: "Decoupling", Demographics, and the Middle-Income Trap
China, the country with the fastest economic growth in the last 40 years, provides a good real-world example of how the middle-income trap and demographic deterioration are pressing issues. China's GDP per capita is just over $10,000 and is currently in the middle of the trap (see Figure 5-2), while its working-age population has shrunk since 2012 (see Figure 5-3). 2020 census data suggests that China's total population could begin to shrink as early as 2022. As a result, economists worry that China will lose momentum due to unfavorable demographics before it fully emerges from the middle-income trap and joins the ranks of advanced economies.
As mentioned earlier, for an export-led growth model to be successful, two necessary conditions must be met: the ability to manufacture competitive products and access to foreign markets where those products can be sold. There is no doubt that the Chinese have made great progress in meeting the first condition. Today, China manufactures almost everything with high quality and at a competitive price.
For the second condition, against the backdrop of protectionism, Chinese economists need to pay more attention to the question of who will buy Chinese products. After all, it is these people who will carry out the expansion that China's economy needs to continue to grow.
China's reform and opening-up has fueled the greatest economic growth in human history. At the beginning of the reform and opening up, China recognized the importance of securing markets for products made in China. When China opened its economy to the world in the 80s of the 20th century, fierce US-Japan trade frictions were also staged. China fears that if Japan and the United States, which are military allies and share similar values, get into a fight, the outlook for U.S.-China trade is unlikely to be bright given the differences in values between China and the United States. In order to avoid such an outcome, China has fully opened up its Chinese economy to foreign direct investment, so that foreign companies investing in China have a foothold in the local economy, which Japan has not done.
History shows that China's economic growth rate has exceeded that of any other country in history. Chinese people are industrious and have gained the ability to produce competitive products through hard work and Xi hard work, but it is the decision of reform and opening up that has enabled China to gain a market for these products. Reform and opening up has also enabled millions of Chinese students to go abroad to study Xi in the West. Soon after, millions more people went abroad as tourists. This is in stark contrast to the completely closed societies of Eastern Europe. Reform and opening-up prompted China to be invited to join the WTO and contributed to the largest economic growth in history.
In recent years, the continuous trade friction between China and the United States has prompted China to rely more on domestic demand to achieve economic growth, which is known as the domestic large cycle or dual cycle economic cycle. This has also led to a lot of people talking about "decoupling".
There is no doubt that China, with a population of 1.4 billion, is a huge domestic market. Chinese is also known for their willingness to learn Xi, work hard, and have an entrepreneurial mentality. These qualities have led many to believe that China's economic growth is unstoppable, but at the same time, China's economic growth is challenged as exports slow.
So far, China's economic growth has largely depended on its competitive export prices. At the height of the export boom in 2006, exports accounted for nearly 35% of China's GDP. Today, that figure is still around 18 percent. As long as the price of exports is competitive, foreign consumers will expand for China (even if they themselves believe that it is not enough), and exports will grow rapidly.
With their exports able to sell, Chinese manufacturers have contributed greatly to employment and economic growth by expanding their domestic investment. In other words, China is in a golden age, and Chinese companies have good reasons to expand while pursuing Strategy B, as they export to regions that are richer than themselves.
When the U.S.-China trade friction began in 2018, China claimed that 59% of the products subject to U.S. tariffs were actually made in China by foreign companies. This is not surprising, because when the reform and opening up took place in 1978, there was no longer a single capitalist in China, and all capital, technology and management knowledge had to be provided by foreign-funded companies. These foreign companies also provide overseas markets for their products made in China.
"Decoupling" from Western markets means that Chinese companies may have to sell to regions that are not wealthy. As shown in Figure 5-4, Western economies (including Japan) account for 56.8% of global GDP, while Russia, Africa, and other regions account for only 25.3% (China accounts for 17.9%).
Western economies have 4.5 times the GDP per capita of other economies. Given that China's GDP per capita has only recently surpassed the $10,000 mark, this could drastically reduce the size of the market in which Chinese companies can sell their products. The Chinese market is certainly important to the West, but it is important to recognize that Western economies (including Japan) account for 56.8% of global GDP, while China accounts for only 17.9%.
Future economic growth will require a vigorous expansion of business and consumption
Fundamentally, an economy must be made to have some people spend more than they earn in order for an economy to grow. If businesses and households behave cautiously and spend only the money they earn in each period, the economy may be stable, but it will not grow. In order for the economy to grow, entities must expand – either borrowing money or reducing savings.
Therefore, economic growth needs to have enough opportunities to continue to attract businesses to borrow money to invest, or exciting new products to emerge that entice consumers to want to buy, even if it means increasing debt or reducing savings. Population and productivity are just two of the factors that influence investment opportunities and the availability of "must have" products. Whether such an opportunity exists depends on the stage of the economy's development and the unpredictable technological innovations that lead to new products or new ways to manufacture existing products more efficiently.
For China's economy to thrive in the current external environment, domestic businesses and consumers must expand. To do this, companies need to keep coming up with new products that will wow and excite consumers. In other words, they have to adopt strategy A, despite the fact that they have fewer customers and are clearly not wealthy. This makes their situation similar to that of the countries mentioned above that are pursuing an import-substitution growth model.
There are many companies in China that have the ability to develop exciting new products. But the key question for policymakers is whether there are enough companies to support and drive the economy of 1.4 billion people. Despite China's phenomenal economic growth over the past 40 years, there are still 600 million people with monthly incomes of 1,000 yuan or less, and 900 million people with incomes of 2,000 yuan or less. As a result, China can still use foreign markets and Strategy B to provide gainful employment for these 900 million people, thereby improving their living standards.
The government must also protect intellectual property rights for Chinese companies to develop new products – without intellectual property rights, companies will not feel comfortable investing resources in R&D. Since Strategy A is inherently more risky than Strategy B, the financial system will have to be reformed to ensure that these companies have access to more venture capital. In fact, the Chinese government will have to implement the various policies that the US government has been demanding for years.
While these policy reforms may indeed happen, the new environment – where consumers are fewer and less affluent – will be more challenging than what Chinese companies are already Xi to. As a result, economic growth is likely to slow as "decoupling" progresses. The fact that few countries in the postwar period turned to the more difficult to achieve strategy A when per capita GDP was still low, and that no country succeeded in achieving sustained economic growth, shows that China faces enormous challenges.
In addition, when foreign companies that have set up factories in China begin to scale back their operations to meet the challenges of low wages elsewhere (the middle-income trap), or face the challenge of higher foreign tariffs on Chinese-made products, companies must take their place in order to maintain output and employment. While more and more capable Chinese companies are emerging that can both produce at home and sell abroad, the question is the same: Will there be enough companies to provide gainful jobs for people after foreign companies leave?
A country in the middle-income trap should make a conscious effort to increase the rate of return on domestic capital so that both foreign and domestic firms can continue to invest. Only by keeping entrepreneurs expanding will the economy not be dragged down.
In the short term, the government can keep the economy from shrinking by expanding. But unless the social returns on these public works are high enough to be self-sustaining, the growing budget deficit and the financing burden of maintaining the cost of new projects will eventually force governments to reduce fiscal stimulus. Once these fiscal support measures are removed, economic growth will slow unless businesses continue to succeed in launching exciting new products.
As mentioned earlier, China's working-age population began to shrink in 2012, when China crossed the Lewis inflection point. From a demographic point of view, it is highly unusual for the entire labor supply curve to begin to shift to the left at a time when an economy reaches the Lewis inflection point. Both Japan and South Korea have enjoyed about 30 years of labor growth after reaching the Lewis inflection point.
The instructive significance of the Japanese example is that the decline in the total population, which is expected to begin as early as 2022, will weigh on the growth of the population growth. If China does not get out of the middle-income trap before the momentum of demographic growth fades, it may be difficult for an aging country with an increasing social burden to achieve its goal of US$20,000 per capita GDP by 2035.
"Decoupling" does not mean that all of China's trade with the West will disappear overnight. Even in the 60s of the 20th century, at the height of the Cold War between the United States and the Soviet Union, the United States and Great Britain imported a large number of single-lens reflex cameras from the GDR and used them in photography classes in public schools. This is due to the fact that cameras in the GDR were much cheaper than their counterparts in the Federal Republic of Germany and Japan.
With the help of fiscal policy, China's economy is likely to continue to grow in the coming years without an actual military conflict. However, at a time when the population is aging and domestic wages have reached the hallmark level of the middle-income trap, "decoupling" from the West could lead to a significant decline in growth rates.
In this sense, if China wants to reach this standard of living by 2035, there is no time to waste and there is no room for policy errors. Policymakers in China must understand which companies have expanded so far and which ones will expand in the future.
Caught Up Economies: How Advanced Economies Understand and Respond to New Realities
Author: Richard Koo Translator: Xu Zhong, Ren Qing November 2023 CITIC Publishing Group
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