China in Its Labyrinth

A few weeks ago, at a conference in Beijing, a friend told me that one of the most popular Chinese sayings is that that the ignorant are not afraid of anything. The evolution of the Chinese economy in recent decades exemplifies this saying. After the terrible oppression of the Cultural Revolution, the Chinese people opened up to capitalism without knowing how it worked. The basis of capitalism—private entrepreneurship—requires ignorance, since the probability of success of a new business is well below 50 percent. If entrepreneurs understood this probability they would never launch any venture. To escape rural poverty, the Chinese people rushed en masse toward capitalism. Success ensued after several failures. The lucky winners of the capitalist lottery are now billionaires. The vast majority of the population has reached the middle class. The society has urbanized. As my colleague at the Peterson Institute Nicholas Lardy says in his book Markets of Mao, China has progressed thanks to private-sector activity. Capitalism works.

Today China is in a situation that is very different from the post-Mao transition. There is no ignorance. After decades of transitioning to a market economy, liberalizing financial markets, and opening the capital account, China is now an almost "normal" economy. This normality has spooked markets and world leaders. Because what is abnormal is that an economy of its size has had the extraordinary development of the last decades. It has enjoyed a unique situation: the combination of the dividends of development, the transformation into a market economy, and the openness to international trade. These three impulses have generated an average GDP growth of almost 10 percent annually over the past 20 years. China's GDP has multiplied by 25 since 1978. Today the Chinese economy represents almost 15 percent of world GDP.

But all good things must come to an end. The dividend of urbanization is waning. China is approaching the feared Lewis turning point when there is no more surplus rural labor and wages begin to increase. It has also exhausted the dividend of large-scale industrialization and of a development strategy based on the external competitiveness of very cheap labor. This "normal" China is now facing the problems of more advanced economies: population decline (due to the disastrous one-child policy) and slowing productivity. China needs reforms, that much maligned concept in the developed world, to improve its productivity and continue to grow rapidly.

The problem is that China needs multidimensional reforms. China is undergoing multiple transitions from industry to services, from investment to consumption, from external demand to domestic demand, from large state enterprises to the private sector, all while reducing its very high level of debt: a labyrinth of transformations that is impossible to manage without making mistakes and while guaranteeing a stable rate of growth. China should stop announcing growth targets, which only generates unrealistic expectations and suboptimal policies.

Many analysts doubt the veracity of the GDP growth data supplied by the Chinese authorities. Until now, it did not matter. Markets had confidence in the authorities' ability to manage the transition. China has been, after all, the pillar that has supported growth in the developed world. Since the global financial crisis, it has generated more than a third of global economic growth; in 2009 all global growth was due to China.

The management of the stock market crisis and the exchange rate adjustment fiasco, however, have broken that trust in the Chinese authorities. The idea of promoting the stock market made sense as a medium-term strategy to reduce leverage in the economy and improve governance of state enterprises through the promotion of investment in stocks—but not when stock prices were already at bubble levels. The adjustment of the exchange rate to better reflect the interaction of supply and demand was necessary but should have been explained immediately and in detail to avoid creating the image of a surprise devaluation to rescue a declining economy, which caused unnecessary panic. The impression given to the outside world has been one of improvisation and lack of professionalism.

In addition, the high-frequency Chinese economic data are skewed towards sectors that are in decline, like manufacturing and investment. The opacity about the health of its financial system, the doubts about the composition and liquidity of its foreign exchange reserves, and the acceleration of capital outflows have fueled the suspicion that China is facing a sharp economic slowdown.

Given the global importance of China's economy, the fragility of other emerging economies—Russia and Brazil are in recession—the persistent doubts over Europe, and the fear that the Federal Reserve could have made a policy mistake by hiking rates prematurely, it is not surprising that markets decided to revise down asset valuations. The panic shown by international monetary authorities when they realized that further liberalization of the Chinese exchange rate could lead to a sharp depreciation indicates that perhaps the criticism in recent years of Chinese foreign exchange intervention was exaggerated.

It is still early to issue a verdict. The signs of a sharp slowdown in China have not been observed yet. Consumption and services remain robust. The effect of the stock market crisis on China's domestic demand should be small. Fiscal policy has room to support growth, and the new measures of privatization of large state enterprises are positive at the margin. But it is clear that the world is going to have to get used to a Chinese economy growing in a slower and, importantly, more volatile manner.

It is the end of the BRICs (Brazil, Russia, India, and China) as the foolproof insurance for the world economy.