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Xi's best chance lies in liberalization

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Traffic during a hazy day in Beijing on Nov. 18, 2015   © Reuters

It's sometimes said that the challenge China faces in the coming decade is avoiding the "middle-income trap" -- a stagnation in per capita income growth that many countries have hit after reaching China's level of development.  But the problem is more complex. China must avoid two pitfalls: the "Brazil trap" of excessive reliance on state-led investment, and the "Japan trap" of an aging population and excessive reliance on debt. 

     Analogies from history are never perfect, but parallels are often illuminating. From 1950 to 1979, Brazil enjoyed a long economic boom during which gross domestic product growth averaged 8% a year, and per capita income grew at 5% a year. Much of the growth came from investments in infrastructure and heavy industry by state-owned companies. During the second half of that period, Brazil was ruled by a military government that relied heavily on economic growth for legitimacy. Does this sound familiar? 

     In those years, Brazil was one of the world's great growth stories. But then the music stopped, and the country never regained its momentum. Since 1980, GDP has grown just 2.5% a year -- less than the U.S. -- and per capita income has increased by less than 1% per year.  

BRAZIL'S WOES   The proximate cause of Brazil's abrupt slowdown after 1980 was an external debt crisis, and the structural causes of its malaise since then are numerous. But a big one was a heavy reliance on state-owned economic institutions long past their sell-by date. State companies and development banks can do a fine job of building a country's infrastructure and basic industries. These are capital-intensive projects whose main payoff comes from long-run economic growth, not short-run financial returns. But state companies are terrible at the tasks in a mature economy: maximizing the efficiency of investment and catering to fast-changing consumer demand. 

   It took decades for Brazil to privatize its state companies, and even today around 40% of the nation's fixed investment is financed by the Brazilian Development Bank, a state-owned policy bank. Failure to move more economic decision-making into private hands imposed a heavy "growth tax" that Brazilians are still paying, more than three decades after the end of the infrastructure boom. 

Today, China faces a similar need to prune the role of the state. Much of its growth of the past 15 years came from investment in infrastructure and heavy industry, sectors dominated by state companies. Despite gains by the private sector in many areas, China has by a wide margin the biggest state sector of any major economy. A 2011 OECD study found that state-owned assets in China were 145% of GDP, more than double the figure for the next most statist economy (India). Since 2008 the financial return on state-owned industrial assets has steadily deteriorated and is now less than half the return on private-sector assets. Maintaining state ownership at the current level risks imposing a "growth tax" of efficiency losses. 

     Today's China differs from 1980s Brazil in many ways, of course. Brazil was essentially a closed economy that practiced import substitution, exported mainly commodities and did a poor job of keeping up with global technologies. China is a dynamic, open trading nation, accounting for 18% of the world's exports of manufactured goods, and an emerging power in many technological fields. It has also enjoyed far more stable and competent technocratic government than Brazil ever did. In general, it resembles Brazil far less than it does Japan, which like China rose to become the world's second biggest economy on the back of manufacturing and export prowess. 

JAPAN'S WORRYING PRECEDENT   But this precedent is also cause for concern. Japan hit its peak in 1990 and then suffered from the bursting of a huge real estate and credit bubble. Instead of recognizing bad debts and deregulating its service sectors to open up new avenues of consumer-driven growth, it papered over its problems with a huge expansion of government debt. This enabled it to avoid an outright crisis, but trapped the country in a high-debt, low-growth equilibrium from which it has not escaped. Another reason for this outcome was rapid population aging, which reduced the proportion of workers and increased the number of retirees. In 1990 Japan had five workers for every retiree; today it has about two.  

     Conditions in China now are analogous to those of Japan in the early 1990s. Since the global financial crisis of 2008, gross debt has soared from 140% to 240% of GDP. While debt-financed stimulus was a perfectly reasonable short-term response to the crisis, it has since become a long-running strategy to avoid the hard work of structural reform. And demographics, which for much of China's reform period have acted as a powerful tailwind, are now blowing the other way. Today, China has about six workers for every retiree; by the 2040s it will have just two. 

     Can China avoid the Brazil and Japan traps and sustain fast growth of 5% or so through the 2020s? Yes, but only if it moves boldly in the next few years. The state sector must be severely retrenched, and barriers to private companies in high-growth service sectors must be dismantled. Reform is also needed to fix tax structures that cause wealth to accumulate in the hands of big state companies and a narrow elite, rather than flowing broadly throughout society. And political control of academia, the media and civil society must be relaxed, or there is no hope for China to generate the kind of innovation required to sustain a dynamic postindustrial economy. 

XI'S PATCHY RECORD   So far the government of Xi Jinping has talked a good game on economic reforms, but its accomplishments have been patchy. It liberalized interest rates and the exchange rate (at some cost in market confidence), began to get local governments' chaotic finances in order, made the pricing of energy more market-based, and made some progress in tax reform. Xi's administration has made it easier to start new business and begun to relax residence permit requirements that make it hard for the country's 260 million migrant workers to participate fully in the modern urban economy.

     These achievements are significant and have contributed to a slow shift in favor of consumer spending and services, and away from capital spending. But much more must be done, and on the core issues of debt control and pruning the state sector there is little evidence of progress. A tepid state enterprise reform program published last September makes clear Beijing is determined to maintain the state's economic role at about the present level. Most important, Xi is relentlessly tightening the Communist Party's political control, slowly suffocating the innovation economy. He can keep headline GDP growth up for a few more years by ramping up debt, but sustainable, high-quality growth will prove elusive unless Xi loosens his grip and shifts to a more liberal course. 

Arthur Kroeber is head of research at economic consultancy Gavekal Dragonomics. His book "China's Economy: What Everyone Needs to Know" will be published in April 2016 by Oxford University Press. 

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