Albert Keidel is Senior Associate at the Carnegie Endowment for International Peace. This enote is based on his presentation at the FPRI Asia Program’s March 12, 2007, conference, “China Rising: Assessing China’s Economic and Military Power.” His policy briefs and other writings on this and related topics are available at www.carnegieendowment.org.
Since its market reforms began in 1978, China’s economy has grown at close to 10 percent a year, according to official data, and has even accelerated since the year 2000. Internationally accepted measures of China’s growth show it to be even faster than officially reported. This growth success is no flash in the pan. It will likely continue at better than decade-doubling rates until close to the middle of the century.
The implications of China’s continued rapid growth include China’s overtaking the U.S. in overall GDP terms sometime around 2040. Such a large and fast-growing economy will change global patterns of production, trade, and pricing, and also implies adjustments in the balance of global military force projection capabilities.
However, China’s economic size will not quickly translate into comparable degrees of military prowess. The slow process of accumulating military hardware and global bases means that China’s rise to global military preeminence will necessarily be much slower than its economic rise. This gives the U.S. time to consider its policy options.
China’s growth rate since 1990 has well outstripped the twentieth-century growth records of Japan other East Asian “miracle” economies like South Korea, Taiwan, and Singapore. This record is consistent with a basic theme in the study of economic development and the spread of the benefits of the industrial and scientific revolutions: the later an economy starts the catch-up process, the faster it should be able to modernize.
China’s size and the still considerable scale of its impoverished population make it difficult to compare its current stage of development with historical time periods in other countries. It is perhaps most comparable to Japan’s in the early 1950s at the latest, and to South Korea’s and Taiwan’s in the late 1960s and early 1970s.
Since 1978, China’s domestic economy has experienced wrenching change. After raising prices for farm products dramatically in 1979, China converted its socialist communes to family farming in the early 1980s, when it also created banks and replaced government budgetary financing for enterprises with bank loans. In the latter 1980s, China shifted operational control of factories from Communist Party secretaries to factory managers, who were given incentives to make money.
By the late 1990s most state enterprises had been sold to private interests, and banks had been transformed to operate increasingly as businesses. Government budgets morphed from a system of slush fund cubbyholes into a modern tax revenue system, with expenditure discipline, based on a single-treasury account. The population has shifted in droves to urban areas, education now brings premium pay in virtually all jobs, and public education through nine grades is now universal. Limited-access highways crisscross every province, and a telecommunications and internet backbone stretches to county towns and beyond.
China’s integration into the international community also goes far beyond what Japan or South Korea ever attempted at this stage of their development. China’s embrace of the World Trade Organization and foreign direct investment is unprecedented and contributes importantly to its growth success. Some parties, especially special interest groups, allege that China engages in unfair commercial practices, such as policies affecting exchange rate levels, intellectual property rights, subsidies, and accumulation of foreign exchange reserves. However, both the U.S. Treasury Department and the International Monetary Fund have repeatedly confirmed that China’s management of its economy meets global standards for fairness.
After a 1980s period of rapid and destabilizing fast-slow fluctuations, since the 1990s China’s growth surges have come in more extended waves. Today China is in the longest sustained period of rapid expansion since reforms began. This growth surge ironically received stimulus during the SARS epidemic of 2003. Government investment promotion intended to counter the epidemic’s impact turned out to be unnecessary and hence excessive. But good monetary control over cash in circulation and other steps contained overinvestment in bubble-prone sectors, and by 2006 officially reported consumer and retail price inflation measures were below 2 percent.
Extremely rapid growth in both exports and imports after China’s 2001 WTO accession has also provided overall economic stimulus. However, because import growth kept up with exports until late 2004, trade’s direct contribution to GDP growth was minor until 2005. Even then, domestic demand—rapid growth in consumption and domestically funded investment—dwarfed international trade’s direct contributions to Chinese GDP expansion.
Observers in the U.S. and elsewhere are understandably most impressed with the impact of China’s rise on foreign trade and “outsourcing” of traditional production facilities and employment. But the dominant foundations of China’s rise are clearly domestic. This extends not only to domestic demand, but also to China’s political system, to its policy focus on public investment. It extends to China’s financial system’s directing credit to bottleneck sectors, to rapid reform in corporate governance, and to a culture of confidence in China’s ethical and moral potential for global primacy.
The international development record strongly suggests that economic success for poor countries hinges critically on the quality of governmental leadership. In this regard, China’s leadership—its development-oriented ideology, its ability to promote capable individuals, and its system of collaborative policy review—deserves first place in looking for overall explanations of China’s economic success. This is all the more so when we make comparisons with other examples of political and economic leadership we see throughout much of the developing world today. Leadership rankings would also consider the motivations and commitment of those social elites who most directly influence the makeup and behavior of particular individuals in official positions of public responsibility. For whatever reasons, China’s leadership, in this broad sense, has shown itself focused daily on the thousands of practical decisions needed for sustainable rapid increases in output and its distribution throughout the population.
Among the various underpinnings of China’s growth performance, it is difficult to overemphasize the importance of public investment. Typical examples are good roads and highways, ports, airports, high-throughput telecommunications networks, education, public health, law and order, mass transportation, and water and sewer treatment facilities. A wide variety of other structures and facilities provide much needed physical space for profit-oriented enterprises and individuals.
One of the reasons China can effectively concentrate so many resources in public investments is the effectiveness of its two-pronged financial system. The first prong is a well-run directed-credit system that channels funds from bank and postal deposits to policy-determined public uses; the second is a profit-oriented and competitive system, albeit in early and inefficient stages of development. Both prongs continue to undergo rapid government-sponsored reforms to make them more effective. This approach to financial development has been an East Asian tradition for over a hundred years, beginning with Meiji Japan in the late nineteenth century.
The statistical test of the Chinese financial system’s medium-term efficiency is the reasonably low level of additional capital China has needed for additional GDP output—i.e., its incremental capital-output ratio, or ICOR. Averaging over 5 years, 10 years or 15 years, China’s ICOR has been lower than 4.0. It is lower than India’s and quite good for a fast-growing developing economy. China’s for-profit financial sub-sector suffers from typical problems for such systems—more short-sighted investments, including prevalence of real estate investment bubbles. The most important source of investment finance in China, however, is not directed credits or for-profit indirect credit, but retained earnings and equity contributions—perhaps the most profit-oriented financial sources of all.
The post-1978 regeneration of its business models in the direction of market-based and for-profit incentive mechanisms has also provided a powerful domestic basis for China’s successful rise. Land reform in the early 1980s distributed commune-managed land to individual households for family farming on a fairly egalitarian basis at the village level. Family farming provided both a boost in productivity and flexibility for household labor to manage its own choices of work both on and off the farm as non-farm employment opportunities multiplied.
Corporate structures have changed dramatically since the early 1980s and have enabled increasingly efficient use of the world’s available modern technologies. The large majority of state-owned enterprises and virtually all collectives have been sold to private owners or converted to for-profit operations. Transformation of the largest state firms still has a way to go, but the direction has been clear and the pace fast. A major barrier has been former workers, who have guaranteed lifetime urban jobs and benefits. State-owned enterprise (SOE) employment declined by more than 50 million workers from 1996 to 2005. The resulting gains in operational efficiency and responsiveness to market demand patterns have contributed to productivity gains not attributable to the economy’s obvious overall increases in capital and labor inputs.
Finally, ancient threads of China’s culture seem to tug many Chinese toward belief in their system’s moral and ethical superiority—sometimes called the “Middle Kingdom” complex—despite its technological backwardness. Looking to historical traditions that far predate its communist era, China does not see itself as representing an inferior political or cultural tradition. How these traditions will evolve and express themselves in coming decades, when provided with the productivity of modern industry and science, is not clear. This bears directly on the potential for global convergence in “shared values” and concerns over China’s future military and foreign policy intentions.
All of these shifts and developments in China’s domestic circumstances have not only generated growth in their own right, they have also enabled it to capitalize on the increasingly open commercial practices and more advanced technologies available from global markets. China can grow so fast because it is so easy to see what the long-term economic goals are and because it is so easy to purchase and otherwise acquire the means to pursue those goals. This “catch-up” growth involves more than factory technologies and modern machinery for ensuring output quality. Like Japan in the nineteenth century, China is studying and importing management and regulatory systems, innovation techniques, and other institutional solutions to its public and for-profit governance challenges.
When China first attempted to use oil revenues to purchase foreign equipment on a large scale in 1977-79, after Mao’s death, its various domestic institutions were incapable of successfully choosing or absorbing those technologies. Productivity stagnated as new machinery rusted. Today, after thirty years of rapid domestic system reform, China chooses and uses foreign technologies well.
Despite the importance of trade and technology transfer for China’s economic rise, its growth has been led by domestic, not export, demand. For both the fast and slow portions of the five fast-slow economic cycles since 1978, shifts in exports and the trade surplus usually played no role at all. For example, rather than suffering slower growth like other Asian economies during the U.S. recession of 2002, China’s GDP growth had begun to speed up in 2001 and accelerated right through 2002-03, continuing to gain speed up to today.
Despite China’s successful economic rise to date and the many strong domestic and international supports for continued fast growth for decades to come, numerous weaknesses and potential weaknesses challenge China’s policymakers.
One of the most serious weaknesses involves the central government’s difficulty disciplining local government behavior. Local officials’ primary priority has been to promote themselves and their careers by pushing for high investment rates and output levels. In contrast, central officials are more concerned with excessive investment, unsold inventories, and local policies’ risking nationwide price inflation. Local behavior is difficult to control because China’s center-local relations are basically corporate in nature, not federal. The central government accomplishes its goals at the local level by operating through local government offices, not alongside them. Hence, central officials must often operate through the very local offices they are intended to investigate.
Quasi-federal solutions to this center-local governance problem have been slow to appear. China’s central bank has consolidated its provincial branches with regional branches modeled after the U.S. Federal Reserve System. China’s central environmental agency has established its own regional offices, although their authority is still weak. China’s tax bureau has in principle established its own offices to collect the central government’s portion of the value added tax, but in practice this office is weak. The most successful development is in China’s statistical bureau, which has shifted control of local survey teams’ pay, benefits and career dossiers to the center. These few exceptions offer a possible direction for future reform of center-local bureaucratic relations.
Economic statistics themselves continue to represent a weakness in the management of China’s economic rise. Instead of using seasonally adjusted data, rates of change—such as output, trade, inflation and money aggregates—still rely too heavily upon year-on-year measures that delay recognition of major short-term shifts. What is more, China’s official GDP data appear to understate growth in fast periods and overstate it in slow ones. Each of China’s periodic economic censuses has shown serious under or over counting through regular reporting and survey channels. Perhaps most importantly, the failure of China’s dual urban-rural household survey system to capture the economic behavior of more than 100 million active rural-to-urban migrants handicaps relevant policies.
One of China’s most serious problems, corruption, is shared with other developing countries. In China it is mainly a local government phenomenon. There is little evidence that what corruption is uncovered at the national level has seriously threatened the integrity of economic policymaking. International corruption surveys by the World Bank and Transparency International rank China’s corruption as less serious than that found in countries like Indonesia, India, the Philippines or even Argentina.
It is in its efforts to control corruption that the central government most clearly experiences the limitations of its corporate national system. Local corruption investigations are most frequently carried out by special ad hoc task force from either the central or provincial level. There is no equivalent of the national anticorruption functions performed by the U.S. FBI, as supported by independent federal prosecutors, courts and prisons.
Corruption especially affects government handling of a wide range of local problems stemming from economic reforms and the need to compensate losers in the process of modernization, such as farmers whose land was requisitioned for non-farm use or citizens whose homes have been torn down for construction projects. Official compensation is often barely adequate, but even this is frequently reported diverted.
Corruption also figures heavily in local governments’ frequent failure to enforce environmental regulations. Environmental degradation is one of the most serious challenges facing the government. Lucrative alliances between local business interests and officials contribute heavily to egregious incidents of pollution. That said, both pollution and some degree of corruption have been standard features of other Asian economies going through the same phase in their rapid growth. As per-capita GDP rises in coming decades, it is likely that China will find ways to address both pollution and corruption.
Risks to China’s Continued Success
The two most serious risks China faces, to its financial system and in its rural areas, are also likely to find resolution in a combination of ad hoc policies and systemic reforms.
Most commentators see risks from the potential collapse of China’s financial sector because of non-performing loans and the failure to accelerate liberalization of the financial sector in market directions. U.S. Treasury Secretary Henry Paulson has repeated on many occasions that financial sector liberalization and opening to foreign participation are in China’s best interests. But as explained above, China’s financial system is basically healthy and well suited for the country’s current financial needs. Ironically, rapid financial liberalization and privatization, including rapid introduction of foreign control over domestic institutions, pose a greater threat to sustained growth. So-called banks enjoy the invisible equivalent of vast contingent government assets on their balance sheets. China’s government is virtually certain to bail out the depositors should cash shortages occur—although currently the major banks’ problem is a surfeit of liquidity not being put to productive use.
Second, interest rate liberalization at this point would undermine the affordability of financing for China’s infrastructure. The Chinese point of view seems to be that anyone who just wants to keep money safe in a bank deposit does not deserve much of a return. Instead, for a higher rate of return, that person should expend some effort to find and support one of the many private efforts made possible by China’s reforms and infrastructure expansion. A continued measured and flexible gradualism in financial sector reform is most likely to serve China well. To sum up: Rapid privatization and liberalization would risk financial collapse for many institutions and the loss of vital public investment funding.
A very different risk comes from government policies that restrict diversification of farm output and hence opportunities for rural households to improve their standards of living. China has long refused to import more than a very small share of the grain it needs to meet domestic demand. Instead, it uses arm-twisting policies to enforce unprofitable grain planting—mostly wheat and rice. By preventing farmers from producing more produce, meat, and fish products, rural incomes suffer, and urban-rural income and consumption gaps increase. This current pattern encourages stepped-up rural-urban migration, but it also risks heightened related social tensions—both in urban and rural areas.
Given recent developments, what can China’s economy become in coming decades? Even with conservative assumptions that China’s growth will slow significantly and steadily in coming decades, and supposing that the U.S. will grow on trend at well over 3 percent a year, China’s total GDP will become larger than that of the U.S. sometime between 2035 and 2040. After that, China’s GDP will likely become twice that of the U.S. by sometime in the 2060s.
Even though China’s overall GDP will surpass America’s, because China’s population is so large, its per-capita standard of living will lag far behind that of the U.S., most likely for the remainder of the century. China’s significantly lower per-capita income levels at mid-century, however, do bear on the likely overall level of sophistication of its society, productivity and even military capabilities.
One critical point is that even if China’s annual military budget should grow apace with its GDP to approach in size that of the U.S., this does not tell us much about China’s force projection capabilities. In the economics of production, it is not annual investment and cost data that matter but the accumulated stock of productive physical capital and skilled human capital. Even if China came close to spending annually what the U.S. does on military activities and procurement, it would take China many decades to accumulate the stock of aircraft carrier task forces, command and control installations, space-based platforms, and other combinations of hardware, software, and talent that reflect many decades of U.S. high-quality expenditure and accumulation, especially when one considers the U.S. accumulation of basing rights around the world. These are generally not for sale. China’s economic prowess at mid-century may help it acquire bases and basing rights in strategic locations, but it would take a long time for that process to begin to match the U.S. global presence.
The sophistication of China’s society and scientific establishment will also figure in its potential for acquiring space-based military platforms. These capabilities are very expensive and rely on decades of proprietary technical developments not linked to the total economic size of a large, populous country like China. There is no adequate method for pricing technologies that China does not possess.
In short, China’s overtaking the U.S. in economic size before mid-century has much less military significance than it seems to have at first glance. It hardly implies that China will be in a position to challenge the U.S. globally, or even regionally, although it could bear on the very local strategic situation in the Taiwan Strait.
As per-capita living standards have risen in many economies, especially in East Asia, their political and social structures have become more sophisticated as well. The United States of course needs to hedge against all realistic contingencies for conflict with China. But at the same time we need to ask, what U.S. policies and postures could influence China’s intentions with regard to military confrontation? In this regard, China’s strategic intent is more important than its very long-term strategic capabilities.
Many U.S. observers see a serious difference in values between China’s society and polity and their own. Japanese Foreign Minister Taro Aso has promoted the concept of an “arc of freedom and prosperity” encircling China from the east, south and west, beginning with Japan, swinging through Taiwan, the Philippines, Malaysia, India and jumping over the Middle East to Europe. He considers this an important aspect of the U.S.-Japan alliance. Values of freedom are implicitly juxtaposed with values represented by mainland China’s ideology and governance systems.
These value differences between China and the U.S. and its allies underpin concerns that China’s military and other foreign policy intentions will eventually lead it to harm U.S. interests. But the important question is whether China’s economic development will change the Chinese outlook and possibly also that of the U.S, leading to more compatible approaches. This is possible but not certain, and ought to be the major strategic motivation behind our diplomatic and military planning.
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