Reforms will determine whether China can return to rapid growth

The International Monetary Fund (IMF) in its latest World Economic Outlook highlighted China’s recent rebound and said that China would contribute a third of global economic growth in 2023. Given the global economic environment, a rebound in China is essential to support global growth—as the US and Europe face rising interest rates, stubborn inflation and pockets of financial instability.

China’s first-quarter gross domestic product (GDP) showed an economy on the rebound following one of its worst years for growth in decades—growing by 4.5% year-on-year. It helps that China’s first-quarter recovery is more consumption and services-sector based, reflecting households’ accumulated savings and pent-up demand following the covid controls, rather than from a debt-heavy fiscal stimulus that China has used in the past. At the same time, a consumption-led recovery will have more of a domestic impact than internationally.

The questions that now arise are whether China can meet its target of 5% growth for 2023, and, more fundamentally, re-establish its historic global growth leadership.

As of now, it’s too early to say. Its recent recovery has been uneven and China’s own National Bureau of Statistics has assessed that the foundation for an economic recovery is not solid yet. Further, China’s Politburo has said: “Demand is still insufficient… and many difficulties and challenges still need to be overcome to promote high-quality development.” In this context, while services were strong in April, the manufacturing index fell.

Given China’s growth history, the question is what happens next. Can China extend its unique and historically spectacular growth over the last five decades? In under a generation, China has lifted its status from low-income to upper middle- class, defying scholars who periodically pointed to the likelihood of ‘mean reversion’ (or a middle- income trap). Although its growth has halved over the past decade from ‘super-fast’ to a 5-6% range, this has been reflective of Beijing’s official recognition of a need to rebalance growth engines.

Overall, China has tried to manage its persistent growth imbalances since the global financial crisis (GFC) by shifting away from its external imbalance visible in its vast current-account surpluses and large accumulation of international reserves that had global effects.

The shift that has taken place is that internal imbalances arising from credit- and debt-financed investment have overtaken external imbalances. Since the GFC, as fiscal stimulus rose and stayed high and corporate debt doubled, capital efficiency has steadily fallen, with total factor productivity significantly declining and reducing its contribution to the Chinese economy’s overall growth.

As a result, China’s high and rising investment since the GFC has left a legacy of high debt in less productive sectors, such as real estate, and with local governments. The impact was multiplied, as much of this investment was implemented by state-owned enterprises (SOEs) and provincial governments that built excess capacity in sectors such as coal, cement, steel and housing. This debt-heavy growth model has especially affected China’s poorest regions, where the property market remains in a slump, and has been a key factor in China’s rising youth unemployment (close to 20%) and inequality. This debt legacy has also been mirrored in countries that have become part of the Belt and Road Initiative.

Can China replicate its global growth leadership? The urgency of further reforms arises also from the looming demographic changes in China that will raise labour costs and reduce corporate profits, unless matched by rising productivity (that has been declining over the past decade). It helps that in its early recovery this year, the drivers have been household consumption and the services sector, rather than the usual public investment and its manufacturing-export machine. Looking ahead, especially for the revival of private investment, much will depend on the transparency and predictability of Chinese policies, and the avoidance of moral hazard in dealing with the provincial debt overhang.

To sustain its recent rebound in growth without exacerbating its debt imbalance, China needs to shift to an economy driven by innovation and increasing productivity in a new growth model. The global implications of this transition will be significant, given the size of China’s economy and degree of its integration with world trade and global value chains. Global scrutiny on the manner and means of this transition has become a compelling factor in its trade linkages (and trade war) with the US and other advanced countries. China is attempting to balance its reliance on overseas sources of technology, which have helped it well, with efforts to strengthen purely domestic innovation capabilities—intended also as a hedge against the risks of a US-led ‘decoupling’. Its challenge is to do this in accordance with international standards, for which a role would have to be played by the World Trade Organization (WTO). The challenges facing China are considerable, but the country has so far shown an ability to undertake sizeable reforms without social dislocations.

Looking ahead, these long-awaited reforms in China need to bolster potential growth through productivity gains by encouraging a more efficient allocation of resources and building a more competitive economic environment. This is also a critical lesson for other emerging markets.

Among the policies needed to do this, China needs to be on a firmer trajectory towards a more modern financial system, one that is capable of addressing the challenges of a more mature and complex economy. This is also crucial for making the renminbi an international currency.

Most importantly, as promised by Chinese authorities, it needs to increase the role of market forces by reducing implicit subsidies to SOEs, sparking competition in the banking system and opening more key sectors to private entry, investment and credit. Immediate steps should include deleveraging SOEs with continued regulatory and supervisory tightening, much greater recognition of bad assets and more market-based allocation of credit to dynamic economic sectors.

Financial liberalization should be part of the next big wave of reforms in China. It could help lay a foundation for complementary reforms elsewhere and thus for sustainably strong growth in China over the medium term.

Anoop Singh is a distinguished fellow at the Centre for Social and Economic Progress, and a former member of the 15th Finance Commission