China's Economic Problems

China’s Economic Problems [and Ours] By David Dollar

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China has been a star in the development firmament for two decades, managing the largest reduction in poverty in human history and transforming the country into an economic power to be reckoned with. Even if growth slows somewhat – as one would expect when the easy ways to raise productivity are exhausted – it is likely to emerge in the next few decades as both the world’s largest economy and largest trading nation. But China’s transition to a mature economy supporting a high standard of living for its citizens is not a sure thing. There are plenty of examples of long-vibrant economies that have slipped off

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china the growth track – Japan being the most recent example. And no deep insight is needed to identify a variety of ways that China must change if it is to sustain rapid growth. Here, I assay the major challenges and examine the rest of the world’s stake in China’s race for the gold.

Since 1990, China’s investment in productive capacity has been rising more rapidly than domestic demand, tilting the economy toward production for exports. Export-led growth has proved a successful development strategy for China, as it was for Japan, South Korea and Taiwan before it. And in recent years, domestic policies that, one way or another, encouraged exports at the expense of consumption at home have been complemented by U.S. policies that increased demand for Chinese goods. The big surge in deficit spending by Washington since 2001 has bolstered growth in the United States as well as in its trade partners. Indeed, 2004 was one of the best years on record for the world economy in general, and for low- and middleincome countries in particular. But global prosperity built on America’s need to borrow roughly $600 billion abroad each year to finance imports – and the rest of the world’s willingness to lend it that $600 billion – is prosperity built on a fragile foundation. And nowhere is the fragility more evident than in China. America’s seemingly insatiable hunger for everything from bigscreen televisions to the overstuffed couches from which to view them has been a blessing

DAV I D D OL L AR is the World Bank’s country director for China. The views expressed are not necessarily those of the bank or its member countries.

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in the near term for both Chinese entrepreneurs and workers, but is sure to create major adjustment problems ahead. In the past two years, China’s exports have increased at 35 percent annually, while investment has grown by an equally remarkable 26 percent. These numbers are clearly not sustainable. China would have to carve out huge new external markets every year – markets already crammed with efficient producers across Asia, Europe and the United States – to keep this

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righting global financial imbalances

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up. By the same token, the United States cannot remain the Energizer Bunny of debtors, borrowing and borrowing and borrowing just to maintain the status quo. But extricating the United States and China from this codependency will be no simple matter. The U.S. Congress, recently joined by a heretofore reluctant-to-criticize Bush administration, is focusing on the Chinese side of the relationship, arguing that Beijing is “manipulating” the value of its currency in order

to promote exports. This criticism is misguided in two ways. First, China’s overall trade (as opposed to its bilateral trade with the United

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States) has been roughly in balance for most of the past decade. So it is apparently not acting on a long-term strategy of building its economy on the rock of endless trade surpluses. Indeed, China runs a bilateral trade deficit with many of its neighbors, a reality that is much appreciated around Asia. Second, co-dependency is just that – the United States has the power (if not the political will) to trim the U.S. trade deficit by reducing its own budget deficits. China alone couldn’t solve America’s trade woes by making it more expensive to buy Chinese goods, even if it were amenable.

Chinese officials are always happy to reiterate these valid arguments. But that does not mean China has the luxury of letting others cope with imbalances that are driven in large part by U.S. fiscal policy. International banks, investment funds and multinational firms are becoming increasingly reluctant to hold their working capital in dollar-denominated assets, leaving it in substantial part to the Chinese government to finance U.S. trade deficits by buying Treasury securities – and at low interest rates, to boot. Smooth adjustment in this situation would probably require a serious commitment on the part of Washington to reduce its fiscal deficit, combined with an agreement by Beijing to allow some exchange appreciation of its currency, the renminbi. To manage the consequences of slowing sales to the United States, China would need to shift some productive capacity from exports to domestic consumption. This is certainly feasible in the sense that there are plenty of unmet public and private needs in China. Indeed, if Chinese consumers were willing to buy the same mix of products now exported (and at the same prices), the adjustment could be relatively straightforward. China’s financial system would simply need to be changed to encourage the country’s citizens to consume more. This would include easing access to consumer loans and credit cards (which are rarely issued today), as well as offering better pension savings vehicles and health insurance to reduce the need for individuals to sock away disproportionate sums from their incomes. Even very poor people in China save up to half their incomes because they rightly fear the consequences of serious illness, unemployment and old age in a country lacking a robust government safety net. Adjustment is enormously complicated, however, by the fact that increases in domestic consumption are unlikely to follow the

pattern of the current mix of exports. First, consumption in every country includes a lot of services – everything from food preparation to housing construction – that aren’t easily traded on international markets. Second, the manufactures demanded in the Chinese market are often different from the products that succeed in the United States. And since a lot of capital has been devoted to supplying export markets, a slowdown in sales abroad would be extremely costly to manufacturers. Firms would not be able to service their loans, and nonperforming loans would weigh heavily on a banking system that is still recovering from decades of bad state-directed investments in obsolete state-owned enterprises. Still, with luck and skill, China might be able to roll with the punch, finding its way to a more balanced pattern of growth without a serious recession. The real worry is that a lack of political will on both sides of the Pacific could lead to a hard landing. Suppose Washington does not make any serious move to reduce its fiscal deficit and Beijing chooses to hold the line on the exchange value of its currency, leaving China with the ongoing task of buying the surplus dollars flooding the market. But suppose, too, that private investors (and perhaps some smaller countries’ central banks) decide they won’t risk being left holding the bag when the dollar eventually falls in value, and attempt to bail out. China, finally overwhelmed by the task of mopping up the dollars nobody else wants, allows the renminbi to float and its exchange rate to appreciate against the dollar – say, by 30 percent, the middle of the range of estimates of what might be required to restore balance in the absence of central bank intervention. Many export-directed Chinese companies would be devastated and the resulting tsunami of loan defaults would force Beijing to intervene to keep the banking sys-

tem from drowning. Wait; this situation could get worse. Chinese households hold much of their savings in bank deposits earning next to nothing. If they decided that the process of recapitalizing the banking system would lead to inflation, they would naturally want to withdraw some of their inflation-vulnerable deposits and buy tangible assets – real estate, precious metals and the like. This would complicate the cleanup for the government and probably require some significant increase in interest rates.

On a per capita basis, the availability of renewable water resources is only about one-third of the world average. China could very well end up with a financial system that is so preoccupied with keeping the banking system afloat that it couldn’t help to finance either expanded domestic consumption or the new investment required to meet the changing demand.

keeping the lights on, the taps running and the air fit to breathe Even if – or rather, especially if – China manages this structural adjustment in production and consumption, it will still face the problem of development within the constraints of natural resource scarcity. For, in recent years, the rate at which resources are being consumed has become unsustainable. First, consider water. China is a dry country; on a per capita basis, the availability of renewable water resources is only about onethird of the world average. Furthermore,

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much of its water flows where the population isn’t; a disproportionate amount of it is in the south. As a result, those who live in the northern half of the country have less than onequarter as much water per person at their disposal as Thais and Indonesians. Note, too, that the problem of scarcity is compounded by environmental damage. All major river systems – and especially those in the north – are badly polluted. China’s policy for wringing value from the water it does have is hardly up to the challenge. One weakness is that the price of water in urban areas is very low, so that waste is not penalized. The average price in Chinese cities is the equivalent of 15 cents per cubic meter, compared with 51 cents in the United States (a water-rich country) and $1.45 in Germany. Water prices are even lower in rural areas. While it is understandable that the government is reluctant to add to the financial burden of its impoverished peasants, the waste that cheap water promotes isn’t destined to make anyone happy. By contrast, more rational water policies would encourage farmers to concentrate on high-value food crops (notably rice, fruits and vegetables), while opening up more space for imports of the grains consumed by animals. In theory, urbanization will save water in the long run, as urban demand for water by both industry and households is generally lower than rural demand. However, both enforcement of water pollution standards and pricing policies that reflect the true cost of developing and maintaining water resources are needed to realize the savings potential. Energy (or the lack of it) also figures strongly in China’s development equation. While the country is rich in coal, it apparently has little of the oil or natural gas needed for environmentally benign growth. Over the past 15

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years, China’s oil imports have been climbing at the astonishing rate of 30 percent annually. Today, it is the second largest importer in the world, and there is every reason to believe that it will soon top the United States in consumption of foreign petroleum. That’s bad news in light of tightening global supply and the reality that much of the oil and gas comes from politically unstable Middle Eastern and African countries. While it is virtually inevitable that total energy use will grow along with China’s economy, much could be done to increase the energy efficiency of the country’s development. Not surprisingly, China uses more energy per unit of output in industrial processes than do the advanced economies with their more modern capital equipment. By the same

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energy could go a long way to complement command regulation. Yet with energy, as with water, China has a long way to go in getting prices right. The retail price of gasoline (about $1.50 a gallon) is below the U.S. level, and far below prices in Japan and Western Europe. It’s hard to say what the optimal price is for China, but a variety of factors suggests that erring on the low side could prove very costly in terms of the economy’s long-term growth prospects. China in many ways is following the U.S. policy from the 1950s, one that committed the country to a car-centered culture by pricing fuel low and building tens of thousands of miles of highways. Whether this has been a good policy for the United States is debatable. But the reality that China is much more densely populated than the United States and concerns that tight petroleum supplies may be here to stay make this a very questionable development choice. Imposing a hefty gasoline tax now would probably lead to more conservation as well as provide a dedicated source of funds for subsidized mass transit.

Most of the remaining

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poor are, for one reason or another, cut off from the market economy. token, China’s poorly insulated houses, typically heated by aging boilers, use 50 to 100 percent more energy per square foot than those in rich countries with comparable climates. Given the rapid pace of housing construction, enforcing strict energy efficiency standards now would make a big difference for future energy demand. Much the same is true for automobiles and trucks. Market-based incentives for conserving

a “harmonious” transformation? China deserves credit for the most successful campaign ever in reducing poverty. But most of this reduction was achieved in the early stages of reform – first with the breakup of the communes and the return to family farming between 1978 and 1985, then with the export boom that led to massive rural-urban migration between 1990 and 1996. Since the late 1990s, poverty reduction has slowed markedly in spite of the fact that China’s economic growth has been the wonder of the world. That’s because most of the remaining poor are, for one reason or another, cut off from the market economy. Some live in remote rural locations, far from cities that function as

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china engines of economic mobility. Others are members of ethnic minorities that are not well integrated into the majority culture. Still others are disabled. Some increase in inequality was inevitable as markets began to spew out “winner take all” millionaires. Moreover, it is worth noting that, compared with Latin America, the degree of inequality is still low. Still, the lack of headway in raising the living standards of the remaining poor is a real worry. China’s recent growth is also having less impact on other measures of social welfare

meager outlays for public health. China spends just 2 percent of GDP on public health, compared with 3 percent for other middle-income countries and much higher levels in rich countries. Ironically, a country pursuing socialist ideals has one of the most privatized health care systems in the world. A variety of measures are needed to give those at the bottom a leg up on their way to a decent living standard. One is related to claims on the value of agricultural land. Urbanization is driving the conversion of vast amounts of farmland to urban uses. At the moment, conversions are handled by govern-

Rural-urban migration is needed to move people from low-productivity agriculture to higher-productivity urban employment, in the process leaving the remaining rural population with a better ratio of land to people. than one might expect. Infant mortality – a useful marker for public health – has declined at a rate of 1.8 percent annually since 1990, which is slower than the decline in India (2.2 percent) or middle-income countries (2.6 percent) despite the much slower increase in income in those nations. High-income countries, where infant mortality was already low, have also managed to maintain a rapid rate of decline (3.6 percent). Acknowledging the problem, China’s top leadership talks frequently now of developing a more “harmonious society.” The slow pace of social progress partly reflects the unbalanced pattern of growth noted above. A lot of resources have gone into investment, creating a lot of jobs for poor people in the process. But government spending has grown less rapidly, and that is reflected in

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ment administrators, with little of the windfall going to the farmers who are displaced. There are reasons that China may not want the full market value of the converted land to go to individual peasants. That doesn’t imply, however, that it wouldn’t make sense to tilt the benefits toward rural families, giving them a stake in the economic boom and constraining the drift toward income and wealth inequality. Another reason the poor have gotten the short end of the stick is that local governments have few sources of revenue to finance physical infrastructure and social expenditure. Moreover, the resulting problems are exacerbated by the fact that 10 million to 15 million people are migrating to cities each year in search of an alternative to rural poverty. One way or another, China must find

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ways to bolster spending on the basic services that guard against extreme poverty and offer opportunities for mobility. The challenges facing China are plainly interrelated. China’s degree of urbanization (about 40 percent of the population lives in cities) is low for its level of income, especially in light of the scarcity of water and arable land. Rural-urban migration is needed to move people from low-productivity agriculture to higher-productivity urban employment, in the process leaving the remaining rural population with a better ratio of land to people. But for migration to proceed relatively smoothly, it is important that the still-large rural population be assured decent public health and education, along with a chance to accumulate savings needed to give them a start in the cities. By the same token, energy-efficiency standards for buildings and cars, along with gasoline taxes that contain car use and provide funds for urban mass transit, are needed to

prepare cities for the near certainty that hundreds of millions of rural immigrants will arrive in the next few decades. In preparing its most recent urban plan, Beijing took the unprecedented step of polling citizens about priorities. And, no surprise to those of us who live in the capital, the two most important issues on peoples’ minds are pollution and traffic. Redirecting some of China’s economic resources toward meeting these domestic needs is a win-win play, improving China’s standard of living and making China’s looming economic presence less threatening to the rest of the world.

helping china help itself Contemporary discussions of foreign aid usually focus on Africa, the only part of the world in which aid represents a significant chunk of consumption. What is less well known is that, in absolute terms, China remains a major aid recipient. Indeed, it was the second largest recipient of aid (after India) during the 1990s.

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china If the main point of development assistance is transferring income, it is hard to argue that aid has been important to China; foreign aid has never amounted to as much as 1 percent of the country’s GDP. But China’s experience suggests that the primary contribution of foreign aid is knowledge and that knowledge buttressed by relatively small sums can have powerful demonstration effects. The Chinese, it is well worth noting, are very good at carrying out aid-financed projects. China has had by far the largest World Bank program over the past quarter-century, with some $38 billion going to 250 projects ranging from public health to energy to the environment. The bank’s independent evaluation unit has rated more than 90 percent of these projects as successes. More striking, the unexpected benefits have often far exceeded the direct benefits – say, the numbers of children inoculated or gigawatts generated. For example, the World Bank’s Lubuge hydropower project in 1984 introduced international competitive bidding to public infrastructure construction in China. The Chinese government found that it saved a bushel of money; thereafter both Beijing and many provincial governments chose to make competitive bidding the norm, saving billions of dollars thereafter. Or consider the World Bank’s work in the Loess plateau. This ecologically fragile part of China had become seriously degraded by the 1980s, with almost complete deforestation in parts of the region. Tens of millions of people were nevertheless trying to eke out a living in this environment, denuding more acreage and drawing down the water table in the process. Photographs from the time show a barren, brown landscape. Together, the bank and several provincial governments developed a plan for raising in-

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comes and restoring the natural landscape. Goat herding was banned from large tracts to give grasses an opportunity to grow back, while a microcredit financing scheme was introduced to allow local peasant women to raise pigs instead of goats. Some parts of the plateau were reforested, while others were terraced for tree crops. Better roads were built to connect the isolated areas to market towns, and out-migration was encouraged to reduce the environmental overload. Large parts of the Loess plateau are now green again, and poverty has been cut sharply. The big bonus here, though, is that the project yielded a model for restoring degraded land in other parts of western China. Similar efforts are under way now at the headwaters of the Yangtze and Pearl Rivers. All that said, it is still natural to ask whether China should continue to receive support from the rich countries to address its development challenges. China has emerged as a major economic powerhouse, in the process accumulating hundreds of billions of dollars in foreign currency reserves. It has a large military and has sent a man into space. So, why should the world help China to continue to develop? Because the way China manages its transition will have a large impact on the rest of the world. The Chinese economy is already so big that failure to manage its financial system, to adjust rationally to natural resource scarcity, or to cope with its enormous air and water pollution problems will be felt by its neighbors, its trading partners and its geopolitical rivals alike. No less important, its failure to deal with remaining poverty would represent a global moral failing as well as a potential threat to the political stability of the world’s largest country. And from this perspective, it seems downright foolhardy not to help China M to succeed.