China has been making a lot of noise lately, with desperate interventions to halt a crashing stock market and a surprise currency devaluation that has analysts everywhere concerned that China’s relatively tepid growth is even worse than expected. While these events serve as a warning sign that China’s growth may indeed be faltering at a quicker than expected pace, the Chinese government’s actions highlight the difficulty of finalizing an economic transition that began over 30 years ago.

This is the transition from a communist to capitalist economy, the initial reforms of which have allowed China to experience unprecedented levels of growth. But, it is becoming increasingly evident that the current growth model is unsustainable in the long run. China’s leaders will need to continue with the free-market reforms begun in the early 1980s as well as empower its consumer base with greater purchasing power in order to build an economy based on sustainable long-term growth.

Early Reforms and their Effects

At the December 1978 Third Plenary Session of the Eleventh Central Committee of the Communist Party of China, under the new leadership of Deng Xiaoping, it was decided that the management of China’s economic system would be transformed. This new economic system would emphasize greater openness and cooperation with other countries, increased efforts to adopt world-leading technology and equipment, and increased education to bring about modernization. It also recognized the need to bring the level of centralized management down and the importance of fostering economic efficiency and development by terminating bureaucratic and political hurdles.

Beginning with the phasing out of the communal system of collectivized agriculture, China implemented reforms gradually. These reforms liberalized prices, granted greater autonomy to state enterprises, grew the private sector, opened trade and investment to foreigners, and developed a stock market and modern banking system.

From the initial reforms started under Deng Xiaoping up until the 2008 global financial crisis, the Chinese economy grew at an average rate of nearly 10% per year which is about three times the global average. As the reforms encouraged more efficient uses of both labor and capital, much of China’s strong growth was influenced by increases in total factor productivity. Capital investment also contributed to the growth, but as greater amounts of capital lead to diminishing returns it cannot be the sole basis for growth. (For more, see: 5 Things to Know About the Chinese Economy.)

The Global Financial Crisis and the Middle Income Trap

While China’s growth up until the global financial crisis was largely fuelled by productivity gains, since the crisis, growth has significantly slowed down and has been primarily driven by investment. Feeling the effects of falling exports from global recessionary pressures, the Chinese government rolled out a huge stimulus package with massive amounts of spending targeting infrastructure and construction. This capital investment has helped to fuel growth, but since 2011, additional capital has become the only source of increased output, as total factor productivity contributions have been nearly absent.

This growth model, based on excessive credit and investment, is unsustainable. In fact, debt has exploded from $7 trillion in 2007 to $28 trillion by the middle of 2014 as entire cities in China sit completely vacant. China’s debt sits at 282% of GDP, a level that is larger than both German and U.S. debt. Meanwhile, from 2011 to 2014 output growth slowed to an average rate of 8%, and in the first two quarters of this year growth dropped to 7%.

Facing weaker global demand and a near future debt overhang, China is facing the challenge of having to reorient its economy away from export and investment-driven growth towards a more consumption-driven model. This is a common problem for many emerging economies attempting to make the jump from middle income to high-income status known as the middle-income trap. (See also, How Can Emerging Markets Avoid the Middle-Income Trap?)

The New Normal—Slower but more Sustainable Growth

Since Xi Jinping’s inauguration as China’s president in 2013, he has been preaching his commitment to structural reforms, calling forth a new normal of slower but more sustainable growth. The recent slowdown that predicts growth for this year will likely be lower than the 7% target is just a part of this bumpy transition. In order to make this transition from the unsustainable debt and investment-fuelled growth, China is hoping to encourage service sector growth, consumer spending and private entrepreneurship.

Directing investment away from infrastructure projects towards health and educational services will not only help to create higher paying service sector jobs instead of low-wage factory positions, but it will also help develop a healthier, more productive and innovative workforce. This should help to grow household incomes, stimulating greater domestic demand through increased consumer purchasing power.

However, at 50% of GDP in 2013, China’s gross savings rate was among the highest in the world, meaning that reforms will need to reduce this to encourage greater consumption. One of the main problems in this area is that China’s wealthiest 5% save around 70% of their incomes, accounting for half of total household estimates according to one estimate. A more redistributive tax system that reduces China’s extreme inequality will help to reduce the savings rate and stimulate greater consumption.

Finally, in order to foster private entrepreneurship, the government will need to wean support away from its massive state-owned enterprises (SOEs), and develop equity, rather than debt-fuelled financing. Reducing capital controls and developing deeper financial markets to encourage greater foreign investment in stock markets will help fund private enterprise through equity financing.

The Bottom Line

With economic growth slowing to its lowest rates in over a quarter century, the new Chinese government led by Xi Jinping is recognizing the need to continue the structural reforms begun by Deng Xiaoping over 30 years ago. But, as recent events, such as the interventions to keep the stock market from crashing, have shown, this transition will not be easy. It is yet to be seen whether the current government will have the political will and strength to carry through with needed reforms or will look for easy, albeit unsustainable ways, to prop up the economy. 

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