“Where is China Headed?”



What’s with China? Its exports are declining.  Its markets are in turmoil.  Its growth goals are regularly lowered.

We made a bunch of predictions in late 2014. All but one (we predicted continued
food inflation) turned out to be correct.  So we’ll make some more observations about        China’s future over the next few years.

Most observers are still optimistic – too optimistic in our view. They believe China will make the transition – albeit bumpy – from an export to a consumer economy.

China has lots of problems that make this unlikely to us:

  • A huge real-estate bubble.
  • Endemic corruption.
  • Bad and worsening environment.
  • Overcapacity and the threat of deflation.
  • A weak banking system and high debt levels.
  • An aging population supported by too few workers.
  • Huge income inequality.
  • A disastrous imbalance between males and females.
  • Vested interests of the military.

These problems are daunting. But they mask two even greater and more basic problems:

  • The middle-income trap.
  • Hubris in the Chinese Communist Party


The Middle Income Trap

China’s rise from backwardness to the world’s second largest economy in 25 years is           incredible and unprecedented. But the process is relatively easy compared to continued      future growth.

Why? Saving any institution involves relatively few, basic decisions:  Cut costs; become the low- cost producer; reinvest in infrastructure, plant and equipment.  The Chinese took or bought land cheaply; sold it to make money to invest in infrastructure; made sure            Chinese labor remained abundant and cheap; managed the currency; limited foreign       competition; and insisted on foreign technology transfer.

The Chinese also postponed expenditures on pollution abatement and environmental renewel. They spent little on healthcare or on developing a legal system.

These actions helped create the Chinese export juggernaut and keep it going. But to        advance further, many more sophisticated allocation issues must be addressed.  No       centrally planned economy has ever successfully navigated these shoals.  The markets, messy as they are, become the only way forward.

This leads to the second basic problem:

Hubris in the Chinese Communist Party

Until 2008 the Chinese were content to be our junior partner. But the Great Recession    convinced many Chinese that their system of command economics is better.  Their track record convinced them they could continue to guide the Chinese economy forward.

The last four days show the folly of their over-confident hubris. The market turmoil, capital outflow, and showing internal and declining export growth are reflections of problems that have been growing for years.

The Chinese government reminds you of the Japanese and USSR in the 1980’s. Remember when MITI, the Japanese central planning arm, was going to rule the world?  MITI was sure it could guess the future.  Instead it led to over two decades of Japanese economic          stagnation.

Remember when Gorbachev thought he could “reform” Russian Communism by tweaking it?   He couldn’t – no one could – and the whole house of cards came tumbling down.

The Chinese can’t tweak their way to success either. Fundamental reforms are necessary if they are to avoid stagnation or worse.  Anything less could trigger huge problems, with negative implications for China, its neighbors, and the world.


Richard Levy

Richard Levy, HBD’s President, studied East Asia and economics. He has travelled to China over 40 times since 1994.  He speaks regularly to bankers, business people, China officials and China experts.

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2 thoughts on ““Where is China Headed?”

  1. The underlying issues described above are all accurate. China faces a host of challenges as it continues to establish itself as a world power.

    I believe, however, that China IS capable of tweaking its way into a complex economy that includes both robust manufacturing and services economy.

    There are two main reasons this will happen:

    1) Chinese communism is very different from the communism that existed in the USSR. China has embraced capitalism in a way that the USSR never did, and they have proven determined to make it work. It appears this trend will continue. Structural elements in the way Chinese communism is administered also work in their favor (such as term limits for party members). These differences will allow them to adjust to their evolving place in the world in a way the USSR never could have.

    2) Despite the economic slow down, Chinese growth will continue at a rate high enough to continue building the middle class at a healthy clip. This will keep social unrest manageable. A recent statistic that caught my eye — box office ticket sales for movies were up over 49% in 2015. Middle class Chinese people will continue to enjoy 1st world services and consumer goods which will in turn support their transition into a more complex economy.

    1. Your thoughtful response reflects the majority view, but to me it is wrong on both points:
      – China is certainly, as you say, more market-oriented than the old USSR. But so was Japan, and they floundered, too. All three share (d) a belief that central planning can work, a view I reject.
      – China’s huge middle class rests on factors that must be addressed. There are already signs of a real consumer spending slowdown. If the big Chinese problems I mentioned are not addressed satisfactorily, it could get much, much worse.

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