China must balance institutional innovation with orderly reforms to preserve the integrity of its economic foundations and emerge from the forthcoming slowdown in good shape.

During three decades of favorable global economic conditions, China created an integrated global production system unprecedented in scale and complexity. But now its policymakers must deal with the triple challenges of the unfolding European debt crisis, slow recovery in the United States, and a secular growth slowdown in China’s economy. All three challenges are interconnected, and mistakes by any of the parties could plunge the global economy into another recession.

To assess the risks and options for China and the world, one must understand China’s “Made in the World” production system, which rests on four distinct but mutually dependent pillars.

The first of these pillars, the China-based “world factory,” was created by foreign multinational corporations and their associated suppliers and subcontractors, as small and medium-size enterprises (SMEs) with direct access to global market carried out the labor-intensive processing and assembly required. Starting modestly in coastal areas and special economic zones, the “world factory” supply chain has spread throughout China, producing everything from stuffed animals to iPads.

The “world factory” could not have been built without the second pillar: the “China infrastructure network,” installed and operated mostly by vertically integrated state-owned enterprises in logistics, energy, roads, telecoms, shipping, and ports. This pillar relies heavily on central planning, large-scale fixed investment, and administrative control. Its quality, scale, and relative efficiency is strategic to Chinese competitiveness and productivity.

The third pillar is the “Chinese financial supply chain,” which provided the financing needed to construct and maintain the infrastructure network. This supply chain is characterized by the dominance of the state-owned banks, high domestic savings, relatively under-developed financial markets, and a closed capital account.

The final pillar is the “government services supply chain,” by which central and local officials oversee every facet of production, logistics, and financial networks through regulations, taxes, or permits. Most foreign observers miss the scale and depth of institutional and process innovation in this supply chain, which aims to protect property rights, reduce transaction costs, and minimize risks by aligning government services with market interests. For example, local governments in China became highly adept at attracting foreign direct investment (FDI) by providing attractive infrastructure and supporting services that facilitate the expansion of global production chains.

With the onset of the current global crisis, and given dramatic changes in social media, demographics, urbanization, and resource constraints, all four pillars are now under stress. Production chains are facing labor shortages, wage increases, and threats of relocation to lower-cost countries. Meanwhile, global investors are questioning local governments’ solvency.

Chinese experts are now debating a key governance question: which top-level architecture would enable the country to adopt the reforms needed to meet global and domestic pressures? Investors are concerned about Chinese equities’ erratic performance, regulatory risks, and policy surprises, as well as the uncertainties stemming from greater volatility in asset prices, property prices, interest rates, and the exchange rate.

What makes the Chinese economy more difficult to read is the increasingly complex interaction of all four of its production system’s components, with each other and the rest of the world. For instance, favorable conditions for the growth of the “world factory” have begun to dissipate. Production costs – in terms of labor, resources, regulation, and infrastructure – have been rising domestically, while consumption bubbles in the West have burst. The early success of “China infrastructure” was built on cheap land, capital, and labor, yet despite modern infrastructure, logistical costs within China now make up 18% of production costs, compared with 10% in the US, owing to various internal inefficiencies. China’s financial system has also yet to adequately address the challenges of financial inclusivity, particularly funding of SMEs and rural areas, and exposure to excess capacity in selected industries.

Last but not least, the three pillars could not have remained standing without the anchor provided by the fourth. Until now, its success was based on positive competition between local governments and different ministries, benchmarked according to performance indicators such as GDP and fiscal revenues. Unfortunately, this has led to problems of social equity and environmental sustainability, which require complex coordination of bureaucratic silos in order to overcome the resistance of powerful vested interests.

There is general recognition and consensus that the path of reform requires profound re-engineering of all four pillars. First, the production chain must shift from export dependence toward domestic consumption. Realigning China’s infrastructure means emphasizing quality over quantity, and reducing state ownership and controlled prices in favor of market forces. State orchestration should instead be focused on fighting corruption, reducing transaction costs, promoting competition, lowering entry barriers, and removing excess capacity.

For the financial supply chain, the key is to address systemic risks and realign incentives in order to induce investors to support the engines of real economic growth, rather than the creation of asset bubbles.

The Chinese miracle was engineered by institutional and process innovation at all levels of the government services supply chain. China requires nothing less than another radical re-engineering to become a more balanced, socially equitable, and sustainable economy. That process has already begun with another round of experimentation through three new Special Economic Zones in Hengqin, Qianhai, and Nansha to pilot the emergence of a creative, knowledge-based services economy.

Of course, such an economy relies crucially on the quality of governance. The real challenge for Chinese officials is how to balance creativity and institutional innovation with order, thereby ensuring the integrity of all four of its economy’s pillars.

*[This article was originally published by on August 16, 2012].

The post Tending to the Pillars: China’s Next Economic Transformation appeared first on 51³Ô¹Ï.

Faced with an economic slowdown, China can no longer enjoy both higher growth and efficient structural adjustment. It must choose between them.

China’s annual GDP growth slowed to 7.6% in the second quarter of 2012, down from 8.1% in the first quarter and the lowest growth rate since the second quarter of 2009. The newly released growth data may have dispelled fears of a hard landing for China, but have nonetheless prompted many to argue that China must stimulate its economy further to guarantee 8% annual growth.

Since early 2010, in order to contain inflation and property bubbles, the Chinese government has tightened monetary policy. As a result, in June inflation fell to 2.2%, a 29-month low, and house prices, for which the National Bureau of Statistics unfortunately has stopped issuing official data, seem to be stabilizing, and may even have fallen, albeit modestly.

The slowdown in China’s growth rate is, to a certain extent, a reflection of the success of the government’s effort to rein in the real-estate bubble, as well as of other official policies aimed at rebalancing the economy. The growth rate of investment in real-estate development, which directly accounts for more than 10% of GDP, plummeted by 16.3% year on year in the first half of 2012. That led to an investment slowdown in many related industries, such as construction materials, furniture, and appliances, causing annual growth in fixed-asset investment to fall from 25.6% to 20.4%.

The trend for household consumption is less clear. But many economists have found evidence that growth in household consumption in the first half of 2012 was stronger than official statistics have shown.

The slowdown of the economy in 2012 should have been anticipated in 2011 by the government. In early 2012, in his speech to the annual People’s Congress, Premier Wen Jiabao, explaining why the government’s indicative target for economic growth in 2012 was 7.5%, pointed out that the purpose was “to guide people in all sectors to focus their work on accelerating the transformation of the pattern of economic development and making economic development more sustainable and efficient.”

In fact, in order to create adequate space for changing the GDP-centered growth pattern, China’s 12th Five-Year Plan set an indicative target of 7% annual average GDP growth in 2010-2015.

China’s investment rate is about 50% of GDP, while real-estate investment accounts for more than 10% of GDP. Given the prevalence of repetitive constructions and ubiquitous waste, investment efficiency is deteriorating quickly. With an annual growth rate of 10%, an investment rate of 50% implies a capital-output ratio of five, which is unusually high relative to other countries.

China’s consumption rate is 36%. If government statistics are not entirely unreliable, this rate is simply too low. While huge amounts of money have been poured into physical infrastructure, public expenditure on human capital and social security is below the world average. More resources should be reallocated from physical capital formation to human capital formation.

Thanks to persistent current-account and capital-account surpluses for two decades, China has accumulated $3.2tr in foreign-exchange reserves. But, as a country with huge net foreign assets, China runs a deficit on the investment-income account. Since 2008, China’s current-account surplus as a proportion of GDP has fallen significantly. But China is still running twin surpluses, and there is a lingering question about whether the fall is structural or cyclical.

Indeed, China needs to accelerate its economic adjustment, even at the expense of growth. Otherwise, it will have to pay an even higher adjustment cost later.

For many years, the government has maintained an implicit minimum growth target of 8% per year, which was considered necessary to create 10m new jobs annually. But demographic and other structural changes may have altered labor-market conditions: so far, despite below-8% growth, there seem to be few signs of distress.

The question now is whether the government will be unnerved by the poorest quarterly growth performance in three years and usher in a large stimulus package, with the consequences that China has experienced whenever such a package is implemented.

Wen said recently that China “should continue to implement a proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth.” Moreover, in recent months, the government has approved some large steel and energy projects, and more such approvals may come.

It is certainly appropriate for a government to respond to changing circumstances in a timely fashion. But the slowdown to 7.8% annual growth in the first half of 2012 does not warrant a change of policy direction. China must choose between higher growth and faster structural adjustment. It cannot have both at the same time. Faced with the current slowdown, China can afford to stay the course, at least for the time being.

*[This article was originally published by on July 31st, 2012].

The post How Should China Respond to the Slowdown? appeared first on 51³Ô¹Ï.