Crisis in Europe, Transformation in China

NOV 17 2011, 2:49 PM ET

Chinese leaders know that, with Europe and the U.S. struggling, they can't rely on exports forever. China's future may hinge on whether its leaders can make the necessary changes in time.

A 1979 poster promotes China's steel industry / AP

"I want to remind those cadres who are staying on the job beyond me: my biggest worry right now is an overheating economy," Chinese Premier Zhu Rongji said in a January 2003 cabinet meeting, his last before leaving office. "I've already worried about this for a year now. I wouldn't say this publicly, but only bring it up to the top leadership, that overheating is the one thing that preoccupies my mind. Many signs seem to have emerged, and if we're not vigilant, the economic situation will be difficult to rein in." Zhu's comments, recently published for the first time, are translated to English here.

The next premier, Wen Jiabao, warned in 2007 that China's economic model of skyrocketing export-based growth was "unstable, unbalanced, uncoordinated and ultimately unsustainable." Fortunately, he and his government seem to know how to fix it. But the question isn't whether China's economy can accommodate the necessary changes. It almost certainly can. The big question is whether China's political system can accommodate those changes. If it can't, Chinese citizens may begin to more aggressively question the Communist Party's model of rule, which delivers tremendous economic growth at the cost of political and human rights.

When they issued their calls for change, neither Zhu nor Wen could have possibly foreseen the financial crises that have crippled the U.S. and European economies. Though China's leaders have long planned to change the country's economic model -- which is also at the heart of its political model -- these crises mean that China must accelerate its plan to restructure its economy. Right now, China's economy is based on exporting to wealthy, developed countries. For that export-driven system to work, China's economy needs to remain weaker than those of its buyers. One of the biggest reasons that China sells so much stuff is because it can produce that stuff cheaply. But as China's growth accelerates and European and American growth slows due to financial crises, China is catching up with the developed economies faster than anyone had anticipated. If and when China gets too wealthy to continue exporting cheap products -- or if the developed economies become too weak to keep buying them -- it will be in big trouble.

China will have to shift its economic emphasis from exports -- driven by state-run industrial enterprises -- to individual households. This means moving wealth from the state and state-run companies to Chinese households, which would then drive China's continued growth. This is feasible -- China has nearly 1.5 billion consumers, after all, an increasing number of whom are entering the middle class, where they will be willing and able to power the economy. This wouldn't be so different from how the U.S. economy became the largest in the world: our consumer base is big, rich, and it loves to shop.

"It's true that Chinese authorities are hotly discussing how and whether they can move away from the export-dependent model of development," colleague James Fallows wrote in an email when I asked him about how China was handling the worsening European crises. "But this has been the main topic of discussion for at least three years, and the real question is whether they can do so, and how, and over what period of time. For outsiders the real question is whether there is anything the rest of the world can do to hasten the process."

The timeline for how quickly China needs to restructure its economy appears to be shortening, and not just because of the ever-expanding European debt crises. Housing authorities just capped real estate prices in a second city to try and prevent a housing bubble, informal lending markets arebooming, export growth is already slowing ahead of expectations, and the gap between mainland China's managed currency rate and Hong Kong's floating currency rate is expanding. China doesn't appear to be anywhere near financial calamity or anything like it, but the urgency for China to change its economic model is increasing.

The changes that China's leadership knows it needs aren't just about making Chinese households better off and finding a way to responsibly manage overall growth. They're about maintaining the very stability of the Chinese system. In a democracy, if people feel their government has failed them then they can vote that government out of office. But in an autocracy like China's, popular discontent can be more dangerous. Demonstrations, some of them violent, have already broken out in a number of interior cities this year. Last month, a young man lit himself on fire in Tienanmen Square, an eery echo of the self-immolation that set off Tunisia's revolution in December.

China has remained largely stable since 1989 for a number of reasons, perhaps the most important of which are its ever-rising economy (which gives Chinese good reason to be happy with their government) and, to a lesser extent, China's ability to prevent and stifle dissent. It's a carrot-and-stick approach. But the Chinese government knows it can't maintain power through censorship, propaganda, and riot police alone. They need to keep growing to keep Chinese citizens happy, but they also need to slow that growth down to keep the economy healthy in the long-term.

This is a difficult balance, but not an impossible one by any means. Michael Pettis explains how and why it's achievable. And Chinese leaders seem to understand what they need to do. But as Damien Ma recently wrote, "It's not that the Chinese leaders don't get what's at stake -- they know such a reckoning must be had. But recognizing what must be done is quite different from summoning the political chutzpah to achieve it." If Chinese leaders want to continue to behave as disinterested and benevolent rules, and make the necessary but difficult changes, they'll have to overcome the same problem that partially inspired the recent "Occupy Wall Street" protests in the U.S.: industrial capture.

China's growth has created some very powerful industries and interests in the country. The firms that made a lot of money became politically connected, and vice-versa. Think of how much of a problem the coziness between business and government has become in the U.S., making it tougher for the U.S. government to regulate industry and to not be overly influenced by commercial interests that might conflict with the greater good. And that's just in the United States, which has a (relatively) free market economy with a (relatively) transparent and democratic political system. Imagine how much more influence American corporations would have over our government if we had a closed autocracy that partially ran our industries and you can get a sense of the scale of China's potential problem. The Chinese firms that rose with China are going to want to resist change -- even changes that might be beneficial to China overall -- and now they've got the political connections to make that possible.

In the Eurasia Group's lengthy report on China's new Five-Year Plan, they warn that Chinese Community Party will have to overcome some deeply entrenched financial interests to make the necessary changes. Their prediction is severe: "China's leadership will fail to introduce the bold reforms necessary to meaningfully redistribute wealth from corporations and government to households. For instance, big state-owned firms will fiercely resist contributing large chunks of their dividends to government social security funds."

But the same tendency to intervene in the economy, particularly in China's financial system, could well set up a battle over capital allocation and investment decisions, in which powerful stakeholders will resist any attempt to transfer wealth to new constituencies. And China's leaders are unlikely to deal with these powerful "losing" interest groups holistically. Nor is a strongman or tightly knit group of leaders likely to be able to overcome them. Ultimately, then, China's political environment will defeat many elements of the FYP. Without significant changes to governance structures--and to the role the state plays in capital allocation--China's economic landscape will not change as fundamentally as the FYP's designers (and many foreigners) hope.

... The senior political leadership is not receptive to reforms that would weaken the Chinese Communist Party's power over the financial system and thus jeopardize its ability to bankroll massive industrial policy spending on powerful constituencies, which constitutes another major 12th FYP priority. Given this discord, Beijing is unlikely to articulate or pursue a convincing plan for remedying the financial sector's most glaring inefficiencies over the next five years.

The report warns that the Chinese Communist Party could endanger the very stability of Chinese politics if they fail to implement the needed reforms. "China's rebalancing agenda is not merely about economics but, ultimately, the political viability of the Chinese system. Beijing has delivered economic prosperity to many Chinese citizens. But those very successes have yielded numerous problems--some large--that could undermine the regime's legitimacy if left wholly unattended," they conclude. "That income and development gap is unsustainable both economically and politically."

One of the immediate issues will be, as in the U.S., jobs for grads. "Disenchanted graduates earning only slightly more than migrant workers will be a source of significant political pressure and Beijing will intensify its efforts to employ them," the Eurasia Group report warns. "Meanwhile, as Chinese workers' expectations rise, Beijing will continue grappling with demands for better working conditions and representation, even as the country tries to remain an attractive investment destination." While China remains politically stable -- stabler than a number of European democracies -- dissent and protest are increasing. Government censorship and repression -- including through violence -- are also increasing. China's autocratic government, though a frequent and severe human rights abuser, is still relatively open and stable for an autocracy. If it's going to stay that way, the Chinese Communist Party will need to make some significant changes to the country's economy.

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