Betting on a Liberalized China

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Investment firm Goldman Sachs recently sent out a self-congratulatory report marking the fifth anniversary of "our launch of the BRICs concept."

BRICs, for non-Wall Street types, is an acronym for Brazil, Russia, India, and China and is now a popular emerging-markets investment theme. Goldman Sachs predicts the four economies could become bigger than the combined developed economies of the G-6 by 2035. And key to that forecast is continued white-hot growth by China.

Indeed, anything more than a quick pass at the financial pages will surely give the impression that the Chinese economy is an unstoppable juggernaut destined to sweep aside Japan, the EU, and, finally, the United States. It recalls somewhat the "perma bull" talk about the American economy in the late 1990s–just before the recession and stock market implosion.

So now is probably a perfect time to read The Writing on the Wall: Why We Must Embrace China as a Partner or Face It as an Enemy. British journalist Will Hutton, former economics editor of The Guardian, makes the persuasive case that the current Chinese economic model–authoritarian, high-saving, export-driven, unproductive, unaccountable–is nearing a breaking point:

China has made the transition from a planned economy to a more market-based economy, has joined the World Trade Organization, and is so obviously successful that the magic ingredient must be its commitment to markets, the profit motive and private property. … But the reality is more complex. … This is an economy and society over which the party seeks and so far has maintained extensive direct and indirect control despite a broad liberalization of prices, a rollback of planning, a boom in foreign direct investment, and substantial autonomy among all forms of enterprise. … China is half pregnant and that is the way the party intends to keep it.

But as Hutton sees things, economics and politics cannot forever be separated. He notes that China's economic growth has been based on state-owned banks channeling billions in peasant savings–some 40 percent of GDP–into huge investment projects with terrible returns. At the same time, its exports–which he estimates will surpass $1 trillion this year–are growing at an unsustainable 25 percent annual pace. Can peasants keep creating such savings? Can exports keep expanding at such a pace that they will represent half of global trade by 2020–without causing a tremendous anti-China backlash in the United States, the EU, and Japan? In short, Hutton writes, China needs to become a "more normal economy" where consumers save less and spend more–but won't without property rights and a social safety net. But doing so, he writes, would create an "empowered" middle class that would demand more accountability, thus challenging the role of the Communist Party as China's maximum helmsman:

Welfare systems, freedom of association, representative government, and enforceable property rights are not simply pleasant options. They are central to the capacity for a capitalist economy to grow to maturity. … The current halfway house of trying to retain political control of what is in truth only half a market economy is unsustainable. … China has few great companies capable of competing internationally and almost no global brands. Its private sector consists of a plethora of small transient companies usually dependent on political patronage. China's state-owned, state-directed companies, or state-influenced companies may have the freedom to set prices and wages, but only within the limits laid down by the party. Their productivity is disastrous.

Hutton tells the story of Kelon Electrical Holdings, China's leading refrigerator manufacturer in the late 1990s that was partially privatized and had its shares traded in Hong Kong. It had ceased production by 2005 after charges of embezzlement. Kelon was still being run by a provincial government and forced to buy an unprofitable air conditioner maker. To keep its head above water, management cooked the books, its eventual undoing. That's no way to build an economic superpower.

So, Hutton concludes, China needs to transform its economy without being convulsed by the process. Growth must stay high to prop up its fragile banking system and create some 24 million new jobs every year to employ millions of farmers migrating to the cities. But Hutton is convinced that the longer the current economic program continues, the more China will have to loosen political control. And it's the role of the West to make it impossible for China to turn back by continuing to stay open and not to embrace economic isolation. In event of a trade war, he writes, "flows of Chinese finance to support the dollar and U.S. asset prices would collapse; there would be a selloff in world stock markets. … The Chinese economy would rapidly slow down with incalculable implications for its political stability."

The best way to meet the China challenge, Hutton recently wrote in an essay, is "not to close our markets and build our armies–a strong impulse in the United States. It is to stay open, confident that China will only be able to truly compete with the West if it becomes more like us."

Related content: Q&A: Author Will Hutton on China's Future