China's economy: Some cooling, then fair weather long term

Nobel Prize-winning economist Lawrence Klein was one of the first Western scholars to establish close ties with China's economic policymakers. Since his first visit to the mainland in 1980, Klein has been a consultant to the State Information Center, helping it establish economic models for policy planning. "When I first came to China at the beginning of reform, you wouldn't say that China was a leading power and that it should be taken into account in the shaping of the global system," says Klein. "That is no longer the case." He believes it is in everyone's best interest to ensure that China's development proceeds without any major upsets — and the key to this development is efficiency, particularly in the service sector.

China's economy will experience a slight cooling in the near term, although it's future looks good — and that's positive news for the rest of the world, according to economist Lawrence R. Klein, speaking at the Third Annual Executive Forum in Shanghai hosted by the W. P. Carey School of Business and the Shanghai National Accounting Institute.

Klein, who was awarded the Nobel Prize in economic sciences in 1980, was one of the first Western scholars to establish close ties with China's economic policymakers. Klein became a consultant to the State Information Center after his first visit to the mainland in 1980, helping it establish economic models for policy planning. By tracking a broad range of economic indicators, Klein and his colleagues predict China's short-term economic performance every two weeks.

"When I first came to China at the beginning of reform, you wouldn't say that China was a leading power and that it should be taken into account in the shaping of the global system. That is no longer the case," said Klein, now the Benjamin Franklin Professor Emeritus of Economics at the University of Pennsylvania. According to him, it is in everyone's best interest to ensure that China's development proceeds without any major upsets. The key to this development is efficiency, particularly in the service sector, says Klein.

During the 1990s, the U.S. "achieved very high steady growth rates and the key factor in this expansionary period was the improvement in American productivity — and that is where the service sector has played a big role," he said. Explaining that information technology services and productive efficiency were largely responsible for the high rate of growth, stable prices, and surplus budget of the '90s, Klein urged China to "observe the rules of the game, be a good player on a level playing field and seek efficiency in the production of goods and services."

Overcoming inefficiency

Despite China's record-setting growth rates — between 9 and 10 percent every year since 1978 — Klein believes that current levels of inefficiency are standing in the way of what he terms the country's "magnificent expansion," and could slow down the economy if not addressed properly. Overcoming this inefficiency, however, will require widespread economic and eventually political reform that addresses the numerous factors from which it arises, analysts argue.

One obvious factor is the combination of China's sheer size and its underdeveloped transportation infrastructure. Moving raw materials to factories and finished products to market can take two or three times what it would in a more developed country, says Udo Jung, a vice president at the Boston Consulting Group.

Distribution channels are also limited, especially throughout the central and western regions of China, making it difficult for companies wishing to expand beyond their provincial markets to maintain streamlined operations. Unfortunately, there is little to do but wait for further transportation infrastructure development, which will continue to slowly radiate outwards from important urban and industrial centers and into areas of "strategic importance" (the recently completed Tibetan railway, for instance).

Another source of inefficiency that is slowing China's development is the shortage of experienced managers on the one hand and the lack of technical expertise to produce globally competitive products on the other. Chinese Internet and media companies such as Baidu, Alibaba, and Focus Media and multinationals such as P&G, Unilever, and Coca Cola are training a new breed of managers that will play an increasingly prominent role in the coming decade, especially if the market is liberalized sufficiently to allow private companies to compete with state-owned enterprises (SOEs), analysts say.

Additionally, the recent spate of high-profile Chinese attempts to take over American companies — unsuccessful in the case of Maytag and Unocal and successful in the case of IBM's laptop business — suggests that the Chinese are trying shore up their technical deficiencies through mergers and acquisitions. Given the country's extensive foreign exchange reserves and global ambitions, it will continue to do so in the future. Again, there is little to do but wait.

Help for private enterprise

In the meantime, however, a thorough reform of China's disorganized and stagnant financial sector would remove many of the obstacles that hinder further economic development. Foremost among analysts' recommendations is a complete overhaul of China's state-run banks, whose nonperforming loans are helping to stem the tide of development, says Diana Farrell, director of the McKinsey Global Institute.

Thanks to a combination of obtuse regulations and poor credit assessment procedures, banks continue lending to atrophied state-owned enterprises, effectively preventing nimble private enterprises from raising enough capital to compete with the state-owned behemoths. And because the corporate bond market is virtually nonexistent in China and stock offerings are tightly controlled, private companies trying to raise capital are effectively stuck unless they can find foreign investment.

Though the creation of the Shenzhen and Shanghai stock exchanges has slightly improved the situation, the Chinese government is reluctant to undertake the creation of a robust debt market to finance new development for two reasons, says Farrell. First, the lack of reliable means of gauging and tracking creditworthiness, which the government is in the process of addressing by establishing a national credit bureau; and second, the government's fear of the great swell in unemployment that would inevitably result from competition with private enterprises forcing SOEs to restructure or go out of business.

Farrell and other financial experts, however, predict that subsequent market growth would create enough jobs to quickly absorb the unemployed and produce a noticeable increase in the country's GDP. As the Chinese economy grows and increasingly shifts its focus from production to consumption, the government also will have to focus on encouraging consumer spending if it is to achieve sustainable growth. The Chinese save almost half of their income, and despite the recent real estate boom, the majority keep most of their assets in savings accounts or cash.

Analysts believe that by encouraging the use of credit, creating robust and liberalized financial markets, and replacing the unwieldy paper-based fund transfer system with an electronic system, the government could ensure better returns on savings while promoting spending among the growing middle class to further fuel the economy's growth.

Great expectations

The growth of the middle class also presents an important opportunity to rescue China from a different kind of inefficiency — the entrenched corruption of a single-party political system. For the first time, Chinese are having to foot the bill for their housing, education and health care, and that's making them a lot more conscious of how the government is using their taxes, says Larry Diamond, a senior fellow at Stanford's Hoover Institution and co-editor of the Journal of Democracy.

As Chinese become experienced consumers in their country's new market economy, they're going to expect something for their money. Diamond predicts that this could force the issue of government to a head. Wu Jinglian, the former executive director of the Development Research Center of the State Council of the People's Republic of China and professor of economics in the graduate school of the Chinese Academy of Social Sciences, believes that China has already reached that crossroads.

The choice in his view is between a free market under the rule of law or a dismal form of crony capitalism; the outcome is contingent on political reform. Klein, however, predicts that China's development will continue unhindered as long as efficiency is maintained and a reliable degree of transparency established. The resulting "level playing field" will continue to sustain China's growth for the next 20 years, he believes. Though his forecasts only reach six months into the future, his conclusion is that "from where we sit at the present time, China is on the right track."

Bottom line:

• According to Nobel Prize-winning economist Lawrence Klein, China's economy currently shows no signs of dropping below the 9-10 percent growth rate it has maintained for the last 20 years.
• Certain obstacles to might arise to the sustainability of this growth in the future if efficient transportation networks and liberalized equity and debt markets aren't developed and the banking system and state-owned enterprises are not reformed.
• Some experts believe that the one-party system will prevent the creation of a free market that can continue to sustain China's economic growth.