China changes economic model

Rafael Pampillón. Professor. IE Business School

22 September 2015

The Asian giant is leaving an export and investment-led growth model behind and embracing another more oriented to private consumption. The metamorphosis will be worth the effort.

According to a recent article in The Economist, the Chinese economy will grow by 6.9% this year, and by 6.7% in 2016.  This means that China’s GDP (Gross Domestic Product) is growing at its lowest rate of the last few decades. This slowdown could result in rising levels of unemployment and bankruptcies in the corporate world, further fuelling social tension that is already high. It can come as no surprise that markets, international organisms and governments around the world are worried about the impact that the deceleration of the Chinese economy can have on the rest of the world.

There is reason for concern because China has the world’s largest population. According to the International Monetary Fund (IMF), in 2014 China became the largest economic power in the world. It is responsible for 16.5% of Global GDP if measured at purchasing power parity, positioned above the US, which slipped into second place with 16.3%. This is because over the last 35 years China has been growing at an extraordinary pace (averaging 10% per annum), while the US has grown at a far lower rate (average 2.7% per annum). This is why China has overtaken the US when measured at purchasing power parity.

Also, as from 2008, China is the world’s leading exporter of goods, overtaking the US and Germany. China’s current level of participation in world exports stands at 12% (the US quota is 8% and Germany’s at 7%). China is still a very popular destination for foreign investment thanks to low labor costs and plentiful workers. It is increasingly a services market in which finance and telecommunications firms, both Chinese and foreign, seek to meet the needs and demands of over 1,350 million consumers.

The importance of consumption

Consumer demands are on the increase. Effectively, since 2011 the Central Committee of the Communist Party has been working on proposals to improve the standard of living of Chinese citizens. In order to achieve this it planned a change of economic model to provide support for domestic consumption while reducing the role played by exports. Measures applied by the Chinese government between 2011 and 2014 include a currency (yuan) appreciation policy to reduce exports and cheapen imports. The rate of exchange went from 7 yuans / dollar in 2011 to 6 yuans / dollar at the beginning of 2014. The objective of this policy was to enable the Chinese to consume and enjoy a greater number of goods and services. 

But one of the results of this change of model has been less economic growth, given that exports ceased be an engine for growth, not only because of the appreciation of the yuan, but also because of drastically lower growth in other emerging countries, bringing with it a drop in demand for imports from China. In order to prevent a possible collapse and to claw back levels of growth, last year China’s Central Bank Para launched a policy that consisted of devaluing the yuan until it reached the current parity of 6.4 yuans / dollar, having intensified the process over the summer.   

The depreciation of the yuan

As well as affording support to exporters, China’s currency depreciation policy has neutralized the entry of speculation-driven currencies which aimed at making the yuan continue to appreciate. The fact that China’s economy is finding it difficult to recover despite the depreciation of its currency is yet more proof of how weak the world economy still is, and of the time delay between taking economic policy decisions and seeing their impact on the economy.  

In short, we do not know if the Chinese government will be capable of replacing the current export and investment-based growth model for one that is more oriented to private consumption. The change is, however, worth making. This week Christine Lagarde, director of the IMF, said she was willing to help China while it is suffering the consequences of a change of economic model that is channeling more resources toward making private consumption an engine for growth. 

That is why, in spite of the negative short-term consequences, China’s production structure should continue to gradually replace a production sector that is dedicated to helping exports, to build a production model that is more oriented to meeting domestic demand, and will thus serve as an engine for economic growth. An increase in consumption should be accompanied by greater social equality and justice. And this is important because the big social inequalities in China and the low regard for a large part of the workforce leave China a long way off the paradigm of equality proclaimed by the communist party. Moreover, the imbalances will continue into the future because, according to the UN, levels of consumption among the poorest segments of the Chinese population are growing far more slowly than those among the richest. A key figure: China has the second highest number of millionaires in the world (after the US).

Ensuring a successful transition toward a new economic model is also going to depend on how China handles some of the following challenges it still has to meet in order to attract more foreign investment. 1) An effective reduction of state participation in the economy and the liberalization of the services market, something that will be particularly advantageous for European companies present in the country. 2)  Inspiration of greater confidence by introducing more transparency in terms of economic information and a reduction in levels of corruption. 3) More compliance with international trade regulations, which it signed up for in 2001 when it entered the World Trade Organization, especially those related to intellectual property.

Given the circumstances, the Chinese authorities find themselves in a position of having to decide whether or not to commit to the change of model, and, therefore, an improvement in the economic situation of its population. The paradox is that the process of transition toward greater levels of consumption among its inhabitants could result in a short-term economic recession which could in turn fuel social unrest. Nevertheless, in the medium-term, the new model would bring greater wellbeing which would open up the path to greater freedom of expression and sorely needed greater respect for human rights in general. 

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