China's big challenge

We are so used to runaway economic numbers from China that this week's data dump seems to betoken hard times for the world's second biggest economy. The bears prophesying doom from their caves scent their hour of vindication., However, though one has to be cautious in assessing such a unique animal as the last major state headed by a Communist party, they are almost certainly wrong. Setting aside the short-term negative market reaction, the data is in fact positive rather than negative – so long as the people in charge keep their nerve.

Of course, the 7.6% growth figure for the second quarter is down from 8.1% in the first three months of the year – and contrasts sharply with the double-digit performance reached as a result of the country's massive fiscal and monetary stimulus package launched at the end of 2008. If June brought a big trade surplus that was due mainly to falling demand for imports of the commodities China has sucked in to fuel its turbocharged expansion. Other figures – for electricity usage or rail freight – do not look good. A big cloud of bad loans to local authorities for projects undertaken during the stimulus drive hangs over the banks.

But such factors should not cloud the big picture. For all its success in the 34 years since Deng Xiaoping launched economic reform in 1978, China needs to find a new economic model. Relying on abundant cheap labour, cheap capital and welcoming export markets is no longer a viable road map to the future in a nation where the leadership from Deng's days on has embraced growth as a political weapon to buttress the party's claim to power; and where, as a result, materialism rules rather than communism or Confucianism.

Wages are rising by more than 10% a year as blue-collar workers' pay is used to drive up consumption, which plays much too small a role in driving the economy. Cheap credit produces dangerous liquidity bubbles. Foreign demand has fallen sharply as rich countries run into problems of their own.

Above all, Chinese leaders know that they need to steer the country away from the volatility of the past five years – big boom in 2007, slump in late 2008, revival in 2010-11, and now a slowing down again. What they need is a more stable medium-term outlook to coincide with the assumption of power by a new generation of Communist party leaders at the end of this year and the appointment of a new government next March.

That means a sustainable growth rate of 7-8% and a steady move up the industrial value chain while developing the service sector and adequate provision in health, education and pensions. It means mastering the inflation cycle driven by food. Longer term it means getting to grips with the deep weaknesses concealed by the heady growth numbers and the assumption that China is on an unstoppable role to global domination.

This requires undertaking the structural reforms – for example in land ownership, labour mobility, capital market and pricing of energy and water – that Hu Jintao, the party secretary, and Wen Jiabao, the premier, have fought shy of. Xi Jinping, the politburo member who will replace Hu when the party holds its five-yearly congress late this year, is not known as a risk-taker – he got to the top as a consensus figure who keeps his mah-jong tiles close to his chest. But a real debate about the need for economic – not political – reform is going on.

The snag is that carrying out the second stage of the Deng revolution would lead to lower growth and higher inflation for several years: a big risk for a leadership marked by risk aversion. The probability is that the economy has bottomed out this summer, with an upturn in the autumn and winter.

Having brought China down from the growth high of the stimulus programme, the leadership has to use the new base as the platform for reform. The true test for China is not in the quarterly data, but the political will at the top.

Jonathan Fenby is a British writer, journalist and analyst.

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