China’s old recipe book for economic success, based on market distorting policies, is hindering the process toward a market-driven economy and the chance of being granted Market Economy Status (MES). The consequences of policy passivity may derail China into the middle income trap and pose severe uncertainty to global markets. As China’s debt keeps mounting, particularly due to financial repression, mere domestic monetary reform may not be enough and may further harness the transition. Given China’s fiscal and financial space, prudent fiscal policy, along with an acceleration in domestic economic reforms, can improve the social safety net, promote consumer confidence and spending and may be the most effective way to balance the China’s economy and make its finances stable.
China’s economic rebalancing stands at the centre of global economic attention. In a way, slower manufacturing output, higher domestic consumption and the increasing importance of the services sector seem to suggest China’s transition to a demand-driven economy is steadily progressing. However, data on a slowing economic activity, in itself a natural part of a rebalancing economy, are subject to interpretation and few would concur that China is rebalancing as fast as it should. Moreover, while China’s rebalancing is important for the health of the world economy, failure to generate positive consequences from it trigger concerns about one of its consequence – falling rates of growth. Last year a McKinsey survey of executives found that respondents widely cited the slowdown of China as the riskiest factor for the future, along with geopolitical instability. At every investment conference on Asia and China today, there will be repeated references to “zombie” firms and overcapacity in manufacturing and heavy industry, and how they prevent China to sustain economic growth at the current level.
The worst may be yet to come, however, and China’s leadership should prepare itself for tougher international scrutiny. Its mixed economy, with a significant role of the state in the business sector, causes legitimate concerns, and not just about rebalancing. They are now at the heart of China’s ambition to earn so-called Market Economy Status (MES). Other leading trade powers, however, do not seem to share China’s view of itself as a market economy. The row centres upon the terms of China’s agreement of accession to the World Trade Organization (WTO) in 2001, which China has long interpreted as automatically entitling the country MES by the end of 2016, 15 years subsequent its formal accession to the WTO.
The Obama Administration and several European governments, under pressure from businesses and trade unions at home, are concerned about the impact of Chinese imports on jobs and are so far rejecting automatic MES recognition. Political opposition to Chinese MES graduation has also emerged from Members of the U.S. Congress and European Parliament; the latter institutions recently rejected MES graduation it in a non-binding vote. The final result remains to be seen. Some in Europe are willing to award China MES on substantive grounds. Others are eager to attract Chinese investments and opposition to granting China MES may eventually crumble in the face of China’s check book diplomacy. However, China’s government will still have a hard time convincing others that it is reforming its economy and reducing the role of the state in a way that creates better terms for competition and foreign firms.
Indicators of overcapacity and subsidies to certain industries feed the suspicion that China is not rebalancing its economy fast enough – and, regardless of WTO definitions, that it does not work as a market economy. The Wall Street Journal recently documented how public companies in China get billions of dollars in cash assistance from the Chinese government, electricity subsidies, and other benefits. “Recipients include steelmakers, coal miners, solar-panel manufacturers, and other producers of other goods including copper and chemicals”, the Journal noted (WSJ, May 9 2016). Despite general overcapacity problems in world commodities markets, China has seen continued export growth of key products such as steel and aluminium. Both American and European policymakers urge rapid changes in China and have issued threats of trade remedies against China’s steel exports.
China’s subsidies not only risk causing trade disputes, protectionism, and retaliatory actions. They also sit at the centre of the much-vaunted rebalancing of its economy. Fuelling credit to a saturated manufacturing sector and a market with low global demand also puts the country’s banking system at risk, and further dulls the government’s declared objective of re-allocating resources towards domestic consumption and domestic-driven industries, especially those in the services sector. The way China has regulated its financial sector has exacerbated economic imbalances and created vested interests that would be disadvantaged by economic reforms. China can rebalance its economy, but it will not happen without deeper economic reforms.