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.
Escaping the middle-income trap
China may go slow on its ambition to rebalance its economy, but it is increasingly troubled with the risk of getting stuck in the “middle income trap” – and for the country to avoid it, it needs to address the problems caused by its old model of growth. Cutting overcapacity and transitioning into higher value-added manufacturing, as Yiping Huang of the Peking University argues, is “a lifeline for China in avoiding the middle-income trap”. For him, “the transition to high income status is probably one of the most important economic questions facing the world today. Success can lift the living standards of 1.4 billion people. Failure may lead to economic and social instability in China and the world could lose one-third of its global economic growth engine” (Yiping Huang 2015).
For economists, a country becomes middle income when its GDP per capita reaches $US7,500. China entered this stage of economic development in 2014. What haunts the country’s economic-policy observers is that relatively few countries in the past three or four decades have graduated to achieve high-income status, or reached per capita income levels of over $US16, 000. As for China, its GDP is steadily losing steam and has gradually lost 2 percentage points on a yearly basis for a while now, but at same time China is approaching a median income of $17.000 when measured in purchasing-power parity. The timing of these developments signals that China is getting closer to the “middle income trap”. If that happens, China would end up joining the group of economies that caught up fast with frontier economies but failed to rise to the stage of being a high-income economy (Eichengreen et. al. 2013).
What is delaying China’s transition into a higher stage of market-driven growth? Every answer should start by pointing to the huge factor-market distortions in the Chinese economy, many of which have been enacted in the past decades by the Chinese government in the pursuit of growth. Those factors still spur the investment-driven economic model, and give powerful stakeholders a reason to thwart the process towards a market-driven model (Lardy 2008; Borst and Lardy, 2015). Importantly, government controls on energy, land use, and household savings have massively advantaged manufacturing investors. They have worked as a subsidy to domestic and foreign firms to relocate activities in the country. In the last two decades, control policies favouring investment over consumption and the services industry have made China’s export-led manufacturing sector a success story. However, these controls have caused financial repression. They generate resources which are captured by the government and transferred to state entities – and these resources amount to a big part of the nation’s wealth. Lardy (2008) argues that only the interest rate established by the PBoC for the whole Chinese banking system represents a hidden tax on household savings that equals “more than three times the proceeds from the only tax imposed directly on households—the personal income tax”.
Withdrawing this wealth from savers has compressed consumption, lowered capital investment to the private sector, boosted credit expansion and spurred the build-up of debt, now standing at about 228 percent of GDP. In the early stage of industrialization, financial repression aimed at curbing domestic consumption via low interest on deposits and that helped to create faster capital accumulation. As expected in the Gerschenkron model (Gerschenkron 1962), financial repression worked as an accelerator of Chinese industrialization.
Currently, this form of financial repression originates domestically via government-led policy (Lardy 2008; Johansson 2013), combined with external factors such as developed-country central bank policy based on “zero-bound” interest rates. In the current dollar standard, the U.S. Federal Reserve’s short-term rates and downward pressure on long rates through quantitative easing affect the countries in the dollar standard’s periphery. Since the European Central Bank, the Bank of England, and the Bank of Japan have followed the same direction as the Fed, central banks in emerging markets economies, which have naturally higher interest rates, are forced “to use capital controls on inflows and repressive bank regulations to lower their domestic deposit rates of interest” (Schnabl 2012, McKinnon, and Schnabl 2013). In other words, emerging economies (including China) have to operate with interest rates that are excessively low. If they did not do that, McKinnon and Schnabl argue, they “would lose monetary control as foreign hot money poured in the recipient emerging market government would be forced [to] intervene to prevent its exchange rate from appreciating precipitously” (McKinnon, Schnabl 2013).