asia is the miracle over - george magnus ubs

UBS Investment ResearchEconomic Insights — By George

Asia: is the miracle over? 10 September 2012

George Magnus, Senior Economic [email protected] Tel. +44 20 7568 3322

This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 26. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Economic Insights - By George 10 September 2012

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Asia: is the miracle over? According to conventional wisdom, Asia, with a rising China at its heart, is the future. And since the Western financial crisis, it has become more common to view the rise of China and Asia as a massive change in the structure of the world system, reverting to a type that predates the Industrial Revolution and the ascendancy of the West by more than a thousand years, sending the world ‘back-to-the-future’. The popular proliferation of estimates about when China’s economy will overtake the US, or other Asian economies will rival or overtake those in Western Europe, adds a certain excitement or frisson to this perspective, depending on one’s point of view.

But the Asian miracle, heralded by the World Bank in a major report in 1993, has been the subject of heated debate. Paul Krugman’s infamous article, The Myth of Asia’s Miracle, published in Foreign Affairs in 1994, suggested that the miracle was more about perspiration than inspiration. In other words, impressive Asian economic development could be fully explained by demographics, high savings, rising investment, improving education, labour transfer to the modern sector and other measurable inputs. Sooner or later, growth would become more pedestrian in the absence of strong innovation-led productivity growth. In 1997-98, during the Asian crisis, some people wondered incorrectly whether the Asian miracle was over. Financial and balance sheet excesses, that precede periodic financial busts, can of course depress potential output growth, as nowadays in Western countries, but they didn’t have a permanent effect on Asia post-1997. When the Western financial crisis erupted, balance sheets were in good shape, the capacity to implement strong stimulus measures was high, and Asia came through it with economic guns blazing.

Developing Asia’s GDP growth rose from 7% to 9% per year between 1994-2003 and 2004-2011, largely paced by a sharp acceleration in China and India in the years preceding the financial crisis. In 2008, just as the Western financial crisis erupted, one of Asia’s most prolific cheerleaders, Kishore Mahbubani, Dean and Professor at the Lee Kuan Yew School of Public Policy at the National University of Singapore, published a book called ‘The New Asian Hemisphere: the irresistible shift of global power to the East’. On cue, so to speak, Asia weathered the financial crisis and ensuing global recession successfully, and growth rebounded strongly in 2011 with a near 10% rise in GDP.

Since then, however, economic growth has been sliding and is now back to around 7% or so. A reasonable enough growth rate by any standards, but not necessarily for investors. Since the start of 2011, for example, developed world equity market indices have consistently outperformed those for Asia. At first glance, slightly slower growth and relatively disappointing equity returns over the last 18 months should be of fleeting concern. Why shouldn’t Asia be able to find new sources of growth to compensate for its high exposure to world trade and to Western aggregate demand formed over many years?

The answer is it can, but to do so, countries in developing Asia have to address structural and political issues that are pulling down total factor productivity, and therefore, potential growth.


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In China, for example, the faltering property market is the leading edge of a broader investment slowdown and profit squeeze that is reflected in production and price weaknesses in numerous industries, and rising debt and loan problems. Increasingly, it looks as though the utilisation of copious volumes of capital and labour inputs, and debt financing to sustain rapid growth is approaching exhaustion. And the more the authorities attempt to offset the current economic slowdown by easing monetary policy or increasing new infrastructure spending and financing in the face of rising capacity and weakening prices, the more unstable the economy will likely become. So far, Beijing has been surprisingly restrained in trying to offset the economic slowdown - to its huge credit. But a recent editorial in People’s Daily marked a definite change in tone, warning that China must plan and be prepared to take new measures to support economic growth. As the 18th Party Congress draws nearer, with powerful party positions in play, this call may well be heeded. The latest macro readings certainly don’t suggest the slowdown has ended.

We should not be fooled into thinking that the summer rally in some residential investment indicators, such as floorspace sold, and sales transactions and prices in some major cities is the end of the downswing. Unsold inventories amount to perhaps 1-2 years of supply, despite reports of much lower figures in large cities such as Beijing and Shanghai. Floorspace under construction in relation to sales is higher than at any time since 2010, and developers are saddled by significant leverage.

Yes, you can argue that China’s demand for housing, and the outlook for prices, are strong, bearing in mind that it is still a middle income country in which urbanisation and modernity are still increasing. However, this structural perspective isn’t really that helpful because the actual demand for housing that matters is the demand that exists at current price and inventory levels. Since both would appear to be too high, we should expect the private housing market to continue to trend weaker.

But the property sector is just one, if very important, part of the picture. The labour market and ageing consequences of three decades of the one-child policy, are compromising China’s trend growth rate, along with the complexities of rebalancing the economy, and the uncertainties generated by the leadership change. Trend growth in China may already be dropping a couple of percentage points to around 6-7%, and a successful rebalancing could even entail growth sliding down to 4-5% in the next few years1. Citizens care about income growth, jobs and opportunities, not GDP, so this sort of outcome need not be disastrous at all. But it’s different from what most people expect - and a shock for commodity producers and others that have profited from the working of China’s economic model to date.

1 There’s a lot of argument about the accuracy of Chinese macroeconomic statistics, and about reported GDP growth in particular. See, for example, Janet Koech and Jian Wang, China’s slowdown may be worse than official data suggest, Federal Reserve Bank of Dallas, Economic Letter Vol 7 No 8, August 2012, or go to www.dallasfed.org/research/eclett/2012/el1208.cfm


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In India, the rethinking about trend growth is even more trenchant. The degradation of state institutions, according to one commentator, lies behind the fragility of the country’s growth story2. This is a serious context, against which we have to consider, for example, inadequate investment, poor infrastructure, energy bottlenecks, and twin deficits. Only a few years ago, popular thinking was that India would be the next 10% growth story, but, as things stand, it may be more realistic to think of India’s underlying growth as closer to 5-6%. This is a big deal because banks, energy companies and others that predict what the world will look like in 2030, for example, assert that India will be the third largest economy by then. However, if India’s sustainable growth rate is nearer to 5-6%, then it is back to the drawing board!

In these two Asian behemoths, as well as in the region generally, the cyclical drags on growth in 2012, such as exports in many countries, are much more visible than the deeper structural problems of sector imbalances, rising income inequality and weak institutions. Leaving aside poor late-comers such as Myanmar, Asian countries face choices between accepting slower growth or political and economic reforms to the models that have driven the Asian growth story so far.

Mahbubani says that Asians have finally understood, absorbed and implemented Western best practices from free market economics to modern science and technology, and from meritocracy to the rule of law. Even if this assertion were at least partially true for some countries, it is surely a profound over-statement, as we shall examine below. In our view, he is right that Asians do not lack understanding of international best practices when it comes to the appropriate institutions of government and governance needed for sustainable and rapid economic development. The problem as we see it, though, isn’t about understanding, but about implementation, because there are often deep conflicts between these practices, and the vested interests, who oppose them because they would lose out, or because they want to sustain traditional customs, and power relationships. So, it is not churlish to ask if the Asian miracle is over?3.

Moreover, he and others may be under-estimating the speed with which the US, for example, is rebuilding its competitive cutting edge, even if it has a mountain to climb in addressing familiar budgetary, job creation, income inequality and demographic problems. Cheap energy, courtesy of the evolving shale gas story, and America’s lead in additive manufacturing, or 3D printing, and other advanced production and materials technologies hold out huge promise for the country over the next decade. New advanced manufacturing technologies are expected to turn our understanding of manufacturing, outsourcing, and supply chains on its head as the focus shifts sharply to the development of local and customised manufacturing. The biggest losers will probably be countries,

2 Ramachandra Guha, Fantasies of power in my land of muddle along, Financial Times, 2nd August 2012 3 This is knowingly controversial, but it doesn’t mean that Asia can’t become what many investors and others imagine, or that there aren’t good, investable Asian companies. But you can’t look at the macro and political picture in the same forensic way as you would a company’s balance sheet and management. The crisis aftermath has exposed contentious economic and political flaws that need to be addressed in the face of strong opposition to social, market and institutional reforms.


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especially China perhaps, that have become embedded in long, complex global supply chains. This is a major long-term risk, more so than the current focus on the cyclical and property-related economic slowdown.

To pose the question about the Asian miracle is not to doubt China’s and Asia’s economic potential and significance, but to throw down the gauntlet to the conventional thinking that extrapolates Asia’s past economic performance into the indefinite future, and assumes that the competitive challenge from the US and other Western countries and companies is now a spent force. So while no one thinks Asian growth will come to a grinding halt, absent another financial crisis, the region’s underlying rate of expansion could easily become much more pedestrian, and politically constrained.

A more Asia-centric world, regardless Back in 1944, as the tide in the Pacific War turned towards the United States, the recently deceased geographer and strategist, Nicholas John Spykman’s book, The Geography of Peace, was published. Spykman emphasised the strategic and maritime significance to the US of what he called the ‘rimland’, or the countries and islands on the rim of the continental powers of the US, Europe, and the then USSR. The geography of the rim ran from southern Europe and the Maghreb, east through the Persian Gulf, into the Indian Ocean, across to the South China Sea and up to Japan and the north-west of China. Spykman asserted the importance of the population characteristics, resource endowments and industrial development potential of the Asia-Pacific rim, in particular. He said that whoever controlled this rimland, would rule Eurasia, and the destinies of the world. This judgement has seemingly become firmly embedded in US foreign and international economic policies to this day.

Inevitably, China’s transformation from a poor, high growth consumer of Western products to a sophisticated middle income competitor and geo-political rival has changed the economic and political balance within Asia, and between Asia and the rest of the world. Age-old frictions that have characterised China’s relationships with its Asian neighbours has become more significant with the waxing of China’s economic and financial strength, particularly since 2007.

Indeed, the impact of the financial crisis on US prestige and economic prowess, set against China’s own economic performance, has emboldened politicians’ claims that it - and Asia - have better models than the now broken free market, liberal capitalist variety that malfunctioned in 2008. There may be no ideological divide, as there was between the US and the former USSR and Maoist China, but there are strong differences in thinking about economic and social models, the role of the state in the economy, and its consequences, for example, for trade, commerce and procurement. The wider political implications of economic and foreign policies carried out by state-owned or sponsored institutions in securing access to resources in the Middle East and Africa, and in participation in global capital and commodity markets are becoming increasingly apparent.

The economic significance of Asia is fact. It is home to the world’s busiest trade routes and manufacturing hubs, and some 3.5 billion people, over half the world’s population. It has 2 billion people of working age, and will add around 770 million in the next 40 years, mostly in India and Indonesia. The ‘next billion


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consumers’ in the global economy will be based largely in Asia, and the size and spending of an Asian middle class is expected to rise in the next 20 years from about $4 trillion to over $30 trillion, or roughly 42% of worldwide consumer spending4.

Moreover, we are witnessing the rise of Asian global companies, that is, with headquarters in the region. In the global Fortune 500, ranked by revenues, there were 26 Asian companies in 2005. Today there are 91, two thirds of which are based in China5. This summer, Lenovo, the Chinese computer company announced a deal to sponsor the American National Football league, and the Economist magazine had a lead story about Huawei, now the world’s largest telecommunications equipment maker6. The US and European grip on single aisle passenger aircraft will doubtless be challenged in coming years by the Commercial Aircraft Corporation of China’s C919 model. India’s Tata Corporation has bought iconic brands, such as Jaguar, Land Rover and Tetley Tea. China’s Geely Holdings bought Volvo, while Samsung, Hyundai and Taiwan’s HTC are longer-established global brands.

Chart 1: Asian companies in the Global Fortune 500

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In 2011, 67 years after Sykman’s book appeared, President Barack Obama toured Asia to assure allies of America’s total commitment to the region, promote deeper trade links (after Congress had just approved a trade deal with South Korea), and in passing, he announced the deployment of 2,500 marines plus naval ships and aircraft to a base in Darwin, northern Australia. As his chair

4 Measured in 2005 PPP dollars by the IMF. 5 While this rate of penetration is impressive, most of these Asian companies are concentrated in energy and utilities, except for those in Korea, Taiwan and Singapore. So, the revenue criterion alone doesn’t necessarily define global companies in the full sense. For example, Sinopec and State Grid of China rank 7th and 8th in the global revenue rankings, while Samsung Electronics, ranks a relatively lowly 32nd. Whether or not Asian companies can produce the ‘brands’ associated with the more developed countries in the region, remains to be seen. 6 Who’s afraid of Huawei?, The Economist, August 4th, 2012


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of the joint chiefs of staff, General Martin Dempsey, noted at the time, ‘all of the trends, demographic trends, geopolitical trends, economic trends, and military trends are shifting toward the Pacific. So our strategic challenges will largely emanate out of the Pacific region, but also the littorals of the Indian Ocean’. The centrepiece of current US strategy is the newly formed Trans-Pacific Partnership, a free trade bloc designed to solidify America’s economic, political and military influence in Asia.

During the President’s Asia trip, the US announced, along with leaders from Australia, Brunei, Chile, Malaysia, New Zealand, Peru. Singapore, and Vietnam, the creation of a Trans-Pacific Partnership agreement, designed to bolster trade, investment and innovation among the signatory countries. Most import tariffs are to be eliminated by 2021, and the agreement also covers services, intellectual property, the internet and free data movement, regulatory coherence7, and investments, including by state owned enterprises.

The significance of US trade with TPP countries is small, and overshadowed by much bigger geo-political interests. In 2011, the US imported goods worth USD91 billion from TPP countries, 70% of which were from Malaysia, Singapore and Vietnam, and exported around USD105 billion, half of which were to Australia and Singapore. On average this amounts to about 5% of total US trade.

The TPP doesn’t yet include Japan, though it will once current negotiations are completed. Japan has strong interests to join: it doesn’t want to be left behind by the US free trade agreement with South Korea; the political clout of its agricultural lobby has waned; and it wants a place of solidarity, shielded from Chinese foreign policy assertiveness, for example, in relation to on-going disputes about islands in the East China Sea (Senkaku or Diaoyu Islands for Japan and China, respectively8). With Japan, US trade with TPP countries would more than double. Canada and Mexico were invited to join at the G20 Summit meeting in Mexico in 2012. With them, around 40% of US trade would then be with TPP countries9.

It doesn’t include China, by design, which accounts for over half of US imports from the Pacific Rim and 28% of exports to the broad region. And China was none too pleased at the Japan-TPP negotiations, prompting Chinese Commerce Minister, Chen Deming, to remark recently that ‘they should not be allowed to influence progress on other types of co-operation in the East Asian region’.

7 This is a fancy term for making regulatory systems generally compatible with those of the US. 8 The biggest anti-Japan protests in 7 years flared up in China in August, after Japanese activists landed on some of the disputed islands. Ostensibly about fishing rights, the islands are seen as strategically important, potentially with oil and gas reserves. 9 Asia’s significance for Europe has grown in importance too, but more narrowly in the areas of trade and finance. EU27 exports to Asia now amount to over €330 billion, or 22% of total of external exports, and imports from Asia are over 30% of external imports of €530 billion. If we take out the US and other advanced nations, Asia represents almost 40% of imports and 30% of exports. On average, China is roughly half of total trade with Asian countries, with EU exports to that country doubling since 2004.


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What we believe he meant was that Japan should prioritise free trade agreements, which China is trying to promote among the ASEAN countries +3, that is, China, Japan and South Korea.

Chart 2: US trade with TPP, other Pacific Rim and all countries (%)

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American insistence that the creation of the TPP was not anti-China, did not appear to cut much ice in China, even though Beijing’s response was relatively restrained. But from media coverage it would appear there is little question that it sees the TPP as yet another hostile American policy designed to restrain China’s development, and to suppress its claim to be Asia’s prominent, if not dominant, economic and political power. The US is also seen by some within China as trying to foment dissent internally, for example by championing internet freedom and political rights groups, and to fan fears externally of China’s growing regional role.

Reportedly the TPP has also been seen by some Chinese leaders as a means of frustrating China’s policy of internationalisation of the Yuan, for example, by limiting the extent to which China might promote the Yuan as payment for trade and as a denominator for financial transactions and instruments. US trade alliances, on the other hand, extend US financial influence, and perpetuate the use of the US dollar, which runs counter to China’s stated interest of promoting the use of the Yuan. China argues strongly for ending the US dollar’s dominant role in and, what it regards as America’s abuse of, the global monetary system.

These sometimes parochial issues concerning the role of the US dollar and the internationalisation of the Yuan aren’t just esoteric finance. As Joseph Schumpeter pointed out, ‘The monetary system of a people reflects everything that the nation wants, does, suffers, is’10. And yet, China faces a long uphill struggle to internationalise the Yuan, let alone make it a reserve currency. Going down this path will require root-and-branch political and financial reforms affecting the structure of financial institutions and capital markets, and the determination of interest rates that might not be compatible with the primacy

10 Quoted in The Economist, Staring into the abyss, 12th November 2011


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of the Communist Party of China. And we shouldn’t expect the United States to want to relinquish the primacy of it own currency to make China’s task any easier.

But no growth miracle

For the many that proclaim the inevitability of the Asian century, there are a few for whom the end of the Asian miracle is equally obvious. Nearly 20 years ago, Paul Krugman - guru or bete noire, depending on your point of view - published what became a notorious article, entitled ‘The Myth of Asia’s Miracle’11. He expected Asian growth to outpace the West for some time, but not for any special or region-specific reason, and for not much more than a decade or so. Concluding, he wrote ‘The newly industrialising countries of the Pacific Rim have received a reward for their extraordinary mobilisation of resources that is no more than what the most boringly conventional economic theory would lead us to expect. If there is a secret to Asian growth, it is simply deferred gratification, the willingness to sacrifice current satisfaction for future gain’.

Krugman’s thesis that Asian output growth could be fully explained by input growth, and that as the latter became exhausted, the former would slow down was rejected out of hand in Asia, and still is. The argument is about what happens after the initial ‘catching-up’ surge of the last 20 years, once labour transfers to urban areas have ended, high savings and investment rates plateau, basic educational attainment levels have risen, essential levels of public investment have been completed and so on. As Asian countries, particularly China, reach the limits of physical resource mobilisation and the constraints imposed by the exploitation of existing technologies, their growth prospects are expected to depend more and more on the long-term technological capacity and robust institutional arrangements that underpin total factor productivity growth (TFP).

Although the empirical TFP analysis is equivocal, recent evidence suggests there was nothing remarkable about Asian TFP until about 200012. Historically, it has been consistently higher than in other emerging markets, accounting for half of the 4% economic growth premium over Latin America, for example, since 1980. It certainly rose in the 2000s, as shown below, though it is not clear how much of this was down to globalisation, itself, and the growth resurgence following the Asian crisis, and how much was more structural. Nevertheless, the growth of TFP in Asia in recent years has undoubtedly been underpinned by efficiency gains arising from technological achievement on the one hand, and high savings and the absence of balance sheet and financial stress on the other. The development of educational attainment levels, electrical power consumption, air transportation, telecommunications and internet usage, and higher value added exports have all contributed to Asia’s faster TFP growth.

11 Paul Krugman, The Myth of Asia’s Miracle, Foreign Affairs: Nov/Dec 1994, Vol 73, Issue 6 12 Jungsoo Park, Projections of Long Term Productivity Growth for 12 Asian Economies, Asian Development Bank, Economic Working Paper No. 227, October 2010


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The following charts show real GDP growth for developing Asia and China, broken down by the contributions from physical capital, labour supply, and TFP.

Chart 3: Asia: growth contributions (%)

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In China, the higher contribution of TFP to economic growth in the 2000s shows up clearly in Chart 4. Roughly half of China’s TFP growth has come from the transfer of labour from the rural sector to higher value-added, urban-based, jobs, mostly in industrial manufacturing for export. But in Chart 5, the sequential changes in growth contributions stand out more clearly. The labour contribution is just about drying up, while the investment and TFP contributions are clearly sliding.

Chart 4: China: growth contributions (%) Chart 5: The debate over China’s potential GDP growth

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The slowdown in TFP growth, along with investment, testifies to the need for reforms to raise the growth and levels of efficiency, and as explained later, to change the contributions and functions of the State vis-a-vis the private sector - probably one of China’s biggest structural challenges in the next decade.


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For China and Asia generally, higher sustainable economic growth, based around greater efficiency and innovation, depends on political and institutional reforms. Without these, we believe the miracle could fade and slower long-term growth will result - not a cheery prospect, given high expectations. And, of course, high growth expectations are important in a continent, where all countries except Malaysia are still low- to middle-income, with income per head ranging from less than $1,250 in Myanmar to about $9,000 in Thailand (measured in $PPP13).

Chart 6: Asian income per head (2010, $PPP)

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Source: IMF, World Economic Outlook

Even Malaysia has its work cut out: in the mid-1960s, it was slightly richer than South Korea and Taiwan, but it started to drop behind in the 1970s, and has fallen further behind all the time. Since the Asian crisis, the share of investment in GDP has more than halved to just 20.2% (2011), with the private sector share falling from 33% to 9.5% of GDP. Although Malaysia plans to boost its per capita income to become a high income country by 2020, its course will be determined by the attention given to building strong local export companies, reducing fiscal and organisational barriers to investment, distortions, and promoting knowledge-based growth.

To reap the TFP harvest that Asia’s economic and demographic potential promises, we believe governments will need to dismantle barriers embedded in political and legal institutions that restrict or stifle growth, investment, and innovation. These include the absence or limited application of the rule of law, over-dependence on the state as an owner and producer of goods and services, rather than as a provider of non-tangible financial and commercial services to support entrepreneurship and innovation, weaknesses in the quality of and access to post-school education and training, low levels of development in financial and risk-capital markets, and discriminatory policies involving procurement, taxes and subsidies, information security, and intellectual property protection.

13 In current, market US dollar terms, you have to scale these numbers down a fair bit. Malaysia’s, for example, is $9,700, while China’s is $5,400.


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Asian decoupling is alive and...well, not as it used to be But is this being churlish? Wasn’t Asia supposed to have decoupled from the advanced economic nations of the world, establishing higher endogenous, sustainable growth, regardless?

To investors, the idea of decoupling, so far as equity markets and returns are concerned, has become tinged with disappointment. Since the start of 2011, the broad indices of Asian equity markets have underperformed those of developed markets, notwithstanding the fractious state of the latter economies. But whatever the reasons for this phenomenon, they appear unrelated to measurements of economic growth.

Chart 7: Decoupling – 10 year moving avg of Asian and advanced economies’ real GDP 1970-2012

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As the above chart shows, the long-term growth rates (shown as a 10 year moving average) of developing Asia and advanced economies have been diverging for many years. Trend growth in developing Asia, derived from labour input and productivity growth, has been a good 5-6% higher than in advanced economies, and still 3-4% higher excluding China and India.

The wedge between Asia and advanced economies thickened after 2000 in the wake of the major expansion in China’s growth rate, accelerating globalisation, and as a result of the Western financial crisis. But we think the 7.5% growth rate gap in the decade to 2012 looks unsustainably high.

The economic environment is changing. Buoyant consumer markets in the West have gone for the foreseeable future, and the sharp bounce back in global growth in 2010-11 has faded into a slowdown that may not end in 2012. The downshift in global growth is partly due to the combination of fiscal stress and lost growth drivers in advanced economies, but is also attributable to weaker performance in China and India. Other large emerging markets, such as Brazil and Turkey, have lost their economic fizz too.

Decoupling shows a rather different pattern when considering annual, rather than long-term, changes in growth rates, as shown below. In fact, there are only


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a few instances of divergence in the directional movement of growth. Asia’s sensitivity to the global business and international trade cycles, and to protracted economic problems in the West, means that the region is, to an extent, still hostage to the economic fate of the West, in the absence of offsetting shifts in the sources of growth towards domestic demand.

Chart 8: Decoupling – annual growth in Asia and advanced economies 1961-2012

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No one doubts that Asian growth will continue to dwarf that of advanced economies, but the quality of that growth matters as much as the quantity. Some of the factors that have contributed to significant decoupling and thickened the growth gap are going to become less robust. China’s investment boom, for example, is already slowing down, and seems bound to end, one way or another, in the next 2-3 years as the economy rebalances. Export prospects for China and the more trade-oriented countries in Asia do not look promising. Already in 2012, the growth in the value of Asian exports has slumped to 5.5%, compared with 23% in 2010, and they are lower, year on year, to the EU. In volume terms, exports are flat or negative year on year. Korean and Taiwanese economic growth has been slowing down, due mainly to double digit falls in exports. China’s exports in July were a mere 1% higher than a year ago.

The credit cycle and the deterioration in balance sheets comprise another important growth constraint in the medium-term. In this respect, Asian countries do not face an immediate threat, it should be said, but the trends are going the wrong way, and governments must be careful not to substitute credit expansion for more difficult and politically complex structural reforms. The chart below shows why.

In the eight years before the Asian crisis, bank credit to GDP surged from 65% to a peak of 96%. After the bust, Asian countries succumbed to several years of deleveraging. Particular areas of vulnerability proved to be short-term banking sector liabilities in South Korea and Thailand, large maturity mismatches in the borrowings, for example, of Indonesian companies, and skinny levels of foreign exchange reserves. There are few major concerns today about these phenomena. Asia’s local banking systems in general still have relatively low leverage ratios,


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contained by high rates of economic growth and conservative regulators, and bank capital adequacy ratios in the low-to-mid teens that exceed most regulatory norms.

Since 2002, however, the bank credit to GDP ratio in Asia has grown sharply again to 106%, much of the rise occurring since 2008, in the wake of China’s credit surge. Loan to deposit ratios in Asian banking systems are rising significantly again, as re-leveraging gathers pace. While balance sheet risks in the private sector look contained for the time being, we believe the rising credit intensity of GDP is a warning sign of weakening investment returns, misallocation of capital, over-lending, and eventually an abrupt end.

Chart 9: Bank credit to GDP ratio (2007 Nominal GDP weighted)

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Source: CEIC/UBS

China’s credit trends are being watched closely as the boom following the 2008 stimulus programme unwinds, aided and abetted by quite conservative responses from the government and the central bank. In July, Chinese bank loans again failed to hit the target, growing by just RMB 540 billion, the bulk of which was short-term lending. It is a moot point whether the banks will be urged or allowed to lend more, or whether the demand is there to allow the RMB8-8.5 trillion annual target for bank loans to be realised.

On the other hand, total social financing, which included bank loans but numerous other non-equity channels for non-monetary institutions to get access to loans, rose by RMB 1 trillion in July, or 17.6% year-on-year, bringing the year-to-date total to almost RMB 9 trillion. Annualised at over RMB 15 trillion, this represents a sharp rise from the 2011 increase of RMB 12.8 trillion, and even the 2010 rise of RMB 13.9 trillion.

Fiscal deficits in Asia are relatively low, except in India and Malaysia, public sector debt as a share of GDP is low except in India, and gross external debt as a share of GDP is low other than in Vietnam (leaving side the financial entrepots of Hong Kong and Singapore). Note that in the charts below, China’s virtuous position may a little more apparent than real. The fiscal data are opaque and often refer to central government only. According to some private estimates, total public debt may be in excess of 60% of GDP. Something around this level would give China the second highest ratio of public debt to revenues in the


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region at 263%14. The generally comfortable fiscal positions of Asian governments, though, isn’t carved in stone from a cyclical perspective, nor from a structural standpoint given the rising pressure on Asian economies to address income inequalities, build social safety nets, and in the cases of China and the original Tiger economies, support ageing populations.

Chart 10: Asia: general government fiscal deficit as % GDP 2012

Chart 11: Asia: general government debt as % GDP 2012

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In the face of rising credit intensity and the risk of growing fiscal imbalances, Asian countries will have their work cut out to sustain the very high growth premia of the recent past relative to advanced economies. To do so, they will have to promote faster domestic economic growth though models that promote

14 The IMF estimates acknowledge that outstanding levels of public debt have been stated officially to be significantly larger than has been reported, and there is a working assumption that three quarters of the levels of local government debt will be amortised by 2015, and the remainder thereafter.


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stronger household consumption of goods and services, a reorientation of trade to other Asian and emerging countries, and the adoption of political and institutional reforms to sustain a vibrant and entrepreneurial private sector. A critical factor we see here, especially for countries such as China and India, is a re-think about the role of the state in economic development. As stated earlier, this should entail a new and larger focus on social investment, policies to redress growing income inequality, the right kind of education and training infrastructure, the fiscal and commercial governance that helps to strengthen private firms and innovation, and, above all, the introduction or strengthening of the rule of law, and trust in contracts.

New growth hurdles - politics... The outlook for Asia’s economic growth and incomes per head then, and the particular prospects for both China and India, may be much more in the balance than people generally acknowledge. Asia may now, in fact, be at a point where past turbo-charged performance cannot be extrapolated any longer, without strong qualifications. Recently, none other than Antoine Van Agtmael, who coined the term ‘emerging markets’ and wrote the book ‘The Emerging Markets Century’ in 2007, offered some interesting thoughts that were changing his perspectives15. After an extended tour of Asia, he asked whether the confidence that has been characteristic of Asia in the past, is giving way to a new sense of vulnerability, and whether the US, itself, is restoring its competitive edge faster than many of us would guess.

His principal concern is about policy indecision, corruption and weak leadership in several countries, including China and India. In the latter, these have been highlighted by poor economic and political governance at the centre of government and reflected visibly in the recent power grid failure, and less so in India’s troublesome twin deficits. In China, they moved centre-stage with the events surrounding Bo Xilai, the aftermath of which has raised important questions about political legitimacy and about the implications for the change in China’s leadership now underway.

At the time of writing, there is no resolution of the Bo Xilai affair. Uncertainty is fuelling talk about the severity of the charges that may eventually be brought against him, and the extent to which this may be a tied to political disagreement in China, especially relating to the Politburo Standing Committee. The size of the Committee may be cut from 9 to 7, which could make finding political agreement before the 18th CPC Congress even more significant16.

Regardless of the outcome, though, Van Agtmael sees problems in China’s willingness to enact political reforms, and wonders about China’s economic future and its ability to sustain its dominant global manufacturing status. While its unquestioned advantages in large-scale production, modern infrastructure and market size will not erode rapidly, they will probably be undermined cumulatively by rapidly rising wage costs, rapid population ageing, the

15 Antoine van Agtmael, The End of the Asian Miracle, Foreign Policy, online, 11th June 2012 16 No date has been set for the Congress, which will present and authorise the new leadership, but is widely expected to be some time in October.


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development of low cost manufacturing in the rest of Asia, and beyond, say, in Mexico, and, importantly, new advanced manufacturing technologies favouring Western countries.

Demographics... Asian demographics, including the starkly different situations facing China and the original Asian Tigers on the one hand, and India, Indonesia, Malaysia and the rest of developing Asia on the other, are pretty well acknowledged nowadays17. It is debatable whether rapid ageing will have an immediate and measurable impact on trend growth in the former group of countries, especially as the labour supply input to growth accounting is already quite low. But there’s little question that it represents a big social problem and that raises other issues, including social safety nets and income inequalities, that also have a bearing on growth. For China, the problem can be summarised as the imminent decline in the working age population, the collapse in the support ratio (working age people to over 60s) from 5 to 2 that will quickly follow, the decline in aggregate savings and the inevitable rise in entitlements and unfunded liabilities.

For more youthful developing Asia, the advantage of not being where China is until the 2030s or later, is balanced by the disadvantage of low labour force participation rates, especially of women, and inadequate rates of employment creation. For India, for example, low employment and labour force participation rates, and weak education and training levels will become increasingly problematic as the size of the 790 million working age population swells by 133 million by 2020, and another 110 million by 2030. In Pakistan and Bangladesh, the increase from a roughly 200 million base, is predicted to be 50 million, and 40 million, respectively.

And technology... More immediate than demographics, though, is something that causes Van Agtmael to think that the US and parts of Europe and Japan are, slowly but surely, fighting back as they exploit cheaper energy and the keys to successful, advanced manufacturing.

The US technological lead, for example, in the exploitation of cheap energy from shale gas and oil deposits, is already starting to shift the economic pendulum back in its direction again. While US companies should enjoy lower energy costs, and chemicals and energy infrastructure suppliers in particular should prosper, the US stands to benefit in other ways, from greater energy independence, and from becoming an energy exporter. The Energy Information Agency estimates that US exports of gas could double by 2020, with gas trade in surplus by 2025. Cheap energy development will lower America’s trade deficit and attract a lot of foreign direct investment in energy.

UBS economists have warned about over-extrapolating the benefits for the US, bearing in mind the small percentages of output and employment, represented by oil and gas production and drilling activity, and the high capital intensity of the

17 See, for example, your scribe’s own offerings on this topic in The Age of Ageing (2008), and Uprising (2010) both published by John Wiley & Sons.


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sector18. Nevertheless, they reckon that the net effects of energy import substitution, energy investment, positive spillovers to non-energy manufacturing, domestic energy substitution towards gas, and US dollar appreciation might boost growth by about 0.5% per annum over coming years. This is a third of the estimated effects of the technology boom in the 1990s, but remember there may be unquantifiable benefits from the achievement of energy independence, per se, as well as the ripple effects of cheaper energy throughout the economy, and those arising from broader technological advances.

Second, as Van Agtamel says, the US technological lead in advanced, top-end manufacturing, smartphones and smartpads, and its capacity to create smart companies, is already starting to pay off. Whether these particular products - lifestyle changing as they are - will accelerate US growth is a moot point. But they may be the cutting edge of the coming global manufacturing revolution provided by additive manufacturing technology, or so-called 3D printing. This revolution is expected to tilt economic advantage back towards the US, and to other Western companies.

Localised and customised manufacturing won’t employ much labour, though in ageing societies, labour supply will fall, or stagnate anyway. It will, however, increase the importance of being close to one’s market, resources, and centres of technological excellence, and diminish the significance of long global manufacturing supply chains, and large-scale process manufacturing, both of which characterise Asia’s and China’s functions in the global economy.

China’s huge attraction to Western companies hasn’t worn off totally, but it is already being undermined by rising labour costs, reservations about the policy of indigenous innovation, concerns about intellectual property rights, and complaints about corporate discrimination. Reflecting some of these, the Taiwanese technology hardware company, Foxconn, which assembles for Apple, Sony and Nokia, for example, announced last year that it planned to introduce 1 million robots over the next 3 years. As the company employs 1.2 million workers, we shall see how far this automation goes, but it certainly seems as though the programme will displace large if unspecified numbers of jobs19.

But this could all be the tip of an iceberg, even if China were to match the US, Japan, Germany, Taiwan and so on at the frontiers of new manufacturing technologies. There would be no reason any more for foreign companies to assemble products in China, and ship raw materials and components in, and products out over long distances.

Surely, though, China is already a formidable technological competitor, with a highly sophisticated education system. Yes, it is, but consider some of the claims and counter-claims about China’s ability to eat our technological lunch, so to speak, more closely.

18 Maury Harris et al, Could natural gas and oil fuel next US boom?, UBS Investment Research, 3 June 2012 19 Foxconn to replace workers with 1 million robots in 3 years, Xinhua News Agency, 30th July 2011


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Chinese research and development spending has been growing rapidly, as one would expect, and it is now the second biggest spender in the world, with an estimated 13.2% share in 2011. But its R&D spending was half that of the EU’s combined $330 billion, and a little more than a third of US spending. It is good at incremental process innovation, patent registrations and so on, but it lags behind key advanced economies when it comes to the ‘know-how’ embedded in product innovation, management organisation, and the fusion of new information, biological, and materials technologies.

Well-publicised patent filings and scientific publications, hailed by many as proof of China’s growing prowess in scientific and technological innovation, are perhaps misleading. According to Thomson Reuters, China is indeed already the world leader in patent application volume, and second only to the US in published scientific papers, which it could overtake in 2013. According to the US Patent and Trademark Office, China registered 1655 patents in the US in 2009, compared with just 90 in 1999.

But this is a bit like saying that the loudest growls on the Formula One starting grid belong to the fastest racing cars. In reality, China lags a long way behind the US and many European countries, when it comes to cited patents, and to the filing of patents globally. Less than 6% of Chinese patents are protected by global patents, compared to 49% for the US, and nearly 40% for Japan, and China scores far less well than the US or Europe in terms of the number of publications per head published in top scientific journals, according to Thomson Reuters’ Essential Science Indicators20. Further, China produces 0.54 papers per head, compared to 10 or more in the US, Germany and much of Western Europe, and Chinese scientific papers received less than 6 citations per paper, compared to 10-15 in the US, Europe and Japan. Chinese scientists and engineers are reportedly given lucrative incentives to publish, but this results in a surfeit of quantity over quality, and alleged widespread plagiarism, and data duplication and possible falsification21.

According to Professor Peng Gong of Tsinghua University and Berkeley, China’s problem isn’t the amount of R&D it produces, but the quality, and this is related to two cultural genes that have passed through generations of Chinese intellectuals22. The first is the Confucian proposal that intellectuals become loyal administrators, the second comes from the writings of Zhuang Zhou who proclaimed that a harmonious society would arise from isolating families to avoid exchange and conflict, and by shunning technology. The modern consequence, he says, is a society that discourages curiosity, critique, challenge, commercialisation and collaborative technology.

China’s celebrated high speed rail network may be a case in point. Until 2003, the Ministry of Railways sought to develop high speed rail and track without foreign assistance, and in an official attempt to take on world bullet train

20 http://thomsonreuters.com/products_services/science/science_products/a-z/essential_science_indicators/ 21 Chris Wickham, China rises in science, but equation may have flaws, Reuters, 28th May 2012 22 Peng Gong, Cultural history holds back Chinese research, Nature, 25th January 2012


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manufacturers. But this indigenous technology initiative failed seemingly for many of the reasons suggested above, and was abandoned abruptly in favour of a ‘market access for technology transfer policy’, which resulted in approaches to major high speed companies in Japan, France, the UK and Germany. The programme accelerated rapidly, with China buying the patents, but its suppliers retaining the intellectual property rights23.

Anecdotes and examples, such as this, can certainly be seen as half full, or half empty examples of where China has arrived. But there’s a strong view that China’s innovation and technology shortcomings are rooted in a socio-cultural system, and an incentive system that emphasises incremental over radical change, and quantity over quality and uniqueness. No one can say that these problems will retard Chinese innovation and technological competitiveness forever. But in our view they emphasise that in the absence of on-going political reform, and the creation of robust institutions, China’s technological cutting edge may forever lag behind that of its western competitors and rivals.

Reforms needed to avoid the trap We will look at China in more detail below, but we should not overlook the fact that in many Asian countries, modernity and backwardness make for strange bedfellows. In developing Asia, excluding China and the original Tiger economies, for whom rapid ageing will become a pressing economic and social challenge, almost 30% of people are aged under 15, and will grow up to become workers in the coming years, underpinning a demographic dividend while low old age dependency ratios persist for another 20-25 years. But only if they can be educated, trained and employed productively. Employment participation rates, however, are low, especially for young people. Only 60% of young men and 40% of young women are classified as employed, often loosely classified.

Unemployment, including underemployment, averages about 25%. About 700 million people in Asia do not have unrestricted access to drinking water, 1.9 billion people experience poor sanitation, 100 million children in Asia are not enrolled in primary schools, school and in some countries, teacher drop-out rates are high, and over 100 million children under the age of five are underweight24.

These blots on Asia’s landscape will become more pronounced in the absence of economic and institutional reforms. Some countries, as we have seen already, like Malaysia and Thailand are already solid middle income nations, but the quality of institutions isn’t close to, for example, Hong Kong and Singapore25. Indonesia scores pretty well overall, but has weak legal and regulatory institutions. India is of course still a low income, curiously perhaps with satisfactory legal institutions, but weak governmental, labour market and regulatory institutions. And China, which could, on present trends almost triple its income per head by 2020 to around $13,000 to become borderline high

23 Railroaded into a Fast-Train Technology Trap, Caixin online, 11th July 2012 24 Rajat M. Nag, Leadership in a New Asia, at 2009 Asia Leadership Dialogue, Manila, Philippines 25 For a 141-country comparison of the quality of institutions, spanning government, legal, monetary policy, regulatory, openness, see Economic Freedom of the World Annual Report 2011, Fraser Institute


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income, scores well in terms of government institutions, but poorly in terms of its legal, entrepreneurial, and commercial institutions.

The linkages between strong institutions and sustainable rapid development, which become tighter as income per head rises, have been understood for a long time26. The key point is that as countries become middle income, many catch-up benefits diminish and disappear, as discussed earlier, and according to Paul Krugman’s depiction. The rural labour surplus wanes, pushing up wages and eroding competitiveness. The productivity surge arising from the reallocation from agriculture to manufacturing, and the associated technological catch up and exploitation of existing technologies runs out of steam. The key to the next phase of development lies in innovation- and efficiency-led productivity enhancement, which is essentially about robust institutions, as well as smart people.

With China as its focus, the World Bank examined these issues in great detail in a recent report, written in conjunction with Beijing’s Development Research centre, and provided strong backing for this view27. In the report, the authors emphasise how hard it is for countries that have attained middle income status to break out of this grouping into the high income universe of countries. They show that only 13 of the 101 countries, deemed middle income in 1960, had done so by 201128. This is a sober observation that basically says that past economic performance is not a good guide to the future, and that for most countries, a middle income trap beckons.

What about China? The World Bank report says that to realise its potential over the next 20 years, China has to change. It proposes that China should rethink the role of the state and the private sector in encouraging competition in the economy; stimulate innovation through openness and links to global R&D networks; accelerate green economic development; prioritise greater equality of opportunity, income and social protection, especially in view of the consequences of rapid ageing; and strengthen the fiscal system to improve fiscal sustainability. These are all laudable and necessary goals in our opinion, some of which have been written into China’s Twelfth Five Year Plan. But the World Bank also says that these strategies will require China to change many policies and reform its framework of institutions. And that, of course, is where it all gets tricky.

Not that China’s leaders don‘t get it. Premier Wen Jibao recently acknowledged, to the Western media at least, that without political reform, China would be unable to implement economic reform effectively. He said,

26 For a China focus, see George Magnus, ‘Is China tearing the rule-book apart?’ Economic Insights, UBS Investment Research, 16 March 2011. For a comprehensive and historical assessment, see Darren Acemoglu and James Robinson, Why Nations Fail, Crown Publishing, 2012 27 China 2030 - Building a Modern, Harmonious and Creative High Income Society, The World Bank and Development Research Centre of the State Council, PRC, 2012 28 Equatorial Guinea, Greece, Hong Kong, Ireland, Israel, Japan, Mauritius, Puerto Rico, South Korea, Singapore, Spain and Taiwan.


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‘Without successful political structural reform, it is impossible for us to fully institute economic structural reform and the gains we have made in this area may be lost. The new problems that have cropped up in China's society will not be fundamentally resolved, and such historical tragedies as the Cultural Revolution may happen again.’29

Quite what he meant by ‘political reform’ isn’t clear, and won’t be until China’s new leaders are firmly in the saddle. The political ramifications of the Bo Xilai affair earlier this year has made China’s once-a-decade change in leadership particularly noteworthy. For, on taking office, China’s new leaders will have to implement an agreed political agenda for the coming decade and to resolve how they will deal with an economy that is slowing down partly by design and partly for cyclical reasons but in the context of rising structural growth constraints.

Most likely Wen and other leaders believe that the Communist Party has to become more responsive to citizens, and eliminate itself of the kind of behaviour apparently associated with the Bo Xilai affair. They probably don’t mean more liberal, market-oriented reforms and the development of an independent legal system. But these changes are precisely some of those that the World Bank report urges China to make to rectify the major imbalances in the economy, and lessen the chances of economic and financial instability. Although there is a strong focus on the growth drags arising from weaknesses in the property and construction markets, and in foreign trade, it is China’s economic model that needs changing.

Old friends: savings and investment China’s economic miracle was built on the reforms inspired three decades ago by Deng Xiaoping, who forged a consensus for a radical change in economic direction. It was and remains in keeping with Chinese history and custom that this consensus provides for (a) the continuity of the primacy of a strong bureaucracy, i.e. the Communist Party of China (CPC), and (b) the deference of citizens to a benign government that would deliver both an escape from poverty, and rising living standards. The CPC’s legitimacy rests on this simple social contract. It has prevailed and succeeded so far because it has encapsulated the virtues of autocracy and no-nonsense decision making, it has been able to manage social stresses, and it can boast high savings, large international reserves and generally healthy private sector balance sheets.

But China’s needs today are different from those that Deng sought to address 30 years ago, and which his successors have met successfully. Earlier, we alluded to China’s rapid ageing and labour force consequences, the excessive weight of investment in GDP, and the slowdown in TFP and potential growth. The principal task of rebalancing the economy, as is well understood, is to raise the consumption and personal income shares of GDP, while managing the decline of the investment sector’s weight in and contribution to growth.

29 Reported in The Guardian, 14th March 2012


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Chart 13: China: national savings and investment as share of GDP, 1980-2012

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As and if this happens, China’s infamous external surplus, which is the difference between savings and investment, and currency reserve accruals should decline permanently. But we see little persuasive evidence that this rebalancing is happening yet. True, China’s current account surplus has fallen from 10% of GDP before the crisis to 2.8% of GDP in 2011, i.e. the imbalance between savings and investment has declined already. Investment has risen for structural reasons, due to strong manufacturing productivity, the relocation of global manufacturing to China and its low domestic cost base. Cyclically though, the main factors were the surge in investment after 2008, weaker foreign demand for exports more recently, and some decline in the terms of trade (higher import prices and real exchange rate).

Shouldn’t we expect this sort of rebalancing to continue? As China’s urbanisation rate rises, aggregate consumption should increase. Rapid ageing and labour market effects should push real wages up and lower aggregate savings. And slowly, government policies designed to bolster income security and transfer income to people with a high marginal consumption propensity, should also help to lower savings. In the last 3 years alone, access to primary healthcare has improved, especially in rural areas, the government has acted to achieve universal health insurance by the end of this year, government pension schemes have been expanded and made more flexible for job changers, and a major social housing programme is underway.

At the same time, the growth of fixed asset investment has been slowing down to a near 5 year low (20.4% in the year to June)30. It portends weaker growth in real capital investment growth to levels that are more in line with or a bit higher than real GDP growth. Last year, the increase was around 9%, down from 19% recorded in the wake of the 2008 stimulus programme. The monthly fixed asset numbers will soon tell us if the government’s latest moves to ease monetary and

30 Fixed asset investment, released monthly, shouldn’t be confused with and isn’t the same thing as domestic capital formation, presented quarterly with a long lag in the GDP accounts.


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credit restraints and spur new infrastructure investment are succeeding in stabilising the investment rate, or failing regardless.

Unfortunately, there aren’t strong reasons to expect current savings and investment trends to linger, and absent a major change in economic direction, China’s surplus is likely to start expanding again before long. The IMF has recently revised its projections of China’s current account surplus to 2017 lower, but it is the directional change, back to 4-4.5% of GDP, that is more important than the eventual level.

Familiar flaws When we look at core savings and investment trends and determinants, there isn’t really much that’s changing, bearing in mind that successful rebalancing requires much of the heavy lifting to be done by lower national savings, not even faster investment growth. High levels of corporate savings have not fallen much, despite stronger wage growth, higher import prices and a stronger Yuan. The squeeze on corporate profits that seems to be happening now may be changing this, though we shall have to see if any decline is compensated for by higher personal sector savings.

There is certainly no evidence that aggregate household savings are declining as a share of GDP, or that the aggregate consumption share has started to rise from a deep trough - regardless of the buoyancy of retail sales. And for all the plaudits of social and income security reforms, benefit levels and scales remain relatively low and limited.

The slowdown in investment growth, as such, is welcome. But the danger is that easier financial policies and higher infrastructure spending approvals will simply prop up a model that is sustaining uneconomic levels of production and investment. Consider, for example, the case of LDK Solar, established only 7 years ago, and now the world's largest producer of solar wafers in terms of capacity, and a leading producer of high-purity polysilicon and solar modules. Here is a modern company operating in a space that many people think is cutting edge.

The company has suddenly found its sales revenues in the first half of 2012 down 75% on a year ago, it has high levels of inventories, and it has reportedly defaulted on payments of 600 million Yuan to 20 raw material and equipment suppliers. And yet, officials in Jiangxi, where it is based, are endeavouring to protect its creditors and improve its financial position31. LDK Solar isn’t alone. It is one of the 10 large solar companies in China that have collectively accumulated debts of 111 billion Yuan, and it isn’t the only company facing financial difficulties. And solar manufacturers aren’t alone either. Many other industries are facing year-on-year declines in profits, even as nominal revenues continue to grow, and producing at levels, or at all, that can only be sustained through state largesse of some form or another32.

31 Shining a Light on Too Big To Fail in China, http://english.caixin.com/2012-08-13/100423409.html, 13th August 2012 32 Ministry of Finance data show SOE profits down to 1.2 trillion Yuan in the first half of 2012, down 13.2 % over a year ago, while revenues were up 10.4%.


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These anecdotes bring us back to the ‘model’, rather than any particular policy or strategy. Part of the problem is the pure economics of factor prices: the prices of land, water, energy, labour, money and capital are not sufficiently high to drive resources out of investment- in to consumer-centric economic activities33. Part of it is politics: to have a real and lasting effect on factor prices, and therefore on resource allocation and overall economic efficiency, there have to be sweeping changes in the structure of factor prices, taxes, subsidies and so on. Never an easy task, this actually requires China to oversee a shift in power in the country, away from the political interests that have benefitted during the last 20 years, including SOEs, banks, prominent families, and local and provincial government and the military party hierarchy.

While the government has maintained, for the most part, a policy of ‘tough love’ with regard to the weakening property market and floundering developers, it hasn’t embraced the idea of ‘model change’, in which the functionality and role of the state are reformed, and the drivers of growth shift from less quantity- to more quality-related.

One way or another, China is going to rebalance. The question is whether it occurs in an orderly fashion with the investment side of the economy slowing to a rate less than the growth in GDP, but still growing. Or whether it happens in the context of a sharp decline in investment, with more alarming economic and political consequences that will cut across the economy.

After two decades of unparalleled economic success, we believe China now needs a reform programme on a scale similar to that adopted 30 years ago. Without it, a heavily investment-centric and credit-intensive economic model could soon become unstable, and later stall in a middle income trap. There’s only so much labour transfer from rural areas to urban factories. There’s a limit to how high the investment share of GDP can go. Rapid population ageing is chipping away at Chinese growth. The exceptional impact of accession to the WTO a decade ago is fading. And the significant, direct role of the government, state banks and SOEs in the economy as agents of economic policy, and owners and providers of heavy investment and infrastructure may no longer be appropriate as the economy becomes richer, more complex, and in need of greater competition and innovation.

In our view, the bottom line about reform is whether the CPC is willing and able to do three fundamental things. First, we feel it should move towards a fuller market economy, changing the legacy role of the state. Second, it should allow power to drain from itself, regional governments, state entities and the military towards the private sector and households. And third, it should introduce rules and transparency, including adoption of the rule of law, into the overall system of governance.

33 For example, there is no market-based cost of capital, land is provided free to enterprises to attract investment, and water prices are a third of the global average. The total value of factor market distortions may amount to around 10% of GDP. See Ashvin Ahuja et al, An End to China’s Imbalances?, IMF, Working Paper WP/12/100, Washington DC, April 2012.


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You can be optimistic or pessimistic about the outcomes, but you can’t speak of the China or, by implication Asia, miracle nowadays, without considering the chances of successful political and institutional reforms. More to the point, perhaps, what would the consequences be for China if, for existential reasons, the CPC wasn’t willing or able to go down this path?

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