China’s Economic Boom:
What Does It Mean for the Rest of the World?
By Pieter Bottelier

The doomsayers on China’s economy were wrong. China’s meteoric rise has surprised most observers, with its economy easily outperforming even the most optimistic expectations. In recent years, China became the world’s fourth-largest economy and third-largest trader. Goldman Sachs predicted in its BRIC (Brazil, Russia, India and China) study that China would become the world’s second-largest economy somewhere around 2015 (third-largest if the European Union is counted as one). No other large economy has grown so fast for so long—over 9 percent per year on average for a quarter-century.

Many of us were skeptical of China’s ability to transform itself so quickly and so drastically without tearing itself
apart. We underestimated the capacity of China’s leadership to recognize problems and take corrective or preventive action.

Most pundits expected much slower economic growth after the Asian financial crisis of 1997–98; some predicted stagnation or even collapse. As recently as 1999, Gerald Segal, then-director of the International Institute for Strategic Studies in London, wrote in Foreign -Affairs, “In truth, China is a small market that matters relatively little to the world, especially outside Asia.” At the time, Segal’s opinion was widely shared.

Many factors have contributed to China’s extraordinary economic growth. Among them:

• the quality of leadership and the singleminded dedication to development of the political system;
• the government’s pragmatic, institution- building approach to managing the reform process;
• the country’s high domestic savings rate, which permitted unusually high investment and the creation of modern infrastructure;
• openness to foreign trade and investment combined with enormous efforts to learn from international experience;
• constancy in reform direction and relatively effective macroeconomic management; and
• the unleashing of domestic private entrepreneurship.

Uneven Results
Although per capita income has increased tenfold since the start of re-forms in the late 1970s, China is still in the
ranks of “low-income” countries. China’s growth has lifted hundreds of millions out of poverty and created an urban middle class. But it has also caused serious environmental degradation and social inequality.

Most remaining poverty is concentrated in resource-poor rural areas, but urban poverty, once practically eradicated, is returning. Access of the poor to basic health and education services has become more difficult. One of the main sources of frequent rural protests is the lack of fair compensation to farmers for land needed for urbanization and
industrialization. The new national social security system (including special safety nets for redundant workers) is a
work in progress. Sharply increased labor mobility and upward social mobility are important safety valves on the system. Recognizing the severe social stresses and environmental problems that have developed, the government is focusing more on social and sustainable development in the 11th Five-Year Development Guidelines (2006–10).

China’s economic transformation is based on gradual, homegrown, often unorthodox reforms. In the 1980s and 1990s, most price controls were eliminated through the use of temporary dual-market structures that have no place in “Washington consensus” thinking about reform. State banks served as fiscal agents and social shock absorbers for many years. Serious financial sector reform was kept for later. During the first 18 years of reform, state banks accumulated nonperforming loans on their balance sheets while a more efficient non-state economy was encouraged to grow in parallel. In this way China avoided massive layoffs in the public sector before the system could deal with the consequences. Between 1998 and 2003, public sector employment fell by no less than 45 million, but unemployment increased only marginally because the large and rapidly growing non-state sector was able to provide alternative job opportunities. The state’s share in manufacturing output declined from over 80 percent in 1979, when reforms began, to about 22 percent today. The relative importance of private enterprise and private sector employment, already dominant, continues to grow.

Although all parts of China are expanding, the pace of reform and development is unequal across the land. Coastal provinces have grown faster than inland ones for most of the period since 1978, but in recent years some inland provinces such as Anhui, Chongqing and Xinjiang have been the star performers. Some provinces (Zhejiang, Fujian and Guangdong, with a combined population of 165 million) are already largely private sector economies. Private sector dominated provinces are growing faster than provinces where the state remains a key economic player.

Manufacturing output, employment and productivity growth have benefited enormously from large inflows of foreign direct investment (FDI)—initially mainly from the Chinese diaspora in Asia. Service sector development has also benefited from FDI inflows. In spite of these huge inflows, China has become a large net exporter of capital. Its official foreign exchange reserves, now approaching US$1 trillion, far exceed the country’s total external debt. China contributes significantly to America’s net-capital import requirements due to large current account (i.e., savings) deficits. China’s sovereign bonds are among the most highly rated on international capital markets.

Although the quality of macro-economic management has steadily improved, China is still struggling with serious
macroeconomic imbalances, based in part on a tendency to “over-invest” and “under-consume.” Its large and still growing external surpluses reflect for the most part internal economic imbalances.

Last Economic Frontier
Much progress has been made in strengthening the role of markets and reducing the role of the state in the economy, but the country’s financial sector remains largely state-owned and state-controlled. It is the last major frontier in China’s economic transformation process. Under the terms of its WTO membership, China committed to open the financial sector to foreign participation and competition by the end of 2006.

The pace of financial sector reform, including the corporatization and recapitalization of state banks, has quickened in recent years, but much remains to be done. Corporate governance standards are relatively low, in part because financial system reform has not been completed. Through the financial system and state ownership of land, China’s government exercises more control over the economy than its modest (and declining) share in output would suggest.

Impact on Other Countries
Because of its size, China’s rather sudden economic rise presents enormous challenges for many countries, including the United States. Although economic reforms are incomplete, the Chinese economy is already so large and so deeply integrated in global markets and supply chains that the effect of China’s growth is felt globally. The positive effects far outweigh the negative ones. An economic crisis in China is not something to wish for; it would have significant harmful spillover effects in Asia, North America and Europe.

Reasons for China’s current international competitiveness go well beyond low wages and an undervalued exchange rate. Other factors are: (1) the large size and growth potential of domestic markets, (2) a relatively open trade regime, (3) relatively high quality physical and information technology infrastructure, (4) relatively low overheads and capital costs, (5) generous tax incentives for foreign investors (which will have to be removed under the WTO’s level playing field requirement), (6) macroeconomic stability and consistency in reform policies, (7) availability of highly trainable and disciplined labor, (8) growing availability of managerial and scientific personnel and (9) large local networks of inter-firm supply chains.  

Even if China revalued its currency by 15 to 25 percent, permitted free labor unions and complied fully with international trade and intellectual property rights rules, it would still be a formidable competitor on the world scene and a threat to many established industries in developed countries. China’s entry into the world economy in this age of free trade, capital mobility, low transport costs and information technology for everyone means nothing less than a relatively sudden enlargement of the global labor force, linked through integrated markets, by an astonishing 25 to 30 percent. The challenge of absorbing such a huge increase in the globally linked labor force in a relatively short period of time is without precedent.

The impact of China’s growth on other countries is unevenly distributed. For example, Japan, Mexico, South Korea and Taiwan are affected more deeply than the United States. Following termination of the Multi-Fibre Arrangement on January 1, 2005, the most affected economies, at least in the short term, are those that depend heavily on the production and export of garments and textiles—products in which China has strong comparative advantage—such as Bangladesh and Morocco. On the other hand, resource-based economies such as those of Argentina, Australia, Brazil, Canada, Chile and Peru experience fewer adjustment problems and enjoy more immediate benefits from China’s rise. For many African countries, China is a major customer for raw material exports, a competitor on consumer markets, an important source of foreign aid and investment or all of these.

Neighboring countries in Asia that saw China’s rise primarily as a threat only five years ago, including India, are now more focused on actual and potential benefits from trade and investment relations with China. To exploit the opportunities more fully, several regional free trade agreements have been formed or are under negotiation. Industrialists in Japan and South Korea now fear a possible slowdown in China more than its continued rapid expansion. For both countries, China has become their largest foreign customer. India-China trade is also blossoming for the first time.

Over the past decade, China has become one of the most open large developing economies (as measured by the trade/gross domestic product ratio and FDI inflows and outflows) and also serves as an engine of regional and even global growth. China’s ferocious appetite for imports accounted for over 30 percent of global export growth in 2004 and 2005. U.S. exports to China (about 6 percent of the total in 2004) more than doubled since 2000, while U.S. exports to the rest of the world essentially stagnated.

Looking to the Future
Longer-term international economic effects of China’s rise are harder to predict. Much depends on the outcome of Doha Round negotiations (assuming they resume), the containment of rising protectionist sentiments in the United States and Europe and other factors. Having benefited so much from globalization already, China likely will continue on this route, strengthening its global supply and client networks through outward FDI and free trade agreements, supported by diplomatic initiatives.

Many of China’s current cost advantages are only temporary. Unit production costs will probably rise as productivity growth is unlikely to match the 8 to 10 percent annual rise in real manufacturing wages observed since 2001. Multilingual, experienced Chinese managers and technical specialists already command salaries that are approaching international levels. Overheads (for example, office space, legal costs, consultancy services) and utility costs are also rising. Tax advantages for foreign firms will gradually disappear as China establishes level playing fields required by the WTO. Because costs are rising at unequal rates across its country-sized provinces, countries like Vietnam, Bangladesh and even India may compete with inland provinces in China for new FDI and the relocation of industries. Much more China-related change lies ahead for the world.

Will China also reform its political system? Political change has lagged far behind economic reforms. If we accept Nobel Laureate Amartya Sen’s thesis that development is a process of “expanding the real freedoms that people enjoy,” China will have to democratize if it is to reap the full benefits of its economic success.

Pieter Bottelier is a senior adjunct professor of China Studies.