China's Development: Assessing the Implications

• Accomplishments
• Economic Engine?
• Cultural / financial issues
• Future of the World?
• Bubble?

Introduction

China has been achieving an impressive rate of development of its economy and increase in its regional / global economic and political influence. There has been speculation about its future potential to act as a major driver of the global economy, and whether its methods will provide the model that others will now seek to emulate.

In relation to this, the present document will suggest that:

• China's accomplishments have been remarkable over the past 2-3 decades, especially when considered in the light of its history;
• acting as an 'engine' of the global economy would be impossible unless China fundamentally changes the economic methods which have underpinned its recent progress - because the latter involved unproductive use of capital and protecting financial institutions with bad balance sheets by maintaining a current account surplus (both in China and in many of its economic 'tributaries');
• cultural features affect China's ability to achieve such a transformation;
• if China were to be the pacesetter for the future of the world, this would be a world founded on practices that are incompatible with the principles that Western societies have sought in influencing the international order in recent centuries (eg individualism, individual freedom, a rule of law, coordination of economic activities through financial outcomes, democracy, and universal ethics which value all people rather than a particular group);
• China's rapid export / investment driven growth is likely to prove to be a 'bubble' because of its: state-driven economy reliant on administrative methods for managing economic and financial outcomes; dependence on exports and on others' ability to productively use its financial 'waste'; exposed banking institutions; environmental stresses; fast aging population; and unstable political climate.

China's History and Recent Accomplishments

China has achieved spectacular recent progress in the face of immense difficulties.

Some History

China has the longest continuous national history (something like 4000 years) and was politically, militarily and economically dominant in its region (and also globally significant) for most of that period.

For much of that period, this was based on a system of imperial regimes - administered by Confucian bureaucracies who sought wisdom from a study of the past.  This seems to have been based on views about the nature of knowledge, society, power, economic goals and governance that are quite different to those of Western societies (see East Asia).

In overly-simplistic terms China was apparently held together through cultural conformity (backed by force) [1]. 'Harmony' and learning were idealized under Confucian traditions and achieved through a form of centralized soft-power ('thought control'). Under the examinations system the Emperor (the chief examiner) determined which of the best students the education system produced he favoured to control administration, and the bureaucracy then exerted state power primarily by guiding the way ordinary people understood the world. 

China's traditional regimes seemed incapable of coping with the more decentralized initiative and empirical (ie does it actually work?) knowledge of European powers during the latter's period of economic, military and political expansion from the 15th to the 19th centuries.

In 1911, China emerged from its feudal order - and then experienced decades of instability. It was governed to 1949 mainly by the Nationalist Party in the face of conflict with: imperialist warlords; Communists (at times); and expansionist Japan. The Nationalists favoured building China on the basis of traditional values and Confucian administration but were forced out in 1949 by the Communists led by Mao Zedong - who favoured breaking down the traditional social order, abandoning some of China's cultural traditions and adoption of a Marxian version of Western methods. Mao's 'cultural revolution' then largely deprived the country of its traditional intellectual capital (and made initiative impossible for ordinary people) - resulting in widespread suffering and economic setbacks.

Recent Progress

It is only in recent years, following liberalization reforms and a cultural counter-revolution in the late 1970s (under Deng Xiaoping initially), that China has made appreciable progress.

Massive external (manufacturing) investment was first attracted based on education and cheap skilled labour, while equally massive internal investment has more recently been mobilized in modern infrastructure and urban (including consumer) facilities especially in major cities. Despite China's intense population pressure, there was no shortage of land as traditional uses were simply demolished to make way - and existing residents apparently compensated with an apartment and better job prospects (though this process frequently generates dissatisfaction [1]). In China all land belongs to the state, and occupants only own the structures erected on it.

A key feature of China's rapid growth is seen to have been its ability to reform its economy very quickly to become more efficient [1].

In China's recent progress it is possible to see lessons learned from (a) Singapore's experience in building a modern 'Chinese' city with foreign investment (b) Japan's neo-Confucian 'industry policy' methods and disregard of Western financial disciplines (c) the Nationalist Party's preferred cultural alternative to Mao's version of Communism and (d) Taiwan's adoption of some US techniques. China seems to be attempting to implement a system of socio-political economy that has been little studied and probably can't be understood in terms of Western analogies or cultural assumptions (for reasons like those outlined in Structural Obstacles).

The short-term result has been an unprecedented and impressive rate and magnitude of gains in China's real economy [1, 2, 3, 4, 5, 6, 7, 8, 9], and a perception that it has excellent future prospects - even recognizing that it suffers structural defects [1, 2, 3]. Moreover some analysts have recently seen China as a 'safe haven' for investors concerns about a US asset bubble, and the structural problems facing Japan and Europe [1].

It is also argued that that China is playing, and will continue to play, a key role in promoting regional and global collaboration [1, 2].  It is seen to be challenging Japan's status in Asia, and to be the only country able to sustain a view of the world which is different to that of the US [1].

China has also been seen as a rising power that will force others to adjust because of factors such as: its huge human resources and markets; the emergence of a high class education system; and the external resources of Greater China which will provide the skills to allow its structural problems to be overcome [1]. A China-centred 'Confucian Union', similar to the EU, has been speculated for Asia [1]. 

China-led Asia has been seen to be returning to its historical role at the centre of affairs - which has had a huge impact on the global economic system similar to the long rise of Europe (and its American offshoot) to pre-eminence 500 years ago. [1] Its emergence has (as also in the case of India) been suggested to be simply a restoration of the position which had existed for most of recorded human history [1, 2]. The take-off by these two poor countries which account for 1/3 human population will make a huge difference to the global (and especially Australia's) economy. [1]

China has shifted from a unilateral stance in opposition to global institutions to working (often with great effectiveness) within those institutions [1]. A 'Chinese consensus' has been suggested to be a better alternative to the (so called) 'Washington consensus' (free societies and free markets) for developing economies [1].   The 'Beijing consensus' is seen to be characterized by putting political stability and development before (democratic / human rights) reforms [1].

Some have even argued that China is 'the future of the world' [1] - undergoing a rapid developmental process, building infrastructure and industrial capabilities that will put it into a position of immense power in 20 years - and replace the US as the world's dominant power by 2050 [1].  It has been suggested also that China's role as an economic engine shows that the 'Asian century' has already arrived [1]. 

China is seen to have features which are quite different to earlier challenges to the US's 20th century global dominance (eg Soviet Union, Japan) and to have the potential to create a future Asia-centred economic regime which others including the US can either be part of, or be excluded from [1].

A popular image now seems to be presented within China of a trendy, super-modern consumer society that will eventually be able to satisfy every material desire.

Though there are obvious environmental and political problems behind this image and China's model for socio-political economy may prove financially / economically un-sustainable, China's leaders present a confident face to the world and to Chinese people.

China as the Engine of the Global Economy

It has long been speculated that (because of accumulated debts) the United States is losing its ability to provide a strong source of demand and by doing so to support the growth of the global economy

This is considered in Structural Incompatibility puts Global Growth at Risk, which also argues that the US current account deficits party have an external source (ie an unsustainable potential deficit in global demand now exists because of the way in which the monetary and financial systems of major East Asian economies are managed - a deficit which the US has temporarily filled by creation of credit and foreign borrowings).

It has been argued for years that East Asia, China in particular, must in future provide the demand to sustain growth in the global economy [1, 2,  3,  4]. 

It has seemed that China's ability to act as a regional or global economic 'engine' depends on a strong US economy to provide export demand and on massive domestic capital spending which is ultimately likely to be unsustainable.

In 2004 there was also an expectation that Japan would be able to take the role of driving global growth because of its expansionary macro-policies [1] - a hope that clearly has not been realised.

In 2007 global financial instability (which initiated in the US) was accompanied by expectations that 'decoupling' of the global economy from that of the US (with growth driven in future by emerging economies especially China - and also India) would allow strong global growth to continue [1]. 

This is considered further in Decoupling: A New Urgency which suggests that, though dependence on exports to the US might be reducing, there are much more complex requirements for real decoupling and that the most important of these relate to success in the 'symbolic' economy rather than to outcomes in the 'real' economy.

Cultural and Financial System Considerations

Despite the emergence of growing consumer demand [1, 2], It seems culturally implausible that East Asia generally (or China in particular) will ever be more motivated or capable than Japan has been to develop a sufficiently strong economy to provide a primary source of support for either domestic or global demand. 

Before (say) China could increase demand enough to act as a real 'engine' of the global economy:

• it would have to increase domestic demand to the point where it has a substantial current account deficit which would steadily erode its accumulated foreign reserves; and thus
• the balance sheets of its financial institutions would have to be sound enough to be able to borrow in international capital markets - which must be impossible if the basic mechanisms of its economic / enterprise management remain biased against achieving positive financial outcomes. 

In reality, despite efforts that have been made at reform, China appears to be at more risk of suffering a financial dislocation than it does of curing the balance sheet problems facing its institutions and driving global growth.

China's reported shift in early 2006 towards boosting consumption (rather than exports) to drive growth [1] (and the weakness of US demand associated with its 2007 financial problems) seem likely to eventually expose China's 'skeletons'.

China as the 'Future of the World'?

An even more ambitious view has been that China is 'the future of the world', and will be the world's dominant power by 2050 - a view which parallels 1980s' expectations about Japan. Moreover a case can still be made, from the viewpoint of Asia's nationalists, that Western economic and military strength must decline.

The address by China's president Hu to Australia's parliament in October 2003 laid out what may be seen as the high-minded and constructive principles which China would support in continuing its rise. It gained many very favourable reactions [1, 2, 3, 4].

However there are unstated aspects of this proposal that also need to be considered. These include: China's radically different approach to universal values and human rights; the practical consequence of cultural differences (including the unfamiliar character of China's 'market' economy); and China's efforts to re-establish its historical dominance in Asia (perhaps now including Australia?).

The suggestion that the 'Beijing consensus' (which emphasizes social / political stability enforced by autocratic elites) would be an alternative to the 'Washington consensus' (which emphasizes liberty) as the basis for a model of socioeconomic development is undoubtedly valid. However both suffer from the limitation that they can not be extended globally without transmission of the cultural characteristics which are required for them to work.

The Western model (typified by the 'Washington consensus') requires (for example) individual liberty as an essential feature because it is at the level of individuals that rationality / abstract analysis can be most effective in making economic decisions.

Similarly the 'Beijing consensus' is contingent on specific cultural features, in particular "the ancient Chinese philosophical outlook that makes little distinction between theory and practice" [1]. This is essential for the model to work, because where economic theory is separated from practice, theory oversimplifies reality (because of the huge complexity of economic reality) and thus results in poor decisions. This is the foundation of the neo-liberal view of economics - which is embodied in the 'Washington consensus' and ultimately based on Hayek's recognition that it is impossible for any central authority to assemble the information required for correct economic decisions (see 'The Use of Knowledge in Society', 1945). When there is little distinction between theory and practice (ie where elites encourage decision making by practitioners, rather than themselves making decisions on the basis of abstract analysis), this difficulty can be reduced. However in countries which lack this cultural feature, attempts by authoritarian elites to guide development must result in economic and political failure.

Outside East Asia, adoption of the 'Beijing consensus' would (as for the 'Washington consensus') only be successful if the cultural foundations on which it is based were also adopted by others;

• Constraints (Economic, Financial, Environmental, Demographic and Political)
• Initiatives
• Is Optimism Justified?
• Crisis Scenarios

China as a Bubble?

As noted above, no one should doubt the spectacular progress which China has achieved in the face of immense difficulties, or the creativity and effort which that progress reflects.

But, tragically, rather than regional and global leadership in economic and political affairs, the more probable outcome is that China's future prospects will be limited by its economic, financial, environmental, demographic and political challenges.

The possibility that rapid growth could be disrupted due to economic overheating was recognised in 2004. Efforts to avert this (and seriously deal with other constraints) were redoubled, but may have been inadequate.

Global financial instability in 2007 adds to China's risks despite official confidence in its invulnerability. It also made the possibility of real 'decoupling' of emerging economies (especially China's) from economic conditions in US a matter of considerable global economic importance (see Decoupling: A New Urgency - which addresses in particular the apparent dependence of East Asian economic models on strong financial institutions in other countries, eg US).

It is the present writer's suspicion that China's rapid progress is unlikely to be sustainable though when and why the 'bubble' will burst is unpredictable.

Constraints

Economic Constraints

The Chinese economy appears to work on neo-Confucian dynamics which are a different version of the (supposedly 'non-capitalist market' economy) that Japan practiced.  Government influence is strong in all aspects of society, and this arrangement is perceived by elites to be as it should be [1].

In particular China retains a 'state-driven' economy and has experienced highly unbalanced development. For example:

• many sectors (eg agriculture, mining, basic manufacturing) remained backward in the 'growth at all costs' emphasis on infrastructure and foreign 'high tech' investment [1] - and as this imbalance is recognized and the most obvious backward sectors / regions are addressed, new backward sectors must emerge if the economy remains state-driven;
• serious infrastructural deficiencies have emerged [1]. Energy industries have been developed on the basis of national self-sufficiency rather than market requirements [1]. Huge losses were incurred (related to poor corporate governance) when state enterprises engaged in futures trading [1, 2]. Fuel shortages have emerged because local oil prices were not allowed to rise when global prices increased [1].
• growth has been export dependent - because a current account surplus has been needed to protect financial institutions from the need to borrow internationally - as the latter would lead to a financial crisis because of their poor balance sheets (see above);
• growth is overwhelmingly driven by investment, rather than consumer demand [1]. Investment has mainly been by state institutions (eg in infrastructure) and foreign investors. The former have been adding to bad debts in the banking system (see below). Very high rates of industrial investment could have created an overcapacity which could have a deflationary impact [1]. Most of that capacity has been created on the basis of expected:
  • strong export demand [1]. In practice this can not be maintained unless the growth of demand elsewhere allows the US current account deficit to be reduced. And there does not appear to be anywhere else for that demand to arise (see Structural incompatibility puts global growth at risk). Moreover, in late 2007 financial / economic difficulties facing the US economy seemed likely to reduce consumer demand for China's exports (see Financial Market Instability: Two Sides of the Story).
  • domestic consumption - which is constrained (for reasons outlined above);

In 2004 China apparently concluded that its investment-driven economy had become overheated because of:

• fast growth of steel, aluminium, cement and property industries; accelerated fixed investment; shortages of coal, power, oil, transport; fast money supply / credit growth; potential inflation; and the failure of banks to follow instructions to curb lending [1];
• overcapacity which emerged in many industries [1].

Many observers suggested that government actions to slow growth would lead to a 'soft' landing [1, 2, 3, 4] - though not all agreed [1] - and in fact little slowing occurred.

'Blunt' tools are all that are available to manage economic growth. Altering interest rates will not do so as these are not main mechanism used to ration credit, and provinces (who control much infrastructure investment) apparently resist central government economic directives [1, 2]. Restraining high risk investment by state companies in the face of an uncertain economic environment seemed to remain a problem for government in 2007 [1].

Furthermore it is hard to anticipate the consequences of administrative controls on credit (eg it is easy to over-correct, while targeting specific sectors for slowdown will create unpredictable repercussions for other activities that depend on them).

Economic history does not suggest that administratively orchestrated investment is likely to be sustainable. For example:

• the Soviet Union experienced very rapid investment-driven growth in the 1950s but subsquently stagnated economically because investments determined by socialist administrators often turned out to be in things that were not really needed
• in the 1980s Japan's success with state orchestrated exports led to economic triumphalism and a massive investment surge overseen by neo-Confucian with little regard for profitability. This ended badly, and Japanese observers have suggested a parallel with China's current situation [1]

China's private sector (which operates in parallel with large and traditionally unprofitable state-owned-enterprise) is weak. Industrial growth has mainly been achieved on the basis of foreign investment, rather than by creating an environment which would support the initiative of indigenous firms [1, 2]. Moreover historically China's mandarins and cadres have always given low status to domestic enterprises - and favoured foreign businesses [1]. Rather than enhancing the environment for private indigenous firms, efforts in recent years to improve China's economy have focussed on raising the productivity of state enterprises and claimed achievements in this may be based (at least in part) on 'cooking the books'. 

Moreover:

• those who have become rich in China are well connected politically. There is confusion between ownership and management. Those who control and personally gain from assets may never have paid for them - but argue that previously the assets belonged to the people, and 'we are the people' [1];
• while foreign investment has a significant role in driving growth, it has typically been unprofitable for investors [1, 2, 3, 4]. Many firms have invested not because of current profit expectations, but because of hope for future profits [1].  China has a reputation for demanding much, and giving little - and for foreign partners gaining much less, and spending much more, than they expected [1, 2]. As this may not be a transitional situation but rather reflect the the communitarian / nationalistic nature of the business environment (featuring a preference for thin margins and accumulating wealth through savings rather than profits, as well as subsidies for those with connections [1] and a desire to make sure that foreigners do not profit), a high rate of ongoing foreign investment appears uncertain - though there are claims that this situation has started to change [1]. But, though profits have increased in recent years, profit levels remain well below those gained elsewhere [1].
• based on slender evidence as the subject does not seem to have been studied, it seems that an industrial development system has been deployed - which has parallels with that in Japan and has mainly had the effect of accelerating (without directing) change by engaging social elites in intelligence gathering and networking through various institutional arrangements;
• emphasis is traditionally given to 'real' production, rather than to profitability (see above), and this is reflected in the losses incurred by banking institutions;
• there is a critical sustainability difference between economic activity which is driven by the volume of business (ie by market share, as has apparently been the motive in Japan and now China) as compared with that driven by the value-added. Profitability is a much more discriminating indicator for efficient resource allocation, than is turnover. Even though the latter initially yields impressive results through increased (low cost) inputs, growth can only be sustained in the long term if it is based on productivity (value-added) growth. Other indicators of this constraint involves a reported heavy emphasis on investing in 'things', rather than in human capital [1].
  • It has been suggested that China's growth could be surpassed by India because of the latter's emphasis on domestic businesses rather than on foreign investment, and on business profitability [1, 2]. India's balanced approach also involves greater reliance on growth of domestic demand [1], and on R&D [1]. Moreover India is globalizing in services and these offer far better margins than manufacturing, and with an effective legal system and financial system it is much easier for others to work in. [1]
• the measurement of economic growth is subject to uncertainty [1, 2, 3] - because 'financial' statements about what is being achieved don't necessarily mean much;
• China's competitiveness ranking is not high - given concerns about state industries and corruption [1];
• currency controls have stabilized the exchange rate against $US and directed resources to production rather than consumption. Such controls may have been damaging [1, 2] by:
  • limiting imports which are a major part of the gains from trade - through providing (a) access to goods and services which would otherwise not be available, or be more costly; and (b) the stimulus of competition to domestic producers;
  • increasing domestic money supply (as hard currency inflows have to be exchanged for yuan or government debt) leading to inflationary pressures, and to an unsustainable expansion of public sector debt. The availability of surplus cash is seen to have created bubbles in automobile purchases, real estate and steel [1];
  • minimizing pressures on government for policy reforms;
  • increasing the risk of inflation [1] - which in 2007 was becoming a major problem.

The World Bank pointed out that China's growth pattern is based on cheap capital - and this is unsustainable. Rapid gains in manufacturing productivity and stagnant agricultural productivity drive inequality. Growth, it suggested, can't be sustained without household demand and service industries and reduced emphasis on exports and resource inputs. [1]

Financial Constraints

China seemed to be becoming a new economic 'bubble' at risk of bursting eventually (and creating renewed Asia-wide / global financial turmoil) because:

• a huge fiscal stimulus (ie high public spending and deficits) was required for years to achieve a sufficient rate of growth to absorb labour force growth and workers displaced from failed state enterprises in the face of international economic weakness [1, 2].
• investment has accounted for a very high percentage (eg > 50%) of output and mainly involved development of infrastructure and urban facilities by state institutions financed (often unprofitably) by banks drawing on local savings - and generating bad debts [1];
• China's growth appears to be being driven largely by massive investments with limited concern for return on investment [1]
• the banking system has been a disaster area in terms of non-performing assets, and technically insolvent institutions [1, 2, 3]. The IMF warned of the risk of a financial crisis [1]. This system transforms the savings of China's people into bad debts. As argued above this seems more likely to be a consequence of cultural traditions rather than the residual effect of a socialist history. It was not subject to internal reform pressure or to external checks because China finances itself internally (and has generated large foreign reserves) - but there are no precedents suggesting that these contradictions can be continued indefinitely.  External financial institutions have to be allowed entry by 2007 under WTO requirements [1]. The value of China's bad debts exceeds its foreign exchange holdings [1] - and some foreign exchange holdings are already committed. The possibility of a financial crisis is considered further below;
• there is uncertainty about the financial viability of massive housing investments - as the average price / household income ratio is three times greater than normal [1]
• China's economy has grown rapidly but not been very productive - as shown by bad debts in the banking system and huge government debts. It may be seeking to correct decades of economic mismanagement through pressures imposed by seeking WTO membership but there is little room to manoeuvre and time is running out [1]
• emerging private areas of the economy also have limited concern for profitability - and a significant economic downturn could emerge if banks are forced to tighten up on credit conditions [1];
• the buffer of foreign reserves which has protected China's perhaps-insolvent financial institutions started to be eroded by:
  • a current account deficit which emerged - as growth was increasingly driven by urban / infrastructure investment rather than exports, and imports of components of goods to be exported increased from elsewhere in Asia;
  • weakening of export growth [1];
  • the need for Chinese companies to make mainly-defensive foreign investments (which may result in losses because of management difficulties and paying too much in an economic / resource boom) [1];
  • drawing upon foreign reserves to recapitalize insolvent banks [1];
  • drawing upon foreign reserves in a $20bn bid by CNOOC (a state owned company) to buy Unocol to increase China's oil security [1].
• also China's balance of payments surplus depends on continued high rates of foreign investment - given reduced current account surpluses - and this is not assured because of such investment is frequently unprofitable and would not be maintained if export demand faltered.
• there is a further risk of very large foreign reserve losses if the US current account deficit is not reduced and financial markets devalue the $US (in which most foreign reserves are held) at some time after the Yuan is untied from the $US;
• massive overcapacity, and a collapse in profits, have emerged in vehicle production by investment on the assumption of continued 70% pa growth in domestic demand which has not eventuated [1]. A low level of capacity utilization (around 60%) appears (in mid 2005) to have emerged in many industries - and this will increase the exposure of banks to bad debts;
• much urban investment is simply being wasted - and there is vast industrial overcapacity and low returns [1]
• problems that create the risk that the bubble may burst include: artificially high property prices; a weak banking system; poor corporate regulation; an immature legal system; and official corruption [1];
• intense competition within China could lead to a classic business downturn. As margins are small and pricing power is nil, weak profits could lead to low investment / growth. [1]
• China's economy is unbalanced - with 45% of GDP invested (suggesting over-investment). Its low interest rate policy (a bye product of $US currency peg) has led to property speculation - which could bust. High reliance on exports could halt growth as the world will not indefinitely tolerate its mercantilist exchange rate policy. China's growth has not been due to productivity improvement but to huge investments in bringing part of its rural labour surplus into a market economy - and it won't achieve high rates of productivity gain without adopting free market economic principles [1]
• China has made significant progress since opening in 1978 - but liberalization has stopped before dealing with financial sector. Investment funds are channelled through state banks, while equity markets are dominated by state-owned enterprises. Financial repression has created a sea of bad debts; mis-allocation of capital; overinvestment in the state sector and private under-investment; politicisation of decisions; widespread corruption; poor stock-market performance; undervalued real exchange rate; and stop-go monetary policy. Financial reform is vital for development to continue [1];
• Chinese people are seeking profits through stock market and real estate investment which is like a pyramid scheme. It seems similar to Japan's asset bubble. China like Japan at that time has a loose monetary policy - which favours asset booms. China's growth is supported by foreign investment - that assumes that the currency is undervalued. This can't be corrected without large losses in China's $1.4tr in foreign exchange reserves [1];
• while China's share-market does not reflect the real economy, companies have come to depend on it and on property as a major source of profits - alongside their core businesses in which profits are increasingly squeezed [1];
• economic openness has increased the potential for instability within China's financial system [1]. For example:
  • large foreign capital inflows to China [1] (by investors seeking to reduce $US exposure in 2007 [1]) was seen as a risk of further over-heating (say) property markets, and China attempted to prevent foreign investment in such sectors [1].
  • falling US interest rates, while China's rise, makes it harder in 2007 to prevent rapid growth in property / stock prices in China. Continuing international turmoil encourages capital to flow to China, and strains it financial / regulatory system [1]

Blunt tools also appear to constrain China's ability to reform its financial system. For example:

• reforming China's financial institutions by making them act more commercially is problematical (as suggested above) if their characteristics are not (as Western observers apparently tend to believe) a product of socialism / communism but are rather a product of a communitarian / mercantilist economic regime which has deep cultural roots (eg emphasizes the 'real economy', rather than financial, outcomes - and involves economic coordination by 'connections' rather than by calculation of financial outcomes). Reform could disrupt the basic dynamic of China's rapid growth and development (as perhaps occurred in Japan); 
• government instructions to the banking system in 1999 to behave more commercially were apparently ignored [1];
• China's economic progress to date has been achieved by eliminating the most extreme obstacles to markets but the next stage (creating the institutions required for fair and stable markets will be much harder), and political changes needed to contain community demands for liberty could lead to instability [1]
• China has the most restricted capital market in Asia - and this has huge costs. Development can't continue unless capital restrictions are loosened - but such liberalization would put the current governing regime at risk of losing power  [1]
• problems in reforming China's financial institutions might be solved by privatization, and obstacles to this (eg lack of methods for setting values, and negative net worth) have been reduced by establishment of a State Asset Supervision and Administration Committee [1]. However this may not be an easy option if state ownership of banks is seen as essential for a 'socialist' economy [1] in an environment in which a (so-called) 'Chinese consensus' (a form of autocratic corporatism) is being promoted as a superior alternative to the 'Washington consensus' (free financial markets) as a path to economic development [1].

There have been ongoing financial reforms (as mentioned below), and possible progress. For example:

• amid rising input and wage costs, China's corporates are making best gains and efficiencies in sectors with strongest wage and material-cost pressures (which have been absorbed with little price rise, and profits contribute to high levels of corporate savings). Profit growth is high (37% yoy). China is now importing less intermediate goods from elsewhere in Asia - and this could improve the profitability of Chinese companies [1]

There are also plausible suggestions that reform has often been only superficial [1, 2]. Furthermore;

• while reform of its banking system is China's top priority because of the risk of a financial crisis, this may not be possible [1];
• while China is striving to present a number of major financial institutions (eg Bank of China) as financially sound and worthy of foreign investment and offshore listing, this seems likely to be being achieved by 're-arranging the deck chairs' rather than by solving structural problems [1]. In particular one major bank was recapitalized by drawing upon foreign reserves which merely transferred losses to China's central bank [1]. And in attempting to write off the bad debts of banks, it appears likely that state-owned companies (under no pressure to make a profit) would out-bid foreign investors [1] - and this outcome would (of course) merely 're-arrange the deck chairs';
• 'red chip' firms are experiencing rapid growth in China by buying up other firms - but their operating position is poor. Profits seem to come from financial engineering rather than performance [1];
• corporate profits have been boosted at least partly by squeezing workers' share of national; income. Wages' share of GDP fell to 41% in 2005 from 53% in 1998 [1]

Various other observers have have identified the potential for a serious China-centred financial dislocation [1] or suggested that this is inevitable in the next few years - and that this has the potential to turn an economic downturn into a global depression [1]. It can be noted that in the event of a banking crisis, it would China's government, rather than its (insolvent) banks, which would borrow heavily [1]. However China's government also has very high debt levels due to past public spending to sustain growth.

Environmental Constraints

China seems likely to follow the USSR as a place where (with the help of 'Soviet trained planners') the 'limits to growth' are transformed from an ecologist's theory into a nasty fact. For example:

• China has a huge population. Its cities occupy 50% of the countryside in fertile areas.
• it has immense constraints on soil and fresh water - which seem to be near their limit.  The water table drops 1.5m pa in major grain growing regions in North China [1]
• traditional sustainable agricultural practices have been traded for 'industrialised' agriculture.
• industrialization adversely affects people's health (eg air pollution has a wide impact) and the environment (eg loss of vegetation causes concern about desertification [1, 2]);
• the UNEP has argued that China could never achieve a high level of consumption due to environmental and resource constraints [1];
• as in the USSR very real environmental hazards have been ignored by autocratic government in the push to industrialize (eg the Three Gorges Dam project [1] was driven apparently by Li Peng, an influential Soviet trained engineer). Similar (smaller) projects in China have failed to live up to expectations due to silting - while international experience and experts on the environmental and economic impact of large dams suggest a more cautious approach);
• many people suffer diseases caused by pollution which have been ignored so as not to disrupt economic growth [1]
• China's environmental problems are mounting and pose a risk to economy and to public health. The economic miracle could end due of this - officials have warned. Central government has announced measures to address these problems, but it has little influence in the provinces. Solving this problem requires revolutionary political reforms.[1]

Furthermore the world does not yet have (and has no guarantee of ever having) a way of meeting China's escalating energy needs. It seems inevitable that global conventional oil production will peak sometime over the next decade - leading to shortages and rapidly rising prices. Fossil fuel usage really could become problematical given the possibility that global climatic change could be more severe and rapid than traditionally assumed [1]. Alternative energy sources seem to remain unproven. China's economy uses energy very inefficiently in relation to GDP [1].

There were signs in early 2008 that the 'peak oil' phenomenon - and priority being given to the production of biofuels - could give rise to famine in vulnerable regions (and that China might be vulnerable) [1].

A radical change in China's economic model has been seen to be needed if growth is to continue [1].

Demography

China will face the most severe 'aging population' challenge in the world around 2030 because of its one child policy, and even now is suffering shortages of skilled young workers in its major cities (partly because lower educational standards in rural areas make rural migration an ineffective solution to the cities' problems) [1]

Political Constraints

China's political system is autocratic - and sits on top of a seething mass of minor potential local 'protests' - which constantly need to be suppressed [1] and which could get out of control if for some reason they were to gain critical mass [1, 2].

Moreover, the growth-at-all-costs approach has led to increasing social unrest [1] and problems in rural regions [1].

• China is planned economy - ruled by a single party.  Since Tiananmen Square great efforts have been made to ensure that educated elites are enmeshed with party - but this is not true of the masses [1];
• China has been seen to be close to revolt in regional areas because: population growth has reduced size of holdings; desertification has reduced arable land (just 14% of China); deforestation and pollution have reduced water available for irrigation; officials have imposed heavy taxes; and only 20% of farmers can access credit for productivity improvement - at the same time that urban middle class is entering an era of conspicuous consumption. [1]
• potential instability across Asia as a whole is seen as possible because rapid economic growth has not been matched by jobs growth, and unemployment rates are very high [1];
• there are now vary large numbers of affluent consumers who are not included in the one-party state [1]. In the absence of political reform economic growth can lead to instability, because of demands of rising middle class [1].
• Traditional authority structures (based on a Confucian 'merit-aristocracy') may not be viable because:
  • to some extent power requires access to superior information to influence subordinate's thinking and this is at risk because of widespread access to the Internet - as demonstrated by heroic efforts that have been made to devise an Internet system which allows censorship of disruptive ideas [1]. Such efforts to suppress access to information must inevitably prove futile in a networked society;
  • the Communist Party's practice of making no distinction between news and propaganda in the information which is released [1] is unlikely to work if a more knowledge-based economy is eventually to emerge;
  • Japan's economy stagnated for a decade, because of its traditional 'merit-aristocracy' - whose economic leadership promotes mercantilist goals (ie excessive 'real' production without ensuring financial profitability so as to accumulate US paper assets despite the insolvency of its bureaucratically-controlled financial institutions - see Scenario).  Writing-off the bad debts that Japan's financial institutions accumulated in the 1980s' asset bubble was vital to their future financing role, but this would have required a loss of status and control of the banking system by the elites descended from the Ministry of Finance (and also by the nationalistic gangsters (yakuza) who provide the discipline in Japan's social order [1], and control the often-technically-insolvent construction industry);

China reputedly has a 3000-4000 year history of repeated conflict between the commercial and materialistic cultures of South China and the rural and spiritual cultures of North China (see Seagrave S., Lords of the Rim). Conflict between these has seen the merchants driven out of China in many waves - to become the offshore Chinese. If China's commercial drive falters then the 'northern' influences concerned with 'higher' values may well again mobilize to suppress the 'greedy' merchants of the 'south'.  The potential for a new civil conflict is suggested by:

• the perceptions that public morality has collapsed in China in recent years [1, 2] and that East Asia now exhibits many of the worst elements of Western modernization [1]; and
• north-east China's continued status as a huge economically under-developed region [1];
• the emergence of Falun Gong in 1992 in the tradition of the White Lotus Society, which has been the source of earlier grassroots attempts to gain political power in China [1].

Tensions have also grown over Taiwan [1] which could, if not resolved, have an adverse effect on foreign investment into China.

Initiatives

There have been indications that China is getting serious about the constraints it faces.

Indicators include:

• comments on China's energy and environmental challenges [1, 2, 3];
• a peaceful transition of political power was achieved in 2004 [1];
• courts have been used in attempts to constrain arbitrary state power [1];
• the World Bank's positive assessment of the political and economic outlook - which also argued in 2003 that there is a very long way to go especially in relation to breaking export dependence and reforming financial practices [1];
• the leverage which WTO membership will provide to force structural reforms - though not all agree that this can be managed [1]
• the possibility of economic [1, 2], political [1] and social [1, 2] reforms;
• the IMF's argument that China had a strategy to build a sound financial system [see also 1, 2,] This appears to involve an intention to make China's banks 'real' and act commercially [1] and privatize them [1]. Some of the bad debts of China's banks are to be sold to foreign institutions [1]. Rules have been tightened making transactions more transparent - resulting in a significant decline in non-performing loans [1]; 
• efforts have been made to: boost domestic demand; use market mechanisms to manage economy [1]; and clean up the balance sheets of two major banks to attract foreign participation [1];
• a reported decision to abandon the 'growth at all costs' strategy in favour of reducing internal inequalities [1, 2] - a decision which (as noted above) seems inconsistent with acting as a regional / global economic 'engine';
• wages have been raised in rural regions in order to inhibit movement to the cities [1] - a strategy which will also favour economic development if the skill base is raised by discouraging investors interested only in cheap labour;
• Government has sought to reduce taxes on farmers. Also higher spending on health, education and the environment will increase socio-political stability [1]

• efforts have been made to boost consumption (rather than exports) to drive growth [1, 2].

Whether such reforms will prove sufficient is unknown.

Is Optimism Justified?

A case can be made that China's growth and development is assured despite the many constraints it faces. For example:

• China has huge human resources and potential markets. It has a high class education system, and can draw on external resources (Greater China) for the skills to allow its structural problems to be overcome [1];
• past obstacles have been successfully navigated, and (as above) this process is continuing;
• China's response to indications of over-heating in 2004 were satisfactory because (a) the problem was addressed by administrative controls rather than raising interest rates and (b) despite the bad debts of its banking system, China has large international reserves, a more-or-less balanced current account / a modest fiscal deficit and a closed capital account which prevents capital outflows [1];
• the 2007 credit crisis illustrates China's strength. A $1.3tr cash reserve has been built up in the 10 years since the Asian financial crisis - and the Peoples Bank of China believes that this provides insulation against crises elsewhere. Entrepreneurs have flourished in China, and the stock market has risen rapidly. There has been a flight of capital to Asia because of the credit crunch. The US / UK economies are heavily dependent on financial services - and these are in doubt [1]

There appears to be a very high level of confidence amongst China's leaders, and the message given to the people is that China's rise to world prominence / dominance is assured. The political consequences if this does not eventuate could be severe.

Crisis Scenarios

China's prospects are uncertain and (because of the constraints outlined above) its spectacular growth is likely to be derailed at some time.

There are many potential sources of crises including:

• economic imbalances - especially:
  • very fast growth driven mainly by investment by the state and foreign investors without adequate concern for return on state capital, and limited profitability of foreign investments directed towards China's consumers;
  • dependence on strong economic conditions elsewhere to provide demand for exports;
  • the unsatisfactory environment for domestic businesses, which are vital to filling the economic gaps left by foreign and state investors and so creating a balanced economy;
  • overheated markets (eg an apparent property bubble) that are at further risk from capital flows as a result of global financial instability in 2007
• the poor balance sheets of financial institutions, the dependence on strong financial markets elsewhere to productively invest the current account surpluses which are needed to protect those institutions and prevent currency appreciation; and the uncertain claims about improved productivity by state-owned enterprises;
• the blunt 'administrative' tools that are mainly used (and are all that are really available without extensive further reforms) for managing potentially-unstable economic and financial systems;
• environmental / resource obstacles to long term growth; and
• potential political instability. 

Moreover the interactions between such risk factors make government into a difficult (impossible?) juggling act. For example:

• the current account surpluses that are needed to protect financial institutions contribute to the global financial imbalances that put export demand at risk. Moreover the foreign exchange reserves that protect them are subject to other demands;
• the dependence on export demand can't safely be overcome without improving the balance sheets of financial institutions, and the latter seems to be constrained by cultural features (see above);
• there is a fundamental incompatibility between maintaining strict political control and essential reforms of financial systems;
• seeking to create a 'private sector' to fill economic gaps while maintaining political control has resulted in 'entrepreneurs' who tend to be crony capitalists and whose 'success' breeds domestic resentment.

It has reasonably been suggested that, though China is implementing reforms that are headed in the right direction (eg reducing environmental degradation and social inequality and reigning in overheated sectors), they are too slow - and China faces huge risks because its economy is now open and exposed to external shocks [1].

For example, with an overheated economy in early 2008 which needs to be slowed by higher interest rates while others are reducing rates to stimulate growth, there is a risk of rapid revaluation of the yuan - which would erode competitiveness and lead to large losses in foreign exchange holdings (perhaps the 'financial tsunami' an Australian treasurer warned about?). This could arise because hot money inflows (attracted by higher interest rates and the prospects of currency appreciation) add to the already significant problem of sterilizing current account surpluses by acquiring ever more foreign exchange reserves  (see more).

The US argued that unless China implements much deeper reforms of its economy it will be unable to sustain rapid growth [1].

Ultimately however, because of the apparent inability of the methods for problem solving which are the basis of economic 'miracles' in East Asia to ensure success if this is measured in terms of financial outcomes, the control of global financial systems seems likely to be an ever more important source of international disputation (see Friction over global financial systems).

September 2002  - and amended October 2003 and from November 2007