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Western analysts view Asia’s Regional Comprehensive Economic Partnership (RCEP) as a Chinese victory against Washington’s efforts to isolate it. Far more important are the implications for China’s economy.
The RCEP and the free trade agreements that China wants to conclude with its major trading partners portend an epochal change in Chinese governance. Together with Beijing’s decision to allow state-owned enterprises to default on bond market debt and take the consequences, the free trade measures are aimed at China’s productivity sink among state-owned enterprises.
There’s something of the world-turned-upside-down in the frenetic pace of China’s trade offensive. For years, China’s trading partners complained that China shielded its domestic market from foreign competition while persuading other countries to open their markets to Chinese goods.
Now China is tearing down its own import barriers, among other things eliminating 90% of tariffs on imports from Japan. The “Japanese rice cooker” has become proverbial among Chinese consumers, who think Japanese consumer goods are better than the local equivalents.
For years, Western analysts from the World Bank to McKinsey Consultants have complained of falling capital productivity in China. These critiques generally refer to measures like total factor productivity, as in the chart below.
China has gained a diminishing boost in output per unit of capital investment, at least by the usual measures. With its enormous national savings rate, China has maintained high growth rates nonetheless, but declining investment returns eventually will retard its growth.
“By shifting decisively to a productivity-led growth model, it would ensure that capital flows to businesses that can invest in productivity, growth and the creation of sustainable jobs,” McKinsey recommended back in 2016.
That’s easier said than done, because tens of millions of workers at China’s state-owned companies view their employers as an iron rice bowl that guarantees lifetime employment.
Beijing continued to subsidize loss-making enterprises by throwing good money after bad and rolling over debts in order to avoid political problems.
Beijing’s new willingness to force it domestic industries to compete with Japanese and South Korean multinationals, and it’s refusal to bail out failing SOEs, reflect a dramatic change in Beijing’s outfit.
It’s as if the State Council had hired Western management consultants and turned them loose on the state sector’s dead wood.
Three big changes made this possible.
The first is the steady shrinkage of the state sector’s importance. State-owned enterprises today employ 57.4 million urban Chinese, compared to 139.5 million employees at private businesses.
In 2008, China had 64.5 million employees at urban SOEs compared to only 51.2 million at private enterprises. Beijing shrank the iron rice bowl over time and mitigated the political cost of smashing it.
The second big change is the advent of the Fourth Industrial Revolution, with a wide-ranging of productivity-enhancing technologies available to Chinese enterprises, supported by the world’s biggest 5G broadband network, with an expected 10 million base stations installed by 2024.
The opportunities for productivity growth are far more tangible than they were even a few years ago.
And the third big change is Donald Trump, who made trade a matter of pride for China. China’s leadership in the RCEP negotiations is a novelty; as Francesco Sisci has observed, it was China that delayed the conclusion of a trade agreement originally advanced by Southeast Asian countries who wanted better access to China’s internal market.
But the Trump Administration’s trade-and-tech war gave China’s leaders the opportunity to place themselves in front of the parade, to the cheers of a nation united against perceived American unfairness.
Washington, so to speak, threw Xi Jinping into the briar patch. The trade war created political conditions that made it possible for China’s State Council to undertake radical economic reforms.
Beijing wants foreign competition to force its enterprises to muscle up to world standards. That would imply a more efficient use of capital, which means in turn that China would get more bang for the yuan of savings. More efficient use of capital means that China would require less savings, and could increase consumption at the expense of savings.
That’s the nub of President Xi Jinping’s “dual circulation” theme: Higher productivity growth and a strong currency will increase domestic consumption. Reducing import tariffs has the immediate effect of spurring consumption, because tariffs are the equivalent of a sales tax.
But the productivity implications are more important than the near-term benefit of higher spending on imported goods, which does not increase the value added to China’s domestic economy. Global competition is the productivity driver.
After four years of demanding that China open its market, Washington has found itself a bystander to the opening of China’s market to practically everyone except the United States. Washington simply didn’t see it coming.
After the Covid-19 pandemic started in China, American strategists spoke of China’s “Chernobyl moment,” and expected the Chinese economy to suffer disproportionately. Just the opposite occurred: China crushed the pandemic within weeks and China’s economy bounced back in the third quarter.
Evidently, the outgoing Trump administration still hasn’t grasped the magnitude of its misestimation. It sent up a trial balloon for “an informal alliance of Western nations to jointly retaliate when China uses its trading power to coerce countries,” in a leak to Dow Jones November 24, while American allies South Korea and Japan reportedly started talks for a free trade agreement with China.
The proposed American-led coalition would compensate countries affected by Chinese trade restrictions, for example recent barriers to Australian exports of agricultural products. Australia nonetheless signed the RCEP along with China, despite its trade dispute. China’s share of Australia’s exports has reached a new all-time record.
Extremely low total factor productivity in China is a statistical artifact of the country’s past unwillingness to write down bad investments, that is, to shrink or shut unproductive state-owned enterprises.
As China-based economist Michael Pettis observed in a June blog post: “The fact that a large and rising share of economic activity in the country consists of nonproductive investment that isn’t correctly written down means two things.
First, the relationship between Chinese GDP growth and growth in the real economy isn’t consistent. Second, Chinese GDP growth is not comparable with that of other countries.
“Those with an accounting background would say that what in other countries would be expensed is in fact capitalized in China: this approach necessarily must result in faster growth and higher asset values on paper in China compared to the underlying value of the economic activities themselves.”
Expensing rather than capitalizing nonproductive investment, in Pettis’ terminology, simply is the difference between writing off bad debts to zombie SOEs and allowing them to go bankrupt.
China’s leaders evidently believe that the time has come to cull the herd and redirect a diminished flow of savings into high-productivity investments, while increasing consumption.