Now we can see the full script of what I once called Likonomics, the policy framework of the new Chinese leadership. The policy document approved by the Third Plenum is indeed very comprehensive, containing reform measures in 60 areas. Two distinctive features stand out, compared with previous reform programs: top-level authority and full market system.
Top-level authority represents at least a partial departure from the traditional bottom-up, ‘crossing the river by touching the stones’ approach. For many of the forthcoming reforms, such as capital account liberalisation, a bottom-up approach is no longer even possible. There are no more stones to be touched. Reform has to rely more on top-level design. Top-level authority is also necessary for overcoming strong resistance by vested interest groups.
The new reform agenda will likely also serve as the last kick to complete China’s transition to a market economy over the past 35 years. The most important statement of the entire policy document is perhaps the following: wherever market mechanisms work in allocating resources, the government should not intervene. The government will continue to play an active role, but only to provide public goods and overcome market failure.
One central change will be the transformation of China’s growth model — the transition from economic ‘miracle’ to ‘normal’ development. The current growth model is best known for the combination of both rapid economic growth and serious structural imbalances.
But this growth model is already changing, with deceleration of growth and rebalancing of the economy taking place. So far the changes are caused mainly by rising wages, associated with emerging labour shortage. Higher wages cut into profit margins, investment returns and export competitiveness but increase household income. Therefore, activities slow and external account surpluses decline. Higher wages improve income distribution as low-income households rely on wages and high-income households rely on investment returns. They also raise the consumption share of GDP as household income outpaces national income.
But this is only the beginning. Completion of the growth model’s transition depends critically on implementation of the reforms announced at the Third Plenum, especially financial liberalisation.
This transition should be accompanied by important changes in at least the following six areas: further growth deceleration, because the economy is now more advanced and the labour force is already shrinking; higher inflation pressure, as a result of broad-based and continuous cost increases; improving income distribution, due to not only wage increases and interest rate liberalisation but also more proactive income distribution policies; a more balanced economic structure, with much greater shares of consumption and services in the economy; accelerating industrial upgrading, as rising costs rapidly change the competitiveness of industries; and more volatile economic cycles, as a natural feature of a market economy.
The changes will also impact interactions between and with the rest of the world. For instance, China’s contribution to the global economy should continue to rise, but sooner or later we might see the first external recession triggered by a sharp deceleration of Chinese growth. China used to be a contributor of global disinflation. It may become a source of global inflation in the future. The rapid ascent by Chinese firms in the value chain may constantly force new international divisions of labour.
There are some important implications for international investors.
First of all, predictions of China collapsing should be treated with caution. For years the market has seen waves of crisis warnings related to problems such as property price, shadow banking and local government debt. While investors cannot simply ignore the risks, it is equally important to be mindful of the fundamentals, balance sheets and reform momentums. Some economists in China have been forecasting the bursting of a property bubble for 10 years now. While economists benefited from their insights, investors who followed their advice lost 10 years of investment opportunities.
There is increasing opportunity to benefit from Chinese outward investment. China is already the third-largest FDI investor. And China’s net capital outflows could be equivalent to 4–8 per cent of GDP if China liberalises its capital account, according to one recent IMF study. Chinese direct investment overseas may expand from resources to manufacturing and infrastructure. Countries that do not welcome Chinese money risk seeing it go elsewhere.
The privileged position of monopoly SOEs is coming to an end. Investments in such enterprises probably paid off handsomely in the past, but this will change as China moves toward a full market system.
Certain assets will always be in shortage in China, especially resources and food, and thus present attractive investments. The challenge of land scarcity is also unlikely to ease. The commodity market too is likely to grow as, while the super cycle might be over, China should still remain a major importer.
China’s new consumer market is also growing. This includes luxury goods and mass products, as GDP per capita rises from US$6000 to above $12,000. The service sector’s GDP share could easily add another 10 percentage points in the coming years. This also provides important opportunities for foreign investors. For instance, the Shanghai Free Trade Zone will experiment entry of foreign companies into finance, accounting, auditing, architecture, childcare and elderly care, culture, healthcare, logistics and e-commerce. This experiment could be extended to the rest of China very quickly. One advice for foreign companies doing business in China: be there early. Being late, even by one step at the beginning, could mean missing many steps later, as the market shares of Volkswagen and Toyota in China attest to.
Finally, there is much opportunity for investors to ride on China’s technological upgrading rocket. Many doubt China’s ability to innovate, but China’s economic development during the past 35 years has been a process of innovation. And innovation is happening everyday, everywhere. Measured by both number of patents and ratio of patents to R&D expenditure, China is ranked at the top of the world, alongside the US and Japan. China’s ability to innovate is clearly demonstrated by its automobile, IT and space industries. Zhongxing and Huawei are among the world’s top three companies for patent numbers. The internet is also revolutionising finance, commerce and publishing. Today, e-commerce accounts for 6 per cent of total retail sales. A 30 per cent price discount from department stores implies efficiency gain equivalent to 1 per cent of GDP.
China presents enormous opportunities for international investors. Even if only a portion of the proposed Third Plenum measures are rigorously implemented, by around 2020 China should be a market economy, a high-income country, and the world’s number-one economy and most vibrant consumer market. Between now and then, lots of things will change, and these changes will affect the world.
Yiping Huang is a professor of economics at the National School of Development, Peking University