Executive Summary[i]

The Chinese economy is at a pivotal point in its modern history.  On the occasion of this 40-year anniversary of reforms and opening up, it is tempting to look backward and celebrate the extraordinary accomplishments of economic development.  The greater challenge is to look forward to 2050 and the aspirational goals of China’s New Era.

The transition ahead is daunting to the say, the least.  On the one hand, it will entail a full complement of internal adjustments aimed at the structural rebalancing of the Chinese economy – from manufacturing to services from exports to household consumption, from surplus saving to saving absorption, and from State-directed to market-based resource allocation.

But the rebalancing of China’s internal economic structure cannot occur in a vacuum. Important shifts in the global economy and in China’s relationships with other major economies in the world will also have a critical bearing on the outcome.   In that vein, China has much to learn from recent developments in a volatile and crisis-torn world – including lessons from the Asian Financial Crisis of the late 1990s, the Global Financial Crisis of 2008-09, and the long string of “lost decades” in Japan.   In all of these cases, the lasting impacts of volatile and destabilizing outcomes underscore both the severity and complexity of the global challenges China is likely to face in the next phase of its economic transition.

Japan, as modern Asia’s first troubled growth miracle, offers three lessons that are especially relevant for a debt-intensive Chinese economy: First, avoid the currency suppression of a mercantilist, export-led growth model and the trade tensions it provokes.  Second, do not ignore the potentially lethal interplay between asset bubbles and leverage.  And third, avoid subsidizing ossified zombie companies and the risks they pose to underlying productivity growth. While China has grounds for concern on all three counts, its recent focus on deleveraging and stability – especially the establishment of a new financial stability oversight committee – are hopeful signs that it can avoid the Japan syndrome.  At the same time, the recent shift in SOE reform strategy toward the mixed ownership restructuring approach of China Unicom is worrisome in that it promotes a structure of share cross-holdings that is reminiscent of Japan’s keiretsus, the epicenter of that nation’s post-bubble zombie problems.

China’s global challenges point to a more immediate risk: mounting trade tensions with the United States.  The Trump Administration, which is focused on reducing an outsize bilateral deficit with China’s by initiating aggressive tariffs and other sanctions, doesn't appreciate the scope of America’s multilateral trade deficits with 102 nations.  This macroeconomic imbalance stems from a shortfall in domestic saving that is about to get a good deal worse as federal budget deficits rise following the enactment of large tax cuts late last year. If the US opts for protectionism at a time when its current account and multilateral trade imbalances are likely to widen, financial markets could come under considerable pressure. And then another lesson of Japan could come back to haunt those economies who have become overly dependent on asset appreciation as the sustenance of growth.

Notwithstanding these potential risks, the broad consensus of forecasters has turned increasingly optimistic in assessing prospects for the world economy. That’s very much the view in still frothy financial markets following a brief correction in early February. Ten years after the global financial crisis, long-awaited hopes of post-crisis healing appear to have finally taken hold.  Those hopes may prove short-lived, however.  As central banks start to normalize monetary policy, excess liquidity will be drained from over-valued financial markets — putting pressure on asset-dependent economies, with collateral damage to major trading nations like China.

All these considerations should weigh heavily on China as it frames macroeconomic policies and reforms for the years ahead.  Particularly worrisome would be a premature celebration of the New Era – hailing the final destination of a long journey without paying attention to the pitfalls that might be encountered along the way.  This will require a deepening of China’s strategic approach to meeting its economic challenges, shifting its focus from the quantity to the quality of growth, from the targets of state-directed industrial policy to the forecasts of a market-driven private economy, from imported technologies to the indigenous innovations required to escape the dreaded middle-income trap.

For 40 years, strategy has been one of China’s greatest strengths.  That may be all the more essential for a nation aspiring to Great Power status by 2050. History tell us that nations are truly great only if they draw strength from within.  Yale historian Paul Kennedy famously warned of the destabilizing interplay between shifts in relative economic power and global stability – cautioning against the temptations of geostrategic overreach without attending to the foundations of strength at home. China’s ambitious Belt and Road Initiative raises especially important questions in that context.

In the end, China’s powerful economic takeoff was very much a levered play on globalization, global trade, and ultimately the global economy.  Yet the lessons of Japan, the Asian Financial Crisis, and the Global Financial Crisis all underscore the systemic perils of an externally focused growth strategy. In the 19th Party Congress, President Xi Jinping and the Party leadership focused attention on the “unbalanced and inadequate” characteristics of China’s great successes in the first stage of its development. Staying the old course is no longer an option for a nation and a Party that is determined to resolve this so-called principal contradiction. Clarifying a new course becomes all the more urgent as a result.

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[i] Based on a paper prepared for the 19th annual China Development Forum, March 24-26, 2018, Beijing