China's Transformation

China’s chief economic challenge for the next decade is clear: how to shift from an export-led growth model to one driven by consumption and innovation, while maintaining social stability and avoiding a hard landing. When an economy as big as China’s – now the fourth largest in the world – is growing at a 10%-plus clip, that task is the macroeconomic equivalent of getting a charging elephant to turn the right corner without crashing or slipping. But make the turn the giant must. Heavy fixed-asset investment has led to overcapacity in many industries, while China’s high savings rate of over 40% of GDP is unsustainable, particularly as the population ages. Meanwhile, in 2004, pollution was estimated to have resulted in economic losses equivalent to 3.05% of GDP. “We cannot continue with the traditional development approach and growth pattern,” concluded Zeng Peiyan, Vice-Premier of the People’s Republic of China, in a special address to open the World Economic Forum’s China Business Summit 2006. “We have to transform our approach.

The key to that transformation was obvious from the Summit theme: Sustainable Growth Through Innovation – China’s Creative Imperative. Among the buzzwords of development discourse, “sustainability”, “innovation” and “creativity” are practically regarded as off-the-shelf ingredients for a magic potion to combat the pressures of globalization. But China’s current five-year plan offers a real recipe for action that can hardly be dismissed as glib: stimulate domestic demand, shift investment away from industries with too much capacity such as automobiles and steel, and shore up the financial system so that it can better absorb the savings of Chinese and mobilize more capital to productive investments. As for innovation, the plan commits China to increasing R&D spending from the current 1.2% of GDP to 2.4%, just above the OECD average. “Only by constructing new ways of development can China enhance overall growth,” said Summit Co-Chair Chen Yuan, Governor of the China Development Bank.

But there are obstacles and risks. “To keep growing quickly, China needs to improve its institutions,” warned David Dollar, Country Director, China and Mongolia, World Bank, Beijing. For example, a basic impediment to implementing much of the transformation plan is the lack of safety nets for unemployment, healthcare and retirement. Without them, Chinese will continue to save at prodigious rates, instead of channeling funds to more productive purposes. The absence of social security also limits entrepreneurship and the willingness of investors to take risks. “Savings are high because there is insecurity,” said Pierre E. Cohade, President, Asia Pacific Region, Goodyear Tire Management Company (Shanghai).

The weak rule of law is another hindrance. Take intellectual property rights. Enforcement of IPR protection, while improving, remains patchy due to feeble commitment at the local level and the lack of a sufficiently independent legal system. This is not just a problem for foreign investors. In fact, about 90% of IPR infringements involve domestic firms. “The general issue is the extraordinary degree of decentralization in China,” Dollar explained.

This problem also undermines efforts to boost China’s energy efficiency, secure its energy needs, and improve environmental protection. “Energy and the environment are two sides of the same coin,” said Pan Yue, Vice-Minister of China’s State Environmental Protection Administration. “Local governments want to focus on increasing GDP and, in doing so, favour vested local interests such as factories that may also be polluters.” Pan called for an honest evaluation of the state of China’s environment and urged local governments to adopt sustainable practices. “Not all central government policies are fully implement in the localities,” noted Zhang Xiaoqiang, Vice-Chairman of China’s National Development Reform Commission. “We need to improve the quality of our civil servants and the whole administrative mechanism has to deal in a balanced way with short- and long-term issues, all of which have to be coordinated on a national basis.”

The onus for action must also fall on enterprises. “Many companies in China have focused on the short term such as on increasing revenues from sales and marketing,” said Zhang Weiying, Vice-Dean, Guanghua School of Management, Peking University. Instead of focusing on racking up double-digit sales, enterprises have to put more effort and investment into R&D and generating sustainable profits, Zhang advised. Said Chen Tonghai, Chairman of China Petroleum & Chemical Corporation (Sinopec), which leads Chinese enterprises in annual patent applications: “In our industry, we not only have to look for new types of energy but to develop environmentally friendly products. We have to constantly conduct systematic innovation or else we will be eliminated by the competition.”

The obstacles and risks that could block China’s economic transformation offer the very commercial opportunities that could drive new, sustainable growth. Japan and the US could supply China with the technology to enhance energy efficiency. The lack of social safety nets represents a “humongous opportunity not just for improving the quality of life in China but for unleashing all these savings,” said Cohade. He predicted that “empty nesters”, parents born during the years of the Cultural Revolution whose single child has already grown up and left home, would be “the engine of consumption” in coming years. “Understanding the empty nesters is going to be critical” for retailers and financial services providers.

Indeed, the maturation of China’s economy will surely speed up its transformation – naturally. The services sector already contributes 40% of GDP, Hellmut Schutte, Dean, Asia Campus, INSEAD, Singapore, remarked. “As manufacturing productivity growth comes in, more people will be laid off with many of them starting their own little shop along the street,” he explained. “It’s pretty obvious that as China’s economy grows, consumption patterns will change, with very high growth in the leisure industries, healthcare and education.” The elephant is making the turn, but will it keep its balance?