China/Economic Rebalancing: New Growth

UNCLAS SECTION 01 OF 04 BEIJING 001556

SIPDIS
SENSITIVE

TREASURY FOR OASIA/DOHNER
USDOC FOR 4420, 5130 and 6510
STATE PASS USTR FOR STRATFORD

E.O. 12958: N/A
TAGS: ECON ETRD EINV EDEV CH

SUBJECT: China/Economic Rebalancing: New Growth
Model Needed to Avoid Stagnation

This cable is Sensitive but Unclassified (SBU) and
for official use only. Not for transmission outside
USG channels.


1. (SBU) SUMMARY. China's export-dependent growth
model has served it well, but that model has now
reached its limits, according to locally-based
foreign economists. Domestic consumption could fuel
future growth but it will take many years -- even
decades -- to achieve the fundamental economic
reforms necessary, including provision of a
comprehensive social safety net, achieving increased
rural incomes, developing a middle-class that
extends beyond the major cities, and building a much
larger services sector. Increasing productivity
through competition and financial sector reform
could help China avoid economic stagnation in the
medium term. While Chinese policymakers are aware
of the need for such reforms, there is some question
as to whether they have the political ability and
will necessary to realize such fundamental changes.
Certainly at the moment, Beijing appears more
concerned with stimulating short-term growth through
government-led investment. The economists expressed
concern that the very success of the stimulus plans
in restoring growth could lead to complacency and
slow--or possibly even stymie--vital reforms. With
reform, China could be able to achieve growth rates
in the 7 percent range; much slower than over the
past decade, but fast enough to preserve social
stability. END SUMMARY.


2. (SBU) On May 4, 2009, World Bank Director David
Dollar, Dragonomics Managing Director Arthur
Kroeber, and Peking University's Guanghua School of
Management Professor Michael Pettis participated in
a roundtable at the Embassy during the annual
Economic Reporting Conference and discussed the
economic challenges China faces following the global
economic downturn.

Domestic Consumption Must Drive Future Growth
--------------

3. (SBU) Dollar commented that China had done well
using the "Asian" development model, where state-
encouraged investment in industrial capacity created
excess production that was absorbed by foreign
markets through exports. In part, this model
succeeded because U.S. consumption had been driving
rapid import growth. Now, however, due to the
financial crisis, U.S. import demand has declined,
presenting a dilemma for China's economic planners.


4. (SBU) Pettis agreed that U.S. consumption will
grow more slowly than GDP, causing the overall U.S.
trade deficit to fall -- although it was hard to
determine the short-term impact on the bilateral
U.S.-China trade balance. At the moment, China's
trade surplus remains high. This, according to
Pettis, is not sustainable. As foreign trade
deficits contract and global demand declines,
China's trade surplus must also contract. He
estimated that the United States' ability to absorb
China's excess production was "dead for the next six
years," nor could Europe be counted on as an
importer of last resort if China continues to
produce more than it can consume. Pettis,
therefore, proclaimed "the death of the Asian
economic development model" for China. Pettis stated
that future Chinese growth must be driven by
domestic consumption.

Income Redistribution and Liberalization Important
--------------

5. (SBU) All three commentators noted that China
needs basic social safety nets to encourage
consumption, but noted that other reforms were also
important. Kroeber explained that Chinese consumers
were still poor, with the per capita GDP of around
USD 3,000 per year. He noted that the returns from
economic and productivity growth fell
disproportionately to corporations; this money

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needed to be redistributed to households for
consumption. Dollar too stated that, although the
household saving rates were high, the big change
came from increasing enterprise savings, and
household income as a share of GDP had been
declining. For China to develop a more consumption-
driven growth model, incomes as a portion of GDP
needed to rise.


6. (SBU) Kroeber and Dollar added that in a
consumption economy, producers must be able to move
goods efficiently within the country. They
advocated major reform and opening up of the
distribution, logistics, and transportation sectors.
Dollar emphasized the need to remove regulatory and
local monopoly barriers to internal movement of
goods.


7. (SBU) Beyond increasing consumption, the
observers noted that China needs to find a way to
increase productivity without relying on investment
in production. Dollar commented that China needed a
more developed, open services sector. Kroeber added
that China needs more competition in non-competitive
sectors such as services, but also in certain
resource and energy sectors. He said 2008 was the
year in which China's manufacturing peaked as a
share of GDP. Pettis argued that reform of the
financial sector was necessary to increase China's
productivity. China's stock market is not good at
allocating capital because the lack of transparency
and structure of the market encourages speculation;
a solid governance framework and sound financial
data do not exist. Kroeber agreed that China must
liberalize its financial sector, eliminating
restrictions on capital flow among provinces.

Transition Politically Difficult
--------------

8. (SBU) Kroeber said that, although policymakers in
Beijing increasingly accept that Chinese growth can
no longer rely on external demand, unfortunately
there is currently little evidence of serious action
by Beijing to transition the economy to one driven
by domestic consumption.


9. (SBU) Kroeber opined that China's leaders had
accepted somewhat lower efficiency implied by a
large state-owned sector as the price for
maintaining social control over certain politically-
important sectors. He acknowledged that significant
political barriers to reform and deregulation exist
in a state-run economy. Pettis pointed out, for
example, that significant financial reform implied
significant political reform. Control of the
financial system allows wider control of the
economy.


10. (SBU) Dollar noted that leaders at the central
and local levels are more concerned with public
opinion, leading to what he called the
"democratization" of policy making. He noted that
earlier leaders were bolder risk takers, offering as
an example Zhu Rongji's reform of the state sector
in the late 1990s. Now, he said, the leadership
bases their decisions on broad public opinion,
making bold reform initiatives less likely.

Moving in the Wrong Direction?
--------------

11. (SBU) Pettis noted that when the U.S. faced the
need to devolve away from a heavy reliance on
exports in the 1920s, the transition took twenty
years and was not smooth. China, like the United
States before it, is responding to the drop in
external demand by increasing investment and
retaining workers, rather than decreasing production
capacity as necessary.


12. (SBU) Pettis thought that China's massive new
lending was being misallocated. In part, these
loans might go to increased production capacity.

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Alternatively, the misallocation of funds would
significantly increase non-performing loans (NPLs),
he thought. He offered the example of the large
state-owned enterprise AVIC, which reportedly has
taken out loans worth USD 35 billion, but has no
immediate need for the money and now has to find
projects. Because the cost of failed corporate
loans would ultimately be assumed by the taxpayers
(through government bailouts) or small depositors
(through suppressed deposit rates),these NPLs would
suppress domestic consumption in the future. Pettis
predicted a difficult decade: "not the hard landing,
not the soft landing, but the long landing."


13. (SBU) Dollar was less concerned about
overinvestment as a result of the stimulus plan. He
agreed that investment -- and in particular
government-led infrastructure investment -- was
currently driving economic growth. However, he said
the infrastructure projects were aimed at improving
consumption, such as high-speed passenger rail and
urban public transport. Dollar, however, was
concerned that the state sector was crowding out the
private sector and predicted that this will not
create an environment for productive private
investment.

Disagreement on Future Prospects
--------------

14. (SBU) Dollar's main concern was that the early
results from China's stimulus plan were so good that
Beijing could lose enthusiasm for further reforms.
To increase the share of household income as a
portion of GDP, China must reform many sectors, but
Dollar commented that he was not impressed with
progress and was concerned about complacency. He
thought if Beijing relied exclusively on its fiscal
stimulus and monetary loosening, China might face a
"W" shaped double-dip recession. Further, attempts
to recapture the past and stimulate exports would be
a detrimental approach for China. Dollar saw a
decade of stagnation if China did not reorient its
economy towards domestic demand.


15. (SBU) Kroeber shared the same concerns about the
Chinese government becoming complacent due to a
fairly successful stimulus program. Kroeber
thought the stimulus program was in part a
propaganda exercise to support consumer confidence
in the face of a fundamental external shock. He was
fairly confident moving forward that Beijing would
find a way to muddle through the transition. He
highlighted the fact that there already has been a
shift towards a consumer-driven economy, that the
government has made a commitment to a national
healthcare program, and that the percentage of the
budget directed at social services should increase.
Although confident that Beijing would reorient the
economy in the next few years, Kroeber noted that
future growth rates would be much lower, probably
around seven percent. This was because, without
exports and foreign investment, China's productivity
growth rate would decline, while Beijing's reliance
on the state-owned sector further hinder efficiency.
Mitigating this somewhat was the government's
recognition of the benefits of competition for
productivity growth and long term economic growth.
In addition, the downturn was weeding out weaker
companies, particularly in the export sectors, which
should be good for future growth. Kroeber stated,
"at the end of the day, they will come around to
keep growth and to keep growing at a solid clip."


16. (SBU) Pettis offered the most pessimistic
assessment of China's future growth. He said that
Beijing's central bankers and Ministry of Finance
officials knew what needed to be done but didn't
have the power to effect the necessary changes. He
suggested that reasonable academics also knew that
China needs to appreciate the Remminbi, liberalize
markets, and allow workers to organize, but remained
pessimistic that the government could implement such

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reforms. According to him, China has needed to
reduce its demand on export-led growth by increasing
domestic demand for years, and yet Beijing has not
proactively addressed these problems. Pettis also
expressed concerns that China's policies would
result in trade friction, which would
disproportionately hurt China.

Social Stability Not an Issue
--------------

17. (SBU) None of the commentators felt that the
current economic downturn would result in social
instability. Pettis shared his opinion that social
instability does not stem from unemployment, but
rather it usually occurs when there is a significant
split in the leadership. He stated that the current
economic crisis has brought factions together.


18. (SBU) Kroeber agreed, stating that lower growth
-- for example in the achievable range of seven
percent -- was all that was necessary to meet China's
employment needs. He said that, although Chinese
citizens and policymakers were accustomed to
ridiculously high growth rates, the country would
operate a perfectly successful society at a lower
growth rate.

Comment
--------------

19. (SBU) Most foreign observers and a growing
majority of Chinese economists and policymakers
concede that China has outgrown an export economic
model and needs to reorient its economy towards
domestic-demand driven growth. The current debate
within China is over the reforms necessary to
achieve this fundamental reorientation of the
economy, with some advocating state-led growth and
others pressing for more market-oriented reform.
Complicating matters are the large and powerful
special interest groups that have grown up around
the current investment- and export-oriented regimes,
seeking to preserve jobs and profits within these
formerly-favored sectors. We are seeing signs that
the government, while not moving boldly, would like
to enact the policies necessary to create a strong,
self-propelling domestic economic system. The
question for most outside observers remains whether
China can realize the necessary level of reform with
enough speed to prevent a prolonged period of below-
potential growth.

PICCUTA