Mark Williams

System in need of changed climate

The financial crisis has left many reputations looking rather tattered. China's policymakers are among a small group who have emerged with their standing enhanced. Acting boldly and swiftly, they not only insulated China's economy from the worst of the turmoil elsewhere, but also helped stabilize conditions in the rest of the world.

The clearest evidence of the boost China has given the world is the fall in China's trade surplus, which this year will probably be down by a third from its pre-crisis peak. The surplus fell because imports held up better than exports during the global slowdown thanks to the government's loan-fuelled stimulus. Another way of putting that is to say that China became a net source of demand for the rest of the world.

A key question now, for China and the global economy, is how sustainable this will be. The recovery in the US and Europe still looks fragile and the world will be in need of any source of demand it can find in the years ahead. Unfortunately, there are good reasons to think that the fall in China's surplus will be reversed soon unless the government is able to push through significant structural changes.

This is because the source of strength in Chinese imports has been a policy-induced surge in investment. Already strong before the crisis, investment accounted for close to half of all spending in China's economy last year. Some of the investment may encourage more consumption spending - for example better roads and railways could boost domestic tourism. But the main effect will be to raise the volume of goods produced by China's factories.

If there is no equivalent increase in domestic consumption, this added supply of goods will be exported or, failing that, contribute to a build-up in excess capacity and a subsequent investment slowdown. In other words, the recent fall in the trade surplus notwithstanding, China faces either slower growth or the reappearance of a big surplus unless consumption growth accelerates. Neither would be a palatable outcome.

The optimistic view is that, as China puts recent difficulties behind it, the government can focus in earnest on the policy changes needed to support faster growth in consumption. This probably requires raising the share of national income being paid to households. In turn, this demands faster wage growth and job creation. But bringing about such structural reform will be easier said than done. Despite headline-grabbing increases in the last few weeks, wages still account for a smaller share of China's income than a couple of years ago.

Indeed, the share of national income going to households has been falling for well over a decade. One of the most effective means of boosting job growth would be to encourage the proliferation of small and medium-sized businesses.

But such steps are likely to be resisted by the large State-owned enterprises that currently enjoy monopolies. With only a little over two years left in office, it is unclear whether the current government has the authority to challenge those that benefit from the status quo.

Underlining the difficulties the government faces, we cannot simply assume that consumption will continue expanding at a steady pace in the absence of significant reform. Household spending has held up remarkably well over the last two years. But this is at least partly due to government policy support for purchases of cars and domestic appliances. The government now promises to keep such schemes running to the end of next year, but their impact already seems to be starting to fade.

The upshot is that while China has emerged from the global economic crisis in a far stronger position than most other economies and with confidence in the capacity of its policymakers riding high, it faces significant challenges in sustaining rapid growth in the years ahead.

Perhaps the worst outcome would be a sharp resurgence in the trade surplus which would be seen as sucking demand from an already demand-starved world and, rightly or wrongly, could trigger a protectionist response. China won great praise for doing its share to prevent the global economy from sliding into depression 18 months ago. It will have to demonstrate great leadership to sustain that reputation in the years ahead.

The author is senior China economist at Capital Economics, one of the world's leading independent macroeconomic consultancies.