There's nothing inevitable about China's economic rise

PUBLISHED : Monday, 07 February, 2011, 12:00am
UPDATED : Monday, 07 February, 2011, 12:00am

Open any major business publication these days and the chances are you will come across an article about how China is destined to overtake the United States as the world's dominant economy.

Commentators disagree about when exactly this momentous event is likely to occur. Some think it could take another 20 or 30 years. Others believe it is likely to take place around the middle of the next decade. A handful argue it could be as soon as next year or even that it has already happened.

But few doubt that it will happen. Most forecasts present China's rise to global economic dominance as inevitable.

Indeed, many portray China's relative backwardness since the beginning of the 19th century as an historical aberration. For hundreds, even thousands of years before that China, with its huge population and strong centralised state, was by far the world's largest economy. Then Europe and the United States stole a temporary lead thanks to their industrial revolution, while China stagnated under Qing dynasty rule.

Now, after the economic reforms of the past 30 years, China is catching up fast. With the US and European economies crippled by financial crisis, few doubt that China is poised to resume its rightful place as the world's number one economic power at some point in the next couple of decades.

Yet despite their ubiquity, there is a big problem with these forecasts. Most rely on a simple linear extrapolation of current growth rates. Typically they assume that China will continue to grow at 8 to 10 per cent a year with low to moderate inflation, and that its currency will appreciate modestly to come up with a comparative growth chart that looks a lot like the one shown here.

But as George Magnus, senior economic adviser to Swiss bank UBS, points out in his new book Uprising, history seldom proceeds in a linear fashion.

Magnus notes that the 'inevitable' decline of US economic primacy has been predicted plenty of times before.

In the mid-1950s economists thought that the Soviet Union, with its superior investment and growth rates and its clear technological edge following the launch of the first Sputnik satellite, was destined soon to eclipse an ailing US.

US economic decline was detected again in the 1970s following the Vietnam war and the oil crisis, and yet again in the 1980s as US debt levels and deficits soared. The US economic model was broken, lamented economists, and America could no longer hope to hold its own against the surging economies of Germany and Japan.

Those forecasts relied on the same sort of linear projections that economists use today to predict China's inevitable ascendancy.

However, as we now know, the US economy proved resilient and flexible enough to reinvent itself, while it turned out there was nothing inevitable about the Soviet Union's rise, nor about Japan's 30 years later. Now, warns Magnus, there is nothing inevitable about China's ascent.

Looking behind the headline growth trends, Magnus finds serious weaknesses in China's economic political and social institutions that threaten to derail its growth track.

His survey of economic history makes clear that China today is in danger of repeating the same policy mistakes which hobbled US growth in the 1920s and 1930s and German and Japanese growth in more recent decades.

Like past emerging powers, China has followed policies - low domestic interest rates and an undervalued currency - designed to boost investment in and enhance the competitiveness of its export sector.

Those policies certainly produced rapid growth, but they also resulted in a rapid growth of international economic imbalances. As Magnus writes 'the emerging powers failed to reconcile domestic and external policy responsibilities. They rejected structural reforms designed to lower their dependence on exports and did not countenance sufficient... exchange rate flexibility as a means of changing their growth models'.

The problem in China is that the very sectors that have benefited most from Beijing's pro-investment and export policies - heavy industry and exporters - today form powerful constituencies within the ruling Communist Party with a strong vested interest in resisting economic reform.

That ingrained resistance to necessary change raises the danger that Beijing will continue to pursue its current policies, and that the current investment boom will continue.

As Magnus warns: 'Investment booms never last.' Unless Beijing can engineer a change in policy direction in the near future, it will risk following the same boom and bust trajectory that plunged Japan into its lost economic decades of the 1990s and 2000s.

That threat along with other weaknesses - environmental degradation, China's unproven ability to foster homegrown technological innovation, and a legal system subordinate to the interests of the ruling political party - mean that China's smooth ascent to global economic dominance is far from assured, warns Magnus.

It does not mean China cannot achieve the number one slot at some point in the future. But it does mean that projections like the one shown in the chart here are almost certain to be wrong.