China is facing its third major deflationary episode in the past three decades, and it is yet to be seen if policymakers can implement the ‘circuit breakers’ necessary to break out of the economic downturn. With diminishing returns to China’s investment-led development model and the geopolitical implications of a manufacturing stimulus, China needs to reorient towards a consumption-led growth model. The possibility of Chinese accession to the Comprehensive and Progressive Agreement for Trans-Pacific Partnership could provide the external pressure to undertake such reforms, similar to the strategy for liberalisation during China’s accession to the World Trade Organisation.
China’s economic problems are everyone’s economic problems. As Huw McKay writes in this week’s lead article, China is ‘in the middle of its third major deflationary episode in the past three decades’. The lesson of China’s recovery from its first two major deflationary shocks — the aftermath of the Asian Financial Crisis and the dotcom bust in the early 2000s, and the Global Financial Crisis later that decade — is that to exit periods of sustained deflationary pressure, dramatic circuit breakers are needed.
Is the Xi-era policymaking elite up to the task of supplying such a ‘circuit breaker’ to break out of the current slump?
The diminishing returns to China’s investment-led development model are deeply implicated in its contemporary economic malaise. McKay’s analysis reflects a growing consensus among analysts in and outside China that priority needs to be put on ‘supply side reforms for those legacy industrial sectors where domestic demand weakness has undermined profitability … This could be coupled with an attempt to unwind the large implicit subsidy regime that has built up in conventional upstream sectors’, which, combined with reforms to central–regional fiscal transfers, would make room for ‘[a]n unapologetically expansive fiscal policy package aimed at households’, kickstarting the badly-needed transition to a more consumption-based growth model.
Chinese industrial policy is unduly insulating some industries from the rigours of market competition, with the incentives the system gives for regional governments to encourage manufacturing investment a big part of this. These issues are well understood among technocrats in China — including in the upper reaches of government.
But moving away from an investment-led growth model does not come without costs for Beijing. The domestic political incentives all point towards delaying reform, and the international politics of China’s role in the global economy make things even more difficult.
Any delay will not endear China to American or European policymakers, who already blame it for the deindustrialisation of their own economies and will be none too pleased if Beijing signals that it will end it by exporting its way out of a slump which, in the eyes of Washington or Brussels, is of China’s own making. Given the renewed political importance of industrial policy in North America and Europe, Chinese stimulus that targets its manufacturing sector will be interpreted politically by its geopolitical antagonists as hostile.
Regardless of the economic sense it makes for China to make a major structural change, no amount of external pressure on it to do so will be effective if Beijing feels cornered, and particularly if the United States and Europe try to force change through a renewed trade war.
Inspiration ought to come from the most fruitful episode of Chinese liberalisation: its long, difficult but ultimately wildly successful accession to the WTO. The end goal of WTO membership was enticing enough domestically that Beijing was able to use the prospect of accession as leverage to undertake difficult liberalising reforms that could have aroused insurmountable opposition without a substantial prize.
The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) accession process offers a political arena in which other members can negotiate market reforms with China in a similar way. And it allows China to make unilateral concessions and reforms that further the accession cause. Many of the structural issues that produce domestic distortions and international spillovers — industry policy, capital markets distortions, foreign investment policies, the financial sector, SOEs and sundry subsidies — would all be key objects of the CPTPP accession negotiations.
Political barriers abound — not least of which is the wholesale turn away from multilateralism and free trade in the United States, and the securitisation of its trade relationship with China. Washington’s protectionist turn rules out US participation in CPTPP any time soon, and while this does reduce the economic incentive for Beijing, the long-term prize remains. Other CPTPP members can nonetheless think about what they could put on the table and what they might ask in return in terms of liberalisation on China’s part if it were to begin the accession process.
There are also ideological barriers on the other side of the Pacific. ‘Socialism with Chinese characteristics’ is, after all, a way of describing the mainland Chinese version of the investment-heavy developmentalism that proceeded elsewhere in East Asia. This was marked by a prominent role for the state in key areas of the economy, modest social safety nets and policies which had either the intent or effect of encouraging households to save rather than spend — especially since they could not rely on a welfare state to help much in their old age. Xi Jinping himself is said to hold both the socialist’s wariness of consumerism and the East Asian developmentalist’s scepticism of ‘welfarism’.
If JD Vance becomes the next Vice President of the United States, perhaps he can connect with Xi over their shared passion for rugged self-reliance and their support for domestic manufacturing of household appliances — no matter what the economic cost.
That’s an outcome which the Chinese leadership and the American electorate would be wise to avoid.