China’s Strategic Challenges amid a Daunting Transition

The latest five-year plan lays out key steps in the process of economic reform – and could well represent the country’s most important test

The formal unveiling of the 13th Five-Year Plan has come at a pivotal moment in the nation’s development journey. After 35 years of extraordinary success, the Chinese economy faces a tough combination of external and internal pressures. To remain effective, China’s strategy must adapt to those pressures.

And for good reason. The global economy is in the midst of a protracted period of weakness, unable to support the external underpinnings of China’s long powerful export-led growth structure. And the domestic economy suffers from a multitude of imbalances – from surplus saving and excess investment to high debt and mounting income inequality. The growth strategy that worked so well in the first stage of development – basically a producer model that was closely aligned with a vigorous expansion of global trade – is ill-equipped for the daunting transition to the next stage.

The leadership has long been aware of these challenges. The now-completed 12th Five-Year Plan focused on the imperatives of a consumer-led rebalancing as the only viable option for sustained development. While there was good success in several key aspects of this plan – especially the development of services and the push toward urbanization – much remains to be accomplished. The 13th Five-Year Plan is aimed at filling in the missing pieces of the core development strategy.

The urgency of the country’s strategic challenges has been underscored by a significant slowing of GDP growth, the bursting of an equity bubble and pressures on its currency. Inasmuch as the economy has been the major driver of world output over the past decade, these concerns have led to heightened anxiety in world financial markets over prospects for global economic growth. The result is an increasingly powerful negative feedback loop – with China’s problems leading to global concerns, which then exacerbate the angst over an externally dependent Chinese economy.

In keeping with this broad constellation of pressures, the 13th Five-Year Plan focuses on both the demand and the supply sides of the economy. It continues to emphasize private consumption, underpinned by the services- and urbanization-led rebalancing featured prominently in the prior plan. But it ups the ante by an intensified focus on the social safety net – namely, consolidating social security and health care systems, hukou reform, and a relaxation of the one-child family planning policy. The hope is to provide more security for a new generation of middle-class consumers – encouraging them to convert fear-driven precautionary saving into a new and vigorous source of growth in discretionary consumption.

At the same time, a new supply-side agenda is aimed at improved efficiency and productivity enhancement. The 13th Five-Year Plan actually features a specific, albeit narrow, productivity target – a first for modern China. The stated goal is to boost per capita labor productivity (i.e., output per worker) in so-called advanced industries (high-end manufacturing, modern services, and strategic and emerging industries) from 87,000 yuan in 2015 to over 120,000 yuan by 2020. That works out to a 38 percent increase over the five-year planning period, or roughly a 7 percent average annual rate of labor productivity growth in this key segment of the economy. That would be a spectacular result, by any standards – if, of course, it can be achieved.

The new supply-side initiatives also feature the elimination of excess capacity in “zombie state-owned enterprises,” meaning coal, steel, cement, glass and shipbuilding; associated headcount reductions in SOEs of at least 5 million workers; a reduction of excess housing inventory; and a deleveraging from the post-crisis credit binge. In the end, productivity will be the ultimate arbiter of success. As China transitions from capital-intensive manufacturing to labor-intensive services, its productivity growth will slow naturally. The key is to cushion the downside of this slowing. Its commitment to a broad program of supply-side initiatives and productivity enhancement in its advanced industries should be viewed in that critically important context.

In keeping with this focus, the new five-year plan makes repeated references to a more sophisticated and innovative manufacturing sector, stressing new features of higher-value added industrial development. Under the broad umbrella of a high-profile push launched in 2015 dubbed “Made in China 2025,” the plan emphasizes entrepreneurship and new business formation as well as state-directed focus on strategic emerging industries from biotech and electric cars to alternative energy and new materials. Similarly, there is a comparable emphasis on “Internet-Plus” – driven by innovation in cloud- and big data-based increases in e-commerce – with equally important implications for productivity enhancement in China’s modern services sector.

Alas, there is an important twist to the growth strategy that became evident in the rollout of the new five-year plan. In his “work report” presented to the recent National People’s Congress (NPC), Premier Li Keqiang put supply-side reforms at number two in the top “eight tasks” for 2016 – second only to the government’s focus on economic stability in countering the growth slowdown. By contrast, emphasis on boosting domestic demand – long the focus of the consumer-led rebalancing strategy – was downgraded to third place on the so-called work agenda.

In China, where internal debates are carefully scripted, nothing happens by accident. In the keynote speech at this year’s China Development Forum, a high-level event that follows immediately on the heels of the NPC, Vice Premier and Politburo Standing Committee member Zhang Gaoli drove this point home, emphasizing the need to direct supply-side initiatives at China’s “main threat.” By contrast, there were only passing mentions of consumer-led rebalancing.

Maybe I am guilty of splitting hairs. After all, every economy needs to focus on both the supply and the demand sides of its growth equation. But this shift in emphasis – in the 13th Five-Year Plan as well as in the debate and messaging at this year’s China Development Forum – appears to be an important signal. I worry that it could indicate a premature shift away from the consumer-led model back to China’s comfort zone of a producer model that has long been more amenable to the industrial engineering of central planning.

Yet much remains to bring the consumer to life. It is, indeed, a tough challenge. But de-emphasizing that commitment could call into question a crucial shift now required of core economic strategy.

In the end, strategy is China’s greatest strength, lending credibility to its commitment to structural transformation. This sets the country apart from more short-sighted economies in the West, where strategy was once mockingly referred to as “the vision thing” by former U.S. President George H.W. Bush.

The 13th Five-Year Plan could well represent modern China’s most important test. In theory, it lays out important steps in the right direction – absolutely essential if the nation is to avoid the dreaded “middle-income trap” by making a successful transition to a new growth model. But with less margin for error, there is heightened much urgency to accelerate reforms. That puts the pressure squarely on implementation – ultimately the nation’s greatest challenge.

 

Stephen S. Roach is a faculty member at Yale University, former chairman of Morgan Stanley Asia and the author of Unbalanced: The Codependency of America and China (2014). This article is drawn from a longer paper (click here to read) presented at this year’s China Development Forum

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