Keep China on the capitalist road

By Fred Hu

Of the many actual and possible victims of the current global slowdown, one of the most troubling could turn out to be China’s process of economic opening and reform. Turmoil at Western financial institutions and the credit crunch are causing many in China to question the wisdom of importing wholesale a similar capitalist model. Meantime, the effects of a global recession on China’s export-dependent economy are straining Beijing politically and might diminish interest in tough reforms. Now is a critical moment for China in more ways than one.

Up to now, China has been the poster child for market-oriented economic reform success. Reform has led to an unbroken 30-year record of 9% or greater annual real GDP growth, a 10-fold increase in average per capita income, and the lifting of 300 million people out of abject poverty. China’s pre-reform and post-reform history offers a vivid and compelling case study in the capacity of the free-market economic system to unleash entrepreneurial energy and the potential for wealth creation. Yet recent events are exposing some of the cracks in this effort. The economy remains highly dependent on exports instead of domestic consumption, and a slowdown in the U.S. and Europe has caused thousands of factories to close, putting thousands of workers out of jobs.

The danger is that Beijing is extracting the wrong lesson from recent events at home and abroad. Reformers have won many battles in recent years, but not quite the intellectual war yet. Now a growing number of policy makers seem wary of further economic reforms. Emboldened by the current global financial crisis, anti-free-market critics have grown increasingly boisterous. Some pundits in China have gleefully declared the beginning of the decline of U.S.-led free market capitalism. These critics attribute the global financial crisis mainly to the failure of laissez-faire philosophies, and note Western governments’ nationalization of well-known financial institutions.

This debate could have serious policy consequences. Many point to the current financial turbulence abroad to justify further tightening state control and regulation of the economy. Nationalist and populist sentiments have crept into the national policy-making process, with growing backlash against inward foreign direct investment, especially acquisitions by foreign companies of Chinese businesses. Chinese companies also face rising domestic hurdles for investing abroad, with Beijing “discouraging,” if not outright banning, equity investments in Western financial institutions. New initiatives of further market liberalization have been completely frozen.

This re-evaluation of the idea of reform couldn’t come at a worse time. While China has achieved tremendous success in recent decades, its transition to a free-market economy remains incomplete. Rule of law and protection of property rights, including those of peasants, remain inadequate. Vast swathes of the economy continue to be directly owned and controlled by the state. Heavy-handed and often arbitrary government interventions have caused massive distortion in the economy, as shown in the case of price controls for electricity and fuels.

China’s financial markets are still underdeveloped and inefficient. A closed capital account and insufficiently flexible yuan have contributed to widening trade imbalances skewed toward exports at the expense of domestic consumption. The failure to create a nationwide social safety net comprising old age pensions, unemployment insurance and health insurance has imposed growing strain on China’s social fabric.

All of these reforms are absolutely critical to sustain China’s long-term economic growth. The ongoing global financial crisis has however shaken China’s faith in the Western free-market system. China deserves credit in responding to the global crisis by swift stimulus actions to tackle immediate economic problems, but since the crisis the Chinese leadership seems to have increasing doubts about continuing the path of economic opening and reforms that China has successfully embraced for three decades.

If China overreacts to the current crisis by stopping altogether necessary reforms, it would be most unfortunate. While the free-market system is prone to periodic financial crises, China’s own experience has shown that, regardless, countries can gain from undertaking market-oriented reforms and integration into the global market system. A single financial crisis, even with the severity of the present one, does not discredit the free-market economic system in delivering long-term prosperity and human progress.

China’s own history of pushing such reforms in the face of unfavorable external factors shows the way. When Deng Xiaoping launched economic reforms in 1978, the Western economies were still mired in stagflation. Chinese leadership did not blink in the face of the Asian crisis of 1997 and stayed steadfastly on the course of market reforms. After the meltdown of the dot-com bubble in 2000 and the 2001 U.S. recession, China again chose to accelerate reforms and opening up, culminating in its accession to the World Trade Organization.

China should, therefore, avoid misreading the lessons from the present global crisis. Turning the clock back would be a tragic mistake for the world as well as for China’s own sake. China naturally aspires to play a greater leadership role in the global economy and financial system. But as the biggest beneficiary of globalization, China can lead most effectively by her own example if the country shows confidence in the free-market economic system and commits to continued market liberalization.

Fred Hu is chairman of greater China at Goldman Sachs and co-director of the National Center for Economic Research at Tsinghua University.

© Wall Street Journal Asia

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These critics attribute the global financial crisis mainly to the failure of laissez-faire philosophies, and note Western governments’ nationalization of well-known financial institutions.

We're having the same debate here. In an excellent post by Ariana Huffington entitled "Laissez-Faire Capitalism should be as Dead as Soviet Communism," she quotes Alan Greenspan as acknowledging he "made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."

He wasn't alone in that assumption, which has led many to reevaluate the importance of a sound regulatory framework for a well-functioning market.

This is what is holding up China's reforms. Beijing has set the country firmly on the capitalist road, there's no going back. Yet their decentralized administrative structure has enabled lower level officials to subvert the intent of the reforms for personal gain.

Land is the last asset to be privatized and there's big money to be made. Many a mysterious fire has forced residents to move and sign over title to the local government in exchange for relocation assistance. Viola, after the place has been emptied the land ends up in the hands of a wealthy developer. This is not something the legal system is able to address, unless individuals in the local leadership fall out of favor for other reasons.

China’s financial markets are still underdeveloped and inefficient.

That's because they lack the means to regulate things like insider trading.

China's at a weird point; it claims the world's first commercial high-speed maglev train line which offers free WiFi to passengers as they are whisked from the airport into Shanghai. But what's the point if the govt blocks access to www sites?

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Greenspan made no mistakes, he got every thing right!

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As long as their 1,500 consulates (Wal-Marts) stay open in America, China will stay on the capitalist road....

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Capitalisim lifted many people out of poverty everywhere. However it is also has some dark sides. Such as taking excessive risks with other people fortune. Loosely regulated & unbridled capitalism is not suitable for China.

Finanicial Market needs to be monitored & bank assest needs to be protected for depositors interest.US congress is nationalizing the failed private institutions. China has to learn from US mistakes. China needs prudential regulatory authority. Incompetent, failed & cruel financial wizards should be punished with no mercy.

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[According to a Princeton prof a few years back] the problem was not that Americans spend too much, but that foreigners save too much. The Chinese have piled up so much excess savings that they lend money to the United States at low rates, underwriting American consumption.

This colossal credit cycle could not last forever, he said. But in a global economy, the transfer of Chinese money to America was a market phenomenon that would take years, even a decade, to work itself out. For now, he said, “we probably have little choice except to be patient.”

Today, the dependence of the United States on Chinese money looks less benign. And the economist who proposed the theory, Ben S. Bernanke, is dealing with the consequences, having been promoted to chairman of the Fed in 2006, as these cross-border money flows were reaching stratospheric levels.

In the past decade, China has invested upward of $1 trillion, mostly earnings from manufacturing exports, into American government bonds and government-backed mortgage debt. That has lowered interest rates and helped fuel a historic consumption binge and housing bubble in the United States.

It also put a lot of Chinese with few job skills to work and enabled them to earn more than they could farming. Now their future prospects are a lot grimmer. The question is can China pump up its own consumption level? Probably not enough to keep these workers employed. I saw a photo of several in Guangdong Province's garment district parading around in Santa outfits that were never sold. They did not look festive.

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China had themselves to thank for not opening its financial market to derivatives, which has been abused for underwriting greed instead of risk. My opinion is that to a certain extend China is resembling the bubble years of Japan. Somehow no country can avoid going through some bubbles if they adopt capitalism.

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Chinese leadership did not blink in the face of the Asian crisis of 1997 and stayed steadfastly on the course of market reforms.

That's because they were largely unaffected; having ignored the advice of the "Washington consensus" to allow the Yuan to float. Simply because they avoided the fate of Thailand, Malaysia, and Indonesia which all suffered market-induced currency devaluations of 50 percent or over when foreign capital fled, didn't mean their export-led economic development strategy was viable over the long-term.

Real estate bubbles should be easy to spot. The price of housing cannot continue to climb indefinitely. Tech stocks are more difficult; who knows which company might be the next Microsoft?

China isn't in a bubble; that won't happen as long as they keep their currency undervalued. Given the Chinese propensity to save, an economic stimulus package aimed at putting money in the consumer's pocket won't do much since most people will put it in the bank.

The Chinese government has invested very heavily in infrastructure which has facilitated economic growth. It's hard to see how government spending would have much effect either.

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There was a housing bubble in Hong Kong during the final years of British rule, but it was structurally induced. The origins lie in the lack of trust between the Chinese and the British. The Hong Kong people had no input in the handover and nobody looked out for their interests.

Hong Kong has a very low flat-rate tax. The government gets most of its operating revenues from landownership. All land is publicly owned except for that of a few indigenous communities which existed prior to colonization. The land is leased out to developers on lengthy terms who put up housing. The Chinese worried the British would lease out all the land, take the money and run. So they stipulated only so much could be developed a year. It was insufficient to meet demand in the 1990s and this was reflected in rents. I can recall visiting someone with a four-bedroom flat in a nice location for which they paid USD 14,000 a month (I'm serious).

The bubble burst a day after the handover as the 1997 Asian financial crisis hit the region. But it never went into China proper and Chinese tourists were welcomed in Hong Kong since nobody else could afford a vacation there.

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"Rule of law and protection of property rights, including those of peasants, remain inadequate. Vast swathes of the economy continue to be directly owned and controlled by the state."

You cant have indefinite economic freedoms/expansion without well defined political liberties. The Chinese govt cant have it both ways. The ignorant market Marxists get what they deserve now for their ruthless suppression of freedom and civil liberties.

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While China has achieved tremendous success in recent decades, its transition to a free-market economy remains incomplete.

Since free market capitalism is now a globally proven failure, why the heck SHOULD China "complete" its "transition"? Atlas didn't shrug, he tripped and fell, and broke his nose.

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I recently read the book The Ascent of Money: A Financial History of the World. This is a nice summary of China's emergence on the world economic stage:

Deeply in debt to the rest of the world, [the US] has become part of a “dual country” that [Niall Ferguson] calls “Chimerica.” “In effect, the People’s Republic of China has become banker to the United States of America,” he writes. Until the current global financial crisis, this seemed to be a fairly reliable relationship. American consumers over-bought goods and over-borrowed from China, and the Chinese in turn accumulated huge dollar surpluses that they plowed back into Wall Street investments, thereby supplying profligate Americans with the financing we needed to consume and sustain ourselves as the lone superpower. “For a time it seemed like a marriage made in heaven,” Ferguson writes. “The East Chimericans did the saving. The West Chimericans did the spending.”

Suddenly, however, it’s looking more like a marriage made in hell. According to Ferguson, much of the current crisis stems from this increasingly uneasy symbiosis. It turns out “there was a catch. The more China was willing to lend to the United States, the more Americans were willing to borrow.” This cascade of easy money, he argues, “was the underlying cause of the surge in bank lending, bond issuance and new derivative contracts that Planet Finance witnessed after 2000. . . . And Chimerica — or the Asian ‘savings glut,’ as Ben Bernanke called it — was the underlying reason why the U.S. mortgage market was so awash with cash in 2006 that you could get a 100 percent mortgage with no income, no job or assets.” Going forward, the system seems likely to be increasingly unstable, as Treasury Secretary Henry Paulson suggested recently when he warned that unless fundamental changes are made, “the pressure from global imbalances will simply build up again until it finds another outlet.”

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