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