Are Reforms (Still) Necessary in China?


As an outside observer, it’s hard not to succumb to the temptation of continuously praising China for its post-1978 economic results. Indeed, the reforms implemented by its post-1978 leaders, from Deng Xiaoping to Xi Jinping, have generated impressive economic growth in a way that past generations would have had difficulties even trying to comprehend.

However, pragmatism is the operative word.

China’s upward trajectory has been explosive, with double-digit GDP growth numbers being the norm up until 2010 and in such a scenario, it’s impossible not to make irrational exuberance-driven mistakes, as Schiller and/or Greenspan would tend to refer to them. When it comes to anything from unrealistic real estate projects to China bidding up the price of various assets all over the world, misallocation of capital has been just as much of a constant as impressive economic growth.

At the end of the day, why should this bother us?

After all, even with all of the capital misallocation mistakes that have been made throughout its journey, the economic growth numbers still paint the picture of a record-breaking economic success story. While today’s 6 to 6.5% yearly GDP growth goals may not be as spectacular as the previously-mentioned double-digit ones, it’s still blatantly obvious that China is still as “hot” as it gets.

Again, why worry then?

The answer may not be very anchored in the present but rather based on rational fears one should have with respect to the future and a proper understanding of the past when it comes to economic superpowers. Capital is pouring into China at this point, everyone seems to want a piece of the action and there is little doubt in the mind of any self-respecting economist that it’s a matter of WHEN rather than IF China becomes the world’s dominant economy by nominal GDP as well rather than just its PPP counterpart.

But browse through any half-decent economic history book and ask yourself this when it comes to the various economic superpowers that have dominated the world over the years: has their growth always been linear, uninterrupted by exogenous shocks?

Of course not!

One need not look any further than today’s #1 economic superpower, the United States. From civil war situations to economic calamities, political uncertainty and so on, the path of the United States has not been the smooth, linear progression many tend to make the mistake of envisioning. As spectacular as the economic might of today’s United States may be, there were major bumps along the road and there are no reasons to believe the same will not be true about China.

And it’s precisely when the journey becomes bumpy that it will be crystal-clear just how important additional reforms would have been.

Whenever we’re in a secular bull trend as we have been in China, people tend to just sweep concerns under the rug and tolerate mistakes such as gross capital misallocation decisions. However, when times get rough, those same people and entities with they would have been wiser in the foresight department. Indeed, few people bother to worry when everyone is busy counting profits but when the party stops (even if only temporarily), all of the systemic vulnerabilities become blatantly obvious.

The risks when it comes to China aren’t related to an exogenous shock which would permanently destroy its chances at becoming the world’s #1 economic superpower, as this scenario is extremely unlikely and would require calamities of truly record-breaking proportions. However, while unlikely to permanently alter China’s trajectory, exogenous shocks can and will generate a great deal of pain… even if only temporary.

The more thorough the reform process of the presence proves to be, the more future pain can be minimized. It’s ultimately all a matter of economic common sense and a sound macro-prudential approach. While it’s difficult to the point of being quasi-impossible to put together a reform package that eliminates the very possibility of even experiencing short-term pain (fighting the business cycle is more in tune to what Don Quijote de la Mancha would do than what a responsible economist should recommend), it’s definitely not just possible but very probable that a well-thought-out reform plan will dramatically lower the pain and disruption caused by unavoidable exogenous shocks.

The conclusion is therefore crystal-clear: while almost nothing can stop China from eventually becoming the world’s dominant economy, the journey is bound to eventually get bumpy and if left unaddressed through reform packages, today’s capital misallocation mistakes will inevitably haunt China down the road.

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