commentary

(South China Morning Post)

August 7, 2003

Fault Lines: Eight Threats to China's Economic Miracle

by Charles Wolf, Jr.

Among the four so-called "economic miracles" of the past half century—Germany after the second world war, Japan in the 1970s and 1980s, South Korea in the 1970s through to the mid-1990s, and China between 1980 and the present day—that of China has been the most remarkable.

For example, China's average annual economic growth has been 8.6 per cent, well in excess of the 5 per cent recorded by Japan in the 1970s and 1980s. If China can sustain this, by 2025, its gross domestic product (GDP) would be only a little below that of the United States, although its per capita product would still be less than 15 per cent of that of the US. But there is an array of "fault lines"—obstacles which could seriously hinder this rosy scenario. A RAND study, Fault Lines in China's Economic Terrain, focuses on eight potential threats that are considered especially serious. While many have been confronted and adequately managed in the past, certain adverse scenarios could seriously impede, if not reverse, China's buoyant economic performance.

These eight fault lines, together with rough estimates of how they might reduce China's annual economic growth, are: first, unemployment, poverty and social unrest. Total unemployment amounts to more than 20 per cent of the workforce, or about 170 million people. This is largely due to population growth in the 1980s, privatisation and the downsizing of inefficient state-owned enterprises, and the effects of China's efforts to comply with its World Trade Organisation commitments. Rural poverty is accompanied by increased income inequality between rural and urban areas, by rural-to-urban migration, rising urban unemployment and social unrest. A worsening of these circumstances could cause a reduction of between 0.3 and 0.8 per cent in China's annual growth during the coming decade.

Second, corruption. Pervasive corruption could set back growth by distorting resource allocations. Were corrupt practices to worsen, China's position would decline in the country indexes that link economic growth with the prevalence of corruption. Such a shift could reduce the expected annual growth rate by perhaps 0.5 per cent.

Third, HIV/AIDS and epidemic disease. It is estimated that between 600,000 and 1.3 million people are infected with HIV/AIDS, with an annual rate of increase of between 20 and 30 per cent. Plausible projections of these trends would seriously affect China's economic growth through the cost of treatment, and reductions in productivity. "Intermediate" rather than "pessimistic" scenarios predict annual deaths from HIV/AIDS of between 1.7 and 2.7 million in the second decade of the 21st century. This could lead to annual reductions in GDP growth of between 1.8 and 2.2 per cent, up to 2015. The incidence of Sars and other epidemics could further impede growth.

Fourth, water resources and pollution. China is beset by water distribution problems. North China, with more than 33 per cent of its population, has only 7.5 per cent of naturally available water supplies. South China, typically, has an abundance of supplies, sometimes accompanied by serious flooding. Pollution discharges from industrial and other sources aggravate the shortage of water for consumers and industry in the north. Growth will be significantly affected by whether policymakers push for less efficient, capital-intensive water-transfer projects from south to north, or opt for more efficient recycling, as well as conservation, in the north. If economically inefficient policy decisions are made, China's annual GDP growth would be reduced by 1.5 to 1.9 per cent in the coming decade.

Fifth, energy consumption and prices. China has shifted from being a net exporter of oil in the early 1990s to importing nearly half its oil, and nearly a fifth of its natural gas supplies. The major risk posed for sustained growth in the energy sector depends on oil and gas prices, rather than on the share of imports in total energy consumption. A sharp increase, lasting a decade, would mean a reduction in growth of between 1.2 and 1.4 per cent.

Sixth, fragility of the financial system and state-owned enterprises. The fragility of China's state-dominated financial institutions is suggested by the high volume of non-performing loans on the balance sheets of the four major state banks. Estimates of total non-performing loans vary enormously, but they may amount to more than 60 per cent of China's GDP. China could experience a panic bank "run", large-scale capital flight, a significant reduction in savings and a decline in capital formation. The ensuing financial crisis and credit squeeze could lower annual GDP growth by at least 0.5 to 1 per cent.

Seventh, possible shrinkage of foreign direct investment (FDI). In the past 15 years, China has experienced a steadily rising volume of annual FDI, reaching US$50 billion (HK$390 billion) last year, significantly boosting growth. Adverse internal developments include possible future tension following the leadership succession, the possibility of a financial crisis and the inconvertibility of the yuan; external impedance might result from improvements in the investment climate in Eastern Europe, Russia, Indonesia, India and other countries that compete for foreign capital. A sustained reduction of US$10 billion a year in FDI may result in a reduction in annual GDP growth of 0.6 to 1.6 per cent.

Finally, Taiwan and other potential conflicts. Although cross-strait relations are currently relatively benign, it is conceivable that tensions might escalate into conflict, with growth-inhibiting consequences for resource allocations, exchange rates and equity markets. The bottom line could be a decline in annual growth of between 1 and 1.3 per cent.

Were all these scenarios to occur, China's annual growth would be reduced by between 7.4 and 10.7 per cent. While the probability of them all happening at once is extremely low, the chance that none will occur is also low. And if one scenario happens, it would become more likely that others would ensue as well. For example, an internal financial crisis would very likely have a negative impact on FDI, unemployment and corruption.

The ramifications of these eight fault lines are likely to extend into all levels of Chinese society, government and party structure. To mitigate the ensuing stresses will demand an enormous set of consultations, negotiations and transactions among central and provincial governments, and the party apparatus—which will probably preoccupy China's leaders in the next decade, predisposing them to avoid external distractions.


Charles Wolf is senior economic adviser and corporate fellow at RAND and a senior research fellow at the Hoover Institution.

This commentary appeared in South China Morning Post on August 7, 2003