China’s real economic problem is way bigger than the stock market

There's a bigger, scarier problem lurking behind China's recent stock market crash: The basics of its economy are totally out of whack, forcing it to grow in a fundamentally unsustainable way. According to Damien Ma, a China analyst at the Paulson Institute, the issue is "real, true, serious — and much more important than whether the stock market is going up tomorrow or going down the next day."

It's not just that this problem poses a serious risk to China's future, Ma says, but that the very nature of Chinese Communist Party rule makes it far more difficult to solve.

I spoke with Ma over the phone to get a sense of the nature of China's big economic problem, how bad it could get, and what the CCP could do to head off the worst. What follows is a transcript of our conversation, edited for length and clarity.

Zack Beauchamp: In simple terms, what's the fundamental problem with China's economy?

Damien Ma: When you look at the typical breakdown of GDP, your standard equation is investment, consumption, net exports, and government spending. In the China case, investment is extraordinarily high relative to the other parts of its GDP.

Domestic consumption should be much higher that what it has been in China for the past 10 or 15 years, which is under 40 percent, probably in the low to mid-30s. In the US, it's about 70 percent.

"If they don't succeed by 2022, you're looking at pretty tough situation for China"

The problem with China's balance is that you run out of things to invest in. There are only so many roads and bridges you can invest in before that entire sector gets saturated, and it becomes less productive to put your money there. So you have to switch over to a consumption model more focused on wage increases, productivity, and efficiency. That makes sense for China: It's the world's biggest market of consumers.

Many developing countries don't make that transition from an investment-driven economy to a more domestically focused consumption economy. The problem is called the "middle-income trap": Countries get stuck at or below a $10,000 GDP per capita range. If you look at historical precedent — South Korea, Japan, Taiwan, those East Asian countries that have made the transition — they've all made the transition from production-intensive, investment-intensive economies to a more productivity-focused, innovation-driven economy.

ZB: What happens if reform efforts fail?

DM: As part of its big reform package about two years ago, China gave itself until 2022 to make major changes. [The leadership set a goal of accomplishing major rebalancing reforms by 2022, when President Xi Jinping is set to retire, apparently believing that it'd be too risky to wait longer.] If by 2022, they're dragging their feet, and none of the major reforms seem to be really taking hold, they will be in pretty serious economic trouble.

And they know that. They look at a lot of the structural trends — an aging population, labor market volatility, a lot of economic headwinds they can't control — and they're really being forced to change, whether they want to or not. If they don't succeed by 2022, you're looking at pretty tough situation for China. By then, it'll look a lot like Japan's "lost decade" [in which productivity and growth dropped substantially] starting in the 1990s.

Now, politically: If you think about the Chinese state now, they basically have to deal with three different constituencies. One constituency is the establishment coastal urbanites, who are fairly easy to deal with because the party itself is an elite establishment party. The second constituency is the 600 million or so rural, relatively poor people. Stuff like the stock market doesn't really affect them, and the government knows how to deal with them too.

But there's a third constituency. I call them "the in-betweens": the 200, possibly 300 million migrant workers that are floating back and forth between rural areas and second-tier cities to first-tier cities. They are potentially a great future labor force and source of growth and consumption. They're also relatively young and educated, and want the kind of lives the urban dwellers have.

A migrant worker in Beijing. (Zhang Peng/LightRocket/Getty Images)

I think they're going to be the major political challenge for the government. They want what the urbanites have, but they can't really get it because of inequality in terms of residence permits, as well as access to social services and opportunity. If you don't deal with them, that could be a potential problem for the future.

ZB: You mean like real political discontent, on the scale we haven't seen in decades?

DM: Possibly! Migrants definitely have protested in various parts of China. It's about how you deal with the fact that people's expectations have changed quite a bit, especially among migrants. Some of them have lived in cities for 10 years, but they're not properly considered urban citizens, technically speaking. That means they're not entitled to the same opportunities and services as their peers who have an actual residence permit.

So there could be potential resentment, there could be other types of dissatisfaction. And it's a big number of people — possibly 300 million. That's the size of the US population.

ZB: So China needs to make sure its economy stays rolling and getting these people the kind of opportunities they want — not just for their own sake, but also to stave off a potential threat to the Communist Party. If the stakes are so high, why is it so hard for China to transition to a consumption-based economy?

DM: Well, there are quite a few reasons. There are a lot of distortions in how it allocates capital right now — for example, financing incentives tend to be geared toward property, like the roads and bridges I mentioned earlier, because that's been the traditional model.

If you think about it, China's actually the victim of its own success. It's grown its economy really quickly, but in doing so geared its entire financial system toward this investment-driven model.

(STR/AFP/Getty Images)

A smoggy cement factory in China. (STR/AFP/Getty Images)

And it's not just finance. There are fiscal problems; local government is really incentivized to sell land to developers to build your next high-rise. They're not really geared toward what's needed now for the transition: more social services and welfare-type provisions that would actually benefit households. That would help individuals let go of some of their savings, and actually start spending and generating consumption.

I don't want to get too weedy, but everything ties into the fiscal and financial system that was made and entrenched to serve the current growth model. But they have to figure out how to really transform some of the underlying incentives in the system, plus the political incentives, so that the local governments don't focus on building the next power plant, but instead think about social services and education.

ZB: The examples you gave of countries that got out of the middle-income trap — South Korea, Japan, Taiwan — they're all liberal democracies now. Is China's authoritarian political system part of the reason the transition is so tough?

DM: For the last 15 or 20 years, China has built up a set of really powerful domestic interests that are invested in the status quo. Some of them are state-owned enterprises, some of them are patronage networks that have benefited from the current model. It's very hard to dismantle that, or at least weaken it significantly, so you can push through policies that are more conducive to the private sector.

The CCP has said all of the right things about reform, so far. But the current model has [empowered economic elites] who wear dual hats: They're not just economic actors, but also political actors because of their ties to the state. It's extraordinarily difficult to make sure that they will not throw up huge obstacles [to changes that might hurt their interests]. The type of rebalancing reform we're talking about here is not an intellectual question — it's a political one.

"Expect a lot of volatility — and for this to be a tough, slow slog"

For example, there's constant talk about shale gas. But the Chinese energy sector is dominated by three oligopolies: The biggest one is the China National Petroleum Corporation, CNPC. They have something like 1.5 million people on their payrolls, so you can see their political importance. They were the ones awarded all of the best shale gas blocks.

While the Chinese government has talked about wanting to introduce more private sector competition into shale gas, because that's how you get a boom, it's very difficult for anyone to compete with CNPC. They already have the gas blocks, much stronger ties to the government, and all the resources in the world. And that's just one example: People self-select out of the energy sector, because they just don't want to compete.

So at this point, the issue about reform is really about where the cleavage of interest-driven politics is. The resistance is coming primarily from people who have benefited tremendously from the existing model and don't really want to move. Why would they want to?

ZB: What does that mean for China's system of government?

DM: You can't run a future Chinese economy, as they envision it, with the current governance model. It has to be a lot more nimble — purely top-down is really hard when you're trying to promote innovative dynamism and have the private sector do a lot more lifting when it comes to economic growth and job creation.

That doesn't mean they'll move away from a single-party system, but it'll have to change. They recognize that there is a sense of urgency to this, because they want to leave a legacy of putting China above and beyond the middle-income trap, and become one of those advanced economies. If you think about post–World War II economic history, very few countries have actually achieved that.

I think the state will find some way to exert some kind of control over elites. There are talks about inserting certain party cells or committees into private firms. That hasn't completely taken hold, but those ideas are coming up.

And China has had some pretty strong wage increases over the past several years. I think it's slowed down a bit because of the economic slowdown, but a few years after the financial crisis, wages were going up pretty fast.

But the politics are really hard. So expect a lot of volatility — and for this to be a tough, slow slog.

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