The Cost of Wealth

Xi Jinping was already set to make headlines as he stepped up to the podium at the Davos World Economic Forum in January. No Chinese leader had ever addressed the conference before. But it was only when he opened his mouth that it became clear he was also set to make history with his words.

The speech that followed was remarkable, centering around an unprecedented basket of progressive themes. Xi urged countries to not renege on the Paris Climate Change Agreement, invited more foreign investment into China, and, perhaps most importantly, championed free trade and globalization as the driving forces of progress. In short, he channeled his inner Ronald Reagan.

Despite, or perhaps because of the speech’s eccentricity, some commentators interpreted his remarks as cynical opportunism. By prominently defending free trade, he could have been setting China up to dictate the terms of the post-2016 global economy. After all, Xi was speaking only a week before Donald Trump’s inauguration. This interpretation of his speech makes intuitive sense considering that Xi might try to grab power in an arena that some believe the US will soon vacate. Still, at the same time, given Xi’s record of human rights violations and lopsided trade agreements, it is hard to take seriously his promises to keep China “wide open” to investment and maintain a “level playing field” for trade.

Of course, there is another side of the story. China’s economy has been growing at its most sluggish rate in decades: Exports fell last year for the first time since 2009 and only the second time in 25 years; likewise, overall GDP growth bottomed out at 6.7 percent in the final quarter of 2015 — the lowest rate since the Great Recession — and has only increased slightly to 6.8 percent in the final quarter of last year. Even more concerning, Beijing has taken on an enormous and increasingly unstable amount of debt — which now stands at 300 percent of GDP — to fuel its growth.

For most economies, these figures would signal rough sailing ahead. For China, a country that has been obsessed with clockwork economic expansion, such signs of instability can signal serious squalls on the horizon. And although any combination of current economic conditions — from potential trade wars with the US to continued expectation of a strong dollar despite domestic political instability — could be considered the source of China’s stagnation, the heart of the matter is a simple, well-documented structural issue: the Middle Income Trap.

Conceptualized by economists to explain the hockey-stick model of international development, the Middle Income Trap theory explains the difficulties that countries whose populations rocket to middle class status through economic imitation can experience. As wages rise and productivity declines, these countries and their populations have trouble entering upper-income brackets. There is plenty of evidence to substantiate these claims: According to a World Bank report, although global wealth has increased markedly since the 1960s, the majority of nations achieve “middle class” status and then remain there.

Today, adjusting for purchasing power parity, China is about to hit the edge of the upper middle class, where it is likely to be stuck for a while. Chinese economic leaders recognize that they have a crisis on their hands, and have structured their Thirteenth Five Year Plan (which ends in 2020) along a few prongs that they believe will kick-start the economy. Yet there is a catch: the established playbook of reforms to make countries jump over the upper middle class border generally involves diminishing state economic power. China has heavy state involvement in its economy already, so the threat of compromising control poses real political danger.

On a domestic level, Beijing’s current innovation policy provides a good example of this dilemma. China currently employs a top-down approach to entrepreneurship that focuses on state-granted subsidies. These policies have a solid track-record, as billions in low-interest government loans helped China control more than half of the global market for wind turbines. A pledge of 121 billion dollars guarantees further domination of the clean energy market. Beijing has dedicated 100 billion dollars to control the semiconductor industry by buying out foreign technology.

For China, a country that has been obsessed with clockwork economic expansion, such signs of instability can signal serious squalls on the horizon. And although any combination of current economic conditions…could be considered the source of China’s stagnation, the heart of the matter is a simple, well-documented structural issue: the Middle Income Trap.

But current economic conditions indicate that these policies cannot continue indefinitely. As concerns about debt continue to stack up, China may not have the flexibility to spend so freely: Chinese investment, according to the World Bank, is likely to drop to 25 percent of GDP from its current perch in the mid 30s. By the same measure, China’s obsessive push for infrastructure has gobbled up many “easy” investment projects and left mainly those that are harder to find and harder to implement. Together, these trends indicate that Beijing will have to explore more focused strategies for spending, and may realize that on a more structural level, its state-oriented type of investment is inefficient. The government cannot pick winners as well as the free market can, and some of China’s hottest companies — including e-commerce giant Alibaba — initially grew without state support.

There are reams of data to back these points up in the World Bank’s China 2030 report. The efficiency increase in State Owned Enterprises (SOEs) in China averaged a third of that of private sector companies; further, a quarter of SOEs suffered efficiency losses. Private companies simply grow better than those that the state owns and directs. More pointedly, the size and power of SOEs actually create higher barriers to entry into industries. The companies that manage to fit a foot in the door face increased competition thereafter. SOEs also have the unnatural advantage of access to state banks and protection from competition, keeping them afloat even when their output is mediocre.

Of course, there is a potential solution, albeit not one that plays well with the Communist Party of China crowd. Most countries encourage innovation through research and development. And, most R&D occurs through large, sometimes multinational corporations. If China truly wants to sponsor growth, it needs to create a stronger corporate culture, which in turn, means deflating some of its state-owned enterprise. The tradeoff here is clear.

Internationally, China faces nearly the same issues. The same World Bank study believes that China has reached maximum global penetration on its rung on the value chain, and faces two choices: lose exports or produce goods of higher value, especially in the service sector. But, the main way to grow the service sector would be to open up markets to freer foreign investment. And, right now, anger is running high at the asymmetry of China’s investment law and policy (which involves huge infusions of cash into other countries and strict investment laws). China can beat its punishment to the punch by re-negotiating its 2001 World Trade Organization agreement and opening up its markets to more foreign investments.

Beijing is cornered. State-led policy has let China produce massive growth, but now economic headwinds domestically and political headwinds globally suggest that the country may have to tread a new path — and do so at the cost of relinquishing state authority.

In other words, Xi’s speech — seen by some as triumphant opportunism — may have signaled just the opposite: a surrender to forces of the free market that China has successfully resisted for decades.