China Losing Its Low Labor Cost Edge, While Systemic Inefficiencies Become More Obvious – Conservative Leaders Probably Unable To Promote Needed Reforms – Difficult Times Ahead

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By Paolo von Schirach

November 16, 2012

WASHINGTON – China has had a fantastic 30 year ride. It managed to transform itself from a sclerotic and hopelessly inefficient collectivist society into a quasi-modern, profit driven manufacturing economy with an almost invincible low cost edge in foreign markets.

Fantastic ride now about to end

Rather skillfully, the Communist Party managed to arrange and drive this historic shift away from orthodox Marxism, this way re-legitimizing itself as the steward of economic growth and more broad based prosperity. That’s the good news.

The bad news is that all is probably over. Even worse, it is unlikely that this Communist Party governance system based on secret arrangements among top leaders will be able to adjust to a new environment in which the economy needs to be truly competitive, while an emerging Chinese middle class demands accountability, transparency and the end of privilege (think of the almost dynastic rule of the “Princelings”) and corruption.

Reforms ahead?

The recent changes at the top in Beijing, with the elevation of Xi Jinping to the top post, have invited speculation as to whether the “reformists” will now gain the upper hand and steer China towards greater efficiency in economic matters and a more pluralistic, tolerant system in political matters.

I doubt that Xi jinping and the other new leaders can do any of the above. The Chinese Communist Party is a complicated and rather delicate machinery. It has managed to ensure bloodless changes at the top only by fostering sameness.

It is unlikely that anybody with novel, truly reformist ideas will be allowed to rise to the top. Being a status quo conservative is a lot safer for any party fonctionnaire aspiring to higher leadership positions. Besides, this is still in large part management by committee. And this formula based on collective decision-making usually favors continuity over change. It is normally easier to agree on doing more of the same, then to move into uncharted territory, as this would require flexibility and adjustment.

China needs structural reforms

That said, it is obvious that the Chinese one party rule political system is an inadequate instrument to push forward and then successfully manage China’s needed changes. The mismatch is really huge.

In order to have a chance to become a truly modern society China needs more economic freedom and higher governance standards. But this would imply genuine (as opposed to only partial) economic liberalization and accountable elected leaders. It is unlikely that these instinctively conservative leaders will contemplate any of this, for the simple reasons that they do not want to set in motion the process that would most likely lead to their demise. Nobody in Beijing wants to be China’s Gorbachev.

From cheap labor to quality products

If this is so, then expect turbulence ahead. China’s economic miracle has run its course. it was based on a workable formula of large public and private investments in manufacturing, (aided by an efficient new logistics infrastructure that allowed to move goods at a high speed and low cost), and dirt cheap labor costs.

This combination was the delight of large western retailers who could source consumer products from China at a fraction of what it would cost them to buy the same goods from domestic producers. So, while American and European manufacturers suffered, Western consumers and Chinese corporations did well. At the same time millions of rural poor move to China’s factories, this way improving their income levels.

The problem is that this ride is almost over. China’s rising standard of living also means higher wages. As salaries go higher, the cheap labor-cheap goods advantage has progressively been eroded. Soon enough it will disappear.

Many inefficiencies

When that happens, China’s systemic dysfunctions will be fully exposed. Indeed, China’s fantastic growth masked the inherent inefficiencies of a still preponderant state run economic sector. Chinese state owned enterprises are run largely as tools of political patronage. Many of them lose money, while they still get easy financing from state owned banks.

The private sector, with few exceptions could thrive mostly because of its lower costs advantages in export markets. There are very few Chinese firms that are internationally competitive because of superior quality and technological leadership. In other words, Walmart and Target buy Chinese products for their megastores not because they are superior but because they are cheap. Whereas Western consumers by German made BMWs because of superior German engineering, regardless of price.

Conservative leaders unlikely to promote reforms

I very much doubt that a mostly top-down, still largely statist Chinese economy will be able to transform itself and become super competitive. The Western experience teaches us that competitiveness takes place in a highly decentralized eco-system made out of a myriad of start ups, research universities, eager venture capitalists, abundant R&D spending, both private and public and reasonably regulated capital markets in which investors can gather information on what is actually going on. China is light years behind in developing a comparable eco-system.

Political unrest

Finally, the emerging Chinese middle class is fed up with super polluted cities and increasingly scarce clean water. Likewise, it is fed up with the land grabs at the source of the construction boom. Indeed, until now much of Chinese growth came from cheap land resold at a high price to developers who would build luxury condos and shopping malls counting on eager investors. The insiders-only system made a lot of people rich. But it also created a real estate bubble, while it angered many people at the local level who see local officials and developers getting rich at their expense.

Turbulence ahead

Combine all these inefficiencies with widespread graft, corruption and lack of accountability and you have a rather unpleasant mix. The notion that a slow moving, inherently cautious newly installed leadership will be able to steer China out of this swamp and into real modernity is rather optimistic. As I said, brace yourself for turbulent times ahead.


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