In memory of Dr. Andreas Höfert

Some reflections about this week’s “other” political event

While all eyes have been on the US presidential elections, the second largest - and soon to be largest - economy in the world is also going through political changes. The fifth generation since Mao will officially assume power in China at the 18th National Congress of the Communist Party of China, scheduled to open on 8 November.

While the National Congress hasn’t received the same media attention as the US presidential elections, it is an event of similar importance. The top two Chinese political jobs, president and premier, will see new faces: it is widely speculated that Xi Jinping and Li Keqiang will succeed Hu Jintao and Wen Jiabao.

China is poised to become the largest economy in the world within the next 10 years or less. A simple rule of thumb allows you to approximate how many years it will take for an economy to double in size at a certain growth rate: just divide 70 by the annual growth rate in percent.

So if an economy is growing at 2% a year, it will take 35 years to double in size; if something is growing at 4%, it will only take 17.5 years, and so on. China today is half the size of the US economy, according to very conservative measures. An equally conservative projection of only 7% average growth over the next 10 years would see China’s economy doubling in size during this period. Now, you might argue that the US will also grow over the next 10 years, but again both assumptions for China - half the size of the US and 7% growth on average - are rather low estimates.

This means that Xi, Li and their colleagues in the Politburo Standing Committee will face major challenges in the next decade. China’s size alone will not be a problem as such. But to achieve this size will require two changes in the orientation of the economy:
1) continuing to refocus it from export-led growth to more balanced growth, and
2) escaping the so-called middle-income trap.

China’s last five-year plan already acknowledged that the Chinese economy needs to find a more harmonious growth mix. Economies as big as China’s - for example those of the US, the EU and even Japan - are far more closed, meaning that the export sector has far less weight in their gross domestic product. Only “smaller” economies like Belgium, Singapore and Switzerland can maintain an export-oriented economic mix in the long run, as they specialize in a couple of key industries and services. A large economy like China or the US can achieve a broad division of labor within its borders and doesn’t need the international markets to do so.

Moreover, to the ire of the Americans, China has so far relied on keeping its currency in a managed peg against the US dollar. This has allowed China to export at cheaper prices than it would have otherwise, but it has also had some downsides, beyond the usual nagging from some US politicians: China has been importing at higher prices than it could have otherwise. This has led to a burst of inflation, especially in key imported goods like food and energy.

China’s new leadership could face the dilemma suggested by the “Phillips curve”, which documents a negative relationship between unemployment and inflation observed in postwar UK. Either China continues its export-led growth with the risk of inflation getting out of control, or it chooses a more balanced growth mix with the risk of lower growth and hence higher unemployment.

The second challenge, the middle-income trap, is even more formidable. China is currently entering the group of countries labeled as middle-income countries. One situation that has been observed over and over again, is that many countries get stuck in this group and go on to experience much lower growth rates than they did in the past. Just think of Brazil, which was already a “country of the future” in the 1960s, and still is today.

Countries fall into the middle-income trap when they stick to labor- intensive sectors, which are increasingly challenged by cheaper-producing countries. If a country fails to climb the quality ladder and build up industries more strongly tied to capital, human capital and technology, then its per-capita growth will stall. But climbing the quality ladder is not a given, and the countries that have done so successfully have also opened their political systems, especially those in South East Asia. The relevant economic research is not yet strong enough to state that political opening is necessary to escape the middle-income trap, but anecdotal evidence so far hasn’t rejected this thesis, either.

Whichever path China takes under the new leadership, I am very convinced that the next generation change in 10 years or so will have much broader international media coverage than this one. China has become much too important to be ignored - and that is why everyone should wish its new leaders the best of luck in mastering the challenges ahead.