SIPA Adjunct Professor Edits New Handbook on Understanding the Chinese Economy: A Q&A with Ron Schramm

Image

A new edited volume examines the trajectory of China’s economy and industry at a time of tremendous change. The Sage Handbook of the Chinese Economy, edited by Ron Schramm, a SIPA adjunct professor of international and public affairs, provides an in-depth analysis featuring the diverse perspectives of 42 contributors across 28 chapters and their detailed assessments of where China is heading economically. A throughline of the book is that China must now strive for quality of economic growth, rather than quantity. Grappling with declining demand, labor, and productivity; distorted relationships between central and local government and financial institutions; side effects of urbanization; and complex international relationships, China faces difficult choices in the years ahead about how to steer its economy, according to Schramm. 

Schramm has taught at Columbia Business School and formerly was an economist at the International Monetary Fund and Fulbright Scholar in Beijing. In this Q&A, he expands on the handbook’s findings and discusses the broader implications for China’s domestic industrial progress, innovation, and stability, as well as its geopolitical relationships. 

In the handbook, you argue that China has reached a turning point, facing both long-term supply constraints and short-term demand pressures. How does this moment differ from the late 1970s, when things first started to change?

Historically, China's economic policy has all been about supply. Demand is an afterthought, and that attitude reflects itself even today, as China has successfully increased supply and the ability to produce and export things, as well as build infrastructure. But that has slowed down, as would be true of any economy. Diminishing returns to capital and the shrinking labor force are hindering China’s capacity to rely on supply as a source of growth. What's less obvious is the current demand side problem that relates to a number of factors, including trade wars and trade frictions. China's historical emphasis on supply has made it ignore demand, and now finally, demand has become very important, especially consumer demand. 

For example, the collapse of the housing market which has been a key component of demand, creates challenges for economic growth. China has had its ups and downs in terms of supply, but now it's facing a serious problem because of diminishing returns and a shrinking labor force.. 

Could you expand on this dynamic between supply and demand? To what extent is this relationship economic versus institutional or political?

It's certainly both. The notion of diminishing returns is an economic outcome, since China's investment in capital is at a historic [high] since 2008; and as that surge in capital accumulated, returns have diminished. Of course, there's also a political institutional factor, which is that the state has prioritized economic growth in terms of quantity of growth. 

Nathan Dong, an assistant professor at Boston College, and Zigan Wang, an associate professor at Tsinghua University, discuss the Five-Year Plan in Chapter 16, and they consider the role of the government. In earlier Five-Year Plans, the emphasis has always been on production. In contrast, Chapter 18 discusses China’s low consumption and observes that consumption cannot be high unless incomes are high. There's an institutional question about why household incomes are so low and several chapters look at this question from a variety of angles.. 

Chapter 16 explores the notion that the central government is all-important, but local governments are another form of state power, and since 1994, much of the spending responsibility has been with them. But they also follow these Five-Year Plans in their own way, and even if the central government pursues reform, there are still local governments with a degree of autonomy, which creates challenges for coordination.

Several contributors pointed to this fragmentation that you mentioned, and the relationship between central and local governments. How does this relationship affect China's ability to make long-term changes and rebalance toward a more sustainable and productive economic growth model?

Historically, the central government has always been trying to keep tabs on local governments and have them respond to what the central government wants, particularly collecting taxes. There's always been this tension where the government doesn't want to create too large a bureaucracy, because that's unwieldy, and yet it needs a certain level of bureaucracy at the local level to make sure things get done. This is the very reason why local mayors and officials are usually not from that locality,but are appointed and moved around so that the central government has greater control. 

China has managed pretty well through Five-Year Plans to get the main thrust of policies out. Meanwhile, it has allowed experimentation by local governments to see what works and then rolls out those policies more broadly. Yet, local governments, when you have a system of top-down command, inevitably have a degree of autonomy which can at times create problems..

Fundamentally, the central government has created this problem for itself in recent history, because in 1994 – and this is detailed in Paulo Regis’ Chapter 17 – the central government moved a lot of the spending responsibilities to the local governments. The problem was that while the spending responsibilities were at the local government level, the revenue responsibilities primarily stayed with the central government. As a result, local governments didn't have enough funds, which created a set of perverse incentives, where local governments were scrambling to find funds to meet Five-Year Plan expenditure mandates. This resulted in land sales by localities, which in part led to the exploitation of rural land and rural populations that had land rights. This also led to the creation of special financing vehicles, an early form of shadow banking. 

To what extent do you think that the government has a responsibility to aid or reform shadow banks in some way to improve efficiency, since they are a part of the economic system, whether they like it or not?

“Shadow bank,” as a term, has a bad connotation, but the formal definition refers to anything other than traditional banks. The four largest banks in China are state-owned, and they make up most of the financing today. Since they primarily lend to state-owned enterprises, other types of entrepreneurs or small businesses have lacked access to finance. 

There was a surge in shadow banking beginning around 2013, but the government closed most of these institutions down right before COVID hit, because they were engaging in bad practices. The question for China is: given the current structure of state-owned banks being the major source of finance, how do small and medium-sized entrepreneurs, innovators, and other kinds of new ventures access a legitimate source of financing that creates value? What the central government doesn't want is for people to take their funds out of banks and put them into shadow banking. Chapter authors, including Franklin Allen, suggest that there will be institutional change, which will allow shadow banking to exist, but in a very controlled form. Whether or not that will promote the innovation and technological progress that China needs is a different question.

To what extent are the issues with the labor market related to the urbanization of China and the shift to a service economy, and is that a good direction for China to take? 

The urbanization is intimately tied with the service sector. As more people urbanize, the service sector grows. The problem is that they're low-productivity service sector jobs. Rural workers come to urban areas, but don't have the same rights as urban workers because of the Hukou system. While this may be efficient, it's not a fair solution. Workers who enter into cities work in the informal sector and don't benefit from the social services or the social safety net that urban workers have. Historically, China has discriminated against rural workers in terms of income. While urban workers had many benefits, including education and better pay, rural workers had limited to no benefits, except for certain land rights – and even those are gradually being chipped away by local governments. 

You discuss China's global economic footprint, particularly the Belt and Road Initiative (BRI). How do China's domestic economic conditions and constraints shape the way it engages with the global economy?

It's not accidental that the international picture is put at the end of the handbook. So much has been said about China's macroeconomy and international relations that I wanted this handbook to have a different focus – the industry focus, which comes at the start of the handbook. We try to get very specific by sectors, whether it be agriculture, real estate, digital economy, or the service sector, right at the beginning of the handbook. 

The fact that China has reduced demand at home, including consumption and investment in the real estate sector, means it has to find other sources of demand, and one of those sources is its exports, (the other, as discussed throughout the handbook is consumption). One bright spot on the macroeconomy has been exports to and investment in other countries, which help China work around the geopolitical problems it has had with the US and, even before Trump, with Europe and the United States. 

I decided to write my own chapter on the motivations for the BRI. The developing world needs investment, and China has the capacity to make investments. The chapter discusses specific projects in Africa, such as looking at the rail line China built in Kenya. The first point to note is that the rail line has been losing money. As a result, Kenya's ability to pay China back is strained. But does that matter? What's China's endgame? Is BRI still a good strategy? If China is building a global supply chain network with Kenya as a part of it, then this program – while not viable within Kenya – is valuable in terms of this global supply chain, because of all of the spillovers that can occur. So the institutional question becomes: how do those spillover benefits accrue to Kenya or other BRI recipients and to regular citizens of those countries? China is very good with the hardware in its projects abroad, but the institutional software is lacking.

What do you hope readers – particularly Chinese and US policymakers – take away from this handbook?

China is now in a mode where it desperately needs quality growth rather than quantity of growth. That is, it needs to be making investments where returns are greater than the real cost of capital, not greater than the artificial cost of capital. 

There's an excellent chapter by Haili Wu, associate professor at Xi’an Jiaotong-Liverpool University, on how China thinks about the cost of capital in the context of quality of growth. Historically, the way China viewed capital budgeting, or whether or not to make a decision about investing in something, has been based on two questions: Is the government in favor of this project, and can the investor tap into an artificially low cost of funds? If the answer to both of those questions is yes, then the business will make the investment. 

What Wu argues is that this approach is no longer viable. Chinese investors can no longer afford to just commit to a project, simply because the government's in favor of it and because the cost of capital is artificially low. They now have to think about the real costs and real benefits in a more refined way if quality of growth is to be achieved.