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Photo: Bloomberg
Photo: Bloomberg

China’s painful structural changes

Economic development based on diversified domestic demand is more complicated than export-driven development

For more than a year, headlines worldwide have been pointing to a Chinese economic slowdown. But a closer look tells a different story—one that is less about deceleration than changing gears.

After the 2008 financial crisis, when slower growth became the “new normal" for many countries, China began to accelerate its economic rebalancing by shifting the drivers of growth from manufacturing and exports towards goods and services for domestic consumption.

This transition has had far-reaching implications for the future dynamics of China’s economy. With its previous export strategy, the government’s main priority was to integrate domestic manufacturing operations into global production chains. Now, however, its aim is an economy that meets domestic consumers’ diverse demands, and it is the industries closely connected to those demands that are quickly expanding.

Previously, the economic activities that are now flourishing weren’t categorized as manufacturing industries at all, but as “services". But services do not exist in a vacuum. All businesses need manufactured products, transportation, information and communications technology (ICT), logistics, real estate, finance, insurance and more. Thus, new demand for new services has virtuous-cycle effects in terms of capital investment in infrastructure and equipment.

According to a paper by economists Jong-Wha Lee and Warwick J. McKibbin, service-sector productivity growth in Asia “benefits all sectors eventually, and contributes to the sustained and balanced growth of Asian economies". Examining economic development trends in South Korea, the authors find that the average value added per worker in transportation, real estate and ICT is now higher than the average in manufacturing, and they point to similar dynamics in the US, Japan and China.

This finding suggests that rapid development in China’s service economy could reverse the externally triggered dampening of growth since 2008. But, as the Japanese and South Korean transitions from export to domestic demand-driven growth demonstrate, structural transformation is a slow and painful process.

China is in the midst of that process. This points to fundamental challenges ahead. For starters, economic development based on diversified domestic demand is more complicated than export-driven development, because these new sectors rely more heavily on sophisticated financial services, free and equitable market access, better educated workers, and higher investment in research and development.

As a result, the new businesses emerging from the shift to a new growth model are demanding far more from China’s current economic-governance system than it can bear. Further structural reforms would go a long way towards fixing this problem, but they will require China’s leaders to make tough political decisions that won’t please everyone.

Another fundamental challenge is China’s slow rate of urbanization. Each of a thriving service economy’s major components—ICT, finance, insurance, transportation and real estate—needs the others to prosper, and cities are what bring them all together. Unfortunately, China’s enduring system of dividing urban and rural regions, together with poor urban planning, has led to fragmented metropolitan communities without diversified networks that would otherwise have helped boost productivity.

China’s cities will be a key ingredient of its long-term economic success. Urbanization should start accelerating today, and over the next 10-15 years, with the expansion of metropolitan areas geared towards the needs of services-led economic growth. If China can rise to that challenge, it will be well-positioned to clear the remaining hurdles in its path towards high-income status.

©2016/PROJECT SYNDICATE

Zhang Jun is professor of economics and director of the China Center for Economic Studies at Fudan University.

Comments are welcome at otherviews@livemint.com

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