Bear in a China Shop

It's not the booming economy that's about to burst -- it's bigger than that. Social discontent and, yes, income inequality could rip China apart at the seams.

Time and again, China has defied the skeptics who claimed its unique mixed model -- an ever-more market-driven economy dominated by an authoritarian Communist Party and behemoth state-owned enterprises -- could not possibly endure. Today, those voices are louder than ever. Michael Pettis, a professor at Peking University's Guanghua School of Management and one of the most persistent and well-regarded skeptics, predicted in March that China's economic growth rate "will average not much more than 3% annually over the rest of the decade." Barry Eichengreen, an economist at the University of California, Berkeley, warned last year that China is nearing a wall hit by many high-speed economies when growth slows or stops altogether -- the so-called "middle-income trap."

No question, China has many problems. Years of one-sided investment-driven growth have created obvious excesses and overcapacity. A weaker global economy since the 2008 financial crisis and rapidly rising labor cost at home have slowed China's vaunted export machine. Meanwhile, a massive housing bubble is slowly deflating, and the latest economic data is discouraging. Real growth in GDP slowed to an annualized rate of less than 7 percent in the first quarter of 2012, and April saw a sharp slowdown in industrial output, electricity production, bank lending, and property transactions. Is China's legendary economy in serious trouble?

Not just yet. The odds are that China will navigate these shoals and continue to grow at a fairly rapid pace of around 7 percent a year for the remainder of the decade, overtaking the United States to become the world's biggest economy around 2020. That's a lot slower than the historical average of 10 percent, but still solid. Considerably less certain, however, is whether China's secretive and corrupt Communist Party can make this growth equitable, inclusive, and fair. Rather than economic collapse, it's far more likely that a decade from now China will have a strong economy but a deeply flawed and unstable society.

China's economic model, for all its odd communist trappings, closely resembles the successful strategy for "catch-up growth" pioneered by Japan, South Korea, and Taiwan after World War II. The theory behind catch-up growth is that poor countries can achieve substantial convergence with rich-country income levels by simply copying and diffusing imported technology. In the 1950s and 1960s, for instance, Japan reverse-engineered products such as cars, watches, and cameras, enabling the emergence of global firms like Toyota, Nikon, and Sony. Achieving catch-up growth requires an export-focused industrial policy, intensive investment in enabling infrastructure and basic industry, and tight control over the financial system so that it supports infrastructure, basic industries, and exporters, instead of trying to maximize its own profits.

China's catch-up phase is far from over. It has mastered the production of basic industrial materials and consumer products, but its move into sophisticated machinery and high-tech products has only just begun. In 2010, China's per capita income was only 20 percent of the U.S. level. By most measures, China's economy today is comparable to Japan's in the late 1960s and South Korea's and Taiwan's around 1980. Each of those countries subsequently experienced another decade or two of rapid growth. Given the similarity of their economic systems, there is no obvious reason China should differ.

For catch-up countries, growth is mainly about resource mobilization, not resource efficiency, which is the name of the game for lower-growth rich countries. Historically, about two-thirds of China's annual real GDP growth has come from additions of capital and labor. Mainly this means moving workers out of traditional agriculture and into the modern labor force, and increasing the amount of capital inputs (like machinery and software) per worker. Less than a third of growth in China comes from greater efficiency in resource use.

In a rich country like the United States -- which already has abundant capital resources and employs all its workers in the modern sector -- the reverse is true. About two-thirds of growth comes from efficiency improvements and only one-third from additions to labor or capital. Conditioned by their own experience to believe that economic growth is mainly about efficiency, analysts from rich countries come to China, see widespread waste and inefficiency, and conclude that growth must be unsustainable. They miss the larger picture: The system's immense success in mobilizing capital and labor resources overwhelms marginal efficiency problems.

All developing economies eventually reach the point where they have moved most of their workers into the modern sector and have installed roughly as much capital as they need. At that point, growth tends to slow sharply. In countries that fail to make the tricky transition from a mobilization to an efficiency focus (think Latin America), real growth in per capita GDP can virtually grind to a halt. Such countries also find themselves stuck with high levels of income inequality, which tends to rise during the resource mobilization period and fall during the efficiency phase. Some worry that China -- which for the last decade has had by far the highest capital spending boom in history -- is already on the edge of this precipice. But the data do not support this pessimistic view. First, much surplus agricultural labor remains. Just over one-third of China's labor force still works in agriculture; the other northeast Asian economies did not see their growth rates slow noticeably until the agricultural share of the workforce fell below 20 percent. It will take about a decade for China to reach this level.

And despite years of breakneck building, China's stock of fixed capital -- the total value of infrastructure, housing, and industrial plants -- is not all that large relative to either the economy or the population. Rich countries typically have a capital stock a bit more than three times their annual GDP. For China, the figure is about two and a half. And on a per capita basis, China has about as much fixed capital as Japan did in the late 1960s and less than a third of what the United States had as long ago as 1930. Further large-scale investments are still required. So China's economy can continue to grow in part based on capital spending, though a gradual transition to a consumer-led economy does need to begin soon.

One illustration of China's enduring capital deficit is housing. Scarred by the catastrophic U.S. housing bubble, many observers see an even scarier property bubble in China. Robert Z. Aliber, who literally wrote the book on financial manias, called China's housing boom "totally unsustainable" this January. And it's true: Since 2005, land and housing prices have rocketed, and the outskirts of many cities are dotted by blocks of vacant apartment buildings.

But China's housing situation differs dramatically from that of the United States. The U.S. bubble started with too much borrowing (mortgages issued at 95 percent or more of a house's supposed market value), which caused a rise in housing prices far beyond the well-established trend of the previous 40 years and sparked the construction of far more houses than there were families to buy them. In China, mortgage borrowing is modest; price appreciation was mainly a one-off growth spurt in an infant market, rather than a deviation from established trend; and there is a desperate shortage of decent housing.

Since 2000, the average house in China has been bought with around 60 percent cash down, according to research by my firm, GK Dragonomics, and the minimum legal down payment has been something in the range of 20 to 30 percent -- a far cry from the subprime excesses of the United States. House prices rose rapidly, but that's partly because they were artificially low before 2000, when state-owned enterprises allocated most of the housing and there was no private market. Much of the home-price appreciation of the last decade was simply a matter of the market catching up with underlying reality. And despite articles about "ghost cities" of empty apartment blocks, the bigger truth is that urban China has a housing shortage -- the opposite of what typically happens at the end of a bubble.

Nearly one-third of China's 225 million urban households live in a dwelling without its own kitchen or toilet. That's like the entire country of Indonesia living in factory dormitories, temporary shelters on construction sites, basement air-raid shelters, or shanties on city outskirts. Over the next two decades, if present trends continue, another 300 million people -- equivalent to nearly the entire population of the United States -- will move from the countryside to China's cities. To accommodate these new migrants, alleviate the present shortage, and replace dilapidated housing, China will need to build 10 million housing units a year every year from now to 2030. Actual average completions from 2000 to 2010 were just 7 million a year, so China still has a lot of building to do. The same goes for much basic infrastructure such as power plants, gas and water supplies, and air cargo facilities.

Yet the housing market also illustrates China's true problem: not that growth is unsustainable, but that it is deeply unfair. The overall housing shortage coexists with an oversupply of luxury housing, built to cater to a new elite. Although most Chinese have benefited from economic growth, the top tier have benefited obscenely -- often simply because of their government or party connections, which enable them to profit immensely from land grabs, graft on construction projects, or insider access to lucrative stock market listings. A 2010 study by Chinese economist Wang Xiaolu found that the top 2 percent of households earned a staggering 35 percent of national urban income. A handful of giant state firms, secure in monopoly positions and flush with cheap loans from state banks, has almost unlimited access to moneymaking opportunities. The state-owned banks themselves earned a staggering $165 billion in 2011. Yet private firms, which produce almost all of China's productivity and employment gains, earn thin margins and suffer pervasive discrimination.

At the root lies a political system built on a principle of unfairness. The Communist Party ultimately controls the allocation of all resources; its officials are effectively immune to legal prosecution until they first undergo an opaque internal disciplinary process. Occasionally a high official is brought down on corruption charges, like former Chongqing party secretary Bo Xilai. But such cases reflect elite power struggles, not a determined effort to end corruption. In a few years' time, China will likely surpass the United States as the world's top economy. But until it solves its fairness problem, it will remain a second-rate society.



Dereliction of Duty

Despite the rhetoric, the NATO summit offers no concrete plan to protect Afghan rights.

The just-completed NATO summit in Chicago highlighted two competing visions for Afghanistan. The first -- focusing on the Afghan people -- seeks democracy, civil rights, and the rule of law. The other, driven by NATO's rush for the exits, settles for a modicum of security to prevent Afghanistan from being used as a base for attacking the West. Rhetoric at the summit embraced the grander vision, but the dearth of concrete commitments raised fears that the minimalist one will prevail.

Like the U.S.-Afghan strategic partnership agreement signed earlier this month in Kabul by U.S. President Barack Obama and Afghan President Hamid Karzai, many of the world leaders assembled in Chicago -- though, notably, not Karzai -- spoke eloquently about their commitment to human rights, particularly for women. But the test of that commitment is whether anybody cares enough to put in place a concrete plan to carry it out. The United States and its NATO partners have fallen disturbingly short on three key issues -- ensuring that security forces abide by the law, marginalizing the warlords at the heart of the Karzai power structure, and providing meaningful protection for the rights of women. 

As the troops depart, NATO's hopes for keeping the Taliban at bay rest in large part on organizing and arming villagers as members of the new Afghan Local Police (ALP). The program, begun in 2010, now counts some 13,000 ALP members, with plans for 30,000.

But simply handing an Afghan an AK-47 and a couple weeks of training is a recipe for disaster. Because villagers can so easily abuse their new power -- mistreating suspects, pursuing private vendettas, stirring ethnic conflict -- paramilitary forces of this sort are inherently dangerous. A Human Rights Watch report released in September 2011 documented many such abuses. An internal Pentagon study obtained last week by the Los Angeles Times found ALP units making little contribution to security while engaging in assault, rape, extortion, and drug trafficking. 

The Pentagon's plan for avoiding such abuses is to vet would-be ALP members, train them, and hope the Afghan Interior Ministry will hold them accountable. But given the troublesome record of Afghanistan's traditional security forces -- torture by the intelligence services is rife, for example -- there is little reason to think these measures will suffice.

One way to improve accountability for the ALP and other Afghan security forces would be to establish an independent mechanism -- some sort of national ombudsman -- where civilians could file complaints about the use of abusive force, and where officials would be authorized to investigate and, if appropriate, recommend prosecution. The respected Afghanistan Independent Human Rights Commission told me when I visited Kabul in March that it is willing and able to house such a mechanism. Several NATO governments said privately at the time that they liked the idea. But there was no evidence at the Chicago summit that these governments were pushing such oversight as a condition of the $3.6 billion in military aid that they hope to provide Afghanistan. A senior Defense Department official told me in Chicago that the Pentagon would prefer Afghans to adopt such a plan on their own. (Meaning: They like the idea in principle but don't want to spend their time or capital fighting for it.) And given the resistance of Afghan security forces, that is unlikely to happen without a strong external push.

One reason the Afghan government finds discussion of accountability for abuses uncomfortable is that Karzai has built a political base that includes many powerbrokers and warlords, each with their own record of atrocities. A prime example is Vice President Mohamed Fahim, a former senior commander of the Northern Alliance who is implicated in war crimes from the 1990s and continues to face allegations of abuse and corruption. Any effort to remove these tainted and distrusted figures from a governance role must begin with official acknowledgment of their record. The Human Rights Commission has produced a detailed "mapping report" documenting these crimes, but Karzai has insisted that it not be published. NATO's silence on the subject suggests it backs him, or at least is willing to look the other way. Like many of his colleagues in Kabul, U.S. Ambassador Ryan Crocker left me thinking as much when he told me in March that the report "would not be helpful now."

Afghan women, having made important gains in the past 10 years, have the most to lose as NATO withdraws. Since the Taliban were overthrown, women, particularly in urban areas, have made real progress in access to healthcare, education, and employment opportunities. Yet those gains are under threat, not only from the Taliban, but also from the Karzai government. The government has sought to bolster its power base by appealing to socially conservative forces -- such as when it recently endorsed a religious council's guidance to the effect that women must work and study separately from men, must travel outside the home only with a male chaperone, and in certain circumstances, may be beaten.

In Chicago, a senior State Department official spoke passionately to me about the importance of respecting women's rights in post-NATO Afghanistan. But there seems little beyond fervent desire -- and a wish and a prayer -- to make that happen. Washington seems to have a plan for Afghan troops once it leaves; it should also have a plan for the protection of Afghan women. 

No one expects any of this to be easy. But the United States and its NATO partners haven't tried nearly hard enough. True, their influence decreases as NATO troops depart, but the promised delivery of massive military assistance -- aid that will be essential to the Afghan government's survival -- still provides considerable leverage. It would have been nice if the NATO governments' high-sounding rhetoric at the summit about their vision for Afghanistan were matched by some tough, no-nonsense pressure to realize it.