Democracy Lab

Reinventing China, Again

China made it big by saving money. Now it needs to spend it.

Note: This article is an abridged version of an in-depth country study produced as part of the Prosperity Index project of the Legatum Institute. Complete versions of all 12 are available on the Institute website.

For much of the five centuries in which China has showed its face to the West, foreigners have been preoccupied with how to make money in the Middle Kingdom. The dream seems especially vivid right now, as China hints that it is reinventing itself as a consumer economy.

But that transition won't be easy. First, to move the economy into the big leagues, it will need to build supporting institutions ranging from comprehensive pension and health care systems to far more sophisticated financial markets.  Second, China will need to change from a dazzlingly successful export machine to a balanced economy that both meets the needs of domestic consumers and plays a stabilizing role in the global economy. Third, it must manage its growing geopolitical power and hunger for raw materials carefully in order to preserve the benefits of global economic integration.

FIRST PHASE: 1978 - 1989

Post-revolutionary China first strayed from its ideological redoubt in 1978 -- the year Deng Xiaoping cautiously led his impoverished nation away from 29 years of central economic planning and state ownership. Back then, state enterprises made up 78 percent of the China's productive capacity, and collectives owned the rest. One billion Chinese lived (and sometimes starved) on collective farms. Per capita income was around $500 a year in today's purchasing power.

First, farmers were permitted to choose which crops to plant; later they were paid for what they grew on their own plots. And they were paid more generously, reversing a strategy developed by Lenin to extract every last crumb from agriculture in order to feed heavy industry. Agricultural production doubled in a decade, even as underemployed farm workers streamed to the cities.

Industrial reforms followed agricultural. Deng created special export zones that welcomed foreign investors and by 1984, they were thriving in 14 coastal cities. Deng had put the country on a path to a mixed socialist-capitalist economy without sacrificing any political control.

Contemporary China's first phase of development ended with a bang at Tiananmen Square on June 4.  Foreign investors paused after the United States and other nations imposed sanctions on China. But not for long -- which brings us to the period in which China became the factory to the world.

SECOND PHASE: 1990 - 2008

Foreign direct investment took off, rising from $5 billion in 1990 to close to $100 billion annually by late in the last decade. Beijing (correctly) viewed foreign business as the key to transferring the management techniques and advanced technology needed to leapfrog a long period of industrial trial and error. What's more, it needed to find jobs for tens of millions displaced by the agricultural reforms.

So foreign companies got tax breaks and land, conveniently cleared of villagers. They also got cheap wages and few restrictions on pollution or working conditions. All they had to do was turbo-charge China's climb up the production ladder from simple labor-intensive goods (apparel and toys), to consumer electronics, to machinery demanding complex industrial organization, long supply chains and sophisticated process technology (cars and commercial aircraft).

By the end of this second phase, China was the world's second-largest economy. In three decades, China had lifted 600 million people out of poverty and peasants who lived most of their lives at subsistence had children who routinely earned close to $5,000 annually.

THIRD PHASE: 2008 - ?

From 1980 to 2008, per capita income, measured in terms of purchasing power, rose eleven-fold!  But growth is no longer the only objective for Chinese political leaders. Nor, for that matter, is it clear that the Chinese economy could keep growing at anywhere near that pace without fundamental structural change.

China faces both developmental and demographic challenges. The former is what's been dubbed the "middle-income trap": the vast majority of developing countries -- more than 85 percent in the postwar era, according to the World Bank -- get stuck in middle-income territory ($4,000-$12,000 in today's purchasing power).

Can Beijing beat the odds? One glaring weakness is the immaturity and lack of independence of the banking system. Though nominally privatized, the handful of huge banks are regularly asked to perform government functions -- for example, lending billions to local governments to fund infrastructure projects with little prospect of repayment.

The government has in the past bailed out banks that have marched off fiscal cliffs to Beijing's tune -- and it certainly has the resources to prevent their collapse in the future. But, lacking independence and free-market incentives, the banks have failed to develop the skills to allocate capital to its most productive uses. A "shadow banking" sector has mushroomed to serve private enterprise largely ignored by the government-chartered banks. It is virtually unregulated, though, and would constitute a real danger to China's financial stability in the event of a serious economic downturn.    

Equally to the point, China must manage modernization even as its population grows old. The ratio of those over 65 to the working-age population will double in two decades. This demographic shift is happening all over the world -- but in China, the pace will be unprecedented thanks to the government's draconian effort to contain population growth since the 1980s.

China's baby boomers start retiring in a few years, putting immense pressure on health care and other dependents' services. When Deng set loose the collective farmers, he also abandoned socialized medicine in the countryside. The government acknowledges the vacuum it created, as well as the reality that modern health care systems require major inputs from the public sector. And Beijing has been working on an ambitious reform model of universal private health care bolstered by heavily subsidized, government-run health insurance. But it's decades away from meeting the goal of providing first-rate care to all Chinese.

Actually, more is at stake here for China than the risk of getting caught in the middle-income trap. The sharp decline in Chinese exports during the global financial crisis brought home the urgency of China's need to move beyond the status of factory to the world.  China will continue to make computers and furniture and auto parts for Westerners to buy. But Beijing wants to refocus its increasingly sophisticated productive capacity on the domestic market.

In theory, that should be easy. All Beijing must do is to convince the Chinese to spend their money instead of saving nearly half of it. To that end (among others), many cities have raised minimum wages by double digits since 2008. But lacking a safety net, older Chinese households will be hard to persuade.

There's another reason China is determined to move past its phase-two policy of growth at any cost. The Chinese are complaining more. They complain about corrupt party officials stealing their land and selling it to real estate developers. They complain that three decades of insider deals and backs turned to abuse of the environment have left the air dangerous to breathe and the water sometimes deadly to drink.

As part of its defense of the legitimacy of one-party rule, Beijing is becoming more responsive to their wishes. In several demonstrations this year, regional officials have sided with rioters instead of corrupt local officials -- something once unthinkable.

Younger Chinese have very different attitudes than their parents. Chinese who lived during the turmoil of Mao's rule are less willing to risk the unknown and more willing, as the Chinese saying goes, to "eat bitterness." But those who have mostly grown up in one-child families in a period in which GDP was doubling every eight years, have higher material aspirations.

One paradox here: Even as modern China makes the pivot to production for domestic markets, the economy is becoming more closely connected with the rest of the world. Production and marketing chains, for example, reach across multiple continents. But this amounts to interdependence, not dependence -- China doesn't need the outside world as much today as a source of managerial skills and process technology.

Two trends -- one in manufacturing, one military -- are bringing China and the world closer together economically, but pushing them apart politically. Consider manufacturing, where raw materials went in one end of the assembly and finished goods came out the other.  No longer.  Take something as seemingly simple as a shirt with buttons down the front.

Fabric woven by a factory in Korea or India may be shipped to Vietnam or Cambodia, where other workers cut out the panels of the shirt, which are stitched together in yet another factory. Then the half-finished shirt goes to China, where workers attach buttons (imported from Japan). Chinese workers sew on the label and attach a price tag before shipping the finished product to Walmart or Brooks Brothers.

Or consider the iPod. The brains (software) were created by a team of engineers at an Indian company. The liquid crystal screens come from Japan, the flash memory chips from Korea. Those get shipped to mainland China -- to huge factory complexes owned by the Taiwanese sub-contractors that make what Apple sells.

Today, lots of companies are like Apple: they either no longer make what they sell, or no longer sell what they make. This change in manufacturing dynamics has changed global trade patterns, and that in turn is changing geopolitics. Nations all across Asia that used to rely on the United States as their biggest trading partner are now equally dependent on China.

Japanese companies make the high-tech electronics for computers, but rely on China to assemble them. Australia avoided recession after the global financial crisis by turning itself into China's mine shaft. Today, Australia trades more than twice as much with China as it does with the United States.

Hence the bifurcation.  Asia-Pacific's middle- and high-income countries are bound to China in economic terms -- ties that only grew tighter during the global recession when China's demand for imports never flagged. But they remain dependent on the United States in military terms.

China has begun using its new economic leverage to squeeze its neighbors. For instance, when the Philippines objected to its fishing boats entering disputed waters, Chinese travel agents boycotted the Philippines and Chinese port inspectors allowed fruit imported from the Philippines to rot on the dock.

And back in 2010, after Japan arrested the captain of a Chinese fishing boat in waters both countries claim, China briefly banned exports of rare earth minerals that Japanese companies needed to make their most sophisticated products -- including the high-end electronics components that Japanese companies mostly ship to China for assembly.  Meanwhile, the looming source  of friction is oil and gas deposits in the South China Sea, where China, Malaysia, Vietnam, Taiwan, Brunei and the Philippines all have competing claims.

Nor is China depending entirely on its economic muscle to make its geopolitical points. It is also building up its military capacity, including its first blue-water navy in 500 years.  By no coincidence, the Pentagon announced it would deploy 60 percent of U.S. warships in Asia-Pacific theater, instead of half.

China may be ever more closely connected with the rest of the world by globalization, but as China moves deeper into stage three of development, it's political leaders are choosing their own path. And there is no guarantee that China's preferred way forward will dovetail neatly with the interests of the rest of the world.    

Photo by STR/AFP/GettyImages


Chuck Hagel's Biggest Task

Obama's new defense secretary will first and foremost need to get the Asia pivot right.

Chuck Hagel may be a former grunt, but his most important task as America's next secretary of defense -- should his nomination pass the Senate -- could be a trying job for a landlubber: executing the military component of the Obama administration's pivot to Asia. It's a mission that will require an appreciation for the finer points of maritime strategy, a deft diplomatic touch, and an expansive worldview.

But first, Hagel must understand what the pivot is, while viewing it against the grand sweep of U.S. diplomatic history. A historically and geostrategically minded secretary will stand a good chance of configuring the U.S. Navy, Marine Corps, and Coast Guard prudently -- and of arranging sea-service forces on the map to accomplish America's goals.

What is a foreign-policy pivot? Metaphors have their uses, but they can distort meaning if deployed cavalierly. A pivot is a central shaft, axle, or pin around which machinery rotates. The engineering metaphor encourages practitioners and commentators to interpret the administration's initiative in physical, geospatial terms. In these literal terms, Washington, D.C. is presumably the axle around which U.S. foreign policy revolves. Hence many observers' lament that the United States is turning its back on perennial theaters like the Atlantic community to oversee events in East and South Asia. There's a degree of truth to this, but applying the pivot metaphor implies an about-face. Seldom are things that pat. 

I define a pivot as a foreign-policy enterprise that combines elements of geography, strategy, and diplomacy to mount a sustained presence in some distant and potentially contested overseas theater. In military terms, pivoting means building up preponderant armed might in East and South Asia in concert with friends and allies to accomplish strategic and political goals. Pivoting is a matter of strategic mass, strategic maneuver, and alliance relations. It also means setting priorities. American leaders must be prepared to relegate secondary theaters to secondary status, lest they scatter finite resources hither and yon. Dispersal thins out military power at any spot on the map, perhaps leaving U.S. commanders at a local disadvantage against weaker foes. Armed forces that try to do everything, everywhere, at the same time end up doing little anywhere.

While the term "pivot" may be novel, its substance is anything but. Indeed, U.S. diplomatic history can be interpreted as a series of pivots. Writing in the 1940s, Yale professor Nicholas Spykman -- arguably the foremost geopolitical thinker of his day -- recalled that the New World had been an object of struggle for the Old World since Christopher Columbus sailed the ocean blue. In those early centuries, influence radiated across the Atlantic and Pacific toward American shores. Eurasian empires fought for supremacy and prosperity in the Americas. They sustained their efforts largely through overseas commerce, their newfound territorial holdings, and great merchant and naval fleets -- the sinews of sea power according to U.S. Navy Captain Alfred Thayer Mahan, a fin-de-siècle pundit who knew a thing or two about the subject. 

The United States first pivoted from North America to the Caribbean Sea and Gulf of Mexico, turning its eyes from the continental interior to the maritime near abroad. Let's call this turnabout Pivot 1.0. This was the age of the Monroe Doctrine (1823), when Washington appointed itself the protector of American republics' independence of European imperial rule. In principle, the republic forbade Europeans to expand their holdings anywhere in the Western Hemisphere. In practice, U.S. leaders confined their energies to the Caribbean basin. They were thinking geostrategically, and they set priorities. Once dug, a canal across the Isthmus of Panama would shorten sea voyages between Atlantic and Pacific by thousands of miles, sparing mariners the journey around Tierra del Fuego -- the odyssey the Pacific-based battleship USS Oregon underwent to get into the fight off Cuba in 1898.

America executed its first seaward pivot on the cheap. Erstwhile foe Great Britain ruled the waves, and it had reasons of its own for wanting to keep rival empires out of the Americas. Owing to this confluence of interests, Britain's Royal Navy was a silent partner in the Monroe Doctrine. British, not American seafarers enforced the hands-off policy for most of the 19th century. Washington achieved its geopolitical aims while freeriding on the preeminent fleet of the day. Why invest in an expensive U.S. Navy when powerful outsiders would do the navy's work for it? Except for a brief buildup for Civil War blockade duty, the U.S. Navy remained a backwater until the 1880s. Only then did the United States lay the keels for its first armored, steam-driven battle fleet -- amassing the wherewithal to put steel behind its pivot to the sea. No longer would Washington entrust the doctrine to external guardians whose goodwill could prove fleeting.

In Spykman's words, U.S. leaders fixed their strategic gaze on "America's Mediterranean" to the south. They set ambitious goals, such as preserving Latin American republics' independence while keeping stronger imperial powers at bay. And expediency determined the implements they used to attain those goals. Having an external benefactor like the Royal Navy appeared providential during the founding decades, when the United States was subduing a continent and pursuing internal improvements. By the 1880s, however, the Industrial Revolution had delivered such material abundance that Washington could take charge of North America's environs. The United States started accumulating strategic mass, manifest in a strong navy. Victory over Spain in 1898 furnished strategic mobility in the form of an island base network to support naval operations in the Caribbean Sea and Gulf of Mexico.

Policy energy, strategic mass, strategic maneuver -- these were the struts supporting America's first foreign-policy pivot. But if Pivot 1.0 swiveled U.S. attention to the Caribbean, it also ushered in Pivot 1.5. Adm. George Dewey's Asiatic Squadron crushed the Spanish fleet at Manila Bay during the Spanish-American War, handing the United States an offshore outpost in the Far East. Washington scooped up islands such as Hawaii and Guam -- islands suitable for naval stations -- in the aftermath of war. America had established a bridgehead off the China coast, complete with island stepping-stones to reach it. It just needed a Central American canal to expedite access from the North American east coast to the Pacific Ocean, and thence to the riches of Asia.

America's Pacific strategy remained in limbo until the Panama Canal opened in late 1914, completing the arc of Pivot 2.0. In an arresting turn of a phrase, Spykman vouchsafed that the transoceanic waterway in effect lifted the United States and turned it 90 degrees southward on its axis -- rotating the republic's strategic gaze wholesale toward the isthmus and the broad Pacific. In reality the canal split U.S. foreign policy. The republic's leaders surveyed events not just along the traditional eastward vector toward Western Europe, but also along a new westward vector pointing toward Asia.

With the opening of the canal, the strategic-maneuver component of the Pacific pivot thus fell into place alongside strategic mass. As the United States continued its ascent to great power, consequently, the longstanding pattern -- in which the Old World was the arbiter of events in the New -- reversed itself. Having won grudging European acquiescence in the Monroe Doctrine, the United States cast eyes on the western and eastern rimlands of Eurasia. Statesmen like Theodore Roosevelt had long considered it dangerous to allow a single great power or hostile coalition to wrest away control of Western Europe, East Asia, or both -- gaining sufficient military resources and a geographic platform from which to menace the Americas. Hardscrabble logic like TR's summoned the United States to Eurasia for two world wars and a Cold War.

The logic of Pivot 2.0 persisted through the Cold War, although the nature of East-West strategic competition drew U.S. strategists' attention further into the Eurasian heartland occupied by the Soviet Union than during the days when Imperial Germany and the Axis were on the march. Samuel P. Huntington, the great political scientist, contended that U.S. maritime strategy entered a "transoceanic" phase following World War II, fixing American attentions on events deep within Eurasia while empowering U.S. forces to act from forward bases scattered around the rimlands. Call Huntington's transoceanic strategy Pivot 2.5 if you like. But it was another variation on the same theme.

The difference between the Cold War and the world wars, then, was in emphasis more than substance. The Cold War threw the contest between land and sea power into stark relief. Moscow operated mainly within the bounds of Eurasia, projecting power outward from the heartland along railways, roads, and other land lines of communication. Seagoing Western forces ranged around the circumference, transmitting power inward from the sea. But despite the change of adversary, from the rimland alliances of the world wars to a central Eurasian power, Washington's determination to prevent a hegemon from ruling the eastern and western rimlands endured.

As in Pivots 1.0 and 1.5, the elements of Pivot 2.0 were policy focus, strategic mass, and maneuver. But two additional elements injected themselves this time. Alliance politics granted the U.S. military access to the Eurasian rimlands, helping forces overcome the tyranny of distance. At the same time, Eurasian opponents boasted growing capacity to dispute entry into their backyards. These elements persist to this day. No pivot can succeed without access to the theater.

Viewed against the backdrop of history, the Obama administration's maneuver qualifies as Pivot 3.0. How does it differ from its predecessors? First, in effect the administration has pivoted from Western Europe to the greater Indian Ocean, shifting America's gaze from the western to the southern rimland for the first time. That imparts a north-south character to U.S. policy toward Eurasia, modifying its historically east-west, horizontal alignment. The vertical dimension will become even more pronounced should climate change open the Arctic Ocean -- and thus the polar rimland of Eurasia -- to shipping more often and more reliably in the coming decades.

But it overstates matters to fret, as worried Europe-first commentators often do, that the pivot presages American neglect of the Atlantic theater. Unless the United States rearranges its basing structure in the critical theaters -- say, by basing heavy U.S. Navy forces in western Australia, thereby shifting the navy's center of gravity to the region -- it will keep dispatching expeditionary forces from east-coast seaports like Norfolk and Groton to the Arabian Sea and the Persian Gulf. They're the closest North American naval stations to the western reaches of the greater Indian Ocean.

For the foreseeable future, then, Washington will continue to depend on the Atlantic Ocean, Mediterranean Sea, and Red Sea as a thoroughfare for U.S. naval forces. The pivot has deflected the administration's policy attention to the south by a few compass points, from Europe to South Asia, while Washington has come to regard Europe less as an object of U.S. foreign policy in its own right than as an enabler for U.S. policy in Asia. But Europe has been a platform for U.S. warmaking in the Middle East and Indian Ocean region for more than two decades now. Does looking past Europe mark that radical a break with history, and is the shift that worrisome so long as the Atlantic Ocean and Western Europe face no real threat? I can't see why.

Second, the South Asian rimland is inaccessible relative to the eastern and western rimlands, theaters reachable from North America by way of direct if long sea and air routes. Look at the map. U.S. forces bound for the Indian Ocean from the Atlantic must transit narrow seas like the Strait of Gibraltar, Suez Canal, and Bab el-Mandeb Strait. Units coming from the Pacific must traverse the Malacca, Lombok, or Sunda straits. If denied passage through these chokepoints, mariners must undertake arduous voyages around the Cape of Good Hope, at Africa's southern tip, or around the southern rim of the South China Sea, scudding between Indonesia and Australia. In extreme circumstances, U.S. Pacific Fleet units might find themselves forced to detour around the southern Australian coast. Strategists must not blithely discount hard geographic realities -- realities compounded by the lethal, long-range, precision weaponry increasingly found in hostile hands. 

Third, the United States shouldered an increasing share of the resource burden in its early pivots. It could afford to. But an increasingly cash-strapped Washington would now like to offload some of the burden onto friends and allies. Indeed, the 2007 U.S. Maritime Strategy, which foreshadowed Pivot 3.0, instructs U.S. officials and commanders to seek out alliances, coalitions, and partnerships to help share the load. That makes Pivot 3.0 a stiffer diplomatic challenge than its forebears. It's one thing for allies to grant access to their soil or conduct combined exercises or operations with U.S. forces. The American taxpayer foots most of the bill for such enterprises; what's not to like? It's quite another for allies to agree to help fund a made-in-Washington strategy out of their own taxpayers' pockets. Deft diplomacy will be a must as the strategic pirouette proceeds.

Here's hoping America's next secretary of defense, whether it's Hagel or somebody else, will see U.S. diplomatic history for what it is -- a handy yardstick for today's endeavors.