China needs to overhaul its growth model

In June， China’s financial market was struck by a so-called “money shortage，” as the central bank refused to inject cash into struggling State banks. Although the central bank eventually relented， pumping in capital to ease the shortage， the standoff exposed China’s vulnerability to financial crises. But while a bailout from the central bank can solve a short-term liquidity problem， it cannot solve the long-term distortion of the economy， nor can it alter China’s investment-driven growth model.

Although the central government has long been aware of the problems inherent in its growth model， and pledged to“restructure” as early as 1995， the bulk of China’s growth has continued to come from boosting investment. This model has been pushed to the extreme， creating a range of problems including overissuance of paper currency， swollen debt， and macroeconomic instability， all of which have contributed to the current economic slowdown.

In recent years， whenever China has found itself with economic worries， the government has resorted to boosting growth with vast injections of investment， a method dubbed “the Chinese Model.” As an authoritarian government， China is able to mobilize resources to stimulate the economy. Following the global financial crisis， the government unveiled a four trillion yuan （US$652bn） stimulus package and rolled out 10 trillion yuan （US$1.6bn） in loans， helping China to succeed in maintaining a growth rate of 8 percent.

Under the surface， the various problems embedded in this model have become more and more serious， not only in the form of problems like environmental pollution and the over-exploitation of natural resources， but also in the economy itself.

One direct result of the frequent use of stimulus plans is that their effectiveness begins to diminish. For example， the four trillion yuan stimulus package issued in 2009 was only able to buoy up the economy for a year， after which China saw five quarters of continuous economic slowdown.

Since May 2012， many local governments have again been resorting to increasing investment in real estate and industrial projects to ensure GDP growth. In some provinces， annual investment in fixed assets is astonishingly high， reaching 120 percent of GDP in some cases.

Many of these investment projects， aimed at boosting growth rates， now have a very low or even negative return， manifested in the widely reported phenomenon of “ghost towns” uninhabited real estate developments in various places around the country. All these efforts only increased the growth rate in the fourth quarter of 2012 by 0.9 percent. In the first quarter of 2013， growth fell again.

As the economy slows down， another problem has become worryingly acute thanks to massive investment in recent years， as the degree of financial leverage of China’s Stateowned enterprises， banks， and local governments reaches dangerous level. With massive debt and poor returns， the financial system has become vulnerable， as insolvency of individual financial institutions can spread to the entire financial system， and lead to a financial crisis. Currently， a major concern is that a stronger US dollar may trigger an exodus of hot money， precipitating a financial crisis similar to the Asian Financial Crisis of the late 1990s.

To solve the problem， it is necessary for China to overhaul the institutional foundations of its investment-driven growth model. At the core of the Chinese model is the existence of authoritarian government， which dictates the distribution of resources. In order to adjust with its growth model， China’s political system is in need of reform. Otherwise， the government could find itself unable to steer away from its current path， even when it eventually realizes that it can no longer depend on stimulus plans to ensure economic growth.

Unfortunately， China’s society and leadership remain divided on some of the basic questions about China’s future， including the issue of what kind of system the country should adopt. It may take a long time before a consensus is reached in the meantime， China is left to face a looming crisis.