China: What’s Next

The Diplomat has launched a special feature on China, featuring slideshows, reporting, analysis, and statistics on a number of issues facing the country. From an article titled, “China’s Bumpy Road Ahead” by Minxin Pei:

Judging by the enormous domestic and challenges Beijing faces in 2011, perhaps the most optimistic thing that can be said about how China will fare in the year ahead is that since most of the damage to its economic health and foreign relations is self-inflicted, Chinese leaders are better positioned than anyone else to repair the damage. Of course, rectifying mistakes isn’t the only path—things could conceivably get worse if politicking on the eve of the leadership transition gets in the way.

At home, the most critical issue is, without doubt, taming inflation. Over the past decade, China has adopted a loose monetary policy (printing far too much money) and maintained financial repression (keeping deposit rates negative and loan rates artificially low). Such a combination may have delivered double-digit growth because it unleashes a torrent of funds available for China’s investment-driven development.

But it also inevitably results in rising prices and asset bubbles (in China’s case, a housing bubble in urban areas). Combating inflation requires not only short-term measures such as raising interest rates and revaluing the currency. A long-term solution lies in difficult financial sector liberalization, fiscal reforms and privatization. Since China entered the World Trade Organization, the economy has become, contrary to expectations, more statist and less liberal. Supported by easy access to credit and government protection against competition from foreign firms and the private sector, state-owned companies now dominate key sectors of China’s economy (finance, banking, energy, telecoms services, natural resources, steel and automobile) while the business climate for dynamic private firms has deteriorated significantly.

At the same time, local governments collude with real estate developers to maximize their revenues from the booming residential housing market. Because of an implicit deal between local governments and Beijing, Chinese provinces and municipalities derive nearly half of their fiscal revenues from land sales. In other words, high housing prices are an inevitable outcome of the current Chinese fiscal system because they are simply taxes in disguise. So making housing affordable for the average Chinese means lowering taxes.

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