What’s the most important policy uncertainty investors face? If your time horizon is the next six months, the likely answer is how the U.S. will address the approaching fiscal cliff. If your framework is the next year or so, it’s probably how the European debt mess will evolve. But if you’re thinking about this decade, it’s almost surely about China. To see why, let’s look at China’s current five-year economic plan, its twelfth.
Since the strict Maoist years, Chinese planning has evolved from requiring so many tons of wheat or steel, units of workers’ housing and watts of power to more qualitative objectives. Even the plan itself is no longer called a plan; rather, it is now referred to as a set of guidelines. But those guidelines matter because the same central authority that adopts them is also the controlling shareholder of the country’s largest companies—including its banks—and therefore has a significant say in what happens in the economy.
The qualitative objectives in the current plan, like “rise in domestic consumption, breakthrough in emerging strategic industries, and service sector value-added output to account for 47% of GDP,”1 represent a major shift from the manufacturing, fixed investment and export thrust that was behind China’s remarkable growth over the past two decades. If and to the extent that shift takes place, the results will reshape not only the Chinese economy, but they’ll have major implications for ours as well.
China faces limits to its established growth model for at least two reasons. The first is the result of the “Lewis turning point,” or middle income trap. This economic theory predicts that growth in countries that depend on cheap labor to compete in the world market will eventually stagnate as demand for workers pushes wages to the point where those countries no longer have a cost advantage. “Why Nations Fail,” a recent book that’s well worth reading, makes the additional argument that countries like China—and the Soviet Union during the mid-twentieth century—can make impressive material progress by forcibly adapting existing production methods on a massive scale. However, the authors predict that progress in such countries, which they call “extractive” regimes, will eventually fade because they cannot generate the internal innovation required for self-sustaining growth.
China’s current five-year plan is an implicit recognition of both of these traps and an attempt to break out of them. If this attempt fails, not only will a source of demand for everything from coal to fancy pocketbooks weaken, but the country’s political stability may come into question as well. If it succeeds and achieves some greater measure of autarchy, consumers should feel the impact globally. If the Chinese economy becomes more self-contained, what will happen to the price of t-shirts and flat screen TVs and the demand for 1.5% 10-year treasuries? I’m betting on some measure of Chinese success, which means that I’m worried about investments that can’t compete with inflation, even at today’s remarkably low levels.
1. Xinhua, 3/5/2011. “Key Targets of China’s 12th Five-Year Plan”