Make or Break for China

2014 is the year of the horse in China. But for the rest of us, it might prove to be the year of China. The country faces a historic turning point: either it will revamp its economic system, deal with some of its growing environmental and social problems and set itself up for another decade of growth and stability that will ensure it becomes the world’s largest economy, or 2014 will be the year that the great Chinese miracle hits a serious road bump–with seismic consequences.

People have been making such predictions about China for years, even decades, and the worst has never come to pass. While it has faced formidable challenges–creating a market economy from scratch, building world-class infrastructure, urbanizing hundreds of millions of peasants–Beijing has adjusted its policies along the way and continued to grow at an unprecedented pace.

But this time it feels different. China has built up economic imbalances for some years, and they are not sustainable for much longer. The basic problem is that for almost a decade, China’s economic growth has been fueled by cheap credit and government spending–a classic developing-nation problem. Even before the financial crisis of 2008, Beijing’s top officials acknowledged that the economy was, in former Premier Wen Jiabao’s words, “unstable, unbalanced, uncoordinated and unsustainable.” The government needed to stop the flow of easy money to infrastructure, state-owned companies and the housing sector. But this decision was tough to implement, since growth was dependent on easy money. In addition, those getting the money were politically powerful, including state-owned companies and local party bosses.

Then came the financial crisis and the global economic slowdown. But slowing down was not an option for Beijing: the Communist Party’s legitimacy derives not from ideology but from competence. So it pursued the world’s largest Keynesian response to the crisis, spending over 10% of GDP to keep the economy going. It worked. China’s growth rate has averaged more than 9% in the past few years.

But the price has been high. According to a column in the Wall Street Journal by Morgan Stanley’s Ruchir Sharma, China’s total public and private debt is over 200% of GDP, an unprecedented level for any developing country. Businesses and local governments have piled on debt. Borrowing has fueled a property boom. Without serious policy changes that wean large sectors of the economy off cheap credit relatively soon, this is a bubble that is going to burst and a model that cannot keep performing.

Beijing faces other serious challenges. Chinese people almost anywhere in the country experience serious air and water pollution, and they have begun to complain vocally. They are also increasingly outraged by something almost as ubiquitous: corruption. China’s corruption is masked because of the state’s tight control of the media, but the Communist Party is well aware of the problem and has pledged to revamp its systems of promotion and party discipline to ensure that officials are less corrupt and more focused on ecological damage, not just growth.

Any such changes are bound to face political resistance and backlash from within the Communist Party and from some powerful sectors of society. President Xi Jinping has launched an anticorruption campaign, though many in China believe enforcement has been selective. He has also sought to stabilize the party’s power by tightening the noose on any critics in the media and universities and even those who are private businesspeople. Xi has created a national security council focused largely on internal security, a sign of not only where his priorities lie but also where he sees his greatest challenges.

I’m not ready to bet against China. Its leadership has shown itself to be capable of difficult decisions and smart execution. Xi has accumulated an unusual degree of authority and clearly intends to use it to go down in history as the man who reformed China’s system to make the country stronger and more powerful.

If China’s leaders manage this transition well, the country will emerge stronger and more stable and become the largest economy in the world. If they don’t, China will likely face a slump, one that will look a lot like those of other high-flying developing countries–such as South Korea and Taiwan–that ended a period of rapid growth and settled into a more normal trajectory. In many of those cases, slow growth coincided with widespread protests and the opening up of the political system.

Keeping China’s growth model going will prove hard enough. But to do that with all the associated political challenges will test even China’s extraordinary leaders.

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