Where is the Chinese economy heading? Sorry, we couldn’t understand!

The International Monetary Fund (IMF) announced a couple of weeks ago that the Chinese economy was heading towards the right direction, saying it is transforming to a new normal. The main risk, however, was the Chinese government's push for economic reforms that might prove "insufficient", it said.

In its regular economic assessment, the IMF said that the Chinese economy was moving toward "slower but safer and more sustainable growth", reported the New York Times.

But on August 11, financial markets were shaken by China's decision to abruptly devalue its currency, days ahead of the publication of the IMF report.

For all the IMF's assurances that this was a minor adjustment after a sharp appreciation of the currency until then, a welcome step that "should allow market forces to have a greater role in setting the exchange rate," investors seem to have taken it as an unsettling signal that the Chinese authorities are desperate.

Diana Choyleva of Lombard Street Research wrote: "The stumbling economy desperately needs a weaker currency." It further asked: "Is this the start of a more flexible currency regime or an old-style devaluation?"

No one believes China's official statistics anyway. What if the country's economy is slowing faster than anybody knows? Developing countries - already reeling from the collapse of China's demand for their raw materials - could feel the screws tighten further. And if China resorted to further devaluations to bolster exports and work itself out of an economic morass, it would undercut growth worldwide.

On August 25, after a 22% drop in Shanghai's main stock market over three days, the Chinese government unleashed a new sets of measures to try to stop the slide, including cutting interest rates and reducing the reserve requirement on banks to stimulate lending again.

This added to a rash of less orthodox interventions over the last few weeks, from encouraging borrowing to buy stocks to pledging billions to state-controlled banks to lend to favored projects.

These aggressive actions signal their growing concern over the country's declining stock market and weakening economy. But, these sorts of moves are not quite what the IMF means when it calls on China to transition from a single-minded export machine into a more complex market economy powered by consumers.

And this brings up a deep, lingering mistrust about Chinese economic governance: There is scant evidence from history that an authoritarian, undemocratic regime like China's could actually pull off the kind of transformation that it is being called on to make.

"On average, autocratic nations grow faster than democratic ones up to around where China is now," said David Dollar, a former China hand at the World Bank and emissary to China at the Treasury Department who is now at the Brookings Institution.

It's easy to get things wrong. Spending in rural areas on health and education has been dismal. For all the progress of urban schools, the low quality of rural education suggests China may face an acute shortage of skilled labor as it moves up the development ladder.

China's succession of five-year plans has given local government officials a single goal: grow. This set them off on a binge of borrowing to build everything from roads to industrial parks, often generating lucrative kickbacks for local officials and their families.

Dollar wrote: "Local governments have been very successful at generating investment and growth, contributing to China's extraordinary growth performance."

To understand China's predicament, Dollar compared its experience with some of the best known stories of successful economic development of the last half-century: Japan, which reached China's income level per capita in the early 1970s; Taiwan, which passed this threshold in the early 1980s; and South Korea, which hit it around 1990.

What is most striking is not how all three countries followed quite similar paths, but how China's trajectory has diverged from the others'.

Household spending was always the main source of demand in all three, declining gradually to about 50% of gross domestic product when they were about as rich as China is today. Investment rates, which rose sharply in the early stages of their development, peaked at that time at around 35% of GDP.

By these metrics, China's economy is upside down: Consumer spending by households is only 35% of the nation's GDP - one of the lowest levels in the world. Its investment rate - nearly 50% of GDP - is extraordinarily high. And the productivity of this investment is dismal.

To a large extent, its authoritarian command and control economic governance is to blame. Limits on legal migration to cities promoted an underclass of illegal urban workers toiling for meager wages, slowing consumer spending and hindering urban development. State-owned monopolies plowed profits back into investment rather than into government spending on social welfare. Near-zero interest rates on deposit accounts provided cheap loans to business but penalized savers.

And this means the Chinese transition will be much more complicated. Unlike Japan, Taiwan and Korea - which went into their transitions with substantial trade deficits, which swung into surplus to to pick up the slack when investment rates declined - China has been running a hefty surplus for years. A still-fragile world economy is in no position to absorb even more Chinese imports.

And then there is the democratic deficit. The changes China needs today will require enriching - and empowering - its own citizens. Perhaps that's why despite repeated pledges from top Chinese authorities to reform and "rebalance" its lopsided economy, not much has happened. As the IMF report noted, in most areas China's progress "has just succeeded in slowing the pace at which vulnerabilities rise."

Perhaps that's why financial markets are spooked. "The Chinese, too, think it is unclear where their economy and society will be 10 years from now," Lieberthal said.

(Image: Indiatimes)