Li Xunlei reissued old works over the weekend: Will yesterday's driving force become tomorrow's trap?

On September 22nd, Li Xunlei reposted an old work on his WeChat public account, which was published in the September issue of "New Fortune" magazine in 2011. Summary The economic development trap China may face in the future will not be due to the pressure of rising labor costs after the Lewis turning point, nor will it be caused by excessive social welfare spending leading to the middle-income trap. Instead, it will be caused by the two main drivers that have propelled China's economic growth in the past, namely exports and investment. For a country with a population of 1.3 billion, maintaining high-speed economic growth for over 30 years is truly remarkable. The formation of an export-oriented model is based on the advantage of low human capital and the ability of a large country to accept industrial transfers; and China's ability to maintain high growth is mainly driven by investment dominated by continuous borrowing by local governments. However, the negative effects of these two models that have boosted China's economic growth are becoming increasingly apparent. If local government debt is not strictly controlled and the real estate bubble is allowed to expand unchecked, what may seem like a windfall now could become a trap in the future. The export-oriented model has already led to an excess of monetary scale. China's development strategy in the 1980s was import substitution, as there was a shortage of foreign exchange at that time. By producing domestically instead of importing, the amount of foreign exchange used could be reduced. The import substitution strategy allowed China's basic industries to develop rapidly, and with China's accession to the WTO, the background of an undervalued yuan and a continuous transfer of cheap rural labor to urban areas further highlighted China's export advantage. In 2009, China's total exports reached $1,201.7 billion, surpassing Germany to become the world's largest exporter. Complementing the export-oriented strategy is the adoption of various preferential policies to attract a large amount of foreign investment in manufacturing. Therefore, the result of the export-oriented model is not only an increase in trade surpluses but also an increase in FDI (Foreign Direct Investment). In 2008 and 2009, China was the world's largest recipient of FDI. Nearly half of China's total exports come from foreign-invested enterprises. Under the structure of the exchange and sales system aimed at increasing foreign exchange reserves, the inflow of foreign investment (including FDI and hot money) and the trade surplus have continuously expanded the foreign exchange reserves. By the end of 2010, China's foreign exchange reserves had reached $2.8 trillion and by the end of June 2011, it reached $3.19 trillion. The increase in foreign exchange reserves inevitably leads to an increase in foreign exchange deposits, which in turn is a major factor in the sharp rise in the money supply (M2). By the end of June 2011, China's M2 had reached 78 trillion yuan, with the increase in foreign exchange deposits posing a liquidity pressure on the domestic economy. To hedge against liquidity, the central bank generally adopts measures such as increasing the reserve requirement ratio and issuing central bank bills. However, it has been found that the central bank has been unable to fully offset the basic money supply. From the issuance of central bank bills in April 2003 to the end of 2010, large-scale offsetting operations had been ongoing for 8 years, but the ratio of offsetting (reserve balance + central bank bill balance / foreign exchange deposit balance) was about 75-80%, with about 5.5 trillion yuan remaining unmatched, making it an important source of money creation. Of course, from a historical perspective, the export-oriented model effectively addressed China's funding shortage and made China a major manufacturing country, solving the problem of massive employment. These facts prove that choosing the export-oriented model was not wrong. Moreover, the export-oriented model does not necessarily lead to excess money supply. This model has helped to increase foreign exchange reserves and deposits, which is related to China's relatively rigid financial system. Channels for outward investments are not smooth enough and there are many restrictions on overseas investments for residents. This makes it easier for foreign exchange to flow in than out, and the slow reform of the mechanism for forming the yuan's exchange rate has made it difficult to reverse the continuous inflow of hot money under the expectation of yuan appreciation. Therefore, it is evident that China's current real estate bubble and inflation pressure are related to excessive money supply, which in turn is related to excessive inflows of foreign exchange. Excessive foreign exchange inflows are the result of the combination of the export-oriented strategy and conservative exchange rate policies. Clearly, the real estate bubble will create future financial risks for China. Corresponding to the excess money supply is the rapid increase in China's foreign exchange reserves. The only investment choice for these reserves is US Treasury bonds. As of June 2011, China held $1.1655 trillion in US Treasury bonds, making it the largest foreign holder of US Treasury bonds. This not only makes China dependent on US domestic demand in foreign trade but also relies on the stability of the US economy for the security of its foreign exchange reserves. In conclusion, the export-oriented model itself is not wrong, the problem lies in not taking effective measures to counter the increase in foreign exchange reserves and the money-creating power of foreign exchange deposits. In order to hedge against foreign exchange deposits, China has raised the reserve requirement ratio to an unprecedented level of 21.5%. The maneuvering space for monetary policy will become increasingly limited. The investment-driven model has led to a sharp increase in local government debt. If the export-oriented economic growth model has brought huge foreign exchange reserves to China and corresponding base money injections, then the investment-driven economic growth model has promoted the process of money creation and scale expansion. Currently, the proportion of M2 to GDP in China is close to 200%, while Japan and South Korea, which also experienced investment-driven economic growth models during their high-speed economic growth stages, have a proportion of M2 to GDP around 100%. This shows that the combination of the export-oriented and investment-driven models has made China's money creation capacity stronger. Why is this? As pointed out by Zhang Wuchang in the article "Chinese Economic System", fierce competition in county-level economies is the main reason for China's high-speed economic growth. In other words, the investment-driven model led by local governments is the main driving force behind China's high growth. Of course, whether county-level economies contribute more to investment than city-level or provincial-level economies still requires sufficient data for verification. However, because the creditworthiness of local governments or ministries under the State Council is much higher than that of enterprises, they have very strong ability to obtain bank loans, making them a major source of credit for bank loans. As with the export-oriented model, the investment-driven model also has its strengths and weaknesses. By understanding and effectively managing the potential risks associated with both models, China can prepare for a more sustainable economic future.As the scale of credit continues to expand, it becomes the main reason for the rapid expansion of M2.China's current market economy originated from a planned economy, so we are still formulating and implementing five-year plans. Looking at the various goals proposed in the five-year plan, local governments still undertake tasks and responsibilities similar to those in the planned economy era, with the difference being that plans have replaced original plans. Therefore, governments at all levels still consider economic growth rate as the main indicator of performance, and fixed asset investment is seen as a shortcut to increasing economic growth, which the government can lead and control. For example, in the expenditure structure of local financial budgets, the proportion allocated to education, health, and social security is too low, even lower than that of developing countries. A large amount of fiscal revenue, both on-budget and off-budget, is invested in physical infrastructure construction, which has become a target of criticism for the central government's repeated construction, regional industrial homogenization, and land finance phenomena. Therefore, the high economic growth rate of around 10% over the past 30 years in China has actually been achieved at the expense of sacrificing most public services and welfare. Why did local government investments in the past 30 years not result in too much debt, while suddenly skyrocketed in the past two years? There are four reasons. First, initially, government borrowing for transportation infrastructure investment had a higher average return rate, such as substantial toll revenues from highways, but by 2007, there were widespread cases of highway overcapacity. Second, debt accumulation is a gradual process. Due to the relatively small total amount in the initial period, the debt balance only reached over 5 trillion yuan between 1979 and 2008, which did not attract much attention from society. Third, in the ten years after the housing reform in 1999, housing and land prices continued to rise, further enhancing the debt repayment capacity of local governments and their ability to finance through bank mortgages. Fourth, in 2009, to prevent an economic downturn caused by the US subprime mortgage crisis, the State Council issued a two-year plan for four trillion yuan in investment, significantly increasing the debt level of local governments. According to the statistics of the National Audit Office, by the end of 2010, the balance of local government debt was about 10.7 trillion yuan, of which around 5.1 trillion yuan was formed in two years from 2009 to 2010, accounting for about 48% of the total. In addition, public data shows that 72% of local government debt is used for transportation, municipal construction, and land acquisition. This also indicates that local government borrowing is to support investment-driven economic growth. Currently, China is facing pressures such as inflation, high raw material prices, and rising labor costs, similar to the predicament encountered by the US and Japan in the 1970s. At that time, they promptly promoted economic transformation, with the US focusing on developing the service industry and Japan mainly advancing the upgrading of the manufacturing industry. For local governments, to maintain the original investment-driven model, they can only continue to borrow. The National Audit Office found that by the end of 2010, the debt ratio of local governments was 70.45%. Apart from local government bonds and various financial transfers, most of the income and expenditure of local government debt was not included in budget management and supervision, meaning that local governments did not consider how to repay the debt. The national requirement to build 20 million units of affordable housing in the next two years will increase the debt scale of local governments. Looking at the fixed asset investment growth rate in the first seven months of 2011, although it is still maintained at a high level of 25.4%, it is mainly driven by investment in the manufacturing and real estate industries, with growth rates of both sectors exceeding 30%, while infrastructure investment related to local government-led investment has dropped below 20%. Forcing transformation may be the only choice The transformation of economic development in China has been talked about for many years, but progress is perceived as slow. The ultimate reason lies in the current administrative system, or more in the ineffective coordination of the existing financial, tax, and financial systems with economic transformation. For example, in 1995, the central government proposed that economic development should shift from "outward expansion to inward development," which was the initial expression of changing the economic development model, but it was not implemented. Similarly, the economic growth targets proposed by the national "Fifteen-Year Plan" implemented since 2001 and subsequent "Eleventh Five-Year Plan" were 7% and 7.5%, respectively, but the actual results exceeded 10%. The "Twelfth Five-Year Plan" once again proposed an economic growth target of 7% for the next five years, but the execution in 2011 was at least 9%. This indicates that without changing the current model of the central and local fiscal decentralization in China, local governments will always have an impulse to expand investment through borrowing, and they are unwilling to increase the proportion of fiscal expenditures for people's livelihood. After over ten years of the Western Development strategy, the investment growth rate in the western region was much higher than that in the eastern region, but the efficiency of investment was much lower. In the past ten years, the total investment received in the central and western regions exceeded that of the eastern region, but the share of GDP has decreased from 52% before 2000 to the current 48%. The results of the population census also indicate that over the past decade, the population has been flowing from the central and western regions to the eastern region, with Guangdong replacing Henan as the province with the largest population. High input and low output, investments and population flow in opposite directions, the ultimate outcome of this phenomenon may be the need for the central government to foot the bill for the massive debts of the local governments in the central and western regions. Contrastingly, in various major developed economies worldwide, there are numerous cases of economic concentration-driven development, but no successful examples of balanced development across regions. Looking at historical cases of reform triggered in China, although the reforms are top-down, the impetus for pushing forward the reforms comes from the exposed problems in economic operations. For example, the integration of the dual-track pricing system in the 1990s was implemented due to the prevalence of profiteering, which disrupted the economic order; the integration of exchange rates was due to the increasing scale of foreign exchange black market trading; the fiscal tax-sharing system reforms were due to severe central fiscal deficits, financial power concentrated in local areas, and the central government's difficulty in effective regulation. Many scholars now like to apply foreign theories such as the Lewis turning point and the middle-income trap to the current economic issues or future dilemmas faced by China. Personally, I believe that the differences between the urbanization backgrounds of small and medium-sized countries and the urbanization process of a super-populous country like China are too large to easily determine China's Lewis turning point. Similarly, the middle-income trap experienced by Latin American countries has not been replicated in the development process of the Asian Tigers. The path that China is taking towards socialist characteristics will be the key to its development.Road, the development path of Latin American countries is not comparable, we cannot simply copy and paste.Therefore, the economic development trap we may face in the future will not be the pressure of rising labor costs after the Lewis turning point, nor will it be the economic development stagnation caused by excessive social welfare spending. It will be the two main drivers that have propelled China's economic growth in the past, namely export-led growth and investment-driven growth. As we can see from the attached figure, in order to deal with the impact of the 1997 Asia Financial Crisis and the 2008 subprime crisis, China adopted a large-scale expansion of local government investment and borrowed massively from banks. Local government debt increased by 48% the first time and by 62% the second time. So, how should China deal with another global crisis? Obviously, embarking on another 4 trillion yuan investment plan would be unsustainable. The best solution is to reduce China's external dependence by changing the export-led model, boosting domestic demand, increasing the share of consumption in GDP, and reducing the share of investment in GDP. Changes in the growth rate of local government debt balances across the country since 1997 (unit: %) Data source: National Audit Office Of course, stimulating domestic demand and restructuring will be a long process. Currently, the reform pressure driven by intensified contradictions in various sectors of the economy is not strong enough, and major measures from the government in terms of economic transformation are yet to be seen. However, central government supervision of investments made by local governments or relevant departments has been significantly strengthened. For example, the scale of investment in high-speed rail by the Ministry of Railways has been reduced, and project approvals and bond issuances for local infrastructure investment are now subject to strict scrutiny. As China's economic growth further declines in the future and signs of a bursting real estate bubble emerge, with slow growth in local government revenue and increasing debt repayment pressure, as well as a worsening unemployment problem, the calls for reform and transformation will become increasingly louder. This article is sourced from the WeChat public account "lixunlei0722"; GMTEight edit: Wenwen.