China's rise means risks for Asia as well as opportunities

It has taken nearly seven years of internal debate, but China now seems set to embark on a new economic course. Its long awaited pro-consumption rebalancing is finally at hand, or at least that seems the verdict to be taken from last November’s Third Plenum of the Central Committee of China’s 18^th Party Congress.

The debate over China’s growth strategy began in earnest in March 2007, when former Premier Wen Jiabao pondered the fate of an economy that looked strong on the surface, but which in his own words was beneath the surface increasingly “unbalanced, unstable, un-coordinated, and ultimately unsustainable.” These “Four Uns” underscored the realisation that China’s highly successful “Producer Model” powered by exports and fixed investment had outlived its usefulness. That left the option of a rebalancing towards more of a consumer society, a strategy that was formally endorsed in March 2011 in the 12^th Five-Year Plan.

But that plan was always more of a broad framework than a detailed transformational blueprint. It was up to China’s newly installed fifth generation of leaders headed by Xi Jinping to put the plan into action. The Third Plenum provided that opportunity, and by focusing on social reforms it filled in an important missing piece of the 12^th Five-Year Plan. Committing 30% of the profits of China’s state-owned enterprises to funding woefully under-funded safety-net programmes like retirement and healthcare will make Chinese families’ futures much more secure. Other reforms to the one-child family planning policies, the residential permit (hukou) system, and a likely shift to market-based deposit interest rates also featured prominently in the Third Plenum.

China now has a well-articulated strategy (the 12^th Five-Year Plan) as well as a comprehensive implementation framework (Third Plenum), both of which complement each other in the transition to a new economic model. The plan established new opportunities for emerging middle class consumers – more job creation via the development of an embryonic services sector and higher wages that come with aggressive urbanisation. Together, they will provide an important impetus for higher incomes and more consumer purchasing power. The social reforms of the Third Plenum complete the circle by prompting shifts in behavioural norms that should provide incentives for Chinese families to reduce their fear-driven precautionary saving and allocate more income toward discretionary spending.

With China on the cusp of a major structural transformation, there’s enormous opportunity for its major trading partners to participate in what could well be the most spectacular consumption bonanza of the 21^st century. Unlike Japan, which was modern Asia’s first growth miracle, although a relatively closed economy, there is good reason to believe that China will be much more effective at spreading the wealth. China’s imports have averaged 28% of its GDP since 2002 – triple Japan’s historical ratio – and its neighbours in Asia are specially well positioned to benefit from the coming upsurge in Chinese consumption – not just because of their proximity but also because they have long provided critical supply chain inputs to Chinese producers and assemblers.

A simple extrapolation helps convey the dimension of this coming opportunity. It is based on three key assumptions: One, that average Chinese GDP growth will tail off to about to about 7% between now and 2025. Two, that the growth rate in U.S. dollar terms will be about 1.5 percentage points faster per annum due to the steady appreciation of China’s currency, the renminbi. Three, that the consumption share of Chinese GDP increases by about 1 percentage point a year, starting in 2014, from its current rock-bottom portion of 35%. Under those conditions, Chinese consumption would increase between now and 2025 by about $10 trillion in U.S. dollar terms. If the import share of its GDP holds at the historical norm of 28%, that would translate into incremental growth of nearly $3 trillion that would be available to China’s trading partners.

Export-led Asia will be first in line to benefit from this rebalancing bonanza, because China is now many Asian countries’ largest export market. It wasn’t always that way; throughout the 1990s, the United States and Europe were the largest export markets for most Asian economies other than China. Then, around the turn of the century, Asian exporters started to draw greater support from China, and that’s especially true of Japan, South Korea and Taiwan. The World Trade Organisation says their exports to China account for an average 23% of their total export earnings. For ASEAN countries like Indonesia, Malaysia, the Philippines, Thailand and Singapore, shipments to China generally rank in the top three export destinations and account for around 12% of their total exports.

So as an increasingly open Chinese economy shifts from export-led to consumer-led growth, the rest of Asia will be well positioned to capitalise on this latest shift in China’s development. The China-centric character of Asia’s export-led growth dynamic offers the region a new and potentially powerful source of economic growth at just the point in time when many are questioning the dynamism of the developing world.

The coming structural transformation of the Chinese economy will only deepen China’s now well-established role as the dominant economic engine in Asia. Data from the International Monetary Fund underscores recent dramatic shifts in China’s economic leadership position. In 2012, the Chinese share of world output was estimated at 14.7% when measured on a purchasing-power parity basis which adjusts for international disparities in pricing structures. In other words, China accounted for nearly 43% of total Asian output in 2012, up from about 36% of the Asian total in 2000. China’s export impetus was even more powerful, its one-third share of all Asian exports in 2012 was 2.3 times the 14% share in 2000.

The rebalancing from the producer model towards a consumer society will undoubtedly change the character of China’s economic leadership in Asia. It will become an economy that relies increasingly on its trading partners – not just in Asia but even in the developed economies of Europe and America – as sources for its emerging internal demand of both goods and services. That stands in contrast with the first phase of the Chinese development miracle from 1980 to 2007, where the producer model squeezed out others for market share. In that vein, the rebalancing of China’s economy should be viewed as an opportunity for its major trading partners, especially in Asia.

But the opening up of a rebalanced Chinese economy to Asian partners comes with a possible offsetting wildcard – mounting pan-regional strategic frictions between China and its neighbours. This would be, to say the least, a disconcerting development. That’s especially true of the deep-rooted animosity between China and Japan now being exacerbated by the territorial dispute over the Diaoyu/Senkaku Islands in the East China Sea. It will be especially difficult for two nationalistic leaders, Xi Jinping and Shinzo Abe, to defuse these tensions without damaging their carefully cultivated public support for the “China Dream” or the rejuvenation of Japan after two lost decades. The establishment of overlapping air defence identification zones over the disputed islands is already heightening the risk of a military accident that could then escalate.

There isn’t as much geopolitical tranquillity as might be wished elsewhere on China’s borders. Tensions over maritime security lanes in the South China Sea have been mounting, leading to frictions with the Philippines, Vietnam, Malaysia, Indonesia and India. Add Washington’s “Asian pivot” to the equation, with its shift in American naval strategy back towards Asia, and there’s little mistaking China’s growing sense of geo-strategic isolation. Acutely sensitive to these risks, the Third Plenum’s establishment of a new State Security Council, rumoured to be headed by Xi Jinping and apparently modelled after the U.S. National Security Council, looks set to elevate geostrategic security concerns as a major consideration for China.

This is a precarious balancing act. The pan-Asian economic opportunities that will stem from China’s pro-consumption rebalancing could go for naught if regional security tensions were to boil over. Historians have long warned of the risks of its rising power, and the record-breaking speed of China’s economic ascendancy only accentuates these risks.

Modern China’s leaders have long spoken of the “peaceful rise” of their nation, and its focus on internal stability and rising prosperity, with an absence of territorial ambitions. The rest of Asia has benefitted greatly from the economic rise of China, and is likely to realise even greater benefits from the coming consumer-led transformation of the Chinese economy. The risk that escalating geostrategic security considerations might compromise those benefits remains a worrisome wildcard for Asia and the world at large.