China's slowdown is a sign of middle-class gains, not a reason for panic

It’s too easy to think China’s economy is in a downward spiral, given recent headlines in the US press, from “China’s Middle-Class Dreams in Peril” to “Is China Really Collapsing?”

The world has been awash with such pessimism. And fumbled reactions by China’s leaders to disasters, excessive financial speculation and other problems raise concerns about governance. It may even raise questions of long-term stability.

A transition away from a reliance on exports toward consumption and services is under way, as well as the rapid creation of a middle class. It is not an easy or smooth transition, and financial markets around the world have been disturbed, most recently when China’s stock exchange boomed and then crashed, and indexes like the Dow Jones Industrial Average seesawed by thousands of points in a matter of days.

Economic growth in China has long been premised on high levels of savings and investment, growth of manufacturing and exports, migration of low-productivity rural workers to higher-productivity urban jobs and integration of new technologies. These trends could not be sustained, and as a result growth is slowing.

But that’s not a bad thing and not so unlike the economic history of developed economies of the US, Europe and Japan. It’s also a long path that will require more effective leadership and greater openness than we’ve seen thus far. The question is, how well can Chinese leaders manage in this new environment, and will they be able to find a better way forward?

The focus of my research is in the health care industry, but I also explore broader economic themes and history. During a recent half-year sabbatical in China, I had the opportunity to search for answers to these questions, with the management of its health care industry as a prism.

Two massive explosions ripped through an industrial area in the northeast Chinese port city of Tianjin in August, killing 17. Chinese leaders' fumbled reaction raised concerns about governance.Reuters

In search of the Chinese dream

The Chinese have been through a lot. After devastating famine in the late 1950s followed by social upheavals of the Cultural Revolution in the ’60s and ’70s, China turned to a more pragmatic approach to economic development when Deng Xiaoping ascended to power at the end of that period.

The market approaches he ushered in have delivered remarkable gains, and never have so many people become so prosperous so fast. Half the country is now urban and half of them are middle-class, a stark change from even 37 years ago, when 82% was rural. Today China’s economy is already larger than the US in terms of purchasing power parity.

Continuing that process of transformation from a state-run economy to consumer-driven capitalism presents challenges for both future growth and the Communist Party. Rapid gains in productivity are easier to achieve in manufacturing than services. But the fast-paced and often double-digit growth that propelled such prosperity can’t be maintained as services become a larger share of the economy.

Chinese leadership, perennially concerned about stability, has acknowledged the necessity of economic deceleration and is orienting its companies and citizens for slower growth. The shift to services is part of a planned process. The reward for slower income growth is better environmental quality and an improved social safety net.

This shift also underpins a more vibrant middle class that is an increasing source of strength. But this growing segment of the population has aspirations not dissimilar to the “American Dream,” with a nice home, car and college education for their children.

And now there are concerns that growth will decelerate into stagnation and China will fall into a middle-income trap, with weak manufacturing, exports and construction. Increasing services provides a substitute for these sectors. But over the long run, services must also improve productivity to drive the economy. This underscores the need for governance and institutions capable of generating more efficient services over the long haul.

Can China reinvent these sectors in ways that have eluded developed countries?

Traditional medicine is still used throughout China, alongside modern medicine.Reuters

Health care’s transition

The health sector is an interesting case in point. It was all but abandoned by the state when China liberalized in the ‘80s and '90s.

Hospitals and other health care organizations were largely left to cover their own costs. The safety net for health services, especially in rural areas, fell apart. The threat of medically related financial ruin loomed large over Chinese families, and the World Health Organization ranked Communist China 188 out of 191 countries in terms of fairness in financial contribution.

Chinese leadership, after realizing mistakes had been make, in the early 2000s set a new course, which included schemes to provide health insurance for all.

I have spent much of 2015 in Shandong Province researching China’s shift toward a consumption-based economy. In particular, I looked at the effect of improved health insurance on precautionary savings and household consumption. Urban and rural Chinese now have health insurance entitlement programs, and the government is opening the sector up more toward private providers, more skilled health care managers are being trained and public health infrastructure is improving.

Yet insurance remains limited largely to hospitals that cap payouts with high copayments. Much more needs to be done to improve the system over the long run to encourage both efficient production and consumption. The sector remains overreliant on hospitals and has relied on overprescribing drugs to generate revenues. There are parallel systems of Western and traditional medicine and problems of coordination throughout.

The macroeconomic potential of health insurance is to reduce savings, increase consumption and stimulate growth as part of the shift to a service economy. This is not yet happening in an unambiguous way, perhaps in part because health care prices are rising to offset the benefits of health insurance.

The health care sector, with some promising green shoots, is emblematic of China’s economy as a whole as it slogs toward one based on consumption and services.

Challenges and opportunities

Improving productivity will be difficult given institutionally entrenched interests and culture. The ability of the Communist Party to navigate such waters is uncertain. A rising middle class will expect results but can also be a source of stability as a buffer absorbing and facilitating necessary reform.

China’s neighbor and rival Japan experienced rapid economic growth both before and after World War II. It built a prosperous high-consumption society that hit a wall of stagnation around 1990. The world survived this downshift and so has Japanese democracy. China still has much room for catch-up, and such dramatic and sustained deceleration is not expected. But it illustrates the dynamic nature of economic development.

China’s Communist leadership discovered how to generate economic growth by the 1980s. It has delivered remarkable gains since then. But the old formula relying on manufacturing and exports is giving way to a more mature economy driven by consumption and services.

Current planning and policy facilitates this transition, but the longer-run challenges of boosting productivity in services has not really been addressed. The welfare of China and beyond depends on this.

China, a country deeply rooted in Confucian tradition with emphasis on family and social order, values meritocracy and the ability to get things done. Implementation of this approach within the Communist Party leaves much to be desired. But it is a worthy objective that can carry on in one form or another.

Perhaps we should have a little more confidence in China’s ability to navigate the shift from manufacturing to services, accept slower growth rates and focus a bit more on pragmatic governance at home.

Peter Hilsenrath does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.