Reducing inequality should be the main focus of China's future growth strategies

Rationality is not a personality trait associated with stock investors en masse. And so it proved recently when global markets plunged in response to news that factory activity in China shrank for the first time in seven months in May.

Yet these manufacturing figures represent the latest evidence that the Chinese government is in fact succeeding in engineering an orderly slowdown in its previously rapid economic growth, an adjustment that has long been absolutely essential for long-term stability.

Rather than being a cause for concern, it is, by some measure, a cause for optimism. In other words, it shows that the Chinese government is serious about sustainable development.

Some number crunching of economic data from last year backs this up - as well as confirming the serious challenges to progress that show few signs of dissipating.

China, the world's second-largest economy, saw slower GDP growth of 7.7 percent in the first quarter of 2013, down from 7.9 percent in the final quarter of 2012, and lower than the 8 percent predicted by Reuters.

This prompted JP Morgan to cut the country's growth estimates for 2013 from 8.2 percent to 7.8 percent, with the data in line with a stabilizing trend that began taking shape last year as the new leadership moved to prioritize balanced development over fast growth.

China encountered many internal and external challenges last year amid the continuing fallout from the global financial crisis and the European debt crisis. Externally, export growth and foreign capital inflows slowed due to a sharp contraction in bilateral trade between China and its largest trading partners, the EU, the US and Japan.

Despite its efforts to diversify its international trade with the likes of India, Brazil, Russia, Africa and the Association of Southeast Asian Nations, China's trade volume grew by only 6.2 percent, compared with 22.5 percent in 2011. In addition, the inflow of foreign direct investment (FDI) declined unexpectedly after sustained growth from 2009 to 2011.

Internally, asset bubbles, especially high house prices, rising land and labor costs, and currency appreciation, reduced China's international competitiveness. Numerous small and medium-sized enterprises specializing in export processing in Guangdong and Zhejiang provinces closed down or downsized as a result of rising production costs and weak foreign demand.

Yet despite all these difficulties, GDP in China reached a record high of 52 trillion yuan ($8.48 trillion; 6.38 trillion euros) last year. Although economic expansion slowed down significantly, it still outperformed most of the world's major economies by a wide margin.

GDP growth in 2012 in the US stood at 2.3 percent, the EU at -0.4 percent, India at 4.5 percent, Russia at 3.6 percent and Brazil at 1 percent. China's GDP accounted for 9.5 percent of the world's total, up by 0.7 percentage points from 2011. China's per capita GDP rose from $5,500 in 2011 to $6,100 in 2012.

Despite a significant slowdown in trade volume, China overtook the US to become the world's largest trading nation for the first time in 2012.

Crucially, China's export structure is also changing. General exports, up 7.7 percent, are increasing much faster than processing exports, up 3.3 percent. General exports tend to have a larger proportion of domestic-made components and hence can generate more added value than processed exports.

A gradual shift from processed to general exports implies that China has been forced to accelerate its trade reform, focusing more on value-added and technology-intensive manufacturing than low-cost processing, in response to the external shock caused by the financial crisis.

There are encouraging signs too in the government's efforts to reduce the country's geographical inequality. Fixed assets investments in the central and western regions grew much faster than in the eastern or coastal region. The growth rates of the former two regions were 26.3 percent and 23.1 percent respectively, compared to 16.5 percent for the latter. This indicates the first sign of a convergence between the prosperous coastal regions and the less advanced inland provinces.

Although labor costs are rising and economic growth is slowing, China remains attractive to foreign investors. But, rather than being solely a recipient of investment, its spending power overseas now commands real clout. China's outward direct investment reached $70 billion in 2012, up 38 percent, and is expected to touch $150 billion by 2015, meaning that China will soon become a net foreign investor and one of the two or three largest investors in the world.

According to the National Bureau of Statistics, consumption contributed over half of China's growth in 2012, overtaking investment to become the key driver of economic growth.

In 2012, rural and urban per capita disposable incomes increased by 12.6 percent and 9.6 percent respectively, much higher than GDP growth. On this basis, we can expect personal consumption to continue to grow at a higher rate than GDP and will contribute an even larger percentage of total GDP in the coming years.

If this pattern holds, China will be able to gradually reinvent itself from an export-reliant and investment-driven economy to a consumption-led economy.

All the above figures show that China is making solid progress but this year may well be regarded as the turning point, where China was forced to take stock and rethink its future development path.

However, obstacles to a smooth journey abound. On a recent visit to China, David Lipton, the deputy managing director of the International Monetary Fund, indicated that while China still has significant policy space and financial capacity to maintain stability, the margins of safety are narrowing. He called for decisive action on reforms to contain vulnerabilities and move the economy onto a more sustainable growth path.

China has still made only limited progress in rebalancing its economic structure in spite of pledging to do so over the past decade. The share of manufacturing to total GDP is, at 45 percent, still unusually high in international terms; heavy industry, particularly high-polluting sectors, still dominates the industrial sector; domestic consumption remains substantially lower than that of any industrialized or emerging economy in the world; the regional divide between the coastal and inland areas and the persistent urban-rural divide are only closing gradually.

China also faces continuing threats to its energy security. In 2012, China consumed 3.6 billion tons of coal and 5 trillion kWh of electricity, up 3.9 percent and 5.5 percent from a year earlier. It now imports 59 percent of its oil, leaving it worryingly reliant on the vagaries of the global market. In addition, China's heavy use of coal has exposed its citizens to potentially devastating long-term health problems.

The financial sector is in desperate need of reform. In 2012, the total profits of all the Chinese banks were 1.24 trillion yuan, up 194 billion yuan on the previous year. Together, they contribute almost one third of the total global profits.

However, trouble lurks within. Firstly, the problem of non-performing loans may emerge again. Although they have remained below 1 percent, extensive infrastructure projects over the past few years have seen a surge in local government financing vehicles.

It is estimated that when, not if, local government debt and surging property loans go bad, the proportion of non-performing loans could soar to as high as 20 to 30 percent. This explains why China is reluctant to embark on another large-scale stimulus plan now.

The second problem lies in Chinese banks' profit-generating capabilities. More effective policies are needed to break up the monopoly of a small number of major banks and to further improve the efficiency and transparency of the whole banking system.

During the 18th National Congress of the Communist Party of China, the new leadership re-emphasized the government's mission to develop an "all-round, well-off" society by 2020 and proposed, for the first time, that by 2020, China would double both its GDP and per capita income from 2010 levels.

This marked the first time that the Chinese government had connected the two indicators - personal income and GDP growth. According to the National Bureau of Statistics, the Gini coefficient, a widely used indicator that measures income inequality, was 0.474 in 2012, making China one of the most unequal societies in the world.

Hence, the need to reduce inequality is not just about making people happier; it is about making the country more stable, socially and politically.

Finally, corruption remains an issue. In 2012, Wang Qishan was chosen as the secretary of the Communist Party of China Central Commission for Discipline Inspection to lead the country's anti-corruption campaign.

Nevertheless, despite being welcomed by the majority of Chinese, the people are unconvinced as to whether the government can indeed eliminate corruption.

The IMF believes that these issues represent a challenging reform agenda for the Chinese government and would require strong determination and administrative capacity to implement. Whether or not China succeeds will be of paramount importance not only to China, but also to the rest of the world.

The author is head of the School of Contemporary Chinese Studies at University of Nottingham. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 06/14/2013 page11)