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Debt will keep consumption weak in the developed economies, and the aftereffects of the Middle Eastern revolutions will keep oil prices very high for the next decade. China's need for rebalancing has been exacerbated by a combination of weak export demand and production costs. Unless the economy becomes less dependent on exports and, by extension, investment, China could face stagflation.
Stagflation will certainly lead to social instability. Double-digit growth in the past decade supported stability even though the household sector's share in the economy declined dramatically, because the pie was expanding fast enough to keep the household income rising despite its declining share. In a slow economy, the same won't happen.
The heart of China's investment and export-led development model is the government's desire and ability to extract resources out of the economy to fund its investment plan. Export dependency has been its crux. No restructuring reforms are meaningful without limiting the government's expenditures and ability to collect revenue.
The reform should start with decreasing income tax rates and decreasing property prices. The government should decrease the top personal income tax rate to 25 percent from 45 percent and increase the capital gains tax to above 50 percent in residential property transactions. The central government has 100 percent power to implement these changes.
Beyond tax and property, the government must pursue positive real interest rates to support the purchasing power of savers. Negative real interest rates pushes savers who are consumers and rewards debtors who are investors. Keeping negative real interest rates exacerbates China's imbalances.
The more difficult reforms are in education and healthcare. Their high costs, due to their current state of dysfunction, inspires fear among consumers and decreases their consumption preferences.
Worried at the NPC
China has experienced double-digit GDP growth rates for the past decade. The economy became the second-largest in the world last year. There is much to celebrate. But, worries seem to dominate conversations inside China. Adding to a list of usual concerns (e.g., income distribution, property prices, environmental degradation, unsafe food, unsafe and unaffordable healthcare, and the inflated cost of education), inflation received more attention than any other issue. For the first time in a decade and a half, a considerable proportion of China's population seems to be falling behind in purchasing power and wealth. This new element in the social dynamics was deservedly on top of the worries at the NPC.
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