Why China Isn’t Ready Yet to Lead Globalization

As the United States under President Donald Trump retreats from its leadership role on global integration, China is well placed to take the position. It is the world’s largest exporter and by some measures also the world’s largest economy. It is time for China to play a bigger role in setting international rules.

Premier Li Keqiang appears ready to take up the mantle. He is saying all the right things, explaining the benefits of free trade—from consumer gains to economic growth—and calling for stronger international rules. China has also indicated a new openness to free trade agreements, including with Mexico.

By reducing transportation costs, China’s “One Belt One Road” initiative could be as important as any major trade agreement. As tariffs have come down, transportation costs have become the binding constraint to trade. Filling this infrastructure gap will help integrate isolated countries into the world economy and could create a new wave of globalization.

China now needs to take bold action on domestic reform to match its global initiatives. To be sure, it has made significant progress towards becoming a market economy since joining the World Trade Organization (WTO) in 2001. It no longer runs an enormous current account surplus: After hitting 10 percent of GDP in 2007, its current account surplus fell below 2 percent of GDP in 2016. Private and foreign-invested firms now account for over 80 percent of exports, up from roughly 50 percent before China joined the WTO.

In recent years, however, economic reform has slowed or even reversed. Reform of state-owned firms has taken the form of mega-mergers, which has reduced the number of firms without reducing the share of output coming from the state sector. Of the 1,000 largest firms in the world by revenue, 136 were Chinese in 2014, as compared with only 41 in 2006, and 70 percent of these giants are state-owned. The strategy of creating super-sized state-owned firms is neither good for growth nor good for global business.

The problem is particularly acute in some industries where Chinese state firms have become export powerhouses and are distorting global markets. Consider steel, where production grew at double-digit rates in the mid-2000s as China industrialized. As recently as 2004, China was a net importer of steel. It is now the world’s largest producer and exporter of steel products. The four largest Chinese steel companies are all state-owned.

Like steel, civil engineering and construction is an industry that grew out of the infrastructure boom in China. The four largest firms in the world in this industry are all Chinese state-owned firms. As construction has slowed in China, these firms have started bidding on global roads, bridges, and metro systems, making their foreign competitors anxious. The presence of these large state-owned firms in construction and steel raise concerns that the real intention of the “One Belt One Road” initiative is to export excess capacity.

Reforming the state-owned enterprise sectors would be good for China and for the stability of the world economy. For China, the state firms crowd out financing to more productive private firms. China would grow faster if the most productive firms also absorbed the most capital. Indeed, as economic studies have shown, private firms accounted for most of China’s rapid growth during the 1990s and 2000s.

The large state firms are also straining the global trade system. Private firms facing competition from Chinese state-owned firms are justified in believing that the playing field is unlevel. State-owned firms typically are more focused on jobs and revenues than profitability and are not subject to the same hard budget constraints as private firms. The rise of these super-sized state firms is partly responsible for the backlash against trade with China.

Reforming the remaining state-owned firms, through closures and privatizations, would help China to maintain strong growth and go a long way toward showing the world that China is serious about being a good global leader.

Much of what the president of the United States says about trade is wrong. But there is a kernel of truth to the notion that China is competing unfairly in steel and a handful of other sectors. While it is admirable that China is defending free trade and investing in better global infrastructure, becoming the world’s leader on free trade will require action. China needs a renewed agenda of market-oriented reforms to boost domestic growth and ease pressures on the global economic system.