[William Pesek] China needs to upgrade economic software

Mark Zuckerberg shouldn’t lose too much sleep about China’s Facebook beating him to Wall Street.

Renren Inc. is the first social-networking website to go public in the U.S., raising $743 million with which founder Joseph Chen can tap China’s 1.3 billion people. China is a market Facebook Inc. has yet to friend and the U.S. equity market is a place Zuckerberg has yet to tread.

Here’s the thing, though. Renren investors are paying a huge premium for future spoils ― the belief that China will grow 10 percent indefinitely. To do that, the country will have to upgrade its economic software.

This vital bit of reengineering isn’t unfolding on schedule and China’s undervalued currency is partly to blame. It stifles incentives for the Zuckerberg and Chen wannabes out there, imperiling the nation’s outlook.

It sounds counterintuitive that the anchor of China’s success in raising living standards over the last three decades now is holding it back. As China enters the age of an Internet it obsessively censors, the yuan has lulled officials who must move the economy away from manufacturing that relies on cheap labor. The longer the currency is artificially weak, the more difficulty China will have nurturing the innovation vital to its future.

A recent report by Barry Eichengreen at University of California, Berkeley, shows why and, perhaps appropriately, it’s gone viral in cyberspace. His prediction that China will run into trouble around 2015 is inspiring lively debates from the blogosphere to the conference halls of Hanoi, where policy makers are gathered for the Asian Development Bank’s annual meeting.

The study ― co-written with Donghyun Park of ADB and Kwanho Shin of Korea University ― argues that China will hit a wall when per-capita income approaches $17,000. That could be in the next three or four years at current growth rates.

This so-called middle-income trap tripped up one-time growth stars Malaysia, the Philippines and plenty of other developing countries. Were China to fall into it, investors betting on Renren would be in for a brutal reality check.

At its $14 initial price, Renren is valued at 72 times last year’s sales, compared with 25 times for Facebook based on the value of Goldman Sachs Group Inc.’s investment in the U.S. company. Renren’s premium is a no-brainer: China’s economy may grow three times faster than the U.S. and about two-thirds of the population isn’t online.

What isn’t a no-brainer is how China will deliver on those expectations. Officials know what they need to do: Stop relying on exports for growth and go up-market. The export- and investment-led model that last year enabled China’s economy to surpass Japan as the world’s second-largest has run its course. Not only is it holding back wage growth, but it’s also bumping up a against a feeble world economy. The U.S., Europe and Japan are limping along.

Hence the urgency to rebalance things. China needs to build a service-based economy that boosts productivity and empowers entrepreneurs to create good-paying jobs. That would lead to a far more sober allocation of the nation’s wealth, much of which is pumped into government-favored champions. Such investments tend to return far less than those of innovators building new, globally competitive businesses.

It’s an economic software issue. While China’s hardware is first world ― airports, roads, bridges and dams ― it has yet to cultivate cutting-edge industries based on ideas and knowledge, not factory floors and low-cost labor.

An undervalued currency skews incentives and priorities. It exacerbates imbalances ― like credit bubbles ― that make China’s financial system vulnerable. In their study, Eichengreen, Park and Shin looked at international data since 1957. They conclude that an undervalued exchange rate, maintained for significant periods of time, increases the odds of economies falling into the middle-income trap.

This is an Asia-wide risk, says Rajat Nag, managing director at ADB. He points out that there are two routes the region could travel. One will propel 3 billion people toward affluent, Europe-like levels by 2050. The other would see growth stagnating in many key economies, including China and India, and not making the transition to broad-based prosperity.

China’s challenge is emblematic of what governments must do to realize the first scenario. Policy makers must modernize governance systems and remake institutions to ensure transparency and accountability, and that rules and regulations are enforced. Creating a thriving and innovative private sector also is important.

Until now, economists have tended to fret that the weak yuan fans China’s inflation and undermines nations as disparate as the U.S. and Indonesia. Today, the concern should be about how it’s reducing the urgency to replace the sources of growth and wealth creation with something more promising and enduring.

If China succeeds here, investors piling into Renren will be a happy bunch. If the yuan gets in the way, China will merely be the source of the world’s next great Internet bubble and crash. It’s a surefire way to get unfriended by investors the world over.

By William Pesek

William Pesek is a Bloomberg News columnist. The opinions expressed are his own. ― Ed.

(Bloomberg)