China's Strength Could Become Its Weakness

Federic Dubray | AFP | Getty Images

China's President Xi Jinping speaks at a press conference in Port of Spain, Trinidad, on June 1.

Who's afraid of China? Everyone apparently.

As China's economic might grows, trading partners from Europe to Asia to the U.S. are crying foul, some louder than others.

But growing domestic tensions and internal economic imbalances are forcing Chinese leaders to overhaul the very economic model that has served them so well for the past decade.

"China's economic policymakers are facing a crunch moment in the next few years because the economic model that has served them well for the past decade is no longer working," said Mark Williams, chief Asia economist at Capital Economics.

The new blueprint for the world's second largest economy—just now taking shape—promises to transform China's relations with U.S. and the rest of the world.

This week's upcoming summit between President Barack Obama and newly installed Chinese President Xi Jinping comes as an emboldened new Chinese leadership seeks to establish a larger role in world trade. As growth in the developed world slows, China's global ambitions have drawn fire from its trade partners.

The latest U.S. complaint centers on China's state-sponsored theft of trade secrets, an issue that is expected to top Obama's agenda at Friday's meeting in California.

The U.S.-China summit follows a series of announcements by the new Beijing regime aimed at liberalizing the state-run economy, relaxing regulations, allowing market forces to set interest and exchange rates and encourage greater competition from privately owned companies. Led by Xi and Premier Li Keqiang, the new leadership—barring some catastrophe—is expected to rule for the next 10 years.

If those reforms succeed, they would also transform China's model of state-sponsored capitalism in ways that could level the playing field with trading partners like the U.S.

"You're not going to get a more vibrant private economy unless you have greater protection of intellectual property," said Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics. "Clearly one of the things that inhibit private economy is lack of protection for intellectual property."

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For the past three decades, China's technocratic leadership has invested heavily in coastal factories, modern cities and transportation and shipping infrastructure. The resulting export juggernaut, aided by an artificially depressed Chinese currency, helped Beijing accumulate vast reserves of foreign currency from massive trade surpluses.

Much of that cash—some $1.3 trillion—has been plowed into U.S. Treasury debt. That makes China the largest foreign holder of U.S. government debt, leading some to wonder if Beijing's role as "America's banker" could give it outsized influence on U.S. policies.

But dumping U.S. debt in any quantity would likely reduce the value of China's remaining holdings. And harming the U.S. economy—one of China's most valuable markets—would be self-defeating.

That's why fears of China using U.S. debt as a diplomatic or economic weapon are overblown, according to a Pentagon report last year assessing the national security risk of China's large holdings of U.S. debt.

Instead, China has used is vast holdings of trade surplus cash to invest in more infrastructure and expand state-owned enterprises. Until recently, the formula sparked the nation's unprecedented pace of double-digit economic growth and launched China as a global power.

But beginning in 2008, the state-run economic engine began to sputter. Demand for exports shrank sharply as the world slipped into recession. For the next few years, massive state spending and investment helped blunt the impact.

But the heavy reliance on state investment produced unintended consequences. Overbuilding of housing created a real estate bubble. The government stimulus produced painful bouts of inflation, including spikes in food prices that threatened to spark social unrest.

The investment spurt that produced a surge in construction of new roads, airports and factories also left the Chinese economy with more capacity to produce goods and services than demand for those products, both domestically and overseas. Meanwhile, rising wages and a strengthening currency eroded the Chinese manufacturers' global competitive edge.

Now, that massive government spending has left China with a debt problem of its own—not unlike that faced by the developed economies of the U.S. and Europe. Fitch Ratings has estimated that China's overall sovereign debt amounts to roughly 75 percent of gross domestic product, about the same as the U.S.

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To wean its economy from massive government spending, China's new leaders are embarking on a bold series of reforms intended to shift the source of future growth from government spending and investment to a beefed-up, market-driven private sector.

Analysts say a recent flurry of political appointments demonstrates that China's new leaders are moving aggressively to implement the changes. Still, transforming an $8 trillion economy in a country of 1.3 billion people is an epic undertaking.

"They are well positioned to pursue a more liberal economy policy," said Cheng Li, director of research and a senior fellow at the Brookings Institution. "But the resistance from the interest group—particularly the state-own enterprises—are overwhelming."

The hope is that a more market-driven economy will attract enough new private capital and expand consumer spending to create the diverse base of growth found in the developed economies of the U.S. and Europe.

China's leaders have their work cut out for them. Today, for example, consumer spending accounts for about a third of China's GDP—compared with 70 percent for the U.S. and roughly 57 percent in Europe.

Spurring greater consumer spending means shifting away from policies based on capital investment toward programs that create more jobs and spread China's expanded wealth more widely.

But those reforms will likely face resistance from the very government and Communist Party officials tasked with implementing them, according to Williams.

"The benefits (of China's economy) have been captured by an elite," he said. "That also suggests that it's going to be difficult to reform because that elite has been doing very well for the past couple of decades. They're likely to resist efforts to reform the economy even though that's what's needed over the long term."

_ By CNBC's John W. Schoen. Follow John Schoen on Twitter.