China: The Next Twenty Years of Reform and Development · ASEAN Association of South-East Asian Nations BMCDR Beijing Municipal Commission of Development and Reform BMI Basic Medical

CHINA: THE NEXT TWENTY YEARS OF REFORM AND DEVELOPMENT

Other titles in the China Update Book Series include:

1999 China:TwentyYearsofEconomicReform

2002 China:WTOEntryandWorldRecession

2003 China:NewEngineofWorldGrowth

2004 China:IsRapidGrowthSustainable?

2005 TheChinaBoomanditsDiscontents

2006 China:TheTurningPointinChina’sEconomicDevelopment

2007 China:LinkingMarketsforGrowth

2008 China’sDilemma:EconomicGrowth,theEnvironmentand ClimateChange

2009China’sNewPlaceinaWorldofCrisis

CHINA: THE NEXT TWENTY YEARS OF REFORM AND DEVELOPMENT

Ross Garnaut, Jane Golley and Ligang Song (eds)

SOCIAL SCIENCES ACADEMIC PRESS(CHINA)

THE AUSTRALIAN NATIONAL UNIVERSITY

E P R E S S

E P R E S S

PublishedbyANUEPressTheAustralianNationalUniversityCanberraACT0200,AustraliaEmail:[email protected]:http://epress.anu.edu.au/china_20_citation.html

China Bookinternational

Co-published with SoCial SCienCeS aCademiC PreSS (China) under the China Book international scheme. This scheme supports co-publication of works with international publishers.

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Contents

Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xvii Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxi

1 . Chinese economic reform and development: achievements, . . . emerging challenges and unfinished tasks . . . . . . . . . . . . . . . . 1

Jane Golley and Ligang Song

Part I Long–Term Development: Trends and Issues

2 . The turning period in China’s economic development: a conceptual framework and new empirical evidence . . . . . . . . 19

Ross Garnaut

3 . China model and its future . . . . . . . . . . . . . . . . . . . . . . . . . 39

Yang Yao

4 . How will China’s central–local governmental relationships evolve? An analytical framework and its implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Yongsheng Zhang

5 . China’s metal intensity in comparative perspective . . . . . . . . 73Huw McKay, Yu Sheng and Ligang Song

6 . Assessing China’s energy conservation and carbon intensity: how will the future differ from the past? . . . 99

ZhongXiang Zhang

7 . Prospects for diminishing regional disparities . . . . . . . . . . . . 127Jane Golley

Part II: Global Integration: Challenges and Opportunities

8 . Exchange rate policy and macroeconomic adjustment . . . . . 153Geng Xiao

9 . The real exchange rate and the renminbi . . . . . . . . . . . . . . 163 Rod Tyers and Ying Zhang

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China: The Next Twenty Years of Reform and Development

10 . China and East Asian trade: the decoupling fallacy, crisis and policy challenges . . . . . . . . . . . . . . . . . . . . . . . 193

Prema-chandra Athukorala and Archanun Kohpaiboon

11 . Asian foreign direct investment and the ‘China effect’ . . . . 221 Chunlai Chen

12 . The global financial crisis and rural–urban migration . . . . . . 241 Sherry Tao Kong, Xin Meng and Dandan Zhang

Part III: Policy and Reform: Unfinished Business

13 . Avoiding economic crashes on China’s road to prosperity . . 269 Wing Thye Woo

14 . Rebalancing China’s economic structure . . . . . . . . . . . . . . 293 Yiping Huang and Bijun Wang

15 . Urbanisation with Chinese characteristics . . . . . . . . . . . . . 319Cai Fang and Meiyan Wang

16 . Indigenous innovation for sustainable growth . . . . . . . . . . 341 Yanrui Wu

17 . China’s health system and the next 20 years of reform . . . 363 Ryan Manuel

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393

vii

Tables

4 .1 Different structures of intergovernmental relationships . . . . . . . . . . . . . . 57

4 .2 Share of central and local governments in government revenue

and expenditure (per cent) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

5 .1 Major results from simultaneous equation estimation, 1890–2008 . . . . . . 88

5 .2 China’s economy and steel demand per capita, 1980–2008 . . . . . . . . . . 90

5 .3 UN projection of China’s future development path . . . . . . . . . . . . . . . . . 92

6 .1 Consumption tax rates for cars in China (per cent) . . . . . . . . . . . . . . . . 104

6 .2 Vehicle emission standards and the time to enter into force in China, ASEAN and the European Union . . . . . . . . . . . . . . . . . . . . . . . . 106

6 .3 Preliminary and final values for total primary energy consumption and coal consumption in China, 1990–2008 . . . . . . . . . . . . . . . . . . . . 114

6 .4 Reduction in China’s energy intensity: preliminary value versus final value (per cent) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

6 .5 Differentiated tariffs for eight energy-guzzling industries in China (RMB/kW .h) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

7 .1 Regional snapshot, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

7 .2 Per capita GDP levels and growth rates . . . . . . . . . . . . . . . . . . . . . . . . 131

7 .3 Industry-wide NRCs and growth rates of industrial output, 2000–07 . . . 135

7 .4 Regional NRCs and location components by sector, 2000–07 . . . . . . . . 137

7 .5 Regional shares of industrial output, 2007 (per cent) . . . . . . . . . . . . . . 139

7 .6 Shift-share analysis of provincial industrial growth . . . . . . . . . . . . . . . . 140

9 .1 Contributions to China’s real exchange rate change 1997–2006 (per cent) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

9 .2 The balance sheet of the People’s Bank of China, ca . 2009 . . . . . . . . . . 177

9 .3 Estimates of the foreign share of total assets, selected countries . . . . . . 180

9 .4 Country rankings on foreign shares of total assets . . . . . . . . . . . . . . . . 180

10 .1 Composition of manufacturing exports, 2006–07 (per cent) . . . . . . . . . 196

10 .2 Share of parts and components in manufacturing trade,

1992–03 and 2006–07 (per cent) . . . . . . . . . . . . . . . . . . . . . . . . . . . 198


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10 .3 Share of parts and components in bilateral trade flows, 2006–07 (per cent) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199

10 .4 China’s trade with the rest of East Asia (per cent) . . . . . . . . . . . . . . . . 200

10 .5 East Asia–China manufacturing trade . . . . . . . . . . . . . . . . . . . . . . . . . 202

10 .6 Intra-regional shares of manufacturing trade: total parts and components and final trade, 1992–93 and 2006–07 (per cent) . . . . . . . . . 203

10 .7 East Asia: growth of total merchandise exports and imports, 2007Q1–2009Q3 (year-on-year percentage change) . . . . . . . . . . . . . . 207

10 .8 China: growth of total merchandise exports & imports by trading partner countries, 2007Q1–2009Q year-on-year percentage change, current US$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

10 .9 China: growth of merchandise exports and imports by commodity category, 2008Q1–2009Q3 year-on-year percentage change, current US$ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

11 .1 Regression results of the effects of FDI flows into China on FDI inflows into East, South and South-East Asian developing economies, 1992–2008, fixed-effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

11 .2 China’s imports of raw materials from Asian economies (US$ million) . . . . . . . 231

11 .3 Two-way trade between China and Asian economies in electric and electronic equipment industries (HS 85) . . . . . . . . . . . . . . . . . . . . 233

11 .A1 Appendix . Variable list of the impact of FDI inflows into China on FDI inflows into other Asian developing host economies . . . . . . . . . . 239

12 .1 Summary statistics for migrant and rural samples . . . . . . . . . . . . . . . . 246

12 .2 Employment and earnings of migrants in cities (migrant sample) . . . . . . 248

12 .3 Results from the hours and hourly earnings equations for migrants in cities (migrant sample) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252

12 .4 Return migration, employment and earnings for rural labour force (rural sample) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

12 .5 Migration and off-farm status for a panel of individuals (rural sample) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257

12 .6 Results from hours and hourly earnings equations for rural off-farm work (rural sample) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260

12 .7 Per capita income comparisons across different type of households . . . . 262

12 .A1 Appendix . Migrant survey timing distribution by survey year

Tables

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(migrant sample) (per cent) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264

12 .A2 Appendix . Occupational distribution of self-employed migrants by year (migrant sample) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264

14 .1 Estimated cost distortions in China, 2000–08 (per cent of GDP) . . . . . . 307

15 .1 Numbers and growth rates of migrant workers and the urban employed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324

15 .2 Adjustments of urban minimum wages (numbers, per cent) . . . . . . . . . 332

15 .3 Duration of migrating work and mobility of migrant workers (numbers, per cent) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335

16 .1 China’s regional research and development statistics 2008 . . . . . . . . . . 344

16 .2 Econometric estimation results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349

16 .3 World’s top five research and development spenders 2007 . . . . . . . . . . 352

16 .4 High-technology sector exports in selected economies 2007 . . . . . . . . . 355

16 .5 High-technology sector research and development intensity in selected economies, 2006 (per cent) . . . . . . . . . . . . . . . . . . . . . . . . . 357

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Figures

5 .1 Competing theories of metal intensity . . . . . . . . . . . . . . . . . . . . . . . . . . 76

5 .2 Crude steel output per capita of selected economies, 1890–2008 . . . . . . . 84

5 .3 Crude steel output and GDP, scaled by population, 1890–2008 . . . . . . . . 86

5 .4 Urbanisation ratios of selected economies, 1890 - 2005 . . . . . . . . . . . . . 86

5 .5 Projection of steel demand per capita, extrapolating current trends . . . . . . 91

5 .6 China’s consumption of crude steel, 1978–2008 (million tonnes) . . . . . . . 93

6 .1 Energy use per unit of GDP in China, 1990–2007 (tonnes of coal equivalent per US$1000 in 1980 prices) . . . . . . . . . . . . . 102

6 .2 Comparison of fuel economy standards for vehicles . . . . . . . . . . . . . . . . 105

6 .3 Cumulative installed wind power capacity by country, 1980–2009 . . . . . 109

7 .1 Map of China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

7 .2 Regional shares of GVIO (per cent) . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

9 .1 Chinese sectoral price indices, 1990–2009 . . . . . . . . . . . . . . . . . . . . . . 166

9 .2 The Mainland China–US real exchange rate on GDP prices . . . . . . . . . . . 167

9 .3 The Mainland China–US real exchange rate on producer prices . . . . . . . . 167

9 .4 China’s investment–saving and external balances (percentage of GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

9 .5 Real wage growth in agriculture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

9 .6 Dynamics of the PBOC’s balance sheet: assets and liabilities as a percentage of GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

10 .1 Growth of merchandise trade: East Asia, developing East Asia, China and ASEAN, January 2008–November 2009 (year-on-year, per cent) . . . . . . 206

11 .1 FDI inflows into China (at current prices) . . . . . . . . . . . . . . . . . . . . . . . 223

12 .1 Age distribution of the sample from the migrant and rural surveys . . . . . . 247

12 .2 Wage/salary workers’ log weekly hours worked by industry . . . . . . . . . . 250

12 .3a Wage/salary earners’ log hourly earnings by industry (total sample) . . . . 251 12 .3b Wage/salary earners’ log hourly earnings by industry (panel sample) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251

14 .1 Comparison of the investment rate and consumption rate between China and the Chenery Standard, 1990–2008 . . . . . . . . . . . . 296


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14 .2 China’s current account balances, 1986–2009 (per cent of GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

14 .3 China’s saving and investment rate, 1978–2009 (per cent of GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298

14 .4 Gini coefficient among households and the urban–rural income gap . . . . 298

14 .5 Proportion of residential, firms’ and government income in primary distribution and the urban–rural income gap . . . . . . . . . . . . . . . . . . . . . 299

14 .6 China’s annual increased loan, 2004–10 . . . . . . . . . . . . . . . . . . . . . . . 301

14 .7 Estimated cost distortion and structural imbalances . . . . . . . . . . . . . . . 309

15 .1 Changes in the ratio of physical to labour inputs in Chinese agriculture . . 323

15 .2 Quantitative relationship between agricultural and non-agricultural employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

15 .3 Usual urban population versus non-agricultural hukou population . . . . . . 329

16 .1 China’s research and development intensity and personnel, 1990–2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343

16 .2 Numbers of patents applied for and accepted, 1995–2009 . . . . . . . . . . 344

16 .3 China’s research and development intensity and performance, 2008 . . . . 346

16 .4 China’s research and development expenditure shares and sources of funds, 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346

16 .5 Research and development intensity and per capita GDP of major economies, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353

16 .6 Research and development spending shares (basic and applied research) in selected economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

16 .7 High-technology sector value added (in 1995 constant prices) . . . . . . . 355

17 .1 Levels of healthcare provision in pre-1978 rural China . . . . . . . . . . . . . 365

17 .2 Public spending in the post-collectivisation period, 1990–2003 . . . . . . . 368

17 .3 People declining hospitalisation in the post-collectivisation period, 1990–2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369

17 .4 Sources of healthcare spending in the post-collectivisation period, 1990–2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370

17 .5 Changes in tax revenues versus expenditures, 1993–2004 (per cent) . . 371

17 .6 Urban and rural health profession skills and ratios . . . . . . . . . . . . . . . . 372

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Abbreviations

ACFTA ASEAN–ChinaFreeTradeAreaADB AsianDevelopmentBankASEAN AssociationofSouth-EastAsianNationsBMCDR BeijingMunicipalCommissionofDevelopmentandReformBMI BasicMedicalInsuranceBPCB bare-printedcircuitboardsBSH Balassa–SamuelsonhypothesisCAFE corporateaveragefueleconomyCAM centrallyadministeredmunicipalityCCP ChineseCommunistPartyCDR countrycreditratingCHIBOR Chinainter-bankofferedrateCIC ChinaInvestmentCompanyCIS CommonwealthofIndependentStatesCMS CooperativeMedicalSchemeCNY yuanCOMTRADE CommodityTradeStatisticsDatabaseCPI consumerpriceindexDPD DevelopmentandPlanningDivisionEC EuropeanCommissionEI engineeringindexEIA EnergyInformationAdministrationEU EuropeanUnionEW efficiencywageFAO FoodandAgricultureOrganizationFDA FoodandDrugAdministrationFDI foreigndirectinvestmentFTA free-tradeagreementG20 Groupof20nationsG4 GroupofFournationsGATT GeneralAgreementonTariffsandTradeGDP grossdomesticproduct


xiv

GFC globalfinancialcrisisGR growthrateGtCO2 gigatonnesofcarbondioxideGW gigawattsICT informationandcommunicationtechnologyIEA InternationalEnergyAgencyILO InternationalLabourOrganizationIMF InternationalMonetaryFundIPCC IntergovernmentalPanelonClimateChangeIPR intellectualpropertyrightsISSS InstituteofSocialScienceSurveyISTP indextoscientificandtechnicalproceedingsIU intensityofuseKCS KuznetscurveforsteelkW.h kilowatthourLMEs largeandmediumenterprisesMFN most-favourednationMNE multinationalenterpriseMOF MinistryofFinanceMoHRSS MinistryofHumanResourcesandSocialSecurityMST MinistryofScienceandTechnologymtce milliontonnesofcoalequivalentMW megawattsNAFTA NorthAmericanFreeTradeAgreementNBER NationalBureauofEconomicResearchNBS NationalBureauofStatisticsNCMS NewCooperativeMedicalSchemeNDRC NationalDevelopmentandReformCommissionNEA NationalEnergyAdministrationNHS NationalHealthService(Britain)NIEs newlyindustrialisedeconomiesNPL non-performingloanNRC netrelativechangeOECD OrganisationforEconomicCooperationandDevelopmentOLS ordinaryleastsquaresPBOC People’sBankofChinaPCBA printedcircuit-boardassembly

Abbreviations

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PPP purchasingpowerparityPRC People’sRepublicofChinaRMB renminbiROO rules-of-originRUMiCI Rural-UrbanMigrationinChinaandIndonesiaProjectSAEP StateAgencyforEnvironmentalProtectionSASAC State-OwnedAssetsSupervisionandAdministration

CommissionSC supercriticalpowerplantSCB state-controlledbankSCE state-controlledenterpriseSCI sciencecitationindexSEZ specialeconomiczoneSHI socialhealthinsuranceSIC StandardIndustryClassificationSITC StandardInternationalTradeClassificationSOE state-ownedenterpriseSUR seeminglyunrelatedregressiontechniqueSUV sportsutilityvehicletce tonnesofcoalequivalentTFP totalfactorproductivityTHC townshiphealthcentreTSS TaxSharingSystemTVE townshipandvillageenterpriseTW.h terawatthoursUN UnitedNationsUNCTAD UnitedNationsConferenceonTradeandDevelopmentUNDP UnitedNationsDevelopmentProgrammeUSC ultra-supercriticalpowerplantVAT value-addedtaxWFDIOUT worldtotalforeigndirectinvestmentoutflowsWRDP WesternRegionalDevelopmentProgramWTO WorldTradeOrganisation

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Contributors

Prema-chandra AthukoralaArndt-Corden Division of Economics, Research School of Pacific and AsianStudies,TheAustralianNationalUniversity,Canberra.

Chunlai ChenCrawford School of Economics and Government, The Australian NationalUniversity,Canberra.

Cai Fang Division of Labour and Human Capital, Institute of Population and LabourEconomics,ChineseAcademyofSocialSciences,Beijing.

Ross Garnaut UniversityofMelbourne,MelbourneandTheAustralianNationalUniversity,Canberra.

Jane GolleyChinaEconomyProgram,CrawfordSchoolofEconomicsandGovernment,TheAustralianNationalUniversity,Canberra.

Yiping Huang China Centre for Economic Research, Peking University, Beijing and ChinaEconomy Program, Crawford School of Economics and Government, TheAustralianNationalUniversity,Canberra.

Archanun KohpaiboonThammasatUniversity,Bangkok.

Sherry KongResearch School of Economics, College of Business and Economics, TheAustralianNationalUniversity,Canberra.


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Ryan Manuel UniversityofOxford,Oxford.

Huw McKayWestpacBank,Sydney.

Xin MengResearch School of Economics, College of Business and Economics, TheAustralianNationalUniversity,Canberra.

Yu ShengAustralianBureauofAgricultureandResourceEconomics(ABARE),Canberra.

Ligang SongChinaEconomyProgram,CrawfordSchoolofEconomicsandGovernment,TheAustralianNationalUniversity,Canberra.

Rod Tyers BusinessSchool,UniversityofWesternAustralia,Perth.

Bijun WangChinaCentreforEconomicResearch,PekingUniversity,Beijing.

Meiyan WangDivision of Labour and Human Capital, Institute of Population and LabourEconomics,ChineseAcademyofSocialSciences,Beijing.

Yanrui Wu BusinessSchool,UniversityofWesternAustralia,Perth.

Wing Thye WooBrookingsInstitution,WashingtonDC;UniversityofCalifornia(Davis);CentralUniversityofFinanceandEconomics,Beijing.

Geng Xiao Brookings-TsinghuaCentreforPublicPolicy,TsinghuaUniversity,BeijingandBrookingsInstitution,WashingtonDC.

Contributors

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Yang YaoChinaCentreforEconomicResearch,PekingUniversity,Beijing.

Dandan ZhangResearch School of Economics, College of Business and Economics, TheAustralianNationalUniversity,Canberra.

Ying ZhangBusinessSchool,UniversityofWesternAustralia,Perth.

Yongsheng ZhangDevelopmentResearchCentreoftheStateCouncil,Beijing.

ZhongXiang ZhangEast-WestCenter,Honolulu.

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Acknowledgments

The China Economy Program gratefully acknowledges the financial supportfor the China Update 2010 from The Australian Agency for InternationalDevelopment(AusAID)andtheassistanceprovidedbyRioTintothroughtheRioTinto-ANUChinaPartnership.

1

Chinese economic reform and development: achievements,

emerging challenges and unfinished tasks 1Jane Golley and Ligang Song

The economic transformation that has taken place in China since the late1970sisnowregardedasoneofthemostsignificantsocialchangesinhumanhistory. Within just three decades, China has succeeded in transformingitself from a centrally-planned closed economy into one of the world’s mostdynamicandglobally-integratedmarketeconomies.ThedynamicsunleashedbyDengXiaoping’sreforms,open-doorpoliciesandinstitutionalchangeshaveunleashedenormousentrepreneurialenergyandpropelledcontinuouscapitalaccumulation,productivitygainsandtradeandincomegrowthonascaletheworldhasneverseenbefore.Duringthisperiod,China’stotalgrossdomesticproduct(GDP),industrialoutput,foreigntradeand,importantly,itspercapitaincome increased respectivelyby factors of 16, 27, 124 and12.1As a result,the incidence and severity of poverty have declined dramatically in China.According to a recent World Bank report (2009), between 1981 and 2004,thefractionofChina’spopulationconsuminglessthanUS$1adayintoday’spurchasingpowerfellfrom65percentto10percentandabouthalfabillionpeoplewereliftedoutofpoverty.Thisachievementhascontributedcriticallytoglobalprogressinreducingworldabsolutepovertyandindeed‘afallinthenumberofpoorofthismagnitudeoversuchasshortperiodiswithouthistoricalprecedent’(WorldBank2009:iii).2

The fundamental causes of this remarkableperformance arebynow familiartomostChinaobservers.Market-oriented reforms centredon changes in thepricesystemledtoimprovedresourceallocationandallowedthemostdynamicprivatesectortoflourish,therebyincreasingtheoveralllevelofefficiencyintheeconomy.Liberalisationprogramsallowedtradeandforeigndirectinvestment

1 CalculatedusingthedatatakenfromNBS(2009).2 The Millennium Poverty Reduction Target aims to halve the proportion of people living in absolutepovertyby2015comparedwiththelevelin1990(Thirlwall2006).


2

(FDI) to flourish according to China’s underlying comparative advantage,resulting in enormous gains from trade. Decentralisation and ownershiptransformationhelpedtosolveincentiveproblemsandenhancetheperformanceoffirmsandlocalgovernments.Andinstitutionalreformsthatabandonedthedecades-longrestraintsonthemobilityoflabourunleashedanunprecedentedscaleofurbanisation,withtheratiooftheurbaninthetotalpopulationrisingfromlessthan20percentinthelate1970sto46percentin2009.Thisgradualprocessof‘reformandopeningup’coincidedwithasurgeintheproportionoftheworking-agepopulation,generating ina ‘demographicdividend’,which,according to Cai and Wang (2005), accounted for about one-quarter of thegrowthrateinpercapitaGDPbetween1982and2000.ThesustainedhighratesofeconomicgrowththatresultedhavefundamentallytransformedtheChineseeconomyanditspositionintheworld.

Chinahasalsobenefitedduringthepast threedecades fromsomefavourableinternalandexternalconditions.Internally,thereweresomepositivelegaciesinheritedfromtheplanningsystemthatwereconducivetoreformandgrowth,includingabasic industrialbaseandreasonable infrastructure, the irrigationsystemandarelativelywell-developededucationsystem.IntheaftermathoftheCulturalRevolution,therewereoverwhelmingdomesticforcespushingforreformthathelpedovercometheresistancetochange,especiallyduringtheearlyyearsofreform.ThelowbasefromwhichtheeconomystartedenabledChinatobenefitfromlow-costadvantagesinproductionthatcontributedenormouslytotherisingoutputandcompetitivenessoftheeconomy.Moreover,asalatecomerto economic development, China enjoyed the advantage of backwardness—thatis,theabilitytoadopttheworld’smore-advancedtechnologiesrelativelyrapidly.

Externally, China’s reforms have coincided with a new era of globalisation,characterised by a more open global trading environment, resulting fromsignificant reductions in tariffs and other forms of trade protection throughvariousroundsofmultinationaltradenegotiationsinthepost-warperiod,andfrom the mid-1980s through unilateral liberalisation in the Western Pacificregion.Thiserahasalsobeencharacterisedbyrapidglobaleconomicstructuraladjustmentinresponsetocross-borderflowsofcapital,peopleandtechnology;and by rapid reductions in transaction costs stemming from substantialimprovements in transport,communicationand informationmanagement. ‘Asa result, international markets have provided China with opportunities (andalsorisks)thatfarexceedthoseavailableatthetimeofJapan’sandKorea’sbiggrowthspurts’(BrandtandRawski2008:13).

Whilesomeofthesefavourableconditionswillremaininplaceduringthenexttwodecades,manyofthemwillnolongeryieldthesizeablebenefitstoChina’seconomicgrowththattheyhaveinthepast. IfChinaistocontinuealongits

Chinese economic reform and development

3

remarkablepathofeconomicreformanddevelopment,itwillneedtoadapttothesechanginginternalandexternalconditionsandtosteerskilfullythroughanumberofchallenges.Thisbookhighlightshowthedeepeningofreformsincriticalareassuchasdomesticfactormarkets,theexchangerateregimeandthehealthsystem,combinedwiththestrengtheningofchannelsforeffectivepolicyimplementation and the rebalancing of economic growth, will enable Chinatocopewith thechallenges that lieahead. These includeresponding to thependingexhaustionoftheunlimitedsupplyoflabour;playingaconstructiveroleinreducingglobaltradeimbalances;enhancingfirms’abilitytoinnovateandcompeteintheglobaleconomy;copingwithmigration,urbanisationandrisinginequalitiesonscalesunknowninworldhistory;anddealingwithrisingenergyandmetaldemandinanerainwhichlow-carbongrowthhasbecomeanecessityratherthanachoice.

Evidence presented in this volume and elsewhere indicates that China hasenteredtheturningpoint—ormoreaccurately,theturningperiod—ineconomicdevelopment,signalledbytheendofsurpluslabourandtheconsequentrapidriseinwagesinsome,albeitnotall,sectorsoftheeconomy.ThetighteningofthelabourmarketwillbecompoundedbythecombinedimpactofthreedecadesoftheOne-ChildPolicyandrapidincomegrowthonChinesefertilityrates,whichhasalreadyheraldedarapidlyageingpopulation,withthegrowthrateofthelaboursupplypredictedtoturnnegativebyabout2020(Tyersetal.2009).Thiswillnecessitatechanges inthe industrialstructureandcompositionof trade,asChina loses its comparativeadvantage in the labour-intensiveexports thathavebeenanengineofgrowthinthepast.Tofacilitatethesechanges,buildinghumancapital througheducation, accelerating technological change throughinnovation and raising labour productivity through further labour-marketreformarebecomingincreasinglyurgentnationalpriorities.

Economic growth in the past has been characterised by extensive growthresulting in a number of structural imbalances, including highly resource-and energy-intensive production. Now China has entered a stage of growthinwhichmetalandenergyintensities(thatis,consumptionperunitofGDP)areexceptionallystrong.Thiswill significantlyaddto theglobalpressure tobalance the supply of, and demand for, resources and energy products, andtheimpactonworldmarketsfortheseproductsislikelytobeintense(Garnautand Song 2006). Confronting this challenge will require China to accelerateitspaceofstructuralchangebymovingmorequicklytowardshighervalued-addedindustrialproductionandtheservicesectorandbyadoptingresource-and energy-saving technologies in all productive sectors. Reforming thepricingsystemsforenergyandresourcessothatpricestrulyreflectthebalance


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betweensupplyanddemandwillbecriticalinthisregard.Suchpricingreformswill enhance supply capacities and encourage resource- and energy-savingtechnologicalchange,substitutionsforresourceuseandconservation.

Asoneof the largesteconomiesandthe largestcarbonemitter in theworld,China needs to confront environmental degradation and climate changeby moving more rapidly towards a low-carbon growth economy.This is notonlyforthehealthandwelfareofChina’sownpopulation,butfortheworldto stand any chance of achieving the goal of significantly reducing globalemissions before catastrophic problems occur (Stern 2007; Garnaut 2008). Inso doing, China will need to overcome many difficulties associated with thecurrent levelofpercapita income, themid-phaseof its industrialisationandthevastregionaldisparitieswithrespecttothelevelsofincomeandindustrialdevelopment.Thetransitiontowardsdevelopingalow-carboneconomymightnotnecessarilycompromiseeconomicgrowth,asdevelopingenvironmentally-friendlyindustriescangeneratenewsourcesofgrowth.Thekeychallengeistosetupanappropriatesysteminwhichallpartiesinvolved,includingthecentralgovernment,localgovernments,firmsandhouseholds,willhaveincentivestomakethenecessaryadjustments(CaiandDu2008).ThestarkconflictbetweenthecontemporarystyleofindustrialdevelopmentandthehealthofthebiosphereindicatesstronglythatnowisthetimeforChinatomaketheadjustmentsthatwillunderpinsustainablelong-termgrowth(McKayandSong2010).

Enhancingproductivityisacrucialcomponentoftheshifttowardsalow-carbonmodeofeconomicgrowth.Technologicalprogressandinnovationholdthekey.ThereishugepotentialforChinatochangetherelationshipbetweeneconomicoutput and carbon emissions through the absorption, mass production andimprovementofgreentechnologiesfromthedevelopedcountries.Governmentwill play a crucial role in ensuring that China reaches this potential, mostimportantlybyfacilitatingthedynamicprivatesector’sactiveengagementinthisendeavour.Aconcertedefforttogenerateandcommercialiseenvironmentally-soundtechnologieswouldalsoenableChinatoquickenthepaceofindustrialstructuralchangeandalterthecurrenttrajectoryofitsindustrialisationpath.

AnotherfeatureofChina’sgrowthstrategyhasbeentherelianceonexportsandinvestment,whichhascontributed to the rise inglobal imbalances in recentdecadesandtonumerousstructuralproblemswithinChinaaswell.Whilenotallof theremedies lie inChina’shands, there isnowwidespreadrecognitionthat a rebalancingof growth is called for, in thedirectionof a strategy thatreliesmoreheavilyonthegrowthofdomesticconsumptionandproductivity.Boostingdomesticconsumptionwilltaketimebuttherearesomeclearreformoptions thatwillplayapositiverole.Songetal. (forthcoming), forexample,show that aneffectivewayofboostingdomesticdemand is to accelerate thepace of ‘urbanising’migrant workers (estimated to have reached 160 million


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in China in 2009) by granting these workers urban residency, which wouldchangetheirconsumptionbehaviour.Thisparticulartaskcanbeaccomplishedonly by deepening institutional reforms affecting labour mobility and thesocial security system. Ongoing economic development will also play a role.AsChinaenterstheturningperiod,higherwageswillnaturallyleadtohigherdomesticconsumption,possiblyhavingagreaterimpactthananyinstitutionalreforms.HigherconsumptionwillraiseChina’simportdemand,enablingthecountrytocontributetomorebalancedgrowthintheglobaleconomyandtobecomeasustainableengineforglobalgrowth.ReformstoChina’sexchange-rateregimeandland-managementsystemwillalsoplaycrucialrolesinsolvinga range of imbalance issues. Low domestic consumption is just one of manyindicatorsthatChina’sgrowthstrategyneedstobereadjustedasfarasitssocialimpact isconcerned.Forexample, theWorldBank(2009)hasfoundthattheresponsivenessofpoverty reduction to economicgrowthhas fallen in recentyears.Risingincomeinequalityandwideningregionaldisparities,alongwithuneven access to health services and social welfare systems, are some of themost undesirable outcomes associated with the rapid economic growth ofthe past. Failure to deal with these issues could pose the greatest threats tosocialstability,whichinturncouldbecomeaseriousobstacleforgrowthanddevelopmentinthedecadesahead.Whileenteringtheturningperiodwilloffersomerespiteforincomeinequality,muchmorewillneedtobedone.Apartfromstrengthening the redistributive functionsof thegovernment andbuildingamorecomprehensivesocialsecuritysystem,furtherreformstoenhancerural–urbanmigrationwillbecrucialforthecontinuedgrowthofproductivityandincomewhilenarrowingtheincomeinequalityamongdifferentsocialgroups.Strengthening local public finance through reforming the current system ofintergovernmental transfer payments and improving the health system willalsobecriticalifthegovernmentistoachieveitsobjectiveofmoreequitabledevelopment.

Finally,China is likely tobecome the largesteconomy in theworldby2030,regardlessof themeasurementused (Maddison2001).China’sriseasaglobaleconomic powerhouse will thrust on it increasing responsibilities in a rangeof global affairs—whether it wants those responsibilities or not. China willthusbeexpected,andwillsurelyfinditdesirable,tocontributepositivelytoglobalstability,progressandprosperitythroughcooperationwithotherplayersin the global system. High on the agenda for China’s strategic engagementare reducingglobal imbalances, reforming the internationalfinancial system,pushing forwardwithmultilateral tradenegotiationsunder theWorldTradeOrganisation(WTO),confrontingthechallengesofclimatechangeandfightingglobalpoverty.Inalloftheserealms,itisnotmerelyaquestionofhowChinamanagesitsexternaleconomicrelationsbuthowitconductsitselfpolitically.


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Chinahasmadetremendousprogressinreformingitsinstitutionsinthefirst30yearsofreformandtransformation.WhathasbeenachievedinthepasthaslaidthegroundworkforChinatodeepeninstitutionalreformsduringthenextstageofitsdevelopment.Thereisreasontobeoptimisticasfarasthelinkbetweenfuture institutional change and growth is concerned, since ‘[o]nce economicgrowthhasbegun,institutionschangemoreandmoreindirectionsfavourabletogrowth,andsostrengthentheforcesmakingforgrowth’(Lewis1955:143).China’sexperienceduringthepast30yearsillustratesthispoint.

Thenexttwodecadesofreformanddevelopmentarelikelytobemorechallengingthanthepast,asChinaembracesanewmodeofeconomicgrowthdrivennotonlybyefficiency,but also sustainability andequity considerations. Indeed,theoverarchingchallengeforChinainthedecadesaheadistosuccessfullyshiftintothisnewmodeofgrowth.ThiswillnotbepossibleunlessChinatacklesthe overarching task that remains unfinished: completing the transition to atruemarketeconomybyfurtherreformingthecountry’s factorsmarketsandcarrying out more comprehensive institutional reforms—in the economicsystem, in governance, in its legal and regulatory systems, as well as in thepoliticalsystem.Ifsuccessful,thenexttwodecadeswillseeChinaelevatedtoapositionofglobalprimacyoratleastof‘co-primacy’alongsidetheUnitedStates.Success is,however,moreeasilypresumed thanachieved.AsmoothChineseascendancytoglobalprimacywillrequiremanychangesfromthestatusquo,aseachofthechaptersthatfollowdemonstratesfromavarietyofdifferentangles.

PartIofthisbookfocusesonChina’slong-termdevelopmenttrendsandissues.It begins with Ross Garnaut’s (Chapter 2) analysis of the turning period inChinesedevelopment.GarnautpresentsanewconceptualframeworkbasedonArthurLewis’smodelofeconomicdevelopmentinalabour-surpluseconomy,which provides the basis for understanding China’s transition through theendofthisperiodoflaboursurplusandbeyond.Hereflectsonchaptersinthe2006ChinaUpdatebook,The Turning Point in China’s Economic Development,whichprovided early andpartial evidence thatChinahad alreadybegun itsentryintotheturningperiod.This isfollowedbyasummaryofmorerecentevidencethattheeconomyhasnowmovedmoredecisivelyanddeeplyintothisperiod,signalledinparticularbyrapidlyrisingrealwagessince2004.GarnautseesChina’seconomicsuccessinthefuturedependingontheflexibilityoftheeconomy;itsopennesstoforeigntrade,investmentandideas;andthequalityofhumanresourcesandregulatorysystemsthatarerequiredtodealwiththemorecomplex economy that is emerging. He argues that, with this flexibility andstructuraladjustment,thegrowthoftheChineseeconomywillnotnecessarilyslowduringtheLewisturningperiodandbeyond.

China’sgradualandpiecemealapproachtoeconomicreformhasbeenheraldedbymanyasanalternative—andpreferable—pathtoeconomicdevelopment,as


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reflectedinthediscourseaboutthe‘BeijingConsensus’versusthe‘WashingtonConsensus’. Where the Beijing Consensus has often been interpreted as adevelopmentmodelinwhichanauthoritariangovernmentisheavilyinvolvedinmosteconomicactivities,theWashingtonConsensushasbeeninterpretedasadevelopmentmodelrequiringarelativelyrapidtransitiontoamarket-basedeconomyasprescribedbyneoclassicaleconomics.YangYao(Chapter3)contestsbothoftheseinterpretationsinhisanalysisofChina’sdevelopmentmodelandseesChina’s reformanddevelopment asbeingperfectly compatiblewith theWashington Consensus, and the ‘China model’ as a process of convergencetowards neoclassical ideals. Yao describes the Chinese government as a‘disinterested’governmentthathasmanagedtoremaindetachedfromvarioussocial groups within China rather than being captured by exclusive interestgroups. This ‘disinterest’—rather than its authoritarianism—has enabledgrowth-enhancing policies, which, while creating winners as well as losers,havecollectivelydeliveredhigherlivingstandardsacrossthenationinthepastthreedecades.Despite thissuccess todate,YaoconcludesthatChina’s futuredevelopmentmodelwillinevitablyrequireexplicitpoliticalreform,andideallydemocratisation,tocounterbalancetheformationofstronginterestgroupswithincreasinglycontradictorygoals—beyondthatofeconomicgrowthalone.

Where Yao argues for democratisation in the future as a way of balancinggovernmentactionsandpublicinterests,YongshengZhang(Chapter4)seesitasawaytoestablisheffectivecentral–localgovernmentrelationships,theevolutionofwhichwillhaveacrucialimpactonChina’sfuturedevelopment.Heproposesanewanalyticalframeworkforintergovernmentalrelationsbasedontwodistinctdimensions—personnelandfiscal—eachofwhichcanbeeither‘topdown’or‘bottomup’.Thisgivesrisetofourpossiblestructuresintowhichtheworld’swide range of intergovernmental relations can be categorised. Zhang arguesthat most industrialisedWestern countries fall into Structure 1, representedbythecombinationofbottom-uppersonnelrelationshipsandtop-downfiscalrelationships.China’sevolvingcentral–localrelationsduringthereformperiodare then depicted as a journey from Structure 3 (top-down personnel, top-downfiscal)toStructure4(top-downpersonnel,bottom-upfiscal),asaresultoffiscaldecentralisationbetween1978and1994,andthenbacktoStructure3afterthe1994taxreforms.ZhangsuggeststhatthemostlikelyoutcomeforChinaintheforeseeablefutureisthatcentral–provincialrelationscontinuetobe top-down personnel and top-down fiscal (Structure 3), while provincial–local relations become increasingly bottom-down personnel, top-down fiscal(Structure1).ForthesuccessfulevolutiontowardsStructure1foralllevelsofintergovernmentalrelationsinChina,Zhangseestwocriticalrequirements:thestrengtheningof the rule of law and thedeepening of grassrootsdemocracy


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overtime.LikesomuchofChina’sreformanddevelopmentprocess,however,ZhangisclearthatthisprocesswillbegradualandcertainlynotwithoutChinesecharacteristics.

HuwMcKay,YuShengandLigangSong(Chapter5)revivethetheoreticalfieldthat relates economic development to metal usage and shed light on China’sfuturepathofferrous-metaldemandbyreferencingtheexperienceofrelevantpeers over the entire course of the industrialisation process. Their chapterformallyidentifiestheexistenceoftheKuznetsinverted-Ucurveforsteel(KCS)andvalidatesthesynthesisviewofmetalintensity,whichseesaroleforbothtechnologicalleapfroggingandevolvingconsumerpreferencesindeterminingchanges in metal intensity. Their econometric analysis indicates that Chinawillreachtheturningpoint in itsownKCSwhenitsgrossdomesticproduct(GDP)percapitaexceedsaboutUS$15000—predictedtobeabout2024.Theyconcludethat,asChinaprogressestowardshigh-incomestatus,itisunlikelytocontinue toclosely followtheKoreanpathcharacterisedby its exceptionallyhighmetalintensity.ThisisbecauseChinawillbecompelledtoalteritsmodeofeconomicgrowthawayfromthecurrentrelianceonheavyindustry,investmentandexportorientation.Asaconsequence,China’sfinalpathofmetalintensityislikelytobeablendofcertainaspectsoftheexperiencesofNorthAmerica,theCommonwealth of Independent States,Western Europe, Japan and emergingAsia.

TheglobalandlocalenvironmentalconsequencesofChina’srapidgrowthandindustrialisation during the past three decades have been immense.There isincreasingpressurewithinandoutsideChinafortheChineseleadershiptobemoreambitiousintheirplanstocombatglobalclimatechangeand,accordingtoZhongxiangZhang(Chapter6),theyareatleastbeginningtostepuptotheplate.ThisisreflectedfirstandforemostinChina’stargettoreduceitscarbonintensityby40–45percentby2020—atargetthatgoeswellbeyond‘businessasusual’.Zhangiswellawarethatstatingambitioustargetsisonething,whileachievingthem is another. On this front, he recognises that the (lack of) reliability ofChina’senergyandGDPstatisticsmakesitdifficulttoassessrealprogresswhileraisingtheissueofcredibilityaswell.Moreover,theconflictingobjectivesoflower-level governments could result in actions that counteract rather thansupportnational-levelenvironmentalobjectives.Theseissuesnotwithstanding,he provides considerable and detailed evidence of the achievements to datein terms of energy conservation and carbon-intensity reductions. ZhangconcludesthatthelikelihoodofChinaachievingitsenvironmentalgoalsrestson the strengtheningof existingpolicies, industrial restructuring away fromhighlyenergy-consuming,pollutingandresource-intensiveindustriesandthecooperationoflocalgovernments.


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JaneGolley(Chapter7)reflectsonanissuethathasplaguedChineseleadersformillennia:regionaldisparitiesindevelopment.By2050,thecurrentleadershiphassetitselftheformidabletaskof‘considerablyreducing’thedisparitiesthatexist between western China and the other regions—most prominently, theeast,wherethevastshareofChina’sindustrialisationhasoccurredthroughouttime, and in particular, throughout the reform period. Golley’s analysis ofprovincial-level industrial growth rates during the period 2000–07 providessomeindicationthattheglorydaysoftheeasternregioncouldbecomingtoanend,althoughitsdominanceintermsofChina’sindustrialoutputisstillclearlyevident.Althoughshefindssometheoreticalandempiricalreasonsforoptimismon the likelihood that some industrieswill spreadwestward in thenext twodecades,thebalanceofevidencesuggeststhiswilltranslateintonomorethanaminimalreductioninregionaldisparitiesduringthistime.ReducingregionalinequalitieswillremainunfinishedbusinessinChinaforalongtimetocome.

PartIIofthebookturnstothechallengesandopportunitiesrelatingtoChina’sglobal integration. Xiao Geng (Chapter 8), and Rod Tyers and Ying Zhang(Chapter 9) contribute to the continuing renminbi exchange-rate debate.Both chaptersbeginby reflectingon the internationalpressure for renminbiappreciation, which stems from the expectations of the Balassa–Samuelsonhypothesis (BSH): a developing country experiencing productivity catch-up in its tradablegoodssectors is likely toexperiencea risingrealexchangerateasaconsequenceoftheassociatedrise inwagesandnon-tradablesectorprices. Focusingon theproblemof global imbalances, Xiao takes it as giventhat China will remain reluctant to appreciate the renminbi and considersalternativeChinesepolicyoptions—suchasprivatisationandderegulation—toreducetheexcessivesavingsofthecorporatesectorandmeasurestoincreasedomesticconsumption.Hethenturnstowhatheseesasthekeyfactordrivingglobal imbalances: cheap money. This, he argues, has created property andstock-marketbubblesallovertheworld,includinginChina,andhasalsohadasignificantimpactondrivingdownthepricesofChinesegoods(therebykeepingthe real exchange rate low).Xiao calls for ahigherChinese interest rate andimprovedcapital-controlmechanismstocombatthis,byensuringthatcapitalflows into efficient investments—whether domestic or international—ratherthantowardsspeculativeandinefficientinvestments.HeclosesbynotingthattheriseinChinesepricesinthefuturecanachievethenecessaryrealexchangerate appreciation, if andwhenChina is able to tolerate this.The sooner thishappens,thesoonerexternalpressureforrenminbiappreciationwillsubside.

TyersandZhanglookcloselyatChina’srealexchangeratemovementsovertime,observingthat,despitetheexpectationsoftheBSH,itshowednotendencytoappreciateuntilafter2004.Sincethen,substantialrealappreciationhastakenplace,whichtheyattributeprimarilytorisingpricesandwagesinagriculture,


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along with the slowing of trade reforms.They then explain clearly why thesettingoftherenminbirateisnotasdiscretionaryfortheChineseauthoritiesassuggestedbycriticsandthat,shouldinternationalpressureresultinanominalappreciation either via a monetary contraction or via export disincentives,the consequences would be harmful for Chinese and global interests. Boththis chapter and Xiao’s demonstrate the importance of understanding thepeculiarities of China’s transitional economy when entering into one of theworld’shottestdebates.

ChunlaiChen(Chapter10)addressesthequestionofwhetherChina’sphenomenalsuccessinattractingforeigndirectinvestment(FDI)duringrecentdecadeshasbeenattheexpenseofotherdevelopingeconomies—inAsiainparticular.Hiseconometricanalysisofthe‘Chinaeffect’onFDIinto12otherdevelopingAsianeconomiesduringtheperiod1992–2008suggeststhecommonlyexpressedfearsaboutChina’sFDIdominanceareunfounded.Inparticular,ChenfindsthatanincreaseinFDIinflowsintoChinaispositivelyandsignificantlyrelatedtoFDIinflowsintootherAsianeconomies.Heattributesthisinvestment-creationeffectduring theperiodof analysis to the increased resourcedemandbya rapidlygrowing Chinese economy and the production-networking activities withinAsia.Chenpredictsthatthesepositivelinkagesarelikelytostrengtheninthenexttwodecades,inlightofdeepeningAsianintegrationandexpectationsofcontinuedrapidgrowthforChina.Moreover,with theageingand increasingwealthofChina’spopulation,notonlywillotherAsianeconomiesbecomemoreattractive alternative locations for labour-intensive manufacturing, they arelikelytobethedestinationsofchoiceforChina’sincreasinglylargeFDIoutflows.FordevelopingAsia,onaverageatleast,China’sFDIsuccessisawin-winstory.

Prema-chandra Athukorala and Archanun Kohpaiboon (Chapter 11) examinetheexportexperienceofChinaandotherEastAsianeconomiesintheaftermathoftheglobalfinancialcrisisagainstthebackdropofpre-crisistradepatterns.Theanalysisismotivatedbythe‘decoupling’thesis,whichpositsthattheEastAsianregionhasbecomeaself-containedeconomicentitywiththepotentialformaintainingdynamismregardlessoftheeconomicoutlookintheindustrialisedworld.AthukoralaandKohpaiboondispelthisthesisbyexaminingthechangesinintraandextra-regionaltradesharesinEastAsiasincetheglobalfinancialcrisis.Emphasisingtheimportanceofincludingpartsandcomponents—aswellasfinalgoods—intrade-flowanalysis,theyshowthattherisingimportanceofglobalproductionsharinghasinfactstrengthened,ratherthanweakened,EastAsia’slinkswiththewiderglobaleconomy.Notingthattheglobalrecoveryislikelytoremainpatchyatbestinthemediumterm,theycallforanintegratedEast Asian policy response that emphasises rebalancing growth away fromexportsandtowardsdomesticmarkets,particularlyinthecaseofChina.Theirfindingscautionagainstapossiblepolicybacklashagainstopennesstoforeign


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trade arising from the newly found enthusiasm for rebalancing growth andthey make a strong case for a long-term commitment to non-discriminatorymultilateralandunilateraltradeliberalisation.

Ontheimpactoftheglobalfinancialcrisisonrural–urbanmigration,SherryTaoKong,XinMengandDandanZhang(Chapter12)revealsomeunexpectedfindings.Withtheglobalfinancialcrisisleadingtoasharpreductioninexportorders in the second half of 2008, it was expected that the most significantimpactswouldfallonruralmigrants—intermsofeitheremploymentorwagereductions—and indeed millions of laid-off migrants lamented lost jobs andprotestedoverclosedfactories.Drawingonthepanelsurveysofrural–urbanmigrants and rural households in the Rural-Urban Migration in China andIndonesia(RUMiCI)Project,Kong,MengandZhangfind,however,onlyverysmallchanges inemploymentandalmostnowagereductions formigrants incitiesbetween2008and2009.Instead,theyfindthattherealeffectswerefeltmainlyintheruralsector,towhichcloseto15millionruralmigrantsreturnedin2009,andwith80percentofthosetakingupjobsintheruralagriculturalsector. Thus, it was the agricultural sector that effectively provided anemploymentbufferforreturnmigrantsandalsoforworkersintheruraloff-farmsector,whichwasalsohitbytheeconomicdownturn.Althoughthisevidenceindicatesarelatively—andsurprisingly—positiveoutcomeformigrantsduringtheglobalfinancialcrisis,theauthorspointoutthattheagriculturalsectorisunlikelytoprovidesuchabufferinthefuture,somigrantemploymentshockswillhavetobeabsorbedinotherways.Auniversalwelfaresystemandpropertyrightsoverrurallandareseenascrucialinthisregard.

Section III of the book focuses on ‘Policy and reforms: unfinished tasks’. ItbeginswithWingThyeWoo’sdepiction(Chapter13)oftheChineseeconomyas a speedingcar that is running the riskof threepotential typesof failure.Fiscalinstabilityandaslowdowninproductivitygrowtharediscussedastwopotential ‘hardware’ failures—or breakdowns in a key economic mechanism.Flaws in governance are likened to a crash caused by people fighting in thecar—apotential‘software’failure—whilesevereenvironmentaldegradationisseenasanaturalorexternallyimposedlimit,a‘powersupply’failureanalogoustocrashingintoawall.Afterexplainingthereasonswhyeachoftheseparticularfailuresmightoccurintheforeseeablefuture,Woopresentsareformagendatoaverttheoccurrenceofthese,andother,potentialobstaclesalongChina’sroadtoprosperity.Hisagendaforaddressinghardwarefailuresincludesthecreationofmorenewentrepreneurs,urbanisationaccordingtotheprincipleoffuturehomeownershipandthedevelopmentofamodernfinancialsysteminwhichtheprivatesectorhasagreatlyenhancedrole.Politicalreformslieattheheartofhis‘softwarereforms’,whichrequiretheadoptionoffreeelections,afreepressandanindependentjudiciary.Thesolutionto‘powersupply’failuresrestson


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China’sability tomobilise internationalconsensus,cooperationandscientificresearchonkeyglobalissues.Ifadheredto,Woo’sreformagendaoffersmuchhopethatChina’srockypathtoprosperitycanbesmoothedoutsignificantly.

YipingHuangandBijunWang(Chapter14)examinetheevolutionofstructuralimbalancesinChinaandofferoneoverarchingsolution:factor-marketreform.Inparticular,theydemonstratethatthefundamentalcauseofChina’sstructuralimbalances—reflected in its very high investment share of GDP and currentaccountsurplus,inefficientresourceuse,incomeinequalitiesandenvironmentaldegradation—liesinthegradualandpiecemealapproachtoeconomicreformsinwhichproductmarketshavebeencompletely liberalisedwhiledistortionsinfactormarketshaveremained.Thishasresultedintherepressionofpricesfor labour, land, capital, resources and the environment, which Huang andWanginterpretasprovidingsubsidyequivalentsforproducers,exportersandinvestors.WhilethishasclearlybeenbeneficialforChina’seconomicgrowthinthepast, ithasalso increasedthestructuralrisksassociatedwith incompletereforms,whichwillthreatenthestability,balanceandsustainabilityofChina’sgrowthpatterninthefutureunlessadequatelyaddressed.HuangandWangnotethattheeffortsoftheChineseleadershiptodateinaddressingtheseissueshavebeenlimitedandtheycallforamajorshiftinpolicytowardsacomprehensivepackage of factor-market reforms. Only after the successful implementationofthesereforms—whichislikelytotakedecadesinsomeareas—willChina’stransitiontoamarketeconomybetrulycomplete.

AlmostallaspectsofChina’seconomicreformanddevelopmentprocesshaveexhibiteduniquely ‘Chinese characteristics’ andCai Fang andMeiyanWang(Chapter 15) show that urbanisation is no exception. Their chapter beginswithevidencethatChinahasalreadyreachedtheLewisturning‘point’,whichtheypointoutisinfactmoreatransitional‘period’,beginningin2004.Theirinvestigation of recent trends in rural-to-urban migration and more generalchangesinthelabourmarketshowsthatagriculturenolongerservesasapoolof surplus labour,but rather that ruralworkers’migration toandsettlementin urban areas have become irreversible and inevitable. As a consequence,oneoftheirkeyargumentsisthatChinesepolicymakersneedtoletgoofthe‘Todarodogma’,whichdepictslabourmigrationinadualeconomyasapatternof‘comeandgo’,ratherthanofpermanentsettlement,andwhichthusresultsin the implementation of policies that control and even restrict the processof rural-to-urban migration—as exemplified by China’s hukou system.Whileacknowledgingprogressinreformingthehukou systemtodate,CaiandWangexplainthatimpedimentsinthesystemhaveresultedinthetransformationoffarmers into migrant workers without entitlement to crucial public servicesandsocialprotectionintheirurbandestinations,therebydrivingurbanisation


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with Chinese characteristics. Further hukou reforms are seen as critical fortransforming these farmers-turned-migrant workers into migrants-turned-urbanresidentsinthedecadesahead.

ForYanruiWu(Chapter16),indigenousinnovationwillbecrucialforsustainablegrowthanddevelopmentinChinainthedecadesahead.AfterreviewingChina’sachievementsininnovation,skillsandcapacityduringthepastthreedecades,WupresentsaneconometricanalysisofChineseinnovationatthefirmlevelandthenconsidersChina’sperformanceinaninternationalcontext.Aftershowingthatrapidgrowthininvestmentininnovationhasresultedinarapidexpansionof innovation outcomes, Wu then demonstrates a significant gap betweenChinaandtheworld’sleadinginnovatorsandquestionswhethergrowthinthequantityofinnovationshascomeattheexpenseofquality.WhileclosingthisgapandpromotingqualityaretwoobviouspolicyrecommendationsthatstemfromWu’sanalysis,hisfirm-levelanalysispresentsmoreofapolicydilemma.Inparticular,heshowsthatstate-ownedenterprises(SOEs)haveperformedmuchbetterthanforeign-investedfirmsandprivatelyownedChinesefirmsasfarasresearchanddevelopmentpropensityandeffortsareconcerned.Wucalls forspecificpoliciestoencouragetheparticipationofnon-statefirmsininnovationandtoimprovethelegalsystemandprotectionofintellectualpropertyinordertoensurethatprivatisationdoesnotcomeattheexpenseofinnovationinthefuture.

Finally,RyanManuel(Chapter17)focusesononeparticularaspectofChina’sreformsthatissparkingmuchdiscontent—andwithgoodreason:thehealthcaresystem. Manuel provides some historical context for China’s healthcareexperience.Afternotingtheachievementsofthecollectiveperiod(1950–79),inwhichChina’spublichealthsystemwasworldleadingintermsofitshighlevelsof‘bangforyourbuck’,hedescribesthesecond,post-collectivisationperiod(1980–2003)asonethatbecameincreasinglyinequitable,costlyandineffective.Sincethen,theintroductionoftheNewCooperativeMedicalScheme(NCMS)andthebeginningofthe‘coverthecountryside’campaignofpublicfinancehaveresultedinfargreaterpublicfundsbeinginjectedintothehealthcaresystem.Despitethisincreaseinfunding,Manuelseescontinuingproblemsduringthenext20yearsofhealthreform,unlesstheChinesegovernmentcaneffectivelyaddresstheflawedincentivesfacingindividualhealthserviceprovidersandthelackofsupervision,coordinationandgovernanceinthesystem.


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Song,L.,Wu,J.andZhang,Y.(forthcoming),‘Urbanisationofmigrantworkersandexpansionofdomesticdemand,’Social Sciences in China,vol.XXXI,no.3(August).

Stern,N.2007,The Economics of Climate Change: The Stern review,CambridgeUniversityPress,CambridgeandNewYork.

Thirlwall, A. P. 2006, Growth and Development with Special References to Developing Countries,PalgraveMacmillan,NewYork.


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Tyers,R.,Golley,J.andBain,I.2009,‘ProjectedeconomicgrowthinthePeople’sRepublicofChinaandIndia:theroleofdemographicchange’,From Growth to Convergence: Asia’s next two decades, Palgrave,London.

World Bank 2009, From Poor Areas to Poor People: China’s evolving poverty reduction agenda, an assessment of poverty and inequality in China,March,EastAsiaandPacificRegion,TheWorldBank,Washington,DC.

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Part ILong–Term Development:Trends and Issues

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The turning period in China’s economic development: a

conceptual framework and new empirical evidence 2

Ross Garnaut

Chinabeganitseraofmarketreformandsustainedstronggrowthin1978asalabour-surpluseconomy.Therapidgrowthofthemodernindustrialeconomycouldbesuppliedwithalloftheunskilledlabourthatitwantedtouseatamoreorlesssteadyrealwage.ThissupportedthefamiliarcharacteristicsofChina’seconomicdevelopmentinthelaterreformperiod:rapidexpansionofexportsofrelativelylabour-intensivegoods;risingratiosofsavingsandinvestmenttogrossdomesticproduct (GDP);eventuallyatendencytowardssurplus intradeandcurrentexternalpayments;andincreasinginequalityofincomedistribution.

There is now compelling evidence that the period of labour surplus andreasonablysteadyrealwagesforunskilledworkers—supportedbycontinuinglarge-scale movement of people from agriculture to industry and from thecountrysidetothecities—hascometoanend.TheimplicationsofthischangeforallaspectsofChinesedevelopmentwillbeprofound.Thischapterexploresthoseimplicationsandreviewssomeoftherecentevidenceoftheimminenceofthestructuraltransformation.

Fouryearsago, theChinaUpdatebookcarried the titleThe Turning Point in China’s Economic Development (GarnautandSong2006).ThisvolumebegananintensediscussionoftheideathatChinawasatorclosetotheimportanttransitionpointfromalabour-surplustoalabour-scarceeconomy(Garnaut2006;Garnautand Huang 2006; Cai and Wang 2006; Garnaut and Song 2006:Chs 1, 2, 9).ImportantcontributorstothatdiscussionwerebroughttogetherinaworkshopinBeijinginApril2010,organisedbytheChinaCenterforEconomicResearchatPekingUniversityandtheInstituteofPopulationandLabourEconomicsattheChineseAcademyofSocialSciences.SelectedandeditedpapersfromthisworkshoparebeingpublishedinaspecialissueoftheChina Economic Journal in2010.CaiandWang(inthisvolume)suggestaprecisedate—2004—fortheturningpoint.


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Chapter 2 in the 2006 volume by Garnaut and Huang (2006), including themacroeconomicsurveyoftheChineseeconomy,summarisedtheaccumulatingevidenceoflabourshortagesinpartsofthecountryandacceleratingratesofwage increases. It touched onWest Indian economist Arthur Lewis’s theoryof the labour-surplus economy that introduced the ideaof the turningpointineconomicdevelopment. Itpresentedsomedemographicand labour-marketprojections,suggestingthattheChineseeconomyby2020wouldbestructurallytransformedbythecombinationofrapidlygrowingdemandforanddiminishingsupplyofrelativelyunskilledlabour.

CaiFangandDewenWanginChapter9ofthatvolumenotedthatChina’sentryinto membership of theWorldTrade Organisation (WTO) in 2001—far fromincreasing problems of unemployment, as many had feared—contributed toan acceleration of internationally oriented growth. The continued strengthof growth in demand for urban labour and China’s emerging demographictransitionwereleadingtotheemergenceof‘ashortageofruralmigrantworkers[that]signals,toacertainextent,thetransitionintherurallaboursupplyfromanunlimitedtoalimitedsurplus’(CaiandWang2006:143).

Thenotionthatlabourshortagesandrisingrealwageswouldsoonplaycentralroles in Chinese development was pushed into the background when therecessionaryimpactofthegreatcrashof2008cametoChina.Inlate2008andearly2009,therewasalargeandsharpreductionindemandforChineseexportsandanassociateddeclineofdemandforlabourinChina’scoastalcities(GarnautwithLlewellyn-Smith2009,especiallyChapter9).

Althoughsevere,thelabour-marketreversalintheglobalfinancialcrisisturnedout tobebrief.Shortagesofunskilled labourandrising realwages returnedquickly,withtheextraordinarystrengthoftheChineseeconomy’sresponsetotheexpansionarymonetaryandfiscalpoliciesthatwereintroducedinlate2008(DuandWangforthcoming).

SoitistimetofocusagainontheturningpointinChineseeconomicdevelopment.

Thischapterprovidesaconceptualframeworkforlookingattheimpactoftheturning point in China and examines the empirical evidence of current andprospectivetendencies.Theconceptualmaterialreproducesthemaincontentofapaperthatwillbepublishedinthespecialissueontheturningpointinthe China Economic Journal (Garnaut forthcoming).The empirical content ofthechapterupdatesGarnaut andHuang (2006) andCai andWang (2006)bydrawingonandcitingmainlyotherpapers in that special issueof theChina Economic Journal.

The turning period in China’s economic development

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The surplus-labour economy

Theideaofthe‘turningpoint’comesfromahighlystylisedmodelofeconomicdevelopment in a labour-surplus economy, first developed by Arthur Lewis(1954).ThemodelwaselaboratedonandappliedtoanEastAsiancontextbyFeiandRanis(1964a,1964b,1966;RanisandFei1961,1963).ItwasembeddedinMinami’s(1973,1986)influentialbooksonJapaneseeconomicdevelopment.

Thelabour-surpluseconomyofthemodelisdualistic,withahighlyproductiveanddynamic‘modern’,‘urban’,‘industrial’or‘capitalist’sectorandarelativelyunproductiveandstagnant‘traditional’,‘rural’or‘village’sector.Inthestylisedlabour-surpluseconomyofthemodel,themarginalproductoflabourinruralareasiswellbelowthelivingstandardsthatpoorresidentsofruralareasenjoy.(Insomeversionsofthemodel,themarginalproductofrurallabouriszeroorevennegativeintheearlystagesofmoderneconomicgrowth.)

Livingstandardsinruralareascanremainabovethemarginalproductoflabourbecausetheyaresupportedbyvillageinstitutions,whichleadstosomesharingofincomesandemployment.Therearerisksandcostsofmovingfromtheruralsectortotheurbansectorforemployment.Assessmentsofthesecostsandrisks,ontopofthecustomaryruralstandardofliving,establishthe‘reserveprice’oflabour—ortheurbanwageatwhichmigrantsarepreparedtomigrate.Itfollowsthatthemarginalproductoflabourinurbanareasisstronglypositive.

Whenaworkermovesfromruraltourbanemployment,thetotaloutputoftheeconomyrises:thereisanincreaseinurbanoutput,butnoorlittlereductioninruralproduction.Rural–urbanmigrationisamainsourceofgrowthinaverageproductivityandtotaloutput.Asamatterofarithmetic,averageoutputrisesin rural areaswithmigration (with the sameoutput and lesspeople). In theearly stages of expansionof themodern economy,however, andperhaps fora considerable while, there is still redundant rural labour and the marginalproductoflabourinruralareasremainsloworzero.Thereservepriceofrurallabourremainslowandforawhileisunresponsivetoincreasedurbandemandforlabour.

Theavailabilityofan‘infinitelyelastic’supplyoflabourfromruralareashasimportant implications for the structure of growth in the urban and ruraleconomies.

Rapidexpansioncanproceedintheurbansectorwithoutincreasesinrealwages.Theimprovementsininfrastructure,labourcultureandmanagementpracticesthatraiseproductivitywiththepassingoftimearereflectedinarisingrateof


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returnoninvestmentandanincreasingprofitshareofmodern-sectorincome.The risingmodern-sector shareof theeconomycontributes toa risingprofitshareintheeconomyasawhole.

Savingsareamuchhighershareofprofitsthanofwages,sothatarisingprofitshareof incomeisassociatedwithahighersavingssharefortheeconomyasawhole.Thehigher savings, in turn, supporthigher levelsof investment intheusualsituationofhome-countrybiasininvestment,withhomeinvestmentfurtherencouragedbythehighandrisingratesofreturnoninvestment.

Afallingconsumptionshareistheothersideofthecointoarisingsavingsshare.Alsoasamatterofarithmetic—althoughnotmentionedintheearlytheoreticaltreatments of the subject—and highly relevant to recent Chinese reality, anincreasingexcessofsavingsoverinvestmentcausestherateofgrowthofoutputtobeunnecessarilylow.Inthelabour-surpluseconomy,thisdoesnotleadtoincreasingunemploymentofdomestic resources.Rather, it leads toeconomicgrowth rates that are unnecessarily low, which therefore cause unnecessarydelaysintheabsorptionofunderemployedlabourinthevillageeconomyintothemodernsector.

Ontheotherhand,ifthehighandrisingreturnstoinvestmentinthemodernsectorcausetheinvestmentsharetorisemorerapidlythanthesavingsshare,therewillbeatendencytowardsdeficitsinexternaltradeandcurrentpayments.Thesameoutcomewillfollowifthepublicsector’sclaimsonresourcesexpandmore rapidly than is necessary to absorb any surplus private-sector savings.Suchexternalcurrentpaymentsdeficitsaresustainableonlyifthecountryhasampleaccesstointernationalmarketsforcapitalonfavourableterms.Wheretheyaresustainable,theirpresenceislikelytoraisethesustainablerateofgrowthandtherateatwhichunderemployedlabourinthecountrysideisabsorbedintomodernandeconomicallyproductiveactivity.

With rising returns on investment and a rising profit and therefore savingsshareof income, itcanbeexpectedthattherateof investmentwillriseovertime.Thecombinationofrisinginvestmentratesandtheincreasingshareoftheexpandingmodernsectorintheeconomyislikelytocausetherateofgrowthinoutputtoaccelerateovertime.

In the rural sector, the marginal product of labour remains well below thecustomary minimum income level. Expansion of the modern sector andmigration from thevillage introducenopressure to economiseon theuseoflabourinproduction.Averagestandardsof livingrise inthevillage,withoutnoticeably affecting the customary income levels of the low-income workerswhoareavailableforemigrationtothemodernsector.


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In the labour-surplus economy, comparative advantage in international tradeis initially in small volumes of commodity exports, before the emergence ofadynamicmodernsector.Moderneconomicgrowthandthedevelopmentoftheurbaneconomysee comparativeadvantage in international trade shift tolabour-intensivemanufacturedproducts;thesecontributemostofthegrowthinexportsasthemodernsectorexpandsandtheproportionofexportsfromthemodernsectorrisesovertime.Therapidaccumulationofcapitalinthemodernsector,combinedwiththelabourforce’slearningofindustrialdisciplinesandtechniques,makesproductionofawider rangeof tradedgoodsandservicesprofitableinthemodernsector.Thiscausescomparativeadvantagetoemergein some more sophisticated manufactured products, without any weakeningofcompetitivenessintheproductionoflabour-intensivetradedgoods.Atthisstagethereisnopressureforabsolutecontractionoflabour-intensiveindustriesinthetraded-goodssector.

Inthelabour-surpluseconomy,thefallovertimeinthewageshareofincomeisassociatedwithawideningofinequalityinthedistributionofincome.Thefastertheratesofgrowthininvestmentandoutput,thefasterwillbetherateof increase in inequality.The faster the rateofgrowth,however, thegreaterwillbe the rateof emigration fromrural tourbanareas, thequickerwillbethe absorption of the surplus rural labour into productive modern-sectoremploymentandtheearlierwillbetheturningpointfromaneconomyinwhichlabourisinsurplustooneinwhichlabourisscarce.

The turning point

Iftherateofeconomicexpansioninthemodernsectorisfastenoughfortherateofemigrationfromthevillagestoexceedthenaturalincreaseoftheruralpopulationthatisofworkingage,soonerorlater,therewillbenosurplusoflabour in theruraleconomy.At thispoint,any furtheremigrationraises themarginalproductivityoflabourinruralemploymentabovetheruralwage.Therealwagerateincreasesintheruralandurbansectors.Thisisthe‘turningpointineconomicdevelopment’.

Fromtheturningpoint,thewageshareofincomerisesandtheprofitsharefalls.Therateofconsumptioncanbeexpectedtorisewiththewageshare.Therateofconsumptioninthewholeeconomyrisesandtherateofsavingsfalls.

Theincreaseinurbanwagesislikelytocausetherateofreturnoninvestmentin labour-intensiveproduction in themodernsector to fall.Thecombinationoflowerprofitabilityofinvestment,andoflowersavingsaccompaniedbytheusualhomebiasininvestment,islikelytoreducetheshareofinvestment.


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Allotherthingsbeingequal,onewouldexpecttherateofgrowthofoutputto fallwith the shareof investment inexpenditure.This isnot,however,aninevitableaccompanimentoftheturningpointineconomicdevelopment.Therearetwocircumstances inwhichtherewillbenofall intherateofgrowthinoutput. One of these circumstances could arise if, before the turning point,savingsfellshortofinvestment,givingrisetoasurplusinexternaltradeandcurrent payments.This would be a case in which the rate of growth beforethe turning point was unnecessarily low and therefore the turning point ofeconomicdevelopmentwasunnecessarilydelayed.Inthiscase,therebalancingof expenditure from investmentdemand to consumption associatedwith therisingwageshareofincomecouldoccurwithoutanyreductionintherateofgrowthinthecapitalstock.

Thesecondcircumstanceinwhichtheremightbenoreductionintherateofgrowthaftertheturningpointwouldbeiftherateoftotalfactorproductivitygrowth increases to balance a reduced rate of investment and reduced rateof increase in the capital stock.There is a reason to expect some increase inproductivitygrowthbeyondtheturningpoint.Higherwagesarelikelytoforceeconomisationintheuseoflabourandtoraiseproductivitygrowthintheruralandurbansectors.

Itfollowsthattherateofeconomicgrowthcouldbefaster,similartoorsloweraftertheturningpointthaninthelabour-surpluseconomy.

Whatevertheimpactoftheturningpointontherateofeconomicgrowth,thetendenciestowardsdeclineinthesavingsratearelikelytobemorepowerfulthanthetendenciesfordecline inthe investmentrate, leadingtoatendencytowardssmallersurplusesorlargerdeficitsinforeigntrade.

Beyondtheturningpoint,thereisareversalofthetendencyforeconomicgrowthtoexacerbatethewideningofincomeinequalities.Atlast,ruralcommunitiesandlow-skilledurbanworkerscometoshareinthefruitsofmoderneconomicgrowth.Thefastertherateofgrowthininvestment,productivityandoutputafter the turningpoint, themore rapidwillbe the rise in rural standardsoflivingandworkers’incomelevelsinruralandurbanareas.Thefastertherateofgrowthaftertheturningpoint,themorerapidwillbethereductioninincomeinequalities.

The critical contribution of rapid growth before the turning point to thereductionininequalityisitsbringingforwardintimethepointatwhichlabourbecomes scarce and labour incomes rise. The critical contribution of rapidgrowthafter the turningpoint to thereduction in inequality is toacceleratetheincreaseinrealwagesandrurallivingstandardsrelativetoincomesfromownershipofcapital.


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Thechangesinlabour’sshareofincomebeforeandaftertheturningpointareone explanation of the ‘Kuznets curve’—the observed tendency for moderneconomic growth to at first exacerbate and to later reduce inequality in thedistribution of income, at least for some time beyond the turning point ineconomicdevelopment.

Thereisnoinevitabilityaboutthelabour-surpluseconomyreachingtheturningpoint.Itwillreachthispointonlyifgrowthinthemodernsectorissufficientlyrapidandsufficientlylabourintensivetoabsorblabourfromthecountrysidesubstantially more rapidly than it is augmented by natural increase. If themodern sector of the labour-surplus economy grows too slowly relative topopulation increase orpolicydistortions causegrowth tobe associatedwithlowincreasesindemandforlabour,moderneconomicgrowthcanbeassociatedwithcontinuedsteadinessinrealwagesandever-increasingdispersionofthedistributionofincome.

Realwagesriserapidlywithcontinuingeconomicgrowthbeyondtheturningpointineconomicdevelopment.Whetherornotthisisinflationarydependsonthestanceofmonetarypolicy.Aslongaseconomicgrowthcontinuesreasonablystrongly, the increase in real wages increases domestic costs relative to thepricesof internationallytradedgoods—that is, it increasestherealexchangerate.Theincreaseintherealexchangerateoccursnomatterhowthenominalexchangerateismanaged.Theconductofmonetarypolicyinawaythatleadstoanincreaseintheforeignexchangevalueofdomesticcurrency—thatis,tonominalexchangerateappreciation—allowstheincreaseintherealexchangeratetooccurwithlowerinflationthanwouldotherwiseoccur.Theavoidanceofinflationaseconomicgrowthcontinuesbeyondtheturningpointrequiresfirmmonetarypolicyalongsideappreciationofthenominalexchangerate.

Heretherearerisksoferrorsineconomicpolicy,which,iftheymaterialise,couldunnecessarilydiminishtherateofeconomicgrowthandtheratesofincreaseinrealwagesandlivingstandardsinruralandurbanareas.Iftheauthoritiesbecomeworriedaboutinflationwhilewantingtoavoidanappreciationofthenominalexchangerate(perhapsinanattempttoprotectthelabour-intensiveindustrieswhose competitiveness is declining), they could seek to tighten expenditurepolicyinanattempttoholdinflationtolowlevels.Thisgeneratesatendencytosurplusinexternaltradeandpayments.Forawhile,thisreducestherateofgrowth below sustainable levels.The payments surplus generates tendenciestomonetaryexpansionandtothere-emergenceofinflationarypressure.Intheend,itislikelythattherateofgrowthwilltendtowardssustainablelevels,withtherealappreciationbeingachievedafteralagthroughinflation.

Anyprotectionofold, labour-intensive industries thatcomeswithavoidanceofappreciationintheforeignexchangevalueofdomesticcurrencyturnsout


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to be temporary. The temporary respite comes with potentially large costs:theeconomywillexperienceunnecessaryinflationandneedlesslyforgosomeincreaseineconomicoutput,realwagesandlivingstandards.Intheworstcase,the inflation will destabilise aspects of political as well as economic life andindirectly leadto larger losses ineconomicgrowthandpotential increases inlivingstandards.

Comparative advantage in foreign trade after the turning point shifts out oflabour-intensiveproductsintomorecapital-intensiveandtechnologicallymoresophisticatedgoodsandservices.Thesemoretechnologicallycomplexproductsrequire higher-quality inputs of human resources (education and training)and infrastructure forcommunications,financeandregulatoryarrangements.These requirements make heavy demands on the quality of various servicesprovidedbygovernment.Weaknessesintheseareasaremorelikelytoemergeasbottleneckstothecontinuationofrapideconomicgrowthafterratherthanbeforetheturningpointineconomicdevelopment.

Real-world variations of the stylised surplus-labour model

Like any model, the Lewis model of the labour-surplus economy embodiessimplifications of reality. Some of these simplifications materially affect itsapplicationtoanalysisofcontemporaryChineseeconomicdevelopment.Thissectionexaminessomeof themost importantdeparturesof thereal fromthestylisedeconomywhenthemodelisappliedtoChina’seconomicdevelopment.

ThemostimportantdepartureofrealityfromthemodelisinthegeographicallydifferentiatednatureofthelabourmarketinthehugeChineseeconomy.WithinChina,thereisimperfectmobilityoflabouramongprovincesandregionsanddifferentiated barriers to movement between various rural areas and cities.Imperfect mobility and differentiated barriers are reflected in differing wagelevelsandmaterialstandardsoflivingacrossthevariouspartsofthecountry.Asaconsequence,asurbandemandforlabourgrows,labourcouldbedrawndisproportionatelyforawhilefromonesourcewhilebeingdrawnlessintensivelyfromothers.Onepartoftheruraleconomycouldfindthatitssurpluslabourhas been absorbed fully into the modern economy and that the real wagesdemandedbypotentialimmigrantsfromthatruralregionbegintorisestrongly,while there is surplus labour and availabilityof labour at ‘traditional’wageselsewhere.Relativelylow-skilledlabourcouldbecomerelativelyscarceandrealwagescouldriseinsomecities,whileitisavailableatlowercostsinothers.


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ThemainconsequenceofChina’sgeographicallydifferentiatedlabourmarketisthatthereisa‘turningperiod’duringwhichrealwagesbegintorisestrongly,ratherthana‘turningpoint’.Realwagesriserapidlyinsomecities,forcingareductionintheprofitshareofincome,increasesinconsumptionandstructuralchangeoutof simple, labour-intensiveproducts and techniques,while lowerwagespersistandlabour-intensiveproductioncontinuestoprosperandexpandelsewhere. Similarly in the rural economy, labour becomes relatively scarce,living standards rise rapidly and production shifts out of labour-intensiveactivitiesinsomevillageswhilelabourremainsabundantinothers.

The surplus-labour model’s second major departure from reality is theassumptionthatthereisastableconventionalstandardoflivingforpotentialmigrants among rural residents until there has been sufficient emigration toraisethemarginalproductofrurallabourabovethatstandard.Evenintheearlystages of emigration frompart of the rural economy,higher averagemateriallivingstandardsandconsumptionarelikelytobereflectedinsomeenhancementofthelivingconditionsofpotentialemigrants.Asaresult,thereservepriceofrurallabour—andthereforethewagesofurbanworkers—risestosomeextentfromanearlystageinmoderneconomicdevelopment.Entryintotheturningperiodwillbemarkedbyanaccelerationofwageincreases,ratherthanbyasharpmovementfromstabletorapidlyincreasingrealwages.

Thethirdmajordepartureisthatinreality,butnotinthemodel,labourishighlydifferentiatedby skills, resulting fromdifferences in education, training andexperienceinthemoderneconomy.Themodelfocusesonrelativelyunskilledlabour,theavailabilityofwhichisdiminishedbyincreasesineducation,trainingandexperience.Changesinthesefactorsinfluencethearrivalanddurationoftheturningperiodduringwhichrelativelyunskilledlabourbecomesscarceanditswagesrise.Inparticular,thehighandonaveragerapidlyrisinginvestmentineducationperstudentandtheaccumulationofskillsthroughexperienceinthemodernsectoroftheeconomyarereducingthestocksoflow-skilledlabouravailable to theurbaneconomy.Thishasbeenbringing forward the turningperiodinChina’seconomicdevelopment.Incombinationwiththedemographiccrunch following from the sharp decline in fertility in the 1970s and 1980s,thesefactorswillcausetherateofincreaseinrealwagesduringandbeyondtheturningperiodtobemuchsharperthaninotherlabour-surpluseconomiesthathavemovedthroughandbeyondtheturningpoint.

The fourth major departure is that the real economy does not contain only‘traditional’and‘modern’sectors.Thereisalsoagovernmentsectorthatprovidesservicesandmodifiesdemandandsupplyforvarioustypesoflabour,andaffectsliving standards in rural and urban areas. The government sector suppliesinputsthatarecriticaltoeconomicgrowth.Thegovernmentsector’scommandoverresourcesandalsoitsroleinprovidingessentialinputsfordevelopment


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arelikelytoberelativelysmallintheearlystagesofdevelopmentofalabour-surpluseconomy.Thegovernment’spotentialcommandoverresourcesexpandswiththemodernsectoranditsroleincontinuedrapidgrowthbecomesmoreimportantovertime.

The main effect of the first two departures of reality from the model is totransformtheturningpointintoaturningperiod.

Themaineffectofthethirddepartureistobringforwardintimetheturningperiodandtoshortenitslength.

Theeffectsofthefourthdeparturearemanifold.Improvementsingovernmentservicesinruralareascanraisethereservepriceofemigrantlabourandthereforetheurbanwageforunskilledlabour.Provisionofeducationservicescanreducethepoolofsurpluslabourandbringforwardtheturningpoint.Public-sectordemand for labour augmentsdemand from themodern industrial sector andbringsforwardtheturningpoint.

Governmentpolicycanaffectpopulationgrowthand,overtime,theamountofunskilledlabourinthecountryside.Itcanaffectthelabourintensityofmodern-sectoreconomicgrowth.Theeffectivenessofgovernmentprovisionofvariousinputsintothedevelopmentprocessaffectstherateofgrowthevenbeforetheturning period. Its effects are, however, larger during and after the turningperiod,asgrowthcomestomakelargerdemandsoninfrastructure,educationand skills, financial services and the sound regulation of private economicactivity.

The 2006 evidence of China entering the turning period

GarnautandHuang(2006)wentthroughanumberoffactorsinfluencingtheturningpointinChina’seconomicdevelopmentandconcludedinapreliminarywaythatitwasnotfaraway.Theanecdotalevidenceofshortagesoflabourinsomeareasandlargerecentincreasesinrealwagesstartedtomakethepoint.Theloomingdemographictransitionderivingfromthelargeandsuddendeclineinfertilityagenerationago,thestrengthofmodern-sectoreconomicgrowth,theimprovementinruraleducation,includingforgirls,andtheevidenceoflabourshortagesinsomeruralaswellasurbanareasallpointedtotheimminentarrivaloftheturningpoint.

WeobservedthatintheearlyyearsofChineseeconomicreformafter1978,thelarge underemployment in the agricultural sector and potential productivitygain from transferring workers from rural to urban employment created the


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conditions for economic growth within the labour-surplus economy. For acoupleofdecadesafterthestartofreform,realwagesofmigrantworkershadbeen fairly stable while large numbers of rural residents entered industrialemployment.Wenotedthatthereportsofshortagesofmigrantlabourseemedodd,giventhatthestandardaccountssuggestedthattherewerestill300millionagriculturalworkers—wellabovetherequirementsofagriculturalproduction,evenwithestablishedagriculturaltechnologies.Therewereseveralreasonswhytheshortagescouldhavereflectedtemporaryinfluences,ratherthanthemajorstructuralfactorsthatwouldbeassociatedwithChinahavingpassedtheturningpoint in economic development. Rising food prices and various governmentmeasures to improve rural living conditions had raised the supply price ofmigrantlabour.Theabsenceofanefficientandinformedlabourmarketallowedregionalshortagestoappeareveniftherewasnonationalshortage.Employersinthecitieswereseekingtoraiseproductivityandseekingtorecruitworkerswithtwotothreeyears’experience,sosomereportsoflabourshortagemightnothaverelatedtounskilledlabourstraightfromvillages.Notallworkersfromthevillagewereinsimilarlystrongdemand:femalesagedbetweeneighteenandtwenty-fivewereespeciallyvalued,andthetotalpoolofabout70millionpeopleinthiscategorywasrunningdry.

Nevertheless,theanecdotalevidencewasconsiderableandwasbackedupbysomerelevantstatisticaldata.Migrantworkers’cashwageshad increasedby20–40percentin2004.Labourfringebenefitswereincreasingrapidlyinscopeandsizeasemployerssoughttomaketheiremploymentoffersmoreattractive.

Wenotedthateventuallyrisinglabourcostswereanormalphenomenonwithsuccessfuldevelopmentofalabour-surpluseconomy.China’srealmanufacturingwagesinUSdollarsin2006wereabout5.6percentofthoseintheUnitedStates.Korea’shadbeenabitbelowthatproportionat5.2percent in1975,but29yearslaterwere49.7percentofthoseintheUnitedStates.Weasked:willittakemoreorfeweryearsforChina’slabourcoststorisetohalfofthoseintheUnitedStates?

China’snominalwageshadfluctuatedwithinflationformorethantwodecadesofthereformperiodwithonlysmallincreasesinrealwages.Realwagegrowthhad lifted sharply from about the turn of the century and had remained indoubledigits fromthat time.Wagegrowthhadbeenevenmorerapid in theless-advancedregionsthanintheestablishedindustrialcities,GuangdongandShanghai.Until2003,realwagesgrewlessstronglythanaverageproductivity,butin2004and2005wagesgrowthranaheadofproductivity.Thishadbeenreflectedinasharpincreaseintheshareofemployeeearningsintotalindustrialvalueaddedfromthelastquarterof2004andthrough2005,reversingmanyyearsofdecline.


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These generalisations were based on general wage data, mixing skilled andunskilled elements. A look at the forward-looking data for unskilled labourpointed to a likely special tightening of the market for unskilled migrantlabour.China’srapiddemographictransformationfollowingtherapiddeclinein fertility in the late1970s and1980smeant that the total labour forcewasnow hardly growing at all, and any significant migration out of the villagescaused the rural labour force to decline.These tendencies would strengthenovertime.Thegeneraldeclineinthelabourforcewouldbeespeciallysharpforunskilledworkers, as increasingpublic investment in educationapplied to afallingnumberofchildrenwasincreasingtheproportionofnewmembersofthelabourforcewhoseeducationremovedthemfromthepoolof‘unskilled’labour.Wenoted that all successful labour-surplus economieshadpassed throughalabour-marketturningpoint,withimmenseimplicationsforthestructureoftheeconomyanditsrelationswiththerestoftheworld.WecommentedthatChinawouldnotbeanexception,anditstimewascomingsoon.

CaiandWang(2006)analyseddevelopmentsindemandandsupplyformigrantlabour,demonstratingthatbothhadcontributedstronglytotherapiddepletionofsurpluslabourintheChinesecountrysidesincetheturnofthecentury.

Onthedemandside,China’sentryintotheWTOin2001andtheaccelerateddomestictradeliberalisationwithwhichitwasassociatedhadliftedgrowthratesandhadalsomadethepatternofmodern-sectorgrowthmorelabourintensiveinlinewithChina’scomparativeadvantageininternationaltrade.Thus,demandforunskilledlabourhadgrownstronglythroughtheearlytwenty-firstcentury,despitethesheddingoflargeamountsoflabourthroughstate-ownedenterprise(SOE)reform.

Onthesupplyside,Chinahadenteredaperiodofdramaticcontractionoftheunskilledlabourforce.Theworking-agepopulationwouldreachapeakin2016andthenfallsteadily.Thenumbersofyoungerelementsofthelabourforce—thoseavailableforrural–urbanmigration—wouldbegintodeclineearlierandthe proportion of that group available for unskilled work would fall rapidlywithexpansionandimprovementofthequalityofeducation.

CaiandWangthoughtthatChinahadreachedtheturningpoint.

The evidence in 2010

The chapters in The Turning Point in China’s Economic Development in 2006werenotingearlyandpartialevidenceofChina’sentryintotheturningperiod.DataandanalysispresentedinthespecialissueoftheChina Economic Journal


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suggestthattheChineseeconomyhasnowmovedmoredecisivelyanddeeplyintotheturningperiod(DuandWangforthcoming;CaiandWang,thisvolume;Caiforthcoming;Garnautforthcoming).

TheimpactoftheglobalfinancialcrisisonChinacomplicatestheinterpretationof theevidencebetween2006and2010,butonlyslightly.Theeffectsof thecrisiswerequicklyoverwhelmedbythelonger-runtendencyfortighteningofthelabourmarket.Theglobalfinancialcrisisledtoasharpreductionindemandforlabourintheexport-orientedcoastalcitiesinlate2008andearly2009.Forawhile,thegreatestmigrationinhumanhistorywentintoreverse,asredundantworkers returned to the countryside.When retrenched workers returned toworkin2009,therewerereportsofdownwardrevisionoftermsofemployment.

TheChineseGovernment responded to the recessionary impactof theglobalfinancial crisis by launching the world’s greatest exercise in Keynesianexpansionarypolicy,tocounteracttheeffectsofglobalrecession(GarnautwithLlewellyn-Smith2009).Thesuccessoftheexpansionarypoliciesmeantthatbythemiddleof2009, theflowofmigrants fromrural tourbanareashadbeenrestoredandthenincreasedbeyondpre-crisislevels,hasteningmovementintoandthroughtheturningperiodinChina’seconomicdevelopment.

ItisthecombinedeffectsofthesetwodevelopmentsthatweseeintheChineselabourmarketthrough2009and2010.

DuandWang(forthcoming)undertakesophisticatedanalysisofChineselabour-marketdatainreachingstrongconclusionsthatrealwagesofunskilledworkershavebeenrisingstronglythroughtheearlytwenty-firstcenturyafteracoupleofdecadesofrelativestagnation,andthatthemomentumofrealwagesgrowthwasquicklyrestoredaftertheshockofthefinancialcrisis.Thepre-crisismomentumofgrowthinrealwagesoflow-skilledmigrantworkerswassostrongthattherewasanincreaseof20percentfor2008,whichendedinthemidstoflabour-marketretrenchment.Momentumwasbrieflylost,butwasresumedintimeforrealwagegrowthtoagainbepositivefor2009.Realhourlywagesformigrantworkersincreasedby90percentfrom2001to2009andby77percentfrom2003to2008(DuandWangforthcoming).Non-wagebenefits increasedmorerapidlythanwages.

Lookingforward,theynotethatassessmentsbasedonthecontinuingpresenceof300millionagriculturalworkersaremisleading.Ahighproportionofthoseworkershavesubstantialnon-agriculturalincome;formany,non-farmincomeisdominant.Theeconomiccensusesin2004and2008showgrowthofmorethan30millioninsecondaryandmorethan50millionintertiaryemploymentoverthe fouryears.Applicationof employment elasticities ofgrowth toplausibleratesofexpansionofthesecondaryandtertiarysectorssuggestsemployment


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increasesofabout24millionperannumintheyearsimmediatelyahead—iftheelasticitiesorgrowthareconstrainedbyneitherlabourshortagesnorrisingrealwages.

Will labour-market realities allow such strong employment growth? Theaverageannualincreaseintheworking-agepopulationisexpectedtofallfromaboutsevenmillionperannumin2006–10toabout3.1millionperannumin2011–15, and then to decline absolutely by about one million per annum in2016–20 and five million per annum in 2021–25. The rapidly increasinginvestment per student in education means that the emerging labour-marketsqueeze is tightest for low-skilled labour.The focusofgovernmentpolicy inrecentyearsonraisingincomesandservicesinruralareas,alongwiththerapidexpansionofoff-farmrural incomesandtheabsorption in thepastofahighproportionofyoungruralworkers—thosewhoaremostlikelytoseekurbanemployment—furtherconstraintheincreasedsupplyofmigrantlabour.

DuandWang’sanalysisdrawsattentiontopowerfultendenciestoaccelerationofrealwagesgrowthforlabouringeneralandlow-skilledworkersinparticular.

Cai Fang (forthcoming) raises questions about the bases of the Chinesedemographic data and the answers all suggest risks of even greater labour-market tightening in the period ahead. The periodic survey of agriculturalcosts suggests that the remainingagricultural labourpotentiallyavailable formigrationtourbanemploymentislessnumerousthanpresumedinanyofthewidely used studies. As a result, the marginal product of rural labour—andthereforeitssupplyprice—ismuchhigherthangenerallypresumed,andrising.

Thedifferencesindatafromthehouseholdsurveyandtheurbanunitreportingsystemsuggestthatthereare95millionmoremigrantworkersinurbanareasthaniscommonlypresumed.

Analysisofthe2000censusand2005samplecensusdatasuggeststhatnationalfertility rates have fallen below those applied to the standard populationprojections.

Theweightoftheevidencepointstoareasonableexpectationofrapidlyrisingreal wages—and more rapidly for low-skilled workers—as the only meansofbringingrunawaygrowth indemandfor labourback in linewith labour’savailability.


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Implications of the turning period for Chinese developmentWhataretheimplicationsoftheturningperiodforChina’scontinuingeconomicdevelopment,forChina’sinteractionwiththeglobaleconomyandforeconomicpolicy? I will focus on four of the most important consequences, mention aconsequence that is widely anticipated and feared, but which need noteventuate,andbrieflydiscussonewayinwhichperceptionsofChina’sgrowthwillbeaffectedbyitshavingenteredtheturningperiod.

AsChinaentersdeeplyintotheturningperiod,therewillbelargeandcontinuingincreasesinrealwagesandinthewageshareofincome.Thepowerfultendencysince the1980s towards increased inequality in incomedistribution is likelytobereversed.Thisisoneimportantconsequence.Theriseinthewageshareof incomeis likelytobereflectedinanincrease intheconsumptionshareofexpenditure.Therewillbeareductioninthenationalsavingsrate.

It is possible that, at least for a while, the investment rate will in fact rise.Whetherornot this is thecase, it is likely thatChina’s savings ratewill fallmorethanitsinvestmentrate.Thiswillreducetheexternalsurplusintradeandcurrent payments. It will therefore ease current international pressures overpaymentsimbalancesandexchangerates.ItwouldbewiseforChinatoensurethat total domestic demand—the sum of demand from private and publicinvestmentandconsumption—expandsenoughtoensurethatthisisthecase.

The reduction in Chinese current external payments surpluses is therefore asecond important consequence of moving through the turning period. Thiscouldeasetensionswithothercountries—especiallytheUnitedStates—whichhave identifiedChinesesurplusesasaprincipalcauseof theirowneconomicproblems. Regrettably, the reduction of Chinese surpluses will not help therealityofothercountries’economicproblemsasmuchasperceptionsofthem.Indeed,alargefallinChinesecurrentsavingsrelativetoinvestmentwouldputupwardpressureongloballong-terminterestratesandincreasetherequirementtoreducedomesticexpenditureongoodsandservicesinthecountriesfacinglargechallengesinthemanagementofexternalandpublicdebt,includingtheUnitedStates.Thiswillmakeeconomicmanagementproblemsinthosecountriesmoredifficult,noteasier.

The third important consequence of China moving through and beyond theturningperiodisthatthecentreofChina’scomparativeadvantageininternationaltradewillshiftrapidlyfromafairlynarrowrangeoflabour-intensiveproductsto a wider range of more capital-intensive and technologically sophisticatedproducts.ThiswilleasesomedimensionsofChina’stradeproblemswiththerestoftheworld(perceptionsofcompetitivepressureonotherdevelopingcountries


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and heavily concentrated pressures for adjustment on particular sectors inindustrialisedcountries)andcomplicateothers(competitivepressureswillbefeltacrossamuchwiderrangeof industries in industrialisedcountries).ThediversificationofChina’scomparativeadvantagewillprobablyhaltthedeclineinChineseexportpricesthatwasassociatedwiththeheavyconcentrationofexportexpansioninasmallnumberofproducts.

The fourth important consequenceof entering the turningperiod involvesapolicyrisktoeconomicstabilityandgrowthintheperiodahead.Risingrealwages and the pressure of strong increases in demand for non-traded goodsandserviceswillbeinflationaryunlessaccompaniedbyacombinationoffirmmonetary policy and an appreciating renminbi. Nevertheless, the ChineseauthoritiesmightbetemptedtomaintainthefixedexchangerateagainsttheUS dollar to avoid adjustment pressures on export-oriented labour-intensiveindustries, which have played such an important part in Chinese economicgrowthsincethemid1980s.

Toseek tomaintainafixedexchangerateagainst theUSdollar throughandbeyondtheturningperiodwouldonlypostponeandnotavoidthestructuraladjustmentsthatareanecessaryaccompanimentofthecurrentstageofChineseeconomicgrowth.Paymentssurpluseswouldeventuallyoverwhelmtheeffortsto sterilise their monetary effects. The adjustments would occur throughinflation.

Itislikelythattheauthoritieswouldrespondtohigherinflationbytighteningfiscal and monetary policies. This would unnecessarily reduce the rate ofeconomicgrowthbelowsustainablelevelsandpostponetheincreaseinChineselivingstandards thatcancome throughandbeyondthe turningperiod.Theinflation and the delays in inequality reductions could be destabilising todomesticpolitical stability.Thedelays inreduction in theexternalpaymentssurpluswouldcertainlybedestabilisingforChina’sproductiveinteractionwiththeinternationaleconomyandsociety.

Iconcludebypointingtooneconsequenceofmovingthroughandbeyondtheturningperiodthatisoftenfearedbutwhichisunlikelytobeimportantunlessthere are mistakes in economic policy, and to one important implication forperceptionsofthegrowthoftheChineseeconomy.

There is no basis for the expectation that China’s rate of growth in outputperworkermustnecessarilyfallasitmovesthroughandbeyondtheturningperiod.The rise in realwages asChinamoves through the turningperiod islikelytoleadtoanincreaseintherateoftotalfactorproductivitygrowth.Inthenatureofthings,thiswillbeconcentratedinindustriesproducingrelativelysophisticated and capital-intensive products, the competitiveness of which


35

is less sensitive to increases in real wages. It is possible that the increase inChinesedomesticdemandthatisnecessarytoreduceexternalcurrentpaymentssurpluseswillrequireanincreaseintheinvestmentrateforawhile.Togetherwiththeexpectedaccelerationofproductivitygrowth,thiswouldsupportanincreaseinthegrowthrateintotaloutputperworker,abovethehighratesoftheearlytwenty-firstcentury.ThatwillsurprisetheworldandalsotheChineseauthorities,butitmightbenecessarytomaintaininternalandexternalbalanceintheperiodahead.

HowsuccessfulChinaiseconomicallyinthisperiodofrapidlyrisingrealwageswilldependontheflexibilityoftheeconomy,itsopennesstoforeigntradeandinvestmentandtheworld’smostproductiveideasaboutmanagingenterprises,the quality of the human resources created by the rapid expansion of theeducationsysteminthepastcoupleofdecadesandthequalityoftheregulatorysystemsappliedtothemorecomplexeconomythatisemerging.Itispossiblethattherateofgrowthintotaloutputcanbemaintainedatsomethingliketheaverageratesofthedecadesofreform,untiltheapproachoftheindustrialisedcountries’ frontiers of productivity and living standards reduces the scopeof rapid productivity growth through ‘catching up’ with the industrialisedcountries.

Whether or not China succeeds in maintaining such high aggregate rates ofgrowth until it reaches the frontiers of the world economy, most observerswillbesurprisedbyhowquicklyChinacatchesupnowthatithasenteredtheturningperiod.China’srealexchangeratewillriserapidly—whetherthatoccursthroughinflation,nominalexchangerateappreciationoracombinationofthetwo.ThevalueofChina’soutputwhenmeasuredinthenationalaccountsandconvertedintointernationalcurrencyatcurrentexchangerateswillconvergetowardsthemuchhigher‘purchasingpower’estimatesofGDP.PeopleinChinaandabroadwho focusonconventionalmeasuresofnationaloutputwillfindthatChinacatchesupwiththeworld’smostproductiveeconomiesinoutputperperson—andwiththeUnitedStatesintotaloutput—muchmorequicklythantheyhadbeenexpectingfromextrapolationofdifferentialsinnationalgrowthrates.

References

Cai, F. (forthcoming), ‘Demographic transition, demographic dividend, andLewisturningpointinChina’,China Economic Journal,SpecialEdition.


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Cai, F. and Wang, D. 2006, ‘Employment growth, labour scarcity and thenature of China’s trade expansion’, in R. Garnaut and L. Song (eds), The Turning Point in China’s Economic Development,AsiaPacificPress,Canberra,pp.143–71.

Du, Y. and Wang, M. (forthcoming), ‘A discussion on potential bias andimplications of Lewisian turning point’, China Economic Journal, SpecialEdition.

Fei, J. C. H and Ranis, G. 1964a, Development of the Labor Surplus Economy: Theory and policy,RichardD.Irwin,Homewood,Ill.

Fei,J.C.HandRanis,G.1964b,‘Developmentofthelaborsurpluseconomy:theory and policy’, Economic Development and Cultural Change, vol. 41,pp.147–74.

Fei, J. C. H. and Ranis, G. 1966, ‘Agrarianism, dualism and economicdevelopment’,inI.AdelmanandE.Thorbecke(eds),Theory and Design of Economic Development,JohnsHopkinsUniversityPress,Baltimore.

Garnaut, R. 2006, ‘The turning point in China’s economic development’,in R. Garnaut and L. Song (eds), The Turning Point in China’s Economic Development,AsiaPacificPress,Canberra,pp.1–11.

Garnaut,R.(forthcoming),‘Macro-economicimplicationsoftheturningpoint’,China Economic Journal,SpecialEdition.

Garnaut,R.andHuang,Y.2006,‘Continuedrapidgrowthandtheturningpointin China’s economic development’, in R. Garnaut and L. Song (eds), The Turning Point in China’s Economic Development,AsiaPacificPress,Canberra,pp.12–34.

Garnaut, R. and Song, L. (eds), 2006, The Turning Point in China’s Economic Development,AsiaPacificPress,Canberra.

Garnaut,R.withLlewellyn-Smith,D.2009,The Great Crash of 2008,MelbourneUniversityPublishing, [Chinese translationpublishedbyChinaAcademicPress,Beijing].

Lewis, W. A. 1954, ‘Economic development with unlimited supplies oflabour’,Manchester School of Economic and Social Studies,vol.XXII(May),pp.139–91.

Minami,R.1973,The Turning Point in Economic Development: Japan’s experience,KinokuniyaBookstore,Tokyo.


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Minami, R. 1986, The Economic Development of Japan: A quantitative study,Macmillan,London.

Ranis, G. and Fei, J. C. H. 1961, ‘A theory of economic development’, The American Economic Review,vol.51,no.4,pp.533–65.

Ranis,G.andFei,J.C.H.1963,‘TheRanis–Feimodelofeconomicdevelopment:reply’,The American Economic Review,vol.53,no.3,pp.452–4.

Acknowledgments

Theconceptualcoreofthischapterisdrawnfromaforthcoming(2010)paperin the China Economic Journal: ‘Macro-economic implications of the turningpoint.’Theauthor isgrateful to theeditorsof the journal for agreeing to itspublicationinthisform.

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China model and its future* 3

Yang Yao

TheChineseeconomy’saveragegrowthrateof9.7percentperannumfrom1978to20081

1placesChinaamongjust13successfuleconomiesthathavemanagedtogrowatarateof7percentorhigherfor25yearsormoresinceWorldWarII(TheGrowthCommission2008).Percapitagrossdomesticproduct(GDP)hasgrownbya factorof12 in real terms to reachUS$3400 in2008.2 During thisperiodChinamovedfromaplannedeconomytoa‘mixedeconomy’withtheprivatesectornowaccountingfortwo-thirdsofnationalGDP.HowhasChinamanagedthisprofoundfeat?

Oneoftheprevailingviewsregardingthisquestion—especiallysincethefinancialcrisis—seemstosuggestthatChinahasbenefitedfromtheauthoritariannatureof itsgovernment;comparedwithademocraticgovernment,anauthoritariangovernment is able tomobilise largeamountsof resources to tackle themosturgent bottlenecks blocking growth and institutional transition. Indeed,theissueisoftenframedinthecontextofthe‘BeijingConsensus’versusthe‘Washington Consensus’—the former being a model of authoritarianism andheavystateinvolvementintheeconomy,andthelatterbeingamodelofneo-liberalandmarket-orienteddoctrines.Forexample,thiscontrasthasbeenclearlystatedbyBruceDickson,whohaspublishedinfluentialworkssuchasWealth into Power: The Communist Party’s embrace of China’s private sectorand‘RedcapitalistsinChina:theparty,privateentrepreneurs,andprospectsforpoliticalchange’ (Dickson 2010). Dickson believes that the Washington Consensus‘assertsthatstateinterventionisnotconducivetoeconomicdevelopment,andthateconomicfreedomsrequirepoliticallibertiesassociatedwithdemocracytoflourish.Thisneo-liberalmodelhasbeenthecornerstoneof internationalaidandlendingprogramsforthepasttwodecades.’Incontrast,

the ‘Beijing consensus’ suggests that rapid economic developmentrequiresactiveleadershipbypoliticalelitescommittedtogrowthand

*AnabridgedversionofthischapterhasbeenpublishedinForeignAffairsOnlineunderthetitle‘TheendofBeijingConsensus’(2February2010,<http://www.foreignaffairs.com/articles/65947/the-end-of-the-beijing-consensus>)

1TheNationalBureauofStatistics(NBS)website:<www.stats.gov.cn>2 Ibid.


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thatauthoritarianruleisnecessarytosustainthesepro-growthpoliciesand limit demands for greater equity and social welfare.The BeijingConsensus therefore is antithetical to theWashington Consensus andhassofardefiedthelogicthateconomicdevelopmentinevitablyleadstopoliticalchange(Dickson,2010:i)

This characterisation, however, neither captures the original meaning of theBeijingConsensusandtheWashingtonConsensusnorstandsthetestofreality.

In JoshuaRamo’s (2004) original formation, theBeijingConsensus comprisesthree elements—none of which is related to authoritarianism: 1) innovation;2) equitable and sustainable development; and 3) self-determination.3 China’sownhistoryalsorejectsthethesisofpureauthoritarianismandhighlevelsofgovernmentinvolvementinregulareconomicactivity.TheChinesegovernmentin the planning period was much more authoritarian and involved in theeconomythanitisnow,butthewholeperiodwascharacterisedmorebyfailuresandevendisastersthanbysuccesses.Anauthoritariangovernmentmightactmorequicklythanademocraticgovernment,andthiswouldmorelikelyleadtodisastersifitspolicieswerewrong.

TheWashingtonConsensushasalsobeenmisinterpretedsinceitwasproposedby JohnWilliamson in 1989.When it comes to economic transition, one ofthe misinterpretations is to treat the Washington Consensus as advocatingfast transition and to compare it with the Beijing Consensus, which is oftenregarded as a model of gradualism. In the first place,Williamson (1990) didnotsayanythingaboutthespeedoftransition,althoughheemphasisedmarketmechanismsas theendresult.On theotherhand,China’sgradualismhas itsrootsinthecountry’srecenthistory.

Tobesure,Chinaisuniqueinmanyways.TheChineseleadershipisunusuallypragmatic,enablingittosucceedinacomplexandconstantlychangingworld.The Chinese transition has followed a gradual trajectory, allowing China toavoidthe institutionalandorganisationaldisruptionsthathaveplaguedmostothertransitionaleconomies.Equally,China’seconomicorganisationslacktheclear-cutfeaturesofastandardmarketeconomy,yettheyhavebeenadaptiveintheevolutionarysettingsoftherecentpast.Thelistcouldgoon;however,aseriousexaminationofChina’sreformprocessraisesthequestionofwhetherthese features constitute a new model of economic growth or whether theyare intermediateyetsometimesnecessarystepstowardsthetraditionalmodel

3 Ramo’s ‘Beijing Consensus’ itself can be debated. While self-determination can rightfully be used todescribeChina’sdealingswithothercountries,China’seconomicgrowthcanhardlybedescribedas‘equitable’and‘sustainable’—norisitdrivenbyinnovations.

China model and its future

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of a market economy. The Chinese leadership adopted a gradual approachto transition because of its aversion to the serious risks associated with fasttransition.The Chinese Communist Party (CCP) made many serious mistakesduring itsfirst30yearsof rule: thegrandexperiments in social engineeringincludingtheaggressivecollectivisationofagriculture,theGreatLeapForwardandthecatastrophicCulturalRevolution.Withthislegacy,theCCPsawarapidtransitiontoafull-blownmarketeconomyasariskyendeavourbestavoided.Atthesametime,manyofChina’ssomewhatunconventionalorganisationalformscanbeunderstoodas reactions to theunconventionalpolitical andeconomiccircumstancesencounteredalongitstransitionalpath.Forexample,governmentownership of township and village enterprises (TVEs), which was hailed bysomeasachallengetoconventionalprivateownership,wasaconsequenceofthegovernment’sambiguous—evenconflicted—attitudestowardsprivatefirmsinthe1980s.Afterprivatefirmsweremadelegalinthe1990s,TVEsvanishedquickly(seeGarnautetal.2005).

A case for the Washington Consensus

Intermsofeconomicpolicy,Chinahasnotcreatedanewmodel.Instead,ithasfollowedcloselytheteachingsofneoclassicaleconomics.Indeed,ifwemakealistofthereformsthatChinahasundertakenandthencomparethatlistwiththe recommendations of the Washington Consensus—which in essence is asummaryofpoliciesthatwouldberecommendedbyneoclassicaleconomics—we might be surprised by the similarities in those two lists. InWilliamson’s(1990) original formulation, theWashington Consensus has the following 10policyrecommendations:

1. financialdisciplinetoavoidaninflationtax

2. publicexpenditureredirectedfromredistributiontoproductiveareas,suchasprimaryeducation,healthcareandinfrastructure

3. taxreformsoastobroadenthetaxbaseandcutmarginaltaxrates

4. financialliberalisation,involvinganultimateobjectiveofmarket-determinedinterestrates

5. aunifiedexchangerateata levelsufficientlycompetitiveto inducerapidgrowthinnon-traditionalexports

6. quantitativetraderestrictionstoberapidlyreplacedbytariffs

7. abolitionofbarriersimpedingtheentryofforeigndirectinvestment(FDI)

8. privatisationofstateenterprises


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9. abolition of regulations that impede the entry of new firms or restrictcompetition

10.provisionofsecurepropertyrights.

During the past 30 years, China has closely followed most of theserecommendations.

In termsoffiscaldiscipline, theChinesegovernmenthasbeenverycautiousinmaintainingaroughlybalancedbudget.Therateofinflationhasbeenkeptin single digits in most years. On the expenditure side, pure redistributiveprogramshavebeenkepttoaminimum;centralgovernmenttransfershavebeenlimitedprimarilyto infrastructurespending.Before2003,theshareof ‘socialspending’ingovernmentbudgetshadbeendeclining.Ithasslowlypickedupinrecentyears,butitslevelisstilllow.

Intermsoftaxation,theoveralltaxburden—measuredbytheratiooftaxestoGDP—declineddramaticallyfrom31percentin1978to12percentin1993,largelybecauseoffiscaldecentralisation in the1980s (Ramo2004).The1994fiscalreformgreatlystrengthenedthecentralgovernment’staxationcapacities,andtheamountofgovernmentrevenuehasincreasedtoapproximately24percentofGDP.Thisrateofgrowthof taxationrevenuehas,however,beguntoconcern the government and the general population. The rate of corporateincome tax was reduced from 33 per cent to 25 per cent and the allowabledeductionsforpersonalincometaxeshavebeenraisedseveraltimes.Eventhevalue-addedtaxhasbeguntoprovideadeductionforcapitalinvestment.

Ontheinternationalfront,ChinahastakenaroadthatleadsdecisivelytotheliberalisationoftradeandFDI,althoughithasfolloweditsownpaceofopeningup. Its special economic zones have served as windows for China to reachthe outside world. The export-led growth model was adopted as a nationaldevelopmentstrategyinthemid1980s.JoiningtheWorldTradeOrganisation(WTO)in2001markedChina’sfullintegrationintotheworldeconomy.Sincethen,China’stradedependenceratio—thatis,theratioofimportsandexportstoGDP—hasbeenmaintainedatover60percent,whichisoneofthehighestamongthelargeeconomies.

Domestically, twomajor themesofChinesereformsince the1990shavebeenprivatisation and deregulation. After 15 years of privatisation that startedin the mid 1990s, most of China’s state-owned enterprises (SOEs) have beenreleasedintoprivatehandsortransformedintopubliclylistedcompanies.Onlyahandful—thoughpowerful—SOEsare still ownedby thegovernment.Theremovalofpricecontrolshappenedevenbeforeprivatisation.Bytheendofthe1990s,governmentreformshadremovedmanybarrierstotheentryandexitofindividualfirmsinspecificmarkets.


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Althoughprotectionofpropertyrightsisstillweakinmanyarenas(especiallyintellectualproperty),Chinahasmadenoticeableprogressinthepast30years.SeveralamendmentstotheconstitutionandtheenactmentofthePropertyLawhave established a reasonable—though still incomplete—legal framework forpropertyrightsprotection.Thesituationisfarfromperfect,butthedirectionhasbeensetdecisivelyforbetterandstrongerprotectioninthefuture.

ItisnoteworthythattheWashingtonConsensus,asemphasisedbyWilliamson,is different from the so-called ‘neo-liberal doctrine’ that adds to the list ofcapital account liberalisation, a floating exchange rate and, above all, therelentlessworkingoftheunbridledmarket,whichChinahasclearlyrejected.Ontheotherhand,Chinahasalsoadoptedotherpoliciesfrequentlyprescribedby neoclassical economics as essential for economic growth—among whichthemostsignificantarehighsavingandinvestmentratesandanemphasisonprimaryeducation.

OneareainwhichChinahasclearlynotfollowedtheWashingtonConsensusisinfinancialliberalisation.Interestratesarestillcontrolledbythegovernment.Despitevastderegulation,theStatemaintainstightcontrolsonwhatitcalls‘thestrategicsectors’oftheeconomy,suchaspetroleum,telecommunicationsandbanking.Controlling interest rates isa tactic that thegovernmentbelieves isessentialforitscontrolofthefinancialsector.Thiscontrolledapproach—evenifitwaswarrantedinthepast—now,however,seemsproblematic.Wewillreturntothispointlater.

The aim of China’s three-decade-long economic reform has been clear—thatis,toestablishafunctioningmarketeconomy.ItishardtoimaginethatChinacouldhavemanagedtogrowat10percentperannumwithouttheintroductionof the market. Some people might admit the importance of the market, butneverthelessbelievethatanauthoritariangovernmentisnecessarytomakethemarketwork.Thisthesishas,however,beenrejectedbythefailuresoftheLatinAmericandictatorships,particularlyinChilebyAugustoPinochet’sregimeofamixtureofmilitaryruleandthefreemarket.At theminimum, itblurs thelinebetweenanauthoritariangovernmentandaregulatorygovernment.Manygovernments in the industrialised world qualify as regulatory governments,buttheyarenotauthoritariananddonothaveaheavyanddirecthandintheeconomy.TheanalysisbelowwillestablishthatanauthoritariangovernmentisnotessentialforafunctioningmarketeconomyinChina.


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The disinterested government

We have to ask a further question when we think about China’s economicsuccessmorecarefully:whyhastheChinesegovernmentadoptedtheprinciplesofneoclassicaleconomics,particularlywhentheCCPstillclaimsthatMarxismisitsideologicalanchor?

Theanswertothisquestion,Isuggest,isthattheChinesegovernmenthasbeena‘disinterested’government.Heretheword‘disinterested’isusedinoneofitsthreemeaningsinaesthetics,4whichis‘detached’or‘unbiased’whenonemakesjudgmentsonobjectiveexistences.Thus,adisinterestedgovernmentistakentomeanagovernmentthattakesaneutralstancewhenconflictsofinterestariseamongdifferentsocialandpoliticalgroups.Inotherwords,itisagovernmentthat does not consistently represent—and is not captured by—any social orpoliticalgroupinsociety.Thisdoesnotmeanthatsuchagovernmentisdevoidofself-interest;quitethecontrary.Itcanhavenotonlyitsowninterests,butbepredatorytowardssocietyatlarge.Thekeyisthatitspredationis‘identity-blind’inthesensethatitdoesnotcareaboutthesocialandpoliticalstatusofitsparticularprey.Asaconsequence,itismorelikelytoadoptgrowth-enhancingpoliciesthanisagovernmentthatconsistentlyrepresentstheinterestsofcertainsocialorpoliticalgroups.

Tounderstandthisassessment,consider thatbiasedgovernmentsareobligedtoadoptpoliciesthatconsistentlybenefittheirownfavouredgroups,andthuscreateamismatchbetweenproductivityandgovernmentallocationofresourcesbecause other groups, not similarly favoured, might be more productive. Incontrast,adisinterestedgovernmentisautonomousinthesensethatitisfreeof social and political constraints and is thus more likely to allocate publicresourcesaccordingtosector/groupproductivity.Inthatsense,adisinterestedgovernmentpromoteseconomicgrowth.It iswillingtomakethishappenfortworeasons.First,highereconomicgrowthbringstangiblegains(rewards)toitsmembers.Second,highereconomicgrowthbringssatisfactiontothepeople,whointurnmightbemorewillingtoacknowledgeitslegitimacy.

Acorollaryoftheabovereasoningisthatthepoliciesadoptedbyadisinterestedgovernmentareoftenselectiveandhavethepotentialtoenlargeincomegapsin the society.Unless thegaps lead to serious threats to its rule, however, adisinterestedgovernmentwillhavelittleincentivetocorrectthem.

TheChinesegovernmenthasactedasthoughithasbeendisinterestedforthepast 30years.This startedwith the establishment of the ‘growth consensus’

4 Theothertwomeanings,accordingtoRind(2002),are‘uninterested’and‘withoutselfinterests’whenapersonexaminesanobjectiveexistence.


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attheendofthe1970s.ThisconsensuscameoutoftheCCP’srealisationthatcontinuingwithStalinist-stylesocialismwouldnotonlyretardChina’sriseintheworld,itwouldendangeritsownlegitimacy,whichwasalreadyfalteringin the mid 1970s. The need was to discourage growing discontent and puteconomicgrowthatthecentreofallgovernmentalandsocietalendeavours.

Looking back, it is clear that the Chinese government intentionally adoptedselective policies to promote reform and economic growth—that is, policiesthatcreatedwinnersandlosers.China’sintegrationintotheworldeconomyisacaseinpoint.Attheendofthe1970s,theUnitedStateswaseagertobringChinaintoitscampasabufferagainstSoviethegemony.Chinaquicklygraspedthe opportunity.Yet that early adoption of the ‘Open-Door Policy’ was notwithoutdomesticresistance.Thespecialeconomiczonesenjoyedanabundanceofpreferentialtreatmentsthatotherpartsofthecountryenvied.Theexport-led growth model required that China embrace an unbalanced developmentpaththatencouragedrapidgrowthontheeastcoastandrelativeneglectoftheinterior;today,nearly90percentofChina’sexportscomefromtheninecoastalprovinces.China’saccessiontotheWTOin2001wasalsoaselectivemove.Beforeaccession, it was widely believed that China would have to undergo painfulstructural adjustments in agriculture, automobile manufacturing, banking,telecommunicationsandretailingifitweretojointheWTO.Amidthedebate,the central government actually sped up negotiations with WTO members,especiallytheUnitedStates.Despitemanydetrimentaleffects,accessiontotheWTOhasgreatlyacceleratedChina’sgrowthofexports.Between2002and2007,Chineseexportsgrewbyanannualrateof28.9percent,comparedwiththeaveragerateof14.5percentinthepreviousdecade.55

PrivatisationofSOEsprovidesanothercaseinpointofareformmeasurethatwasnotwelfareimprovingforeverygroupinsociety.Inthe1990s,duringthemostdramatictransformations,theCCPhadtofacenewchallengesemergingfroman increasinglydiversifiedpopulation.Between1995 and2004—thepeakofprivatisation—nearly50millionSOEworkerslosttheirjobs.ThisputtheCCPinaconundrum:bysupportingprivatisationitriskedlosingsupportfromitsmainpowerbase—theworkingclass;ontheotherhand,itslargergoaloftransitiontoamarketeconomywouldbehaltedif itabandonedprivatisation.TheCCPfinessedthisdifficultpassagebyquietlypushingcontinuedprivatisationwhilesimultaneouslydoingallitcouldtore-employlaid-offworkers.

Perhapsthemostcontroversialillustrationofthegovernment’sselectivepoliciesistheurban–ruraldivide.Withurbanpercapitaincomestandingat3.5timesruralpercapitaincome,Chinahasthelargesturban–ruralincomedifferentialintheworld.Therearemanyexplanationsforthislargegap,someofwhichare

5 ThefiguresquotedinthisparagraphareallfromtheNBSwebsite:<www.stats.gov.cn>


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relatedtotheinstitutionalbarriersinheritedfromtheplanningperiod.Fromanefficiencypointofview,however,thislargegapwouldnotbebothersometothegovernmentbecausecitiesenjoymuchhigherproductivityandwagesthancanbefoundinthecountryside.

Thegovernmenthasalsobeenwillingtocorrectmismatchesbetweengovernmentresourceallocationandtheproductivityofsocialgroups.Thedual-trackpricesysteminstitutedbetween1985and1994isacaseinpoint.Underthissystem,SOEsweregiventheopportunitytoselltheirproductsandbuyinputsintheemergingmarketafter they fulfilled theirplannedquotas.While this systemopenedupawidedoorforeconomicincentivestoplayaroleinSOEdecisionmaking, the increasinggapsbetweenmarketprices andquotaprices createdenormousscopeforrentseeking.SOEmanagersandgovernmentofficialswhocontrolledthequotasofkeyinputscouldeasilygetrichbysellingtheirquotastootherenterprisesandindividuals.Thebrightersideofthedual-tracksystem,however,wasthatitalsocreated—unintentionally—newelementsthatbenefitedonlyfromthemarket.TheTVEsandprivatefirmswereparticularlyhelpedinthisregard.Theydidnothaveaccesstoplannedresourcessuchasbankcreditsandkeyinputs,butinsteadhadtorelyonthemarkettosurvive.Despitetheseperils,theyhadbecomeimportantplayersintheChineseeconomybytheearly1990s.Forexample,TVEscontributed40percenttoChina’sindustrialgrowthand40percentofitsexportsintheearly1990s(LinandYao2001).Thesenewcircumstancesforcedthegovernmenttogiveupthedual-tracksystemsoTVEsandprivatefirmswere treatedequitablywiththeSOEs.ThishappenedevenwhenthebeneficiariesofthesystemweremostlypowerfulmembersoftheCCP.

Government policy towards migrant workers is another example of thegovernment’s willingness to correct mismatches. Until very recently, freemobilityoflabourwashamperedbyvariousbarriersincludingthehouseholdregistrationsystem(hukou),whichisstillinplacetoday.Inthe1990s,migrantworkerswereoftentreatedassecond-ratecitizensdeprivedofbasicrightstofreemobility,workplacesafety,healthcareandevenequitablesalaries.Bytheendof the1990s,however, ithadbecomeclear that theywere indispensablein thenationaleconomyasChinabecame the ‘world’s factory’. It seems thaturbandwellershadgainedunduebenefitswiththegovernment’ssuppressionofmigrantworkers’rights,andtheshareofnationalincomegoingtomigrantworkers fell below their relative contribution to the national economy.Thisunequaltreatmentignitedwidespreadgrassrootsrightsmovementsandpetitionsbyintellectuals.TheCCPwasalarmedbythepotentialforsocialunrest.Soonthediscriminatorypoliciestowardsmigrantworkersbegantowitherawayafterthemoreequity-mindedHuJintao–WenJiabaogovernmenttookofficein2003.

The question remains why the Chinese government remained ‘disinterested’during the reform era? The CCP’s search for legitimacy is one of the major


47

reasons.Despiteitsabsolutepower,theCCPhasneverbeenfreetoignorethegeneralwishesof thepeople.TheAprilFourthMovement in1976, theJuneFourth Movement in 1989 and numerous protests in subsequent years showthatpeoplearequitewilling to stageorganised resistance. Inaddition,fiscaldecentralisation during the 1980s had considerably weakened the centralgovernment’s authority over local governments, making it more prudent incarrying out regional policies. International monitoring has also played animportant role.As ithas emergedasoneof the largest internationalplayers,Chinanowmust care about its legitimacyon theworld stage. Since it isnotdemocraticallyelected,theCCPdoesnothavethelegitimacyderivedfromthesetofproceduresapprovedbythepeople.Asaresult,ithastoseekperformance-basedlegitimacy—thatis,legitimacycomingfromthedeliveryofcontinuousimprovementstowardspeople’swelfare.

Many other authoritarian regimes, however, also tried to obtain legitimacythrougheconomicgrowth,yettheyoftendidnotenjoypowerforlong.IthasalottodowiththeabsenceofextremesocialinequalityinChinathattheCCPhasremaineddisinterestedinthereformera.

In societies with extreme social inequality—such as many of those withauthoritarian regimes—forming an alliance with the strongest social groupsprovidesthebestchanceforthegovernmenttosurvivebecausethosegroupscan provide sufficient resources for it to suppress any challenges from theunfavouredgroups.Thebiasedpoliciesultimatelylead,however,tostagnationofeconomicgrowthandtheerosionoftheregime’slegitimacy.Incontrast,itisdangerousforthegovernmentinanequalsocietytosidewithanyparticulargroupsbecauseothergroupscanformanalliancetoblockthegovernment—andperhapseventounseatit.

Chinawasmadeasociallyequalsocietythroughaseriesofrevolutionsinthetwentiethcentury.The1911XinhaiRevolution ledbythenationalistsendedtheManchuruleofimperialChinaandestablishedarepublic.Thecommunistrevolutionof1949furtherlevelledoutChinesesociety.Throughcomprehensiveyet brutal land reform, the landed class was effectively eliminated and landdistributionbecameequalised.Largebusinessesoriginallytiedtothenationalistgovernmentwerenationalised.Bytheearly1950s,theMainlandandTaiwan,despite their diametrically opposite ideological outlooks, were surprisinglysimilarintermsofsocialstructureandgovernmentpolicies.Likethecommunistson theMainland, thenationalists inTaiwancarriedouta thorough—thoughpeaceful—land reform. Both governments established SOEs and extractedsurpluses from agriculture in the hope of speeding up the industrialisationprocess.Indeed,theTaiwaneseindustrialsectorextractedmoresurplusesfromagriculture through price cuts than its Mainland counterpart in the 1950s.Between1951and1960,27percentofTaiwan’scapital formationcamefrom


48

net capital outflow from agriculture in the form of price cuts. 6 In the sameperiod,however,theMainlandgovernmentwasinfactpayinghigherpricesforagriculturalproductsthanthemarket(Wu2001).Thedivergenceoccurredin1956whentheMainlandbegantoeliminatefamilyfarminginthecountrysideandprivatebusinessesinthecity.Between1956and1978,theMainlandtookalongdetourandthereformhaslargelybeenaprocessofmovingthecountrybackonthetracksetforitintheearly1950s.

Political scientist Meredith Woo-Cumings (1997) has observed the linkagebetweenanequalsocialstructureandthegovernment’sneutralitywithregardtosocietyinEastAsia.Ontheonehand,TaiwanandKoreaweredesignatedassuppliersofagriculturalgoodsinImperialJapan’sversionoftheGreatEastAsianCommonwealth,sourbanindustrialistsweresuppressedinthosetwoplaces.Ontheotherhand,theJapanesecolonistsintentionallyrestrictedthegrowthofthelandedclass inbothplacesbecausetheyfearedthatthisclasswouldbecomeasourceofnationalistsentimentsandorganisedupheavalsagainstitscolonialrule. Woo-Cumings (1997:331) writes: ‘This discontinuity had a powerfullevelingeffect,equalizingincomesmorethaninmostdevelopingcountriesandprovidingafertilegroundforinstitutingeffectiveinterventioniststates,whichweregivenarelativelyfreehandtoforgeadevelopmentalcoalitionastheysawfit.’

The future?

The selective and efficiency-biased policies have, predictably, led to largeincomeinequalityinChina.TheoverallGinicoefficienthasreached0.47(Cheng2007)andthegapbetweentherichestandthepoorestisincreasingevenfaster.Worsethanthat,governmentsatvariouslevelsconstantlyinfringeonpeople’spoliticalandeconomicrights inordertocreateshort-termgrowth.Arbitrarylandacquisitionsarebutoneexample.Politicalandeconomic inequalityhasledtowidespreadprotestsinthecountry.Inasense,Chinaisindeeda‘fragilegiant’,asSusanShirk(2007)callsit.Yetitseemsthattherearenoclearsignsofanimminentcollapse.HowhastheCCPmanagedtominimisethedownsidesofitsselectivepolicies?

First, the government has delivered continuous economic growth and risingliving standards to thepopulation.Oneof thecurious thingsaboutChina isthatthegovernmenthasconstantlyreceivedanapprovalratingof70percentorabove,nomatterwhodoesthesurvey.7 Thereasonbehindthis is thatthe

6 CalculatedfromestimatesprovidedbyLee(1971:Table3,p.29).7 Forarecentindependentsurvey,seeISSS(2009).


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majorityoftheChinesepopulationisquicklymovingintotherankofthemiddleclass,whobenefitfromthecurrentregime.InChina,themiddleclass—atleastfornow—isnotaforceforchange,butratheraforceforstability.

Second, the government has carried out specific programs that quickly andeffectively address early signsofdiscontent in thepopulation.This includesanurbansubsistencemaintenanceprogramthatcovers20millionlow-incomepeople,re-employmentcentresthatprovideunemploymentbenefitstolaid-offworkersandtrainthemforre-employment,severalprograms(forexample,theWesternRegionDevelopmentProgram) thataimto lowerregionaldisparitiesandtherecentNewCountrysideMovementtoimproveinfrastructure,healthcareandeducationinruralareas.

Third, the government has gradually begun to give more respect to people’sexpressed interests in response to large-scaleprotests.Thepolicy change formigrant workers is but one example. Other examples include the passage ofthe Property Law, increased levels of compensation for those who lose landandbuildingstourbanandindustrialexpansionandlimitedtransparencyofgovernmentbudgets.

Lastly,theselectivepoliciesthemselveshavecertainself-correctingeffects.Beingdisinterested,thegovernmentdoesnotconsistentlyfavourspecificgroups,sointhe longrunfavoursare likelytobedistributedroughlyequally—at leastin areas where institutional impediments are relatively weak. For example,theGinicoefficientswithinthecityandwithinthecountrysidealonearenothigh—bothattherangeof0.35to0.37—whichapproximatesthelevelsfoundinSouthKoreaandJapan(Cheng2007).

Thosemeasuresare,however,only‘painrelievers’—beingtooweaktobreakdown the institutional barriers and correct market imperfections that mightstimulate new and threatening social groups. While the private businesscommunityisrealisingtheimportanceofcultivatingthegovernmentforlargerprofits,itisthegovernmentitself,itscroniesandgovernment-controlledSOEsthat are quickly forming strong and exclusive interest groups. This is theresultoftheCCP’stwopoliticalstrategiestoimproveitschancesofcontinuouscontrolofthesociety.Oneisitstransformationtobecomeanall-people’spartyandtheother is its intentiontofollowtheSingaporeanmodeltomergeitselfwith the government. The first strategy is aimed at broadening its powerbase,whilethesecondisaimedatcontrollingthecountryinthe‘shell’ofthegovernment.Chinais,however,toobigfortheCCPtofollowtheSingaporeanmodeleven if it isamodelworthpursuing.Beinganall-peoplepartymeansthat theCCPgivesup itspolitical conviction to represent theworkingclass.Sincetherearenoothermajorpoliticalorganisationsinthecountry,societyisleftalonetodevelopalongthetrajectorydictatedbya‘natural’process—that


50

is,aprocessunmitigatedbypoliticalcontests—inwhichpowerfulgroupsarelikelytoaccumulatemorepowerandweakgroupsarelikelytolosemorepower.MergingwiththegovernmentcouldsolvetheCCP’sorganisationalissues,butitwilldepriveitoftheautonomythatitusedtoenjoywhenitcametothefightbetweensocialgroupsbecauseitissoinvolvedintheeconomythatitcannolongeravoidtakingabiasedstance.Asaresult,thereisnoassurancethatthegovernmentcanremaindisinterestedandgrowthwillcontinue.

Thesituationhas,however,worsenedinrecentyears.Inthepastseveralyears,governmentinvolvementintheeconomyhasincreased—mostnotablywiththecurrentCNY4trillion (US$586billion)stimulusplan.Government investmenthelped China reach a GDP growth rate of nearly 9 per cent in 2009, whichmanyapplaud,butinthelongrun,itcouldsuffocatetheChineseeconomybyreducingefficiencyandcrowdingoutmorevibrantprivateinvestment.

Theeconomycurrentlydependsheavilyonexternaldemand,creatingfrictionamong major trading partners. Savings account for 52 per cent of GDP andconsumption has dropped to a historic low. Whereas governments in mostadvanced democracies spend less than 8 per cent of government revenue oncapitalinvestment,thisfigureiscloseto50percentinChina.Andhouseholdincomeasashareofnationalincomeisdeclining,makingtheaveragecitizenfeelpoorerwhiletheeconomyexpands.AstheChinesepeopledemandmorethaneconomicgainsastheirincomeincreases,itwillbecomeincreasinglydifficultfor the CCP to contain or discourage social discontent by administering themedicineofeconomicgrowthalone.8

More importantly, the government in its current form is cumbersome whendealingwithmultiplegoalsthatare increasinglybeingdemandedbysociety.Concerted efforts to promote GDP growth will still result in infringementstopeople’s economic andpolitical rights,which in turnwill arouseperiodicresistance. Despite its absolute power and recent track record of deliveringeconomicgrowth,theCCPhasstillperiodicallyfacedresistancefromChinesecitizensand,asalreadynotedabove,numerousprotestshaveprovedthattheChinesepeoplearequitewillingtostageorganisedresistancewhentheirneedsarenotbeingmetby theState. InternationalmonitoringofChina’sdomesticaffairshasalsoplayedanimportantrole;nowthatithasemergedasamajorglobalpower,Chinaissuddenlyconcernedaboutits legitimacyontheinternationalstage.

Allthissuggeststhatsomeformofexplicitpoliticaltransitionwillbenecessaryto counterbalance the formation of strong and exclusive interest groups, toallow the government to deal with multiple goals and even to enhance the

8 ThefiguresquotedinthisparagrapharefromtheNBSwebsite:<www.stats.gov.cn>


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CCP’sownrule.Whiletheprospectofamultipartyandcompetitivedemocracyisnot soclearat themoment, societalpressuresare forcing theCCP toopenup the political process. There is a silent yet steadily growing civil societymovementpressingthegovernmenttoshowgreaterrespectforpeople’srights.The Internet is servingasaplatformnot just for informationsharingamongconcernedcitizens,butforthemtocoordinatepublicprotestsagainstperceivedgovernment wrongdoing. The most powerful resistance, however, is likelyto come from marginalised people and the ‘rights movements’ representingthem. They are the people who suffer the most from arbitrary governmentinfringementsandbenefittheleastfromthestatusquo.

TheCCPmustsoonrealisethatthereisnoalternativetofullerdemocratisationifitwishestomaintainbothhigheconomicgrowthandenhancedsocialstability.Theemergenceofstrongandprivilegedgroupswillblockequaldistributionof the benefits of economic growth in society, which will then render futilethe CCP’s strategy of trading economic growth for people’s consent to itsabsoluterule.TheCCPneedstoactnowtoenable‘ordinarypeople’tochallengeprivileged groups on an open and institutionalised platform. Indeed, thiswill alsoease theCCP’sowntaskofcontrolling thebureaucracybecause thedemocraticinstitutionswillbeabletodothisinstead.Althoughinterestgrouppoliticsiswidespreadandoftendamagingindemocraticsocieties,anopenandinclusivepoliticalprocesshasbeenproventobethemosteffectivewaytoreachabalancebetweendifferentgroups.Indeed,thisispreciselythemandateofadisinterestedgovernment—tobalancethedemandsofdifferentsocialgroups.Ademocraticgovernmentcanstillbedisinterestediftherightinstitutionsareinplacetokeepthemostpowerfulgroupsatbay.

References

Cheng,Y.2007,‘TheGinicoefficientanditsrural–urbandecompositionsincethereform’,Chinese Social Sciences[inChinese],no.4,pp.24–36.

Dickson,B.2010,Whoconsentstothe‘BeijingConsensus’?Cronycommunismin China, Manuscript, The Elliott School of International Affairs, GeorgeWashingtonUniversity,Washington,DC.

Garnaut, R., Ligang S., Stoyan T. and Yang Y. 2005, China’s Ownership Transformation: Process, Outcomes, Prospects, International FinanceCorporation,Washington,DC.

Institute of Social Science Survey (ISSS) 2009,The China Report, PekingUniversityPress,Beijing.


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Lee,T.1971,Intersectoral Capital Flows in the Economic Development of Taiwan, 1895–1960,CornellUniversityPress,Ithaca,NY.

Lin,J.andYao,Y.2001, ‘Chineserural industrializationinthecontextoftheEast Asian miracle’, in Joseph Stiglitz and ShahidYusuf (eds), Rethinking the East Asian Miracle, The World Bank and Oxford University Press,Washington,DC.

Ramo,J.2004,The Beijing Consensus: Notes on the new physics of Chinese power,ForeignPolicyCentre,London,<www.fpc.org.uk>

Rind, M. 2002, ‘The concept of disinterestedness in eighteenth-centuryBritish aesthetics’, Journal of the History of Philosophy, vol. 40, no. 1,pp.65–76.

Shirk,S.2007,China, Fragile Superpower,OxfordUniversityPress,NewYork.

The Growth Commission 2008, The Growth Report: Strategies for sustained growth and inclusive development,TheWorldBank,Washington,DC.

Williamson, J. 1990, ‘What Washington means by policy reform?’, in JohnWilliamson (ed.), Latin American Adjustment: How much has happened?,InstituteforInternationalEconomics,Washington,DC.

Woo-Cumings, M. 1997, ‘The political economy of growth in East Asia: aperspectiveonthestate,market,andideology’,inMasahikoAoki,Hyung-KiKimandMasahiroOkuno-Fujiwara(eds),The Role of Government in East Asian Economic Development: Comparative institutional analysis,ClarendonPress,Oxford.

Wu,L.2001,‘Astudyofthesizeofthe“pricescissors”inChinain1949–1978’,Researches in Chinese Economic History[inChinese],no.4,pp.3–12.

Acknowledgments

I thank Daniel Bromley, Edward Friedman, Ashok Gurung, Yukon Huang,SanjayRupareliaandJianyingZhafortheirhelpfulcommentsandsuggestions.

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How will China’s central–local governmental relationships

evolve? An analytical framework and its implications 4

Yongsheng Zhang

Introduction

Theway inwhich intergovernmental relationships evolve inChina is crucialfor China’s future development. There has been a worldwide trend towardsdecentralisationofpowerandresponsibilitiesinlargecountriessincethe1980s.Nonetheless,decentralisationdoesnotnecessarilymeanaweakenedcapabilityofthecentral(orfederal)governmenttocontrolthebehaviourandactionsoflocalgovernments.

From a fiscal perspective, decentralisation has three related dimensions:responsibility for expenditure; responsibility for raising revenue; andintergovernmentalfiscaltransferpayments.Foreachlevelofgovernment,therelationshipbetweenthesethreeitemsis:expenditure=own-sourcerevenue+intergovernmentalfiscaltransferpayments.

If decentralisation means an increase in own-source revenue (or taxationautonomy)of lower-levelgovernments then itwould result in a reductionoftransferpayments.Inthissituation,thelocalgovernment’sfiscalcapabilityisimprovedandthecentralgovernment’sisweakened.Ifdecentralisationinsteadmeansthedevolutionofexpenditureresponsibilitythenitcouldbeachievedeither through an increase in fiscal transfer payments or an increase in thetaxationautonomyoflower-levelgovernments.Intheformercase,thecentralgovernment’scontrollingcapabilityisenhancedwithdecentralisation,whileinthe latter it is the localgovernment’scontrollingcapability that isenhanced.Therefore,differentformsofdecentralisationhaveverydifferentimplicationsforeachlevelofgovernmentintermsofcontrollingcapability.

The key principle of decentralisation is broadly accepted: jurisdiction overthedeliveryofpublicservicesshouldbeallocatedtothelevelofgovernmentclosest to the citizen, unless such delivery can be taken on more effectivelybyagovernmentthatisfurtheraway.Accordingly,localgovernmentsshouldhave more fiscal autonomy. Nonetheless, it has been a fact that, in most


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countries, higher levels of government control most of the fiscal resources.The worldwide trend towards decentralisation in recent decades is reflectedmainlyinexpenditure,whileonthesideofrevenueitshowsacontrarytrendofcentralisation.Thegapbetweentheexpenditureandown-sourcerevenueoflocalgovernmentsisfilledbyfiscaltransferpayments.Thisbrings‘verticalfiscalimbalance’,inwhichlowerlevelsofgovernmentbecomefinanciallyreliantontransferpaymentsfromhigherlevelsofgovernment.Thus,throughincreasingtransferpayments,thecontrollingcapabilityofcentralgovernmentsoverlocalgovernmentshasbeenfurtherenhancedratherthanweakened.

Why do most countries—including Western countries (either unitary orfederal)—purport to value democracy and decentralised markets, yet adopthighlycentralisedfiscalarrangements?Mostoftheexistingexplanationsfocusoninter-regionalexternalitiesrelatingtoinfrastructure,spill-oversorregionalfiscalequalisation.Thesolutiontotheseproblemsisseentolieinhigherlevelsof government having sufficient fiscal capability (for example, Oates 1972;Seabright1996).Itisnotsoobvious,however,thatcentralgovernmentsneedtocontrolmostoftheircountry’sfiscalrevenueinordertosolvetheseproblems.Forexample,trans-regionalinfrastructureprojectscouldbeprovidedthroughnegotiationbetweentherelevantstakeholders(àlaCoase),ratherthanrelyingonthecentralgovernment.Indeed,trans-regionalinfrastructureprojectsthatareprovidedbythecentralgovernmentcreateanadditionalexternality,sinceinthissituationotherregionsnotbenefitingfromtheprojectbearapartofthetaxburdenaswell.Second,inindustrialisedcountriesinwhichspatialeconomicimbalancesaresmall,thecentralgovernmentsalsocontrolmostofthenation’sfiscalrevenues.Asforfiscalequalisation,inindustrialisedcountriesinwhichspatial imbalances are small, the costsof transferpaymentsoftenexceed thebenefits,particularlywhentransactioncostsaretakenintoaccount.Yeteventhesecountriestendtohavehighlycentralisedfiscalarrangements.Theremustbeafundamentalexplanationforthis.

Andthereis.Thefiscalrelationshipisonlyonedimensionofintergovernmentalrelationships, and the above explanations fail to take into account the otherdimensions,suchasthepersonneldimension.TheobjectiveofthischapteristoprovideanewanalyticalframeworkforintergovernmentalrelationshipsandtoinvestigateitsimplicationsforthefutureevolutionofChina’scentral–localgovernmental relationships. The next section provides a brief review of therelevantliteratureonintergovernmentalrelationships.Afterthat,ananalyticalframeworkonintergovernmentalrelationshipsispresentedandsomesupportiveevidenceisprovided.SubsequentsectionsconsiderthecurrentstatusofChina’sintergovernmentalrelationshipsandhowtheymightevolveinthefuture.Thelast section concludes the chapter and suggests how the framework can beappliedtoalargeresearchagendainthefuture.

How will China’s central–local governmental relationships evolve?

55

Intergovernmental relationships: a brief literature review

Thereare three linesofresearchon intergovernmentalrelationships fromtheperspectiveofverticalfiscalimbalances.First,accordingtoclassicfiscaltheories(representedbyMusgrave1959andOates1972,amongothers),astrongcentralgovernment isnecessary toachieve threenationwidegoals: efficient resourceallocation, equity and economic stability. These theories cannot, however,provide an accurate answer to the question of how much fiscal revenue thecentralgovernmentneedstocontrol,eitherinabsolutetermsorasaproportionofallrevenue.Itseems,accordingtothesetheories,thateitherunbalancedorbalanced vertical fiscal relations could occur, since the centre’s expenditureresponsibilityforthethreegoalsmightbeachievedwithalowercentralfiscalcapability,whichmakesabalancedverticalfiscalrelationpossible.

Thesecondresearchlineisrelatedtotheoptimisationofanation’saggregatetaxrevenue.Itisarguedthatverticalfiscalimbalancesresultfromoptimisinganation’staxrevenueforagiveneconomicandtaxationstructure,stemmingfrom a range of assumptions about incentive mechanisms, fiscal autonomy,accountability, information, tax competition, tax costs and spill-overs.1 Theimplicitassumptionisthatverticalfiscalimbalanceispre-designedbyacentralplannertooptimisethenation’staxrevenue,sothatthemovetowardsamorebalancedfiscalstructurecouldcauseafallinaggregatetaxrevenue,encourageinter-regional transfers of tax resources or increase the taxation costs.Thereare, however, contradictory findings within this line of research, with someauthorsemphasisingtheadvantagesofdecentralisationandothersemphasisingtheadvantagesofcentralisation.

The third line comes from the perspective of constitutional economics.There are threebranches in this line.Thefirst emphasises the advantagesofdecentralisationasamechanismtocontrol inefficientcentralgovernments, inwhichlocalgovernmentsarelikeclubsestablishedbythelocalpopulationtosolvecommonproblems(forexample,Buchanan1965;BrennanandBuchanan1980;North1987).Beneficialtaxation—inwhichtaxispaidaccordingtothebenefitsreceivedfromthesystem—assureslocalaccountabilityandthereisnocaseforthecentralgovernment’sfinancialcontrols.Thisbranchadvocatesfiscalautonomyofthelocalgovernments,whileremainingalerttothepotentialfortheiropportunisticbehaviour.Implicitly,thismeansthatcentralgovernmentswillnotbeencouragedtocontrolmostfiscalresourcesandthentorefundlocalgovernments through transfer payments. The second branch emphasises the

1 See,forinstance,Breton(1996);King(1984);Scott(1952);Hicks(1984);Courantetal.(1979);BoadwayandTremblay(2005).


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advantages of federal governments, as representedbyHamilton et al. (1787).InHamilton’s time, thebiggest challenge for theAmerican federalistswas toestablisha federalgovernmentfromtheconfederation.Theydidnotproposethatthefederalgovernmentcontrolmostofthenation’sfiscalrevenue;ratherthey repeatedly vowed that the power of the federal government should bestrictlylimited.Theirbasicposition,however,wastoemphasisetheadvantagesof a strong federal government.We treat their position, then, as being pro-centralisation.

De Figureiredo andWeingast (2005) andWeingast (2005) represent the thirdbranch.Theyemphasisetheimportanceofthepowerbalancebetweenfederalandstategovernmentsforaself-enforcingfederalism.Theybegintheirstudieswith two fundamental dilemmas of federalism: too strong a centre risksoverwhelmingafederationbyactingopportunisticallyandextractingtoomanyrents; too weak a centre risks a federation’s collapse due to free-riding andinsufficientprovisionofpublicgoods.Thetwindilemmasmakestablefederalismproblematic—in part because they imply a trade-off in the structure of afederation.Institutionsdesignedtoaddressoneofthedilemmasexacerbatetheother.Tobestable,federalismrequiresadelicatebalanceofcentralgovernmentpowerscombinedwithmechanismsforlimitingthecentre’sopportunism.Crisisshocksplayakeyroleinachievingthebalanceofpower(Weingast2005).Theperspectiveemphasisingthebalanceofpowersisconsistentwiththeconceptofequilibriumineconomics.

A new analytical framework and decentralisation

Basedonthetheoryofself-enforcingfederalism(deFigureiredoandWeingast2005),Zhang (2005,2008,2009) furtherdevelopsananalytical framework tocoordinatethethreebranchesinconstitutionaleconomics.Hefurtherdividesgovernmentalcontrollingcapabilityintotwomajordimensions:thepersonneldimension (or democratic dimension) and the fiscal dimension. Whether afederation/nationcanbesustainable isconditionedonthegamebetweenthenationalandsub-nationalgovernments.Forinstance,inademocraticnationwithelections,thefederal/centralgovernmenthasnocontrolovertheelectedofficialsof the states.To achieve sustainable federalism, an institutional arrangementenhancingthecontrolofthecentral/federalgovernmentoverthesub-nationalgovernmentsisneeded.Fiscaltransferpaymentsarethenusedasahostagebythefederal/centralgovernmenttoinfluencethestates/provinces.Verticalfiscalimbalanceandtransferpaymentsthenworkashostage mechanisms,withlower-levelgovernmentsheavilyfinanciallyreliantonthehigherlevel.Thisprovides


57

anexplanationforwhy,inmostcountries,thecentralgovernmentcontrolsmostofthenation’sfiscalresourcesandforwhyhigherlevelsofgovernmentcontrolmostfiscalresourcesintheirjurisdictions.

Since both personnel and fiscal dimensions could be either bottom-up ortop-down, the combinations of these two dimensions consist of four basicstructures for vertical intergovernmental relationships (Table 4.1). A verticalintergovernmental relationship will not be sustainable if it is unbalanced.Crisisshocksthenplayakeyroleinchangingthestructuremakingthenationsustainable (Weingast2005).Vertical balancecanbeachievedthrougha two-way arrangement in personnel and fiscal dimensions.Yet, vertical balance isnotsufficient foranation toachievegoodeconomicperformance.Horizontal balancebetweenthegovernmentandthemarketmustalsobeestablished,whichcould be realised by checks and balances of a government’s power throughconstitutionalrule,aspointedoutbyBuchanan(1965),BrennanandBuchanan(1980),North(1987)andNorthandWeingast(1989).

Table 4.1 Different structures of intergovernmental relationships

Structures Personnel dimension

Fiscal dimension

Examples Result

Structure 1 I . With good rule of law

j k Western countries

Sustainable, efficient

II . Without good rule of law

j k Some Latin American countries

Sustainable but low efficiency

Structure 2 j j European Union, confederation, United Nations

Unstable, inefficient

Structure 3 k j Former Soviet Union-style countries

Central planning regime

Structure 4 k j China before tax-sharing system reform, Hong Kong before 1997

More efficient than Structure 3

Notes:Theletterk=‘topdown’;j=‘bottomup’.Forinstance,ifthepersonneldimensionisj,itmeanslocalofficials arenotappointedbyhigher levelsofgovernment. If thefiscaldimension isk, itmeanshigherlevelsofgovernmentcontrolmostfiscalresourcesandcanputinfluenceonlower-levelgovernmentsthroughtransferpayments,andviceversa.

Source:Author’sownsummary.

InTable4.1,Structure1 represents the combinationofbottom-uppersonnelrelationships and top-down fiscal relationships. In the personnel dimension,the localgovernmenthasautonomy(althoughthisdoesnotnecessarilymean‘election’;autonomycanalsohappeninafeudalorauthoritarianregime),while


58

thehigherlevelofgovernmentcontrolsmostfiscalresourcesandthelower-levelgovernmentshavetorelyfinanciallyontransferpayments.Mostindustrialised-marketcountriescanbeclassifiedasStructure1.Thisstructureisself-enforcing.It can be further classified into two substructures: Structure 1-(I) with, andStructure1-(II)without,goodruleoflaw.

Structure2isonewithaweakfederal/centralgovernmentandisneitherstablenorefficient—liketheAmericanconfederationortheearlystageoffederationintheUnitedStatesandAustralia.

Structure3isonewithastrongfederal/centralgovernment,suchastheformerSoviet Union countries.The central government is too powerful, controllingfiscal revenue and official appointments to lower-level governments. As deFigureiredo and Weingast (2005:127) indicate, ‘too strong a centre risksoverwhelmingafederationbyactingopportunisticallyandextractingtoomanyrents’.Thisstructureisneitherstablenorsustainableinthelongrun.

Structure 4 is a relatively stable structure—such as fiscal federalism inChina before 1994 or the UK–Hong Kong relationship before 1997. To someextent, thisstructurehasestablishedaverticalbalanceon intergovernmentalrelationships. Nonetheless, since the centre controls official appointments tolocalgovernments,localgovernmentsdonothaverealbargainingpoweragainsthigherlevelsofgovernment.Thecentralgovernmentmighteasilychangethefiscal arrangement. If the higher-level government was a democratic regime,or the higher-level government could not change its fiscal relationship, thisstructurecouldbereasonablysustainable.

Different structures have different effects on preventing governmentalopportunisticbehaviour.Correspondingly,therearetwotypesofgovernmentalopportunistic behaviour in the framework: vertical and horizontal. Vertical governmental opportunistic behaviour refers to the opportunistic behaviourbetween different levels of government. A balance of intergovernmentalrelationshipsisrequiredtopreventthis.Horizontal governmental opportunistic behaviourreferstoopportunisticbehaviourinthemarket.Thehorizontalchecksandbalances of governmentpower are toprevent this typeof governmentalopportunisticbehaviour.

AccordingtoSmith(1776),thedivisionoflabouristhespringboardforeconomicgrowth.Yang(2001)developedan‘inframarginaleconomicframework’inwhichthe evolution of the division of labour was driven by increased transactionefficiency,especiallyrelatedtoinstitutions.AccordingtoNorth(1987),economicperformance is conditioned on the level of endogenous transaction costsresultingfromgovernmentalopportunisticbehaviour.Hisideacanbefurtherextendedto twotypesofverticalandhorizontalgovernmentalopportunistic


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behaviourinouranalyticalframework.Asustainableandstablestructure,andthereforealsoapro-economicdevelopmentstructure,mustbeastructurethatcanminimisethetwotypesofgovernmentalopportunisticbehaviour.Amongthe four structures, Structure1 is themost self-enforcing structurewith theleastendogenoustransactioncosts.Structures2and3arenotself-enforcinginthelongrun.Structure4isnotasstableasStructure1.

The framework developed in this chapter can be applied to explain theworldwidedecentralisationtrendinrecentdecades.Therearegoodexamplesofdecentralisation,butalsobadones(Martinez-VazquezandMcNab2003;FismanandGatti2002).Decentralisationhas resulted inmacroeconomicvolatility insomecountriesbutnot inothers.According toStein (1999),decentralisationdidnotincreasethefiscaldeficitsoflocalgovernments.AccordingtoFornasarietal.(2000)anddeMelo(2000),however,theexpansionoflocalgovernmentalexpenditureanddeficitsafterdecentralisationresultsintheexpansionofcentralgovernmentalexpendituresanddeficits.AccordingtoFismanandGatti(2000),there is a high correlation between decentralisation and corruption. Simplydevolving fiscal power from central governments to regional elites withoutinstitutionalreformswouldencouragecorruption.Nonetheless,Treisman(2000)showsno correlationbetweendecentralisation andcorruption. Faguet (2004)shows that decentralisation has not increased corruption, but instead makeslocalgovernmentsmoreresponsible.

Whyaretheapparenteffectsofdecentralisationsovariedandcontradictory?Whyhasdecentralisationhadpositiveeffectsinsomecountries,butnotinothers?Accordingtoouranalyticalframework,theeffectivenessofdecentralisationina nation depends on whether decentralisation makes the intergovernmentalstructuremoresustainableandwhetheritreducestheendogenoustransactioncostsresultingfromthetwotypesofgovernmentalopportunisticbehaviours.Specifically,decentralisationwillbringmoreeffectivenessunderthefollowingconditions.

First,decentralisationshouldnotchangetheverticalintergovernmentalbalance.Within Structure 1(I), decentralisation would be effective. Nonetheless, ifdecentralisationgoestoofarandthelocalgovernmenthastoomuchtaxationautonomy,Structure1(I)willjumptoStructure2.Consequently,decentralisationwill cause more opportunistic behaviour from local governments and affectthe stability and economic performance of the nation. Hence, no matterhowdecentralised it is, remainingwithinStructure1(I) is thebottom lineofdecentralisation for Western countries. Accordingly, the local government’sexpenditureshouldbeexpandedmainlythroughfiscaltransferpayments,ratherthanthroughdevolvingmoretaxautonomy.Second,governmentpowermust


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belimitedandcheckedandbalancedintheprocessofdecentralisation,sothatthedevolvedpowersdonotincreasethehorizontalgovernmentalopportunisticbehaviourofthelocalgovernments.

Thiessen(2003)providesevidenceofhowtheeffectsofdecentralisationchangewiththeextentandtypeofdecentralisation.HisstudiesoftheOrganisationforEconomicCooperationandDevelopment(OECD)showthatfiscaldecentralisationfrom a highly centralised starting point results in improved economicperformance.Furtherdecentralisationbeyondacertainlevel,however,resultsinnegativeeffects.

This analytical framework can be used to understand a wide range ofdecentralisation experiences in time and space, with this section brieflydescribingjusttwo:theUnitedStatesandAustralia.

Sinceitsindependencein1776,theUnitedStates,initsfederal–stategovernmentrelationships,hasexperienceddifferentstages:confederationwithoutnationalgovernmenti federation with weak federal governmenti strong federalgovernmentaftertheGreatDepressionandWorldWarIIidecentralisation.Duringtheperiod1776–87,therewasnofederalgovernmentintheUnitedStates.BeforetheGreatDepression,thefederalgovernmentwasveryweak.ThiswasatypicalStructure2andwasnotsustainable.FromtheGreatDepressionthroughtothe1980s,thefiscalcapabilityofthefederalgovernmenthasbeensignificantlyenhancedandtheverticalintergovernmentalrelationshipjumpedfromStructure2 to Structure 1. Since the 1980s, the decentralisation of expenditure hasbecomeaworldwidetrend,includingintheUnitedStates.Nonetheless,fiscaldecentralisationhappenedmainlyforexpenditure,ratherthanwithregardtothefiscalautonomyoflocalgovernments.USintergovernmentalrelationshaveremainedinStructure1duringtheprocessofdecentralisation,andthefederalgovernmentalwayscontrolsmostof thenation’sfiscal resourcesand imposesinfluencethroughfiscaltransferpayments(Wallin2001;Fox2001).ThroughouttheevolutionofintergovernmentalrelationshipsintheUnitedStates,crisesandshockshavebeencrucialdrivingforces(Weingast2005).

The evolution of federal–state relations in Australia has been similar to thatintheUnitedStates:thecapabilityofthefederalgovernmenthasgrownstep-by-stepandtheevolutionofAustralianfederal–staterelationshipsisaprocessmovingfromStructure2toStructure1.Asthesixcoloniesformedafederationon 1 January 1901, the federal government merely had some enumeratedpowersoninternationalaffairssuchasdefence,tradeandimmigration,whileitsfiscalcapabilitywasweak.Thestatesprovidedcrucialpublicservicessuchaseducation,healthandlawandorder,andreservedallresidualrights(Watts1999). In this case, most people expected that the Australian Constitution providedaguaranteetomakethestatesfinanciallyindependentofthefederal


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government. Nonetheless, it turned out differently. The early Australianfederal–staterelationshipofStructure2wasnotaself-enforcingfederation.ItfacedthefateofeitherevolvingtoStructure1ordissolving.Thedrivingforcefortheevolutionwasaseriesofcrisisshocks,includingtwoworldwars,theGreatDepressionandanumberofdomesticcrises.InStructure1,thefederal–staterelationshipbecamestableandsustainableandthefederationbecameself-enforcing(seeDollery2002).

China’s vertical intergovernmental relations: past and current status

Central–provincial government relations

In China, in the planned economy before 1978, the central–provincialrelationshipfellintoStructure3.Thecentralgovernmentwaslikeacommandcentre.Itnotonlycontrolledtheappointmentofmajorprovincialofficials, itcontrolledthefiscalresourcesoftheprovinces.Thefiscalsystemwascalleda‘unifiedcollectionandallocationoffundsbythestate’(Tongshoutongzhi).Thecentralgovernmentcontrolledthecollectionandallocationoffiscalresources.

Between1978and1994,Chinaadoptedafiscalresponsibilitysystemwherebylocalauthorities tookfull responsibility for their revenuesandexpenditures,whichwasknownas‘fenzaochifan’—thatis‘eachprovinceeatsthericeinitsownbowl’—orfiscalfederalism(QianandWeingast1997).ThischangedChina’scentral–provincial relationship from Structure 3 to Structure 4. In Structure4,thecentralgovernmentcontrolledtheappointmentofmajorofficialsintheprovinces,butnolongercontrolledeachprovince’sfiscalrevenue.Accordingto Qian and Roland (1998), Qian andWeingast (1997) and Shirk (1993), theintroductionoffiscal federalismprovidedstrongincentivesfortheprovincesto develop their economies. This resulted in most fiscal resources in Chinabeingcontrolledbytheprovinces.ThefiscalcapabilityoftheChinesecentralgovernment was insufficient. For instance, in 1993, the share of centralgovernment revenue accounted for only 22 per cent of the nation’s total taxrevenue(Table4.2).


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Table 4.2 Share of central and local governments in government revenue and expenditure (per cent)

Year Revenue ExpenditureCentral Local Central Local

1978 15 .5 84 .5 47 .4 52 .6

1980 24 .5 75 .5 54 .3 45 .7

1985 38 .4 61 .6 39 .7 60 .3

1990 33 .8 66 .2 32 .6 67 .4

1991 29 .8 70 .2 32 .2 67 .8

1992 28 .1 71 .9 31 .3 68 .7

1993 22 .0 78 .0 28 .3 71 .7

1994 55 .7 44 .3 30 .3 69 .7

1995 52 .2 47 .8 29 .2 70 .8

1996 49 .4 50 .6 27 .1 72 .9

1997 48 .9 51 .1 27 .4 72 .6

1998 49 .5 50 .5 28 .9 71 .1

1999 51 .1 48 .9 31 .5 68 .5

2000 52 .2 47 .8 34 .7 65 .3

2001 52 .4 47 .6 30 .5 69 .5

2002 55 .0 45 .0 30 .7 69 .3

2003 54 .6 45 .4 30 .1 69 .9

2004 54 .9 45 .1 27 .7 72 .3

2005 52 .3 47 .7 25 .9 74 .1

2006 52 .8 47 .2 24 .7 75 .3

2007 54 .1 45 .9 23 .0 77 .0

2008 53 .3 46 .7 21 .3 78 .7

Source:NationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing,p.263.

Since the centralgovernment lackedfiscal capability, towards the endof the1980sandintheearly1990s,it‘borrowed’moneyfromtheprovincestwiceandwaseventuallyunabletorepaythatmoney(Sun2004).BeforetheintroductionoftheTaxSharingSystem(TSS)reformin1994,thereweresomespecifictop-down fiscal grants from the central government to the provinces, but therewerealsobottom-up‘transferpayments’fromtheprovincestothecentre.IncontrastwithWesternnationalgovernments, theChinesecentralgovernmentwas somehowfinancially reliant on theprovinces to support its expenditurebefore1994.

Structure 4 provided a relatively balanced vertical relationship between thecentreandprovinces,inwhichtheprovinceshadmoreautonomyandstronger


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incentivestopromotetheirowneconomies.Nonetheless,thiswasnotanormalintergovernmentalrelationshipwithinanationandthecentralgovernmenthadboththeincentiveandtheabilitytochangeit.

Third, having experienced fiscal incapability for more than a decade, thecentral government eventually became determined to change the bottom-upfiscalarrangementandestablishatop-downfiscalarrangementthroughtheTSSreformin1994.AccordingtotheTSS,theratioofthemajortaxsourcesbetweenthecentralandprovincialgovernmentsis75:25.Thishasresultedintherapidgrowth of the central government’s revenue (Table 4.2). The relationshipbetween the centralgovernment and theprovinces jumped fromStructure4to Structure 3. In Structure 3, the central government not only controls theappointmentofmajorprovincialofficials,itcontrolsalargeshareofprovincialfiscalrevenuethroughtransferpayments.Theprovinceshavetorelyheavilyontransferpaymentsfromthecentralgovernment.

The rapid increase of the central government’s revenue came mainly fromincremental taxrevenue,not fromredistributionof theexistingtaxrevenue.TherewasanagreementbetweenthecentralandprovincialgovernmentsthattheTSSreformwouldnotchangethestatusoffiscalrevenueofeachprovince.SincetheChineseeconomygrowsveryrapidlyand75percentofthevalue-added taxbelongs to the centralgovernment, the centralgovernment’sfiscalrevenuehas,however,grownmuchfasterthanthatoftheprovinces.Enormoustransferpaymentshavethereforebecomeanew,powerfultoolforthecentralgovernmenttoinfluencetheprovinces.

Inadditiontotaxrevenue,thecentralgovernment’scontrolovertheeconomycomes from the centrally controlled, large state-owned enterprises (SOEs),most of which are monopolistic. According to a release from China’s State-OwnedAssetsSupervisionandAdministrationCommission(SASAC),in2009,theassetsvalueof centralgovernment-controlledSOEswasRMB14.6 trillion(US$2.14trillion)—accountingforroughly40percentofChina’sgrossdomesticproduct(GDP)in2009—whiletheirprofitswereRMB980billion.Thisfurtherstrengthensthecapabilityofthecentralgovernment.

SincetheTSSreform,China’scentral–provincialgovernmentfiscalrelationshiphas converged with that of Western countries. The central governmentcontrols most of the nation’s fiscal resources and, financially, the provincesrelyheavilyontransferpayments.ThedifferencebetweenStructure3inChinaandStructure1inWesterncountriesisinthepersonneldimension.Thedualtop-down arrangements in personnel and fiscal dimensions have produced asupercentralgovernmentinChina.Hence,withoutchangingthestatusofthetop-downpersonneldimension,simplychangingChina’sfiscalfederalismand


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borrowingthetop-downfiscalarrangementfromWesterncountriestojumptoStructure3fromStructure4alsoriskstheprevalenceofverticalgovernmentalopportunisticbehaviour.

Provincial–local government relations

TheTSSreformin1994wasimplementedonlyatthecentral–provinciallevel,notattheprovincial–locallevel.Withinaprovince,alllocalgovernments’revenuesrelyheavilyontransferpaymentsfromtheprovincialgovernment.Accordingtoour investigation in2004, transferpayments from theprovinceaccountedfor71.1percentoffiscalexpenditureinacountyinSichuan.Inthepersonneldimension,higher-levelgovernmentsnominatemajorcountyofficials.ThisisatypicalStructure3withstronghigher-levelgovernmentandweaklower-levelgovernment.Thisstructureinducesbothtypesofgovernmentalopportunisticbehaviour,whichreinforceeachother.

The first is vertical governmental opportunistic behaviour of the provincialgovernmentsoverthelocalgovernments.Duetothedualtop-downarrangementsinthetwodimensions,localgovernmentsaretooweaktoplaygameswiththeprovince. The second is horizontal governmental opportunistic behaviour.Since thehorizontal checks-and-balancesmechanism for thegovernmenthasnotbeenwellestablishedinChina,tosolvetheirfiscal incapabilityproblemsresulting from the opportunistic behaviour of the higher-level governments,localgovernmentshaveastrongincentivetoactopportunisticallyandextractrentsfromthemarket.Thisinturnaffectseconomicperformance.

To solve thefiscal incapabilityproblemof local governments inChina, somehave argued that local governments should have higher tax autonomy tomatch their expenditure. Nonetheless, as our analytical framework suggests,theuniversalarrangement is that lower-levelgovernments relyfinanciallyontransferpaymentsfromhigher-levelgovernments.Themainsolutionisthereforenottodevolvemoretaxautonomy,butrathertoreformthetop-downpersonnelarrangementtoimprovethebargainingpoweroflower-levelgovernmentsandtoinstitutionalisethetransferpaymentprocesstoreduceopportunisticbehaviourfrom higher-level governments. This change can be achieved through thedevelopmentofgrassrootsdemocracy.Iflocalofficialscouldbeelectedratherthanappointedbyhigher-levelgovernments,andtransferpaymentscouldbeinstitutionalised,aneffectiveverticalbalancebetweentheprovincialandlocalgovernmentscouldbeestablished.


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The future evolution of China’s intergovernmental relations

China’sintergovernmentalrelationshipsareundergoingrapidchange.Therearemanypositivechangesthatarereshapingandre-establishingtherelationships.Forinstance,theChinesegovernmenthasofficiallyendorsed‘socialistdemocraticpolitics’. Grassroots elections and internal democracy in the ruling ChineseCommunistParty(CCP)arebeingwidelypractisedanddeveloped,andtheruleoflawandcivilsocietyarebeingestablished.TheevolutionofChina’sverticalintergovernmentalrelationshipswillhaveaprofoundinfluenceonChina’slong-term development. How will China’s vertical intergovernmental relationshipevolveinthefuture?Theframeworkdevelopedinthischapterseesfourmajorpossiblescenarios.

Scenario 1: Structure 3—top-down fiscal and personnel dimensions

Thisscenariomeansacontinuationofthecurrentintergovernmentalrelationshipinthefuture.Inthisstructure,thecentralgovernmentnotonlycontrolsmostofthenation’sfiscalresources,itcontrolstheappointmentofthemajorofficialsoftheprovinces.Withintheprovince,theprovincialgovernmentalsocontrolsthe appointment of the major local officials and most of the province’s fiscalrevenue.

This structure looks similar to that in the former planned economy. Thesubstantivedifferencesaretheintroductionofrulebylaw(asseenintheTSS)andthemarketeconomy.InStructure3,thecentralgovernmenthasverystrongfiscalcapabilityandauthoritytoeffectivelyrealisethe‘State’swill’andtopushforwardwithnationalreformsanddevelopmentinareassuchassocialsecurity,educationandtrans-regionalinfrastructure.

Nonetheless, as discussed previously, Structure 3 is not sustainable in thelongrunandalsoinducesverticalandhorizontalgovernmentalopportunisticbehaviour.Thesocialcostandpressureofremaining in thisstructurewouldalsobequitehigh.Atthisstage,manycurrenteconomicandsocialproblemsinChina—suchasmassiveconflicts,petitions,farmerquestions,localgovernments’hugedebtsandrisks,distortedmarketsandcorruption—aretheresultsofthetwo types of governmental opportunistic behaviour. Without developmentof grassroots democracy and improving the checks-and-balances mechanismfor government through constitutional rule, these problems might developintocrises.AsWeingast (2005)pointsout,crisisshocksarethedrivingforceforevolutiontowardsaself-enforcingfederalismornation.Toavoidpossibleeconomicandsocialcrisesandtobuilduptheso-called‘harmonioussociety’inChina,asustainableintergovernmentalrelationshipneedstobeestablished.


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Scenario 2: Structure 1(I)—a good market economy

As far as we can see from the practices around the world, this structure isprobablythemoststableandsustainableone.Itnotonlyhasastableverticalstructure,ithasaneffectivehorizontalchecks-and-balancesmechanism.Chinaalready has some of the conditions in place required for evolution to thisstructure.

In the two vertical dimensions, China’s fiscal arrangement at the central–provincial level isalreadyverysimilar to that inWesterncountries.ThekeyforChinatoshifttoStructure1(I)istoreformitsarrangementinthepersonneldimension, or to develop its democracy. Although grassroots elections aredevelopingsteadilyinChina,theyarestillatarelativelyearlystage.Towhatlevel, and when, direct elections can develop in the future in China is stillunclear.

Atthehorizontallevel,Chinaneedstoestablisheffectivechecks-and-balancesmechanismsatvariouslevelsofgovernmentthroughtheruleoflaw,sothatthemarketcanfunctionwell.TheexpansionofcivilsocietyandlibertywithrapideconomicgrowthwillallowtheruleoflawanddemocracyeventuallytobewellestablishedinChina.

Scenario 3: Structure 1(II)—a bad market economy

This structure looks sustainable in terms of vertical intergovernmentalrelationships,butisnotaneffectiveoneforeconomicgrowth.Thisisanexampleofabadmarketeconomy,inwhichtheruleoflawisnotwellestablishedandthelawinstitutionalisestheprivilegesofinterestsgroups,eventhoughithasdemocracy. This would result in the prevalence of horizontal governmentalopportunisticbehaviour(LiuandYang,2001).

At present, vested interests—instead of ideology—have become the biggestimpedimenttoChinadeepeningitseconomicandpoliticalreforms.Corruptionand social injustice are serious. The law has already institutionalised someprivileges of interest groups and the market has some serious distortions. Ifthis situation does not change, China is likely to evolve to this structure inthe future. Ifconstitutionalrulecannotbeestablishedand libertycannotbeguaranteed,democracyalonewillnotbesufficientforeradicatingcorruptionandtheprivilegesofinterestgroups,sincehorizontalgovernmentalopportunisticbehaviourwillprevail.Thiswouldresult inpooreconomicperformanceandsocialinjustice.Hence,thisisastructureChinashouldtrytoavoid.


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Scenario 4: Structure 3 at the central–provincial level and Structure 1 at the provincial–local level

Thisisamixedstructurewithdifferentrelationsatdifferentlevelsofgovernment.Thecentral–provincialrelationshipwouldbeStructure3,whiletheprovincial–localrelationshipwouldbeStructure1.ThisstructureisverylikelytooccurinChinainthefuture.

Sincethecentral–provincialrelationshipisalreadyatStructure3,twofurtherstepsareneededtoshifttothismixedstructure.Oneisthatgrassrootsdemocracyspreadsfurther—uptothecountylevelfromthetownshipandvillagelevel—in thenear future.Another is that thefiscal relationshipbetweenprovincialandlocalgovernmentsbeinstitutionalisedbytheTSSaswell.Ifthisweretohappen, the vertical intergovernmental relationships within each provincewouldbeStructure1andsubstantiallysimilartothoseinWesterncountries.

At the central–provincial level, the vertical relationship would not besubstantially changed, but the horizontal checks-and-balances mechanismwouldbeeffectivelyestablishedthroughastrengtheningoftheruleoflaw.Thiswouldsignificantlyreducebothtypesofgovernmentalopportunisticbehaviour.

This mixed structure implies that China could develop a unique verticalintergovernmentalarrangementdeeplyrootedinits5000-yearhistory,tradition,cultureandvastpopulation.Thismixedstructurealsoprovidesroomforthecentral–provincialrelationshiptofurtherevolvetoStructure1fromStructure3 once conditions mature. This is consistent with China’s gradual reformapproachsince1978. In thismixedstructure,avoidingverticalgovernmentalopportunisticbehaviourremainsamajorchallengeandisdependentlargelyontheruleoflawandthemoralmeritofthetopleaders.

Conclusions

Basedonthetheoryofself-enforcingfederalism,thischapterhasdevelopedananalyticalframeworkforintergovernmentalrelationships.Asustainablefederalnationisconditionedbywhetherdifferentlevelsofgovernmentcanbebalancedto prevent vertical governmental opportunistic behaviour between them.Different arrangements in the fiscal and personnel dimensions have differenteffects ongovernmental opportunisticbehaviour and therefore onwhether afederalnation is sustainable. Inademocraticnation,fiscal transferpaymentsmake local governments hostages to federal/national government influence.Meanwhile,itisequallyessentialtoestablishachecks-and-balancesmechanismthrough the rule of law and democracy to prevent horizontal governmental


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opportunisticbehaviourinthemarket.Economicperformanceisconditionedonpreventingendogenoustransactioncostsresultingfromthesetwotypesofbehaviour.

Intermsoffiscalarrangements,China’scentral–provincialrelationshipisalreadyverysimilartothatinWesterncountries.Thecentralgovernmentcontrolsmostof thenation’sfiscal resources and,financially, theprovinces relyheavilyontransferpayments.ThekeydifferencebetweenChinaandWesterncountriesisinthepersonneldimension.Thedualtop-downarrangementsinthepersonnelandfiscaldimensionsinChinahaveresultedinaverystrongcentralgovernment.Preventingverticalgovernmentalopportunisticbehaviouristhereforeamajorchallenge forChina—and it isnot sufficient to simplyborrow the top-downfiscalarrangementfromtheWest.

This chapter sees four major possible scenarios for the future evolutionof intergovernmental relationships in China. The first is Structure 3—acontinuationofthecurrentdualtop-downintergovernmentalrelationships.ThesecondisStructure1,withgoodruleoflaw,whichisastructurelikethoseinWesterncountries.Thisisprobablythemostsustainablestructureobservableintheworldtoday.ThethirdisStructure1,withoutgoodruleoflaw,whichisthestructureinsomeLatinAmericancountries.ThisisastructurethatChinaneedstoavoid.ThefourthstructureisamixedoneofStructures1and3, inwhich the central–provincial relationship is Structure 3 and the provincial–localrelationshipisStructure1.ThismixedstructureisverylikelytoemergeasgrassrootsdemocracygrowsinChina.ItalsoprovidesroomforfurtherevolutiontoaunifiedStructure1withgoodruleoflawinthemoredistantfuture.

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China’s metal intensity in comparative perspective 5

Huw McKay, Yu Sheng and Ligang Song

Introduction

Thischapterhastwoaims.Thefirstistoreinvigoratethetheoreticalfieldthatrelateseconomicdevelopmenttometalusage,whichhasbeenlyingfallowforconsiderabletime.ThesecondistoshedlightonChina’sfuturepathofferrousmetaldemandbyreferencingtheexperienceofrelevantpeersovertheentirecourseoftheindustrialisationprocess.

In the past decade, a great deal of effort has gone into long-run forecastingprojects in the realm of diet (FAO 2002, 2006), agriculture, food supply andwater(Bruinsma2009),energy(McKibbin2006),carbonemissions(Garnautetal.2008;UNDP2010)andautomobiles (IMF2005a).Long-runmetaldemandhassurprisinglybeenneglected.Thisneglect isparticularlysurprisinggiventhatmetals’priceshaverisensodramaticallyinrealandnominaltermssince2003.Thecommoditypriceboomofthe1970s,whichbroughtissuesofresourcesecuritytothefore,spawnedaproliferationoflong-runforecastingprojectsinthemetalsarena.BeginningwiththepioneeringworkoftheInternationalIronandSteelInstitute(1972)andMalenbaum(1973,1975),whichintroducedandpopularisedtheintensityofusecurve,anumberofstudiessoughttoprojectthedemandformetalsinthelongerrun.Twoofthebest-knownworksareLeontiefetal.(1983)1andMalenbaum(1978).

Inthisstudy,weseektocontributetothebroaderdiscussionbyemployingarichersetofmacroeconomicdatathanthatemployedinearlierempiricalstudies,inadditiontoprovidingaprojectionforChina’sferrousmetaldemandto2030.

This chapter takes as a starting point the observation that the style ofdevelopment—expressed in differing industrial structures, householdconsumptionpatterns,urbanisationpathsandlevelsofopennesstotradeandinvestment—mattersagreatdealformetals.Sincecountriesachieveeconomicgrowthwithdifferentmixturesofthesefactorsovertheshortandlongrun—

1 OneofLeontief’sco-authors,IraSohn,laterwroteasecondpaper(Sohn2006:Table9)scrutinisingthepublishedforecastsfortheyear2000,findingthatalltheprojectionsweresignificantoverestimates.


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reflecting comparative advantageorpolitico-strategicbias—empirical studiesin the field seeking generality should recognise that the varied relationshipbetween gross domestic product (GDP) per capita and metal consumption isreflecting these differences and broaden the boundaries of their empiricalstudiesaccordingly.Ourfirmbeliefisthattherelationshipbetweenmetaluseand standard macroeconomic benchmarks is complex and idiosyncratic.Thefactthatthisstudyaccommodatesdifferencesacrosscountriesisamajoradvanceonpreviouswork.Further,ifwewishtoclaimanygeneralityforourfindings,wehavemetaseveretestifweareabletoexplaintheChinesecase—whichinthepasthasconfoundedexpectationsdrawnfromcross-countryanalysis (forexample,IMF2005b).

Webeginby summarising the existing literatureon the associationbetweendevelopment levelandmetal intensityandexplainingwhereourapproachisdifferent.The intensity-of-use framework, the bottom-up approach applyinginput–outputtablesandthe‘Kuznetscurveforsteel’(theKCS,aninverted‘U’-shapedcurve insteelusepercapitaand incomepercapitaspace),whichweintroduce,donotautomaticallytranslateintoneatforecastingframeworks.Asoundmodelofmetaldemand,whether it is focussedonmetalsdemandperpersonorperunitofeconomicoutput,mustsimultaneouslycaptureflow,stock,cyclical and developmental/structural influences. Although incorporating allofthesevariablesintoamodelisaformidabletask,theattempttodosowillincrease our understanding of the relationship between metal demand andeconomicdevelopment.

ThechapterthenmovesontodiscusstheChina’sdemandformetalsinparticular.It has been noted previously that China’s post-1978 history of ferrous metalusehasmanysimilaritieswiththeKoreanexperience(GarnautandSong2006;McKay2008;McKayandSong2009).WillChinacontinuetofollowapathsuchasKorea’s—anationinwhichmetalintensityofeconomicactivityhasremainedhighforasustainedperiod;orwillthemetalintensityofgrowthonlyremainhighwhileChina isamiddle incomecountryenroute to thecurrentrestingplaceoftheEuropeaneconomiesandtheiroffshoots?Williteventuallysitonthemoremetal-intensivesideofthehigh-incomecohort,inasimilarplacetowhereJapanresides?ThesequestionsareofcentralimportancetoChina’slong-runeconomicstrategyandperformance.

AfundamentalconclusionofthischapteristhatChinaisunlikelytocontinuetocloselyfollowtheKoreanpathonceitmovesdeeperintomiddle-incomestatus.ThisisduetoourcontentionthatChinawillbecompelledtoalteritsmodeofeconomicgrowth.China’scurrentrelianceonheavyindustry,investmentvis-a-visconsumptionandhighdegreesofexportorientationwillhavetobealteredifitistosuccessfullynavigatethenextphaseofitsdevelopment(McKayandSong2009).As a consequence,China’sfinalpath is likely to emulate certain

China’s metal intensity in comparative perspective

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aspectsoftheexperiencesofNorthAmerica,theCommonwealthofIndependentStates (CIS), Western Europe, Japan and emerging Asia, rather than merelyreflectingthecoursefollowedbyonespecificjurisdiction.

The KCS and related theories

Extant theory and our extension

Before1993,theliteratureonmetalusagewasdividedintotwodistinctschools:the consumerpreference school thatpioneered intensity-of-use (IU) analysis,and the leapfroggingschool.Theconsumerpreference schoolargued that IU(defined as the volume of metal consumed per unit of output) increased inlow-incomeeconomiesovertimeasdemandfordurablegoodscreatedderiveddemand for metals (International Iron and Steel Institute 1972; Malenbaum1973). In this view of the world, as economies make the transition towardsindustrialised status, the consumption basket progressively shifts towardsservicessuchashealth,educationandrecreation,attheexpenseofthemetal-intensivedurablegoodsmarket.Thusthedevelopmentofconsumerpreferenceswithrisingincomescreatesan inverted‘U’-shapedIUcurvewithadefinableturningpoint.

The leapfrogging school argued that the ability of low-income economies toskipwholegenerationsoftechnologiesgaveadownwardbiastoIUovertime(Hwang and Tilton 1990). Essentially, the leapfrogging school argued that alow-incomeeconomy’sabilityto importtechnologycouldtransplant it tothesame point on the hypothesised IU schedule as an advanced economy; or,alternatively,theywereabletonavigatetolowerIUschedulesrelativetothosethatpreviousgenerationsof industrial countrieshad inhabitedat equivalentincomelevels.Theimplicationwasthatalow-incomeeconomywasjustaslikelytoseeadeclineinitsIUasitmovedtowardsmiddle-incomestatus,ratherthanseetheriseassumedbytheconsumerpreferenceschool.

Thedifferencebetween the twoschools isbestunderstoodbyreference toadiagram (Figure 5.1). The leapfrogging school argues that the underlyingtendencyforlow-incomeeconomiesistomoveontolowerIUschedulesastheyimportmoreadvancedtechnologies(ashiftfromAonIU2toBonIU3)ortobeconceived immaculatelybeyond the turningpointof the IUschedule,wheretheparabolaisdownwardsloping.Theiradversariesarguedthattheunderlyingtendency for low-incomeeconomieswas to transit along theupward-slopingportionofa singleparabola,or inextreme instances tomoveontohigher IUschedules,astheircitizensconsumedmoresophisticatedgoodsandservices(ashiftfromAonIU2toConIU1).


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Figure 5.1 Competing theories of metal intensity

IU

IU

IU

Source:Authors’adaptationofFigure1inHwang,K.H.andTilton,J.E.1990,‘Leapfrogging,consumerpreferences, international trade and the intensity of metal use in less developed countries’, Resources Policy,September,p.211.

AsynthesiswasachievedbytheworkofLohaniandTilton(1993).Theyarguedthat there was partial truth in the teachings of both schools that could bereconciledintoasingletheorybyarelativelysimpleempiricaltest.BuildingontheimplicationsofHwangandTilton(1990),LohaniandTiltonstudiedchangesinIUofacross-sectionoflow-incomeeconomiesbetween1977and1988totesttheextanttheoriesandtheviabilityofasynthesis.2

TheirhypothesiswasthatIUinthelow-incomeeconomieswaslinearlyrelatedtoincomepercapita(changeinpurchasingpowerandconsumptionpatterns)and time (change in the technological frontier). If theextremeversionof theleapfrogging school was correct, the coefficients derived from their cross-sectionalregressionshouldhavebeenzeroforincomepercapitaandnegativelyrelatedtopositiononthetimetrend.If theextremeversionoftheconsumerpreference schoolwas correct, the coefficients shouldhavebeenzero for thetimetrendandpositivelyrelatedtoincomepercapita.Thesynthesiswouldseeapositivelysignonthecoefficientforincomepercapitaandanegativesignonthecoefficientforthetimetrend.

2 LohaniandTiltonassumeda linearrelationshipfor their test,as theirsample includedonlycountriesgaugedtobeontheupward-slopingsegmentoftheIUschedule.NotethattheywerenottestingtheempiricalrobustnessoftheIUscheduleitself,whichisofcoursenon-linear.ThereforetheyhadnothingtosayabouttheturningpointoftheIUschedule,whichisnaturallyanimportantconsiderationofthischapter.


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Theresultwasthatthesynthesisviewcarriedtheday.Morespecifically,theauthors indicatedthatareal incomegrowthrateofapproximately1percentperannumwasrequiredtokeepIUstableagainsttheunderlyinggravityoftheleapfroggingphenomenon.Therefore, low-incomecountries achieving strongratesofeconomicgrowthwillseearisingIU,butthosethatarestagnatingwillseetheirIUfallduetotechnologicalchange,orotherfactorsthatarecapturedbythetimetrend.3

Thesefindingsreconciledthedebatebetweentheopposingschools.Theauthorsnoted,however,thattheirtestleftabouthalfofthevariationinIUacrossthesample unexplained.The current study extends the analysis in a number ofwaysasanaidtopreparingalong-runprojectionofChina’ssteeldemand.

First,weempiricallyverifynottheIUscheduleitself—whichmeasuresmetalusageperunitofoutputatvariouslevelsofpercapitaincome—buttheKuznetscurveforsteel(theKCS),whichisscaledbypopulation.Ourreasonfordecidingto move away from the IU framework is that we see the KCS as a summarydevelopmentmetric thatwill standalongsideothermeasuresofabsoluteandrelativelivingstandards—andthesemeasuresareinvariablyexpressedinpercapitaterms.UsingpopulationasthedenominatorandsteelconsumptionasthenumeratorofourkeyratioalsohasthebenefitofcouchingtheKCSasademand-sideconcept,whereastheIUframeworkisaproductofthesupplyside.

Beyond verifying the existence of the KCS, we estimate its turning point inincomepercapitaterms.Second,weusetheearlyandmiddleindustrialisationphasesofcurrentlymiddleandhigh-incomeeconomiestoinformtheanalysis,not just the low-income economies of today. Third, we use long time-seriesdataatfive-yearly intervals,ratherthanacontemporarycross-sectionfromaselection of economies at various development levels.We thereby avoid theproblems inherent with cross-sectional analysis, particularly where there aredata constraints (McKay 2008).4 Finally, we broaden our empirical analysisto incorporate macroeconomic variables such as investment propensity,

3 Given the leapfroggingphenomenon reliesheavilyon foreign capitalflow, and economies thatdonotattract the interest of foreign investors tend to be slow growing, it is arguable whether leapfrogging is aterriblystrongdownwardforceonIUinpoorlyperformedjurisdictions.Indeed,ashortageofcapitalwilllimittheinvestmentshareofGDPintheseeconomies,andifinvestmentefficiencyislow(astheabsenceofforeign investorswouldattestbothex anteandex post) then incomepercapitawillexpandsluggishly, ifatall.Conversely,aneconomyabsorbinglargeamountsofforeigninvestmentwillfaceamuchhigherthanaveragedragonitsIUfromtheleapfroggingphenomenon.Thevirtuousrelationshipbetweentheavailabilityofinvestmentfunds,therisinginvestmentsharethataccommodatesitandtherisingefficiencyofinvestmentasimprovingtechnologyreplacestheoldpredict,however,arapidascentinincomepercapitathatmorethanoffsetstheleapfroggingdragonIU.TheKoreanexampleisaclassiccase(HwangandTilton1993).4 Whilecross-sectionalmetalintensitydataofrecentvintageareavailableforawidevarietyofcountriesatvariousstatesofengagementwithanindustrialstrategy,usingthesedataalonehasthepotentialtobehighlymisleading.Afocusoncomparativetime-seriesdataiscrucialtodefinethepathfromA(entry)toB(peak)toC(maturity).Cross-sectionscanhelpwiththistask,buttheycaneasilymisleadratherthanguide.The


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urbanisation rates, openness to trade and automobile penetration.We applythis enhanced data-set in a simultaneous equation system, the estimation ofwhich is intended to capture the impact of thosekeyvariables on aggregatedemand.ThisallowsustotestspecificallywhetherthesynthesisviewofthechangingrelationshipbetweeneconomicdevelopmentandIUholdsovertimeandacrosscountriesandregions.

Beforeproceedingtoadiscussionoftheempiricalmethodologyandthedata,itisinstructivetoconsidertheIUframeworkasasimpleseriesofequationsandidentities.FollowingEtheridge(1981)andHwangandTilton(1990),andwherem=levelofmetalconsumption,IU=metaluseperunitofoutput,Y=GDP,N=population,Si=sectori’sshareinYandii=metaluseinoutputofsectori,wehaveEquation5.1.

Equation 5.1

!

DividingthroughbyNtocastinpercapitatermsgivesEquation5.2.

Equation 5.2

!

Goingfurther,wehaveEquations5.3and5.4.

Equation 5.3

!

Equation 5.4

mY

= (" SiY* iiSi) !

So,

mN ! ,ourcorefocus,dependsonincomepercapitaandIU,whichinturnisa

functionofthesectoralcompositionofeconomicactivitywithrespecttometals.

difficultyisthatwhileacross-sectionisabletodefinestatesofnatureatAandC,thepathbetweenthesetwostatesmightbehidden,andBidentifiederroneously,ifthesampleisimperfect.ThisillustrationisnottobeconfusedwiththeexerciseinthetextcentredonFigure5.1.


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Extendingtoanopeneconomy,allowingfortechnologicalchangeanddividingYintoitsconstituentpartsyieldsEquation5.5.

Equation 5.5

!

InEquation5.5,DDisdomesticdemand,EXPandIMPareexportsandimportsrespectivelyandtistheprevailingstateoftechnology.5

Therefore, metal demand can be altered by a change in income per capita,a change in domestic demand that is occasioned by changes in industrialstructure(inter-sectoraland/orintra-sectoral)andachangeinthenatureofacountry’s international trade. A change in IU could still be achieved in theabsenceofstructuralchangeorincomepercapitagainsthroughthemechanismof technological change.6 Following the leapfrogging school, we assume t isnegativelyrelatedtoIU.7

‘Kuznets curves’ as development metrics and some methodological considerations

The‘Kuznetscurve’—aninverse‘U’-shapedcurverelatingincomedistributiontoincomepercapita—wasfirstadvancedbyKuznets(1955).TheevidenceforthisoriginalKuznetscurvewassomepatchytimeseriesforagroupofindustrialcountries (the United States, the United Kingdom and Germany/Prussia/Saxony)andsingleobservationsofafewcountriesataspreadoflower-incomelevelsfromLatinAmericaandSouthAsia.8Theinverted‘U’wasformedbythismixture of time-series and cross-sectional data.The lower-income economiesprovidedthehumpinthehypothesisedcurve,‘corroborating’thepatchytime-seriesevidence.

SubsequentexperienceofEastAsiandevelopmenttrajectoriesinthequarter-centuryafterWorldWarII,inwhichinequalitywasreducedbetweenthe

5 Inventoriesareignoredhereastheyareassumedtobeneutralforeconomicstructure.6 AchangeinrelativepricescouldalsobringaboutachangeinIU.Ifheavyindustryisastrategicsectorunderadevelopmentalstate,itislikelythatfactorprices(forinstance,land,labour,energy,capital)willbesuppressedtoassistthesector.TheremovalofsuchdistortionswillclearlyimpactonIU.ThisisparticularlypertinentinthesituationofChina(HuangandTao2010).7 Thisframeworkobviouslylendsitselftoinput–output(I-O)analysis,inwhichmetalusecoefficientscanbeestimatedandapplied.Thistechniqueisentirelyappropriateinindustrialisedeconomieswithrelativelystablestructures.GiventheinherentdelayinthepublicationofdetailedI-Otables,however,andtheirfive-yearperiodicity,it isunlikelythattheywouldprovideanaccurate‘leaping-offpoint’forassessingtheIUsituationinacountrydevelopingasrapidlyasChina.8 KuznetsuseddatafromIndia(1949–50),Ceylon(nowSriLanka;1950)andPuertoRico(1948).


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low and middle-income stages of development, has shown that the LatinAmericanandSouthAsianpathsobservedbyKuznetsareidiosyncraticratherthangeneral.Thetworegionsfolloweddevelopmentmodelsthatencouragedthe super-normal growth of a rent-seeking elite, with predictable outcomesforincomedistribution.Therefore,theoriginalKuznetscurveisacautionarytaleforscholarsofdevelopmentlookingtocross-sectionaldataforpredictiverelationships.

Inthemetalssphere,acontemporaneouscross-sectionofcountriesatvariousincome levels can be readily assembled to show an apparent Kuznets-typerelationship. The apex of the hump in the curve relating steel demand perpersontopercapita incomeisprovidedbytwomedium-sizeduppermiddle-income North Asian economies: Korea andTaiwan.They are both relativelynewentrantstoindustrialisationwiththeirengagementoccurringwithinthepasthalf-century.Aretheseeconomiestypicaloratypical?Thisjudgmentcouldvalidate or invalidate the cross-section as representative, as we do not havereadilyavailablemiddle-incomealternativestosubstituteforthem.

PreliminaryinvestigationsbyMcKay(2008)documenttheexistenceofaKCSrelationship ina longtimeseriesofsteelusepercapita in theUnitedStates.The empirical evidence in favour of a Kuznets relationship in the long-runsteeldemandpercapita in theUnitedStates is strong.Thefindingthatsteelusepercapita intheUnitedStatesduringthetwentiethcenturyfollowedaninverted ‘U’shape ‘corroborates’ thecross-sectional ‘evidence’available froma scatter plot, indicating that the Kuznets framework could be applicable totheentirefieldofmetaldemand.Developmentis,however,acomplexprocessconditioninga richvarietyofurbanisationprocesses, investment approachesand sectoral transformations (and inChina’s case, ownership transformations[Garnautetal.2006]andimperfectionsinthemarketsforresources),differingapproaches to international trade, foreign investment, financial systems,institutionalreform,andsoon.Itisthereforepotentiallymisleadingtoreducean economy’sdevelopmentprocess to an aerialviewof ahigh-growthphasefollowinginitialengagementwithindustrialisation,followedbyadecelerationastheabilitytobenefitfromconvergenceofproductivitylevelsisreducedasitapproachesthefrontier.Rather,giventheobservedheterogeneityof‘pathwaysfromtheperiphery’(Haggard1990),itisnecessarytobuildasystemthatcanaccountforthesedifferences.

In short, while the shortcut of generalising from a narrow potentiallyunrepresentativesample is tempting, it isnotappropriate.What isneededisanapproachthatallowsfornationaldeviationsfromtheaveragepathwithinaconsistentaggregateframework.Ourapproach,therefore, is toestimatetheaggregateKCSrelationshipanditsunderlyingdeterminantsinasimultaneousprocedure.


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Model specification and estimation strategy

Model specification

ToexaminethepotentialKuznetsrelationshipbetweenlong-termsteeldemandpercapitaandeconomicdevelopment,we followMcKay (2008)byassumingthatsteeldemandpercapitaisafunctionofincomepercapita,itssquaretermandacontrolvector(Equation5.6).

Equation 5.6

InEquation5.6, denotesthelogarithmofannualsteelconsumption

per capita and and the logarithm of GDP per capita

and its square term of country i at time t respectively.is the control vector, accounting for the impact of automobile penetration(definedasthelogarithmofthenumberofpassengercarsper1000people)andtechnological progress (defined as the time trend).Thus, the null hypothesisfor theKuznets relationship tobe robust is that the estimatedcoefficients infrontofthelogarithmofGDPpercapitaanditssquaretermshouldbepositiveandnegativeinsign,respectively,andstatisticallysignificant.Additionally,anegativeandstatisticallysignificantcoefficientassignedtothetimetrendwillprovide support for the leapfrogging hypothesis. The degree of automobilepenetration is a proxy variable for the consumer preference hypothesis. Apositivecoefficientisexpectedhere.

ThisisamajoradvanceontheworkofLohaniandTilton(1993).Positionedinthis fashion,our test canoffera comprehensiveupdateandextensionof thesynthesisviewoftherelationshipbetweeneconomicdevelopmentandIU.Inaddition,thisapproachcaninfertheturningpointintheKCS—somethingthatisbeyondasingleequationlinearsystem.ItalsohassomeutilityasaprojectionmodelthatwelaterapplytothequestionofChina’sfuturemetaldemand.

Equation 5.6 can be directly estimated by various methods, but the resultsmightnotbeeconomicallyrobustinisolation.Thisisbecauseaparsimonioussingleequationexercisepotentiallyviolatestheempiricalrealitythatthenatureoftheindustrialisationprocessisjustasimportantasthedevelopmentlevelindeterminingthepathoflong-termsteeldemandpercapita.Tocontrolforthisfactor,wechooseasimultaneousestimationofthreeequations(Equations5.6,5.7and5.8),withsteelusepercapita,GDPpercapitaand its squared term,


82

respectively, servingasdependentvariables.Theestimationutilisesfive-yearpaneldata—essentiallysmoothedlongtime-series—forarepresentativesampleoftheglobaleconomy.Thedatacover14countriesandregionsfromasearlyas1890until2008.

Thevarietyoflocalconditionsprevailingattheentrypointintoindustrialisationstrategies, the different states of local and global technological attainmentat each ‘time stamp’, divergent comparative advantages and a diversity ofinstitutionalapproachestothedevelopmenttaskhavegeneratedsubstantiallydifferentdegreesofsteeldemandpercapitaatsimilarincomepercapitalevels.Therefore,intheanalysisoftheKCS,GDPpercapitacanbeplausiblytreatedasanintermediate variablethatisjointlydeterminedbythebroadparametersthat characterise a nation’s mode of economic development. These factorsincludetheurbanisationprocess,investmentpropensity,motorisationandthedegreeofopennesstotrade.Whilethesefactorsareendogenoustothestyleofeconomicdevelopmentadopted,econometricallyspeakingtheyareexogenousdeterminantsofGDPpercapitainourmodel.

Equations5.7and5.8completethesystemrequiredforthetest.

Equation 5.7

Equation 5.8

Inbothequations , isthelogarithmoftotalinvestmentpercapita,9 istheurbanisationrate(definedurbanpopulationshareof

thetotalpopulation)and isanopennesstotradeindex(definedasexportsplusimportsoverGDP).

Equations5.6–8areestimatedusingthesimultaneousequationmethod.Therearetwoeconometricproblemstobesolvedbeforeanunbiasedandconsistentestimationcanbereached.

First,sinceweusepaneldatafortheexercise,thecountry-specificeffectneedstobeeliminated.Iftherearetime-invariantcountry-specificunobservedfactorsdeterminingthedependentvariable(thatis,steeldemandpercapita)thatare

9 WeuseinvestmentpercapitaratherthanthemoreusualchoiceoftheinvestmentshareofGDP.Wedothisbecausewhileadevelopingeconomymighthaveahighinvestmentshare,itismostunlikelytohavealargecapitalstockrelativetoitsworkforce.Thisenablesustocaptureaprolongedprocessofcapitaldeepeningthatwillnotnecessarilybecapturedbytheinvestmentshare(especiallywheretheefficiencyofinvestmentimprovesovertime)aswellastheimportanceofdepreciationexpendituresathigherlevelsofdevelopment.


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also correlated with the independent variables (that is, GDP per capita), theestimatedcoefficientscouldbeeitheroverorunderestimated.Todealwiththisproblem,wetakethefirstdifferenceforallvariablesanduseEquations5.6’,5.7’and5.8’.

Equation 5.6’

Equation 5.7’

Equation 5.8’

Inallthreeequations, representsfirstdifferences.

Second, when the simultaneous equation regression technique is adopted,thepotentialcorrelationamongtheresidualsacrossequations introduces theefficiencyproblemfortheestimatedcoefficients(Zellner1962).Inotherwords,

if we assume that , and are independently and identicallydistributed(asisnormallyassumedinstatistics),theestimatedstandarderror

forallcoefficientswouldbebiasedsince , and couldbecorrelatedthroughthedependentvariablesthatarecorrelatedacrossdifferentequations.Thus,thestatisticalsignificanceoftheregressionisrendereddubious.Todealwiththisproblem,weusetheseeminglyunrelatedregression(SUR)techniquetoadjustthecovariancematrixinourestimation.

Totestthestabilityofourresults,wecarriedouttworobustnesschecks.Ononehand,wesubstitutedtheoriginaldependentvariableswithotherdevelopmentmeasures(suchaselectricityconsumption,railfreightandshippingvessels—allinpercapitaandloggedform).Theresultsdidnotdiffersubstantially.Wealsousedavarietyofeconometric techniques.10Onceagain, theresultswereconsistent in terms of the expected signs and statistical significance of theestimatedcoefficients.

10 Thesubstitutevariableswereelectricityconsumption,railfreightandshippingvessels(allinpercapitaandloggedform).Thealternativemethodswereadynamicpanelregression(withGDPpercapitaspecifiedastheendogenousvariable)andanIVregression(withdifferentmodelspecifications).


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Data description

Thepaneldatausedforthisstudycover14countriesandregionsbetween1890and 2008. The sample comprises Canada, the United States, Latin America,Africa,EuropeanmembersoftheOrganisationforEconomicCooperationandDevelopment (OECD), the Commonwealth of Independent States countries(Russia after 1990), the Middle East, India, China, South-East Asia, Oceania,Japan,KoreaandTaiwan.Toreduceyear-to-yearfluctuations,wesampledthedata atfive-year intervals.The regionaldefinitions are consistentwith thoseusedbytheInternationalSteelAssociation.

Figure 5.2 Crude steel output per capita of selected economies, 1890–2008

Source:DatafromtheWorldMetalStatisticsYearbook,variousissues,InternationalSteelAssociation.

Themacroeconomicvariablesweemployaresteeluse,GDP,investment,electricityuse,privateautomobileownership(allscaledbypopulation),opennesstotrade(scaled by GDP) and the urbanisation rate.The measures of all variables areconsistentacrosscountriesandovertime.Steeluseisdefinedastotalcrudesteelconsumption.GDPismeasuredat1990constantpriceinternationalUSdollars.Investmentisdefinedasgrossfixedcapitalformation.Theurbanisationrateisthepercentageofurbanresidentsinthetotalpopulation.OpennesstotradeisdefinedasexportsplusimportsoverGDP.

The data come from three principal sources. Crude steel production andconsumptioncomefromtheInternationalSteelStatistics;populationdatacomefrom Maddison (2003, 2010; the Penn World Table (Centre for International


85

Comparisonsn.d.)wasusedforobtainingthenationalaccountsvariablesandurbanisationrates;andtheCHIPsdatabaseoftheNationalBureauofEconomicResearch(NBER)providedprivatecarregistrationsper1000people,electricityconsumptionpercapitaandsomeothercountry-specificvariables.

ThereisaclearsimilarityintermsofthepatternofrisingsteeloutputpercapitafortheUnitedStatesfromthemid1930stotheendoftheKoreanWar,andforCanada, Europe and theCIS from the 1950s to the 1970s.The experience ofJapanfromtheearly1950stothe1970sandKoreafromtheearly1970stothepresentday,andChinasince2000,arealsoquitesimilar(Figure5.2).WhilethelevelsofsteelproductionpercapitaintheUnitedStatesandCanadafellsteadilyafterreachingtheirpeaks(therebytracinganinvertedUshape),EuropeandtheCISheldtheirpeaksforlonger.

Japanesesteelusepercapitahasremainedsteadyinthedecadesafteritspeak,whileKoreaisyettopeak,eveniftherateofincreasehasslowedsincethe1990s.Japan’sandKorea’s levelsofpercapitasteelproductionhavereachedapointmuchhigherthanthosereachedbyotherindustrialisedcountries.TheselevelsarethusunprecedentedintheWesternhistoryofindustrialisation.Figure5.2alsoshowsthatinthecaseofJapan,thephaseofaccelerationlastedforabout20years(1950–70)whilethepathhasbeenmoreprotractedforKoreaatalmost40yearsandcounting.ThisillustratesthepointmadeearlierabouttheuniquepathofmetalconsumptioninKorea.Thequestionastowhatextentthelevelof per capita steel production of China will rise and how long the phase ofaccelerationwilllastissignificantandremainstobeaddressed.

Figure 5.3 illustrates the relationship between steel output per capita andincome per capita in the major countries and regions over the long period1890–2008.Thefigurepresentsthreefeatures.First,thetrajectoriesofcertaincountries (especially in East Asia) seem to support the consumer preferenceview—namely,thatsteeldemandcontinuestorisealongwithincreasesinpercapita income.This process is extended even beyond the point where otherindustrialisedcountrieshavereachedthepeakintheirsteelintensities.Second,Western economies have demonstrated a pattern of change that is more insupportoftheleapfroggingview—namely,theirsteelintensitiesbegantofallafterpeakingbetweenUS$10000andUS$15000ofincomepercapita.SteelusethenstabilisesabouttheUS$20000levelbetweenone-halfandthree-quartersofthepeaklevelandthereafterfollowsacyclicalpatternofchange.


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Figure 5.3 Crude steel output and GDP, scaled by population, 1890–2008

12

1

0.8

0.6

0.4

0.2

0

0 5000 1000 15000 20000 25000 30000 35000

Canada

USA

Brazil

OECD Europe

China

Japan

Korea

Steel use per head

GDP Per Capita (1990 International dollars)

Source:WorldMetalStatisticsYearbook,variousissues,InternationalSteelAssociation.

Theseare thebasicdata thatprovide thedependentvariables for the formaleconometricexercisedetailedinsectionsthreeandfour inwhichwetestthevalidityof thedifferent theoriesandtheirsynthesis. It isalso thecontext inwhichthefuturetrajectoryofChina’ssteeldemandpercapitaisprojected.

Figure 5.4 Urbanisation ratios of selected economies, 1890–2005

Source: Center for International Comparisons n.d., The Penn World Table,University of Pennsylvania,Philadelphia.


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Thedifficultyofthemodellingtaskisillustratedwithreferencetooneoftheexplanatory variables: the urbanisation rate (Figure 5.4). The urbanisationprocesstendstobeassociatedwithrisingsteeldemandpercapitaasitdirectlycontributes to GDP growth through the well-known Lewisian dynamics ofsectoraltransfer.Italsorequiresadwellingandinfrastructure-buildingprogramtoaccommodate thepopulationshift.Thebenefitsofagglomerationdriveanincrease in service sector activity, greater specialisation and the associatedproductivity gains. Each of these factors generates income growth, whichincreaseseffectivedemand,andsoon.Asthisshortdescriptionindicates,theurbanisationprocess isanattractivevariableforproponentsoftheconsumerpreferenceview.Thereisnothingrigid,however,abouttherelationshipbetweenurbanisationandsteeluse.Forexample,Brazil’surbanisationratioiscloseto80percent,butBrazilhasarelativelylowlevelofsteelintensity(andincomepercapita).Brazilalsohasarichendowmentofferrousmetalresourcereserves.Atasimilarlevelofurbanisation,Korea’ssteelintensityismuchhigherthanthatoftheUnitedStates.Atamuchlowerlevelofurbanisation,China’ssteelintensityhasalreadysurpassedthosefortheUnitedStatesandBrazil.China’ssteeluseisconvergingwiththatoftheCIS,whereurbanisationissignificantlyhigher.InthecaseofJapan,itssteelintensityismuchhigherthanthatoftheUnitedStateswithalowerlevelofurbanisation,despitethedensityofitspopulationand itsweakresourceendowment (McKay2008). It isboth theoreticallyandintuitivelysoundtoincludeurbanisationratesintheempiricaltest.Yetaquickreviewofthecountry-leveldatahighlightsthedifferencesbetweencountriesinthesample.

Estimation results and projection

Theestimationresultsfromthemodelpresentedabovecapturetheinteractiverelationshipbetweensteelconsumptionpercapita,GDPpercapitaand theircommondeterminants,assummarisedinTable5.1.

ThefirstimplicationofthetestisthattheKCSdoesindeedexist.OurestimationofEquation5.6’yieldsresultsinlinewithourexpectations.AsshowninTable5.1,thecoefficientsassignedtoGDPpercapitaanditssquaredtermarepositiveandnegative,respectively,andaresignificantatthe1percentlevel.Further,themotorisationvariablealsobehavesasexpected,withastatisticallysignificantpositivelysignedcoefficientestimatedforthenumberofautomobilesper1000people. This corroborates the view that consumer preferences have playedanimportantrole indeterminingsteelconsumptionovertime.Generally,thegreaterthedegreeofmotorisationthehighersteeldemandpercapitaislikelytobe.Thetimetrendanditssquaretermaresignificantatthe1percentlevel


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withpositiveandnegativesignedcoefficients,respectively,correctlysignedtocorroboratetheleapfrogginghypothesis.So,withtheconsumerpreferenceandleapfroggingviewsbothvalidatedsimultaneously,thesynthesisviewisupheld(LohaniandTilton1993)andextended,andanewconcept,theKCS(McKay2008),hasbeenmorerigorouslyidentified.

Table 5.1 Major results from simultaneous equation estimation, 1890–2008

Dependent variable: lnsteel Dependent variable: lngdp Dependent variable: lngdp_sq

lngdp 6 .299*** lnnewinv 0 .418*** lnnewinv 6 .664***

(1 .325) (0 .056) (0 .959)

lngdp_sq –0 .313*** urban_ratio 0 .018*** urban_ratio 0 .233**

(0 .078) (0 .006) (–0 .097)

Lncar 0 .118* open_ratio –0 .001 open_ratio 0 .001

(0 .057) (0 .003) (0 .049)

Time trend –0 .028*** Time trend 0 .009* Time trend 0 .145*

(0 .011) (0 .005) (0 .083)

Time trend squared -



- - -

Constant 0 .495** Constant –0 .128 Constant –1 .853

(0 .208) (0 .095) (1 .609)

Adjusted R-squared 0 .48



Number of observations 72



Note:-zero,***p<0.01,**p<0.05,*p<0.1.Forsimplicity,wedonotreporttheestimationresultsforEquation5.8,whichareavailableonrequestfromtheauthors.Thenumbersinbracketsarestandarderrors.

Source:Authors’ownestimations.

Second,whiletheseresultsareamajorupgradeandextensionofpreviousworkinthefieldofmetaldemand, theydonotenableus toproceeddirectlyfromEquation5.6’toaprojectionofChina’ssteeldemand.NotonlyhasChina’ssteeldemandcommonlydefiedattemptstobeexplainedbycross-countrydata-sets(forexample,IMF2005b),butGDPpercapitaalonehasbeenshowntobeatbest a weak predictor of metal usage per capita across all countries.To castforward,wemustalsounderstandthattherearemanycommonfactorsrelatedtothestyleofindustrialisationdrivingbothIUandGDPpercapita.

ThesecommonfactorsarewellcoveredbyEquations5.7’and5.8’, inwhichGDPpercapitaanditssquaredtermareregressedoninvestmentpercapita,theurbanisationrateandthedegreeofopennesstotrade.Eachofthesefactorscanaffectincomepercapitaandmetalconsumptionpercapita.ItisthecombinationofthesefactorsthatgeneratestheapparentKCS.Inourestimationresults,not


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onlydobothinvestmentpercapitaandurbanisationpositivelycontributetoGDPpercapita(atthe1percentlevel),theyexplainthesquaretermofGDPper capita (positively related and significant at the 1 per cent level).11Thus,whenwesubstituteEquation5.7’andEquation5.8’ intoEquation5.6’,steelconsumptionisdrivenbythesethreefactorsinadditiontoproxiesforconsumerpreferencesandtechnologicalprogress.

A projection: China’s metal demand and economic development

ThesubstitutionofthesestylisticvariablesbackintoEquation5.6’allowsustousetheKCSformulationasaprojectionmodelwithoutsacrificingnationalheterogeneity.Thedatapresentedabove,takentogetherwiththeeconometricresultsandaworkingknowledgeofeconomichistory, leadtotheconclusionthatwhileageneralrelationshipbetweendevelopment-relatedmacrovariablesdoesexist, substantialnationalvariations fromthecentralpatharecommon.Thispermitsmanypotentialdegreesofsteeldemandpercapitaatagivenlevelofincomepercapita.WhiletheKCSisagoodstartingpointforthediscussion,itisnottheendgame.Wemustalsotakeaccountoftheotherfactorsunderlyingthemacroeconomicdynamics,whilefactoringinhowtheinstitutionalframeworkismostlikelytoevolveovertime.

Chinahasdefineditsowntrajectoryinthesecontextstoformauniqueeconomichistory.Itsfuturewillalsobedistinctive.China’sfuturedemandformetalwillborrowfromothers—suchasKoreaandJapan,theUnitedStates,theCISandWesternEurope—buttheoutcomeswillreflectChina’suniquecharacteristics.

Table5.2summarisesmajoreconomicdevelopmentindicatorsforChinabetween1980and2008,whichhelpstooutlinehowrapidgrowthinincomepercapitahasbeenachieved.Duringthepastthreedecades,investment,resourcedemandandopennesstotradehaveallexpandedatrapidrates.Theurbanisationratehasbeenincreasing,butataslowerrate,reflectingtheinstitutionalconstraintsimposed by policy. All these factors will contribute to the future course ofincome per capita and, combined with technological progress and changingconsumption preferences, will determine the path of steel consumption percapitaintheperiodahead.

11 Althoughthedegreeofopennesstotradeisnotsignificantinourmodel,wekeepitinourregressionsincewethinkthatitisanimportantcontrolvariablefromaconceptualperspective.


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Table 5.2 China’s economy and steel demand per capita, 1980–2008

Year

Steel per

capita (tonne)

GDP per capita (1990 int’l

dollar)

Investment share (%)

Openness to trade

index (%)

Urbani-sation rate (%)

Electricity per capita

Passenger cars/1000

people

1980 0 .0435 809 25 .1 31 .5 19 .6 307 -

1985 0 .0555 985 34 .3 32 .2 23 374 0 .3

1990 0 .0644 1400 40 .8 25 .4 27 .4 565 0 .7

1995 0 .0789 1754 43 .6 32 .2 31 .4 842 2 .1

2000 0 .1002 2718 37 .1 41 .9 35 .8 1046 4 .9

2005 0 .2716 3297 51 .7 67 .3 40 .4 1131 14 .1

2008 0 .3752 5449 54 .4 69 .0 44 .9 2452 21 .6

Compoundannual growth rate (since 1980)

8 .0% 7 .0% 2 .8% 2 .8% 3 .0% 7 .7%

Compound annual growth rate (since 1990)

10 .3% 7 .8% 1 .6% 5 .7% 2 .8% 8 .5% 20 .8%

Source:NationalBureauofStatistics(NBS)variousyears,China Statistical Yearbook,ChinaStatisticsPress,Beijing;exceptfortheinvestmentshare,whichisfromWorldBankn.d.,World Development Indicators,Onlinedatabase,TheWorldBank,Washington,DC.

Tobegin,wepresent a scenario inwhichcurrent trendspersist through theprojection period. Using the current growth rates in investment per capita,urbanisationandopennesstotradeindexes,(anadmittedlynaivebaseline),weprojecttherelationshipbetweenincomepercapitaandmetalintensityforChinaovertime(showninFigure5.5)withconfidenceintervalsjointlydeterminedbycountry-specificcharacteristicsandmeasuredasstandarddeviations.ThemethodusedforthisprojectionisnotbasedonthepredeterminedKCSrelationshipbutonthecontributionsofourthreecoredevelopmentfactorsrelatedtoGDPpercapitaandsteelconsumptionseparately.Basedona2008leaping-offpoint,weassumethatallthreefactorshaveaconstantmarginalimpactonGDPpercapitaandsteelconsumption(obtainedfromoursimultaneousregressions).Thesumoftheseproductsisthenusedtogeneratetheforwardtrajectoriesofthetwoseries:GDPpercapitaandsteelconsumption.

On this basis, our estimate of the GDP per capita level consistent with theturningpointofChina’sownKCSisUS$15449.GiventhefactthatChina’slevelofpercapitaincomewasUS$5449in2008(Table5.2),percapitaincomemustalmosttriplebeforepeakintensityisattained.ChineseGDPpercapitagrewatacompoundrateof7percentbetween1980and2008.Ifthatrateweresustained,


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China’s steel intensitywouldpeakduring2024. If the somewhat fasterpost-1990paceof7.8percentisused(arateconsistentwithGDPpercapitamorethandoublingeachdecade)thentheturningpointisreachedthreeyearsearlier.Thecentraltendencyoftheprojectionindicatesthatpeakdemandforsteelwillbeintheupperhalfofarangeof700–800kgpercapitaatthisincomepercapitalevel.ThispeaklevelofdemandforsteelinChinawillbehigherthantheonereachedbytheUnitedStatesinthe1950sorEurope,CanadaandtheCISinthe1970s.Itwould,however,belowerthanthosereachedbyJapaninthe1980sandbyKoreaandTaiwanatthepresenttime.

Theusualcaveatsapplytothisprojection,whichisonlyasgoodasthechosentimepathoftheexogenousvariables.

Figure 5.5 Projection of steel demand per capita, extrapolating current trends

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

Steel use per head(tonnes)

actual

projected

GDP per capita (at 1990 international dollars)

5000 10000 15000 20000 25000 30000 35000 40000

Source:Authors’ownprojections.

Discussion and critique of the projection

TheprojectionillustratedinFigure5.5isbasedonthenaiveassumptionthatcurrenttrendspersistintothefuture.Ifeconomichistorytellsusanything,itisthatstasisistheleastlikelyoutcomeforaneconomyatChina’spresentstageofdevelopment.Table5.3showstheforwardassumptionsutilisedinarecentUNreportonthefutureoftheChineseeconomy(UNDP2010).ThecontoursoftheUNscenarioareadeceleratingrateofGDPpercapitagrowth,acontinuingriseintheurbanisationrateandmotorisationthatdeceleratesprogressivelyas


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Chinese levels approach those of high-income economies, a reduced but stillhigh emphasis on secondary industry in overall activity and a peak in steeldemandpercapitaabout630kgby2030.

Table 5.3 UN projection of China’s future development path

2005 2010 2020 2030 2040 2050

Urbanisation rate (%) 43 48 56 62 66 70

Secondary industry share of GDP 48 49 48 46 42 38

Cars per 1000 people 24 70 190 300 356 400

Per capita GDP (spliced to 1990 int’l dollars)* 3297 4990 8868 14 450 22 151 32 079

GDP growth rate (decade average) - 9 .5 6 .6 5 .5 4 .5 3 .5

Population (millions) 1308 1360 1450 1520 1540 1500

GDP per capita growth rate (decade average)* - 8 .7 6 .0 5 .0 4 .4 3 .8

Power generation Terawatt hours (TWh) (business as usual)

2494 3830 6603 8880 10 937 12 360

Steel output (100 million tonnes) 3 .5 5 .6 8 .6 9 .6 9 .1 8

Implied steel per capita (tonnes per capita)* 0 .27 0 .41 0 .59 0 .63 0 .59 0 .53

*Calculatedbytheauthorsfromtheexistinginformation.

Source:UnitedNationsDevelopmentProgramme(UNDP)2010,China Human Development Report 2009/10. China and a sustainable future: towards a low carbon economy and society,ChinaTranslationandPublishingCorporation,Beijing,Annexes3.1,3.2,3.3and3.4,pp.107–8,andTable3.1,p.52.

Runningtheirassumptionsthroughoursystem,wefindthattheUnitedNation’speaksteeloutputpercapitaestimateisprobablysomewhattoolow,althoughtheimplicationthatChinawillremainarounditspeaklevelsforaconsiderableperiod (at least590kgpercapita from2020to2040)seemsreasonable.Also,given that the turning point of China’s KCS is expected to be reached at aGDPpercapitaofUS$15449—alevelthatwecandeducetheUnitedNationsanticipatesbeingachievedin2032—thisroughlyaccordswiththeirassumedtimingof thepeak in steeldemandper capita. In short, theUnitedNation’ssteel projections seem rational enough in terms of overall shape and timing,butwewouldargueforahigherpeakdemandthanthatbasedontheirothermacroeconomicassumptions.

Chinahasdefineditsowntrajectoryinanumberofcontextstoformauniqueeconomicdevelopmentpath. Its futurecouldalsobedistinctive if itwere todefineapathwithrespecttoleapfroggingandconsumerpreferencesthatisoutofthenorm.


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IndeterminingthelikelihoodthatChinawillreachthepeaklevelofitssteeldemandpercapitainthetimeframepredictedbyournaiveprojection,whichof theupperor lowerconfidence intervalspresents themost likelydirectionof error from the central tendency or whether China will or will not followthepathofKoreaintermsofitslong-termpathofsteelconsumption,weneedto leave aside empirics and trust judgment.The question is whether China’smetalconsumptionwillbeinfluencedmorebytheconsumerpreferencevieworbehavemoreaccordingto thepredictionsof the leapfroggingview. It isalegitimatequestionasourmodelprovidesempiricalevidencesupportingthemutualinclusionofeachoftheseviews.

If, for example, the consumer preference dynamic operates so strongly thattechnologicalleapfroggingishugelyoutweighedthenthereisahighprobabilitythatChinawill eitherprolong the period before it reaches thepeakor itwillincrease the absolute peak level of steeldemandpercapita towards theupperconfidenceinterval.EitherorbothpossibilitieswillraisethechancethatChinamightfollowthemetalintensitypathofKorea.

Ontheotherhand,iftheleapfroggingphenomenonoperatessostronglythatitcancelsoutalargerthanusualportionoftheconsumerpreferencedynamic,thiswillincreasetheprobabilitythatChinacouldeithershortentheperiodleadinguptotheturningpointoftheKCSorreducethepeaklevelofitssteelintensitytowardsthelowerconfidenceinterval.

Figure 5.6 China’s consumption of crude steel, 1978–2008 (million tonnes)

Source:NationalBureauofStatistics(NBS)2009,China Statistical Yearbook,ChinaStatisticsPress,Beijing;andauthor’scalculations.


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According to its current level of per capita income,China is still at themidphase of industrialisation characterised by the relatively high proportionof manufacturing in the total economy and a relatively high share of heavyindustriesintotalindustrialoutput(Cheneryetal.1986).Akeyfeatureofthisphase of industrialisation is thepatternof extensive growth inwhich factorinputs—especiallyphysicalcapital—playanimportantrole.Asaresult,metalconsumption has been accelerating sharply (Figure 5.6). China is far fromreachingthesaturationpointofconsumptionofdurablegoods,as illustratedbyitslowautomobilepenetrationratio,whichisjust5percentoftheUSlevel.Thatisespeciallytrueifoneconsiderstheexistenceofthevastanduntappedruralconsumermarket.Thissuggeststhatthereisampleroomfor increasingtheconsumptionofdurablegoodsinChinawiththeassociatedriseindemandformetals.Onthisevidence,wecansafelyassumethattheconsumerpreferencedynamicwillplayastrongroleinthecomingdecades.

On the other hand, looking beyond the immediate horizon, China is nowapproachingtheendofalongperiodofextensivegrowthandwillberelyingmoreon technological change andproductivity to expandeconomic activity(Wang2007;Heetal.2007).Chinaisenteringaperiodinwhichitspatternofgrowthwillbedictatednotonlybythosefundamentalforcesthathavebeenworkinginrecentdecades,butbythestrategiesthatChinahasbeencompelledtoadoptatthisjunctureofitsdevelopmentinordertofacethechallengesofglobalimbalances,climatechangeandtheageingsociety.

Atthecoreofthesestrategiesisadesiretoalteritsmodeofindustrialisationtotakeaccountofshiftingcomparativeadvantageandthefactthat ‘businessasusual’willput immensepressureon thebiospheregoing forward.Structuralchanges will be assisted by altered incentives brought about throughinstitutional changes such as financial system reform and the reform of thepricingsystemforresourcesandotherfactorsofproduction(HuangandTao2010).Theimplementationofthesenewstrategieswillacceleratethepaceoftechnological leapfrogging inChina,moderating future increases in itsmetalconsumptionpercapita.

Whilethedesireforenvironmentalamenityhasawell-documentedrelationshipto per capita income that is ‘Kuznetsian’ in shape, in China and elsewhere(Grossman and Krueger 1995; Bao and Peng 2006), no currently wealthycountryhadtodealwithaglobalenvironmentalbackdropasunpropitiousasthat of today.This implies that the imperative forChina topursue resource-savingtechnologicalchangeinthefutureisgreaterthanthatoftheindividualeconomiesinourhistoricalsample.


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This short discussion highlights only that the consumer preference andleapfroggingdynamicswillbothbeoperatingathighintensityinthecomingdecadesinChina.Fornow,itisnotpossibletoprioritiseoneovertheother.

Finally,weshouldsoundafurthercautionarynotewithrespecttotheprojection.Theobjectiveof this studyhasbeen todefinea rangeofpotentialoutcomesfor China’s steel demand, not to produce a precise forecast.We believe thatour confidence intervals are a reasonable approximation of the likely upsideand downside risks to the central KCS tendency for China. Needless to say,if theunderlyingassumptionsthatgenerate thecentral tendencyareoverorunderestimated,theaccuracyoftheprojectionwillsuffer.

Conclusions

Thischapterhadtwoaims.Thefirstwastomakeacontributiontothetheoreticalfieldthatrelatedeconomicdevelopmenttometalusagebyconstructinganewanalytical framework.The secondwas touse those insights to shed lightonChina’s future path of ferrous metal demand.The outcomes were as follows.First, a new concept—the Kuznets curve for steel—was formally identified.Second, the synthesis view of IU—that sees a role for both technologicalleapfroggingandevolvingconsumerpreferences—wasvalidatedandupdatedforthepercapitaframeworkweprefer.Toaccommodatethistest,abroadersetofdatawasbrought intothediscussionthaninpreviousstudies,alongwitha more advanced econometric technique that allowed for the endogeneity ofsteeldemandandincomepercapitaandtheheterogeneousnatureofindividualeconomichistories.Third,theturningpointofChina’sownKCSwasestimatedatUS$15449GDPpercapita—apointthatonitspost-1980trajectoryof7percentcompoundgrowthChinawouldreachduring2024.Atthattime,China’ssteeldemandpercapitaisexpectedtobebetween700and800kg,butclosertothelatter.That ishigherthanthepeaklevelreachedintheUnitedStates,theCISandEurope,butlowerthanthepeaksseeninJapan,KoreaandTaiwan.Theeventualaccuracyofthisprojectionwilldependonagreatmanyfactors,chiefamongthemthepaceofglobaltechnologicalchangeandthedevelopingpreferencesoftheChineseconsumer.

References

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Garnaut, R., and Song, L. 2006, ‘China’s resources demand at the turningpoint,’(withRossGarnaut),Chapter14inR.GarnautandL.Song(eds),The Turning Point in China’s Economic Development,AsiaPacificPress:Canberra,pp.276-293.

Garnaut, R., Song, L. and Yao, Y. 2006, ‘Impact and significance of SOErestructuringinChina’,The China Journal,no.55(January),pp.35–66.

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International Monetary Fund (IMF) 2005a, ‘Will the oil market continue tobe tight?’, World Economic Outlook, April, International Monetary Fund,Washington,DC.

InternationalMonetaryFund(IMF)2005b, ‘Global imbalances:asavingsandinvestmentperspective’,World Economic Outlook,September,InternationalMonetaryFund,Washington,DC.

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Acknowledgments

We thank Yixiao Zhou for her help with assembling the data used in themodellingexercise.

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Assessing China’s energy conservation and carbon

intensity: how will the future differ from the past? 6

ZhongXiang Zhang

Introduction

China’s spectacular economicgrowth since1978hasbeenheavilydependenton burning dirty coal. This has given rise to unprecedented environmentalpollution and health risks. On top of these domestic environmental stresses,projectedglobalclimatechangeisexpectedtoposeadditionalthreatstoChinaintheforeseeablefuture.

Astheworld’slargestemitterofcarbondioxide,Chinaisfacinggreatpressureinsideandoutside internationalclimatenegotiationstobemoreambitious incombatingclimatechange.Chinacannotaffordtocontinueontheconventionalpath of encouraging economic growth at the expense of the environment,whetheritlooksattheissuefromadomesticorinternationalperspective.ArangeofenvironmentalconcernsandpressureshassparkedChina’sdeterminationtoimproveenergyefficiencyandtoincreasetheuseofcleanenergyinordertohelpitstransitiontoalow-carboneconomy.

Chinaachievedaquadruplingofitsgrossdomesticproduct(GDP)withonlyadoublingofenergyconsumptionbetween1980and2000(Zhang2003).Followingthetrendsofthe1980sand1990s,theUSEnergyInformationAdministration(EIA2004)estimatedthatChina’scarbondioxideemissionswerenotexpectedtocatchupwiththeworld’slargestcarbonemitteruntil2030.China’senergyusehas,however,surgedsincetheturnofthiscentury—almostdoublingbetween2000 and 2007. Although rates of economic growth were similar in the twoperiods,therateofgrowthinChina’senergyuseduringthisperiod(9.7percentperannum)wasmorethantwicethatoftheprevioustwodecades(4.25percentperannum)(NBS2009).Thischangeinenergyintensitywasresponsibleforanincreaseof20milliontonnesofcarbonemissions(mtc)duringtheperiod2001–07,comparedwithareductionof576mtcduringtheperiod1980–2000(Zhang2009d).Asaresult,Chinabecametheworld’slargestcarbonemitterin2007.


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To reverse this trend,Chinahas incorporated a requirement that energyuseperunitofGDP(energyintensity)becutby20percentduringtheeleventhfive-year-plan period, running from 2006 to 2010.This is widely consideredanimportantsteptowardsbuildinga‘harmonioussociety’through‘scientificdevelopment’. Just before the Copenhagen climate summit, China furtherpledged tocut itscarbon intensityby40–45percentby2020relative to its2005levelsinordertohelpreachaninternationalclimatechangeagreementatCopenhagenorbeyond.

ThischapterfocusesonassessingChina’senergyconservationtodateanditsproposedcarbonintensitytarget.1ItfirstdiscussesChina’sowneffortstowardssavingenergy,cuttingpollutionandpromotingthewidespreaduseofrenewableenergy.Next,toputChina’sproposedcarbonintensitytargetintoperspective,thechapterseekstoansweranumberofissuesrelatedtotheproposedcarbonintensitygoalfor2020:isthetargetaschallengingastheenergy-savinggoalssetinthecurrenteleventhfive-yeareconomicblueprint;towhatextentwoulditdriveChina’semissionsbelowprojectedbaselinelevels;andifthecommitmentweremet,wouldChinawillfulfilitsproportionatepartofacoordinatedglobalcommitmenttostabilisetheconcentrationofgreenhousegasemissionsintheatmosphereatthelevelthattheCopenhagenmeetingagreedwasdesirable.

As longasChina’spledgesare in the formofcarbon intensity, thereliabilityofemissionsandGDPdatamatters.ThechaptergoesontoaddressreliabilityissuesconcerningChina’sstatisticsonenergyandGDP.GiventhatChinahasshiftedcontroloverresourcesanddecision-makingtolocalgovernmentsduringthepastthreedecades,effectiveenvironmentalprotectionmustbeplacedinthecontextofgovernmentdecentralisation.

Thechapterconcludesthatthereisaneedtocarefullyexaminethoseobjectiveandsubjectivefactorsthatleadtothelackoflocalofficials’cooperationwithnational policy on the environment, and also that strict implementation andcoordination of official policies and measures are of paramount importancein meeting China’s existing energy-saving goal in 2010, its proposed carbonintensity target in2020andwhateverclimatecommitmentsChinaadopts forbeyond2020.

1 SeeZhang(2000,2009a,2009b,2009c)fordetaileddiscussionofChina’sclimatestrategiesregardingtheformatandtimeframethatitwouldtakeonclimatecommitments.

Assessing China’s energy conservation and carbon intensity

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Increasing energy efficiency and cutting pollutants

While China has been calling for energy savings since the early 1980s, thequantitative target on energy efficiency in the current five-year (2006–10)economicplanisanimportantnewdevelopment.

China achieved a quadrupling of its GDP with only a doubling of energyconsumptionbetween1980and2000(Figure6.1).However,from2002Chinaexperienced faster growth of energy consumption than of economic output,which translates into rising energy intensity.The changing trend on energyefficiency reflects the completion by about the turn of the century of thereductionsofenergyuseassociatedwiththemovementtowardsmarketpricingof energy as a result of reforms in the 1980s and 1990s.The change in thetrajectoryofenergyintensitythatisnecessarytomeetthenewtargetssuggeststhattheattainmentofthetargetswillbeextremelychallenging(Zhang2005,2007d).

Industry accounts for about 70 per cent of the country’s total energyconsumption (Zhang2003),sothat thissector iscrucial forChinatomeet itsowngoal.TheChinesegovernmenthasmadegreateffortstowardschangingthecurrentenergy-inefficientandenvironmentallyunfriendlypatternofindustrialgrowth.Chinaisexploringindustrialpoliciestopromoteindustrialupgradingandenergyconservation.With a surge in energyuse inheavy industry, theChinesegovernmentstartedlevyingexporttaxesinNovember2006onenergyandresource-intensiveproductstodiscouragetheirexportandtosavescarceenergyandresources.Theseincludea5percentexporttaxonoil,coalandcoke;a10percenttaxonrevenuesfromsaleofnon-ferrousmetals,somemineralsand27otherironandsteelproducts;anda15percenttaxonrevenuesfromcopper,nickel,aluminiumandothermetallurgicalproducts.2

FromJuly2007,China eliminatedor cut export tax rebatesunder thevalueaddedtaxfor2831exportitems.ThisisconsideredtheboldestmovetoreininexportssinceChina joinedtheWorldTradeOrganisation (WTO).Amongtheaffecteditems—whichaccountfor37percentofalltradedproducts—are553highly energy-consuming, highly-polluting and resource-intensive products,such as cement, fertiliser and non-ferrous metals.The export tax rebates ontheseproductswerecompletelyeliminated.Thispolicywillhelp to enhanceenergyefficiencyandrationaliseenergyandresource-intensivesectorsaswellascontributetomacro-economicpolicyobjectives(Zhang2008).

2 SeeZhang(2009c)fordiscussionoflinksbetweenChina’sownexporttaxesandcarbontariffsproposedinUSclimatelegislation.


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On the energy-saving front, China established the ‘Top 1000 EnterprisesEnergyConservationActionProgram’inApril2006.Thisprogramcovers1008enterprises inninekeyenergysupplyandconsuming industrial sub-sectors.Theseenterpriseseachconsumedatleast180000tonnesofcoalequivalent(tce)in2004,and togetherconsumed33percentof thenational totaland47percentofindustrialenergyconsumptionin2004.Theprogramaimstosave100milliontcecumulativelyduringtheperiod2006–10,thusmakingasignificantcontributiontoChina’soverallgoalofa20percentenergyintensityimprovement(NDRC 2006a). In May 2006, empowered by the State Council, the NationalDevelopmentandReformCommission(NDRC),China’stopeconomicplanningagency,signedenergy-savingresponsibilityagreementswiththeseenterprises.To ensure that the goal is met, achieving energy efficiency improvementshasbecomeacriterionfor jobperformanceevaluationsof theheadsof theseenterprises. The first year’s results of the program’s implementation areencouraging,withmorethan95percentoftheseenterprisesappointingenergymanagersandtheprogramachievingenergysavingsof20milliontcein2006(NDRCandNBS2007).In2007,38.2milliontceofenergywassaved—almostdoublingtheamountofenergysavedin2006.Ifsavingscontinueatthe2007rate,thetop-1000programwillexceeditstarget(NDRC2008b).

Figure 6.1 Energy use per unit of GDP in China, 1990–2007 (tonnes of coal equivalent per US$1000 in 1980 prices)

Source: Based on National Bureau of Statistics (NBS) various years, China Statistical Yearbook,ChinaStatisticsPress,Beijing.


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Powergenerationisthelargestcoalconsumer,currentlyconsumingmorethanhalf of the total used in China.This share is expected to rise well above 60percent in2020.Thus,efficientcoalcombustionandpowergeneration isofparamount importance toChina’senergysavingsandpollutionreduction.Tothatend,Chinahasadoptedapolicyofacceleratingtheclosureofthousandsofsmall,inefficientcoalandoil-firedpowerplants.Unitsfacingclosureincludethosebelow50megawatts (MW), thosebelow100MWand inoperation formorethan20years,thosebelow200MWandhavingreachedtheendoftheirdesign life, those with a coal consumption per unit of power output 10 percenthigherthantheprovincialaverageor15percenthigherthanthenationalaverage,andthosethatfailtomeetenvironmentalstandards.Thetotalcombinedcapacitytobedecommissionedissetat50gigawatts(GW)duringtheperiod2006–10.Bytheendof2008,Chinahadclosedsmallplantswithatotalcapacityof34.2GW,relativetoatotalcapacityof8.3GWdecommissionedduringtheperiod2001–05 (NDRC2008a).By theendof thefirsthalfof2009, the totalcapacityofdecommissionedsmallerandolderunitshadincreasedto54GW,meetingthe2010targetoneandhalfyearsaheadofschedule(‘SO2cuttinggoalexpectedtocomeaheadofschedule’,7July,Sina Net,<http://finance.sina.com.cn/roll/20090707/04346447872.shtml>).

TheChinesegovernment’spolicyhasconcurrentlyfocusedonencouragingtheconstructionoflarger,moreefficientandcleanerunits.By30June2009,64percentofcoal-firedunitshadcapacitiesof300MWormore(WangandYe2009).China’spowerindustryhaslistedsupercriticalpowergenerationtechnologyasakeydevelopmentfocusduetoitshigherthermalefficiencyandrelativelylowunitinvestmentcosts.Asaresult,anincreasingnumberofnewlybuiltplantsaremoreefficientsupercritical(SC)orultra-supercritical(USC)plants.By2007,theshareofSCandUSCunitsintotalcoal-firedgenerationcapacitywasabout12per cent. In comparison, the corresponding share is about 70per cent inJapanand30percentintheUnitedStates.TheshareofUSCplantsintotalcoal-firedgenerationcapacityisexpectedtogrowto15percentby2010and30percentby2020(Huang2008;IEA2009a).

For residential buildings, China has taken three steps to improve energyefficiency.Thefirststeprequiresa30percentcutinenergyuserelativetotypicalChineseresidentialbuildingsdesignedin1980–81.Second,Chinarequiresthatnewbuildingsbe50percentmoreefficientby2010.Third,theenergy-savinggoalistobeincreasedto65percentfornewbuildingsby2020(Zhang2005,2008).TianjinisthefirstmetropolitancityinChinatoembarkonreformofheatsupplyandcharges.Bytheendof2006,73.5millionsquaremetresofenergy-efficientresidentialbuildingspacehadbeenbuilt inthiscity,accountingfor48percentoftotalresidentialbuildings(ZhengandYou2007).InBeijing,thebuildingsectorconsumed28percentoftotalenergyusein2004.Bytheend


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of2004,175.2millionsqmofenergy-efficientresidentialbuildingspacehadbeenbuiltinChina’scapital,37percentofwhichmettherequirementfora30percentincreaseinenergyefficiency.Theremaining62.9percentmetthe’50percentmoreenergy-efficient’ standards.Theseenergy-efficientbuildings inBeijingaccountedfor65percentofitstotalresidentialbuildings.Beijing’splanisforallnewresidentialbuildingstomeetthe‘65percentmoreenergy-efficient’standardsby2010—onedecadeaheadofthenationalschedule(BMCDR2006).

Inthetransportsector,theexcisetaxforvehicleshasbeenadjustedovertimetoprovideincentivesforthepurchaseofenergy-efficientcars.Theexcisetaxleviedatthetimeofpurchasewasfirstintroducedin1994.Therateincreaseswiththesizeoftheengine—setat3percentforcarswithenginesof1litreorless,8percentforcarswithenginesofmorethan4litresand5percentforcarswithenginesinbetween.Thesetaxratesforcarsremainunchanged.Thenewvehicleexcisetax,implementedsinceApril2006,hasbroadenedthetaxbasefromtheexistingrangeof3–8percentto3–20percentandtosixcategoriesofenginesize.Table6.1demonstratesclearlythelarge,upwardadjustmentintheconsumptiontaxonfuel-guzzlingcarsovertime.Moreover,Chinacutthepurchasetaxrateforcarswithenginesof1.6litresorlessfromthenormalrateof10percentto5percentin2009and7.5percentin2010.Whilethisratecutismotivatedbytheneedtostimulatetheeconomyduringtheeconomiccrisis,itpracticallybenefitssavingenergyandcuttingpollutionaswell.

Table 6.1 Consumption tax rates for cars in China (per cent)

Engine size (litres) Excise tax since 1 January 1994

Excise tax since 1 April 2006

Excise tax since 1 September 2008

1 .0 or less1 .0 < engine ≤ 1 .51 .5 < engine ≤ 2 .02 .0 < engine ≤ 2 .52 .5 < engine ≤ 3 .03 .0 < engine ≤ 4 .0Greater than 4 .0

3555558

3359121520

1359122540

Sources: ‘Special topic on paying close attention to adjustments in consumption tax policy, Sina Net,<http://finance.sina.com.cn/focus/gzxfstz/index.shtml>; ‘Adjustments forvehicleexcise taxeswill takeplacesinceSeptember1,upforcarswithlargeenginesanddownforsmallcarsto1percent’,People Net,14August,<http://auto.people.com.cn/GB/1049/7663221.html>

ChinahassetfueleconomystandardsforitsrapidlygrowingpassengervehiclefleetevenmorestringentthanthoseinAustralia,CanadaandtheUnitedStates,althoughtheyarelessstringentthanthoseinJapanandtheEuropeanUnion(Figure6.2). Implemented in twophases, the standards classifyvehicles into16weightclasses,coveringpassengercars, sportsutilityvehicles (SUVs)andmultipurpose vans. Converted to the US Corporate Average Fuel Economy


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(CAFE)testcycle,newvehicles’averagefueleconomystandards inChinaareprojectedtoreach36.7milespergallon(6.5litresper100km)in2008(AnandSauer2004).

Figure 6.2 Comparison of fuel economy standards for vehicles

Notes:Dottedlinesdenoteproposedstandards;MPG=milespergallon.

Source:AdaptedfromAn,F.andSauer,A.2004,Comparison of Passenger Vehicle Fuel Economy and GHG Emission Standards Around the World,December,PewCenteronGlobalClimateChange,Arlington,Va,<http://www.pewclimate.org/docUploads/Fuel per cent20Economy per cent20and per cent20GHG percent20Standards_010605_110719.pdf>

Inthemeantime,growingChinesecitiesaregivingprioritytopublictransportand are promoting efficient public transport systems. Given an inevitableincreaseinthenumberofvehiclesontheroad,however,Chinahasalsotakensignificantstepstocontrolvehicleemissions.AfterthephasingoutofleadedgasolinenationwideinJuly2000,theStateEnvironmentalProtectionAgencyofChinarequiresallnewlight-dutyvehiclessoldafterApril2001tomeetStatePhaseI(similartoEuroI)vehicleemissionstandardsandafter1July2004tomeetStatePhaseII(similartoEuroII)standardsacrossChina.Beginningon1July2007,ChinastartedimplementingStatePhaseIII(similartoEuroIII)vehicleemissionstandards,withStatePhaseIV (similar toEuroIV)vehicleemissionstandardsscheduledtobeintroducedon1July2010(Table6.2).PollutionfromtheStatePhaseIIIstandardsis30percentlowerthanthatfromStatePhaseIIstandards.PollutionfromStatePhaseIVstandardsgoesbelow60percentofthatfromStatePhaseIIstandards(‘Delaysintheimplementationofstatephase


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IIIvehicleemissionstandards’,Xinhua Net,7July,<http://auto.sina.com.cn/news/2007-07-07/1015290457.shtml>). Clearly, vehicle emission standards inChinahavebecomeincreasinglystringentovertime.NewvehiclesthatdonotcomplywiththenewstandardscannotbesoldinChina.WhileChinaisataboutthe same levels of vehicle emission standards as India and most AssociationofSouth-EastAsianNations (ASEAN)countries, it isacoupleofyearsaheadofthesecountriesinitsschedulestoimplementtheseregulations.Also,whileChinastill lagsbehindtheEuropeanUnion’semissionsrequirements fornewvehicles,thegapwiththeEUrequirementshasgraduallybeenreduced—fromaboutnineyears in2001 tofiveandahalfyears in2010.Clearly, thesenewstandardswillhelptoreducesubstantiallyenvironmentalcosts.

Table 6.2 Vehicle emission standards and the time to enter into force in China, ASEAN and the European Union

Region Euro I Euro II Euro III Euro IV Euro VEuropeanUnion

July 1992

January 1996

January 2000

January 2005

September 2009

China April 2001

July 2004

July 2007

July 2010

Beijing 1999 August 2002

December 2005

First half 2008

India 2000 2005 2010

ASEAN December2005(targeted)

December 2010 (targeted)

Indonesia Early 2006 First quarter 2007

2012

Malaysia Mid 2006 2010

Philippines December 2006

2010

Singapore 2005 October 2006 (diesel)

Thailand Early 2005

2010

Vietnam July 2007

2012

Source:Zhang,Z.X.2008,‘Asianenergyandenvironmentalpolicy:promotinggrowthwhilepreservingtheenvironment’,Energy Policy,vol.36,pp.3905–24.

The use of renewable energy

ConcernsaboutclimatechangeandotherenvironmentalproblemsandhealthriskshavesparkedChina’splanstopursuealternativeenergysourcestomeet


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the country’s increasing energyneeds.China has targeted alternative energysourcestomeetupto15percentofthenation’senergyrequirementsby2020—upfrom8.9percentin2008.Whilethisisabigstepupfromthepreviousgoalof10percentby2020,earlysuccessisencouragingofficialstodevelopevenmore ambitious targets. Under the plan as its stands, China aims to have aninstalledcapacityof300GWforhydropower(includinglargehydropower),30GWforwindpowerand30GWforbio-power(powergeneratedfrombiomass),andtoproduce10milliontonnesofethanoland2milliontonnesofbio-dieselby2020(Zhang2007b).

TheEuropeanUnioniswidelyconsideredtobetheworld’sleaderinrenewableenergy.TheEuropeanUnionisaimingforrenewableenergytomeet12percentofitsprimaryenergyby2010and20percentby2020fromitscurrentlevelof6.5percent(EuropeanCommission2007a,2007b).Atfirstglance,theEuropeanUnion’sgoaloftriplingtheshareofrenewableenergyfromthecurrentlevelto20percentby2020seemsevenmoreambitiousthanChina’srenewableenergygoal.BecauseenergydemandinChinagrowsatleastthreetimesfasterthanintheEuropeanUnion,doublingrenewableenergyinChina’stotalenergymixby2020requiresrenewableenergyinChinatogrowataratefourtimesthatintheEuropeanUnion.

In addition to setting extremely ambitious renewable energy goals, Chinaismaking largeefforts tomeet thesegoals.China investedUS$34.6billion inrenewable energy in2009, causing theUnitedStates to lose the top spot forthefirsttimeinfiveyears,cominginadistantsecondwithatotalinvestmentof US$18.6 billion. In terms of renewable energy investment as a percentageofGDP,China,with0.39percent,investedthreetimesmorethantheUnitedStates,with0.13percent,in2009.Withaninstalledcapacityof52.5GW,Chinaranked second in the world’s total renewable energy capacity in 2009—justslightlybehindtheUnitedStates,with53.4GW(PewCharitableTrusts2010).

WithwindpoweridentifiedasapriorityfordiversifyingChina’senergymix,thissectorhasbeentheprimaryrecipientofrenewableenergyinvestmentandfavourable policies in recent years. In 2003, China adopted theWind PowerConcession Program as its primary strategy to further promote wind powerdevelopment. Feed-in tariffs enacted in 2005 took effect on 1 January 2006.Thisgovernment-runprogramauctionsoffdevelopmentrightsforwindpowerprojectsof100MWormorefora25-yearperiod,whichincludesaguaranteedtariffforthefirst30000hoursaswellasconcessionaryoperationagreements.Thison-gridwindpowertariffisdecidedthroughacompetitivebiddingprocess.Ifthetariffishigherthanthereferenceon-gridtariffofde-sulphurisedcoal-firedpower,thedifferencewillbesharedinthesellingpriceattheprovincialandnationalgridlevels.Fortheremainderoftheperiod(namely,afterthefirst30000hoursuntiltheendingofthetotalconcessionperiodof25years),thewind


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powertariffissettobeequaltotheaveragelocalon-gridtariff.Otherpolicieshaveincludedahalvingofthevalue-addedtax(VAT)forwindpower,fromthenormalrateof17percentto8.5percent;lowerdutyratesleviedondomesticinvestmentinwindpower(6percentcomparedwiththenormalrateof23percent);andnodutiesforequipmentimportedforrenewableenergytechnologiesinjointventures.Somelocalgovernmentshaveprovidedevenmorefavourablepolicies.Forexample,inInnerMongolia,aVATof6percentisleviedonwindpower.

Withthesefavourablepoliciesinplace,thetotalwindpowercapacityinstalleddoubled between 2003 and 2005, reaching 1.3 GW in 2005. With China’sRenewable Energy Law entering into force in January 2006, the pace ofinstallationsacceleratedconsiderably.Thetotalinstalledwindpowercapacityroseto2.6GWin2006,withnewinstallations inthatyearaloneamountingtomorethanthecombinedtotalinthepast20years.WindpowercapacityinChinahasdoubledineachofthepastfiveyears(Figure6.3).Withtotalinstalledcapacityof5.9GWattheendof2007,Chinahadalreadysurpasseditsgoaltoachieve5GWby2010.Withnewinstallationsof6.3GWandatotalinstalledcapacityof12.2GWin2008,ChinaovertookIndiainwindpowerinstallations.During this process, local wind turbine makers—such as Sinovel Wind,Goldwind Science andTechnology and Dongfang Electric—accounted for anincreasingshareoftotalnewinstallations.Together,theynowsupplymorethan50 per cent of a market dominated by foreign firms until 2008. Sinovel andGoldwindarenowamongtheworld’stop-fiveturbinemanufacturers.

In its response to theeconomiccrisis, theChinesegovernmenthas identifiedthe development of wind power as an area of economic growth. With newinstallations of 13.8 GW in China—relative to that of 10 GW in the UnitedStates—ChinaovertooktheUnitedStatesastheworld’stopwindpowermarketin2009.Withatotalinstalledcapacityof25.8GW,ChinaslippedpastGermanyto take second place in total wind power installations in 2009 (GlobalWindEnergyCouncil2010).WhiletheUnitedStatescontinuestohaveacomfortablelead in terms of total installed capacity, at this growth rate of new capacityinstallations,ChinawillovertaketheUnitedStatesin2010tobecomethegloballeaderininstalledcapacityandwillhavemetits2020targetof30GW10yearsaheadofschedule.Indeed,since2008,Chinahasbeenplanninganddesigningthe ‘mega-windpowerbaseprogram’,whichaimstobuildacombinedwindcapacityof127.5GWby2020insixselectedChineseprovinces.ThisprogramisexpectedtoincreaseChina’stotalinstalledcapacityofwindpowerto150GWormoreby2020—fivetimesthe30GWtargetsetaslateasSeptember2007.


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Figure 6.3 Cumulative installed wind power capacity by country, 1980–2009

Sources:BasedondatafromGlobalWindEnergyCouncil2010,Global Wind 2009 Report,March,GlobalWind Energy Council, Brussels, <http://www.gwec.net/fileadmin/documents/Publications/Global_Wind_2007_report/GWEC_Global_Wind_2009_Report_LOWRES_15th. per cent20Apr..pdf>; EarthPolicy Institute 2008, Global Wind Power Capacity Reaches 100,000 Megawatts, 4 March, Earth PolicyInstitute,Washington,DC,<http://www.earth-policy.org/Indicators/Wind/2008.htm>

With both power demand and new installations of wind power capacityincreasingfasterthanplanned,andfurtherdeteriorationoftheenvironment,Chinaissettoraiseitswindpowertarget.Thecountrynowaimstohaveatleast100GWofwindpowercapacity inoperationby2020.Thisrevisedtarget is70GWhigherthanthecurrenttarget,fourtimesitscurrenttotalwindpowercapacityandmorethantheUnitedKingdom’sentirecurrentpowercapacity.Inaddition,theNDRCenactedfeed-intariffsforwindpower,whichtookeffecton1August2009.Thismeanstheendofthecontroversialbidding-basedprogramthathadbeen inplace since2003.According to thequalityofwind energyresourcesandtheconditionsofengineeringconstruction,fourwindenergyareasareclassifiedthroughoutChina.Accordingly,on-gridtariffsaresetatRMB0.51,RMB0.54,RMB0.58andRMB0.61perkilowatthour(kW.h)asbenchmarksforwindpowerprojectsacrossthenation(NDRC2009).ThelevelsarecomparablewiththetariffstheNDRCapprovedinthepastseveralyearsinmostregionsandare substantiallyhigher than those set throughbidding.By letting investorsknowtheexpectedrateofreturnontheirprojectsthroughannouncingon-gridtariffs, the Chinese government aims to encourage the development of windenergy resourcesofgoodquality. In themeantime, thiswill encouragewind


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powerplantstoreducethecostsofinvestmentandoperationandincreasetheireconomic efficiency, thus promoting the healthy development of the wholewindindustryinChina.

It should be emphasised, however, that while China has established a veryambitiouswindpowertarget,manylocalpowergridsaresimplytoosmalltocarryall thewindpowerbeinggenerated.Windturbinesoftenhave towaitfourmonthsormorebeforetheyarehookeduptothepowergrid.Of5.9GWoftotalinstalledcapacityattheendof2007,only4GWwerepluggedintothegrid(Cyranoski2009).Inthefirstquarterof2010,theamountofwindpowernotusedbecauseitwasnothookedintothegridsreachedalmost0.3terawatthours(TW.h).This is a significantamountofgeneration,given that the totalwindpowergenerationreachedonly0.5TW.hinthesameperiod(Chen2010).Thus,Chinaneedstoimproveitspowergridsandcoordinatethedevelopmentofwindpowerwiththeplanningandconstructionofpowergrids.Newtransmissionlineswillhavetobeconstructedasmorewindfarmsarebuilt.Moreover,giventhesignificantlyincreasedwindpowercapacityplannedfor2020,Chinashouldnowplacemoreemphasisoncompaniesensuringtheactualflowofpowertothegridratherthanjustmeetingcapacity.Improvingthequalityofdomesticallymadeturbinesiscrucialforthisendeavour.Whilelesscostly,domesticChinesewindturbinesbreakdownmoreoftenandhaveoverallcapacityfactorsseveralpercentage points lower than foreign models. This few percentage pointsdifferencecouldmakeadifferencebetweenawindfarmthat iseconomicallyviableandonethatisnot.

China’s proposed carbon intensity target: ambitious or business as usual?

Justbefore theCopenhagenclimate summit,Chinapledged tocut its carbonintensityby40–45percentby2020relativetoits2005levels.Alotofdiscussionhas since focused on whether such a pledge is ambitious or just representsbusinessasusual (forexample,Qiu2009).Chinaconsiders itveryambitious,whereassomeWesternscholars(forexample,Levi2009butnotGarnautetal.2009)viewitasjustbusinessasusual.Thereareseveralwaystoevaluatethisissue.

Onewayis toseewhetherthisproposedcarbonintensitygoal for2020 isaschallenging as the energy-saving goals set in the current eleventh five-yeareconomicblueprint.This requiresfirst the establishment ofwhy the current20 per cent energy-saving goal is considered very challenging. As discussedearlier,ChinasetagoalofcuttingenergyuseperunitofGDPby20percentby2010relativetoits2005levels.In2006—thefirstyearofthisenergyefficiency


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drive—whileChinareversedtheriseinitsenergyintensityinthefirsthalfoftheyear,energyintensitydeclinedbyonly1.8percentovertheentireyear.Althoughthisdeclinewasafirstsince2003,itwasfarshortofthetargeted4percent.Amongthe31Chineseprovincesorequivalent,onlyBeijingmetthatenergy-savinggoalin2006,cuttingitsenergyuseperunitofGDPby5.3percent,followedbyTianjin,anothermetropolitancityinChina,withanenergyintensityreductionof4percent,Shanghaiby3.7percent,Zhejiangby3.5percentandJiangsuby3.5percent(NBSetal.2007).3In2007,despiteconcertedeffortstowardssavingenergy,thecountrycutitsenergyintensityby4percent(NBSetal.2009).Beijingcontinuedtotakethelead,cuttingitsenergyintensityby6percent, followedbyTianjinby4.9percentandShanghaiby4.7percent(NBSetal.2008).ThisclearlyindicatedBeijing’scommitmenttothe2008‘Green’OlympicGames.Inthemeantime,however,thereweresevenprovinceswhoseenergy-savingperformanceswerebelowthenationalaverage.Thefirstyear inwhichChinaexceededtheoverallannualisedtarget (4.4percent) forenergysavingswas2008,whenitcutitsenergyintensityby4.6percent(NBSet al. 2009).This was due partly to the economic crisis that reduced overalldemand—in particular, the demand for energy-intensive products. Overall,energyintensitywascutby10.1percent inthefirst threeyearsof theplanrelativeto2005levels.Thissuggeststhatthecountryneedstoachievealmostthesameoverallperformanceintheremainingtwoyearsasitdidinthefirstthreeyearsinordertomeetthatnationalenergyintensitytarget.Moreover,asdiscussedinthenextsection,thesereductionsinChina’senergyintensityhavealreadyfactoredintherevisionsofChina’sofficialGDPdatafromthesecondnationwide economic census—part of the government’s continuing efforts toimprovethequalityofitsstatistics,theaccuracyofwhichhasbeenquestionedbymanyinsideandoutsideChina.SuchrevisionsshowthatChina’seconomygrewfasterandshiftedmoretowardsservicesthanpreviouslyestimated,thusbenefitingtheenergy-intensityindicator.Evenso,itwillnotbeeasyforChinatoachieveits20percentenergy-savinggoal.Thenewcarbonintensitytargetsetfor2020requiresanadditional20–25percentreductioninemissionsintensity,ontopoftheeffectsoftheexistingenergyintensitytarget.AchievingthiswillclearlybeevenmorechallengingandcostlyforChina.

How far does this carbon intensity target drive China’s emissions below itsprojectedbaselinelevels?Ifthisismet,doesChinaplayitsproportionatepartinacoordinatedglobalcommitmenttostabilisetheconcentrationofgreenhousegas emissions in the atmosphere at the desirable level? The World Energy Outlook 2009 (IEA 2009b) has incorporated many policies into the baselineprojectionthatwerenotincorporatedintheWorld Energy Outlook 2007 (IEA2007).ThisprojectionputsChina’sbaselinecarbonemissionsat9.6gigatonnes

3 See Zhang (2007a, 2007c, 2007d) for detailed discussion of why Beijing recorded the most success inachievingitsenergy-savinggoals.


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ofcarbondioxide(GtCO2)in2020.Undertheambitious450partspermillion(ppm)ofcarbondioxideequivalentscenario,China’scarbondioxideemissionsareprojectedtobe8.4GtCO2by2020—1.2GtCO2lessthanthatinthebaseline(IEA 2009b). Now let us put China’s proposed carbon intensity target intoperspective.Myowncalculationsshowthatcuttingcarbonintensityby40–45percentintheperiod2006–20wouldbringreductionsof0.46–1.2GtCO2in2020,whichisequivalenttoadeviationof4.8–12.7percentbelowtheWorld Energy Outlook 2009 baseline set for China in 2020.Two key points need tobemade.First,eventhe lowerendofthatrangedoesnotrepresentbusinessas usual, because it represents a deviation of 4.8 per cent below the World Energy Outlook 2009 baselinelevels.Second,ifChinawereabletomeetitsownproposed45percentcarbonintensitycut,thecountrywouldcut1.2GtCO2ofemissionsin2020fromitsbaselinelevels,asisrequiredundertheambitious450ppmscenario.Thatisequivalentto31.6percentofwhattheworldwouldneedtodoin2020underthe450ppmscenario—asharehigherthanChina’sshareoftheworld’stotalcarbondioxideemissions(28percentin2020).Clearly,thehighendofChina’starget,ifmet,alignswiththespecifiedobligationthatChinaneedstofulfilunderthe450ppmscenario.

Arguably, China will claim to meet its carbon intensity target as long as itcutsitscarbonintensityby40percentintheperiod2006–20.Thisraisesthestringencyissueofthisproposedintensityreduction.TheIEA(2009b)estimatesthat national policies under consideration in China will bring reductions ofabout1GtCO2in2020.Thissuggestsacarbonintensityreductionof43.6percent in2020 relative to its2005 levels, implying that the lowendofChina’scarbon intensity target isconservative. Is itabigdeal toemphasise this fewpercentagepointsdifference?Itmightnotmattermuchforasmallcountry,butforChinaitmattersagreatdeal.

IsthereroomforChinatoachieveadditionalreductionsincarbonintensityby2020,beyonditsowntargets?Itwouldbehard,butnotimpossible.GiventhatmanyofthepoliciesconsideredintheWorld Energy Outlook 2009 thatwillcutemissionsof1GtCO2in2020fromitsbaselinelevelsarenotparticularlyclimatemotivated,Chinacouldacceleratethespeed,andscaleuptheimplementation,of such policies and enact additional policies with explicit considerations ofclimatemitigationandadaptation.Thiswouldbringadditionalreductions inChina’scarbonintensity.

What,then,istheyardstickorboundontheenergyandcarbonintensityofthe Chinese economy in 2020? Assuming that China’s economy grows at theannual average rate of 7.6 per cent used for the World Energy Outlook 2009 andthatChinaisabletolimitthegrowthofenergyusetohalfthegrowthrateof theeconomybetween2006and2020,China’senergyuseperunitofGDPwouldbe cutby42per centby2020, relative to its 2005 levels.Thisback-


113

of-the-envelopecalculationassumesanincomeelasticityofenergydemandof0.5between2006 and2020—as itwas roughlyduring the1980s and1990s.GiventhatChinaexperiencedfasterenergyconsumptiongrowththaneconomicgrowthbetween2002and2005,thiselasticityis,however,likelytobehigherinthefuture,whichwillresultinhigheremissionsgrowth.Thus,a42percentcut in China’s energy intensity by 2020 relative to 2005 levels is consideredanupperboundonChina’s energy intensity target.Withcarbon-freeenergymeeting7.1percentofChina’stotalenergyneedsin2005(NBS2009)andthatsharemandatedtobeincreasedto15percent,this42percentcutinenergyintensityisequivalenttoa50percentcutincarbonintensitybetween2006and2020,implyingthatthereisroomforChinatoincreaseitsownproposedcarbonintensityreduction.Chinashouldthereforeaimfora46–50percentcutinitscarbonintensityintheperiod2006–20.TheIntergovernmentalPanelonClimateChange(IPCC2007)recommendsdevelopingcountriesasagrouplimittheirgreenhousegas emissions to15–30per centbelow theirbaseline levelsby2020.This46–50percentcarbon intensityreductionwill lead toChina’semissions reductions of 15–21 per cent compared with its baseline levels in2020.ThatwillputChina’sabsoluteemissionsreductionsverymuchwithintheIPCC’srecommendedlevels.

China’s energy and GDP statistics: reliability issues

Having an ambitious commitment is one thing. Fulfilling that commitmentisanother.While the levelofChina’scommitments iscrucial inaffecting thelevelandambitionofcommitmentsfromothercountries,itismoreimportanttoknowwhethertheclaimedcarbonemissionsreductionsarereal.ThisraisesreliabilityissuesconcerningChina’sstatisticsonenergyandGDP.

China is not known for the reliability of its statistics (for example, Rawski2001). China’s refusal to budge on demands by the United States and otherindustrialisedcountriesforgreatertransparencyandchecksatCopenhagenwascitedbynegotiatorafternegotiatorasakeyblocktoreachingadeal.AslongasChina’spledgesareintheformofcarbonintensity,thereliabilityofemissionsandGDPdatamatter.

Assuming the fixed carbon dioxide emissions coefficients that convertconsumption of fossil fuels into carbon dioxide emissions, the reliability ofemissionsdatadependsonenergyconsumptiondata.UnliketheenergydataintheindustrialproducttablesintheChina Statistical Yearbook,thestatisticsonprimaryenergyproductionandconsumptionareusuallyrevisedintheyearafter theirfirst appearance.Aswouldbe expected, the adjustmentsmade to


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productionstatisticsarefarsmallerthanthosemadetoconsumptionstatistics,because it is easier to collect information on the relatively small number ofenergyproducerscomparedwiththelargenumberofenergyconsumers.Table6.3showsthepreliminaryandfinalvaluesfortotalprimaryenergyconsumptionandcoalconsumptioninChinabetween1990and2008.Until1996,revisionsoftotalenergyusefigureswereseveraltimessmallerthaninthelate1990sandearly 2000s.The preliminary figures for total energy use in 1999–2001 wererevisedupwardsby8–10percent.Inallthreeyears,theseadjustmentsweredriven by upward revisions of 8–13 per cent made to the coal consumptionfigurestoreflectunreportedcoalproductionmainlyfromsmall,inefficientandhighlypollutingcoalmines.Thesecoalmineswereorderedtoshutdowninawidely publicised nationwide campaign beginning in 1998, although manyhad reopened because in many cases local governments had pushed back topreservelocaljobsandgeneratetaxrevenuesaswellasforpersonalpay-offs.Inrecentyears,preliminaryfiguresforenergyusearealmostthesameasthefinalreportedones.

Table 6.3 Preliminary and final values for total primary energy consumption and coal consumption in China, 1990–2008

Year Total primary energy consumption Total coal consumption

Preliminary value(mtce)

Final value (mtce)

Adjustment (%)

Preliminary value (mtce)

Final value (mtce)

Adjustment (%)

1990199119921993199419951996199719981999200020012002200320042005200620072008

98010231089111712271290138814201360122012801320148016781970223324632656

2850*

98710381092116012271312138913781322133813861432151817502032224724632656

0 .71 .40 .23 .80 .01 .70 .1

–3 .0–2 .8

9 .78 .28 .52 .64 .33 .20 .60 .00 .0

741777816814921968

10411044

974819858884978

11261334153917091846

1958*

752790826866921979

1038988920925939955

100611971382155317091846

1 .51 .61 .36 .50 .01 .1

–0 .3–5 .3–5 .513 .0

9 .58 .02 .96 .33 .60 .90 .00 .0

mtce=milliontonnesofcoalequivalent

*Dataforenergyandcoalconsumptionin2008arepreliminaryvalues.

Source: Based on National Bureau of Statistics (NBS) various years, China Statistical Yearbook, ChinaStatisticsPress,Beijing.


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Similarly,ChinafirstreleasesitspreliminaryGDPfiguresandthenrevisesthem.TherevisedGDPfiguresfortheyears2005–08aresubjecttofurtherverificationbased on the second agricultural census released in February 2008 and thesecondnationwideeconomiccensusreleasedinDecember2009.WithupwardrevisionsofbothGDPandtheshareofservices,thereisabigvariationbetweenthepreliminaryvalueofChina’senergyintensityandthefinalreportedone.AsshowninTable6.4,suchrevisions leadtoadifferentialbetweenpreliminaryandfinalvaluesaslargeas45.5percentforenergyintensityin2006.Withthegovernment’scontinuingeffortstoimprovethequalityofChina’sstatistics,suchdifferentialswillbecomelessimportant.

Table 6.4 Reduction in China’s energy intensity: preliminary value versus final value (per cent)

Year Preliminary value Revised value Final value Differential between preliminary and

final values 2006200720082009

1 .23 (March 2007)3 .27 (March 2008)4 .59 (June 2009)

3 .98b (March 2010)

1 .33 (July2007)3 .66 (July 2008)5 .2a (Dec 2009)

1 .79 (July 2008)4 .04 (June2009)

45 .523 .513 .3

a)BasedonChina’s revised2008GDP from the secondnationwideeconomic census,which raised thegrowthrateofGDPto9.6percentfromthepreviouslyreported9percentforthatyearandtheshareofservicesinGDP.

b)Author’sowncalculationbasedontheNDRC’sreportingthatChina’senergyintensitywascutby14.38percentinthefirstfouryearsoftheeleventhfive-yearplanrelativetoits2005levels(XinhuaNet2010,‘NDRC: the 11th five-year pollution-cutting goals met ahead of the schedule’, Xinhua Net, 10 March,<http://news.sina.com.cn/c/2010-03-10/152019834186.shtml>).

Note:Thedateswhenthecorrespondingdatawerereleasedareinparentheses.

Fromtheprecedingdiscussion,itfollowsthatGDPfiguresareevenmorecrucialtotheimpactsonenergyorcarbonintensitythanareenergyconsumptionandemissionsdata.InCopenhagen,Chinaeventuallycompromisedtoagreetoopenitsemissionsdatatointernationalconsultationandanalysis.TheEuropeanUnionhas identified building a robust and transparent emissions and performanceaccountingframeworkasakeyelementofimplementingtheCopenhagen Accord (EuropeanCommission2010).Howall thiswillbeworkedout remains tobeseen.ChinahasnotagreedtoopenitsGDPfigurestointernationalconsultationandanalysis.AslongasChina’scommitmentsareintheformofcarbonintensity,establishing a robust and transparent emissions andperformance accountingframework ishelpful,butnotenoughtoremove internationalconcernaboutthereliabilityofChina’scommitments.TheaforementionedrevisionsofChina’sGDPfiguresreflectpartofthegovernment’scontinuingeffortstoimprovetheaccuracy and reliability of China’s statistics on economic activity. They arecertainlynotbeingcalculatedtomaketheenergyintensityindicatorlookgoodto


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thegovernment’sadvantage,althoughpracticallytheydobenefitthisindicator.Still,suchrevisionshavehugeimplicationsformeetingChina’sexistingenergy-savinggoalin2010anditsproposedcarbonintensitytargetin2020.

Central–local relations, energy savings and emissions reductions

GivenChina’svastsizeanddiversity,itisimpossibleforthecentralgovernmentinBeijing tooperate single-handedly inpursuingnationwideenergysavingsand environmental outcomes. The ability of, and incentives for, lower-levelgovernments to effectively implement energy-saving and pollution-cuttingpoliciesisthereforecritical,particularlysincethepastthreedecadesofeconomicreformshavewitnessedashiftinthecontroloverresourcesanddecisionmakingtolocalgovernmentsandenterprises.

This devolution of decision making to local governments has placedenvironmentalstewardshipinthehandsoflocalofficials.Theyareconcernedprimarilywitheconomicgrowth,becauseunderthecurrentevaluationcriterionforofficialsinChina,localofficialstypicallyhavebeenpromotedbasedonhowquickly they expand their local economies. This distorted incentive systemtemptsofficialstodisregardtheenvironmentalcostsofgrowth.Moreover,thecurrentfiscalsysteminChinaplaysapartindrivinglocalgovernmentstoseekhigherGDPgrowthbecausethatsystemmakesithardtoreconciletheinterestsof the central and local governments (Zhang2007c, 2007d, 2009a). Since theTaxSharingSystem(TSS)wasadoptedinChinain1994,taxesaregroupedintothosecollectedbythecentralgovernment,thosecollectedbylocalgovernmentsandthosesharedbetweenthecentraland localgovernments.All those taxesthat have steady sources and broad bases and are easily collected—such astheconsumptiontax,tariffsandthevehiclepurchasetax—areassignedtothecentralgovernment.TheVATandincometaxaresplitbetweenthecentralandlocalgovernments,with75percentofVATand60percentofincometaxgoingtothecentralgovernment.Asaresult,centralgovernmentrevenueincreasedby200percentin1994relativetoits1993level.Thisledthecentralgovernment’sshareintotalgovernmentrevenuetogoupto55.7percentin1994from22percentinthepreviousyear,whileitsshareintotalgovernmentexpenditurerosebyjust2percent.By2008,localgovernmentsaccountedforonly46.7percentof totalgovernment revenue,while their expenditureaccounted for78.7percentofthetotalgovernmentexpenditureinChina.Tocovertheirexpenditureforcultureandeducation,supportingagriculturalproduction,socialsecurityandsoon,localgovernmentshavelittlechoicebuttofocusonexpandinglocal


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production.Thisinturnenablesthemtoenlargetheirtaxrevenuebycollectingarangeoftaxes,includingurbanmaintenanceanddevelopmenttax,contracttax,arablelandoccupationtaxandurbanland-usetax.

Anotherexampleofdistortionsassociatedwiththetax-sharingschemeinChinais related todifferentiated tariffs.TheNDRCorderedprovincialgovernmentsto raise power tariffs for eight energy-guzzling industries from 1 October2006onwards(Table6.5),butmanylocalgovernmentsfailedtoimplementthedifferentiatedtariffsthatchargedmoreforcompaniesclassifiedas‘eliminatedtypes’or‘restrainedtypes’intheseindustries,with14ofthemevencontinuingtoofferpreferentialpowertariffsforsuchindustries.Thereasonforthisfailureisthelackofincentivesforlocalgovernmentstoimplementthispolicy,becauseall of the revenuecollected from these additional chargesgoes to thecentralgovernment.Toprovideincentivesforlocalgovernments,theserevenuesshouldbeassignedtolocalgovernments,withthecentralgovernmentrequiringlocalgovernments touse the revenue specifically for industrialupgrading, energysavingsandemissionscutting(Zhang2007c,2007d,2008,2009a).

Table 6.5 Differentiated tariffs for eight energy-guzzling industries in China (RMB/kW.h)

Existing additional

charge

Additional charge since 1 October

2006

Additional charge since 1 January

2007

Additional charge since 1 January

2008 Eight energy-guzzling industries

Eliminated types

0 .05 0 .10 0 .15 0 .20

Restrained types

0 .02 0 .03 0 .04 0 .05

Source: National Development and Reform Commission (NDRC) 2006b, Suggestions for improving thepolicy on differentiated tariffs, September, National Development and Reform Commission, Beijing,<http://www.gov.cn/zwgk/2006-09/22/content_396258.htm>

The evidence above suggests the need to carefully examine those objectiveand subjective factors that lead to the lack of local officials’ cooperation onenvironmentalprotectionandtoprovidetherightincentivesforcooperation.Onewaytoensurelocalofficialsrealisethattheyshouldtaketheenvironmentaldimensionsoftheirjobsseriouslyisdevelopingcriteriathatincorporateenergyconservation and environmental performance into the overall evaluation oflocalofficials’performances.Asdiscussedearlier,toensuretheenergy-savinggoalunderthe‘Top1000EnterprisesEnergyConservationActionProgram’isreached,achievingenergyefficiencyimprovementshasbecomeacriterionforjobperformanceevaluationsoftheheadsoftheseenterprises.Thisperformance-based approach should be strengthened and extended to ensure that localofficialsareheldaccountableforenergysavingsandpollutioncuttingintheir


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regions.TheevaluationoflocalofficialsshouldabandonthesolefocusonGDP.Instead,evaluationneedstolooknotonlyattheeconomicgrowthofaregion,but even more at the model and quality of its development.There are someencouragingsignsinthisdirection,buttheyfallfarshortoftheneeds,giventhehugechallengesChinaisfacing.

Alleviatingthefinancialburdenoflocalgovernmentsisanotheravenuetoprovideincentives for them to focus on objectives beyond economic growth alone.Enlargingtheirtaxrevenueisthekeytohelpingthemcoveradisproportionateamountoftheaforementionedgovernmentexpenditure.Thecentralgovernmentneedstocultivatesteadyandsizeablesourcesofrevenueforlocalgovernments.Enactingpropertytaxesorrealestatetaxesfor localgovernments isurgentlyneeded. In theTSS adopted in 1994, resource taxes onshore are assigned tolocalgovernments,whilethecentralgovernmentcollectsrevenuefromresourcetaxesoffshore.Currently,resourcetaxesinChinaareleviedonthebasisoftheextractedvolumeofresources.Startingin1984,resourcetaxeshavebeenleviedatRMB2–5pertonneofrawcoalandRMB8/tofcokingcoal,withtheweightedaverageofRMB3.5/tofcoal.Forcrudeoil,thecorrespondingtaxisleviedatRMB8–30/t.Whilethepricesofcoalandoilhaveincreasedsignificantlysince1984,thelevelsoftheirresourcetaxeshaveremainedunchangedforthepast25years.Inaddition,currentresourcetaxesareleviedononlyseventypesofresources,includingcoal,oilandnaturalgas.Thiscoverageistoonarrow,fallingfarshortofwhatisrequiredtoconserveresourcesandprotecttheenvironment.Thus,broadening thecurrentcoverageof resource taxationandsignificantlyincreasingtheleviedlevelbasedonrevenuesratherthanvolumeswillalsohelpto increase local governments’ revenueswhile contributing to environmentalconservation.

Conclusions

China achieved a quadrupling of its GDP with only a doubling of energyconsumption between 1980 and 2000. Since 2002, however, the country hasexperienced faster energy consumption growth than economic growth. Toreverse this trend, China has incorporated for the first time in its five-yeareconomicplananinputindicatorasaconstraint—requiringthatenergyuseperunitofGDPbecutby20percentduringtheeleventhfive-yearperiodrunningfrom2006to2010.Thisiswidelyconsideredanimportantsteptowardsbuildingaharmonioussocietythroughscientificdevelopment.Despitesignificanteffortstowardssavingenergy,reducingpollutionandpromotingthewidespreaduseofrenewableenergyinthepastfouryears,Chinahashadlimitedsuccesstodateinachievingthisgoal.


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Whilefacingthisgreatchallengeathomeandinternationalpressurefrominsideandoutsideinternationalclimatenegotiationstobemoreambitiousinlimitingitsgreenhousegasemissions,justbeforetheCopenhagenclimatesummit,Chinapledged tocut itscarbon intensityby40–45percentby2020relative to its2005levels.ThisunilateralcommitmentclearlyindicatesChina’sdeterminationtofurtherdecoupleitscarbonemissionsfromeconomicgrowth.Theproposedcarbonintensitytargetcertainlydoesnotjustrepresentbusinessasusual,assomeWesternscholarshaveargued,becauseeventhelowerendofthattargetrepresents a deviation of 4.8 per cent below the World Energy Outlook 2009 baseline levels,not tomentionadeviationof12.7percentbelowtheWorld Energy Outlook 2009 baseline levels at the higher end. On the other hand,nationalpoliciesunderconsiderationinChinabeforetheannouncementofitscarbonintensitytargetwouldalreadyhaveledtoacarbonintensityreductionof43.6percentin2020relativetoits2005levels.GiventhatChinaisalreadytheworld’slargestcarbonemitteranditsshareintheworld’stotalemissionscontinues to rise, even a few additional percentage point reductions in itscarbon intensity reduction have important implications for global emissions.It ishard,butnot impossible forChina to increase itsownproposedcarbonintensityreductiontarget.WesuggestthatChinashouldaimfora46–50percentcutinitscarbonintensityintheperiod2006–20.ThatwouldputChina’sabsoluteemissionsreductionsverymuchattheIPCC’srecommendedlevelsfordevelopingcountries.

China’sproposedcarbonintensitytargetneedsnotonlytobeseenasambitious,butmore importantly itneedstobecredible.Ascertainingwhetherornot itiscredible involves two issues.One iswhether theclaimedcarbonemissionsreductionsthemselvesarereal.ThisraisesreliabilityissuesconcerningChina’sstatisticsonenergyandGDP,giventhatChinaisnotknownforthereliabilityofitsstatistics.China’scompromiseatCopenhagentoagreetoopenitsemissionsdatatointernationalconsultationandanalysisisastart,althoughitremainstobeseenhowthiswillworkinpractice.AslongasChina’scommitmentsareintheformofcarbon intensity,establishingarobustandtransparentemissionsandperformanceaccountingframeworkishelpful,butnotenoughtoremoveinternationalconcernaboutthereliabilityofChina’scommitments.TherevisionsofChina’sGDPfiguresandenergyconsumptioninrecentyearsreflectpartofthegovernment’scontinuingeffortstoimprovetheaccuracyandreliabilityofChina’s statistics on economic activity and energy use. Such revisions showthat GDP figures are even more crucial to the impacts on energy or carbonintensitythanareenergyconsumptionandemissionsdata.Theyalsohavehugeimplications for meeting China’s existing energy-saving goal in 2010 and itsproposedcarbonintensitytargetin2020.


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Another issue iswhetherChina isreallyabletoachieveitstarget,giventhatChinahasfacedandcontinuestofacegreatdifficultymeetingitsown20percentenergy-savinggoalin2010.Chinaneedstofurtherstrengthenexistingpoliciesandmeasurestowardsenergysavings.Chinahasincreaseditspricesofgasolineanddieselandcutitstotalenergysubsidiesinrecentyearstoprovideincentivesforefficientfueluseandadoptionofcleantechnologiesthatreduceemissionsatsources.Althoughthisisencouraging,removingsuchsubsidiesisbutafirststep in getting the energy prices right. Further steps include incorporatingthecostofresourcesthemselvestoreflect theirscarcityandinternalisingthecostsofexternalities.Moreimportantly,Chinaneedstosignificantlyscaleupitseffortstowardsstrengtheningindustrialrestructuringinordertokeepthefrenziedexpansionofhighlyenergy-consuming,highlypollutingandresource-intensive industries under control. Moreover, given that China has shiftedcontrol over resources and decision making to local governments during thepast three decades, it is also crucial to ensure that local governments act inaccordance with centrally directed policies and have adequate funding toachievetheirownpolicygoals.

Finally,itshouldbeemphasisedthatenactingtheaforementionedpoliciesandmeasurestargetedformeetingChina’sexistingenergy-savinggoalin2010anditsproposedcarbonintensitytargetin2020signalsthegoodwillanddeterminationofChina’s leaders.To really achieve thedesiredoutcomes,however, requiresstrict implementationandcoordinationofthesepoliciesandmeasures,astheaforementioned development of wind power and its coordination with theplanning and construction of power grids have exemplified. This will be adecisive factor in determining the prospects for whether China will achieveitscarbonintensitytarget.Thereisnodoubtthatachievingthistargetposesa significantchallenge forChina.Thewholeworld iswaiting toseewhetherChinacanturnthischallengeintoawin-winoutcomeforChinaandforglobalclimatechange.

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Prospects for diminishing regional disparities 7

Jane Golley

Introduction

In the three decades since Deng Xiaoping declared that China’s economicdevelopment would necessarily involve some people becoming rich beforeothers, inequalities have risen steadily across (and within) China’s provincesandregions.Tosomeextent,thisoutcomehasbeenthenaturalconsequenceofmarketforcesinalargedevelopingeconomyinwhichthenumeroushistoricalandgeographicaladvantagesoftheeasternregionensuredthatindustrialisationwouldoccurthereaheadoftherestofthecountry.Deng’sOpenDoorPolicyand, later, the Coastal Development Strategy, compounded these advantageswitharangeofpreferentialpoliciesthatexplicitlypromotedthedevelopmentoftheeasternregionaboveallelse.YetDenginsistedthattherewouldbe‘nopolarisation of rich and poor’ in the longer term and that people elsewheresimplyneededalittlepatience,referringtothe‘twogreatsituations’inwhichcoastalprovinceswouldbegivenadvantagesduringtheearlyreformyearsbutwouldsubsequentlybeexpectedtosubordinatetheirintereststointeriorareas(Deng1987).

In late 1999, Jiang Zemin announced the Western Regional DevelopmentProgram (WRDP; ‘xibu da kai fa’), declaring that its implementation ‘is animportant move to carry out Comrade Deng Xiaoping’s strategic thinking of“twogreatsituations”,eliminateregionaldisparitiesgradually,consolidatetheunityofethnicgroups,ensureborderstabilityandsocialstabilityandpromotesocialprogress’.Takenfromthe‘OverallPlanofWesternRegionalDevelopmentDuringtheTenthFive-YearPlanPeriod’(2001–05).AseeminglyendlesslistofpoliciesandprojectshasbeenintroducedundertheWRDP,includingpoliciestopromoteinfrastructureandinvestment,protectthewest’sfragileecologyandenvironment,improvethequalityoftheworkforce,pushaheadwithenterpriseand structural reform, encourage east–west cooperation and acceleratedevelopmentinspecificindustrialsectorsandkeyprojectssuchastheWest–EastPowerTransmissionProjectandWest–EastGasPipelineProject.Forfurtherdetails, see the ‘Overall Plan’; Lai (2002); and Golley (2007).The time frame


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forachieving theambitious setofpolicygoalshasbeenset as themiddleofthetwenty-firstcentury,bywhichtimetheintentionisforregionaldisparitiesbetweenthewesternandotherregionstobe‘diminishedconsiderably’.

In2002,thenewlyappointedHuJintaoendorsedtheWRDPasanimportantcomponent of his drive for a ‘harmonious and balanced society’. As if this‘colossal systemic campaign’ was not enough—and perhaps partly to ensurethat he could lay claim to his own regional policy initiative as had hispredecessors—Huandhisteamformallylaunchedthe‘RevivetheNorth-East’(‘zhen xing dongbei’) scheme in2004,whichthey intendtorunalongside theWRDPthroughto2020.Inaddition,the‘RiseoftheCentralRegion’(‘zhongbu jue qi’)schemewasofficiallypronouncedinlate2005,althoughthereappearstohavebeenlittletofollowintermsofsubstantiveoridentifiableprogramswithinit(Chungetal.2009).Witheveryprovincebarthemostdevelopedeasternonesbeingtargetedinonewayoranother,theChineseCommunistPartyappearstobetakingtheregionalissueseriously—onpaperatleast.

Unevendevelopmentisnotonlyaneconomicissuebutanethicalone,particularlyfora regimewhose legitimacyhas longbeenbasedonegalitarianprinciples.Deng Xiaoping might have succeeded in convincing the Chinese people thatsomewouldhavetogetrichbeforeeveryoneelsecould,butifthegapbetweenthosefortunatesomeandtherestofthecountrycontinuestowiden,andifthegovernmentfailstodoanythingaboutthis,‘themoralfoundationsoftheregimewillbeshaken’(WangandHu1999:201).This,inturn,makesthequestionofregionalimbalanceanissueofgreatpoliticalsignificance.

ItisimpossibletosaywithanydegreeofcertaintyhowChina’sregionalpatternofdevelopmentwillunfoldinthenexttwodecades,hingingasitdoesonthecomplex interactionof amultitude of uncertainmarket forces anduncertainpolicy choices. Instead, this chapter first provides a snapshot of China’sregionalsituationasitstandsandreflectsonsomerecenttrendsinindustrialdevelopment.ItthenconsiderssomeofthetheoreticalandempiricalreasonsforoptimismandpessimismregardingthelikelihoodthattheChinese leadershipwillachievejustoneofitsregionalpolicygoals—thatofstimulatingindustrialdevelopmentinChina’svastinterior,andinthewestinparticular.Whilethechapterprovidessomeindicationthattheprocessofindustrialrelocationfromtheeastwestwardshasalreadybeguninsomesectors,thebalanceofevidencepresented here suggests that by 2030, in the absence of significant policyadaptation,disparitiesbetweenthewesternandotherregionsarelikelytohave‘diminishedmarginally’atbest.

Prospects for diminishing regional disparities

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Regional snapshot

At present, China comprises 31 ‘provincial units’, or provinces, centrallyadministeredmunicipalities(CAMs)andautonomousregions(Figure7.1).Thefour centrally administered municipalities are Beijing,Tianjin, Shanghai andChongqing. The five (designated ethnic) autonomous regions are Guangxi(Zhuang), Inner Mongolia, Ningxia (Hui), Tibet and Xinjiang (Uighur). Theterm ‘province’willbeusedgenerically todenote all of these.Thereare alsotwo special administrative regions—Hong Kong and Macau—which will beexcludedfromtheanalysis.Whilemanyalternativeregionalbreakdownsarepossible,thediscussionherefocusesmainlyonthethreemacro-regions:east,centreandwest.TheeastcomprisesthecoastalprovincesofLiaoning,Beijing,Tianjin, Hebei, Shandong, Jiangsu, Shanghai, Zhejiang, Fujian, GuangdongandHainan.ThecentrecomprisesHeilongjiang,Jilin,Shanxi,Henan,Anhui,Hubei,JiangxiandHunan,whilethewestcomprisesXinjiang,Gansu,Ningxia,Shaanxi, Qinghai, Sichuan, Guizhou, Yunnan, Tibet, Inner Mongolia andGuangxi.InnerMongoliaandGuangxiwerereclassified into the ‘west’at thestart of the WRDP in late 1999. All of the calculations below are based onthisnewclassification.Alternatively,thereissomereferenceto‘thecoast’—equivalenttotheeast—and‘theinterior’,comprisingthewestandthecentre.

Figure 7.1 Map of China


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Table7.1providesasnapshotofsomekeyindicatorsfortheeast,centreandwestin2007.Theeastoutperformstheothertworegionsinalltheindicatorsseenhere (andvirtuallyanyother indicatoronemight choose).The rankingfromeasttocentretowestisalsoconsistent,withthewesthometotheleasturbanised, least educated, poorest people with the lowest life expectancy. Itisalsotheregionmostdominatedbystateownershipof industry,producingaminiscule shareofnational exports andwith a tiny shareof foreigndirectinvestment (FDI)—three indicators that reveal it to be the least reformed ofChina’sregions.

Table 7.1 Regional snapshot, 2007

Indicator East Centre WestPopulation (million) 474 .8 461 .5 363 .0

Share of national population (%) 36 .5 35 .5 27 .9

Urban proportion of population (%) 55 .0 43 .3 37 .0

Percentage of population aged 6+ with:

Primary schooling or less 35 .8 36 .7 49 .0

Senior secondary schooling or higher 23 .0 20 .3 15 .6

Life expectancy (in 2000) 74 .3 71 .6 68 .4

Per capita GDP (RMB) 30 131 15 939 12 229

Regional share of industrial output produced by (%):

State-owned and shareholding enterprises 20 .3 44 .6 53 .0

Private enterprises 23 .7 23 .7 19 .5

Hong Kong, Macau, Taiwan and foreign-funded enterprises 41 .1 14 .5 10 .0

Share of national exports produced in (%) 88 .2 8 .0 3 .8

Share of foreign direct investment going to (%) 77 .2 14 .5 6 .1

Share of national total budgetary revenue (%) 59 .6 23 .1 17 .3

Share of national total budgetary expenditure (%) 44 .2 30 .1 25 .7

Sources:Author’s calculations andNationalBureauof Statistics (NBS) 2008,China Industrial Economic Statistical Yearbook 2008,ChinaStatisticsPress,Beijing.

Of course, there are significantdifferences inperformancewithin regions, asdemonstratedforpercapitagrossdomesticproduct(GDP)inTable7.2.In2007,thepercapitaGDPofShanghai,therichestprovince,wasnearly10timesthatofthepoorestprovince,Guizhou.InnerMongolia,onlyrecentlyreclassifiedintothewest,hadmorethantwicethepercapitaGDPofAnhuiandJiangxiinthecentre—justoneillustrationofthenon-linearassociationbetweenregionsandincomelevels.ItisworthnotingherethatwhileallofthewesternprovinceswiththeexceptionofTibethadbelow-averageratesofpercapitaGDPgrowthduringthe period 1994–2007 (and indeed during the first three decades of reform),withtheexceptionofXinjiangandYunnan,theyallperformedaboveaverage


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during the period 2000–07. Moreover, the increase in the west’s aggregatepercapitaGDPgrowth—from11.3percentto15percent—islargerthantheincreasefortheothertworegions,althoughonaveragethisresultedinvirtuallyequivalentgrowthrates forall threeregions in the latterperiod,rather thanthewestoutperformingtheothers.Itisimpossibletosaywhetherthisboosttogrowthrateshasbeencausedbytheshiftinregionalpolicyorotherfactors,butitdoesseemtosuggestthatsomethinghaschangedfortheregioninaggregate.Whetherthischangewilltranslateintosustainabledifferencesingrowthratesoverthelongertermremainstobeseen.

Table 7.2 Per capita GDP levels and growth ratesRegion Per capita GDP

(RMB) 2007Average annual growth rates (current prices)

1994–2000 Rank 2000–07 Rank

EastBeijing 58 204 13 .9 7 14 .6 19

Tianjin 46 122 14 .1 4 14 .4 22

Hebei 19 877 14 .3 3 14 .6 18

Liaoning 25 729 10 .7 24 12 .6 24

Shanghai 66 367 14 .7 2 9 .8 31

Jiangsu 33 928 12 .6 13 16 .3 8

Zhejiang 37 411 13 .9 6 15 .7 12

Fujian 25 908 13 .6 8 12 .2 28

Shandong 27 807 13 .5 10 16 .5 6

Guangdong 33 151 12 .4 14 14 .5 20

Hainan 14 555 6 .1 30 11 .3 30

CentreShanxi 16 945 10 .5 25 18 .6 2

Jilin 19 383 10 .8 23 16 .0 10

Heilongjiang 18 478 11 .6 18 11 .6 29

Anhui 12 045 11 .6 19 13 .8 23

Jiangxi 12 633 12 .6 12 14 .7 16

Henan 16 012 14 .0 5 16 .7 5

Hubei 16 206 13 .6 9 12 .3 27

Hunan 14 492 13 .1 11 14 .4 21

WestGuangxi 12 555 7 .7 29 16 .5 7

Inner Mongolia 25 393 11 .8 16 23 .3 1

Chongqing 14 660 - - 16 .1 9

Sichuan 12 893 11 .3 20 15 .2 14

Guizhou 6915 9 .4 28 14 .6 17


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Yunnan 10 540 10 .9 22 12 .4 26

Tibet 12 109 14 .9 - 15 .0 15

Shaanxi 14 607 11 .7 17 18 .1 3

Gansu 10 346 12 .2 15 15 .2 13

Qinghai 14 257 9 .8 27 15 .9 11

Ningxia 14 649 10 .3 26 17 .1 4

Xinjiang 16 999 11 .2 21 12 .5 25

Average 18 934 12 .3 13 .4

-zero

Sources: Author’s calculations and National Bureau of Statistics (NBS) various years, China Industrial Economic Statistical Yearbook,ChinaStatisticsPress,Beijing

In2007thewesthadanaverageannualpercapitaGDPofRMB12229—just40percentoftheeast’sRMB30131.Between2000and2007,thetworegionshadalmostidenticalaverageratesofpercapitaGDPgrowth(albeitwithsignificantvariationacrossprovincesinbothregions)ofabout15percentincurrentpriceterms.Inordertoclosetheeast–westincomegapcompletelyby2050,thewestwouldneedtogrowsubstantiallyfastereachyearthantheeast.Toillustratethispoint,fromtheirrespectivelevelsin2007,easternandwesternpercapitaincomeswouldbeequalisedin2050iftheeastgrewat10percentperannumthroughouttheperiodwhilethewestgrewat12.33percentperannum.Withthese average growth rates, by 2030 the west would still have a per capitaincome equal only to two-thirds of the east’s. Obviously, narrowing the gapmorequicklywouldrequireagreaterdivergenceinregionalgrowthrates.Thisbegsthekeyquestion:isthereanyreasontoexpectthewest(andthecentre)togrowfasterthantheeastduringthenexttwodecades,therebynarrowingthepercapitaincomegapbetweenregions?

Recent trends in industrial development

Disparities in industrial development have been a critical component of therisingregionalinequalitiessince1978.Figure7.2illustratesthedominanceoftheeasternregioninproducingChina’sgrossvalueofindustrialoutput(GVIO).From59.2percentofthetotalin1978,theeast’ssharerosesteadilytoapeakof72.4percentin2005,droppingmarginallyto70.4percentin2007.Withjust 36.4 per cent of the population, this translates into significantly higherper capita industrial output in the east than in the rest of the country. Is itpossiblethattheimprovementinthewesterngrowthrateofpercapitaGDPinrecentyearsreflectsmorerapidgrowthofindustrialoutputinthewestandaconsequentchangeintheregionaldistributionofindustrialoutput?


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Figure 7.2 Regional shares of GVIO (per cent)

Shift-shareanalysisshedssomelightonthisquestion.AsexplainedinanearlierChina Update (Golley2003),shift-shareanalysisdecomposesprovincialratesofindustrialoutputgrowthintothreecomponents.Inparticular,letΔYijdenotethechange inoutput forsector i inregion j fromthebaseperiod to theendperiod.Bydefinition,thisisequaltototaloutputofsectoriinregionjinthebaseperiod,Yij0,multipliedbythegrowthrateofsectoriinregionjoverthewholeperiod,Rij (Equation7.1).

Equation 7.1ΔYij =Yij0Rij

DenotingthenationalgrowthratesoftotaloutputandofsectoriasRkandRikrespectively,Equation7.1canbedecomposedintothreecomponents(Equation7.2).

Equation 7.2ΔYij=Yij0Rk+Yij0(Rik–Rk)+Yij0(Rij–Rik)

The first term on the right-hand side of Equation 7.2 is called the nationalcomponent of growth, as it shows the growth that would have resulted hadsector i inregion jexactlymatchedthenational trend (Rk).ThesecondterminEquation7.2isthestructuralcomponent,reflectingtheextenttowhichthechangeinsectoricanbeattributedtotheregion’sindustrymix;ifaregion’sindustrial structure is dominated by industries that are experiencing above-average rates of growth (higher Rik), it will experience faster output growththan the rest of the country.The third term in Equation 7.2 is the location(orresidual)component,asitmeasurestheextenttowhichsectoriinregionj grewfasterorslower thanthenationalgrowthrate for thatsector, therebyreflectinghowthelocalcharacteristicsofagivenprovinceinfluenceditsgrowth


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performance.RearrangingEquation7.2givesthenetrelativechange(NRC)forsectori inprovincej,whichisthedifferencebetweentherealchangeandthenationalcomponent(Equation7.3).

Equation 7.3NRCij=ΔYij –Yij0Rk=Yij0(Rik –Rk)+Yij0(Rij–Rik)

TheNRCshowswhethersectori inregionjexperiencedfasterorslowergrowthofindustrialoutputthanthenationalaverage,withapositivevaluereflectingtheformer.TheNRCcanthereforeberegardedasanindexofrelativeperformance,whichtheright-handsideseekstoexplain. It isalsopossibletocalculateanindustry-wideNRCforeachprovince(Equation7.4).

Equation 7.4NRCj=ΔYj–Yj0Rk=Yj0(Rk–Rk)+Yj0(Rj –Rk)

InEquation7.4,NRCjistheNRCforprovincej,andsoon.AsEquation7.4shows, the industry-wide NRC is accounted for entirely by the province’sindustry-wide location component, since the structural component becomeszero.DataaredrawnfromtheChina Industrial Economic Statistical Yearbook (NBS1995,2001,2008)for30provincesBecauseChongqingbecameanindependentprovincialunitonlyin1997,itisincludedinSichuanforthisanalysissothatthe two periods can be compared. and 36 industrial sectors, as listed in thetablesbelow,inordertoconducttwoshift-shareanalysesfortheperiods1994–2000and2000–07.Anumberofinterestingpointsemerge.

Table7.3presentstheindustry-wideNRCsandaverageannualgrowthratesforeachprovince and regionduring theperiod2000–07.Thisdemonstrates thefirstkeymessagecontainedinshift-shareanalysis:apositiveNRCisequivalentto a provincial growth rate that is above the national average annual rate ofgrowth (of22.3percent incurrentprices).Theeast’s and thewest’sgrowthratesareidenticalandmarginallyabovethenationalaveragecomparedwiththecentre’s,whichismarginallybelow.Thus,itdoesnotappeartobethecasethatrelativelyhighergrowthratesofindustrialoutputinthewesthaveunderpinnedthe improvement in its rates of economic growth.These regional aggregatesobviouslyobscureprovincial-levelresultsanditisworthnotingthatoftheeightprovincesinthecentre,fiveprovincesrecordedpositiveNRCs,whileofthe11easternprovinces,fiverecordednegativeNRCs.Thegeographicproximityoftheseeasternandcentralprovincesprovidessomeindication(althoughfarfrompureevidence)that industrialrelocationin linewiththeoreticalexpectationscouldalreadyhavebegun(discussedfurtherbelow).Theresultsforthewesternprovincesaremuchlesspromising,withjustthreeofthe11provincesrecordingpositiveNRCs.


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Table 7.3 Industry-wide NRCs and growth rates of industrial output, 2000–07

Region NRC (RMB100 000)

Average annual growth rate (%)

East 2458.3 22.4Beijing –2526 .4 18 .9

Tianjin –2250 .5 19 .4

Hebei 876 .4 23 .0

Liaoning –1870 .0 20 .9

Shanghai –7043 .3 18 .3

Jiangsu 3920 .7 23 .3

Zhejiang 4533 .9 24 .2

Fujian 349 .4 22 .7

Shandong 10 426 .9 25 .6

Guangdong –3999 .8 21 .2

Hainan 41 .1 22 .9

Centre -2968.0 21.7Shanxi 2125 .3 26 .8

Jilin –1324 .8 19 .6

Heilongjiang –5255 .8 13 .4

Anhui 69 .2 22 .4

Jiangxi 1783 .3 27 .1

Henan 3862 .7 25 .3

Hubei –4950 .8 16 .3

Hunan 722 .9 23 .5

West 509.6 22.4Guangxi –121 .2 21 .9

Inner Mongolia 2436 .0 30 .0

Sichuan 889 .1 23 .1

Guizhou –495 .1 19 .7

Yunnan –741 .6 20 .0

Tibet –38 .5 11 .9

Shaanxi 178 .5 22 .7

Gansu –674 .8 19 .5

Qinghai –106 .9 20 .5

Ningxia –65 .4 21 .4

Xinjiang –750 .2 19 .3

National total 0 .0 22 .3

Sources:Author’s calculations andNationalBureauof Statistics (NBS) 2001,China Industrial Economic Statistical Yearbook 2001,ChinaStatisticsPress,Beijing;NationalBureauofStatistics(NBS)2008,China Industrial Economic Statistical Yearbook 2008,ChinaStatisticsPress,Beijing.

Table 7.4 provides a different slant, by presenting the NRC and locationcomponentsfortheeast,centreandwestforeachofthe36industrialsectors


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for the period 2000–07. Note that all regions can record a positive NRC forsectorsthataregrowingabovethenationalaveragerateofgrowthofindustrialoutput (that is, thosesectorswithpositivestructuralcomponents),while theregionalsumoflocationcomponentsforeachsectormustbezero,reflectingastheydothelocationadvantagesforaparticularregioninaparticularindustry.ThenumberofnegativeNRCsfortheeasternregion,22,indicatesthatnotallindustrial sectors are performing above average in the region—and likewisethe number of negative location components for the east, 18, indicates thattheeast isnotcompletelydominating ineverysector.The18and15sectorsrecording positive location components in the centre and west, respectively,alsoindicatethatthetworegionshavesomethingpositivetoofferwithregardtothesesectorsatleast.Still,fortheotherregionstobeginmakingadentintheeast’sindustrialdominance—accountingasitdoesformorethan80percentofoutputin13sectorsandformorethan50percentofoutputin32sectors(Table7.5)—theyneedtoberecordingpositiveNRCsinsectorsinwhichtheeastisnot.Forthecentre,thiswasthecaseforfivesectorsduringtheperiod2000–07:non-ferrousmetalmininganddressing,non-metalmineralmininganddressing,foodprocessing,foodmanufacturingandspecial-purposeequipment.Inallofthesesectorsotherthannon-ferrousmetalmininganddressing,theeast’sshareofoutputfarexceedsthecentre’s,suggestingthatitwillbealongtimebeforeanykindofbalanced regionaldistributionofoutput is achieved, let alone aconcentrationofanyoftheseindustriesinthecentre.Asforthewest,thiswasalsothecaseforfiveindustries:foodprocessing,foodmanufacturing,leatherandfurs,petroleumprocessingandcokingandspecial-purposeequipment—sectors inwhich the regionproducesbetween4.5 and15.7per centof totaloutput,withtheexceptionofleatherandfurs.Notably,noneofthesesectorsisparticularlylabourintensivebutratherdominatesthecapital-intensiveendof the industrial spectrum—a point returned to further below.The share of‘compensationtoemployees’ intotalvalueaddedforeachsector isusedasameasureoflabourintensity,calculatedusingChina’sinput–outputtablefor44sectorsin2005.Thesesectorsdonotperfectlymapontothe36industrialsectorsusedhere,but thecalculations ranging from0.477 forgarments to0.091 forcrudepetroleumandnaturalgasareatleastindicativeoflabourintensitybysector.Norareanyofthesepotentiallypromisingsectorsforthecentreandwestparticularlylargeintermsoftheircontributiontonationaloutput,withnoneofthembeinginthetop-10industrialsectors.

Table 7.4 Regional NRCs and location components by sector, 2000–07

East Centre WestSector NRC Location NRC Location NRC Location


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Coal mining and dressing 425 .7 –660 .0 1618 .6 94 .1 1089 .6 565 .9

Petroleum and natural gas extraction

–2866 .9 –212 .7 –3045 .2 –614 .5 –646 .5 827 .2

Ferrous metal mining and dressing

812 .2 –0 .6 264 .4 –86 .4 264 .9 87 .0

Non-ferrous metal mining and dressing

–40 .7 –164 .4 305 .4 187 .8 98 .4 –23 .4

Non-metal mineral mining and dressing

–263 .3 –71 .8 10 .8 94 .8 –84 .9 –23 .0

Food processing –446 .5 –337 .7 89 .1 131 .9 181 .9 205 .8

Food manufacturing –1142 .2 –601 .2 120 .7 281 .8 244 .8 319 .4

Beverages –2312 .8 –407 .3 –589 .0 125 .3 –334 .2 282 .0

Tobacco –566 .3 321 .8 –857 .4 28 .1 –1689 .2 –349 .9

Textiles –3615 .1 896 .0 –1527 .8 –695 .8 –567 .5 –200 .1

Garments –3027 .1 –19 .4 –192 .3 28 .3 –56 .2 –8 .9

Leather, furs and down products

–1199 .7 –104 .1 –91 .6 16 .7 52 .3 87 .4

Wood products 96 .7 –201 .1 221 .7 144 .9 80 .4 56 .1

Furniture 657 .5 120 .2 –16 .8 –108 .7 26 .7 –11 .5

Paper making –728 .1 170 .6 –213 .1 –1 .3 –282 .9 –169 .2

Printing and recording medium production

–504 .4 67 .9 –128 .6 –6 .4 –177 .1 –61 .5

Cultural, educational and sports articles

–829 .3 –23 .2 –3 .4 22 .4 –1 .9 0 .8

Petroleum processing and coking

–2651 .8 –533 .1 –1479 .2 –701 .0 956 .7 1234 .1

Chemical materials 762 .4 1096 .0 –933 .8 –835 .6 –320 .4 –260 .3

Medical and pharmaceutical products

–1222 .8 24 .6 –448 .7 44 .0 –422 .8 –68 .6

Chemical fibres –1290 .7 198 .1 –405 .4 –169 .3 –95 .7 –28 .7

Rubber –215 .7 100 .9 –78 .0 –21 .4 –109 .6 –79 .5

Plastic –747 .6 19 .0 –83 .4 6 .8 –70 .0 –25 .8

Non-metal mineral products –1208 .9 57 .1 –284 .1 173 .8 –477 .4 –230 .9

Smelting and pressing of non-ferrous metals

8073 .5 857 .9 2184 .7 –120 .7 978 .7 –737 .3

Smelting and pressing of non-ferrous metals

3456 .2 –55 .0 2621 .6 534 .5 1604 .6 –479 .5

Metal products –415 .2 109 .6 –103 .1 –46 .7 –90 .6 –62 .9

Universal machines 3474 .3 367 .8 389 .2 –130 .0 88 .1 –237 .8

Special-purpose equipment –261 .3 –396 .5 117 .3 82 .2 327 .5 314 .4

Transportation equipment 2335 .0 1360 .8 –939 .8 –1423 .1 285 .4 62 .3

Electrical equipment and machinery

901 .0 –1 .4 120 .6 9 .7 47 .3 –8 .3


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Electronic and telecommunications equipment

4950 .3 1907 .1 –603 .1 –750 .2 –967 .5 –1157 .0

Instruments and meters 228 .6 66 .1 11 .9 –1 .4 –53 .7 –64 .6

Electric power, steam and hot water 2344 .2 –332 .5 1212 .9 103 .5 1010 .6 229 .0

Production and supply of gas 35 .3 –93 .2 –2 .8 –33 .8 146 .3 127 .0

Production and supply of tap water –538 .1 27 .5 –230 .3 –33 .7 –109 .0 6 .2


Finally, Table 7.6 provides a comparison of provincial-level results for thetwo different periods: 1994–2000 and 2000–07. Rather than presenting thedetailed numerical results for each province and sector, the table shows foreachprovincethenumberofsectorsthathadapositiveNRC(whetherdrivenlargelybystructureor location)andthenumberofsectors inwhichlocationmadeapositivecontributiontogrowth.Whileit isdifficulttomakeregionalgeneralisations given provincial-level variations in performance, it certainlyappearsthattheeasternprovinceshavegenerallyrecordedfewerpositiveNRCsand positive location contributions to growth in the 2000s compared withthe 1990s. Guangdong stands out, with the number of sectors with positiveNRCsfallingfrom22to12whilethenumberofsectorswithpositivelocationcomponentsfellfrom29to13.Itisnotalone,however,withBeijing,Tianjin,Hebei,Shanghai,ZhejiangandHainanalsorecordingfewerpositiveNRCsandlocationcomponents.Liaoningisthemostdramaticoutlierofthistrend,withthenumberofsectorsbenefitingfromlocatingthereincreasingfromjustthreein1994–2000to22in2000–07.(NotethatLiaoningisoneofthethreeprovincesincludedinthenorth-east,whichhashaditsownregionalpolicysince2003.)Insum,thisprovidessomeevidencethattheglorydaysoftheeasternregion’sindustrialdominancecouldbecomingtoanend—particularlywhencontrastedwiththeresultspresentedinGolley(2003).

Table 7.5 Regional shares of industrial output, 2007 (per cent)

Sector East Centre WestCoal mining and dressing 27 .5 49 .7 22 .9

Petroleum and natural gas extraction 37 .9 29 .7 32 .4

Ferrous metal mining and dressing 60 .6 22 .1 17 .4


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Non-ferrous metal mining and dressing 26 .9 40 .6 32 .5

Non-metal mineral mining and dressing 51 .5 31 .9 16 .7

Food processing 60 .1 25 .1 14 .8

Food manufacturing 59 .8 25 .4 14 .9

Beverages 50 .9 24 .5 24 .6

Tobacco 37 .1 29 .2 33 .8

Textiles 83 .8 10 .9 5 .4

Garments 91 .6 7 .1 1 .3

Leather, furs and down products 86 .4 9 .1 4 .5

Wood products 68 .9 23 .4 7 .7

Furniture 85 .5 9 .3 5 .3

Paper making 76 .1 17 .3 6 .6

Printing and recording medium production 73 .9 14 .8 11 .4

Cultural, educational and sports articles 95 .5 4 .2 0 .4

Petroleum processing and coking 63 .8 20 .6 15 .7

Chemical materials 71 .9 16 .8 11 .2

Medical and pharmaceutical products 59 .9 24 .2 15 .8

Chemical fibres 87 .9 9 .1 3 .0

Rubber 81 .4 13 .4 5 .2

Plastic 85 .3 10 .1 4 .6

Non-metal mineral products 64 .6 24 .4 11 .0

Smelting and pressing of ferrous metals 66 .8 20 .2 13 .1

Smelting and pressing of non-ferrous metals 45 .4 30 .1 24 .5

Metal products 87 .1 8 .9 4 .0

Universal machines 80 .6 12 .4 7 .0

Special-purpose equipment 70 .0 19 .9 10 .1

Transportation equipment 63 .0 23 .5 13 .5

Electrical equipment and machinery 84 .4 10 .4 5 .2

Electronic and telecommunications equipment 94 .9 2 .4 2 .7

Instruments and meters 88 .5 7 .1 4 .3

Electric power, steam and hot water 57 .3 24 .7 18 .0

Production and supply of gas 62 .4 13 .9 23 .7

Production and supply of tap water 68 .6 17 .4 14 .1

Total industrial output 70 .4 18 .1 11 .5

Sources:Author’s calculations andNationalBureauof Statistics (NBS) 2008,China Industrial Economic Statistical Yearbook 2008,ChinaStatisticsPress,Beijing.

Table 7.6 Shift-share analysis of provincial industrial growth

Positive NRC Positive location

Region 1994–2000 2000–07 1994–2000 2000–07

East


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Beijing 12 7 11 8

Tianjin 18 6 22 8

Hebei 18 10 20 9

Liaoning 8 16 3 22

Shanghai 19 5 14 5

Jiangsu 16 15 16 19

Zhejiang 24 22 27 26

Fujian 21 21 22 22

Shandong 16 26 15 27

Guangdong 22 12 29 13

Hainan 18 8 18 6

CentreShanxi 6 13 7 13

Jilin 11 11 9 13

Heilongjiang 11 4 5 5

Anhui 9 15 5 12

Jiangxi 5 26 4 27

Henan 18 25 22 30

Hubei 18 2 17 2

Hunan 11 21 7 21

WestGuangxi 6 13 2 15

Inner Mongolia 9 21 6 26

Sichuan 11 21 8 27

Guizhou 13 10 13 10

Yunnan 11 11 9 11

Tibet 12 2 12 4

Shaanxi 9 12 8 14

Gansu 13 7 12 9

Qinghai 10 14 11 17

Ningxia 15 12 16 15

Xinjiang 13 13 13 13


Oftheeightprovincesinthecentre,fiveincreasedthenumberofsectorswithpositiveNRCsandpositivelocationcontributions—mostmarkedlyinJiangxi(upfrom5to25andfrom4to27,respectively).ThesearethesamefiveprovincesthatrecordedpositiveNRCsattheindustry-widelevel.Theresultsforthewestaremixed.Curiously,thetwobiggestimprovementsovertimeintermsofthenumberofsectorswithabove-averageratesofgrowthareGuangxiandInner


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Mongolia—thetwoprovincesredefinedaswesternonlyintheearly2000s—althoughinthecaseofGuangxithiswasnotenoughtoensureapositiveNRCattheindustry-widelevel.Sichuan(includingChongqing)alsoappearstobeonthemove,andtoalesserextentQinghaiandShaanxi,whileTibet,Gansu,Guizhou and Ningxia all performed worse on both counts. Based on theseresults, there is little to suggest that theWRDP isproviding the impetus forindustrialdevelopmentintheregiontodate.Ofcourse,thisdoesnotimplythatitcannotprovidetheimpetusinthefuture.

Reasons for optimism

There are numerous reasons—theoretical and real—why Chinese regionalinequalitiescoulddiminishinthecourseofthenexttwodecades.Accordingtoneoclassicalgrowththeory,thehighratesofinvestmentgrowthunderpinningtheeast’srapidgrowthofindustrialoutputreducethemarginalproductivityof capital there and result in firms directing their investment elsewhere inChina,wheretherelativeratesofreturntoinvestmentwillbehigher.Modelsof ‘new’ economic geography, while underpinned by different mechanisms,tend to predict likewise that firms will eventually relocate to less-developedregions in order to take advantage of lower costs there (as long as transportcostsbetweenregionsfallbelowacertaincriticallevelandthereissomelabourimmobilitybetweenregions)(Krugman1991;PugaandVenables1996).Thesemodels are based on the more traditional arguments of Hirschman (1958)andMyrdal (1957),whodescribe respectivelyhowdevelopment in themostindustrialisedcentreswillultimatelytrickledownorspreadtoless-developedperipheral areas. The ‘flying geese’ model developed by Akamatsu (1962)similarlydescribesaprocessofindustrialtransferamongcountries(orregions),whichhassubsequentlybeenusedtodescribethetransferoflabour-intensiveindustriesoutofJapan(theleadgoose)toSouthKorea,Taiwan,SingaporeandHongKongandlatertotheAssociationofSouth-EastAsianNations(ASEAN)economies andcoastalChina (the followinggeese).Dynamic changes in eachregion’scomparativeadvantagegeneratedinthepresenceofsubstantialinter-regionaldiversitycreatetheincentivesforrelocationwiththeresultthat,inthelongrunatleast,allthegeeseindustrialise!Finally,theLewismodelappliedtoa regional contextalsopredicts a long-termequalisationof incomesbetweenregions.Inparticular,considerthatoneregion(thecoast)ishometothemodern‘capitalist’orindustrialsectorthatdrawsinperfectly(orhighly)elasticlabourfromtheotherregion(theinterior),whichspecialiseslargelyinthesubsistencesector.Oncethissurpluslabourisexhausted(orpreventedfromfreemovementbecauseofimpedimentsinthelabourmarket),themodelpredictsthatwagesandpercapitaincomewillrisethroughouttheeconomy(Lewis1952).Inessence,


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allofthesetheoriespredictanequalisationofregionalincomesinthelongrun.DengXiaopingappearedtobewellversedinmost,ifnotall,ofthesetheorieswhenheadoptedtheOpenDoorPolicyandaskedthenon-coastalprovincestohavealittlebitofpatience.

CaiandWang(2006)andCaietal.(2009)providesomeevidencetosupporttheclaimthattheagglomerationofindustryalongChina’scoastlinewillsoonreachits peak—if it has not already done so. In their 2006 China Update chapter,theypointoutthattheemergenceofashortageofruralmigrantworkersandtheconsequentrapidriseinruralwagesintheeasternprovincessignaltheendofChina’sunlimited laboursurplus.Thissuggests thepotential,althoughbynomeansaguarantee,thatfirmswillbeginlookingtoalternativelocationsforproductionwithinChineseborders—namely, inthecentreandwest. Intheir2009China Update chapter,Caietal.takethisideaastepfurtherandassertthatChinaislikelytosustainitslabour-intensiveindustriesforthenextfewdecadesasrisingcostsalongthecoastleadtoindustrialupgradingthereandindustrialrelocationintotheinterior.Inparticular,theydrawonlabourproductivityandwagedataof310000manufacturingfirmsbetween2000and2007toarguethatthe reduction in labour costs in the centre andwest relative to the eastwillenable‘flyinggeesewithinChineseborders’.

LinkedtoCaietal.’s(2009)argumentthatlabour-intensiveindustrieswillsoonrelocatewestward is thenotion thatChinahas already reached its ‘Lewisianturningpoint’—signalledbytheendoftheruralsurplusthathasplayedsuchacriticalroleintheindustrialisationoftheeasternregion.GarnautandHuang(2006)examinethesupplyanddemandforskilledandunskilledlabouracrossChina’sregionsandsectorsandconcludethat:

The dynamic coastal regions will graduate surprisingly quickly fromlabour-intensive activities and re-specialise in capital or technology-intensive sectors of the production process. Rising opportunity costsof labourinthecountrysideandwagesintownswouldbehelpful incontaining the increase in income inequality—a source of growingtensionandconcern.(GarnautandHuang2006:32)

Iftheirargumentiscorrect—andtotheextentthatlabourisalsoabletomigrateacrossprovinces—theriseinwagesincoastalareaswouldlikewiseincreasetheopportunitycostoflabourelsewhere,whilemigrantstotheeastcouldbenefitfrom thehigherwages,henceunderpinning an improvement in the regionalincomedistributionaswell.CombinedwithCaietal.’sdepictionofincreasingcostadvantagesinthecentreandwest,andmorerecentevidencethatChinahasalreadyreacheditsturningpoint(inGarnautandCaiandWang’schaptersinthisvolume)thefutureforChina’sregionaldevelopmentlooksbright.


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Regional policies have the potential to make a positive contribution to therealisation of this outcome. As Lai (2002) notes, the Western DevelopmentStrategy was introduced not only to try to reduce regional inequality anddiscontent, but in order to support necessary state-owned enterprise (SOE)reformsinthewakeofWorldTradeOrganisation(WTO)entryandtoencouragethe opening up of the west more generally. To the extent that these effortssucceed,incombinationwithextensiveimprovementsininfrastructurewithinthewestandbetweenregions, theregion is likelytobecomean increasinglyattractiveplaceforfirmstolocateproduction.TheRevivetheNorth-Eastpolicycanequally—totheextentthatitsucceedsinpromotingmuchneededenterprisereforms—make the north-eastern region increasingly attractive, while thecentralprovincescouldbenefitnaturally fromtheirproximity to theeast,asthe shift-shareanalysis above indicated ishappening to someextent already.Policiestoensurethatsurpluslabourcanmigratetothemostproductiveareas,combinedwithsubstantialeffortstoraiseeducationlevelsandlabourqualityinthecentreandwest,arealsocrucial.Ofcourse,itishighlyunlikelythatalloftheseregionswillindustrialiseandgrowequallyrapidlysimultaneously,butsuccessinanyofthemwillplayapositiveroleinbringingregionaldisparitiesdown.

Finally,anotherreasonforoptimismisthatindustrialdevelopmentisclearlynottheonlythingthatmattersforregionaldevelopment.WesternChinaishometoalargeshareofChina’smineralandenergyresources,whicharekeyinputsintomanyoftheindustrialsectorsconcentratedineasternChinaandtherestoftheworld.TotheextentthattheWestisabletocapturetherentsassociatedwiththeseresources,itcouldsupporthigherthanaveragepercapitaincomeswithlowerthanaverageindustrialoutput(asinWesternAustraliatoday).

Reasons for pessimism

Foreachofthetheoriesabovethatpredictincomeconvergenceinthelongrun,andforeachpieceofevidencesuggestingthatthislongrunmightnotbeallthatfaroff,therearecontradictorytheoriesandevidence.

ThereisavastliteratureonthesourcesofChina’srapidgrowth,inwhichthekeydebatehasbeenoverwhethergrowthhasbeenprimarilyextensive—fuelledbyrapidlabourandcapitalaccumulation—orintensive,basedonproductivityincreasesderivingfromtechnologicaladvances,innovationanddiffusion,andhumancapitalgrowth.See,forexample,Jeffersonetal.(1996)andBorenszteinandOstry(1996),whowereamongtheearlyauthorstoclaimthattotalfactorproductivity growth was the key determinant of China’s rapid economicgrowth—incontrastwithothers,suchasWu(2003)andChowandLin(2002),


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who argued that capital investment was the dominant factor. To the extentthatgrowthisdrivenbycapitalinvestment,standardgrowththeorypredictsconditional convergence across regions as investors eventually seek higherreturnsinplaceswherecapitalstocksarelow.YetChi(2008)showsthatthisideaisoverlysimplistic,giventheroleofhumancapitalstock,andpresentscleartheoreticalandempiricalreasonswhyregionalinequalityislikelytoworsenintheforeseeablefuture.Inparticular,heshowsthatwhentechnologicalchangeisskillbiased,ratherthanfactorneutral,asassumedinstandardgrowththeory,provinceswithhigherstocksofhumancapitalwillcontinuetoattracthigherlevelsofphysicalcapitalinvestment.Thisskill–capitalcomplementarityimpliesthat, contrary to the neoclassical prediction of capital flowing west, it willcontinuetofloweast.Chi’sevidencedemonstratesthattertiary-leveleducationisthemostimportantdeterminantofthisskill–capitallinkand,furthermore,provincial government expenditure on education has done little to increasetertiary-levelstocksinthecentralandwesternprovinces(whilehavingsomeimpact on reducing the percentage of primary-level attainment and raisingsecondary-level attainment). Essentially, the conclusion is that, until interiorprovinces can raise theirhumancapital stock significantly, capitalflowswillcontinuetosupportmorerapidgrowthintheeast,withregionalinequalitiesrisingaccordingly.

TotheextentthatChina’sgrowthisinsteaddrivenbyproductivityincreases,regionaldifferencesintotalfactorproductivity(TFP)couldoffersomepromisefor regional equalisation of incomes. Cai et al. (2009) calculated that TFPaccountedforbetween18and28percentofindustrialoutputgrowthbetween2000and2007,withhighercontributionsfoundinthenorth-east,centreandwest.ThehighestTFPwasrecordedforthecentralregion—offeringsomehopeforcatch-upthere—whiletheTFPoftheeastandthewestwasverysimilar.Thisisencouraginginthesensethatthewestdoesnotappeartobesubstantiallybehindtheeastinproductivityterms,butofferslittlehopeforcatch-upunlessthewest’sTFPcanberaisedevenhigher.

Krugman’s(1991)depictionofthespatialpatternofindustrialdevelopmentinamarketeconomyimpliesthattheprocessofindustrialagglomerationfollowedbydispersalislikelytooccurfirstforthemostcost-sensitive,labour-intensive,‘footloose’industriesthatarenottiedtolocation-specificrawmaterials,becausethese are the industries for which relocation first becomes profitable in theface of rising wages in the industrial core and improving transport linkagesbetweenregions.Iftheshift-shareanalysisfor2000–07hadindicatedthatthesewerethetypesofindustriesstartingtoperformwellinthecentreandwest—particularly industries that rankhighly in termsof industrial output shares,suchaselectronicandtelecommunicationequipment,at9.8percentof totalindustrialoutput,andoneofthemost labour-intensivesectors—therewould


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besomecauseforoptimismthatthisprocesshadstartedinChina.Instead,asdiscussed above, the few sectors that were performing well in these regionswere generally non-footloose (the mining and dressing sectors) and capitalintensive.Inturn,thiscouldrelatetothecentralgovernment’sclearlystatedpreferentialpoliciesforcertain‘priority’sectorsinthewesternregion,whichcouldcontradicttheforcesofthemarketandproveunsustainableinthelongerterm.This is an issue that remains open for further investigation—forwhichthereisnospacetoexpandonhere.SeeGolley(2007:Ch.8)forfurtherdetails.

In reference to the theories mentioned above, another reason for pessimism,with regard to industrial relocation providing the key to regional incomeequalisationinthelongrun,isthattheoryandrealityarerarelyoneandthesame.Itisneitherlikely,norindeeddesirable,thatChina’sindustrialoutputwilleverbeevenlydistributedacrossitsvastanddiverselandscape.Inreality,as observed in the United States, Australia and Italy, to name a few, certainregionswillalwaysremainrelativelypoor,providingsourcesofout-migrationforbetter-developedregionsintherestofthecountry,andpossiblytherestoftheworld.

NoteveryonesupportstheclaimthatChinahasalreadyexhausteditsvastpoolofsurpluslabour.MengandBai(2007)examinedthewagesofunskilledworkersfromsevenfactoriesinGuangdongfortheperiod2000–04andconcludedthatoverthatperiodaveragewagegrowthwaseithernegativeorzeroandthat‘withsuchsmallwageincreases,onecouldhardlyarguethatChinahasreachedtheLewisianturningpoint’(p.172).Similarly,whileAthukoralaetal.(2009)showthatwagegrowthinrapidlygrowingcoastalprovinces(Guangdong,ShanghaiandGuangxi)hasbeenfasterthaninlabour-sendinginteriorprovinces(Sichuan,GansuandQinghai),theystillconcludethat‘eventheofficialdatawhenanalysedat the disaggregate level suggest significant continuing duality and surpluslabourconditions intheChinese labourmarket’ (p.199).Astheynote,apartfromthemorethan100millionpeoplewhohavemigratedfromruraltourbanareasinChina—andlargelyinthedirectionofwesttoeast—industrialreformshavereleasedmorethan40millionworkersfromthestatesectoravailableforpotentialemploymentintherapidlygrowingnon-statesector.Thecontinuingriseintheshareoftheworking-agepopulation(projectedtocontinuethroughto2015)andincreasesinlabourparticipationratesprovidefurthersourcesofurbanlaboursupplygrowth(GolleyandTyers2006),asdothehundredsofmillionsofworkersstillunderemployedinagriculturalactivitiesandtheconservativeestimateof7.1millionregisteredunemployedurbanworkerscountrywide(NBS2008).Thereisclearlyroomforfurtherdebateaboutwhentheturningpointwillbereached,anduntilthatpointitisunlikelythatregionalinequalitieswillbegintofall.


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Onthepolicyside,thereisperhapsmorereasonforpessimismthanoptimismatthisstage,despitethelargeamountofrhetoricamongthetoplevelsoftheChineseleadership.Naughton(2004)pointsoutthatmanyofthekeyprojectsoftheWRDP—mostobviouslythetransnational(east–west)energyprojects—areessentiallynational andnot regionalgoals andareunlikely tobe incomeequalisinginanysignificantway,ifatall.Healsonotestheincentiveproblemsinherentinacentrallydirectedregionalstrategythatleadprovincialandlower-level leaders topleadpovertyandappearneedy inorder to compete for thelimited pool ofWRDP funds. Moreover, the mind-set of leaders in the westandnorth-eastisdescribedasconservativeandreliantoncentralgovernmentsupport,which,incombinationwithampleevidenceofcorruptionandmisuseofallocatedfunding,isamajorconstraintonregionalpolicyefficacy(Lai2002;Chung et al. 2009). Golley (2007) describes the WRDP as a ‘developmentalstate’ approach to regionalpolicy, inwhich thecentralgovernment seems tobe controlling development through state ownership and decree rather thanby adopting policies that are likely to succeed in stimulating self-sustaininggrowthintheregion.Asoneillustrationofthispolicyapproach,awhitepaperreleased in2003states that largenumbersofuniversitygraduates, scientists,techniciansandhighlytrainedprofessionalshavebeen‘assigned’toXinjiang(‘White paper on “the important role of Xinjiang Production ConstructionCorps”’, Xinhua News, 26 May, viewed 6 September 2003, <http://news.xinhuanet.com/english>).IfthisishowaStateCouncilmembercanclaimthatthe‘phenomenonofthepeacockflyingtothesoutheastwillbereplacedbythephenomenonof thepeacockflyingwest’ (Goodman2004:327), ithas little todowiththemarketandalottodowiththeState.ItalsocontradictswhatforNaughton(2004)isthesinglefactormostlikelytoreducepovertyinwesternChinaandhencereduceregionalinequalities:outmigration.Andyetextensiveoutmigration—whileofferingasolutionforthemigrantsandsimultaneouslyrelievingcertainareasthatarenoteithereconomicallyorecologicallyviable—alsobringswithitthethreatofbraindrain,makingitevenmoredifficultforbackwardareastodevelopindustrialcapacityinthelongerterm.Moreover,acontinualsourceofmigrantstotheeastwillhelptokeepwagesdownthere,prolongingthedecisionsofindustrialfirmstolookelsewhereforlowercosts.Combine this with the depiction of recent trends in industrial developmentpresentedaboveand thenumeroushistorical andgeographicaldisadvantagesofthewest—andtoalesserextentthecentreaswell—andthereseemstobeamultitudeofreasonswhythecentralgovernmentwillstruggletoachieveitsregionalpolicygoalsinthenexttwodecades.


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Conclusions

China has entered its fourth decade as a developing, market economy withsignificant and rising regional inequalities.This chapterhas investigated thepossibility that relatively rapid industrialdevelopment in the less-developedcentreandwestcouldofferoneofthekeystoreducingtheseinequalitiesinthenexttwodecades.

Anoptimisticresponsetothisis,yes,itispossible.Theshift-shareanalysisfortheperiod2000–07indicatedthattheglorydaysoftheeast’sindustrialdominancecouldbecoming toanend,with the regionno longerperformingabove theaverageacrossthebroadspectrumofindustrialsectors.CombinethisevidencewithclaimsthatChinaisclosetoexhaustingitslaboursurplusanditispossiblethatrisingcostsintheeastwillprovidetheimpetusforindustrialupgradingtherecoupledwiththeincentivesforfirmstorelocatetowardsthecentreandwest.Aseriousandcommittedpro-west(oratleastnon-pro-east)regionalpolicywithsubstantialfundingwellspentoninfrastructureandeducationcouldplayapositiveroleintriggeringself-sustainingindustrialdevelopmentoutsidetheeastern region. Rising incomes in the east could provide a crucial source ofdemandfornon-easternproducts,withtheeastpossiblybecomingforwesternChina what the industrialised world has been for the eastern region duringitsownindustrialtake-off.Thechancesthatallofthistranslatesintowesterngrowthratesbeingsustainedat2percentagepointsormoreabovetheeast—andthusachievingtheregionalpolicyobjectiveof‘considerablydiminishing’regionaldisparities—areminiscule.Thatisnottosay,however,thatsomedentwillnotbemade,particularlywhenothernon-industrialfactorsaretakenintoaccount,suchasthepotentialforout-migrationandresourcerentstoraisethepercapitaincomesofthosewhoremaininthewesternregion.

Takentoitsextreme,thepessimisticresponsewouldbeno,itisimpossible.Evenif rising costs in labour-intensivemanufacturing in the east led to industrialupgrading there, industrial relocationcouldoccurnot inwards to the restofChinabutratherwouldoccuroutwardstocompetitornationssuchasIndiaandVietnam.WesternChinawould thenbe characterisedby substantialpocketsofpovertyandunderdevelopment—althoughsurelywithafewindustrialisedcitiesinthemix.Alackofdomesticintegrationcouldmaketheeastincreasinglyintegratedintotheglobaleconomy,whilethewestbecameincreasinglyisolatedfrom the rest of the world and the east.This outcome would pose a seriousthreattothelegitimacyoftheChineseCommunistParty—andyettheycouldfailtoeffectivelyimplementpoliciesthatreversethesituation.

Itisunwise—becauseitisimpossible—tolookbackwardinordertotrytoprojectfutureoutcomeswithanykindofprecisionorcertainty,shortofassertingthat


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therealpathofChineseregionalindustrialdevelopmentduringthenexttwodecadeswillliesomewhereinbetweenthesetwoextremes.Togooutonslightlymoreofa limb,thebalanceofevidencepresentedhere, incombinationwithmyresearchonthistopicduringthepastdecadeorso,suggeststhatthenexttwodecadeswillwitnesslimitedimprovementsinthedistributionofregionalpercapitaincomesunderpinnedpartiallybylimitedredistributionofindustrytowards somebutnot all ofChina’snon-coastalprovinces.Tobecategorical,thereisnodoubtthatregionalinequalitiesinsomeformorotherwillcontinuetoplagueChina’spolicymakersuntilthelongrunisreached—andthattimeisaverylongwayoffindeed.

References

Akamatsu, K. 1962, ‘A historical pattern of economic growth in developingcountries’,Journal of Developing Economies,vol.1,no.1,pp.3–25.

Athukorala,P.-c.,Fukao,K.andYuan,T.2009,‘EconomictransitionandlabourmarketintegrationinChina’, inR.Garnaut,L.SongandW.T.Woo(eds),China’s New Place in a World in Crisis,ANUEPress,Canberra.

Borensztein, E. and Ostry, J. D. 1996, ‘Accounting for China’s growthperformance’,American Economic Review,vol.86,no.2,pp.224–8.

Cai,F.andWang,D.2006,‘Employmentgrowth,labourscarcityandthenatureofChina’s tradeexpansion’, inR.GarnautandL.Song (eds),The Turning Point in China’s Economic Development,AsiaPacificPress,Canberra.

Cai, F.,Wang, D. andYue, Q. 2009, ‘Flying geese within borders: how doesChinasustainits labour-intensiveindustries?’, inR.Garnaut,L.SongandW.T.Woo(eds),China’s New Place in a World in Crisis,AsiaPacificPress,Canberra.

Chi,W. 2008, ‘The role of human capital in China’s economic development:reviewandnewevidence’,China Economic Review,vol.19,pp.421–36.

Chow,G.andLin,A.-l.2002,‘AccountingforeconomicgrowthinTaiwanandMainlandChina:acomparativeanalysis’,Journal of Comparative Economics,vol.30,pp.507–30.

Chung,J.H.,Lai,H.andJoo,J.-H.2009,‘Assessingthe“RevivetheNortheast”(zhenxing dongbei) programme: origins, policies and implementation’, The China Quarterly,vol.197(March),pp.108–25.


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Deng, X. 1987, Fundamental Issues in Present Day China, Foreign LanguagesPress,Beijing.

Garnaut,R.andHuang,Y.2006,‘ContinuedrapidgrowthandtheturningpointinChina’sdevelopment’,inR.GarnautandL.Song(eds),The Turning Point in China’s Economic Development,AsiaPacificPress,Canberra.

Golley,J.2003,‘Industrial locationandregionaldevelopment’, inR.Garnautand L. Song (eds), China 2003: New engine for growth, Asia Pacific Press,Canberra.

Golley,J.2007,The Dynamics of Chinese Regional Development: Market nature, state nurture, EdwardElgar,Cheltenham,UK.

Golley,J.andTyers,R.2006,‘China’sgrowthto2030:demographicchangeandthelaboursupplyconstraint’,inR.GarnautandL.Song(eds),The Turning Point in China’s Economic Development,AsiaPacificPress,Canberra.

Goodman,D.S.G.2004,‘Qinghaiandtheemergenceofthewest:nationalities,communal interaction and national integration’, China Quarterly, SpecialIssuesNewSeries,no.5,pp.379–99.

Hirschman, A. 1958, The Strategy of Economic Development,Yale UniversityPress,NewHaven,Conn.

Jefferson,G.,Rawski,T.andZheng,Y.1996,‘Chineseindustrialproductivitytrends’,Journal of Comparative Economics,vol.23,pp.146–80.

Krugman, P. 1991, Geography and Trade, Leuven University Press and MITPress,Cambridge,Mass.

Lai, H. H. 2002, ‘China’s Western Development Program: its rationale,implementationandprospects’,Modern China,vol.28,no.4,pp.432–66.

Lewis,W.A.1952,‘Economicdevelopmentwithunlimitedsuppliesoflabour’,Manchester School,vol.22,no.2,pp.139–91.

Meng,X.andBai,N.2007,‘HowmuchhavethewagesofunskilledworkersinChinaincreased?DatafromsevenfactoriesinGuangdong’,inR.GarnautandL.Song(eds),China: Linking markets for growth,AsiaPacificPress,Canberra.

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National Bureau of Statistics (NBS) various years, China Industrial Economic Statistical Yearbook,ChinaStatisticsPress,Beijing.

Naughton,B.2004,‘Thewesterndevelopmentprogram’,inB.NaughtonandD.Yang(eds),Holding China Together: Diversity and national integration in the post-Deng era,CambridgeUniversityPress,UK.

Puga,D.andVenables,A.1996,The spread of industry: spatial agglomeration in economic development,CEPRDiscussionPaperNo.1354,CentreforEconomicPolicyResearch,London.

Wang,S.andHu,A.1999,The Political Economy of Uneven Development: The case of China,M.E.Sharp,Armonke,NY.

Wu,Y.2003,‘HasproductivitycontributedtoChina’sgrowth?’,Pacific Economic Review,vol.8,no.1,pp.15–30.

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Part II

Global Integration: Challenges and Opportunities

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Exchange rate policy and macroeconomic

adjustment 8Geng Xiao

China’s exchange rate policy and what it means for the dollar

Thedebateover the exchange ratebetween the renminbi (RMB) and theUSdollarisusuallyframedintermsofglobalimbalances:excessiveUSconsumptionbeyond its savings on the one hand and excessive Chinese production andsavingsbeyonditsownspendingontheother.ThisquicklyleadstotheviewthattheUnitedStatesshouldexportandsavemoreandChinashouldimportandspendmore.Thedebatecentresonhowtoachievethisrebalancing.ThefocusintheWestisonshort-termappreciationoftherenminbi,whiletheemphasisinChinaisonlonger-termstructuralandinstitutionalreform(Xiao2008).1

LeadersintheUnitedStateswouldliketherenminbitoappreciatesignificantlyandquicklytoencourageanexpansionofUSexportsandemployment.Chineseleaders, however, regard the pressure to revalue the renminbi and variousprotectionisttradepoliciesfromtheWestasunfair,andbelievetheythreatenChina’s development.2 What accounts for this considerable gap between theviews of China and the West? What is the economic rationale for China’sinsistenceonastablerenminbi?

Theargumentforasustainedappreciationoftherenminbiisrootednotonlyinshort-termconcernsaboutChina’slargecurrentaccountsurplus,butinlonger-termtrendsofChina’seconomic fundamentals, includinghighgrowth, rapidurbanisation and industrialisation, low national debt and low fiscal deficits.ThesetrendsaretheresultofthreedecadesofreforminChinathathaveopenedthecountrytotradewiththerestoftheworldandledtostrongproductivitygains.Basedontheexperienceofotherfast-growingindustrialisingeconomies,theseforceswillincreaseChinesewages,thevalueoftherenminbiandChina’spricelevel—overtime.

1 Someofthekeyresultsaresummarisedandrestatedinthischapter.2 On30November2009, inhismeetingwithEuropeanleaders,ChinesePremier,WenJiabao,saidsomecountriesontheonehanddemandedrenminbiappreciationandontheotherhandadoptedvarioustradeprotectionmeaures.


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China’s stance

ChinaviewsitsrenminbipegwiththeUSdollarasacruciallinkforitstradeand investmentflowswithUSandworldmarkets.China is concerned that aprematureendtothisnominallinkwiththedollarwouldbringaboutfinancialinstabilities such as speculative capital inflows, associated asset bubbles andshort-termnominalshockstoemploymentandbusinessintheexternalsector.

ChinahasnotforgottenhowthelargeappreciationoftheJapaneseyenbroughtaboutbythe1985PlazaAccordcreatedmassiveassetbubblesthatburstin1989,creatinga two-decade-longperiodof sustaineddeflationwithouteliminatingJapan’stradesurplus.

Chinaisalsowaryofhowcurrencyappreciationmightencouragedestabilisingcapital inflows.From2005to2008, therenminbiappreciatedsteadilyagainstthe United States dollar by over 5 per cent a year and China’s stock-marketindexincreasedfromabout1500to6000beforefallingto2000becauseoflargespeculative capital inflows especially from Hong Kong. If China were to userenminbiappreciationtoreachabalanceintradeandtostopspeculativecapitalinflows,therenminbicouldovershootitsequilibriumlevel,leadingtobubblesanddeflation.

Another reason for not having predictable renminbi appreciation relates toChina’s outward investment. For a country with a large net surplus savingsandtradesurplus,awell-functioningfinancialsystemshouldsupportorderlyprivateornon-statecapitaloutflowsofthesameorderofmagnitudeasthetradesurplus.Privatefirmsandfinancial institutionswould,however,bereluctanttobuydollar assets if theywere likely to continuallydepreciate in termsoftherenminbi.Becausefearofdollardepreciation—andthenear-zeroshort-terminterest rates in the United States—reduces outward investment by private-sectorinvestors,thePeople’sBankofChina(PBOC)hastofinancevirtuallyallofChina’stradesurplusbybuildingupofficialexchangereserves,makingitsmonetarycontroldifficult.3

In any case, it is not clear that nominal renminbi appreciation is necessary.TherealexchangeratebetweentherenminbiandtheUSdollarshouldbeself-adjusting.ThisisbecausethechangeinChina’spricelevelrelativetothatintheUnitedStates(the‘realexchangerate’)istechnicallythesumofrenminbiappreciationagainst thedollarandChina’sextra inflationaboveUS inflation.ThisrealexchangerateisdeterminedlargelybyChina’sproductivitygrowth.If China appreciates its currency in excess of its productivity gains, it will

3 See a series of articles by Ronald McKinnon about the exchange-rate policy in Japan and China—particularlyMcKinnonetal.(2009).

Exchange rate policy and macroeconomic adjustment

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experiencedeflation. If,however,China refusesnominal appreciationagainstits productivity gains, the country will experience some structural inflationrelatedtotheincreaseofwagesandpricesinthenon-tradablesector,whichwillkeeptherealexchangeratecompatiblewithitsproductivitychanges.IfChinaexperiencesinflationhigherthanitsproductivitygains,therenminbiwillfacedepreciationpressure.

Indeed, ifChinamakes themistakeof continually appreciating the renminbiagainst the dollar—ostensibly to reflect its higher productivity growth inmanufacturing—then wage growth could well slow by roughly the amountof the anticipated exchange appreciation. Manufacturing firms would riskbankruptcyiftheyraisedwagesinthefaceofanever-higherrenminbi.Indeed,inJapan’sveryhighgrowthphaseinthe1950sand1960s,whentheyenwasfixedat360tothedollar,Japanesewagesgrewveryrapidly—ataboutthesamepace as domestic productivity growth in manufacturing. Then, when Japanwas forcedbytheUSgovernment toappreciate in the1970sandafterwards,wagegrowthslumpedtovirtuallyzeroandremainsatzerotoday.4Chinadoesnotwant to repeat Japan’s experienceofdeflationary stagnationbyallowingexcessiverenminbiappreciation.

ItshouldalsobenotedthatrecentresearchbyHongQiao(2007)hasshownthatcurrencyappreciationhasanambiguousimpactonthenettradebalance.Qiao’s(2007) research is clearly consistent with Japan’s experiences and supportsChina’scurrentexchange-ratepolicy.

When it comes to rebalancing,what reallymatters is the real exchange rate:the relative price levels between economies in international currency, whichdetermine the relative costs of production, exports and imports of tradingpartners.Hence,ifChinapegstherenminbitothedollar,itcanstillachievearapidincreaseinitsrealexchangerateagainsttheUnitedStatesbyhavinganinflationrate5percentagepointshigherthanthatoftheUnitedStates.Manyformerlyfast-growingindustrialisingeconomies—suchasJapan,SouthKorea,TaiwanandHongKong—kept inflationabout5–8percentduringtheir fast-growthphasesasawaytomakenominalwagesandgeneralpricelevelsconvergetowardsglobalstandards.

Hence,both inflationandnominal appreciationcanadjust the real exchangerate.TheChineseapproachtoexchange-ratestabilitythusfarhasfocusedoninflationfirstandappreciationsecond,whichmakesthelonger-termobjectivesofcreatingemployment,productivitygains,wagegrowthandpriceliberalisationtheprioritiesratherthanaddressingtradeimbalancesthroughadjustmentsforexchange-ratechange.

4 SeedetailedanalysisinMcKinnon(2006).


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Policy alternatives

GiventhefactthatChinaiscautiousaboutusinglargenominalappreciationtorebalancetheChineseandglobaleconomies—atleastforthetimebeing—itisimportanttoconsidersomealternativepolicyoptions.AwidelyheldviewinChinaisthattherebalancingshouldfocusonreducingthenetsavingssurplusby shifting disposable income to households, paying corporate dividends,increasing governments’ fiscal spending, and so on—and not simply onadjustingtheexchangerate.

China is well known for its high savings rate, which reached about 55 percentofgrossdomesticproduct(GDP),withacurrentaccountsurplusofabout10per centofGDP,during2007–08.Oneof thekey sourcesofChina’shighnationalsavingsrateisitsstate-ownedenterprises(SOEs),ascorporatesavingscontribute about half of China’s national savings (Prasad 2009). Historically,theselargeSOEscouldnotpayhighsalariesorwagestotheiremployeesduetotightcontrolbythegovernment.Theydidnotdistributedividends.Evenaftertheywerereformedintoamoderncorporateformatinthe1990s,theprimaryfocuswasonreducinglosses,notsharingdividends.Theyalsodidnotgenerateprivate purchasing power when the prices of their shares increased, whichcreated huge capital gains with, as it happens, only small wealth effects onconsumption.ThehighsavingsofSOEsarepronetoinvestmentinsectorswithtendenciestoovercapacity.Hence,privatisationandderegulationarenecessarytoreducesavingsandinefficientinvestmentbythelargeSOEs.5

While China clearly must increase its current consumption, consumption isultimatelylimitedbyincome.Chinahasalongwaytogoinraisingthewagesandproductivityofitsworkforce.Rightnow,householdincomeaccountsforonly35percentofnationalincome.Thelowdisdposableincomeisespeciallyacuteformigrantworkers,whodonotreceivehigh-qualityeducationinruralvillages.TheirwageswerestagnantatalevelofaboutUS$120–200amonthforthe first several decades of reform due to steady high underemployment forunskilledlabour.

ChinesesavingsarealsohighbecausetheaverageChinesehouseholdisfacedwithaveryhighreturnoninvestment,suchasinresidentialproperty.Inoneofourstudies(Sunetal.2009)ofthecomparativelong-termreturnoncapitalforChina,JapanandtheUnitedStates,wefoundthatChina’sreturnoncapitalisabout20percent,comparedwithabout10percentforJapanand5percentfortheUnitedStatesinthepastthreedecades.Moreover,Chinesehouseholdssavetomeetveryhighfutureexpenditures,suchascollegeeducationfortheirsinglechildandmedicalandretirementexpenditures.

5 FormoreonChina’sSOEs,seethediscussionbyXiaoetal.(2009).


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Addressing the West’s concerns

Chineseandforeignobserversalikehaveexpressedconcernsaboutinefficientinvestment in China’s export-manufacturing sector and in some localgovernment-sponsored projects. As a result, China’s central government hasrecentlytightenedmonitoringandcontrolofallnewprojects,especiallythoselikely to lead to overcapacity. The Chinese authorities have not, however,changedtheiroverallstimuluspolicyandcontinuetofocusongeneratingmoreefficientinvestment,employmentandimportssoastocontributepositivelytoglobalrebalancingandglobalrecovery.

ForthosewhoworryaboutChina’sUS$2.2trillionforeignexchangereserves,itisworthlookingatacasethatillustratesChina’sneedforforeignexchange.Thenumberofself-financedChinesestudentsstudyingabroadincreasedfrom102247in2002to161600in2008,whichisacompoundrateofabout8percentayear.Ifweassumethenumberofsuchstudentswillincrease8percentayearforthenext10years,thenumberofstudentsstudyingabroadwillreach348882by2018.Ifeachoutgoingstudentspendsfouryearsoverseas,withUS$60000inexpenditureperannumfortuition,livingexpensesandtravel,thetotalaccumulated expenditure for thoseChinese students going abroadwill reachUS$606.8billion—amountingtoabout30percentofChina’scurrent foreignexchange reserves. It isno secret that evenhighandmiddle-incomeChineseparents need to save for many years or decades to pay for their children’sexpensiveoverseaseducation.

Price distortions and global rebalancing

Oneof thekey factorsdriving theglobal imbalanceshasbeencheapmoney,which,togetherwithweakregulationofhigh-riskinvestment,ledtopropertyand stock-market bubbles in the United States and other economies. ThebubblesbroughttemporarycapitalgainsthatreducedAmericans’savingsandincreased their consumption to levels beyond their sustainable income.Thisis well known now; but what has been overlooked in the public discussionis that this same cheapmoney alsoflowed intoChina through foreigndirectinvestment(FDI)andothercapitalflows.Cheapforeignmoney,combinedwithcheapChineseland,energyandnaturalresources,hasledtohugeovercapacityin China’s manufacturing sector, driving down the prices of made-in-Chinaproducts.

The United States’ current zero-interest-rate policy might be necessary fortheUSeconomynow,butitislikelytocreateacarrytradeasaby-product—that is,where investorsborrowcurrencieswith low interest ratesand invest


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in currencies with high interest rates to make profits when the interest ratedifferential is larger than the anticipated exchange rate change. This bringscapitalflowsintoChinainanticipationofhigherinvestmentreturnscomparedwiththeUnitedStates.Ifmanagedwell,Chinacancombinethisforeigncapitalanditsownsavingstoimprovetheefficiencyofitsinvestment,soastoallowhigher levels of domestic investment for future domestic consumption. Thiswouldcertainlyhelpglobalrebalancing.

RisingChinesehouseholdincomeandlargeofficialreservesmeanthattherewillbe risingdemand fordiversificationbyChinese investors into foreignassets.Overtime,theamountofcross-bordercapitalflowscouldbemuchlargerthantheamountoftradeflows.Tofacilitatethesefuturecross-bordercapitalflows,it would be helpful for China to maintain a stable exchange rate and largeforeignexchangereserves—bothofwhicharecriticalinreducingtheChineseandforeigninvestors’uncertaintythatwouldresultfromavolatileexchangerate. Having a stable exchange rate to facilitate cross-border investment isalso important for the large number of US multinational corporations withextensive and growing investments in China that generate high value-addedcomplementaryjobsintheUnitedStates.

The future for China and the dollar

Thebiggestchallenge forChinesepolicymakersnowishowtodealwith theproperty and stock-market bubbles being formed by cheap money in Chinaand around the world. As asset prices and the consumer price index (CPI)rise,itisimportantforChinatoraiseitsinterestrate—asIndiahasdoneverysuccessfully—to keep the real interest rate at a stable and positive level. Ahigherinterestratewouldattractgreatercapitalinflows.Itisthereforenecessaryfor China to improve its capital-control mechanisms, to allow orderly cross-border capital flows for more efficient investments with higher returns bothdomesticallyandinternationally,whilelimitingthespeculativeflowofcapitalandtheinefficientandlow-returninvestments.

SowhatdoesChina’spolicystancemeanforthedollar?Therearesomeclearimplications.

Given the institutional and structural constraints in China, it does not seemlikely that nominal renminbi appreciation will become a key policy variableinrebalancingChinaandtheglobaleconomyinthenearfuture.ThismeansitwillbedifficultfortheUnitedStatestopursueaweak-dollarpolicy.Withoutdepreciationagainsttherenminbi,anyfurtherdepreciationofthedollaragainsttheeuroandyenwoulddolittletohelpglobalrebalancing—andcouldinsteadcauseshockstotheEuropeanandJapaneseeconomies.


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Given the huge potential for cross-border investment and debt financingbetweentheUnitedStatesandChina,astablerenminbi–dollarexchangerateseems to fit both countries’ long-term national interest. If the United StatesandChinacancooperateeffectivelyinmaintainingthestabilityoftheexchangerateandorderlycross-borderflowsofcapital, there is littlereasontobelievethedollar-basedinternationalcurrencysystemwillcollapseintheforeseeablefuture.

In the longer term—certainly after 2020 and perhaps during 2025–35—therenminbiislikelytobecomeaninternationalcurrencywhenitbecomesfullyconvertibleandtheChineseeconomycompletesitsstructuralandinstitutionaltransformationintoafullymodernisedmarketeconomywithamoredemocraticpolitical system.By that time, the integrationof theUS,European,JapaneseandChineseeconomieswillbesodeepthatthedollar,euro,yenandrenminbiarelikelytobecomeleadingreservecurrenciesoftheworld,withfullyfloatingexchangerates.

Rebalancing the world economy can be accomplished without revaluing therenminbi.Forthis tohappenwithoutmajordislocations,however,structuraland institutionalreformsmustoccurboth inChinaand in theUnitedStates.HigherinflationinChinaanddeflationorlowerinflationintheUnitedStatescanbringabouttheneededadjustmentinreal,ratherthannominal,exchangerates. This implies a stronger dollar, but also requires de-leveraging in theUnitedStates,includingreductionofUSfiscaldeficits.

Challenges in the next two decades

Duringthenext20yearsofreformanddevelopment,thekeymacroeconomicchallengeistodeterminehowtomanagetheexchangerate, interestrateandinflationrateinordertofacilitatesustainable,stable,efficientandharmoniousgrowthofChina’srealeconomyinthecontextofaworldeconomyinwhichtheweightoftheWesterneconomieswillshrinkrelativetotheemergingmarketeconomies.

Toappreciatetheextentofthischallenge,itisessentialtorecognisethatChina’shighgrowthinthepast30yearsisastorylargelyofrapidproductivitygrowthandcatchingup.Theproductivitystoryislikelytocontinueforthenexttwodecades if China continues its market-oriented reform and its trend of rapidindustrialisation and urbanisation. As a result, China’s non-tradable goodsprices—suchaswagesforunskilledlabourandpropertyprices—arelikelytocontinuetorise(seethechapterinthisvolumebyRossGarnaut),relativetothepricesoftradablegoods,whicharesetbyglobalmarkets.


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In thenext twodecades, risingnon-tradablegoodsprices inChinawill leadto a gradual but steady convergence of China’s price levels towards those inHong Kong and the United States, through structural inflation or structuralrenminbi appreciation—or both. It is essential for China’s policymakers andChinesepeopletotoleratethestructuralinflationand/orcurrencyappreciationassociatedwiththisproductivitycatch-up.

More importantly, since inflation and currency appreciation can causedistortions,shocksandincomeredistribution,itisnecessaryforpolicymakerstouseappropriatepolicymixestomitigatepotentialdislocationthatmightbecreatedintheadjustmentprocess.

For example, when structural inflation emerges, it will be critical to raisenominalinterestratessoastoavoidassetbubblesthatarecausedbynegativerealinterestratesaswellastoprotectthevalueofbankdepositsheldbythelow-incomehouseholdswhocannotaffordtoinvestorspeculateinpropertymarketsin order to hedge against the structural inflation. Since 1991, China’s urbanresidentialrealestatepriceshavegrownonaverageabout9percentayear,butthemortgagerateisonlyabout5percentandtheone-yearfixed-depositrateisonlyabout2percent.Thestructuralinflationinpropertyandlowmortgageanddepositratesimpliesaveryseriousproblemofnegativerealinterestratesintermsofinvestinginproperty.ThisistherootofChina’spropertybubblesandtheassociatedhugeincomeredistributionfromdepositors(usuallythepoor)tomortgageholders(usuallytherich).

IfChinacannotmaintainapositiverealinterestrate,itsboomandbustcyclesin the property sector are likely to continue, leading to serious inefficiencyin investment as well as social instability. On the other hand, if China doesraiseinterestratestoalevelhigherthanitsstructuralinflation,itthenneedsadequatecapitalcontroltodealwithspeculativecapitalinflows.

The importance of keeping the real interest rate positive cannot beoveremphasised for China in the next two decades, as China’s key challengein macroeconomic adjustment is to improve its investment and consumptionefficiencysothatitcanabsorbmoreofitscurrentaccountsurplus.Otherwise,Chinawillfaceseriousinternationaltradeprotectionpressure.

On the other hand, this chapter shows that it is not necessary for China torelyonlyonnominalexchangerateflexibilitytofacilitateitsrisingpricelevelif it can instead tolerate higher structural inflation and the associated realappreciation.Infact,itismucheasierforChinatoimplementaflexibleexchangerateregimewhenitallowsreasonablestructuralinflation.Withinflation,therewill be potential for the currency to depreciate when inflation runs beyondproductivitygrowth.So,amixtureofinflationandnominalappreciationcould


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create a regime in which the market exchange rates could go up or down—reducingtheincentiveformassivespeculativeholdingsoftherenminbi,whichhasbecomeoneofthekeydriversofChina’sforeignexchangereservebubble.

It should also be pointed out that when China pegs its renminbi to the USdollar,itshouldnotworrytoomuchaboutrunawayinflationsincethepeghasthestabilisationfunction.IftheinflationrategoesbeyondChina’sunderlyingproductivitygrowth,themarketwillexpecttherenminbitodepreciate,whichwillleadtocapitaloutflowsandthetighteningofmoneysupply.GivenChina’shugeforeignexchangereserves,itiseasyforChinatodefenditspegandavoidrunawayinflation.

As soon as China starts to tolerate reasonable structural inflation and theassociated real appreciation, the pressure for nominal appreciation will bereduced.

Thischapterhasalsohighlightedthefactthattheexchangerateisapricenotjustfortradebutforassets. Infact, thevolumeoftheassetmarkets ismuchbiggerthanthatoftrade.Maintainingstableexchangeratesforfacilitatingstableandefficientcross-bordercapitalflowscouldbemoreimportantthanusingtheexchangeratetobalancetrade.ItcouldbemoreproductivetousetradepoliciessuchasreducingthetransactioncostsforimportstobalanceChina’strade.

References

McKinnon, R. 2006, ‘China’s exchange rate trap: Japan redux?’, American Economic Review,vol.6,no.2,pp.427–31.

McKinnon,R.Lee,B.andWang,Y.D.2009,The global credit crisis and China’s exchange rate,StanfordCenterforInternationalDevelopmentWorkingPaperno.391,StanfordUniversity,Calif.

Prasad,E.2009,‘RebalancinggrowthinAsia’,Finance & Development,vol.46,no.4,pp.19–22.

Qiao,H.2007,‘Exchangeratesandtradebalancesunderthedollarstandard’,Journal of Policy Modeling,vol.29,no.5,pp.765–82.

Sun,W.,Yang,X.andXiao,G.2009,InvestmentrateandFDI:acomparativeanalysisofreturntocapitalamongChina,USandJapan,PaperpresentedatthejointsymposiumofUS–ChinaAdvancedTechnologyTradeandIndustrialDevelopment,Beijing,23–24October.


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Xiao, G. 2008, ‘China’s exchange rate and monetary policies: structural andinstitutionalconstraintsandreformoptions’,Asian Economic Papers, vol.7,no.3,pp.31–49.

Xiao,G.,Yang,X.andJanus,A.2009,‘State-ownedenterprisesinChina:reformdynamicsandimpacts’,inR.Garnaut,L.SongandW.T.Woo(eds),China’s New Place in a World in Crisis: Economic, geopolitical and environmental dimensions,ANUEPress,Canberra,pp.155–78.

Acknowledgments

Thischapterconsistsoftwosections.Sectiononeisareprintofanarticlebytheauthorpublishedon13January2010at‘WhatMatters’webforumhostedbytheMcKinsey Quarterly (<http://whatmatters.mckinseydigital.com/currencies/china-s-exchange-rate-policy-and-what-it-means-for-the-dollar>). Section twoincludesadditionalcommentspreparedspecially for thischapter.TheauthorisgratefultotheMcKinsey Quarterly forpermissiontoincludethepreviouslypublishedcontentsinthischapter.TheauthorwouldalsoliketothankRonaldMcKinnon,AndrewSheng,PieterBottelier,WingThyeWoo,JeffreySachs,BarryBosworth,HarryBroadman,DavidDollar,DavidLoevinger,DavidMeale,DavidSkilling, Jonathan Woetzel, Kenneth Lieberthal, Cheng Li, Xingdong Chen,ChunlaiChen,MinZhu,QirenZhouandHongLiangforhelpfulcommentsanddiscussionsonthiswork.JonathanDelikatandWillHobbsprovidedexcellentresearchassistance.

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The real exchange rate and the renminbi 9

Rod Tyers and Ying Zhang

Introduction

China’srenminbi(RMB)hasbeenatthecentreofpoliticaldebatesovercurrentaccount imbalances formorethanadecade. Inscholarlycircles,whilea few,including McKinnon (2006), argue that a renminbi appreciation would notaddresstheimbalancesofconcerntotheUnitedStates,numerousstudieshavesupported the view that the currency is undervalued—by margins rangingfrom ‘small’ to ashighas50per cent1—andsomeconclude that aunilateralappreciationoftherenminbiisessential(forexample,Cline2005).ExpectationsthatChina’sexchangerateshouldbeappreciatingarebasedcommonlyontheBalassa (1964) – Samuelson (1964) hypothesis (BSH). This implies a positiverelationshipbetweeneconomicgrowthandtheunderlyingrealexchangerate,drivenbyproductivitycatch-upindevelopingcountries’tradablesectorsand,inassociation,risingwagesandpricesintheirnon-tradablesectors.

Empirical evidence from studies by Lu (2006), Fogel (2006) andTyers et al.(2008)suggeststhatChina’stradableproductivitygrowthhasbeendoublethatoftheUnitedStatessincetheearly1990s(Gordon2003,2006).TheproductivitypatternthereforeappearstosupportarealappreciationrelativetotheUnitedStatesconsistentwiththeBSH.Morecontroversial,however,istheexpectationthattheproductivitygainsforcerelativegrowthinrealwages.Thatthisistrueto somedegree isclear fromtheofficial statistics (GarnautandHuang2006).Therealwagesofnon-hukouworkerswere,however,lessformallyrecordedandMengandBai(2007),amongothers,suggestedthatthesegrewmoreslowly,ifatall,atleastuntilthemid2000s.TheBSHthenpositsthatfasterChinesegrowthinbothtradableproductivityandrealwagesshouldcauseariseinrelativenon-tradable(mainlyservice)prices,whichisalsoobservedthroughthemid2000s(Lu2006;Tyersetal.2008).InspiteofallthisevidencesupportingtheBSH,therewasnosignificantrealappreciationbetweenthemid1990sand2004.

1 See,forexample,Frankel(2004);Wang(2004);Goldstein(2004);CoudertandCouharde(2005);Tyersetal.(2008);andCheungetal.(2007a,2007b).


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TheresolutionofthispuzzlerequiresanumberofgeneralisationsoftheBSH,mostsignificantamongwhichistherelaxationoftheassumptionthatthelawofonepriceappliesforalltradedgoods.Thisgreatlybroadensthesetofdeterminantsoftherealexchangerate.TheneteffectofChina’srapideconomicgrowthonits realexchangerate is, then, seen todependon thesourcesof thatgrowthandtheconsequentpatternofendowmentchangesandsectoraldistributionsofproductivitygrowthandtradability.Ofconsiderableimportanceinthedecadetothemid2000sistheshort-runimpactofChina’swideningcurrentaccountsurplus,whichstemmedfromitsextraordinarilyhightotalsavingrateandtheWorldTradeOrganisation(WTO)accessiontradereforms.

Weshowthatastrongreversalof theearlier tendencyfor thereal exchangeratetodepreciateoccurredafter2004,raisingChina’sproductioncostsbyone-third,relativetotheUnitedStates,by2008.Weexplorethischangeanddiscussitsdeterminants,notingmountingevidencenotforareturntothedominanceof the BSH but instead for a tightening labour market associated, at least inpart,withimprovedruraltermsoftrade.Turningtomacroeconomicpolicy,wethenexaminethecontroversyoverChina’sextensiveholdingsofofficialforeignreserves,findingthesetobeaconsequenceofitscapitalcontrolsanditshighsavingrate.Weshow,however,that,byinternationalstandards,theydonotappeartorepresentextraordinaryholdingsofgenericforeignassets.Wethenexaminetheexchangeratetargetasmonetarypolicy,concludingthat,shouldthe Chinese government respond to international pressure with a prematurenominalrevaluationorsomeformofconstraintonitsexports,theconsequenceswouldbeharmfultobothChineseandglobalinterests.

ThenextsectionoffersabriefsummaryofananalysisofChina’srealexchangeratepathtothemid2000s,showingtheimportanceofthesavingrateandtradereformsinthisperiod.Thisisfollowedbyareviewofevidenceofthereasonsfor the more recent appreciating trend and then a discussion of the role ofChina’smacroeconomicpolicy.Asummaryofpolicyimplicationsconcludesthechapter.

The 1994–2004 puzzle

Iftheaverageproductoflabourinthenon-tradable(largelyservices)industriesisthesameacrosscountrieswhilethecorrespondingaverageproductintradableindustries,AT,islowerinpoorcountries,theBSHyieldsthefollowingelegantrelationships between the underlying real exchange rate, eR, and the ratiosofhomeandforeignvaluesofAT,non-tradedprices,pN,andwagerates,W (Equation9.1).2

2 Forthederivationofthisrelationship,seeGolleyandTyers(2007).

The real exchange rate and the renminbi

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Equation 9.1

!Here,therealexchangerateisdefinedasthevalueofthehomeproductbundlerelativetoacorrespondingbundleinforeignregioni.Itisthenumberofforeign-sourcedproductbundlesthatcanbeobtainedifonehomeproductbundleistradedaway.AccordingtotheBSH,aneconomythatisgrowingfasterthanitstradingpartnersalsohas:

1. fastertradableproductivitygrowth, !

2. fasterwagegrowth !

3. relativeservicepriceinflation !

4. anappreciatingrealexchangerate( !).

Thehypothesisthenimpliesthat,ifdevelopingcountriesarepoorerbecausetheir tradable labourproductivity is lower, theircomparativelyrapidgrowthshould be associated with real appreciations against their richer tradingpartners.Giventhatthisisawidelydiscussedtheoryoftherealexchangerate,it isnot surprising thatChina’sgrowth surge since theearly1990shasbeenaccompaniedbythewidespreadanticipationofarealappreciation.

Whilewiderempiricalevidence insupportof theBSH ismixed,whenpricelevelsarecompared through timeandacross largenumbersofcountries, thepattern of real appreciation among the more rapidly growing countries isobserved(Cheungetal.2007b;Berginetal.2006).ForthecaseofChina,weobserve convincing evidence of faster tradable productivity growth (Table9.1) and higher price inflation in the service sector (‘tertiary’ industry andconstruction)throughthemid2000s(Figure9.1).Yet,asFigure9.2shows,norealappreciationwasobserveduntilafter2003.Forareflectionofthis,weusemonthlydataforChineseandUSproducerpriceindicesinFigure9.3,whichshowsthesamerealdepreciatingtrendthroughthemid2000swithasubsequentsharprealappreciationinthelead-uptotheglobalfinancialcrisis.Clearly,tounderstandthepathofChina’srealexchangerate,werequireageneralisationoftheBSH,andthismeansrelaxingitskeyassumptions.


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Table 9.1 Contributions to China’s real exchange rate change, 1997–2006 (per cent)

Faster tradable productivity growth—Balassa Samuelson +1 .6

Faster skill growth –0 .6

WTO accession trade reforms –4 .2

Influx on the financial/capital account of North America –0 .4

Efflux on the financial/capital account (high saving rate) –4 .8

Net effect over 1997–2006 –8 .1

Source:Tyers,R.andGolley,J.2008,‘China’srealexchangeratepuzzle’,Journal of Economic Integration,vol.23,no.3,pp.547–74.

Figure 9.1 Chinese sectoral price indices, 1990–2009

Note:These are sectoral price indices for ‘primary industry’, which is agriculture and rural services,‘industry’,whichisprimarilymanufacturingand‘construction’(thelattertwomakingupthe‘secondary’sector);and‘tertiaryindustry’,whichisotherservices.

Source:ThepriceindicesareimpliedbyvolumeandvaluedatafromNationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing.


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Figure 9.2 The Mainland China–US real exchange rate on GDP prices

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R Y Ye E P P= × ,whereE is thenominal exchange rate inUSdollarsperunitof localcurrency,

YP isthelocalGDPpriceand YP isthecorrespondingUSGDPprice.

Source: International Monetary Fund (IMF) 2009a, International Financial Statistics, InternationalMonetaryFund,Washington,DC.

Figure 9.3 The Mainland China–US real exchange rate on producer prices

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Notes: Here the home prices are, for the United States, the producer price index and, for China, thecorporategoodspriceindex.TheChineseindexhasmorecoverageofcommoditiesandservices,sothisisalessthanperfectcomparison.Theimpliedrealexchangerateisinblack.

Sources: International Monetary Fund (IMF) 2009a, International Financial Statistics, InternationalMonetary Fund,Washington, DC; National Bureau of Statistics (NBS) 2009, China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing;theBureauofLaborStatistics,USA.


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The law of one price for tradable goods

Failures of the law of one price have been observed for tradable goods inspecificinstances(forexample,Berginetal.2006;Crucinietal.2005;DrineandRault2005).Goodsandservicesarenothomogeneousacrosscountriesbutaredifferentiatedatminimumbycountryoforigin.3Supplyand/ordemand-sideshocks that raise thevolumeof tradableproductionmove thehomecountrydowntheglobaldemandcurvesforitsproductvarieties,reducingitssupplypricesandresultingindeteriorationinitstermsoftradeandadepreciationofitsrealexchangerate.Homefactorendowmentgrowthandchangesinpolicythat lead to substitution indemandaway fromhomeproducts therefore alsodepreciaterealexchangerates.

Labour arbitrage

Inmostdevelopingeconomies,thereisaHarris–Todarogulfbetweenwagesinthemodernandruralsectors.Iflabourmobilitybetweentheruralandindustrialsectorsisinferiortothatbetweentheruralandservicesectors(particularlytheconstructionsector),industrialproductivitygrowthdoesnotnecessarilydriveupservicewagesorservicecosts—atleastnottothesameextentonaverage.4

Closed capital account5

Theassumptionthattherealexchangeratedependsonlyoninteractionsamongcountriesassociatedwithtrade inmerchandise isclearlyviolated inmanyoftoday’sdevelopingcountries—andparticularlyinChina.Itsviolation,inconcertwithfailuresofthelawofonepricefortradablegoods,meansthatanyinfluxofpayments(intheformofaforeigndirectinvestment,portfoliocapitalfloworarepatriationofofficialforeignreserves)raiseshomeaggregatedemand.Sincetradablegoodsaresuppliedmoreelasticallyviaimportsthanarenon-tradablegoods—whichdependonhomeresources—suchaninfluxmustraiserelativenon-tradablepricesandthereforeappreciatetherealexchangerate.Conversely,effluxessuchasChina’sextraordinaryforeignreserveaccumulationscauserealdepreciations.

Using a multi-region, multi-product dynamic simulation model of the worldeconomy, Tyers and Golley (2008) evaluate the implications of a variety ofshocksforChina’srealexchangerate.Theyfindthat,intheshortrun,thereal

3 Thisisastandardassumptioninthemostwidelyusednumericalmodelsofopeneconomiesandglobaltrade.See,forexample,Dixonetal.(1982);McKibbinandSachs(1991);Hertel(1997);andDixonandRimmer(2002).4 ChangandTyers(2008)offerevidenceforthis.5 Hereweadoptaworkingdefinitionofthecapitalaccountasbroadlyincludingallflowsonthebalanceofpaymentsassociatedwithassetacquisition.Assuch, itencompasses themorenarrowlydefinedcapitalaccount,thefinancialaccountandofficialreservetransactions.


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exchangerateismostresponsivetofinancialcapitalflows,sothatChina’sexcesssavingtendstodepreciatetherealexchangerate.Inthemediumrun,theBSHforce (relativeproductivitygrowth in tradable industries) is strong, as is theeffectoftradereformsthatdivertdomesticdemandawayfromhomeproductsand therefore depreciate the real exchange rate. In the long run, the realexchangeratedependssensitivelyonfactorsaffectingthecostofnon-tradedservices. They then employ their model to decompose the real depreciatingtrendbetweenthemid1990sandthemid2000s.TheparticularrealexchangeratechosenforthisanalysisisthatbetweenChina(includingHongKongandTaiwan)andNorthAmerica.Thisratedepreciatedby8percentintheperiodofinterest.ItsdecompositionissummarisedinTable9.1.

HigherChineseproductivitygrowthisseentohaveofferedtheexpectedBSHappreciatingforce.NetfinancialoutflowsonChina’sbalanceofpaymentsandinflowson theNorthAmericanbalanceofpaymentsboth tend todepreciatetheChineserealexchangerate.Similarly,skillacquisition(whichreducesthecost of supplying mainly skill-intensive services) and trade reform offer theexpecteddepreciatingforces.Incombination,thecurrentaccountimbalancesin China and North America contribute a real depreciation of more than5percent.Surprisinglysignificant,however,isthedepreciatingeffectofWTOaccessiontradereforms,whichcontributemorethan4percenttotheoverallrealdepreciation.Intheend,thesecurrentaccountimbalancesprovetobe,incombination,themostimportantdepreciatingforcestothemid2000s.

ThesignificanceofthisforChinaisclearfromFigure9.4,whichshowsthatthesaving–investment gap (the current account surplus) expanded substantiallyafter the East Asian financial crisis.This expansion in net outflows diverteddomesticdemandabroadandplaceddownwardpressureonChina’srealexchangerate.Toseethis,notethattheequalityofnetinflowsofpaymentsonthecapitalaccount (net outflowson the current account)6 to the investment–savinggapfollows from the standard aggregate expenditure and disposal identities.7Definingnetinflowsaspositive,thecapitalaccountsurpluscanbewrittenas:

! , inwhichI is investment,SD istotaldomesticsaving,SNF(netforeignsaving)isnetprivate inflowonthefinancialaccountand !is the annual addition to official foreign reserves. In the presence of capitalcontrols, SNF was roughly equal to officially approved inward foreign directinvestment(FDI).BothsidesoftheequationarenegativeinthecaseofChina,indicatingnetoutflows.Extraordinarily,eventhoughinvestmentaccountsfor

6 Forourworkingdefinitionofthe‘capitalaccount’,KA,seethenextnote.7 Theright-handsideofthisidentitystemsfromthecombinationofaggregateexpenditureonGDP,Y = C + I + G + X + M;thefactthatGNPisYN=Y + N,whereNisnetfactorincomefromabroad;theGNPdisposalidentity,YN=C + T + S,andthebalanceofpayments,BoP = 0 = KA + CA,wherethecurrentaccountisCA = X – M + N.


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45percentofChina’sGDP,morethanhalfofitsGDPissaved.Inexplainingtherealdepreciatingtrend,however, thekeyobservation is that thesaving–investmentgapwasincreasingthroughthemid2000s.

Figure 9.4 China’s investment–saving and external balances (percentage of GDP)

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Sources: International Monetary Fund (IMF), 2009a, International Financial Statistics, InternationalMonetaryFund,Washington,DC;InternationalMonetaryFund(IMF),2009b,World Economic Outlook Database,April,InternationalMonetaryFund,Washington,DC;NationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing.

The real appreciation after 2004

Theexchangerate reforms launchedby theChineseauthorities inJuly2005wereintendedtoat leastdemonstrateadeparturefromthedefactofixedUSdollarpeg,nominallyallowingthecurrencytofluctuatebyupto0.3percenteachday.Theappreciationaccelerated in2007amountingtoanaccumulated20percentbyJuly2008,afterwhich theglobalfinancialcrisis induced theChinesegovernmenttoreturntothedefactoUSdollarpeg.The2004-2008roundofrevaluationwasaccompaniedbysignificantdomestic inflation, implyingasubstantially largerappreciationof theunderlyingrealexchangerate (Figure9.2)—amounting to at least 30 per cent. As is evident from Figure 9.3, thedifferencebetweenthebilateralnominalandrealappreciationswasassociatedwithfastergrowthofChina’sproducerpricesthanthoseoftheUnitedStates.


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Morerecently,asFigure9.3shows,theunderlyingrealappreciatingtrendhasresumed. Accordingly,tocontroldomesticinflation,official“flexibility”wasrestoredasofJune2010.

Changes inthepathof therealexchangeratesince2004are toorecent foradetaileddecomposition.TheGFCaside,acleartendencytowardrealappreciationis evident, however. In what follows, we discuss a number of alternativeexplanationsforthisappreciatingtrend.

Decreasing current account surplus

After a rapid increase in the early 1990s, household saving rates fluctuatedbetween20and25percentduring1997–2006(TyersandLu2009).Theinitialsurgeinhouseholdsavingwasassociatedwiththe1990sroundofprivatisationand restructuring, which increased household funding responsibilitiesfor health, education and retirement expenses. In more recent years, thegovernment has embarked on national schemes for health and retirementinsurance,includingtheextensionofmedicalpensioninsurancetocoverruralareas and the establishment of urban subsistence security systems (ChamonandPrasad2008;Wen2008).Thesehave lessenedthisconcern, leadingtoatleast thestabilisationofhouseholdsavingrates.Atthesametime,asurge ingovernmentspendingbeganwiththeonsetoftheglobalfinancialcrisisin2007.This reduced thegovernment’s contribution tonational saving.As shown inFigure9.5,theChinesecurrentaccountsurplushasstabilisedsince2005andrecently contracted.The previous period of real depreciation was associatedwiththeexpansionofthissurplusandhencethediversionofincreasingsharesofChineseincomeintoexpendituresabroad.Thecessationofthistrendwouldatleaststemfurtherrealdepreciation.

Increasing oligopoly rents

Lu et al. (2008) point out that Chinese state-owned enterprises (SOEs) stilldominate industries such as metals, motor vehicles, aircraft, transport,telecommunication, finance and insurance and that they became extremelyprofitable during the 2000s. Tyers and Lu (2009) attribute these profits tooligopolisticbehaviourandseetheassociatedrentsashavingexpandedwiththepost-WTOaccessiongrowthsurge,financingthehugecorporatesavingsoftheperiod.TheeffectoftheserentsonChina’srealexchangeratehastwochannels.First,highermark-upsinlargelynon-tradedindustriesraisepricesandhencecauseappreciation.Second,therentsgainedbySOEsmakeupaprimarypartof corporate saving, which has tended to divert Chinese expenditure abroadand thus todepreciate the real exchange rate.AsTyers andLu showed, thelattereffectwasdominant to2005.Themore recentdecline in thecorporatesavingrate (Bayoumietal.2009)couldhaveshiftedthisbalancetowardstheappreciatingeffectofmark-ups.


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Figure 9.5 Real wage growth in agriculture

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Source:ThenominalwagebysectorandtheCPIarefromNationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing.

Slowdown of trade reform

China’s2001WTOaccessionsawawiderangeoftariffcutsandmarket-openingpolicychanges.Sincethentradereformhasslowed.8Asdiscussedpreviously,tradeliberalisationdepreciatestherealexchangeratesothisslowdownmightbeseenasatleastrelaxingpressurefordepreciation.YettradereformsareneverParetoimprovingwithoutcompensation.ThesectorbearingthemostnegativeeffectsfromWTOaccessionhasbeenagriculture,thestagnationofwhichintheearlyyearsafteraccessionprobablycontributedtothesubstantialrural–urbanmigrationof theperiod (ChangandTyers2008;Rees andTyers2008). Sincethenamajorconcernofthecentralgovernmenthasbeenthewelfareoffarmersand other rural dwellers. Unlike the corresponding experiences of Japan,Korea andTaiwanduring theirgrowth surges, inChina,becauseof itsWTOcommitment,ithasnotbeenabletoaddresstherural–urbandivideusingtradeprotection(AndersonandHayami1986;Anderson2009;Duncanetal.2008).Aconsequencehasbeenatrendfromnegativeassistancetoagricultureintheearlyreformperiodtopositiveandsignificantprotectiontoday,channelledviadomesticmarketing,transport,storageandotherbudgetarymeasures—allowed

8 AccordingtotheWorldTradeOrganisation’sTrade Policy Review(WTO2008), thetariffisstilloneofChina’smaintradepolicyinstruments.TheoverallaverageappliedMFNtariffwas9.7percentin2007—thesameasin2005.TheaverageappliedMFNtariffratesforagriculturalandnon-agriculturalproductswere15.3percentand8.8percent,respectively—alsothesameasin2005.


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under WTO rules for developing countries.9 Beyond agriculture, a numberof trade-biased policies have emerged that cut against the spirit of the pre-accessionreforms.Since2005,thevalue-addedtax(VAT)rebateforexportingfirmshasbeenraisedninetimes—upto17percent—coveringapproximately3800 export products, including textiles, clothing, toys, machinery, electricappliances,medicines,communicationdevicesandsteel(MinistryofCommerceofthePeople’sRepublicofChina2009).Suchexport-encouragingpoliciesdiverthomesuppliesabroad,raisingtherelativepricesofdomesticgoodsandhenceappreciatingtherealexchangerate.

Rising relative wage costs

ThesectoralpriceindicesinFigure9.1arerevealinginthat,sincethemid2000stheydonotshowanyriseinthepriceofservices(the‘tertiary’andconstructionsectors)relativetothetradable-goodssectors.Thissuggeststhattheappreciationsince 2004 is not due to the BSH force (relatively high productivity growthinChina’s tradablesectors). Indeed, thestrikingchange is intheprice indexforprimaryproducts,indicatingasubstantialimprovementintheagriculturaltermsoftrade.Whilethisisdueinparttohigherpricesofimport-competingcommodities,wehavealreadyseenthattherehavebeenanumberoffavourablechanges topoliciesaffectingagricultureandtherural sectorgenerally.Thesechangeswouldhaveraisedthemarginalproductofrurallabourandthereforetheincentiverequiredforruralworkerstomigratetoeasterncities.

Regression results suggest a structural change in real wage growth for theagricultural and construction sectors about 2004, as indicated in Figure 9.5.The labour forces in these sectors are mainly unskilled and the rural labourmarketisthesourceofmostnon-hukouworkersinconstruction,otherservicesandmanufacturing.Theofficialagriculturalrealwagegrewat3.1percentperannum(withastandarderrorof0.0012)intheperiod1994–2004andat4.7percentperannum(withastandarderrorof0.002)intheperiod2005–08.10

In their studyof the realwagesofunskilled factoryworkers inGuangdong,MengandBai (2007)usedpayrolldata to ensure the inclusionofnon-hukouworkers.Theyshowamuchsmallerannualgrowthrateofbetween0.5and1.5percentperannumupto2004,controllingforeducationandfirmtenure.The

9 Huangetal.(2009)showthetrendinassistancetoagricultureclearlyintheirTable3.5.Morerecently,the speech by Wen (2010) indicates the central government’s plans to raise the agricultural subsidy toRMB133billionin2010.ThesamespeechindicatesthatagriculturaltaxreductionswerecarriedoutinAnhuiProvincein2000andwerethenextendedto30provincesin2003.By2005,agriculturalproductiontaxeswerecompletelycancelledin28provinces.Farmers’benefitswereestimatedatRMB133.5billionperannum.10 Thegrowthrateswereobtainedfromasimpleordinaryleastsquares(OLS)regressionofthelogofthenominalagriculturalwagedeflatedbytheconsumerpriceindex(CPI)againsttime.Thestandarderrorsonthegrowthratecoefficientsinbothregressionsareverysmall,suggestingthatthegrowthratesaresignificantlydifferent.


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take-offinruralwagesafterthattimesuggests,however,thatrealnon-hukourateshave increased sinceand this is tobeexpected from the improvementsinnetreturnsfromagriculturalactivity.Increasingly,itislikelythatpotential‘floatingworkers’arechoosingtocontinuetheirruralemployment.Anecdotalindications of tightening labour markets have been abundant, includingof increased labour unrest suggesting improved labour-market power inmanufacturingprovinces.11Whatisevidentisaslowingofurbanlaboursupplygrowth,whichdrivesupthecostoftradableandnon-tradablegoodsrelativetoChina’stradingpartnersandhencecausestherealexchangeratetoappreciate.Whilethisseemstobeassociatedwithagriculturalincentivesintheshortterm—along with improvements in infrastructure that have boosted local servicessectors—inthelongterm,theprospectcanonlybeforacontinuation.ThisisbecausedemographicchangealreadylongintrainwillseeChina’stotallabourforcebegintodeclineduringthenextdecade(CaiandWang2006;GolleyandTyers2006).Inshort,thischangecouldbeheraldingtheendoftheeraoftheDooleyetal.(2003)‘revivedBrettonWoodstradeaccount’regionsgeneratingexportgrowthonthebackofsurplusrurallabour—atleastasfarasChinaisconcerned(FeenstraandHong2007).

Macroeconomic policy and the renminbi

The real and nominal exchange rates are linked by definition as!,where E is the nominal exchange rate (in foreign

currency per unit of home currency), PY is the price of the home productbundle (the GDP price) and P*Y is the corresponding foreign gross domesticproduct(GDP)price.Sincetheforeignpricelevelisoutsidetherealmofhomemonetarypolicy,changesintherealexchangerate(determinedasdiscussedintheprevioussections)aretransmitteddomesticallythroughchangesineitherthenominalexchangerateorthehomepricelevel.Thechoiceastohowthesearecombinedisamatterforhomemonetaryauthorities.Atoneextreme,arealappreciationcanbetransmittedasanominalappreciation(inflationtargeting)or, at another, as inflation (exchange rate targeting). This is complicated,particularly inChina’s case,by thedependenceof the real exchange rateoncapitalaccountflows,whicharedominatedbyreserveaccumulation,wherethechoiceofreservesisalsoaninstrumentofmonetarypolicy.

11 Strikesatkeyjoint-ventureplantsandotheractivismledtosubstantialincreasesinmanufacturingwagesin2009intheengine-roomprovincesofGuangdongandZhejiang(Gardner2010).


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Reserve accumulation and monetary mercantilism

China’sreserveaccumulationhasledtoallegationsof‘monetarymercantilism’(AizenmanandLee2006).Itisimpliedthatreserveaccumulationischosenfreelyinordertokeeptherealexchangeratelow.Inourview,themonetarymercantilistcritique is misplaced.The root of its unfairness is evident from the identityderivedpreviously, ! ,and therefore, !, inwhich !includesapprovedFDIandillegalprivateinflows.AslongastotaldomesticsavingsexceedinvestmentandcapitalcontrolspreventthematchingofinwardFDIbyprivateoutflows,ΔRmustbepositive.Indeed,wecanstatethatChina’scurrentaccountsurplusmustbematchedbyreserveaccumulationandtheimbalanceisnotamenabletofeasiblechangesinmacroeconomicpolicy,narrowlydefined,12if:

• thecapitalcontrolsarejustifiedonstabilitygrounds

• thehighprivatesavingrateisimpervioustomacroeconomicpolicyintheshortrun

• asitapproaches50percentofGDP(Figure9.4), investmentmustbenearabsorptivecapacity.

• government revenue is increasing so quickly that the government cannoteasilyoffsetprivatesavingwithpublic‘dis-saving’.

Consider each of these four conditions in turn. The capital controls areconceptuallysimplest.Theystemfrom‘fearoffloating’andshortmemoriesofthecurrencyrunwithwhichChinawasthreatenedinthelate1990sduringtheEast Asian financial crisis. Moreover, some suspicions remain in the People’sBank of China (PBOC) as to the prudential reliability of China’s commercialbanksinexchanginglargevolumesofforeigncurrency.Financialinstitutionsareperceivedvariouslyasnotsufficientlydistantfromdecadesofsoftbudgetconstraintsassociatedwiththechannellingofgovernmentsubsidies tostate-ownedenterprises (SOEs)throughaccumulateddebt.Andthereareconcernsthatthecommercialbankslackaccesstoorsufficientexperiencewithderivativemarketsforcurrencyanddebtinstrumentstodothenecessaryhedging.ThoughMaandMcCauley(2007)vouchfortheircontinuedeffectiveness,thecontrolsareslowlybeingrelaxed.

As indicatedearlier,China’shighprivatesavingrate isduetocomparativelyhighhousehold saving and extraordinarilyhigh corporate saving.While theformerhasceasedtoriseandisexpectedtodeclineslowlywithtimeashealthandretirementinsurancesystemsdevelop(ChamonandPrasad2008),thelatter,

12 ThisisageneralviewalsotakenbyXiao(2006),whopositsthat‘structuralfactors’andtransactioncostscauseChina’seconomytoadjustwitha lag, implyingthat thecurrentaccountsurplus isnotamenable tomacroeconomicpolicyintheshortrun.


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asarguedbyTyersandLu(2009),isduetotheprofitabilityofkeySOEsandisthereforeanissueforindustrialpolicy,whichwilltaketimetoresolve.Thecausesofhighsavingarethereforedeeplystructuralandthesubjectoflong-termprogramsofmicroeconomicpolicyreform.Noneisamenabletoactionbythecentralbankalone.

AsnotedbyXiao(2006),ithasbeensuggestedthatthesurplusofsavingoverinvestmentimpliesthattherateofinvestmentistoolow.Atmorethan45percentofitsGDP,however,China’sinvestmentisextraordinarilyhigh.Itisdifficulttoimaginehowadditionalprojectsmightbeconceivedandimplementedgivenservice sector planning and facilitation constraints.13 Moreover, China’s lowofficialdomesticfinancingratesnotwithstanding,recentsurveysbythePBOCshowthataverysubstantialproportionofinvestmentstilltakesplacethroughthe informal sector at rates that remain high by international standards. Itwill take some time yet for financial intermediation costs in China to fall toindustrialised-countrylevels,sofinancingcostsmustcontinuetobeabrakeoninvestment.14

Finally,beforetheglobalfinancialcrisis,China’sfiscalpolicymaintainedatightbalancebetweenrevenueandexpenditure.Duringthecrisis,thegovernmentcommittedtoasubstantialfiscalexpansion,includinganambitiousprogramofinfrastructuralinvestments,withaviewtoreducingthenationalsavingrateandraisingprivateconsumptionexpenditure.Thisprospectfacestwodifficulties.First,publicinfrastructureinvestmenttothatpointalreadyabsorbedalargershare of GDP in China than in any other developing country of comparableincomepercapita(Roland-Holstetal.2005).Second,revenuecollectionshavegrownfasterthanChina’sGDPasitstaxsystemhasimprovedineffectivenessandasmoreofChina’seconomicactivityhasoccurredintherelativelytaxable‘modern’sectors.Itisyetunclearwhethertheacceleratedspendinghasoutpacedrevenuecollection.Certainly,therehasyetbeennodramaticriseingovernmentbondissues.15

This supportof the ‘four ifs’ suggests that theChinesegovernmenthas littletruediscretionoveritsrateofreserveaccumulationandthereforeovertherateatwhichdomesticincomeisdivertedintoexpenditureabroad,weighingonits

13 Evidence of “white elephant” projects notwithstanding, this is a point over which there is muchdisagreement.14 TyersandGolley(forthcoming)modeltheeffectofhighfinancialintermediationcostsonChina’sgrowthrate.15 According to theMinistryofFinance,during2006–09, theChinesegovernment issuedbondsworthRMB888billion(2006),RMB798billion(2007),RMB862billion(2008)andRMB778billion(2009)—showingnoincreasingtrend.Besidesthis,RMB1550billioninspecialbondswereissuedin2007andexchangedwiththePBOCfortheequivalentfromitsstockofreserves.Theresultwasasubstitutionontheassetsideofabout8percentofGDPfromreservestodomesticcredit.


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underlyingrealexchangerate.Theextenttowhichthenationalsavingratehasstabilisedveryrecentlysuggests,however,thatreserveaccumulationcouldbeamoreneutralforceinfuture.

Liquidity and sterilisation

Through 2008 at least, the PBOC absorbed foreign currency inflows (exportrevenue) net of import costs because—short of long-term reforms affectingfinancialdepthandwhilecapitalcontrolsremained—theChinesecommercialbankscouldnotmovetherequiredvolumeofforeigncurrency.Thisrequiredacquisition of the foreign currency surplus with newly minted domesticcurrency.Toavoidexcessliquidity,annualreserveincrementsweresterilised.PBOC holdings of domestic credit were insufficient for this sterilisation,however,so‘sterilisationbonds’wereissuedonthedebitsideofthebalancesheetshowninTable9.2.

Table 9.2 The balance sheet of the People’s Bank of China, ca. 2009

Assets LiabilitiesDomestic credit, DC Central bank claims on depository and other financial corporations and on the central government 13 per cent GDP

The monetary base, MBCurrency and bank reserves 43 per cent of GDP

Official foreign reserves, R55 per cent of GDP

Sterilisation bonds, SBDebt to the Chinese public13 per cent of GDP

Other liabilities, OLIncludes government ownership 12 per cent of GDP

Source:People’sBankofChina(PBOC)2009,Balance Sheet of Monetary Authority,People’sBankofChina,Beijing.

Justasthereserveshavecometodominatetheassetsideofthebalancesheet,sterilisationbondshaveassumedsignificanceonthedebitside. Ineffect, thePBOChasactedasaconduitfordomesticsaverswhomightotherwiseacquireforeignassetsbutarerestrictedfromdoingsobycapitalcontrols.Thepressurefrom abroad to revalue therefore creates two difficulties for the PBOC. First,sincetheassetsofthePBOCareprimarilyinUSdollarsanditsliabilitiesareinrenminbi,toopromptanappreciationoftherenminbiwouldresultinsubstantiallosses that would need to be covered in renminbi from the governmentbudget.Thisconcernwasaddressedin2007withtheissueofUS$200billion


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in government debt to be exchanged with the PBOC for reserve assets—thelattertobemaintainedbyChina’s‘sovereignwealthfund’:thestate-runChinaInvestmentCompany(CIC).16

AsshowninFigure9.6,thissterilisationprocesskeptalidonthemonetarybaseasaproportionofGDPuntilthemid2000s.Liquiditygrowthwassubstantialthereafter.Itisourviewthatthishasstemmedfromcontinuingfinancialreforms,whichhavegreatlyexpandedcommercialbankintermediation(inplaceofpre-existingandrelativelycostlyinformalcreditstructuresandcreditcooperatives).Thishasbeenvaluablebuttheassociatedexpansionindepositshasalsoboostedoverallmoneysupplygrowth,contributingsince2006toinflationarypressure.ThePBOCrespondedwithhigherbankreserverequirementsandhighershortinterest rates.The latter added to speculative (illegal) private inflows drivenbytheexpectationthattherenminbiwouldbeallowedtoappreciatefurther,bringingupwardpressureontherealexchangerateinthelead-uptotheglobalfinancial crisis and since. As Figures 9.2 and 9.3 show, however, during thecrisis the drop in export demand caused a temporary real depreciation.Thereturntothedefactopegthennecessitatedcontractionarymonetarypolicyandtemporarydeflation.

Figure 9.6 Dynamics of the PBOC’s balance sheet: assets and liabilities as a percentage of GDP

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Source:ThePeople’sBankofChina.

16 TheCICtakestheformerlyestablished‘foreignexchangefinancialinvestmentcompany’(theHuiJinCo:literallytranslatedasforeignexchangeandgold)asitssubsidiary.HuiJindoesmainlyequityinvestmentindomesticfinancialindustrieswhileitsparentcompany,CIC,focusesonoverseasinvestment.ThanksareduetothePBOCforthisdetail.


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The effect of relaxing capital controls

Ascapitalcontrolsarerelaxed,akeyissuewillbetheextentofprivateoutflowsonthefinancialaccount.Prasadetal.(2005)pointtothepotentialforthistocreateadepreciatingforceasChineseprivateinvestorsseektodiversifytheirportfolios.ThescaleofthisforcedependsonwhetherthePBOC’sexistingforeignreserves are the equivalent of the private sector’s desired foreign holdings.A crude assessment of this canbemadeby comparing the foreign shares ofcollectiveportfoliosacrossindustrialisedanddevelopingcountries.Assetsare,however, many and various and net positions are poorly documented. For asample of countries, we have constructed a crude approximation of foreignshares in collective portfolios using estimates of capital stocks and recordedflowsonbalancesofpayments.Theresultsrequireascepticaleyesincecapitalstocks are measured differently across countries and foreign shares can beexpectedtobehigherinsmallerandmoreopeneconomiesirrespectiveoftheirlevelsofdevelopment—asinthecasesofHongKong,SingaporeandtheUnitedKingdom.

TheresultingforeignassetsharesarelistedinTable9.3.ThecountriesarethenrankedontheirestimatedforeignsharesinTable9.4.Moststrikingisthat,largeofficial foreign reservesnotwithstanding,China ranks rather lowon the list,evenwhencomparedwithotherAsiandevelopingcountries.Itsforeignshareappearstohavedoubledbetween2000and2005anditsrankingrose.By2005,itrankedaboveJapan,Korea,Thailand,IndiaandBrazilbutbelowtheotherindustrialised countries and Malaysia, Taiwan and Chile. Its ranking aboveJapanandtheothertwooftheworld’sverylargedevelopingcountries,IndiaandBrazil,suggeststhatitsforeignsharecouldbeonthehighside,thoughnoneoftheseeconomiesisasopenasChinaalreadyistoforeigntradeandownership(Lardy2006).Ontheotherhand,itsrankingbelowtheindustrialisedcountriessuggests that continued growth, combined with comparative openness, willtakeitssharehigher.Attheveryleast,theseresultsdonotlendclearweighttothethesisthatfinancialliberalisationwillautomaticallyraiseprivateinflowsandappreciatetherenminbi.Moreover,asurgeinprivaterebalancingoutflowscould prove a healthy outcome since the PBOC could readily offset this byrepatriatingitsreservesandsterilisingtheinflowbyliquidatingits‘sterilisationbonds’.ThiswouldtakethepressureofftheCICbyrestoringthePBOC’sbalancesheettosomethingmoreconventionalaswellasstabilisingthehomefinancialcapitalmarket.


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Table 9.3 Estimates of the foreign share of total assets, selected countries

Country Ratio of foreign to total assets (%)

2000 2001 2002 2003 2004 2005China 10 9 9 12 14 18

Hong Kong 55 56 55 59 60 64

Japan 9 12 12 14 14 17

Taiwan 11 14 17 21 22 24

Korea 11 13 13 15 17 16

Malaysia 22 27 28 38 36 41

Singapore 48 50 51 57 57 58

Thailand 18 20 19 19 17 17

India 6 9 9 11 12 11

Brazil 5 6 8 8 7 5

Mexico 7 8 7 8 9 9

Chile 21 23 22 26 25 25

Australia 15 17 17 18 19 21

United States 22 19 18 22 25 35

European Union 15 30 33 30 34 36 47

United Kingdom 63 63 52 54 54 68

Notes:Sharesareapproximatedasthequotientofforeignfinancialandphysicalassetsandtotalfinancialandphysicalassets.Thenumeratoristhestockofcapitalownedabroadplusofficialforeignreserves.ThedenominatorisofficialforeignreservesplusthehomecapitalstockplusthestockofcapitalownedabroadlessthatpartofthehomecapitalstockthatisforeignownedplusM2plusgoldstocks.Internationalcapitalownershipisapproximated,inturn,bydividingcurrentaccountnetfactorincomeflowsbylong-termbondrates.

Sources: Formost countries, foreign reserves,money supplies,gold stocks,net factor incomeflowsoncurrentaccountbalancesandlong-termbondratesarefromtheInternationalMonetaryFund(IMF)variousissues, International Financial Statistics,InternationalMonetaryFund,Washington,DC.ForTaiwan,thesearefromtheTaiwan Statistical Data Book,2006.ForChile,themoneysupplyisfromtheCentralBankofChile;forAustralia,itisfromtheReserveBankofAustralia;andforSingapore,itisfromtheMonetaryAuthorityofSingapore.ForChinaandIndia,bondratesarefromDatastreamand,fortheEuropeanUnion15,MalaysiaandChile,thebondratesarefromtheEconomistIntelligenceUnit.AllcapitalstockestimatesarefromtheGTAPglobaldatabase.

Table 9.4 Country rankings on foreign shares of total assets

2000 2001 2002 2003 2004 2005United Kingdom

United Kingdom

Hong Kong Hong Kong Hong Kong United Kingdom

Hong Kong Hong Kong United Kingdom

Singapore Singapore Hong Kong

Singapore Singapore Singapore United Kingdom

United Kingdom

Singapore

European Union 15

European Union 15

European Union 15

Malaysia Malaysia European Union 15


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Malaysia Malaysia Malaysia European Union 15

European Union 15

Malaysia

United States

Chile Chile Chile United States

United States

Chile Thailand Thailand United States

Chile Chile

Thailand United States

United States

Taiwan Taiwan Taiwan

Australia Australia Australia Thailand Australia Australia

Korea Taiwan Taiwan Australia Korea China

Taiwan Korea Korea Korea Thailand Japan

China Japan Japan Japan China Thailand

Japan China India China Japan Korea

Mexico India China India India India

India Mexico Brazil Brazil Mexico Mexico

Brazil Brazil Mexico Mexico Brazil Brazil

Source:RankingsontheforeignassetsharesinTable9.3.

Unilateral appreciation scenarios

Ifthetendencytowardsrealappreciationsince2004—asshowninFigure9.2—isindeedduetolabour-markettightening,itheraldsalong-termappreciatingtrend.ThiswillmakeiteasyforthePBOCtoallowacorrespondingappreciationintherenminbi.Anydecisiontorevaluefasterthantheunderlyingrateofrealappreciationwouldrequirefurthermonetarytighteningandpossiblyareturntothegrowth-sappingdeflationofthelate1990s.

McKinnon’s (2004) sage preference for an East Asian dollar standardnotwithstanding,thebilateralpressurefromtheUnitedStatesforarenminbirevaluationisunderstandableinonerespect.DespitethebenefitsaccruingtotheUSeconomyfromChineseinvestment,itsgovernmentperceivesasubstantialcurrentaccountimbalance,aproportionofwhichstemsfromitsbilateraltradewithChina,anditexpectsthataUSdollardepreciationwillhelptocorrectit(Woo2006).NotonlydoestheinflexibilityoftherenminbiratefrustratetheUS government—inciting the critical rhetoric (Bernanke 2006) and the draftlegislation to ‘punish’ China (Callan 2007)—it causes frustration in Europe,wheretheburdenofappreciationagainsttheUSdollarisgreatest.17

Ironically,whiletherefusalbysomeotherAsiancountriestoappreciatetheircurrencies significantly against the renminbi might well be motivated by‘monetarymercantilism’,asarguedpreviously,webelievethatthesluggishness

17 SeeRGEMonitor(2007a).Europeanrhetoricalsorepresentsthisview,asinaspeechbyPascalLamy,thenEUTradeCommissioner,on23December2003.


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ofChina’sappreciationagainsttheUSdollarismotivatedinternally.Thestickingpoint is a fear of financial (including exchange rate) volatility, confirmed byadherence to the peg during the global financial crisis. Were the Chinesegovernmentnonethelesstoagreetorevaluefasterthantheunderlyingrateofrealappreciation,itcouldeitherundertakeasubstantialmonetarytightening,andhencefurtherdeflation,oracceleratetheunderlyingrealappreciationwithareturntodistortedtrade.

Appreciation by monetary contraction

In the absence of any substantial upward movement in the underlying realexchangerate,thePBOCcouldsimplydeclareahigherUSdollar/renminbirate.ThisistheoptionadvocatedbyTungandBaker(2004),whosuggesta15percentone-offrevaluationandarguethattheriskofconsequentdeflationisminimal,duetoinflationarypressurefromothersources.Intheabsenceofanunderlyingappreciationoftherealexchangerate,thisargumentlacksfoundation.

The defence of the stronger renminbi would require a contraction of thedomesticmoneysupply(oraslowdowninitsgrowth)andaboosttodomesticshort-terminterestratesandotherfinancingbarriers.Iftherevaluationwerelarge enough, the resultwould likelybe a return to thedeflationof the late1990s and thiswouldhurt employment in the tradable-goods sector. Incomewoulddecline(orgrowmoreslowly),aswouldconsumptionandsaving.Sloweremploymentgrowth in themodern sectorwould reduce capital returns and,combinedwithhigherfinancingcosts,thiswouldalsocontractinvestment(orreduce its growth), so the implications forChina’s external imbalancewouldthendependontherelativesizeofthesavingcontraction.Forexternalbalancethereare,therefore,twocasestoconsider.

First,ifChinesehouseholdsareoptimistic,theyexpectthatthecontractionistemporaryandunrestrainedgrowthwillberestoredinthefuture.Facedwithreduced current income, they would then smooth consumption by reducingcurrent saving. Even with such a reduction in the saving rate, however,simulationspresentedbyTyersandZhang(2010)showthattheeffectofloweremployment growth on capital returns also causes a fall in investment. Thevalueofthesavingdeclineislargerinmagnitude,however,andtheneteffectistoreduceChina’scurrentaccountsurplus.Thereisthereforearealappreciationagainst North America and a slight reduction in the latter’s current accountdeficit. In addition, there is a slight increase in North America’s politicallysensitiveindustrialemployment,thoughthiscomesattheexpenseofaservice-sectoremploymentcontractionduetoNorthAmerica’srealdepreciationagainstChina. Both China and North America suffer losses in overall GDP and realincome per capita. The loss in China is substantial, however, amounting toalmostayear’sgrowth.


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A second possibility is that Chinese households are pessimistic and believethat the contraction is permanent. In response to the monetary contractionandreducedincome,theywouldthenexhibitbehaviourseeninJapaninthe1990s—smoothingtheirconsumptionforwardandraisingtheirsavingrate.18This exacerbates the contraction in Chinese economic activity and income.Moreover, because savingdoesnot fall and investment does,China’s currentaccount surplus is raised. The additional financial outflow causes a realdepreciation, suggesting that, to achieve a particular nominal appreciationtarget, the monetary contraction in this case would need to deliver a largerdeflationthanbefore. Internationally, thisshockreducesglobal interestratesandraisesNorthAmerica’scurrentaccountdeficit.Eventhoughtherearesmallgains inNorthAmerica’s termsof tradeandreal income,theexacerbationofcurrentaccountimbalancesandtheassociateddeclineinindustrialemploymentwouldfurtherfrustratetheUnitedStatespolitically.Itisdifficulttoconcludeother than that there is little to be gained from renminbi appreciation bymonetarycontraction.

Taxing trade

The other ‘unhealthy’ approach to a unilateral appreciation is via tradedistortions.WecandismissariseinimporttariffssinceChina’sWTOaccessionconditionsofferverylittleroombetweenappliedandboundtariffrates.Exportrestraints are possible, however—of the type followed by Japan in the late1980s when it was under similar pressure from the United States.These arenotdirectlyprotectionistandhencewouldnotattractmercantilistobjectionsfromabroad.Inprincipleatleast,likeimporttariffs,theymightbeexpectedtodivertdomesticdemandfromforeigntohomeproductsandtherebyappreciatetherealexchangerate,allowingthecentralbanktoalsoappreciatethenominalexchange rate. The downside is that they would also be a tax on the mostrapidlyexpanding sectors in theeconomyso theywould sacrificegrowth inurbanemploymentandincome.

The corresponding Tyers and Zhang (2010) simulation is of the short-runimpacts of an export tax of 15 per cent graduated over 2007–09 and leviedonly on industrial exports. As previously, they consider scenarios withoptimistic and pessimistic households. Surprisingly, in both cases, Chinaexperiences robust real depreciations against North America.This is becauseChina’scurrentaccountsurplusrisesevenintheoptimisticcase,inwhichthesavingratefallstemporarily.Thiscontradictstheexpectedstorybecausethatemphasisessubstitutioninfinaldemand.Thetruestoryisaboutintermediate

18 Ito (2001:Ch. 11, pp. 329–33) shows that, in the post-Plaza Accord period, the yen appreciatedsubstantiallyagainsttheUSdollarandJapan’scurrentaccountsurplusroseatthesametime,evenwhilerealinvestmentalsorose.


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demand.China’sexport-manufacturingsectorreliestoanextraordinaryextenton imported components—mostly from Asian trading partners.19 When theexporttaxcontractsthissector,importsaresimilarlycontracted.Totalexports,infact,contractbyasmallerproportionbecausethereisoffsettingexpansioninagriculturalandserviceexportsthatarenotintensiveinimportedinputs.TheneteffectisanexpansioninChina’stradesurplus.

InNorthAmerica,thecurrentaccountdeficitrisesand,asbefore,thereareonlysmallchanges inrealGDPandrealpercapita income. Importantly,however,China’s export restraints do raise North American industrial employment—again, at the expense of services employment—even though North AmericaexperiencesarealappreciationagainstChinathatwouldotherwiseadvantagethe services sector. Ineithercase, at least in the short run,export restraintswouldnotmakeiteasierforthePBOCtoappreciatetherenminbi;infact,quitetheopposite.

Conclusions

RelativetotheUnitedStates,Chineseproductivityhasgrownfasterintradablethaninnon-tradablesectors,realwageshavealsogrownfasterandtherehasbeenrelativeservice-priceinflation.Theflattrajectoryofitsrealexchangeratebetween1990and2004isthereforeacontradictionoftheBSH,theresolutionofwhichrequiresgeneralisationtoincorporatefailuresofthelawofonepricefor tradable goods, open financial capital markets and a more sophisticatedrepresentationofthelabourmarket.Thisopensthewayfordepreciatingforcesthat have offset the BSH, including net financial outflows on the balance ofpayments associated with China’s excess saving along with trade and othermicroeconomic reforms. Decomposition of the flat trajectory of the realexchangerateduring1997–2004revealsthattheBSHwasoffsetmoststronglybytheexcesssavingandtheassociatedexpansionofnetoutflowsonitscapitalaccount,alongwithasignificantadditionalcontributionfromWTOaccessiontradereforms.China’srealexchangeratebeganappreciatinginthemid2000swhenthenationalsavingratestabilisedandtradereformswereexhausted.Anexaminationofthetrendsinrelativeproductpricesandrealwagesinthisperiodsuggeststhattherealappreciationisnotduetotheresumptioninthedominanceof the BSH. Instead it appears to be due to tightening rural labour marketsassociatedwithimprovementsintheagriculturaltermsoftrade,combinedwithslowingoveralllabourforcegrowth.

19 AnimportantempiricalliteratureisdevelopingaroundChina’sroleasanassemblerofcomponentsmadeinotherAsiancountries.PartofthereasonforChina’sbilateraltradesurpluswiththeUnitedStatesisthatthis intra-Asian trade is reducing thebilateral surplusesofotherAsianeconomieswith theUnitedStateswhileitexacerbatesthatofChina.See,forexample,Athukorala(2005,2007).


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While much attention is paid in the literature to the past decade’s‘undervaluation’oftherenminbi, it is inourviewincorrecttoblamethisonChina’smonetarypolicy—narrowlydefinedtoincludetheexchangeratetargetandtheaccumulationofforeignexchangereserves.Thekeyconstraintswerecapital controls, motivated by concern about financial (and exchange rate)stabilityinthefaceoftherelativeimmaturityofitscommercialbankingsector,and structurally determined high savings. These constraints will eventuallyberelaxedbut,whiletheyremain,reserveswillaccumulateandexchangerateadjustmentwillnotaddressthecurrentaccountimbalance.Theonly‘healthy’waytoappreciatetherenminbiwillbetofollowthepathoftheunderlyingrealexchangerate.WeshowthatdefianceofthisprincipleintheformofaunilateralappreciationbymonetarycontractionwouldbeverycostlytoChina—anditwould most likely hurt the rest of the world by tightening capital marketsand changing the terms of trade adversely. Moreover, if Chinese householdsweretoreactpessimisticallytotheshock,thecurrentaccountsurpluscouldbeenlarged,backfiringonthosewhoclamourforanappreciationtoaddressglobalimbalances.Theotherconceptuallyfeasible,butnomorehealthy,approachtoaunilateralappreciationisviatheimpositionbyChinaofataxonmanufacturedexports.Asitturnsout,becauseChina’sexport-manufacturingsectorreliessoheavilyonimportedcomponents,suchataxwouldinfactexacerbatethetradesurplus by cutting imports in proportion with manufactured exports whileexpandingother less import-dependent exports.Thiswould increaseChina’scurrentaccountsurpluswhilesacrificingconsiderablegrowth. ItwouldhurttheNorthAmericaneconomyoverall.

Inthenearterm,withanapparentlylabourmarket-drivenappreciatingtrendin theunderlyingreal exchangerate, it is reasonable for thecentralbank toallow a unilateral nominal appreciation of the renminbi to ease domesticinflationpressure.Totheextentthatthisappreciatingtrendisnotfastenoughfor political equilibria in China’s trading partners, international pressurewouldbestbe focusedon the remainingfinancial reforms, including smoothtransitionstopoliciesthatbetterregulatelargeSOEsandaddresstheneedforuniformsystemsofretirementandhealthinsurance.Inthelongterm,whetherthereisasustainedupwardtrendinChina’srealexchangeratewilldependonthe relative strengths of appreciating forces, including tradable productivitygrowth, reduced savings and labour force decline, and depreciating forces,includingproductivitygrowthinitsservicessector.


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Acknowledgments

Funding for the researchdescribed in this chapter came from theAustralianResearchCouncilDiscoveryGrantNo.DP0557889.ThanksareduetoIainBainandPingkunHsufortheirassistancewiththeanalysispresentedinanearlierdraftandtoJaneGolley,YongxiangBu,HuangYiping,RossGarnaut,YanruiWuandWingThyeWooforusefuldiscussionsonthetopic.

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China and East Asian trade: the decoupling fallacy,

crisis and policy challenges 10

Prema-chandra Athukorala and Archanun Kohpaiboon

The ‘decoupling’ thesis—the notion that the East Asian region has becomea self-contained economic entity with the potential for maintaining its owngrowth dynamism independent of the economic outlook for the traditionalindustrialised-marketeconomies—wasapopularthemeinAsianpolicycirclesinthefirstdecadeofthenewmillenniumuntiltheonsetoftherecentglobalfinancialcrisis.1Theempiricalbasisforthiswasprovidedbystudiesoftradepatterns based on readily available trade data, which revealed a continuousincreaseintradeamongthecountriesintheregion(intra-regionaltrade)sincethe late 1980s—a process that received added impetus from the subsequentemergenceofChinaasaworldexportpowerhouse.Afewstudiesquestionedthevalidity of this inference in a context inwhich international productionfragmentation and the related network trade had been rapidly expandingwithEastAsiaasitscentreofgravity(Roach2009:Ch.1;Bergstenetal.2006;Athukorala2005;Garnaut2003).Thedecouplingthesiscontinuedtodominatethepolicyscene,however,presumablybecauseitfittedwellwiththeEastAsiangrowtheuphoriaoftheday.

TheglobalfinancialcrisishasservedtorevealthefragilityofthedecouplingthesissinceallmajorEastAsiancountries,includingChina,haveexperiencedprecipitoustradecontractions.Consequently,thepolicydebateinEastAsiahasmadeaU-turnfromthecomplacencyofthedecouplingthesistoacallfortherebalancingofEastAsiangrowthwithaviewtoreducingitssusceptibilitytothevicissitudesoftheglobalbusinesscycle(ADB2010;IMF2010).

1 SeeUrata(2006),Yoshitomi(2007)andParkandShin(2009)andtheworkscitedtherein.Alltheseauthorsareconcernedwith‘tradedecoupling’asopposedtotheabilityoflargeAsianeconomieslikeIndiaandChinatocontinuetogrowstronglyonthebasisofdomesticdemandexpansionevenifgrowthinthedevelopedworldslowsdown.Thischapterfocusessolelyonthe‘tradedecoupling’debate.


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Whatwentwrongwiththedecouplingthesis?Wasthetrade-integrationstorythatunderpinnedthedecouplingthesissimplyastatisticalartefact,resultingfromafailuretoincorporatetherealitiesofaneraofglobalproductionsharing?WhatarethepolicychallengesfacedbytheEastAsianeconomiesinthepost-globalfinancialcrisisera?Isthereroomforanintegratedpolicyresponsethatmarksacleardeparture from thepre-crisispolicy stance favouringoutward-orienteddevelopmentstrategies?ThischapteraimstoprobetheseandrelatedissuesthroughacomparativeanalysisoftheexportexperiencesofChinaandotherEastAsianeconomiesintheaftermathofthecrisisagainstthebackdropofasystematicanalysisofpre-crisistradepatterns.

The decoupling thesis is based on the traditional notion of horizontalspecialisation,accordingtowhichinternationaltradeisanexchangeofgoodsthatareproducedfromstarttofinishinjustonecountry.Itignorestheimplicationsfortrade-flowanalysisofthecontinuingprocessofglobalproductionsharing2—thebreakingupof theproductionprocesses intoseparatedstages,witheachcountryspecialisinginaparticularstageoftheproductionsequence—andtheincreasinglyimportantroleplayedbyChinaandotherEastAsiancountriesintheresultantglobalproductionnetwork.Inacontextinwhichproductionsharing-basedtradeisgrowingrapidly,trade-flowanalysisbasedontheassumptionofhorizontalspecialisationcanleadtomisleadinginferencesaboutthenatureandextentoftradeintegrationamongcountriesforthreereasons.

First, in the presence of global production sharing, trade data are double-countedbecausegoods-in-process crossmultiple internationalbordersbeforebecomingembodied in thefinalproduct.Thus, the totalamountofrecordedtradecouldbeamultipleofthevalueoffinalgoods.Second,andperhapsmoreimportantly, trade shares calculated using reported data can lead to wronginferencesastotherelativeimportanceofthe‘region’andtherestoftheworldfor the growth dynamism of a given country, even controlling for double-counting in trade.This isbecause ‘fragmentation trade’ and trade in relatedfinalgoods (‘final trade’) areunlikely to followthe samepatterns.Third, theintra-regionaltraderatioestimatedbylumpingtogether importsandexportstendstohideasignificantasymmetryinregionaltradepatternsofimportsandexportsinacontextinwhichnetwork-relatedtradeisgrowingrapidly.

Giventheseconcerns,ameaningfulanalysisoftradepatternsrequiressystematicseparationofparts and components (henceforth referred to as ‘components’)fromfinal (assembled)products inreportedtradedata.Wedothisthroughacarefuldisaggregationof tradedatabasedonRevisionThreeof theStandardInternational Trade Classification (SITC, Rev. 3) extracted from the UnitedNationstrade-datareportingsystem(UNn.d.).3

2 Intherecentliterature,anarrayofalternativetermshasbeenusedtodescribethisphenomenon,including‘internationalproductionfragmentation’,‘verticalspecialisation’,‘slicingthevaluechain’and‘outsourcing’.3 Fordetailsonthedecompositionprocedure,andthelistofpartsandcomponentsusedintheanalysis,seeAthukorala(2009c).

China and East Asian trade

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For the purpose of this chapter, East Asia is defined to include Japan anddevelopingEastAsia,whichcoversthenewlyindustrialisedeconomies(NIEs)ofNorthAsia (SouthKorea,TaiwanandHongKong),China andmembersofthe Association of South-East Asian Nations (ASEAN). Among the ASEANcountries, Myanmar is not covered because of a lack of data and Brunei,CambodiaandLaosaretreatedasaresidualgroupbecauseofdatagaps.TheEastAsianexperienceisexaminedinthewiderglobalcontext,focusingspecificallyonthecomparativeexperiencesoftheNorthAmericanFreeTradeAgreement(NAFTA)andtheEuropeanUnion.

Thischapterisstructuredasfollows.ThefirstsectionexaminestradepatternsinEastAsiaintheglobalcontext,payingattentiontothenatureandextentofproductionsharingandnetwork-basedtrade,EastAsia’sroleinthisnewformofinternationalexchangeanditsimplicationsforregionalversusglobaleconomicintegration.Inthenextsection,thelatestavailabledataareusedtoexaminetheimpactof theglobalfinancial crisison theexportperformanceofEastAsianeconomies.Thenextsectiondealswithpost-crisispolicychallenges,focusingon the emerging debate regarding rebalancing (or reshaping) developmentstrategies.Thefinalsectionsummarisesthekeyfindingsanddrawssomegeneralinferences.

Pre-crisis trade patterns

Rapid export growth has been the hallmark of East Asia’s rise in the globaleconomy.ThecombinedshareofEastAsiancountriesinworldnon-oilexportsrecorded a threefold increase between 1969–70 and 2006–07—from 11 percent to 33per cent.4The region accounted formore than40per cent of thetotalincrementinworldexportsinthisperiod.Inthe1970sand1980s,Japandominatedtheregion’strade,accountingfornearly60percentofitsexportsandimports.Thepicturehaschangeddramaticallyinthepasttwodecades,withtheshareofdevelopingEastAsiancountriesincreasingrapidlyinthefaceofarelativedeclineinJapan’spositioninworldtrade.Bythemiddleofthisdecade,these countries accounted for more than 80 per cent of total regional trade.The riseofChinahasbeen thedominant factorbehind this structural shift,5buttheothercountriesintheregion(Taiwan,Korea,Malaysia,Singapore,thePhilippines,Thailand and, more recently,Vietnam) have also increased theirworldmarketshares.

4 TrademagnitudesthroughoutthechapteraremeasuredincurrentUSdollarsunlessotherwiseindicated.Inter-temporalcomparisoncalculationsaremadeforthetwo-yearaveragesrelatingtotheendpointsoftheperiodunderstudy,soastoreducetheimpactofyear-to-yearfluctuationsoftradeflows.Alldatareported,unlessotherwisestated,arecompiledfromtheUNComtradedatabase(UNn.d.).5 FordetailsonChina’sriseasamajortradingnationandtheimplicationsofthisfortheothercountriesintheregion,seeAthukorala(2009a,2009b).


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RapidexportgrowthinEastAsiahasbeenunderpinnedbyapronouncedshiftintheregion’sexportstructureawayfromprimarycommoditiesandtowardsmanufacturing.By2006–07,manufacturingaccountedfor92percentoftotalexportsfromAsia—upfrom78percentfourdecadesago.Withinmanufacturing,machinery and transport equipment (SITC 7)—particularly information andcommunicationtechnology(ICT)productsandelectricalgoods—hasplayedapivotalroleinthisstructuralshift.TheshareofAsiainworldmachineryandtransportequipmentexportsincreasedfrom14.5percentin1994–05to42.4percentin2006–07,withdevelopingEastAsiaaccountingformorethanfour-fifthsoftheincrement.By2006–07,morethan58percentoftotalworldICTexportsoriginatedfromAsia,withChinaaloneaccountingfor23percent(Table10.1).Inelectricalgoods,China’sworldmarketshareincreasedfrom3.1percentto20.6percentbetweenthesetwoyears.Exportdynamismintheseproductlineshasbeendrivenby thecontinuingprocessofglobalproductionsharingandtheincreasinglydeepintegrationofEastAsiancountriesintoglobalproductionnetworks.

Table 10.1 Composition of manufacturing exports, 2006–07 (per cent)

Commodity group

EA Japan DEA China TW+K ASEAN NAFTA EU15 World

Chemicals(SITC 5)

0 .1 0 .1 0 .1 0 .1 0 .1 0 .0 0 .2 0 .2 0 .2

Resource-based products (SITC 6 – SITC 68)

1 .2 1 .8 0 .9 1 .0 1 .0 0 .7 2 .1 2 .8 2 .0

Machinery and transport equipment (SITC 7)

89 .7 87 .5 90 .3 91 .6 84 .0 94 .7 86 .0 87 .9 88 .1

Power-generating machines (SITC 71)

1 .8 3 .8 1 .1 1 .1 1 .1 1 .2 9 .0 6 .6 4 .9

Specialised industrial machines (SITC 72)

2 .1 3 .5 1 .7 1 .8 1 .1 2 .3 2 .6 3 .5 2 .7

Metal-working machines (SITC 73)

0 .3 0 .6 0 .2 0 .2 0 .3 0 .1 0 .4 0 .7 0 .5

General industrialmachinery (SITC 74)

1 .3 1 .7 1 .2 1 .4 0 .9 1 .2 2 .4 3 .5 2 .3

ICT products 60 .5 33 .2 68 .9 69 .2 59 .7 78 .3 27 .6 22 .9 41 .1


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Office/automaticdata-processing machines (SITC 75)

19 .6 8 .2 23 .1 29 .0 8 .7 27 .0 7 .2 7 .6 12 .4

Telecommu-nication and sound-recording equipment (SITC 76)

18 .7 9 .0 21 .7 28 .3 16 .1 14 .9 9 .6 7 .9 13 .1

Semiconductors and semiconductor devices (SITC772+776)

22 .2 16 .0 24 .2 11 .8 34 .9 36 .4 10 .8 7 .5 15 .7

Electrical goods (SITC 77–772–776)

9 .7 8 .1 10 .2 14 .2 6 .1 6 .4 8 .2 8 .5 9 .3

Road vehicles (SITC 78)

12 .7 35 .0 5 .9 3 .2 12 .6 4 .4 26 .5 36 .4 23 .0

Other transport equipment (SITC 79)

1 .3 1 .6 1 .2 0 .7 2 .3 0 .9 9 .3 5 .7 4 .4

Miscellaneous manufacturing (SITC 8)

9 .1 10 .6 8 .7 7 .3 14 .9 4 .6 11 .8 9 .1 9 .8

Professional and scientific equipment (SITC 87)

5 .5 5 .8 5 .4 4 .0 11 .0 2 .6 8 .2 5 .9 6 .3

Photographic apparatus(SITC 88)

2 .3 3 .6 1 .9 2 .4 1 .2 1 .3 1 .3 1 .8 2 .1

Total manufacturing exports

100 100 100 100 100 100 100 100 100

US$billion 1826 428 1398 656 359 348 739 1366 4517

Notes:StandardInternationalTradeClassification(SITC)codesaregiveninparentheses.EA=EastAsia;DEA=developingEastAsia;TW+K=TaiwanandKorea;ASEAN6=sixmainASEANcountries;EU15=15membercountriesoftheEuropeanUnion;NAFTA=countriesintheNorthAmericanFreeTradeAgreement(UnitedStates,CanadaandMexico).

Source:CompiledfromUnitedNations(UN)n.d.,Comtrade database,UnitedNations,NewYork.

The best available indicator of the intensity of global production sharing isthe share of parts and components in total manufacturing trade.6 Reflecting

6 Henceforth,forthesakeofbrevity,weusetheterm‘components’inplaceof‘partsandcomponents’.


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the rapid growth of global production sharing, the share of components inmanufacturing trade has sharply increased across all major countries in theregion (Table 10.2). In 2006–07, components accounted for 34.1 per cent ofEast Asian manufacturing exports (42.1 per cent of manufacturing imports)comparedwithaworldaverageof27.1percent(27.3percentofimports).Theshareofcomponents isparticularlyhighamongtheASEANcountries.Thereisaremarkablesimilarity incomponentsharefigures inexportsand importsacross countries, reflecting overlapping specialisation patterns in componentassemblyamongcountriesintheregion.

Table 10.2 Share of parts and components in manufacturing trade, 1992–03 and 2006–07 (per cent)

Exports ImportsRegion 1992–93 2006–07 1992–93 2006–07East Asia 20 .2 34 .1 27 .2 42 .1

Japan 23 .9 34 .4 19 .3 29 .9

Developing East Asia 17 .3 34 29 44 .2

China (PRC) 7 .4 25 .6 20 .4 44

Hong Kong, China 15 .8 33 .3 24 .1 48 .5

Taiwan 24 .7 44 .2 29 .5 38 .9

Republic of Korea 18 .1 47 .3 30 .1 31 .9

ASEAN 22 .7 44 .2 36 47 .9

Indonesia 3 .8 21 .5 27 21 .8

Malaysia 27 .7 53 .6 40 .5 50

The Philippines 32 .9 71 .7 32 .6 61 .3

Singapore 29 49 .3 39 .9 60 .4

Thailand 14 .1 29 .9 30 .6 36 .1

Vietnam n .a . 11 .0 n .a . 19 .1

South Asia 2 .3 8 .2 16 .6 23 .8

India 3 10 .4 17 .5 22 .9

NAFTA 28 .4 31 .2 37 .4 28 .8

Mexico 42 .1 34 .6 29 .4 36 .1

EU15 18 .3 22 .4 21 .2 23 .2

Industrialised countries 20 .4 25 .2 22 .6 23 .4

Developing countries 14 .6 29 .2 11 .9 33 .6

World 19 .3 27 .1 19 .6 27 .3

n.a.notavailable

Source:CompiledfromUnitedNations(UN),n.d.,Comtrade database,UnitedNations,NewYork.

The rapid increase in component intensity (percentage shares of parts andcomponents) in East Asian trade is closely associated with cross-bordercomponenttradewithinregionalproductionnetworks.AscanbeseeninTable10.3,componentsaccountforamuchlargershareofintra-regionaltradeinEastAsiathanthesecountries’sharesofworldtradeandtradewiththeEuropean


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UnionandNAFTA.Moreover,theshareofcomponentsintotalintra-regionalimportsismuchlargerthaninexports—andhasincreasedatafasterrate.Thisreflectsthefactthattheregionreliesontherestoftheworldmoreasamarketfor final goods than as a market for components.Within East Asia, ASEANcountries stand out for the high share of components in their intra-regionaltrade flows (more than 60 per cent in 2006–07). According to country-leveldata,theshareofcomponentsinmanufacturingexportsandimportsamountedtomorethanfour-fifthsinSingapore,MalaysiaandthePhilippinesandmorethan two-thirds in Thailand. South Korea and Taiwan are also involved insizeabletrade incomponentswithothercountries intheregion.In2006–07,componentsaccountedfor59.2percentand74percentofChina’simportsfromdevelopingAsiaandASEANcountries,respectively,comparedwith44percentintotalimports.

Table 10.3 Share of parts and components in bilateral trade flows, 2006–07 (per cent)

Reportingcountry

EA Japan DEA PRC ASEAN NAFTA EU15 World

(a) Exports East Asia 47 .6 32 .9 50 .1 51 .6 54 .5 25 .1 24 .1 34 .1

Japan 42 .0 0 .0 42 .0 41 .5 47 .9 31 .5 30 .4 34 .4

Developing East Asia

48 .1 33 .4 53 .9 0 .0 65 .2 22 .7 21 .6 34 .0

China (PRC) 36 .2 25 .2 40 .6 0 .0 49 .1 17 .1 16 .3 25 .6

Korea 61 .9 51 .5 63 .5 57 .3 63 .7 36 .6 26 .8 44 .2

Taiwan 51 .5 59 .0 50 .5 39 .5 61 .2 35 .0 37 .6 44 .2

ASEAN10 58 .2 39 .9 61 .4 64 .0 56 .0 32 .1 33 .9 44 .2

NAFTA 46 .7 36 .5 49 .8 34 .8 67 .9 28 .8 30 .6 31 .2

EU15 31 .4 18 .7 34 .8 30 .4 46 .5 22 .1 22 .0 22 .4

(b) ImportsEast Asia 51 .7 48 .8 52 .8 34 .8 68 .3 54 .7 33 .1 42 .1

Japan 34 .2 0 .0 34 .2 23 .1 44 .9 41 .0 18 .9 29 .9


55 .5 47 .7 59 .5 0 .0 74 .3 40 .3 31 .7 44 .2

China (PRC) 55 .2 47 .5 59 .2 0 .0 74 .0 40 .1 31 .6 44 .0

Korea 33 .0 26 .6 38 .1 26 .1 55 .7 38 .9 22 .9 31 .9

Taiwan 46 .7 33 .8 58 .3 44 .1 68 .8 40 .2 28 .0 38 .9

ASEAN10 50 .3 47 .2 51 .4 40 .1 55 .9 67 .5 41 .7 47 .9

NAFTA 29 .4 39 .3 26 .0 17 .7 40 .5 36 .3 25 .1 28 .8

EU15 25 .0 33 .6 22 .8 14 .9 37 .9 34 .1 22 .1 23 .4

Notes:EA=EastAsia;DEA=developingEastAsia;ASEAN6= sixmainASEANcountries;EU15=15 member countries of the European Union; NAFTA = countries in the North American FreeTradeAgreement(UnitedStates,CanadaandMexico).



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China in East Asian trade

Manufacturing products dominate China–East Asia trade flows, accountingfor nearly 90 per cent of imports and exports (Table 10.4). In China’s totalmanufacturing imports from East Asia, the share of components increasedfrom 18 per cent in 1994–05 to more than 44 per cent in 2006–07. Withinmanufacturing, the share of components is much larger in machinery andtransportequipmentimports,atnearlythree-quartersin2006–07.Thesharesofcomponentsinmanufacturingexportsalsohaveincreasedovertheyears,butthemagnitudesaresignificantly lowercomparedwith those in total imports.Interestingly,althoughChina’simportanceasamarketfortherestofEastAsiahasincreasedduringtheperiodunderstudy(seebelow),theimportanceoftheregionforChina’sexportexpansionhasdeclinednotably,asitabsorbedonly33.7percentofChina’stotalmerchandiseexportsin2006–07—downfrom55.8percentin1993.EastAsia’sshareinChina’stotalimportsincreasedmarginallyfrom21.3percentin1992–03to28.8percentin2006–07.

Table 10.4 China’s trade with the rest of East Asia (per cent)

Exports Imports

A: Commodity composition 1994–95 2006–07 1994–95 2006–07

A1: Total trade 100 100 100 100

Primary products 16 .2 10 .4 23 .5 13 .5

Manufacturing 83 .4 89 .2 76 .1 86 .3

Machinery and transport equipment (SITC 7) 20 .8 46 .6 26 .4 49 .7

Electronics and electrical goods (75 + 76 + 77) 16 .7 40 .6 15 .0 43 .0

Miscellaneous manufacturing (SITC 8) 43 .3 25 .5 7 .7 12 .5

Apparel (84) 18 .5 10 .3 1 .3 0 .4

A2: Parts and components 100 100 100 100


Electronic and electrical goods (75 + 76 + 77) 81 .0 87 .7 74 .6 85 .7

Transport equipment (78) 3 .7 2 .3 0 .7 1 .8

Other 9 .8 4 .5 3 .8 3 .3

B: Parts and component share in manufacturing trade

Total manufacturing 7 .5 25 .6 17 .9 44 .4



Transport equipment 25 .4 50 .1 16 .3 79 .0

Other 1 .4 4 .0 18 .0 14 .4


201

C: Trade with East Asia in China’s world trade

C1: Total trade 55 .8 33 .7 21 .3 28 .4

Primary products 74 .6 59 .2 27 .9 15 .5

Manufacturing 53 .3 32 .2 19 .9 32 .7




Apparel (84) 59 .1 38 .1 45 .1 52 .9

C2: Parts and components 60 .1 44 .7 22 .4 38 .7



Transport equipment 44 .2 23 .2 5 .6 21 .7


Note:EastAsia=developingEastAsiaandJapan.


Table10.5summarisesdataonChina–EastAsiatraderelationsattheindividualcountrylevel.DataonthegeographicprofileofChina’smanufacturingimportsfromtheregionareinPanelA.PanelBgivesdataontherelativeimportanceofChinaasanexportdestinationoftheEastAsianeconomies.Nearly60percentofChina’smanufacturingimportsoriginateinEastAsia.ThebulkoftheseimportscomefromJapan,KoreaandTaiwan.TheshareofimportscomingfromtheotherEastAsiancountriesissmall,althoughgrowingfast.In2007,Chinaaccountedforonly21.2percentoftotalmanufacturingexportsfromtherestofEastAsia.Attheindividualcountrylevel,Chinaaccountedfor33percentand27percentofexportsfromTaiwanandKorea,respectively.ChinawasalsooneofthemostimportantexportdestinationsofthePhilippines,accountingformorethanone-fifthoftotalexports.ForallotherASEANcountries,thefiguresaremuchsmaller—varyingfrom8percentto13.5percent.Clearly,aggregatedatahidesomesignificantdifferencesamongEastAsiancountriesintradelinkswithChina,withChina’sintra-regionaltradeconcentratedlargelyintradewithJapan,KoreaandTaiwan.


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Table 10.5 East Asia–China manufacturing trade

Region A: Geographic profile of China’s imports

B: Exports to China relative to total exports by country/

region

1994–95 2006–07 1994–95 2006–07East Asia 58 .2 58 .6 7 .6 21 .2

Japan 20 .9 16 .4 5 .5 17 .3

Developing East Asia 37 .1 42 .2 8 .2 21 .6

Hong Kong 17 .3 2 .0 29 .6 19 .5

Korea 4 .3 13 .4 5 .8 27 .2

Taiwan 10 .7 14 .0 10 .3 32 .6

ASEAN 3 .7 13 .8 2 .5 13 .7

Indonesia 1 .0 1 .1 3 .3 8 .4

Malaysia 1 .1 3 .4 3 .2 13 .5

The Philippines 0 .2 2 .1 1 .5 21 .3

Singapore 0 .8 2 .3 1 .8 12 .2

Thailand 0 .7 2 .3 1 .8 11 .2

Vietnam 0 .1 0 .1 2 .5 4 .1

Other countries 41 .8 41 .4 1 .5 3 .7

World 100 100 2 .7 6 .7

Sources:Compiled fromUnitedNations (UN)n.d.,Comtrade database,UnitedNations,NewYork; andCouncil for Economic Planning and Development n.d., Trade Data, CD-ROM, Council for EconomicPlanningandDevelopment,Taipei(fordataonTaiwan).

Intra-regional trade patterns

The previous section reveals three important features of the emerging tradepatterns in East Asia compared with overall patterns of global trade. First,componenttradehasplayedamoreimportantroleintradeexpansioninEastAsia.Second,tradeincomponentsaccountsforamuchlargershareinintra-regionaltradethanisthecasefortherestoftheworld.Third,China’srapidtradeexpansionlargelyreflectsitsroleasanassemblycentrewithinglobalproductionnetworks; China’s trade links with the rest of East Asia are dominated bycomponentsforassemblingfinalproducts,whicharedestinedpredominantlyformarketsintherestoftheworld.Giventhesethreepeculiarities,conventionaltrade-flow analysis is bound to yield a misleading picture of the relativeimportanceof intra-regional trade—comparedwithglobal trade—forgrowthinEastAsia.

To illustrate this point, intra-regional trade shares are estimated separatelyfor total manufacturing, components and final goods (total manufacturingnetofcomponents)(Table10.6).ThetablecoverstradeinEastAsiaandthree


203

sub-regions therein, which relate to contemporary Asian policy debates onregionalintegration.DataforNAFTAandtheEuropeanUnionarereportedforcomparativepurposes.Estimatesaregivenfortotaltrade(importsplusexports)as well as for exports and imports separately in order to illustrate possibleasymmetriesintradepatternsresultingfromEastAsia’sincreasedengagementinfragmentation-basedinternationalexchange.7

Table 10.6 Intra-regional shares of manufacturing trade: total, parts and components and final trade, 1992–93 and 2006–07 (per cent)

East Asia DevelopingEast Asia

ASEAN+31 ASEAN NAFTA EU15

Total trade

Exports1986–97 28 .4 25 .1 17 .3 17 .4 49 .1 65 .5

1992–93 47 .2 38 .2 15 .3 20 .7 44 .4 61 .2

2006–07 43 .9 33 .4 21 .9 18 .4 48 .1 56 .9

Imports1986–97 48 .6 22 .9 34 .4 11 .0 29 .9 69 .7

1992–93 58 .2 34 .9 43 .0 15 .5 36 .3 64 .1

2006–07 64 .4 46 .7 49 .3 20 .8 32 .0 57 .9

Trade (exports + imports)1986–97 35 .8 24 .0 22 .9 13 .5 37 .1 67 .5

1992–93 53 .2 36 .5 27 .0 17 .8 39 .9 62 .6

2006–07 55 .1 40 .0 30 .4 20 .1 38 .4 57 .4

Parts and components

Exports1992–93 50 .2 42 .6 33 .7 30 .3 43 .5 62 .3

2006–07 61 .1 53 .9 35 .3 25 .4 46 .9 55 .9

Imports1992–93 65 .9 35 .3 39 .6 20 .2 39 .5 58 .0

2006–07 66 .9 50 .9 47 .8 22 .9 39 .9 55 .2

Trade1992–93 57 .0 38 .7 35 .4 24 .2 41 .4 60 .1

2006–07 62 .9 52 .1 40 .2 23 .1 43 .2 55 .5

Final goods2

Exports1992–93 46 .0 36 .8 11 .4 16 .1 44 .7 60 .9

2006–07 36 .9 28 .3 17 .0 15 .9 48 .7 57 .0

7 Disaggregateddataneededforseparatingpartsandcomponentsfromtotal(reported)tradeareavailableonlyfrom1992(Athukorala2009b).


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Imports1992–93 55 .4 34 .7 43 .4 12 .9 35 .3 65 .6

2006–07 63 .0 42 .8 50 .2 20 .6 30 .2 58 .5

Trade1992–93 50 .3 35 .7 25 .4 14 .3 39 .4 63 .2

2006–07 46 .4 34 .0 29 .1 18 .0 37 .3 57 .7

1ASEAN+Japan+Korea+China

2Totaltrade–partsandcomponents.

Note:Intra-regionaltradeshareshavebeencalculatedexcludingbilateralflowsbetweenChinaandHongKong.

Sources:Compiled fromUnitedNations (UN)n.d.,Comtrade database,UnitedNations,NewYork; andCouncil for Economic Planning and Development n.d., Trade Data, CD-ROM, Council for EconomicPlanningandDevelopment,Taipei(fordataonTaiwan).

Trade patterns depicted by the unadjusted (standard) trade data affirm theperceptionunderlyingthedecouplingthesisthatAsia,andinparticularEastAsia,hasbecomeincreasinglyintegratedthroughmerchandisetrade.In2006–07, intra-regional trade accounted for 55.1 per cent of total manufacturingtrade—upfrom35.8percentin1986–87.Thelevelofintra-regionaltradeinEastAsiawashigherthanthatinNAFTAthroughoutthisperiodandwasrapidlyapproaching the level of the European Union 15. For developing East Asia(AsiaexcludingJapan)andASEAN+3,theratiosarelowerthantheaggregateregionalfigure,buttheyhaveincreasedatamuchfasterrate.Theintra-regionaltradeshareofASEANhasbeenmuchlowerthantheothertwosub-regions.

Thepicturechangessignificantly,however,whencomponentsarenettedout:theintra-EastAsianshareinfinaltradein2006–07was46.4—downfrom50.3percentin1992–93.TheestimatesbasedonunadjusteddataanddataonfinaltradearevastlydifferentforEastAsia,particularlyfordevelopingEastAsiaandASEAN.Theleveloftradeinthetwogivenyearsandthechangeovertimeinintra-regionaltradesharesaresignificantlylowerforestimatesbasedonfinaltrade.Interestingly,wedonotobservesuchadifferenceinestimatesforNAFTAandtheEuropeanUnion.

Theintra-regionalsharescalculatedseparatelyforimportsandexportsclearlyillustratetheriskofmakinginferencesaboutregionaltradeintegrationbasedontotal(importsplusexports)data.Thereisanotableasymmetryinthedegreeofregional trade integration inEastAsia.Unlike intheEuropeanUnionandNAFTA,inEastAsia,theincreaseovertimeintheintra-regionaltraderatio(bothmeasuredusingunadjusteddataanddataforfinaltrade)hasemanatedlargelyfromtherapidincreaseinintra-regionalimports;theexpansioninintra-regionalexportshasbeenconsistentlyslower.ThedependenceofEastAsia(andcountrysub-groupstherein)onextra-regionalmarkets (inparticular, those inNAFTA


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andtheEuropeanUnion)forexport-ledgrowthisfargreaterthanisrevealedby the standard intra-regional trade ratios commonly used in the debate onregionaleconomicintegration.Forinstance,in2007,only43.9percentoftotalEastAsianmanufacturingexportswasabsorbedwithintheregion,comparedwithanintra-regionalshareof64.4percentintotalmanufacturingimports.FordevelopingEastAsia,thecomparablefigureswere33.4percentand46.7percent,respectively.Thisasymmetryisclearlyseenacrossallsub-regionswithinEastAsia.Theasymmetrybetweenintra-regionalsharesofimportandexportsismuchsharperwhencomponentsarenettedout.Thisisunderstandablegiventheheavy‘componentbias’inAsianintra-regionaltradeandthemultiplebordercrossingofpartsandcomponentswithinregionalproductionnetworks.Ontheexportside,theintra-regionalshareoffinalgoodsdeclinedcontinuouslyfrom46percentin1995to37percentin2007,whereastheintra-regionalimportshareincreasedfrom56percentto63percentbetweenthesetwotimepoints.

Insum,thesedatasupport thehypothesis that, inacontext inwhichglobalproduction sharing is expanding rapidly, standard trade flow analysis cangeneratemisleading inferencesregardingtheprocessofeconomic integrationthroughtrade.Whendataoncomponenttradeareexcludedfromtradeflows,theseestimatessuggestthatextra-regionaltradeismuchmoreimportantthanintra-regionaltradeforcontinuedgrowthinEastAsia,whetherornotJapanis included.Thus, the rising importance of global production sharing seemstohavestrengthened, rather thanweakened,EastAsia’s linkwith thewiderexternaleconomy.Aswewillseeinthenextsection,thisinferenceisbasicallyconsistentwiththebehaviouroftradeflowsinEastAsiaaftertheonsetoftheglobalfinancialcrisis.

Trade performance in the aftermath of the crisis

Astrikingfeatureoftheglobaleconomysincetheonsetoftheglobalfinancialcrisisinlate2007hasbeentheprecipitousdropinglobaltrade—ataratefasterthan thatduring theGreatDepression (Almuniaet al. 2010;Krugman2009).FromApril2008toJune2009,worldtradecontractedbyabout20percent,whichamountedtoalmostthetotalcontractioninworldtradeduringthefirst30monthsoftheGreatDepression(startinginApril1929).8Interestingly,thetradecontractionexperiencedbytheEastAsiancountriesduringthisperiodhasbeenevengreaterthanthecontractionintotalworldtrade(Figure10.1andTable10.7).

8 NumbersderivedfromAlmuniaetal.(2010:Figure5).


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Figure 10.1 Growth of merchandise trade: East Asia, developing East Asia, China and ASEAN, January 2008 – November 2009 (year-on-year, per cent)

-150.0

150.0

China

ASEAN


East Asia

Jan 1

2Ap

r 12

Jul 1

2Oc

t 12

Jan 1

3Ap

r 13

Oct 1

3-100.0

-50.0

0.0

50.0

100.0

a) Exports

-150.0

200.0

-100.0-50.0

0.0

50.0

150.0

-200.0

Jan

12Ap

r 12

Jul 1

2Oc

t 12

Jan

13Ap

r 13

Oct 1

3

China

ASEAN


East Asia

b) Imports

Source:BasedondatacompiledfromCEIMdatabase.


207

Table 10.7 East Asia: growth of total merchandise exports and imports, 2007Q1 – 2009Q3 (year-on-year percentage change)

2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3

ExportsEast Asia 20 .6 21 .0 19 .3 –5 .6 –30 .1 –32 .5 –30 .2

Japan 22 .9 16 .4 15 .2 –8 .1 –42 .1 –41 .1 –38 .2


19 .0 21 .3 19 .9 –4 .7 –26 .6 –27 .2 –24 .2

Hong Kong 10 .5 8 .3 5 .7 –2 .1 –21 .0 –23 .4 –20 .1

China 21 .1 22 .4 23 .0 4 .6 –20 .1 –22 .7 –20 .3

Korea 17 .4 23 .2 27 .1 –9 .9 –24 .5 –20 .1 –20 .3

Taiwan 17 .4 18 .2 7 .6 –24 .6 –35 .9 –28 .3 –18 .5

ASEAN 18 .9 26 .9 22 .9 –10 .3 –36 .8 –39 .3 34 .2

Indonesia 31 .9 29 .4 27 .9 –5 .3 –32 .5 –33 .2 31 .1

Malaysia 19 .4 28 .5 21 .6 –12 .6 –27 .6 –28 .2 3 .8

Philippines –2 .0 –0 .6 2 .0 –22 .3 –33 .9 –36 .3 –37 .2

Singapore 21 .7 26 .4 21 .2 –12 .9 –30 .7 –31 .2 –33 .2

Thailand 25 .5 25 .5 27 .2 –10 .2 –23 .0 –24 .4 –26 .3

Vietnam 27 .7 31 .8 37 .5 6 .0 –14 .8 –11 .7 –7 .3

ImportsEast Asia 29 .6 29 29 .8 –4 .1 –32 .5 –33 .1 30 .7

Japan 25 .6 26 .8 35 .8 8 .3 –29 .0 –28 .5 –28 .1


29 28 .9 26 .6 –8 .0 –32 .1 –34 .2 –33 .2

Hong Kong 12 .0 9 .6 7 .0 –4 .0 –20 .8 –22 .3 –25 .2

China 29 .4 32 .9 25 .9 –8 .0 –30 .8 –31 .7 –30 .3

Korea 29 .0 30 .5 42 .9 –8 .8 –32 .8 –35 .6 –11 .9

Taiwan 26 .1 19 .2 20 .3 –21 .9 –45 .9 –46 .3 –47 .2

ASEAN 37 .9 36 .2 32 .6 –5 .0 –37 .2 –36 .7 –35 .3

Indonesia 91 .6 96 .1 82 .3 33 .3 –35 .9 –36 .2 –34 .2

Malaysia 16 .1 17 .3 14 .5 –17 .1 –36 .8 –36 .1 4 .8

Philippines 22 .1 8 .4 4 .5 –23 .4 –30 .3 –31 .3 –32 .1

Singapore 32 .1 35 .4 32 .9 –9 .3 –30 .0 –28 .1 –29 .2

Thailand 39 .6 25 .7 37 .8 3 .8 –39 .7 –40 .5 –37 .3

Vietnam 69 .0 61 .0 22 .8 –8 .2 –36 .5 –34 .1 –31 .1

Note:GrowthratescalculatedusingcurrentUSdollarvalues.

Source:CompiledfromCEICDataCompany.

Krugman(2009)pointstotheincreasedverticalintegrationofglobalproduction(the rise of global production sharing) as a possible explanation for thesurprisinglylargetradecontractioninthepresentcrisiscomparedwiththatintheGreatDepression.Verticalintegrationofproductionimpliesthatagivendegree


208

ofcontractionindemandforafinal(assembled)producthasramificationsfortradeflowsbetweenthemanycountriesinvolvedintheproductionchain.Also,demandforcomponentsissusceptibletorapidstockadjustmentbyproducerscomparedwithfinalgoods.GiventhatglobalproductionsharingismuchmoreimportantfortradeexpansioninEastAsia,thisexplanationalsoseemsrelevantforEastAsia’sgreatertradecontractioncomparedwithoveralltradecontractionat theglobal level.Anumberofother factorsare,however,alsorelevant forexplainingthelargercontractionintradevolumeinthecurrentcrisis.Theseincludethemuchlargercontractionoftradecredit,agreatershareofconsumerdurablesincontemporaryglobaltradecomparedwiththe1930sandtheeffectofrecentadvancesincommunicationtechnologyoninventorycyclesandjust-in-timeprocurementpractices.Thecurrentstateofdatumavailabilitydoesnotpermitustosystematicallydelineatetheimpactofproductionsharingontradecontraction while appropriately controlling for these other possible factors.Instead,thissectionputstogethersomereadilyavailabledatathathavesomebearingonthisissueinordertosetthestageforfurtheranalysis.

All major East Asian countries—including China, which was expected bythe decoupling enthusiasts to cushion the rest of East Asia against a globaleconomiccollapse—experiencedaprecipitoustradecontractionfromaboutthelastquarterof2008 (Table10.7).Theremarkablysynchronisednatureof thetradecontractionacrosscountries in the region—in importsandexports—isgenerallyconsistentwiththeclosetradetiesinEastAsiaforgedwithinregionalproductionnetworksandtheuniqueroleoftheregionwithinglobalproductionnetworks.

Among the East Asian countries, Japan has been by far the worst hit. Alarge shareofJapan’sexportsconsistsof capitalgoodsandhigh-enddurableconsumer goods, such as cars and electrical machinery, machine tools andtheir components.Exports of capital goods andhigh-endconsumerdurablesareconcentratedheavilyintheUnitedStatesandotherindustrialised-countrymarkets and are therefore directly exposed to the global economic decline.Ontheotherhand,contrarytothepredictionsofthedecouplingenthusiasts,Japan’sgrowingexportstoChinahavebeenindirectlyaffectedbydecliningfinal(assembled)exportsfromChina(FukaoandYuan2009).ThedegreeofexportcontractionsufferedbyTaiwanandKoreahasbeensmallerthanthatinJapan,but,onaverage,notablyhigherthanintheotherEastAsiancountries.AsinthecaseofJapan,growingexportstoChinadonotseemtohaveprovidedacushionagainstcollapseinworlddemandforthesetwocountries.TherelativelylowerdegreeofexportcontractionsexperiencedbyKorea,Taiwanandthesecond-tierexportingcountriesintheregioncomparedwithJapancouldpossiblyreflectconsumer preferences for price-competitive low-end products in the crisiscontext.


209

AninspectionofgrowthratesofexportsofindividualEastAsiancountriesbydestinationprovidesnosupportfortheviewthatEastAsianeconomieshavebecomelesssusceptibletotheworldwidetradecontractionbecauseofregionalgrowthdynamism.9Intra-EastAsiantradeflowshaveingeneralcontractedatafasterratethanthesecountries’exportstotheUnitedStatesandtheEuropeanUnion.

ExportstoChinafrommostcountriesintheregionhavecontractedatamuchfasterratethantheirimportsfromChina—perhapsanindicationofde-stockingofcomponentsbyChinesefirmsgiventhegloomyoutlookforexports (Table10.8).China’simportsfromJapan,KoreaandTaiwanhaveshrunkmorerapidly(atanaveragerateof23.5percent)thanimportsfromothercountries.Thisisnotsurprising,giventhedominantroleplayedbythesecountriesinthesupplyofcomponentstoICTassemblyactivitiesinChina,whichareheavilyexposedtocontractionsinimportdemandintheUnitedStatesandotherindustrialisedcountries. Overall, China’s intra-regional imports have contracted at a muchfasterratethanimportsfromtheUnitedStatesandtheEuropeanUnion.

Table 10.8 China: growth of total merchandise exports & imports by trading partner countries, 2007Q1 – 2009Q4 (year-on-year percentage change, current US$)

2008Q1

2008Q2

2008Q3

2008Q4

2009Q1

2009Q2

2009Q3

2009Q41

ExportsEast Asia 23 .7 25 .1 28 .2 4 .5 –23 .4 –24 .2 –18 .0 8 .2

Japan 12 .1 18 .0 18 .1 7 .9 –16 .7 –23 .8 –16 .3 –6 .7


31 .2 29 .2 33 .9 2 .7 –24 .1 –24 .5 –28 .7 7 .5

Korea 33 .1 38 .3 52 .9 7 .5 –29 .2 –36 .6 –35 .0 –3 .0

Taiwan 15 .4 21 .1 17 .3 –10 .4 –34 .5 –38 .8 –21 .4 20 .1

Hong Kong, China

10 .8 6 .5 11 .0 –9 .9 –24 .0 –21 .6 –16 .6 12 .2

ASEAN 34 .2 26 .0 27 .4 2 .8 –22 .6 –16 .8 –9 .6 23 .0

Indonesia 33 .2 41 .5 54 .8 20 .2 –26 .4 –21 .0 –24 .0 21 .3

Malaysia 33 .3 28 .2 20 .8 7 .1 –23 .9 –12 .2 –9 .1 9 .2

Philippines 30 .4 22 .8 34 .5 1 .3 –11 .8 –18 .7 –8 .5 18 .6

Singapore 15 .3 5 .9 17 .1 –0 .6 –17 .1 –12 .3 –16 .2 21 .4

Thailand 37 .2 42 .1 38 .3 5 .9 –27 .3 –29 .6 –14 .3 21 .1

Vietnam 88 .8 45 .1 16 .0 –11 .1 –30 .0 –15 .9 36 .3 58 .9

United States

5 .4 12 .2 15 .3 0 .7 –15 .4 –18 .5 –16 .7 1 .4

9 ThisinferenceisbasedonmonthlyexportdataextractedfromtheCEICDataCompany(notreportedhereforwantofspace).


210

European Union

25 .0 29 .7 23 .5 4 .1 –22 .6 –26 .6 –23 .6 –4 .2

Total exports

16 .3 19 .0 20 .2 0 .9 –21 .1 –23 .5 –20 .3 7 .2

ImportsEast Asia 18 .8 24 .1 13 .2 –18 .1 –33 .7 –23 .1 –12 .5 30 .2

Japan 17 .0 23 .7 18 .7 –5 .0 –29 .8 –21 .4 –13 .4 15 .6


19 .6 24 .3 10 .8 –23 .6 –35 .3 –23 .8 –12 .1 37 .7

Korea 14 .9 25 .0 14 .8 –18 .5 –26 .6 –18 .8 –10 .2 33 .6

Taiwan 24 .5 24 .2 5 .0 –33 .3 –43 .9 –29 .9 –14 .9 43 .8

Hong Kong 26 .0 –2 .5 11 .0 –21 .4 –49 .1 –32 .9 –33 .3 –7 .7

ASEAN 19 .9 23 .8 12 .7 –18 .9 –33 .8 –22 .1 –8 .9 12 .2

Indonesia 31 .7 30 .3 17 .3 –13 .5 –38 .0 –18 .4 –6 .3 69 .6

Malaysia 18 .4 29 .5 22 .4 –16 .1 –25 .0 –17 .0 –3 .5 60 .3

The Philippines

12 .7 5 .7 –23 .2 –48 .6 –61 .3 –51 .7 –30 .3 17 .6

Singapore 6 .7 35 .5 27 .4 –9 .3 –23 .7 –28 .2 –11 .9 27 .2

Thailand 26 .0 22 .9 15 .8 –5 .6 –29 .2 –6 .6 –0 .9 29 .7

Vietnam 64 .3 19 .0 69 .4 6 .8 –7 .9 23 .6 –8 .3 47 .7

United States

29 .7 23 .0 15 .7 3 .7 –17 .7 –13 .1 –6 .4 19 .3

European Union

25 .9 33 .0 22 .7 2 .3 –14 .7 –11 .2 –2 .2 14 .9

Total imports

21 .2 25 .0 15 .1 –12 .2 –28 .3 –19 .6 –11 .9 10 .2

1AverageforOctoberandNovember

Note:GrowthratescalculatedusingcurrentUSdollarvalues.

Source:CompiledfromCEICDataCompany.

DataonexportgrowthbymajorcommoditycategoriesforChineseimportsandexportsaresummarisedinTable10.9.Anotablepatternistherelativelysharpercontraction in thecategoryofmachineryexports (inwhichnetworktrade isheavilyconcentrated)comparedwithotherproductcategories—inparticular,traditionallabour-intensiveproducts(textilesandgarments,footwearandothermiscellaneousmanufactures).Exportsbelongingtothiscommoditycategory—inparticular,ICTproductsandconsumerelectronics—arealsopredominantlyconsumer durables, which, as already noted, are generally more susceptibleto income contraction. In traditional labour-intensive products, developing-countryproducershavetheabilitytoperformbetterpurelyonthebasisofcostcompetitivenesseveninthecontextofdepresseddemand.


211

Table 10.9 China: growth of merchandise exports and imports by commodity category, 2008Q1 – 2009Q3 (year-on-year percentage change, current US$)

2008Q1

2008Q2

2008Q3

2008Q4

2009Q1

2009Q2

2009Q3

ExportsTotal exports 16 .3 19 .0 20 .2 0 .9 –21 .1 –23 .5 –20 .3

Primary 16 .3 24 .9 29 .9 8 .6 –17 .9 –13 .6 –14 .2

Manufacturing 21 .2 23 .8 22 .0 2 .6 –20 .7 –18 .2 –17 .2

Products of chemical or allied industries

48 .5 54 .0 42 .2 3 .1 –25 .2 –24 .9 –23 .4

Plastics and articles thereof, rubber and rubber articles

13 .8 10 .1 16 .1 10 .7 –21 .1 –17 .1 –17 .3

Textiles and textile articles 22 .5 5 .3 4 .1 8 .0 –11 .4 2 .6 4 .2

Footwear, headgear, umbrellas, etc .

14 .7 14 .4 19 .7 21 .3 –1 .3 7 .2 8 .2

Base metals and articles of base metal

23 .3 18 .5 26 .4 22 .0 –9 .0 –1 .5 –4 .3

Machinery and mechanical appliances, etc .

15 .9 –15 .7 20 .9 4 .3 –31 .6 –38 .8 –42 .1

Electronics 6 .2 12 .5 61 .5 17 .2 –33 .5 –36 .5 –37 .3

Electrical machinery and equipment

20 .3 27 .0 20 .4 –1 .1 –21 .5 –19 .5 –20 .2

Miscellaneous manufactured articles

41 .5 39 .0 31 .7 9 .1 –17 .0 –19 .7 –6 .2

Imports 2008Q1

2008Q2

2008Q3

2008Q4

2009Q1

2009Q2

2009Q3

Total imports 21 .2 25 .0 15 .1 –12 .2 –28 .3 –19 .6 –11 .9

Primary 73 .5 74 .9 72 .5 5 .2 –40 .7 –35 .3 –27 .2

Manufacturing 16 .3 19 .1 11 .4 –12 .1 –26 .2 –21 .1 –19 .2

Products of chemical or allied industries

19 .6 23 .5 19 .6 –10 .5 –23 .9 –18 .2 –16 .3

Plastics and articles thereof, rubber and rubber articles

16 .3 22 .5 22 .7 –15 .6 –29 .2 –20 .1 15 .2

Textiles and textile articles 6 .3 2 .7 –3 .4 –9 .2 –22 .8 –22 .8 –23 .2

Footwear, headgear, umbrellas, etc .

47 .5 47 .7 24 .8 12 .6 –2 .8 –18 .7 –22 .2

Base metals and articles of base metal

14 .1 5 .8 8 .3 –15 .0 –26 .3 –16 .9 –2 .7

Machinery and mechanical appliances, etc .

11 .7 18 .0 9 .8 –10 .7 –24 .1 –17 .9 –8 .2

Electronics 16 .3 19 .9 15 .0 –1 .0 –19 .8 –19 .5 –3 .2

Electrical machinery and equipment

9 .5 17 .1 7 .4 –15 .2 –26 .3 –17 .4 –6 .7

Miscellaneous manufactured articles

11 .6 20 .8 1 .4 –8 .1 –5 .4 1 .6 2 .2

Source:CompiledfromCEIMdatabase.


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Policy options

At the time of writing this chapter (mid June 2010), ‘the global recovery isproceeding better than expected’ (IMF 2010:1). Industrial production in theUnitedStatesandothermajorindustrialisedcountrieshasbeguntorecoverandthedownwardspiral inworld tradevolumehasabated.Theeconomic forcesunleashed by the crisis will, however, probably run rampant for years.Therecoveryhassofarbeendrivenlargelybyunprecedentedfiscalandmonetarystimulus and there is considerable downside risk to sustainability stemmingfrom fiscal fragility. In the medium term, the United States and other crisis-affectedindustrialisedcountrieswillhavetosavemoreandspendlessinordertowinddownthemassiveaccumulatedhouseholdandpublicdebt.Giventhisglobaleconomicoutlook,whatarethepolicyoptionsavailabletogovernmentsinChinaandotherEastAsiancountriesthathavehithertodependedlargelyonexport-drivengrowth?

There has been a growing emphasis in Asian policy circles on the need forrebalancinggrowth:engineeringastructuralshift inaggregatedemandawayfromexportsandtowardsdomesticmarkets(ADB2010).Thepolicymeasuresunderconsiderationincludemeasurestoredresstheexportbiasintheincentivestructure,toreducehighsavingpropensitieswithaviewtoboostingdomesticconsumerdemandandtopromotedomesticnon-tradable(services)production.ThemajorfocusofthispolicyadvocacyisonChina.

China’s degree of export dependence is unusually high for a continentaleconomyofChina’ssize.China’sexporttogrossdomesticproduct(GDP)ratio(about40percent)grosslyexaggerates itsexportdependencebecauseof theheavy importdependenceofassemblyexports,whichaccount formorethantwo-thirdsoftotalmerchandiseexports.Eventheavailableadjustedestimates(about20percent),however,seemtoohighforChina’spotentialeconomicsize.Moreover,theunusuallyhighdomesticsavingrates,thevastpopulationbase,highlyrepresseddomesticfinancial systemandexcessivelyhighurban–ruralhouseholdincomegapallindicatethevastpotentialforpolicy-induceddomesticdemand-ledgrowthinChina.GrowthrebalancingwillnotonlyenableChinatodealeffectivelywithmassiveexternalimbalanceswhilecushioninggrowthmomentumagainstexternaldemandshocks,itwillengineeracriticalshiftinthefocusofnationaldevelopmentpolicyfromthequantityto thequalityofgrowth,withaviewtoredressingurban–ruraldisparitiesandachievingsocialharmony.

Theneedtoembarkonamajorstructuraltransitionfromexport-ledtodomesticdemand-ledgrowthwasrecognisedbytheChineseleadershipwellbeforetheonset of the global financial crisis (Roach 2009:229–33). The eleventh Five-


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Year Plan enacted in March 2006 stressed the imperatives of an enhanced,broad-basedsocialsafetynet(encompassingnotjustsocialsecuritybutruralhealthcareandeducation) to improve incomesecurity, therebyreducing theexcessprecautionarysavingsthatcontinuetoinhibittheexpansionofprivateconsumption.Chineseauthoritieshave,however,sofarfailedtoputthispolicyintoaction,presumablybecauseofstrongdomesticpoliticalpressuretomaintainthemomentumofemployment-intensivegrowththroughexportorientation(Yu2007;Fan2008).

Success on the rebalancing front will naturally involve an appreciation ofChina’srealexchangerate10—thatis,areductionintheprofitabilityoftradableproductionrelativetonon-tradableproduction.Butthisisunlikelytoimpede—atleastinthemediumterm—China’sroleasthepremierassemblycentrewithinregionalproductionnetworks.Evenafter threedecadesof rapidgrowth, theaveragehourlywagerate forChinesemanufacturingofUS$3.20 is still (as in2007)only13percentof theUShourlywagerateofUS$24.40.11Abouthalfof China’s massive labour force (about 745 million people) is still engaged inagriculture, where productivity is, on average, barely one-eighth of that inindustryandaboutone-quarterofthatintheservicesector.This,coupledwiththe high skilled–unskilled wage differential—which, according to BlanchardandGiavazzi(2006),hasrisenfrom1.3to2.1inthepastdecade—suggeststhatChinastillhasmuchpotentialformovingunskilledworkersoutofagricultureandintomanufacturingandotherproductiveurban-sectoractivities.12

Thepressureformaintainingexportcompetitioninacontextofslow-growingworlddemandcouldprovideafertilesettingfortheriseoftradefrictionsandprotectionism (Bhagwati 1988; Erixson and Razeen 2009). Fortunately, therehasnotyetbeenaprotectionistbacklash in the formoferectingtariffwalls,ashappenedduring theGreatDepression.There are,however, already signsthatcountriesareresortingtoprotection‘disguises’intheformoffilinganti-dumping complaints and imposing stringent implementation of technical,sanitary and phyto-sanitary standards, in addition to the massive financialsupportextendedbytheUnitedStatesandsomeothercountriestoautomobilemanufacturers (Gamberoni and Newfarmer 2009). The number of legislativemeasures introduced in the US Congress that involve some form of sanctionon China’s trade has multiplied in recent years (Roach 2009:241). There is

10 Whetheritwouldbepreferabletoachievethisbyadjustmentstothenominalexchangerateratherthanbyadjustmentofdomesticpricesremainsasubjectofcontroversy,whichisbeyondthescopeofthischapter.SeethechaptersbyXiaoGeng,andRodTyersandYingZhanginthisvolume.11 DatafromtheUSBureauofLaborStatisticswebsite(<ftp.bls.gov>).12 Inrecentyears,therehavebeenmanyscatteredcasesofrisingwagesandworkershortagesinindustrialcitiesinChina.Onecannot,however,realisticallyinferthisevidenceasindicativeofabroadermacroeconomictrendofemerginglabourshortagesgiventhattheChineseeconomyisstillalongwayfromhavingafullyfunctioning labourmarket.Thesecasescouldwell reflect skillmismatchesand frictionaldislocations inahighlyimperfectlabourmarketratherthangenuinelabourshortages.


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thereforeastrongcasefordevisingstrategiestofightnewprotectionismaspartof a long-term commitment to non-discriminatory multilateral and unilateralliberalisation.TheInformationTechnologyAgreement,whichcameintoforcein1997,seemstobeapromisingexampletofollow(Elek2008).Thereisalsoa case for Asia’s Group of 20 (G20) countries and the ASEAN Secretariat toconsolidatetheirpositionsagainstprotectionisttendencies.Aspartofitseffortstokeepexportmarketsopen,Chinashouldresistthetemptationtouseexportsubsidiesandotherselectivepoliciestosupportitsexportsector.Inaneraofrising unemployment and the resultant backlash against globalisation in theUnitedStatesandotherindustrialisedcountries,givingintosuchtemptationcouldbearecipeforanti-Chinatradesanctions.

OneoptionunderconsiderationinAsianpolicycirclesforsupportingregionaltradegrowthinthefaceofslowgrowthinworlddemandistoformaregion-wide free-trade agreement (FTA), encompassing ASEAN, China, Japan andKorea (andpossibly India) (KawaiandWignaraja2009;ADB2009).The logicbehindthisproposalinrelationtothenetworktradeintheregionisthattradewithin global production networks (both in components and final assembly)isgenerallymoresensitive to tariffchanges than isfinal trade (or total tradeas captured in published trade data) (Yi 2003). Normally a tariff is incurredeachtimeagood-in-processcrossesaborder.Consequently,a1percentagepointreductionintariffsleadstoadeclineinthecostofproductionofaverticallyintegrated good by a multiple of this initial reduction—in contrast with a 1percentdeclineinthecostofaregulartradedgood.Tariffreductionscanalsomakeitmoreprofitableforgoodsthatwerepreviouslyproducedentirelyinonecountry tobecomevertically specialised.Consequently, in theory, the trade-stimulatingeffectofFTAswouldbehigherfornetworktradethanfornormaltrade,otherthingsremainingunchanged.

Inourview,however, this isa riskystrategy,givenAsia’sheavyrelianceonextra-regionalmarketsforitsexportdynamism.SuchamovewouldinviteswiftretaliationbytheUnitedStatesandtheEuropeanUnion,andpossiblyothers.AfirmcommitmentaspartoftheFTAtonotincreaseexistingtariffandnon-tariffbarriersagainstnon-membersisunlikelytoavertthisthreatbecauseanAsia-wideFTA—giventhatitwouldencompassanumberofsignificantworldtradingnations—islikelytoinvolvesignificanttradediversionevenundertheexistingextra-regionaltariffs.Inanycase,thechancesofnegotiatingaregion-wideFTAlook rather slim in the context of the continuing crisis. In particular, Chinamightnotwanttogetinvolvedinsuchanendeavour,notonlybecauseofitsnewemphasisondomestic-orientedgrowthbutbecauseofitsofficialcommitmenttoavertingprotectionistbacklashesinindustrialisedcountries.13Governments

13 See,forinstance,therecentarticlewrittenbytheChineseMinisterofTradefortheWall Street Journal(Deming2009).


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inSouth-EastAsiancountriesarealsoconcernedthatanyregion-wideattempttoliberalisetradewouldgiveChinaanunfairadvantageinattractingforeigndirectinvestment(FDI)involvedinglobalproductionnetworks,givenitsvastdomesticeconomycharacterisedbyregionaldifferencesincostsofproduction.14

Inreality,thetradeeffectsofanyFTAwoulddependverymuchonthenatureof the rules-of-origin (ROO) built into it. In particular, there are three maincomplications involved in bringing network trade under FTAs (or otherpreferentialtradingarrangements).First,formulatingROOsfornetwork-relatedtradeisarathercomplicatedbusiness.Theconventionalvalue-addedcriterionisnotvirtuallyapplicabletothistradebecausetheproductsinvolvedarelowvalueaddedbytheirverynature.TheonlyviableoptionistogoforROOsbasedon‘changeintarifflines’,butthisleadstoinsurmountableadministrativeproblemsbecause trade in electrical and electronic goods and the related componentsbelongstothesametariffcodeattheHS-6digitlevel,whichisthenormalbasisfordesigningthistypeofROO(Kohpaiboon2008:App.2).Forexample,electricalapplianceassemblyplants inThailandthatuse importedbare-printedcircuitboards(BPCB)togetherwithotherlocallyprocuredelectroniccomponents(forexample,diodes,integratedcircuits,semi-conductors)forprintedcircuit-boardassembly(PCBA)forexportarenoteligibleforFTAconcessionsbecauseBPCBsandPCBAsbelongtothesameHScode(853690).

Second,theprocessofnetwork-basedglobalproductionsharingischaracterisedbythecontinuousemergenceofnewproducts.GiventheobviousadministrativeproblemsinvolvedinrevisingROOsintandem,theseproductinventionsandinnovations naturally open up room for unnecessary administrative delaysand/or the tweakingof rules as ameansofdisguisedprotection (Elek2008).Moreover,given the importanceof extra-regionalmarkets forfinalgoods forthe growth dynamism of production networks in Asia, maintaining barrierstotradeagainstnon-members(whileallowingfreetradeamongmembers)canthwart the ‘natural’ expansion of global production sharing.Third, twistingROOsforthepurposeofimport-competingindustriesbecomeseasierwhentheproductionprocessinvolvesprocuringcomponentsfromanumberofsources;tightening ROOs on the procurement of one critical input would suffice toprotectcompetingdomesticproducersofthefinal(assembled)product.15

14 Thispointisbasedoninterviewswithhigh-rankingofficialsintheThaiMinistryofForeignAffairs.15 ROOs relating to television sets (HS852812) in theThailand–Australia FreeTrade Agreement (Annex4.1)canbeusedtoillustratethispoint.Tobecomeeligibleforpreferentialtariffs,televisionproducersmustsource three parts (HS701120, 854011 and 854091) locally. Television picture tubes (HS854011) are not,however,producedinThailandandThaicolour-televisionassemblyisviableonly if this itemisprocuredfromJapan,TaiwanorKorea.Thus,eventhoughapreferentialtariffontelevisionsundertheFTA(20percent)isveryattractive,theThailand–AustraliaFTAisvirtuallyirrelevantfortelevisionassemblyplantslocatedinThailand.


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Finally,itisimportanttonotethattheavailableevidenceontheoperationofFTAsinoperationintheregion(andbeyond)doesnotaugurwellforthepotencyofanewregion-wideFTA.Presumablybecauseoftheoperationalcomplicationsnoted above, the real utilisation rates of tariff concessions provided undertheseFTAsareratherlow—rangingfromabout5percentto20percentacrossdifferentproductcategories(TakahashiandUrata2008;KawaiandWignaraja2009;Kohpaiboon2008).Moreover,thereisevidencethatutilisationratesareoftenfirmor industryspecificandarehigher in largefirms,firmswithclosetradeandFDItiesandfirmslocatedinparticularindustriesinwhichmeetingROOrequirementsissimpleandstraightforward.TheupshotisthatFTAsareunlikelytohavethepotential topromotetrade inaneutralandbroad-basedfashion.

Conclusions

Intra-regional trade shares based on conventional trade data are generallyconsistent with the view that East Asia has become increasingly integratedthroughmerchandisetrade.WhenthecontinuingprocessofglobalproductionsharingandEastAsia’suniqueroleinChina-centredglobalproductionnetworksare appropriately taken into account, it is clearly evident,however, that theincreaseovertimeinintra-regionaltraderatioshasemanatedlargelyfromtherapidincreaseinintra-regionalimports,whileintra-regionalexportexpansionhaspersistentlylaggedbehind.Theasymmetryinintra-regionalsharesbetweenimportsandexportsismuchsharperwhenreportedtradedataareadjustedfortradeinpartsandcomponents.Clearly,theregion’sdependenceontherestoftheworldforitstradeexpansionhasinfactincreasedovertime.

Thisinferenceisbasicallyconsistentwiththebehaviouroftradeflowssincetheonsetoftheglobalfinancialcrisis.TheremarkablysynchronisednatureofthetradecontractionacrosscountriesintheregionisgenerallyconsistentwiththeclosetradetieswithinEastAsia—forgedwithinregionalproductionnetworks.While many had hoped that China would provide a cushion for this exportcontraction—aswouldhavebeenconsistentwiththedecouplingthesis—thisdidnotturnouttobethecase.

Theriseofglobalproductionsharinghasstrengthenedthecaseforaglobal,rather than a regional, approach to trade policymaking. Given the globalorientation of the region’s economies, we question whether there would beanysignificantpositivepay-offfromformingaregion-wideFTA.Inanycase,itisdoubtfulwhetheranFTAapproachtotradeliberalisationisfeasibleinacontextinwhichglobalproductionnetworksarerapidlyexpanding,seamlesslyencompassingmanyindustriesandcountries.


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The recent and prospective developments in the global economy since theglobalfinancialcrisismakeastrongcaseforChinatogoaheadwiththespeedyimplementation of the growth-rebalancing policy embodied in its eleventhFive-YearPlan.Giventhenatureofdomesticfactor-marketconditionsandthecontinuing changes in the process of global production sharing, promotingdomestic demand-oriented growth and engagement in global productionsharing is not a mutually exclusive policy priority for China in the mediumterm.Successfulgrowthrebalancinghasthepotentialtofacilitatethefurtherexpansion of network trade by averting trade friction and retaliation. Anenlarged domestic market would also have the potential to improve theinternationalcompetitivenessofexportingfirmswithinproductionnetworksby reducing unit costs of production. Looking further ahead, increases indomestic income and wages under a successfully balanced growth strategywouldprovidethesettingforChinatomoveupthevalueladderwithinglobalproductionnetworks.Afterall,thebulk(morethan60percent)ofinternationalexchangewithinglobalproductionnetworkstakesplaceamongindustrialisedcountriesand,inthefuture,Chinawillsurelybecomeoneofthese.

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Asian foreign direct investment and the

‘China effect’ 11

Chunlai Chen

Introduction

Since the 1990s and especially after China’s accession to the World TradeOrganisation(WTO),Chinahasbecomeoneofthemost-favoureddestinationsfor foreign direct investment (FDI). In 2008, FDI inflows into China reachedUS$92.4billion.In2009,despitetheglobaleconomicrecession,whichseverelyaffectedworldFDIflows,ChinastillattractedUS$90billionofFDIinflows.Bytheendof2009,ChinahadattractedatotalofUS$760billioninFDIinflows,1makingitbyfarthe largestFDIrecipientamongthedevelopingcountries intheworld.

There are, however, increasing concerns that China’s FDI success has beenexcessive, thereby crowdingout FDI inflows into other countries. Several ofChina’sneighbouringAsianeconomieshaveraisedconcernsthattheemergenceofChinahasnotonlydivertedFDIawayfromthembuthasencouragedtheirowndomesticinvestorstoleavetheireconomies,resultinginacontinuouslossofmanufacturingindustriesandjobs,andfurtherweakeningtheireconomies.

A growing China can add to other countries’ FDI inflows by creating moreopportunities forproductionnetworkingandbyraising thedemandfor rawmaterials andresources.At the same time, lowChinese labourcosts can luremultinationalenterprises(MNEs)awayfromotherAsianeconomieswhentheMNEsconsideralternativelocationsforlow-costexportplatforms.Theoretically,competition for any resourceflowcanobviouslyoccurwhen the resource inquestionisavailableinlimitedamounts.This‘zero-sum’hypothesisis,however,difficulttojustifyinthecaseofFDI.Forexample,FDIinflowsaccountedforonly12.3percentofworldgrossfixedcapitalformationin2008(UNCTAD2009),andadditionalFDIresourcescanbeeasilydivertedfromdomesticresourcesandotherinternationalcapitalflowsshouldinvestmentopportunitiesarise.

1 Atconstant1990USdollarprices.


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This chapter examines empirically the question of whether the success ofChina in attracting FDI inflows has diverted FDI away from—or has beencomplementarytoFDIinflowsinto—otherAsianeconomies.ThenextsectionpresentsanoverviewofFDIinflowsintoChinaduringthepastthreedecadesand discusses the current literature on the effects of FDI inflows into ChinaonFDI inflowselsewhere.The subsequent section setsout the frameworkofanalysis, the hypotheses, the empirical model and the variable specification.Followingthisisapresentationanddiscussionoftheregressionresults,beforesomeconclusionsaredrawn.

The growth of FDI inflows into China

AsshowninFigure11.1, thegrowthofFDI inflows intoChina from1982to2009canbebroadlydivided into threephases: theexperimentalphase from1982to1991,theboomphasefrom1992to2001andthepost-WTOphasefrom2002to2009.

Duringtheexperimentalphase,FDIinflowsintoChinawereatalowlevelbutgrewsteadily.Theywereconcentratedmainlyinthesouth-easterncoastalareas,particularly in the four special economic zones (SEZs).2 In the secondphase,FDI inflows into China increased rapidly during 1992–96, but slowed after1997anddeclinedin1999and2000,followedbyamoderaterecoveryin2001.TheslowdownofFDIinflowsintoChinaduring1997–2000wascausedmainlybytheEastAsianfinancialcrisis.AfterChina’sentryintotheWTO,withtheimplementationofitsWTOcommitmentsandbroaderanddeeperliberalisationin trade and investment, FDI inflows into China increased rapidly—fromUS$46.9billion in2001 toUS$92.4billion in2008,beforedecling to US$90billionin2009intheaftermathoftheglobalfinancialcrisis.

China’ssuccessinattractingFDIinflows,particularlyafteritsWTOaccession,hascausedincreasingconcernsthatithascomeattheexpenseofotherdevelopingcountries, particularly its neighbouring Asian developing economies. AnincreasingnumberofempiricalstudieshavefocussedontheeffectsofFDIinflowsintoChinaonthoseintoothercountries(see,forexample,Chantasasawatetal.2004;Cravinoetal.2007;EichengreenandTong2005;ResminiandSiedschlag2008;Mercereau2005;ZhouandLall 2005;Wanget al. 2007).These studiesdifferinthemeasurementofFDIflowsandinestimationtechniques.

Chantasasawat et al. (2004)usedata for eightAsianeconomies—HongKong,Taiwan, Republic of Korea, Singapore, Malaysia, Philippines, Indonesia and

2 ThefourspecialeconomiczonesareShenzhen,Zhuhai,ShantouinGuangdongProvinceandXiameninFujianProvince.

Asian foreign direct investment and the ‘China effect’

223

Thailand—in addition to China for the period 1985–2001. They estimateequationsforChina’sFDIinflowsandotherAsianeconomies’FDIinflowsusingtwo-stage least squares.They find that the level of China’s FDI is positivelyrelated to the levels of these economies’ inward FDI, although this ‘Chinaeffect’isgenerallynotthemostimportantdeterminantofinwardFDIintotheseeconomies.Policyandinstitutionalfactorssuchasopenness,corporatetaxratesandthelevelofcorruptiontendtobemoreimportant.ZhouandLall(2005)andWangetal.(2007)estimatepanelmodelstoinvestigatetheeffectofFDIinflowsintoChinaonFDIinflowsintootherAsianeconomies.Theyalsofindthat,onaverage,FDIinflowsintoChinahaveraisedratherthandivertedFDIinflowsintoneighbouringeconomies.

Figure 11.1 FDI inflows into China (at current prices)

!

0

10

20

30

40

50

60

70

80

90

100

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

US$

billio

n

Note:ThedatadonotincludeFDIinflowsintothefinancesector.

Sources:NationalBureauofStatistics(NBS)variousyears,China Statistical Yearbook,ChinaStatisticsPress,Beijing.

Mercereau (2005) also investigates the impact of China’s emergence on FDIinflowsintoAsia,usingdatafrom14Asianeconomiesfrom1984to2002andusinganumberofeconometricmethods,includingordinaryleastsquares(OLS)withfixedcountryeffects,dynamicpanelswithalaggedendogenousvariableandinstrumentalvariables.Incontrastwiththeabovestudies,hedoesnotfindapositiverelationshipbetweenChina’sFDIinflowsandFDIinflowsintootherAsianeconomies.Hedoesnotfindevidence,however,thatChina’ssuccessinattractingFDIhasbeenattheexpenseofothereconomiesintheregion—withtheexceptionofSingaporeandMyanmar.Low-wageeconomies,whichcompetewithChinaforlow-wageinvestment,donotappeartohavebeenparticularlyaffectedbyChina’semergence.LowlevelsofeducationorscientificdevelopmentarenotassociatedwithincreasedcrowdingoutbyChinaeither.Someeconomicfundamentals, such as healthy government balances and low inflation, helpexplaintheallocationofFDIinflowsamongAsianeconomies.


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Eichengreen and Tong (2005) employ a gravity model and show that theemergenceofChinaasaleadingFDIdestinationhasencouragedFDIinflowsintoother Asian economies via supply-chain production linkages.They also findevidence,however,suggestingthatFDI inflowsintoChinahavedivertedFDIinflowsawayfromEurope.Theyexplainthisdiversioneffectbythenegativeimpactofdistanceonsupply-chainproductionlinkages.Incontrast,ResminiandSiedschlag(2008)estimateanaugmentedgravitymodeltoanalysetheeffectsofFDIinflowsintoChinaoriginatinginOrganisationforEconomicCooperationandDevelopment(OECD)economiesonFDIinflowsintotheEuropeanUnionandothereconomies for theperiod1990–2004.Their results suggest thatonaverage,FDIinflowsintoChinahavebeencomplementarytoFDIinflowsintootherhostcountriesandintotheEuropeanUnionaswell.Thiscomplementaryrelationshipis,however,notconstantacrosscountries,butisinsteadweakerinEuropethanoutsideit;alsothesecomplementaritiesfollowadecreasingtrendovertheanalysedperiod.

Finally,Cravinoetal.(2007)examinetheeffectofforeigncapitalstockinChinaon theLatinAmericanandCaribbeancountriesandfindnoevidenceofFDIdiversion from OECD countries—in particular from the United States—intoChinaattheexpenseoftheLatinAmericanandCaribbeancountries.WhilethegrowthofcapitalstocksinChinaoriginatingfromtheOECDwasfasterthaninLatinAmericanandCaribbeancountriesfortheperiod1990–97,thisrelativegrowthhasslowedsincethen.

TheaboveempiricalstudiesindicatethatthereislittletosuggestthatChina’sFDIsuccesshascrowdedoutFDIinflowsintoothercountries.Onthecontrary,thereisstrongempiricalevidencethat,onaverage,FDIinflowsintoChinahavebeencomplementarytoFDI inflows intootherhostcountries,especially intoChina’sneighbouringeconomies.

Framework of analysis and the empirical model

ThisstudyusesagravitymodeltoinvestigatetheimpactofFDIinflowsintoChinaonFDIinflowsintootherAsiandevelopingeconomies.Apartfrombeingusedextensivelyinstudiesoftradeflows,thegravitymodelhasbeenusedinstudiesofFDIflows.AselaboratedbyDunning’s (1993) ‘OLI’explanationofFDI, many factors influence the flows of FDI. Since these factors are locatedin different areas, the general argument for the use of the gravity model inlinewiththeOLIframeworkisthateachfactorcanbecategorisedasasource-countryfactor(reflectedinownershipandinternalisationadvantages)orahost-economyfactor(reflectedinlocationadvantages).Source-countryfactorsreflect


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thecapacityofasourcecountrytoconductFDIinallpossiblehosteconomies,whilehosteconomyfactorsarecharacteristicsoftheoverallattractivenessofahosteconomyforFDIinflowsfromallsourcecountries.

Based on the gravity model and the OLI framework in explaining FDI, thefundamentalmodelusedherecanbewrittenasEquation11.1.

Equation 11.1lnFDI*j = β0 + β1lnX* + β2lnXj

InEquation 11.1, FDI*j is themagnitudeof total FDI inflows fromall sourcecountriesintohosteconomyj,X*aretheaggregatesourcecountryvariablesandXjarehosteconomyvariables.

Since source country i’s variables, Xi—which measure the overall outwardinvestmentpotentialofsourcecountryi—aredeterminedbyitsowntechnologicalandeconomicdevelopmentlevels,thekeyfeatureofthesevariablesisthattheyare common to all outward FDI of source country i and are independent offactors in the destination countries.Therefore, the aggregate source-countryvariables,X*, becomeaconstantforeachofthehosteconomies—althoughonethatchangesovertime.Intherealimplementation,weusetheworldtotalFDIoutflows (WFDIOUT) of all source countries to capture the effects of source-country variables, X*. We adopt the log-linear form as the basic functionalformtoconnectthemagnitudeofFDIinflowsfromallsourcecountriestohosteconomy j to the relevant explanatory variables (aggregate source-countryvariablesandhosteconomyvariables).

The hypotheses

Asshown inmanystudies, the location factorsdeterminingFDI inflows intodeveloping economies are mainly market size, economic growth, per capitaincome,labourcosts,resourceendowments,economicandpoliticalstability,andinvestmentincentivesofferedbythehostcountrygovernment.Inthefollowing,weexaminebrieflyhoweachoftheselocationfactorsplaysanimportantroleindeterminingthemagnitudeofFDIinflowsintodevelopinghosteconomies.

Market size and economic growth of host economies

ThemainargumentfortheimportanceofmarketsizeasalocationfactorinthedeterminationofinflowsofFDIisbasedprimarilyoneconomiesofscale:largereconomies can provide more opportunities to realise and explore economiesofscale,torealisethespecialisationofproductivefactorsandtoabsorbmore


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efficientlythetechnologythatforeigninvestorsdesiretointroduce.Therefore,weexpect that themagnitudeofFDI inflowswillbegreater the larger is themarketsizeofthedevelopinghosteconomy.Thesignificanceofthisargumentis,however,debatableinopeneconomies.Thisisbecauseinopeneconomies,enterprisesandindustriescanrealiseandexploreeconomiesofscalethroughinternationalmarketsinsteadofrelyingonlyonthedomesticmarket—andthispointisespeciallyrelevantintheEastandSouth-EastAsianeconomies.Asaresult,insteadofusinggrossdomesticproduct(GDP)orpercapitaGDPasthemeasureofmarketsize,weusetherealrateofeconomicgrowthtocapturethislocationvariable.

Ahighrateofeconomicgrowthisanindicatorofdevelopmentpotential,whichis expected to be an important location determinant affecting FDI inflows.First,thehigherlevelofeconomicgrowthrepresentsabetteroveralleconomicconditionofthehosteconomies,whichisattractivetoforeigninvestors.Second,ahigherlevelofeconomicgrowthisanindicatorof improvingconditionsinlocalinfrastructure,whichisfundamentalforattractingFDIinflows.Third,ahigher levelof economicgrowth impliesa fast expansionof themarket size,arapidriseindomesticdemandandagrowingpurchasingpowerofthehosteconomies’consumers,whichisanimportantdeterminantofmarket-orientedFDI. Clearly, markets that are expected to grow faster will tend to attracthigherlevelsofinwardFDI.Therefore,thehypothesisisthatthereisapositiverelationshipbetweeninwardFDIandeconomicgrowthinthedevelopinghosteconomy.Inthisstudy,therealGDPgrowthrate,denotedbyGR,isusedasthecomprehensivemeasureofdevelopmentpotential inthehosteconomyunderstudy.

Factor costs in host economies

In the FDI literature, the most important factor cost in the determination ofFDIinflowsisthewagerate,especiallywhenFDIisexportoriented.Therefore,the relevant factor cost in the decision to locate FDI in the host economy isthat of labour costs. Inparticular, lower labour costs are expected to inducehigherlevelsofFDIinflows,especiallyforexport-orientedFDI.Alowerwageratecould,however,alsobeaccompaniedbylowerproductivity,andthustheefficiencywagemightnotinfactbelow.Therefore,thebestmeasureoflabourcostsisthe‘efficiencywage’ratherthantheabsolutewagerate.TheefficiencywagecanbemeasureddirectlyasEquation11.2.

Equation 11.2

EWW

jj

j

=!

!


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InEquation11.2,EWjistheaverageefficiencywageinhosteconomyj,WjistheabsolutewagerateinhosteconomyjandΠjistheaverageproductivityoflabourinhosteconomyj.Theefficiencywageasameasureoflabourcostshastheadvantageofbeingunitfree.

There are two major problems involved in international cross-countrycomparisonsofwageratesandlabourproductivity.Oneisthedifferentpricelevelindifferentcountriesandanotheristhedifferentexchangerate,especiallyindevelopingcountries.Toavoidtheseproblems,thisstudyusestotallabourearningsasapercentageoftotalvalueaddedineachdevelopingeconomyasthecorrespondingmeasureoftheefficiencywage.3Infact,accordingtotheabovedefinitionfortheefficiencywage,themeasureoftotalearningsasapercentageoftotalvalueaddedisexactlytheaverageefficiencywageinthedevelopinghosteconomies.4Inthisstudy,weexpecttheefficiencywagetobenegativelyrelatedtothelevelofFDIinflowsintohostdevelopingeconomies.

Country risk (country credit rating)

Studies of FDI in developing countries have put particular emphasis onindicatorsofeconomicandpoliticalrisk (suchasLucas1993;SinghandJun1995).Countryriskcomprisesthreemainelements:macroeconomicstability—forexample,economicgrowth, inflationandexchangeraterisk; institutionalstability, suchaspolicies towardsFDI, taxregimes, the transparencyof legalregulations, intellectualpropertyprotectionand the scaleof corruption; andpoliticalstability,rangingfromindicatorsofpolitical freedomtomeasuresofsurveillanceandrevolutions.Whilethereisavarietyofwaysinwhichcountryriskcanbeapproximatedforempiricalstudies,acommonapproachreliesoncountrycreditratings,whichprovidesinformationavailabletofirmsatthetimeoftheirinvestmentdecision.

Country credit ratings are developed by Institutional Investors, which haspublishedcreditratingstwiceayearsince1979toassessthecreditworthinessofabout150countries,basedonasurveyofsome100internationalbankers’perceptions of creditworthiness, including economic, financial and socio-political stability criteria. The resulting score scales from zero (very highchanceofdefault) to100(leastchanceofdefault).Participants’responsesareadjustedaccordingtotheirinstitutions’assets,withheavierweightsonthoseinstitutions with worldwide exposure and sophisticated country-analysis

3 Totallabourearningsarecalculatedasthewageratemultipliedbytotalemployment.ThedataforwageratesandemploymentarefromILO(n.d.).ThedatafortotalvalueaddedarefromUnitedNationsStatisticalDivision(n.d.,National Accounts).Thecalculationisbasedonlocalcurrencyandcurrentprices.4 Thederivationoftheaverageefficiencywageisasfollows:EW=W/Π=(Y/L)/(V/L)=Y/V,inwhichEWisefficiencywage,Wisthewagerate,Πislabourproductivity,Yistotallabourearnings,VistotalvalueaddedandListotallabour.


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systems.Thisstudyusesthecreditratingofthehostcountrytomeasuretheinvestor’sperceptionofcountry-specificrisk.Thehypothesisisthattheloweristhecountryrisk(thehigheristhecountrycreditrating)thehigherwillbethelevelofFDIinflows.Thecountrycreditrating,denotedasCDR,iscompiledfromvariousissuesofInstitutional Investormagazine.

The empirical model and variable specification

Toinvestigate theeffectsofFDI inflows intoChinaonFDI inflows intootherAsiandevelopingeconomies,weaddFDIinflowsfromallsourcecountriesintoChina—denotedasFDICHN—asanindependentvariableintotheequation.

Thereareatleasttwoaspectsthatneedtobeconsideredhere.First,inexaminingin which low-wage export platform to locate, MNEs can choose betweeninvesting in China versus investing in another developing Asian economy.In this case, theMNEswill study all the factors thatwillmake an economydesirableasasiteforlow-costproduction.InvestinginChinawillthenreducetheFDIinflowsintoanotherAsiandevelopingeconomy.ThesignofFDICHN,accordingtothisargument,isnegative.Wecallthisthe‘investment-diversioneffect’.

ThesecondaspectsaretheproductionandresourcelinkagesbetweenagrowingChinaandtheotherAsiandevelopingeconomies.Inmanufacturing,thistakestheformoffurtherspecialisationandgrowingfragmentationoftheproductionprocesses. An investor sets up factories in both China and another Asiandevelopingeconomyto takeadvantageof their respectivecompetitiveness indistinctstagesoftheproductionprocess.ComponentsandpartsarethentradedamongChinaandotherAsiandevelopingeconomies.AnincreaseinFDIinflowsintoChina is thenpositively related to an increase inFDI inflows intootherAsiandevelopingeconomies.AdifferentbutcomplementaryargumentisthatasChinagrows,itsmarketsizeincreasesanditsdemandformineralsandresourcesrisesaccordingly.Subsequently,MNEsrushintoChinatoproduceandtosellinChina.Atthesametime,otherMNEsalsoinvestinotherAsiandevelopingeconomies to extract minerals and resources to export to China.This line ofreasoningleadstothepredictionthatthesignofFDICHNwillbepositive.Wecallthisthe‘investment-creationeffect’.Theoretically,wecannotdeterminea prioritheneteffectofinvestmentcreationandinvestmentdiversionforChina.Itisthusimportanttoexaminethisissueempirically.

To investigate the China effect on FDI inflows into other Asian developingeconomies,weuseEquation11.3astheempiricalmodel.


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Equation 11.3lnFDI*j,t = β0 + β1lnFDICHN*,t-k + β2lnWFDIOUTt + β3lnGRj,t-k+ β4lnEWj,t-k + β5lnCDRj,t-k + vj + εj,t

Thedependentvariable,denotedasFDI*j,t,istheaggregateinflowofFDIfromallsourcecountriesintoAsiandevelopinghosteconomyjinyeart.ThevalueofFDI—andalltherelevantfollowingvariables—ismeasuredinconstant1990USdollarprices.Therearefiveindependentvariables.TheindependentvariablesofGR,EWandCDRarehypothesisedanddefinedintheabovesection.WeincludetheworldtotalFDIoutflows(WFDIOUT)asanindependentvariabletocontroltheaggregatesupply-sideeffectofFDIonFDI inflows intoAsiandevelopinghosteconomies.ThedependentandindependentvariablesaresummarisedinAppendixTable11.1.

Theindependentvariables,exceptWFDIOUT,arelaggedkyears.Thismodelassumes that theeffectof the independentvariablesat time t-kappearsonlywithin period t and is fully completed within that period.The relationshipshowninEquation11.3willbeexaminedfork=1—themostlikelyappropriatelag.TheindependentvariableWFDIOUT,whichisworldtotalFDIoutflows,isdeterminedbythesource-sidefactorsandisindependentfromhost-economydeterminants; therefore, the current value (k = 0) will be employed in theregressionequation.TheestimatedcoefficientsoflnFDICHN* t-k,lnWFDIOUT*t,lnGRj t-k, lnEWj t-k and lnCDRjt-k variables are elasticities. The econometricregressionanalysisbelowusespaneldataandafixed-effectsmodelinordertoeliminatetheeconomy-specificandtime-invariantfactorsthatcouldaffectFDIinflows.

Regression results and explanations

Inthisempiricalstudy,thereare12Asiandevelopingeconomiesinthesampleandthe timeperiod is from1992to2008.The12economiesareBangladesh,HongKong, India, Indonesia,Malaysia,Pakistan, thePhilippines,Singapore,SouthKorea,SriLanka,TaiwanandThailand.Thefixed-effectsregressionresultsarereportedincolumn1ofTable11.A1.Themodelfitsthedatawell.Alltheindependentvariableshavetheexpectedsignsandarestatisticallysignificant.

As a robustness check, the regression is also run without the four SouthAsiandevelopingeconomies:Bangladesh,India,PakistanandSriLanka.Theregression results remain very similar to those with the four South Asiandevelopingeconomiesinthesampleandarereportedincolumn2ofTable11.1.Themodelperformswell: the independentvariableshavetheexpectedsignsand,exceptforthevariableGR,arestatisticallysignificant.


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Ourmainvariableofinterest,FDICHN,ispositiveandhighlysignificantinbothregressions.A10percentincreaseintheFDIinflowsintoChinawouldraiseFDIinflowsintotheEast,SouthandSouth-EastAsianeconomiesbyabout4.8percent.DespiteconsiderableconcernsthatanincreaseinFDIinflowsintoChinahasbeenattheexpenseofotherAsianeconomies,thissuggeststhatflowsintothose economies have increased as a result of DFI flows to China during theperiodofanalysis.

Table 11.1 Regression results of the effects of FDI inflows into China on FDI inflows into East, South and South-East Asian developing economies, 1992–2008, fixed-effects (dependent variable FDI*j, t)

Variables (1) (2)Constant

. . .fLFDICHN

l . . . . . .f . .LWOFDI

. . . . . .f .LGR

fLEW

fLCDR

–7 .61(–1 .72)*

0 .48(2 .73)***

0 .23(4 .33)***

0 .48(2 .17)**–1 .00

(–2 .40)**2 .42

(2 .42)**

–12 .84(1 .96)*0 .47

(2 .44)**0 .21

(3 .07)***0 .36

(1 .24)–1 .02

(–2 .02)**3 .86

(2 .15)**

No . of observationsNo . of groupsR2: within between overallF-statistics

17012

0 .540 .820 .76

31 .15***

1088

0 .430 .420 .40

15 .77***

*statisticallysignificantat0.10level(two-tailtest)

**statisticallysignificantat0.05level(two-tailtest)

***statisticallysignificantat0.01level(two-tailtest)

Notes:Standarderrorsadjustedforclusteringongroup;t-statisticsareinparentheses.

TheobservedrelationshipcouldbelinkedtotheincreasedresourcedemandbyarapidlygrowingChineseeconomyandtheproduction-networkingactivitiesamong the Asian economies. As Table 11.2 shows, Asian economies havebecome increasingly important suppliers of China’s growing demand for rawmaterials.Forsomeresources,theAsianeconomiesarethemajorsupplierstoChina—forexample,IndonesiaandMalaysiaforanimal,vegetablefatsandoils,Taiwan,IndiaandPakistanfortextilesandIndia,IndonesiaandSouthKoreaformineralproducts.Therefore,China’sfasteconomicgrowthassociatedwithhighdemandforrawmaterialscouldgenerategreatopportunitiesforMNEstoconductresource-basedFDIinAsianeconomies.


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Table 11.2 China’s imports of raw materials from Asian economies (US$ million)

1995 2000 2005 2008All 12 Asian economiesAnimal, vegetable fats and oils (HS 15) hjMineral products (HS 25, 26, 27) sdfsPulp of wood and paper products (HS 47, 48) Textiles (HS 52, 54, 55)

fd954(36)2958(41)1367(43)5290(53)

f804(67)5614(23)2684(40)5893(62)

f2131(64)

16 433(18)2386(23)5932(42)

f7092(63)

43 072(17)2495(15)5830(43)

IndonesiaAnimal and vegetable fats (HS 15)Mineral products (HS 25, 26, 27)Pulp of wood and paper products (HS 47, 48)

f70(3)766(11)180(6)

fa245(21)1104(5)928(14)

f749(23)2282(2 .5)893(8)

f2482(22)5269(2)

1068(7)

MalaysiaAnimal and vegetable fats (HS 15)

f732(28)

ff471(39)

f1271(38)

f4084(36)

SingaporeMineral products (HS 27)

f1123(24)

f852(4)

f2206(3)

f4325(3)

South KoreaMineral products (HS 27)

f398(8)

f2016(10)

f3506(6)

f9945(6)

TaiwanTextiles (HS 54)

dafsd1046(31)

sfad1268(35)

sadffasd1359(36)

adsdas1120(31)

ThailandMineral products (HS 27)

dasfd7 .6

(0 .2)

asdfas383(2)

sdasfd806(1)

safdas1803(1)

IndiaMineral products (HS 26)Textiles (HS 52)

asdfas153(8)24(1)

safdasd373(12)186(7)

asdsfas5509(21)275(4)

asdadsdfsdfsa14 314

(17)1130(15)

PakistanTextiles (HS 52)

sdfsd173(5)

fsdf398(14)

fdsfsfd581(8)

dfgfd599(8)

Notes: Figures inparentheses are shares inChina’s total imports of the commodities.HS15= animal,vegetablefatsandoils,cleavageproducts,andsoon;HS25=salt,sulphur,earth,stone,plaster,limeandcement;HS26=ores,slagandash;HS27=mineralfuels,oils,distillationproducts,andsoon;HS47=pulpofwood,fibrouscellulosicmaterial,waste,andsoon;HS48=paperandpaperboard,articlesofpulp,paperandboard;HS52=cotton;HS54=manmadefilaments;HS55=manmadestaplefibres.

Source: Author’s calculations using data from United Nations Statistics Division n.d., COMTRADE,Commodity Trade Statistics Database, United Nations, NewYork and Geneva, <http://unstats.un.org/unsd/comtrade/default.aspx>

TheevidenceofproductionnetworkingamongChinaandotherAsianeconomiescanbefoundinthesubstantialtwo-waytradeinintermediateandfinalgoods


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inthesameindustriesamongthoseeconomies.ManyoftheAsianeconomies—particularly those in East and South-East Asia—are heavily involved invertical specialisation,particularly in the industriesofelectronicsequipment(HS85).AsshowninTable11.3,thevalueandsharesoftwo-waytradeintheelectronicequipmentindustriesbetweenChinaandAsianeconomieshavebeensubstantial.Theeconomic tiesofmutualdependenceamongthemhavebeendeepeningrapidlysincethe1990s.ThesignificanceoftheChinaeffectinthelevelofFDIinflowsintoAsianeconomiescouldreflectsuchinterdependence.

ItisimpossibletoascertainfromtheaboveregressionresultswhethertheChinaeffect isdrivenprimarilybyresourcedemandorbyproductionnetworking;thisremainsatopicforfurtherresearch.Thecentralresult,however,stillholds:anincreaseinFDIinflowsintoChinaispositivelyandsignificantlyrelatedtoFDIinflowsintootherAsianeconomies.Inotherwords,inrecentdecades,theinvestment-creation effect has dominated the investment-diversion effect, soChineseandAsianFDIinflowshavebeencomplementary.

As for the location variables, the regression results provide strong supportforthehypotheses.Themarketgrowthrate(GR)isapositiveandstatisticallysignificantlocationdeterminantinaffectingthemagnitudeofFDIinflowsintoAsianeconomies,withtheresultsimplyingthatthehigherandfasterthegrowthofaneconomy,thehigherwillbethelevelofFDIinflows.

A host economy’s efficiency wage (EW)—the proxy for labour cost—is anegative statistically significantdeterminantof themagnitudeofFDI inflowsthatacountryreceives.ThisindicatesthatFDIisresponsivetodifferencesinefficiencywagesacrossAsianeconomies.ItalsorevealsthattakingadvantageofAsianeconomies’cheaplabourisoneofthemainmotivesforforeigninvestorsinAsiandevelopingeconomies.

Acountry’screditrating(CDR)isfoundtoexertalargeinfluenceonthemagnitudeofFDIinflowsintoAsianeconomies.Economic,financial, institutional,socialandpoliticalstabilitieswithhighcreditworthinesscanbeconsideredthemostinfluentialtoolstopromoteFDIsincetheyhaveadirectimpactonthesecurityandprofitabilityofFDIprojects.

Finally, the variable of world total FDI outflows (WFDIOUT) is positive andstatisticallysignificant.Thissignifiestheimpactofanoverallsupply-sideeffectontheinflowsofFDItoAsianeconomies.

Itisalsointerestingtonotethat,althoughFDIinflowsintoChinahaveapositiveandstatisticallysignificanteffectonFDI inflows intootherAsianeconomies,theChinaeffectisnotthemostimportantfactordeterminingFDIinflowsintotheseAsian economies.The empirical regression results suggest that, all elsebeing equal, themarginal effect of thehost economies’ locationvariables onFDIinflowsintotheireconomiesismuchlargerthanthatoftheChinaeffect.


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ThemarginaleffectoftheefficiencywageisapproximatelytwotimesandthecountrycreditratingisfivetoeighttimesaslargeasthatoftheChinaeffect,respectively.

Table 11.3 Two-way trade between China and Asian economies in electric and electronic equipment industries (HS 85)

Exports to China

(US$ million)

Share in total exports to China (%)

Imports from China

(US$ million)

Share in total imports from China (%)

Hong Kong1995200020052008

dsfsdf1957320344784153

sdfsdf22 .834 .036 .632 .1

sdfsd5736

10 50743 02980 225

fds15 .923 .634 .642 .1

Malaysia1995200020052008

sdfsdf2022097

12 66417 226

dsfsdf9 .7538 .2763 .0353 .66

sdfsd19092726414938

sdfsd14 .8336 .1424 .9023 .02

Philippines1995200020052008

dsfsd108609146

14 353

sdfsdf3 .6251 .2871 .0673 .59

sdfsd8443814822386

sdfsd8 .1629 .9231 .6126 .13

Singapore1995200020052008

sdfsd499145763706443

sdfsdf14 .6928 .7938 .5731 .94

fdssfd548174566539763

dsfsdf15 .6630 .2940 .0030 .22

South Korea1995200020052008

sdfsdf11035089

25 77437 648

sdfsdf10 .7221 .9333 .5533 .57

sdfsdf47319428241

18 426

sdfsdf7 .0717 .2023 .4724 .92

Taiwan1995200020052008

sdfsdf20056413

28 87741 507

sdfsdf13 .5625 .1538 .6740 .17

sdfsdf485108848877637

sdfsdf15 .6621 .5929 .5329 .52

Thailand1995200020052008

dfsdf5381637065976

sdfsdf3 .2918 .6326 .4923 .29

sdfsdf11341616952962

sdfsdf6 .4518 .5521 .6818 .95

Source: Author’s calculations using data from United Nations Statistics Division n.d., COMTRADE,Commodity Trade Statistics Database, United Nations, NewYork and Geneva, <http://unstats.un.org/

unsd/comtrade/default.aspx>


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Implications for future FDI inflows into China and Asian economies

TheresultsintheprevioussectionimplythatthepositiveimpactoftheChinaeffect on FDI inflows into Asian economies could be linked to the increasedresourcedemandbyarapidlygrowingChineseeconomyandtheproduction-networking activities among the Asian economies. These two channelsgeneratingthepositiveChinaeffectonFDIinflowsintotheAsianeconomies—especiallyintotheAssociationofSouth-EastAsianNations(ASEAN)—willbestrengthenedinthenexttwodecades.

First,with thecreationand implementationof theASEAN–ChinaFreeTradeArea(ACFTA)on1January2010,theeconomicrelationshipbetweenASEANand China entered a new era. The ACFTA covers agreements on trade ingoods and services and investment, which will accelerate and intensify theeconomicintegrationandresultinrapiddevelopmentandexpansionintradeandinvestmentbetweenASEANandChina.ApartfromtheACFTA,Chinahasbilateral free-tradeagreementswithanumberofAsianeconomies, includingPakistan, Thailand, Singapore, Hong Kong and Macao, and is proposing tonegotiatebilateralfree-tradeagreementswithIndia,SouthKoreaandTaiwan.The reduction and elimination of barriers to trade and investment—to theextentthatpreferentialtradingagreementsactuallyhavethiseffect—willnotonlyleadtoanexpansionoftradeandinvestmentamongChinaandotherAsianeconomies,itwillcreateinvestmentopportunitiesforthirdpartiestoinvestinAsia—inChinaandelsewhere—inordertogetintoandtakeadvantageoftheenlargedAsianfree-tradeareas.

Second,oneofthemajordrivingforcesbehindtheeconomicintegrationoftheAsianeconomiesisthefastgrowthoftheChineseeconomy.China’seconomicgrowthandstronginvestmentexpansionareenergisingtheregionandprovidingtheAsianeconomieswithanexpandinganddiversifiedmarket.AccordingtoareportbytheCabinetOfficeoftheJapaneseGovernment(NIKKEI.com2010),theChineseeconomyispredictedtogrow9.1percentannuallyinthedecadefrom2010and7.9percentannuallyinthe2020s.Asaresult,Chinaisexpectedtogenerate 23.9per cent of theworld’sGDP in2030—becoming the largesteconomyintheworld.ThefastgrowthoftheChineseeconomywillcontinuetohaveasubstantialimpactontheAsianeconomies.Ontheonehand,asChina’seconomygrows,itwillincreasethedemandforconsumergoodsastheincomeoftheChinesepeopleincreases.Ontheotherhand,China’srapidgrowthwillalsoincreasedemandforresourcesandrawmaterialstosupportthecontinuingexpansionofproduction.Bothwillgenerategreatopportunitiesnotonly for


235

AsianeconomiestoincreaseexportstotheChinesemarkets,butforMNEstoinvestinAsianeconomiesinordertoproducegoodsandextractresourcestosupplytheChinesemarkets.

Third, with the fast and deep integration among the Chinese and otherAsian economies, production-networking activities—particularly in verticalspecialisation—will intensify with each of the economies specialising in theproductionofthosegoodsinwhichithasacomparativeadvantage.Currently,ChinaandotherAsianeconomieshavealreadydevelopedsubstantialtwo-waytrade intheelectricandelectronicequipment industries. Intheyearsahead,with the upgrading and restructuring of the industrial structures in ChinaandAsianeconomies,itishighlylikelythatthetwo-waytradebetweenChinaand other Asian economies will expand into other industries—for example,automobiles and machinery and equipment. This structural change andupgradingof industries throughoutAsiawillprovidehugeopportunities forMNEstoinvestinChinaandotherAsianeconomiesbasedontheircomparativeadvantagesandcompetitiveness.

Fourth, with rapid economic growth, a high rate of capital accumulationandahugeaccumulationof foreignreserves,Chinahasgraduallybecomeanincreasingly important supplier of outwardFDI.During theperiod2004–08,China’s outward FDI increased from US$5.5 billion to US$55.9 billion—increasingmorethanninetimes.MostofChina’soutwardFDIflowedintoAsianeconomies—accounting for 71.4 per cent of China’s total outward FDI stockat the endof 2008.With rapid economicgrowth, thenext twodecadeswillwitnessarapidincreaseinFDIoutflowsfromChina.Ontheonehand,Chinawill accelerate industrial restructuringandupgrading.Some labour-intensivemanufacturing activities and industries will gradually lose competitivenessdue to the combined effects of increasing labour costs and shrinking labourforceswithanageingpopulation.Asaresult,theselabour-intensiveindustrieswill move out of China and invest in other economies, with other Asiandevelopingeconomiesthemost likelycandidates.Ontheotherhand,China’srapideconomicgrowthwillcontinuetoincreasethedemandforresourcesandrawmaterials.Tomeetthisdemand,Chinawillincreaseinvestmentoverseastoexpandandsecurethesupplyofresourcesandrawmaterials.Asianeconomieswith rich resource endowments will be the primary destinations for China’soutwardinvestment,withChinabecominganincreasinglyimportantinvestorinAsia as a consequence.Overall, then, the relationshipbetweenChina andAsianeconomiesintermsofFDIislikelytoremaincomplementaryinthenext20years.


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Conclusions

ThevastvolumeofFDIinflowsintoChinainthepastthreedecadeshasbeena source of celebration for some and of concern for others. Has China reallycrowded out FDI inflows into other Asian economies or has it been more ofawin-winstory?ThischapterhasbuiltonanextensiveliteratureseekingtoanswerthisquestionbyconductinganempiricalanalysistotestthehypothesesbasedonthelocationadvantagesoftheOLIexplanationofFDI.Thethreemainfindingscanbesummarisedasfollows.

First, for the location determinants of FDI inflows into Asian developingeconomies,theregressionresultsprovidedstrongsupportfortheacceptanceofourhypotheses.Themainfindingsare:economieswithfastereconomicgrowth,highercreditworthinessorlowercountryriskintermsofeconomic,financial,institutional,socialandpoliticalstabilityattractedrelativelymoreFDIinflows,whilehigherefficiencywagesorlowerlabourproductivitydeterredFDIinflowsduringtheperiodofanalysis:1992–2008.

Second,theregressionresultshaveshownthatFDIinflowsintoChinahaveastatisticallysignificantpositiveeffectonFDIinflowsintootherAsianeconomies.ThispositiveandcomplementaryeffectofFDIinflowsintoChinaonFDIinflowsintootherAsianeconomiescouldbelinkedtotheincreasedresourcedemandinagrowingChinaandtheproduction-networkingactivitiesamongtheAsianeconomies.Whiletheresultsdidnotallowtherelativestrengthofthesetwolinkagestobedetermined,itislikelythatthispositiveChinaeffectstemsfroma combination of both, leading to the central result that this effect is aboutinvestment creation, not investment diversion.This complementarity impliesthatmuchoftheconcernaboutChineseFDIisunfounded.

Third, although FDI inflows into China have had a positive and statisticallysignificantimpactonFDIinflowsintootherAsianeconomies,theChinaeffectisnotthemostimportantfactordeterminingFDIinflowsintotheAsianeconomies.Theempiricalregressionresultssuggestthat,allelsebeingequal,themarginaleffect of the host economies’ location variables on FDI inflows into theireconomiesismuchlargerthanthatoftheChinaeffect.Hosteconomies’locationvariables—such as fast economic growth, lower labour costs accompaniedwithhigherlabourproductivity,lowercountryriskwitheconomic,financial,institutional, social and political stability—play the fundamental role inattractingFDIinflows.

In the next two decades, China’s economic growth and strong investmentexpansionwillenergisetheregionandwillprovidetheAsianeconomiesandother countries with an expanding and diversified integrated Asian market.


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Overall,withtherapidanddeepeningintegrationamongtheChineseandotherAsian economies, the positive China effect on FDI inflows into other Asianeconomieswillcontinue.

References

Chantasasawat,B.,Fung,K.,Iizaka,H.andSiu,A.2004,Foreign direct investment in China and East Asia, Hong Kong Institute of Economics and BusinessStrategy,viewed30May2010,<http://www.hiebs.hku.hk/working_paper_updates/pdf/wp1135.pdf>

Cravino,J.,Lederman,D.andOlarreaga,M.2007,Foreign direct investment in Latin America during the emergence of China and India: stylized facts,PolicyResearchWorkingPaper4360,TheWorldBank,Washington,DC,viewed30May2010,<http://ideas.repec.org/p/wbk/wbrwps/4360.html>

Dunning,J.1993,Multinational Enterprises and the Global Economy,Addison-Wesley,Wokingham,UK.

Eichengreen, B. and Tong, H. 2005, Is China’s FDI coming at the expense of other countries?,NBERWorkingPaper11335,NationalBureauofEconomicResearch,Cambridge,Mass.,viewed30May2010,<http://www.nber.org/papers/w11335>

InternationalLabourOrganization(ILO)n.d.,LABORSTA,InternationalLabourOrganization,Geneva,<http://laborsta.ilo.org/>

Lucas,R.1993,‘Onthedeterminantsofdirectforeigninvestment:evidencefromEastandSoutheastAsia’,World Development,vol.21,no.3,pp.391–406.

Mercereau,B.2005,FDI flows to Asia: did the dragon crowd out the tigers?,IMFWorkingPaper,WP/05/189,September2005,InternationalMonetaryFund,Washington, DC, viewed 30 May 2010, <http://zunia.org/uploads/media/knowledge/wp051891.pdf>


NIKKEI.com2010, ‘China’sGDP4 times Japan’s in ’30:govt’,The Nikkei, 29May,Morningedition,viewed1June2010,<http://e.nikkei.com/e/fr/tnks/Nni20100528D28JFA12.htm>


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Resmini, L. and Siedschlag, I. 2008, Is FDI into China crowding out the FDI into the European Union?, Working Paper, European Trade Study Group,JohannesKeplerUniversity,Linz,andUniversityofStrathclyde,viewed30May2010,<http://www.etsg.org/ETSG2008/Papers/Siedschlag.pdf>

Singh,H. andJun,K.W.1995,Some new evidence on determinants of foreign direct investment in developing countries,PolicyResearchWorkingPaper,no.1531,TheWorldBank,Washington,DC,viewed30May2010,<http://ideas.repec.org/p/wbk/wbrwps/1531.html>

UnitedNationsConferenceonTradeandDevelopment(UNCTAD)variousyears,World Investment Report,UnitedNations,NewYorkandGeneva.

United Nations Statistics Division n.d., COMTRADE, Commodity TradeStatisticsDatabase,UnitedNations,NewYorkandGeneva,<http://unstats.un.org/unsd/comtrade/default.aspx>

United Nations Statistical Division n.d., National Accounts, United Nations,NewYorkandGeneva,<http://unstats.un.org/unsd/snaama/dnllist.asp>

Wang,C.,Wei,Y.andLiu,X.2007,‘DoesChinarivalitsneighbouringeconomiesforinwardFDI’,Transnational Corporation,vol.16,no.3,pp.35–60.

Zhou,Y.andLall,S.2005,‘TheimpactofChina’ssurgeonFDIinSouth-EastAsia:paneldataanalysisfor1986–2001’,Transnational Corporation,vol.14,no.1,pp.41–65.


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Appendix Table 11.A1 Variable list of the impact of FDI inflows into China on FDI inflows into other Asian developing host economies

Variable name Specification of variables Sources

Dependant variableFDI*j,t

sdfsdfsdsfdTotal FDI inflows from all source

countries into Asian developing host economy j in year t (millions of US

dollars at 1990 prices) .

sdfsdVarious issues of United Nations,

World Investment Report .

Independent variablesFDICHN*,t

sadsaddasdsasadas

WFDIOUT*dasdasdas

GRj,t

sadsdggggggg

EWj,t

ggggff

cccccccc

CDRj,tvvvvv

Total FDI inflows from all source countries into China in year t

(millions of US dollars at 1990 prices) .dsfsd

World total FDI outflows in year t (millions of US dollars at 1990 prices) .

dsfsdfsdAnnual real growth rate of GDP

of Asian developing host economy j in year t (per cent) .

sdfsdfEfficiency wage of Asian developing host economy j in year t (per cent) .

sdfasdfassd

XasdasCountry credit rating index of Asian developing host economy j in year t

(scale of 0–100, with 100 representing the least chance of

default or the best credit worthiness) .

sdfsdfsdVarious issues of United Nations,

World Investment Report .sdfsdf

Same as above .zfsddsfsdfsdf

United Nations Statistical Division

(n .d ., National Accounts)

Calculated from ILO (n .d .) and United Nations

Statistical Division (n .d ., National Accounts)

fffCompiled from various issues of Institutional

Investor .fffff

241

The global financial crisis and rural–urban migration 12

Sherry Tao Kong, Xin Meng and Dandan Zhang

Introduction

Sincethesecondhalfof2008,theglobalfinancialcrisis(GFC)reducedexportorders sharply and led to a decline in China’s economic growth. As China’sexporting industries are labour intensive and most likely to employ ruralmigrants,itiswidelybelievedthattheglobalfinancialcrisishashadsignificantnegative impacts on the employment and/or wages of rural migrants. At theheightofthecrisis,laid-offChinesemigrantworkersprotestedoutsideclosedfactoriesandmillionslamentedlostjobsandembarkedonjourneyshomemuchearlierthantheusualChineseNewYearvisit.Manywereapprehensive,worryingthattheworstwasyettocome.Atthattime,policymakersandacademicsalikewereconvincedtherewouldbeasignificant,adverselabour-marketadjustmentforruralmigrants(Chen2009;NBS2009;Kongetal.2009).Inlastyear’sChina Update volume,weestimatedthat thetotalemployment impactof theglobalfinancialcrisiswasbetween13and19percent.Wealsoemphasised,however,that the adverse shock to employment was in fact the joint outcome of theglobalfinancialcrisisandChina’sdomesticpolicystance—mostprominently,thecontractionarymacroeconomicpolicyandtheimplementationoftheNewLabourContractLaw(Kongetal.2009).

Withthefiscalandmonetaryexpansionsinresponsetotheglobalfinancialcrisisandthegradualrecoveryofexternaldemand,Chinabouncedbackforcefullyfromagrossdomesticproduct(GDP)growthrateof6.1percentintheyeartothefirstquarterto7.8percenttothesecondquarterof2009.Bytheendof2009,thegrowthrateexceededthe8percenttarget.Nowthattheimmediatecrisis is over, it is time to evaluate how much the global financial crisis hasaffectedmigrantlabour-marketoutcomesandwhethertheseeffectswereshortlivedorlonglasting.

Usingthepanelsurveysofrural–urbanmigrantsandruralhouseholdsintheRural–UrbanMigrationinChinaandIndonesia(RUMiCI)Project,thischapter


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comparesthe labour-marketoutcomesofmigrants incities in2008and2009.Muchtooursurprise,weobservesmallemploymenteffectsandvirtuallynoreductioninworkinghoursorwagesformigrants.Wetrytounderstandthelogic behind our findings.We find that the real adverse effect of the globalfinancial crisis is felt mainly by the rural sector—to where the unemployedmigrantworkersfromcitiesreturned—andthemultipliereffectofthereductionin income of unemployed migrant workers, which suppressed demand inthe rural sector,which, in turn, further suppressed rural off-farm jobs.Thismultipliereffect isvery largeandhasnotreceivedattention in the literaturebefore.

The chapter is structured as follows.The next section reviews the literatureandhypothesisesaboutthetypesoflabour-marketadjustmentwemightexpecttoobserve.Thisisfollowedbyadiscussionofthedataandanexaminationoflabour-marketadjustmentsfromtheurbanandrurallabour-marketperspectives.Thefinalsectionconcludesthechapter.

Earlier findings and our hypothesis

Therehavebeentwoimportantstudiesoftheimpactoftheglobalfinancialcrisisonrural–urbanmigrants:Kongetal. (2009)andHuangetal. (2010).Usingarepresentativesampleof1200householdsinsixprovincesinruralChina,Huangetal.(2010)findthattheinitialnegativeimpactofthecrisisonruralmigrants’employmenthasbeensignificant.TheyestimatethatbetweenSeptember2008andApril2009,17percent(upto45million)ofruraldwellerswithoff-farmemploymenteitherlosttheirjobsordelayedtheirmoveoutoftheagriculturalsector.Farmers,however,adaptedtothecrisismorequicklythanexpected.ByApril2009,25millionofthoseruralworkerswhoinitially losttheiroff-farmjobshadfoundnewpositionsandbyAugustthisnumberhadincreasedto32million.Toexplainthisphenomenon,Huangetal.(2010)suggestthatthequickrecoverywasaresultoftheimprovedflexibilityofChina’slabourmarketandruralworkers’willingnesstoacceptlowerwages.Theyestimatethattheaveragemonthlyearningsoftheemployedoff-farmworkersfellby2.4percent—fromRMB1086in2008toRMB1062inJanuary–April2009.

TwootherreportsfromtheMinistryofHumanResourcesandSocialSecurityofChina(MoHRSS)showanevenmoreoptimisticpicture.Areportentitled‘TheresponseofChina’semploymentofruralmigrantstotheGFC’(MoHRSS2009)showsthat,betweentheendof2008andApril2009,70millionruralmigrantsmoved from the city back to their home villages, including 20 million ruralmigrantswholosttheirjobsincitiesduetotheglobalfinancialcrisis.Amongthe70million returningmigrants, 95per cent obtainednewemployment in

The global financial crisis and rural–urban migration

243

cities.TheunemploymentrateforruralmigrantsinChinesecitieswaslessthan3percent.Thetotalnumberofruralmigrantworkersincitiesinfactincreasedfrom140millionin2008to150millionin2009.

The other report (MoHRSS 2010) focuses on the employment situation ofmigrantsin2009andisbasedonasurveyconductedin90countiesthroughout27provinces inearly2010.Thesurvey interviewed9081ruralmigrantsandcollectedinformationincludingtheiremploymentsituation,wageremuneration,willingness towork in cities andemployment expectations.The surveydatashowedthattheaveragemonthlyearningsofruralmigrantsincreasedby12.9percentfrom2008to2009,with6.7and11.5percentincreasesforwage/salaryearnersandtheself-employed,respectively.

Thesestudiesrevealedthatforruralmigrants,whoboremostoftheinitialbruntoftheeconomicdownturn,theiremploymentlevelshadessentiallyrecoveredfromthecrisisbylate2009.Thesestudiesprovideconflictingevidence,however,onchangesinearnings.Inaddition,alltheabovestudiesarebasedonsurveysconductedatthesending(ormigrant-source)areasandonretrospectivedata,which might not accurately reflectwhat happened to rural migrants in theirdestinationcities.Inthischapter,weuseconsistentsurveysofruralhouseholdsaswellascitymigrantstore-examinethisissueandtopaintamorecompletepictureoftheeffectoftheglobalfinancialcrisis.

In a modern labour market, a negative economic shock will generateunemploymentordepressedwagesinthemarketinwhichtheshockoccurs.Inadevelopingeconomy,however,ademandshocktothe‘modernsector’labourmarketmightnotbedirectlydetectedinthatmarketbecauseoftheduallabour-marketstructureoftheeconomy.Withadualeconomicstructure,the‘traditionalsector’providesa‘fallback’positionformostmigrantworkers.Wheneverthewagesinthemodernsectorfallbelowthereservationwage,workerswillmovebacktothe‘traditionalsector’providedthatthecostofmovingisnottoohigh(Lewis1954;RanisandFei1961).ThisprocesshappenedduringtheEastAsianfinancial crisis in Indonesia, where millions of workers moved back to theagriculturalsectorandverylittleunemploymentwasdetectedinthemodernsector(Hugo2000;Manning2000;FallonandLucas2002).

ThisrelationshipbetweenthemodernandtraditionalsectorsisevenstrongerinChina for the following reasons. First,migrants often come to cities alonedue to the restrictions on welfare access in cities for families and children.Consequently, the cost of returning to rural areas is relatively low. Second,migrantsnormallydonothaveunemploymentinsuranceanddonothavehealthorpensioninsuranceincities.Withoutajob,itisveryhardforthemtosurviveincities,whereastheagriculturalsectorprovidesasubsistencelevelofwelfare(housing and food).The migrants might see this difference between the two


244

sectors either as a lower effective urban sector wage or a higher reservationwagesetinthetraditionalsector.Theendresultistoincreasetheprobabilityofmakingareturnmigrationdecision.Ineffect,theonlywaythatmigrantscancushiontheadverseeffectsofeconomicshocksthataffecttheiremploymentorearningsistoreturntoruralareasandseekalternativeemployment.

Consideringthisspecialinstitutionalsettingofrural–urbanmigrationinChina,the effectof anyeconomic shockonmigrant labour-marketoutcomes shouldbe examined from two directions. First, when economic shocks come, manyaffectedmigrantworkersmovebacktoruralhometownswheretheyfindoff-farm jobsorbecomeunderemployed farmers,which, in turn,couldsuppressagriculturalproductivity.Second,forthoseaffectedmigrantswhoareunwillingtomovebacktotheirruralhometowns,wecouldobserveanincreaseinopenunemployment,shiftingtoinformalemploymentorareductioninwagerates.

Thus,toprovideamorecompletepictureoftheeffectoftheglobalfinancialcrisisonmigrantworkers,weexamineurbanandrural labourmarketsusingsurvey data for sending rural regions and receiving urban cities from theRUMiCIsurveysof2008and2009.Giventhe‘buffer’rolethattheruralsectorplays,weexpectthatmostoftheimpactoftheglobalfinancialcrisisisfeltbytheruralsector.

Data

The RUMiCI survey started in 2008. The sampling strategy and surveyinstruments can be found on the Internet (<http://rumici.anu.edu.au>).TheuniquenessofthesurveyinChinaisthatitsurveysthreegroupsofhouseholds:5000 rural–urban migrant households who worked in 15 designated cities(migrantsurvey);5000urbanhouseholdsinthesamecities1(urbansurvey);and8000ruralhouseholdsfromnineprovinceswherethe15citiesarelocated(ruralsurvey).RUMiCIwasdesignedtobeapanelsurveyandthesecondwavewasconductedin2009.

Due to the high mobility of rural migrants (especially during the economicdownturn),theattritionrateforthemigrantsampleisextremelyhigh(about60percent).Thus,in2009,inadditiontothe40percentoftrackedhouseholds,agroupofnewhouseholdswasrandomlyselectedbasedonthesamesamplingframeandadded into the secondwaveof the survey.As a result, theurbanmigrantsamplein2009contains40percentofthehouseholdssampledin2008

1 Theurbansurveycoversall15citiesincludedinthemigrantsurveyplusfouradditionalcities.Thus,wehaveatotalof19citiesfortheurbansurvey.


245

thatweresuccessfullytracked in2009 (that is, thepanel)and60percentofhouseholdsnewlysampledin2009.Incontrast,theattritionratesforruralandurbanresidenthouseholdsaremuchlower(below10percent).

Webelievetheimpactoftheglobalfinancialcrisiswasconcentratedfromthesecondhalfof2008tothefirsthalfof2009.ThetwowavesofRUMiCIdatacovertheperiodbeforeandduringthisperiod.Themigrantsurveyin2008startedinMarchandendedinJune.About93percentofinterviewswerefinishedbytheendofMay.Thesurveyin2009wasconductedoversixmonthsstartingfromMarchandendinginAugust,with73percentofhouseholdsinterviewedbytheendofMay(seeAppendixTable12.A1foradistributionofsurveytimesinthetwoyears).TheruralhouseholdsurveywasconductedbetweenMarchandMay2008andAprilandJune2009.Thus,weusethe2008datatoindicatethepre-globalfinancialcrisissituationwhileusing2009datatoindicatetheglobalfinancialcrisisperiod.Acomparisonbetweenthetwosurveyyearswillenableus to identifychanges inmigrant labour-marketoutcomesbeforeandduringthecrisis.

Herewefocusonindividualswhoareagedsixteentosixty-fiveandareinthelabourmarket.2Thetotalnumberofobservationsinourmigrantsampleis7153and7567forthefirstandsecondwaves,respectively.Thenumberofobservationsfortheruralsampleis20451and20408forthetwowaves,respectively.Notethat in the rural survey, all household members are reported in the survey,includingthosewhowerenotpresentatthetimeofthesurvey.Forindividualswho were not present at the time of the survey, other household memberswho were present reported their information. In most cases, the respondentwas the household head.We are therefore able to examine the difference incharacteristics between current migrants and non-migrants from the ruralsurvey.Thedataformigrantscouldsuffer,however,fromlargermeasurementerrors.Duetothis inaccuracy, it is importanttocomplementthe informationonmigrantworkersfromtheirruraloriginwithinformationcollectedfromthemigrantsthemselvesinthecities.Table12.1presentsthesummarystatisticsofthebasicdemographiccharacteristicsofthetwosamplesforbothwaves.

Onaverage,themigrantsampleis31.3yearsofagein2008andincreasedbyaboutoneyearto32.2in2009.About58percentaremales,andtheproportionswhoaremarriedorcohabitateare63and66percentforthetwoyears,respectively.Theaverageyearsofschoolingareaboutnineyearsandslightlyhigher(0.17years)forthe2009sample.Thisincreaseseemstocomefromtheslightlyhigherproportionofseniorhighschoolgraduatesinthesamplefor2009.

2 An individual isdefined tobe in the labour force ifhe/she isbetweensixteenandsixty-fiveyearsofageandisstatedtobecurrentlyworking(includingre-employedretiredpeople),anunpaidfamilyworker,unemployedorwaitingtobeassignedtoajob.Thisdefinitionappliestomigrantandruralsamples.


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Table 12.1 Summary statistics for migrant and rural samples

Migrant sample Rural sample

Total sample

Migrant sample

Non-migrant sample

2008 2009 2008 2009 2008 2009 2008 2009

Age 31 .3 32 .2 40 .0 40 .6 29 .3 29 .8 42 .9 43 .3

Percentage of males

58 .3 57 .9 53 .9 52 .8 61 .8 60 .6 51 .8 50 .8

Marital status (%):First marriage

62 .0 63 .9 77 .2 77 .3 54 .9 55 .8 83 .2 82 .7

Second marriage

0 .8 0 .9 2 .2 2 .8 1 .5 1 .8 2 .3 3 .0

Cohabitation 0 .3 0 .7 0 .4 0 .4 0 .1 0 .4 0 .5 0 .4

Divorced 1 .0 1 .2 0 .4 0 .5 0 .6 0 .7 0 .3 0 .4

Widowed 0 .4 0 .6 1 .0 1 .0 0 .3 0 .1 1 .2 1 .3

Single 35 .4 32 .7 18 .8 18 .0 42 .5 41 .3 12 .4 12 .2

Years of schooling

9 .1 9 .2 7 .5 7 .5 8 .5 8 .5 7 .2 7 .2

Level of schooling (%):Illiterate 2 .1 4 .0 4 .9 4 .9 0 .7 0 .8 6 .1 6 .0

Primary school

12 .9 12 .1 17 .6 17 .7 7 .6 7 .4 20 .3 20 .3

Junior high school

55 .6 49 .7 63 .9 63 .4 75 .0 74 .9 60 .9 60 .5

Senior high school

25 .5 27 .6 13 .5 13 .9 16 .7 16 .8 12 .7 13 .1

Post-secondary

4 .0 6 .6 0 .0 0 .0 0 .0 0 .1 0 .0 0 .0

Total no. of observations

7153 7563 20 451 20 408 4317 4110 16 134 16 298

Source:Authors’ownsurvey.

Compared with the migrant sample surveyed in urban cities, the rural totallabourforce(includingmigrantsandnon-migrants)ismucholder.Onaverage,they were forty and forty-one years of age in 2008 and 2009, respectively.Consistentwiththemigrantsurvey,theaverageageofthemigrantpopulationisaboutthirtyyears,whilethenon-migrantsampleismucholder(aboutforty-three).This agedifferential indicates thatyoungpeople aremore likely thanolderpeopletomigrate.WepresenttheagedistributionsfromdifferentsamplesinFigure12.1,whereitisclearlyindicatedthatmigrantsaremoreconcentratedinthetwenty–thirtyagegroup,whereasnon-migrantsaremoreconcentratedinthelate-thirtytofiftyagegroup.


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Figure 12.1 Age distribution of the sample from the migrant and rural surveys


Migrantsarealsomostlikelytobemales.Inthetotalruralsample,about53–54percentaremales,whileforthemigrantsampletheproportionisabout58percent;andformigrantsintheruralsampleitisevenhigheratabout61percent.Migrantsarealsomorelikelytobesinglesanddivorcees.Finally,migrantsarebettereducatedthanthosewhoarenon-migrants.

The effect of the global financial crisis on labour-market outcomes: urban perspective

In this section,we investigate the extent towhich theglobalfinancial crisisaffected the employment and wages of rural–urban migrants who stayed incitiesduring2009.

Table12.2presentssummarystatisticsofemploymentandwagesforthetwoyearsaswellas thedifferences inoutcomesbetweenthe twoyears.Thefirstpanel ofTable 12.2 shows that the employment rate for the total sample fellfrom98.7 in2008to96.6 in2009—that is,anincrease intheunemploymentrateby2.1percentagepoints.Ifwelookatthepanelsample,theincreaseintheunemploymentrateismarginallyhigher—at2.7percentagepoints.Consideringthe huge reduction in exports during 2009, this increase in unemploymentlooksrathertrivial.


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Table 12.2 Employment and earnings of migrants in cities (migrant sample)Total sample Panel sample

2008 2009 Difference 2008 2009 Difference

Panel 1

Employed (%) 98 .7 96 .6 –2 .1 98 .8 96 .1 –2 .7

Self-employed (%) 22 .5 28 .1 5 .6 31 .6 38 .3 6 .7

Wage and salary earners (%)

72 .1 69 .7 –2 .4 61 .5 59 .3 –2 .2

Family workers(%) 5 .4 2 .2 –3 .2 6 .9 2 .4 –4 .5

Total no . of labour force

7153 7567 414 2829 2714 –115

2008 2009 Percentage change (%)

2008 2009 Percentage change (%)

Panel 2

Weekly hours worked (hour)

63 .1 63 .1 0 .0 65 .8 65 .5 -0 .5

Wage and salary earners

58 .4 57 .3 -1 .9 58 .9 57 .7 -2 .0

Self-employed 78 .3 77 .6 -0 .9 79 .3 77 .7 -2 .0

Weekly hours worked by industry:Construction 62 .2 61 .5 -1 .1 61 .7 61 .5 -0 .3

Manufacturing 54 .6 55 .2 1 .1 55 .7 55 .0 -1 .3

Retail/wholesale trade

59 .2 57 .7 -2 .5 59 .6 58 .2 -2 .3

Service 58 .8 57 .4 -2 .4 59 .1 58 .5 -1 .0

Panel 3

Monthly earnings or net revenue (RMB)

1598 1820 13 .9 1648 1842 11 .8

Wage and salaryearners

1411 1631 15 .6 1417 1661 17 .2

Self-employed 2200 2297 4 .4 2098 2128 1 .4

Hourly earnings or net revenueRMB)

6 .4 7 .5 17 .2 6 .41 7 .64 19 .2

Wage and salary earners

6 .2 7 .4 19 .4 6 .2 7 .6 22 .6

Self-employed 7 .3 7 .9 8 .2 6 .8 7 .7 13 .2

First month earnings or net revenue (RMB)

899 .6 978 .1 8 .7


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Panel 4

Percentage of workers receiving welfare insurance (%)

2008 2009 Difference 2008 2009 Difference

Unemployment insurance

11 .9 12 .2 0 .3 11 .8 11 .9 0 .1

Pension insurance

18 .9 20 .6 1 .7 19 .7 20 .8 1 .1

Health insurance

55 .9 68 .2 12 .3 59 .8 67 .9 8 .1

Work injury insurance

17 .5 16 .8 -0 .7 16 .6 16 .8 0 .2

Housing fund 7 .0 7 .0 0 6 .5 7 .2 0 .7


Of the total employed, the proportion of self-employed increased by 5.6percentagepointsforthetotalsample.This increasecould,however,tosomeextentbearesultof sampleattritionbias,becauseself-employed individualsarelessmobilethantheirwage/salary-earningcounterpartsandhencearemorelikelytobetrackedinthesecondwave.Togaugetheextenttowhichsampleattritioncouldcontributetothisincreaseintheshareofself-employment,wefurtherexaminethepanelsample.Forthesampleofthesameindividuals,wefind that in 2008, 32 per cent were self-employed and by 2009, 38 per centwereself-employed—anincreaseof6percentagepoints.Switchingfrombeingawage/salaryearnertoself-employmentcouldhavebeenastrategytocopewiththeeconomicdownturngeneratedbytheglobalfinancialcrisis.DuringtheEastAsianfinancialcrisis(1998),manymigrantworkersinIndonesiaswitchedfromtheformalsectortotheinformalsector(Hugo2000).Indeed,whenwecompareoccupationaldistributionsfortheself-employedin2008and2009,wefindthatthebiggestreductionbetweenthetwoyearsisforsmall-shoporfactoryowners,whilethebiggestincreasesin2009areforstreetvendors,garbagecollectorsandshopassistants(seeAppendixTable12.A2).Thislastgroupismorelikelytobecategorisedasinformal-sectoremployment.

Another way to adjust employment in response to the economic shock is toreduceworkinghours.ThesecondpanelofTable12.2summarisestheaverageweeklyhoursworkedbytotalemployedworkersaswellasbyself-employedandwage/salaryearners,separately.Onaverage,thereishardlyanychangeinweeklyhoursworkedforthetotalsampleandthepanelsample.Self-employedworkersingeneralworklongerhoursthanwage/salaryearnersandthisphenomenondidnotchangeovertime.Moreimportantly,weeklyhoursworkeddidnotfallmuchforeitherself-employedorwage/salaryearnersin2009relativeto2008.Fortheself-employed,there isa1percentreductioninhoursworkedwhiletheproportionforwage/salaryearnersis1.9percent.Giventhefactthattheglobalfinancialcrisisismorelikelytohaveaffectedmanufacturingratherthan


250

other industries,wealsoexaminehoursworkedby industry (alsoseeFigure12.2).Herethesamestoryisobserved:thelargestreductioninhoursworkedis2.5percentfortheretail/wholesaletrades.Themanufacturingindustryhadnoobservabledeclineinhoursbutrathera1percentincrease.Clearly,nojobsharingoccurredintheChineselabourmarketduringtherecession,unlikethesituation in someWestern labourmarkets.This isunderstandablebecause ina country with an abundant labour supply at the unskilled level, employerswouldnothavebeenworriedabouthiringwhentherecessionwasover.

Figure 12.2 Wage/salary workers’ log weekly hours worked by industry

Source:Calculatedbasedonauthors’ownsurvey.

The small change in the unemployment rate and the small change in hoursworkedbetween2008and2009suggestthattheaverageemploymentsituationformigrantswhostayedincitieswasnotsignificantlyaffected.Thisisratherpuzzlingtous.Giventhe20percentreductioninexports(MoHRSS2009),onewouldhaveexpectedamuchlargeremploymenteffect.Perhaps,asthelabourmarketformigrantworkersisflexible,thedemandshockcanbeabsorbedbythewageflexibility.Ifso,weshouldobserveadownwardchangeinearnings.

Panel3ofTable12.2presentsthechangeinmonthlyandhourlyearningsforthetotal,wage/salaryearnersandself-employedworkersforthetotalandpanelsamples.Formonthlyorhourlyearnings,weobservenoreduction,butratheranincreaseinearningsin2009.Evenmoresurprisingly,thelargestincreaseinearningsoccurredamongwage/salaryearners,whoshouldhavebeenthegroupmostnegativelyaffectedbytheglobalfinancialcrisisshock.Theaveragehourlyearnings increaseforwage/salaryearnerswas19percent,while for theself-employeditwas8percent.Figure12.3presentsthedistributionofearningsbyindustriesforwage/salaryearners.Itisclearthateveryindustryhadanhourlyearningsincreasebetween2008and2009anditisparticularlysoforthepanelsample.


251

Figure 12.3a Wage/salary earners’ log hourly earnings by industry (total sample)

Figure 12.3b Wage/salary earners’ log hourly earnings by industry (panel sample)

Source:Calculatedbasedonauthors’ownsurvey.

Wealsoexaminewhethermonthlyearningsfornewarrivalschangedbetweenthetwoyears inPanel3ofTable12.2.This is interestingbecausethisgrouprepresents the most unskilled workers without any work experience. In theRUMiCI survey,we collect informationon earnings in thefirstmonthof thefirstjob.Forthosewhosearrivalmonthandsurveymontharethesameorplus/minusonemonth,weusetheircurrentmonthlyearnings.Manyindividualsdidnotreportfirst-monthearnings,especiallythosewhoarrivedwithinthesurvey


252

year.Thus,wehavearathersmallsample,withatotalof93newarrivalsfor2008and26for2009.Onaverage,thefirstmonthlypayforthefirstjobisabout9percenthigherin2009thanin2008.

Finally,weexaminewhetheremployer-providedsocialinsurancehasfallenaspartoftheadjustmentforearningslevels(Panel4ofTable12.2).Hereagainwedidnotfindmuchchangeand,ifanything,thechangesarepositive.

The above analysis examines only average unconditional hours and earningschanges. To ascertain whether these results are due to the change in thedistributionofdifferenttypesofworkersandtheirworkinglocationsbetweenthe two years, we estimate hours and earnings equations, which control forindividual characteristics and industry and regional variations. Table 12.3presentstheregressionresultsforlogweeklyworkhours(firstthreecolumns)andloghourlyearnings(columns4–6).Weestimatetheseregressionsforthetotalsampleandthesampleofwage/salaryearnersandself-employed,separately.

Table 12.3 Results from the hours and hourly earnings equations for migrants in cities (migrant sample)

log (weekly work hours) log (hourly earnings)Total Wage/

salarySelf-

employedTotal Wage/salary Self-

employed

Age –0 .011 –0 .015 0 .010 0 .039 0 .044 0 .007

[0 .002]*** [0 .002]*** [0 .005]* [0 .004]*** [0 .003]*** [0 .012]

Age squared/100

0 .014

[0 .003]***

0 .021

[0 .003]***

–0 .013

[0 .006]**

–0 .062

[0 .005]***

–0 .069

[0 .005]***

–0 .021[0 .015]

Years of schooling

–0 .016

[0 .001]***

–0 .018

[0 .002]***

–0 .007

[0 .004]**

0 .048

[0 .003]***

0 .053

[0 .003]***

0 .036

[0 .008]***

Years of schooling* dummy for 2009

–0 .005[0 .019]

–0 .013[0 .020]

–0 .004

[0 .046]

0 .069

[0 .038]*

0 .009

[0 .036]

0 .073

[0 .110]

Dummyfor males

0 .016

[0 .005]***

0 .027

[0 .005]***

–0 .023

[0 .012]**

0 .130

[0 .010]***

0 .126

[0 .009]***

0 .123

[0 .028]***

Dummy for married

0 .013[0 .007]*

0 .011[0 .007]

0 .034[0 .021]

–0 .006[0 .015]

–0 .004[0 .013]

–0 .059[0 .051]


253

Year since first migration

0 .003[0 .001]**

0 .004[0 .001]***

0 .002[0 .003]

0 .027[0 .003]***

0 .025[0 .002]***

0 .026[0 .007]***

Year since first migration squared/100

–0 .010[0 .005]**

–0 .014[0 .005]***

–0 .004[0 .011]

–0 .079[0 .010]***

–0 .064[0 .010]***

–0 .090[0 .026]***

Dummy for self-employed

0 .243[0 .007]***

0 .042[0 .013]***

Dummy for 2009

–0 .014[0 .018]

–0 .005[0 .020]

–0 .023[0 .040]

0 .056[0 .036]

0 .153[0 .035]***

–0 .051[0 .096]

Industry dummies

Yes Yes Yes Yes Yes Yes

City dummies

Yes Yes Yes Yes Yes Yes

Obser-vations

13 149 9777 3372 13 149 9777 3372

R-squared 0 .23 0 .11 0 .05 0 .22 0 .33 0 .13

*significantat10percent**significantat5percent***significantat1percent

Note:Standarderrorsareinbrackets.


Controllingforcityandindustryeffects,mostofthedemographiccharacteristicsseem to exhibit normal patterns in both the hours and earnings equations.Wediscussthehoursequationfirst.Forthetotalsample,agehasaU-shapedrelationshipwithhoursworked.This is the sameas forwage/salary earners,but for self-employed the relationship is reversed. The more educated anindividualisthefewerhourshe/sheworksandthisrelationshipdoesnotchangebetweenthetwoyears.Maleswork2–3percentmorehoursthantheirfemalecounterpartsiftheyareawage/salaryearner,but2percentlessiftheyareself-employed. Married workers work slightly longer hours and the relationshipbetween years since migration and hours worked is inverse U-shaped. Self-employedworkersonaveragework24percentmorethanwage/salaryearners.Finally,standardisingforindividual,industryandregionaleffects,workersin2009workedalmostthesamenumberofhoursaweekastheydidin2008.


254

Moving to the log hourly earnings equations, we find the normal inverseU-shapedrelationshipbetweenageandearnings.Anadditionalyearofschoolingincreases earnings for wage/salary earners by 5.3 per cent and for the self-employedby3.6percent.Theseratesofreturndonotseemtochangeovertime.ThenumberofyearssincemigrationalsohasaninverseU-shapedrelationshipwithearnings.Theself-employedearn4.2percentmorehourlyearningsthanwage/salary earners.Controlling for all these characteristics,hourly earningsin2009donotseemtobestatisticallydifferentfromthosein2008forthetotalsample.This,however,isnotthecaseforwage/salaryearners.Forthisgroupofworkers,theirhourlyearningsincreasedby15percentconditionalonotherco-variates.Theself-employed,ontheotherhand,earned5percentlessbutthepointestimateisnotstatisticallysignificant.

Combiningthestoriesonunemployment,hoursworkedandearningschanges,itseemsthatatthetimeoftheglobalfinancialcrisis,thosemigrantworkerswhodidnotlosetheirjobsorcouldfindotherjobswerenotadverselyaffectedintermsofhoursworked—andtheirearningswerenotadverselyaffected.Infact,forwage/salaryearners,theirearningsincreasedby15percent.Thisseemstosuggestthatthelabour-marketflexibilityformigrantwage/salaryearnerscouldbereflectedinhiringandfiring.Ontheotherhand,theself-employedsectordoesseemtohavemorelabour-marketflexibility,whereweobserveincreasedinformalemployment,slightreductioninhoursworkedandslightreductioninhourlyearnings.

The effect of the global financial crisis on labour-market outcomes: rural perspective

Intheprevioussection,weexaminedlabour-marketoutcomesformigrantswhoremainedincitiesduringtheglobalfinancialcrisis.Inthissection,weusetheruralhouseholdsampletoinvestigatethepossibleeffectoftheglobalfinancialcrisisonreturnmigration,ruraloff-farmemploymentandearnings.

Table12.4presentssummarystatisticsonemploymentandmigration.Between2008 and2009, the totalnumberof the rural labour force inour sample fellbyonly42people.Notethathere‘rurallabourforce’isdefinedasthoseagedsixteentosixty-fivewhoareeitheremployedorunemployed,includingthosewhohavealreadymigratedbutstillhavehouseholdregistrationintheirruralvillage,whichisthemajorityofmigrants.Ofthoseinthelabourforce,97.7and98.9percentareemployedinthetwoyears,respectively—thatis,areductionin theunemploymentrateof1.2percentagepoint for thatperiod (Panel1ofTable12.4).3

3 Employmenthereisdefinedasthosewhoidentifiedasbeingcurrentlyemployed(wage/salaryearners,farmingworkersandself-employed),unpaidfamilyworkersorre-employedretiredworkers.


255Tab

le 1

2.4

Ret

urn

mig

ratio

n, e

mpl

oym

ent

and

earn

ings

for

rur

al la

bour

fo

rce

(rur

al s

ampl

e)2008

2009

Diff

eren

ces

Freq

uenc

yA

s %

of

tota

l lab

our

forc

e

As

%

of t

otal

m

igra

nts

Freq

uenc

yA

s %

of

tota

l lab

our

forc

e

As

%

of t

otal

m

igra

nts

Freq

uenc

yPe

rcen

tage

po

ints

(%

)

(1)

(2)

(3)

(4)

(5)

(6)

(1)–

(4)

(2)–

(5)

Pane

l 1

Tot

al la

bour

for

ce20 4

51

20 4

09

–42

Tot

al e

mpl

oyed

19 9

78

97.6

920 1

89

98.9

2211

1.2

3

Pane

l 2

Tot

al n

o . m

igra

ted

for

mor

e th

an 3

mon

ths

5106

24 .9

74667

22 .8

2–439

–2 .1

5

To

othe

r ag

ricul

tura

l are

as401

1 .9

67 .8

5230

1 .1

24 .5

0–171

2 .5

4

To

the

sam

e co

unty

tow

n419

2 .0

58 .2

1348

1 .7

06 .8

2–71

4 .7

7

To

othe

r ci

ty in

the

pro

vinc

e or

oth

er p

rovi

nces

4273

20 .8

983 .6

94074

19 .9

279 .7

9–199

58 .8

9

Oth

ers

13

0 .0

60 .2

515

0 .0

70 .2

92

0 .2

3

Tot

al n

o. o

f fir

st-t

ime

mig

rant

s 725

3 .5

5518

2 .5

3–207

–1 .0

1

Mig

ratio

n in

tent

ion:

Freq

uenc

yA

s %

of

non-

mig

rant

sFr

eque

ncy

As

%

of n

on-

mig

rant

s

(1)–

(4)

(3)–

(6)

With

in 1

mon

th1727

10 .3

21087

7 .0

2–640

–3 .3

0

With

in 6

mon

ths

333

1 .9

9263

1 .7

–70

–0 .2

9

With

in 1

yea

r282

1 .6

9152

0 .9

8–130

–0 .7

1

Not

sur

e1989

11 .8

91155

7 .4

6–834

–4 .4

3

No

12 3

97

74 .1

112 8

32

82 .8

5435

8 .7

4


256 Pane

l 3

Effe

ct o

n ru

ral o

ff-f

arm

em

ploy

men

t:Fr

eque

ncy

As

% o

f to

tal l

abou

r fo

rce

As

% o

f to

tal n

on-

mig

rant

s

Freq

uenc

yA

s %

of

tota

l lab

our

forc

e

As

% o

f to

tal n

on-

mig

rant

s

(1)–

(4)

(3)–

(6)

Agr

icul

tura

l wor

k fo

r 9 o

r m

ore

mon

ths

9835

48 .0

962 .6

811 1

34

54 .5

569 .9

51299

7 .2

7

Non

-agr

icul

tura

l wor

k fo

r 3

or m

ore

mon

ths

5857

28 .6

437 .3

24782

23 .4

330 .0

5–1075

–7 .2

7

Mea

nM

ean

Diff

eren

ces

% c

hang

e

Wee

kly

hour

s w

orke

d in

ru

ral o

ff-f

arm

jobs

:51 .5

749 .9

2–1 .6

5–3 .2

0

Wag

e/sa

lary

ear

ners

52 .1

649 .8

9–2 .2

7–4 .3

4

Sel

f-em

ploy

ed49 .1

750 .0

00 .8

31 .6

8

Agr

icul

ture

wor

king

day

s

Mea

n (d

ays)

154

0–99 d

ays

3620

35 .6

4

99–149 d

ays

1123

11 .0

6

150–199 d

ays

1331

13 .1

200–249 d

ays

1554

15 .3

250–299 d

ays

913

8 .9

9

300–365 d

ays

1616

15 .9

1

Pane

l 4

Hou

rly e

arni

ngs

of o

ff-f

arm

jo

bsD

iffer

ence

s%

cha

nge

Tot

al6 .7

97 .5

30 .7

410 .8

6

Wag

e/sa

lary

ear

ners

6 .3

87 .1

20 .7

411 .5

3

Sel

f-em

ploy

ed8 .4

98 .9

40 .4

55 .3

2


257

Of the total labour force, about 25 per cent in 2008 and 23 percent in 2009migrated to other places to work—a total 2.2 percentage point reduction.Relativeto2008,in2009,theproportionofmigrantsfellby8.6percentfrom5106to4667.Wefurtherdividethemigrantsintofourdifferentcategories:thosewhomigratedtootherruralregions,tolocalcountytowns,toothercitiesintheprovinceorotherprovinces,andtootherplaces.Inbothyears,thelargestgroupisthosewhomigratedtoothercitieswithintheprovinceorotherprovincesandthisisthegroupweusetoidentifymigrantsinoururbanmigrantsample.Thisgroupaccountedfor84and80percentofthetotalmigrantsin2008and2009,respectively,orareductionof4percentagepoints(Panel2ofTable12.4).

Becauseof thepanelnatureofourdata,weare able to examine thenumberofpeoplewhomigrated in2008butdidnotmigrate in2009and thosewhomigratedin2009butdidnotmigratein2008(thetoppanelofTable12.5).Theformerhas1371individualsandthelatterhas1189individuals.Thus,wehaveanetreturnmigrationof182people,whichaccountedfor4.3percentofthetotalmigrantsin2009,translatingtoabout6.5millionpeopleatthenationallevel. Note that in a normal year we would have observed a net increase inmigration.For example,basedon theWorldBank (2009),between2004and2005thenumberofmigrantsincreased—from118.2millionto125.8million—anincreaseof6.4percent.Therefore,the6.5millionobservednetreductioninmigrationisonlyalower-boundestimateoftheeffectoftheglobalfinancialcrisisonmigration.Ifweregardthechangebetween2004and2005asanormalyear, the real return migration between 2008 and 2009 should be no lowerthan10percentofthetotalmigrants—oratotalofnolessthan14–15millionmigrants.Notethatthisestimateexcludestemporaryreturnmigrants.PerhapsthisiswhythisestimateisslightlylowerthanKongetal.’s(2009)lower-boundestimateoftheeffectoftheglobalfinancialcrisisof13percent.

Table 12.5 Migration and off-farm status for a panel of individuals (rural sample)No in 2009/yes in 2008

Yes in 2009/no in 2008

Net difference

Migration (1) (2) (3) = (1)–(2)

Frequency 1371 1189 182

As percentage of 2009 migrated labour

32 .5 28 .2 4 .3

Off-farmFrequency 2537 1431 1106

As percentage of 2009 off-farm labour

53 .0 29 .9 23 .1

As percentage of 2009 total labour force

12 .4 7 .0 5 .4

Source:Basedonauthors’ownsurveys.

Ofthereductioninout-migration,wefurtherinvestigatetheeffectoftheglobalfinancialcrisisonfirst-timemigrationandonmigrationintention(thesecond


258

blockinPanel2ofTable12.4).RUMiCIdataincludeinformationontheyearoffirstmigration.Comparingthetwoperiods—January2007tomid2008andJanuary2008 tomid2009—thenumberoffirst-timemigrantsdropped from725to518people,equivalenttoadecreaseof1percentagepointofthetotalrurallabourforce.4Theformerperiodcanreasonablybeconsideredasnormalcircumstancesandusedasabenchmarktocomparewiththelatter,whichcoverstheshortperiodleadinguptotheheightofthecrisisthroughuntilthepowerofthecrisisstartedtosubside.Thedropof1percentagepointimpliesadeclineofaboutfivemillionfirst-timeruralmigrants.5

With regard to migration intentions, the survey asks individuals who werepresentatthetimeofthesurveytoindicatetheirplantoout-migrate.Comparedwithayearearlier,thenumbersofadultswhoexpectedtomigratewithinonemonth,sixmonthsandoneyearallfell,whilethoseindicatingthattheywouldnotmigrateincreasedsubstantially,from74to83percent(thethirdblockinPanel2ofTable12.4).Asthe2009surveywasconductedmainly inthefirsthalfoftheyear,itislikelythatthememoryofthenegativeshockattheendof2008andthebleakprospectsforemploymentdiscouragedrurallabourersfrombecomingmigrantworkers.

Thedatapresented above indicate a substantial effect of theglobalfinancialcrisisonmigrationoutflow.Aneteffectofnolessthan10percentofthetotalmigrantsreturnedtotheirhometownsduringlate2008andstayedtherethroughthefirsthalfof2009.

What did these migrants do after they returned to the rural areas? Was itrural farming or off-farm employment that eventually absorbed these returnmigrants?Howdidtheswitchingfromout-migrationtoruraloff-farmorfarmworkaffecttheirearnings?

First, we investigate whether the 2009 return migrants were employed infarmingoroff-farmsectors.Wefindthat80percentofthemigrantsreturnedtoafarmingjobandonly20percentreturnedtoworkinanoff-farmjob.

Second,weexaminethechangeinfarmingandoff-farmemploymentoverthetwoyears(thefirstblockinPanel3ofTable12.4).Wefindthatforthosewhodidnotmigrate, theproportionworkingintheagriculturalsectorrelativetothe total non-migrated labour force increased by 7.27 percentage points (or6.24percentagepointsintermsofthetotallabourforcewithruralhukou)andthe samedegreeof reduction is found for thosewhoworked in theoff-farmsector.Amongthosewhoworkedinruralareas,wealsoutilisethepanelnature

4 Inthischapter,wedefinetotalrurallabourasthelabourforcewithruralhouseholdregistration.5 Thisiscalculatedbasedonthetotal labourforcewithruralhouseholdregistration(ruralhukou)using20051percentpopulationsurveydata.Thisnumberin2005was505million.


259

of thedata toexaminethenumberofpeoplewhoswitchedfromanoff-farmjobin2008tofarmingemploymentin2009(thebottompanelofTable12.5).Thereare2537individualsworkinginoff-farmjobsin2008whoswitchedtofarmjobsin2009,whileonly1431individualsmovedfromfarmingjobstooff-farmjobs—anetswitchtofarmingjobsof1106individualsor5.4percentofthetotalruralhukoulabourforce,whichisequivalentto27.3millionpeople.This, however, might be a lower-bound estimate. Assuming that in the pre-globalfinancialcrisisperiodruraloff-farmemploymentincreasedannuallyby2percentagepoints, the real effect of theglobalfinancial crisis on rural off-farm jobs should be no less than 7.5 per cent of the total labour force withruralhukou—equivalentto38millionruralhukouholders.Thisisamuchbiggereffectthanthedirectreturnmigrationeffect.Perhaps,inadditiontothedirectdemandshockoftheglobalfinancialcrisis,thereisasecondarymultipliereffectof returnmigration.Whena largenumberofmigrants lost jobs in the citiesandreturnedtohomevillages,theirincomelevelfell,whichinturnreduceddemandfornon-agriculturalgoodsandservicesintheruralareas,leadingtothemultipliereffectonruraloff-farmemployment.

Basedonourpanelestimates,ifweaddtheimpactoftheglobalfinancialcrisisonreturnmigrationandontheswitchingfromruraloff-farmtofarmingjobs,totaloff-farmemploymentfellby53million (15millionreturnmigrantsplus38 million switching from off-farm jobs to farming jobs) in 2009.6 This is asubstantialemploymenteffect.

Next, we consider whether for rural off-farm jobs there were any hourlyadjustments(thesecondblockinPanel3ofTable12.4).Wefindthattherewereslight reductions in the number of hours worked weekly in 2009 relative to2008 for the wage/salary earners, but not for self-employed. For the former,thereductionwasabout2.3hours,or4percent.Thisslightreductioninhoursworkedforwage/salaryearnersdoesnot,however,takeintoaccountchangesin individual characteristics or industry and regional distributions. Oncecontrollingforthesechanges,therewasnochangeinhoursworkedforeithergroup(seeTable12.6fortheregressionresults).

6 Thelower-boundestimateis34million(the6.5millionreturnmigrationplus27millionreductioninruraloff-farmjobs).


260

Table 12.6 Results from hours and hourly earnings equations for rural off-farm work (rural sample)

log(weekly hours worked) log(hourly earnings)Total Wage/

salarySelf-

employedTotal Wage/salary Self-

employed

Age –0 .004 –0 .006 0 .007 0 .037 0 .03 0 .073

[0 .003] [0 .004] [0 .011] [0 .005]*** [0 .005]*** [0 .015]***

Age squared/100

–0 .002

[0 .004]

0 .001

[0 .004]

–0 .015

[0 .013]

–0 .052

[0 .006]***

–0 .044

[0 .006]***

–0 .095

[0 .017]***

Years of schooling

0 .004[0 .002]*

0 .002

[0 .003]

0 .012

[0 .007]*

0 .024

[0 .004]***

0 .028

[0 .004]***

0 .002

[0 .010]

Years of schooling* dummy for 2009

–0 .007[0 .004]*

–0 .007[0 .004]*

–0 .001[0 .011]

0 .0130 .005]**

0 .012[0 .005]**

0 .018[0 .014]

Dummy for males

0 .01[0 .011]

0 .006[0 .011]

0 .012[0 .030]

0 .274[0 .015]***

0 .259[0 .016]***

0 .319[0 .040]***

Dummy for married

0 .052[0 .020]***

0 .047[0 .019]**

0 .081[0 .077]

0 .007[0 .028]

0 .037[0 .028]

–0 .134[0 .103]

Dummy for self-employed

–0 .058[0 .013]***

0 .239[0 .019]***

Dummy for 2009

0 .043[0 .031]

0 .026[0 .032]

0 .064[0 .088]

–0 .013[0 .044]

–0 .006[0 .046]

–0 .05[0 .118]

Observations 9508 7444 2064 9508 7444 2064

R-squared 0 .06 0 .06 0 .06 0 .13 0 .13 0 .12

*significantat10percent**significantat5percent***significantat1percent

Note:Standarderrorsareinbrackets.


Considering that the land–labour ratio is very low in rural China and isprobablyfixedoverthetwo-yearperiod,anincreaseintheagriculturallabourforce should imply an increase in under-employment. To illustrate the levelof under-employment among agricultural labour, we utilise the 2009 surveyquestion, ‘Howmanydays in2008didyouworkon the farm?’.Onaverage,


261

thosewhoidentifiedthemselvesashavingafarmingjobworked154daysor42percentoftheyearonthefarmifusing365daysasthedenominatorand52percentifusing300days7asthedenominator.Amongtheagriculturalworkers,36percentworkedonlybetweenzeroand99daysonthefarm,while thosewhoworkedmorethan200daysaccountedfor40percent.Theaveragetotalnumberofdaysthisgroupworkedonoff-farmactivitieswas8.4days(thethirdblockinPanel3ofTable12.4).Ifwerestrictthesampletothosewhoidentifiedthemselvesasworkinginthefarmingsectorinboth2008and2009—astrongerindicationoftheagriculturalworkers—theaveragehoursworkedinthefarmingsectorincreasedslightlyto172,or57percentoftheyear,using300daysasthedenominator.Thesedataareindicativeofthelevelofunder-employmenttherehasbeenintheruralagriculturalsector.

Thelastimportantpointtobeinvestigatediswhetherwagesforruraloff-farmjobs were affected by the global financial crisis (see Panel 4 of Table 12.4).Interestingly,hourlyearningsofbothwage/salaryearnersandself-employedincreasedduringthisperiod.Fortheformer,thehourlyearningsincreasedbyalmost12percent,whileforthelattertheincreasewasabout5percent.Oncewecontrolfordemographic,industryandregionalcharacteristics,however,theearningschangeforruraloff-farmworkersbetweentwoyearsdisappears(seeTable12.6).

Itwouldbeinterestingtoexaminehousehold-levelincomeeffectsoftheglobalfinancialcrisis,butunfortunatelyoursurveyrecordsonlyhousehold incomeforpreviousyears.Thus,wehaveonlyhouseholdincomefor2007and2008,whichdoesnotallowustoinvestigatetheeffectoftheglobalfinancialcrisis.Usinghouseholdincomefor2008fordifferenttypesofhouseholds,wecould,however,providesomeindicativeinformationoftheimpactofthereductioninmigrationandoff-farmjobsonhouseholdpercapitaincome.Table12.7presentsthesedata.In2008,ruralhouseholdsonaveragehadapercapitaincomelevelofRMB9428.Wedividethesehouseholdsintofourtypes:1)thosewithbothmigrantsandruraloff-farmworkers;2)thosewithruraloff-farmworkersbutnomigrants;3)thosewithmigrantsbutnooff-farmworkers;and4)thosewithonlyfarmworkers.Comparingtheaveragepercapitahouseholdincomeforthefirstthreetypesofhouseholdswithhouseholdsthathaveonlyfarmworkers,wefindthatfarmworkprovidesthelowestincome.Surprisingly,though,ruraloff-farmworkersseemtoprovidehigherincometohouseholdsthanmigrants.Thisperhapsisbecauseruraloff-farmworkersaremainlylivingathomeandhenceall their incomeiscountedaspartofhousehold income,whereasonlytheremittancecomponentofmigrantincomeiscountedaspartofhouseholdincome.Onaverage,thefirstthreetypesofhouseholdshavepercapitaincomebetween7and27percenthigherthanhouseholdswithonlyfarmworkers.

7 Thatis,300workingdaysisanormalmigrantworker’sannualworkingdaysinacity.


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Table 12.7 Per capita income comparisons across different type of householdsNo. of

householdsPer

capita income (RMB)

Difference to households

with only farm workers

Value (RMB)

% difference

Total households 7912 9428 1001 11 .9

Households with both off-farm and migrant workers (1)

657 10 688 2261 26 .8

Households with off-farm workers but no migrants (2)

2896 10 237 1810 21 .5

Households with migrants but no off-farm workers (3)

2004 9024 597 7 .1

Households with neither off-farm nor migrant workers (4)

2355 8427

2009 household type2008 household type Households

with both off-farm and migrant

workers (1)

Households with off-farm workers but

no migrants(2)

Households with

migrantsbut no

off-farm workers (3)

Households with neitheroff-farm nor

migrant workers (4)

Households with both off-farm and migrant workers (1)

237 106 249 69

Households with off-farm workers but no migrants (2)

104 1803 265 748

Households with migrants but no off-farm workers (3)

188 136 1353 367

Households with neither off-farm nor migrant workers (4)

30 430 174 1759

Total no . of households

559 2475 2041 2943

Percentage transited from other types of households

57 .6 27 .1 33 .7 40 .2


Togaugethedegreeoftheincomeeffectofthereductioninmigrationandruraloff-farm jobs, we also present the transition matrix between 2008 and 2009acrossthefourtypesofhouseholds(secondpanelofTable12.7).Thebottomline is that in2008,2393householdshadonlyagriculturalworkers and thisfigureincreasedto2943in2009.Inaddition,40percent(1184)ofthese2943


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householdshadoff-farmormigrantworkers in2008.Itcanbeexpectedthatthese1184householdssufferedfromtheglobalfinancialcrisisintermsoftheirreducedincomelevels.

Conclusions

This chapter examines the effect of the global financial crisis on the labour-marketoutcomesofmigrants fromtheperspectiveof thosewhoremained incitiesduringthecrisisandthosewhoreturnedtotheirruralhomevillages.

Surprisingly, we found that migrants who decided to stay in cities in 2009sufferedverylittleintermsofemployment,workinghoursandearnings.

Toresolvethispuzzle,wesearchedfurtherandexaminedtheemploymentandearningsconditionsoftherurallabourforce.Itwashereinruralvillagesthatweobservedthemostsignificantemploymenteffectoftheglobalfinancialcrisis:nolessthan15millionruralmigrants(morethan10percentoftotalmigrants)returnedtoruralvillagesin2009.About80percentofthemwentbacktotheruralfarmingsector,wheretheyworked,onaverage,52percentoftheyear.Inadditiontotheeffectoftheglobalfinancialcrisisonreturnmigration,wefoundthatruraloff-farmemploymentfellbyabout38million—or7.5percentofthetotalruralhukoulabourforce.Onceagain,forthoseemployedinruraloff-farmjobs,nodownwardadjustmenttohoursorearningswasdetected.

Basedonthesefindings,weareinclinedtobelievethattheruralagriculturalsectorprovidedtheemploymentbufferforreturnmigrationandruraloff-farmemployment during the global financial crisis. Because of this buffer effect,noopenunemploymentcanbeobserved. Inthecurrentenvironment, this iscertainlyagoodthingforpoliticalstability,althoughithascomeattheexpenseofareductioninagriculturalproductivity.

Inthelongrun,however,itmustbeexpectedthatsmall-scalefarmingwillgivewaytolargelandholdingandhigheragriculturalproductivity.Thisinevitablywill lead to the consolidation of farmland and many small landholders willneedtoselltheirland.Thus,theirfutureemploymentshockswillhavetobecushionedbyothermeans.Thequestion ishowwill thisbedone?HowwillChinamovetowardsauniversalwelfaresystemandgivemigrantstherightstoselltheirland,effectivelytradinganinefficientland-basedtraditionalwelfaresystemforonethatismoreappropriateforamoderneconomy?Inthedecadesahead,policymakers’responsestothisquestionwillhaveaseriousimpactonthewellbeingofChinesemigrants—allhundredsofmillionsofthem!


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Appendix Table 12.A1 Migrant survey timing distribution by survey year (migrant sample, per cent)

2008 2009March 3 .4 18 .3

April 33 .1 35 .5

May 56 .7 19 .7

June 6 .8 8 .9

July 0 9 .4

August 0 8 .1

Total no . of observations 6687 7199

Appendix Table 12.A2 Occupational distribution of self-employed migrants by year (migrant sample)

2008 2009 Difference in %Frequency % Frequency %

Semi-professional 21 0 .01 27 0 .01 0 .00

Owners 968 0 .61 867 0 .42 –0 .19

Street vendors/garbage collectors

185 0 .12 357 0 .17 0 .06

Shop assistants 147 0 .09 394 0 .19 0 .10

Hospitality service workers 29 0 .02 104 0 .05 0 .03

Domestic helpers 4 0 .00 4 0 .00 0 .00

Hairdressers 39 0 .02 52 0 .03 0 .00

Repair/removal/transport workers

63 0 .04 84 0 .04 0 .00

Chefs/kitchen hands 36 0 .02 47 0 .02 0 .00

Drivers 30 0 .02 14 0 .01 –0 .01

Other services labourers 11 0 .01 8 0 .00 0 .00

Construction labourers 19 0 .01 38 0 .02 0 .01

Other labourers 38 0 .02 74 0 .04 0 .01

Total no . of observations 1590 2070

References

Chen, X. 2009, ‘Around 20 million rural migrants lost their jobs, need toconfront these socialproblems’,Caijing.com.cn,2February2009,<http://www.caijing.com.cn/2009-02-02/110051988.html>

Fallon,P.R.andLucas,R.E.B.2002,‘Theimpactoffinancialcrisesonlabormarket,householdincomesandpoverty:areviewofevidence’,The World Bank Research Observer,vol.17,no.1,p.21.


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Huang, J., Zhi, H., Huang, Z., Rozelle, S. and Giles, J. 2010, Impact of theglobalfinancialcrisisonoff-farmemploymentandearningsinruralChina,Unpublishedmanuscript.

Hugo,G.2000, ‘TheimpactofthecrisisoninternalpopulationmovementinIndonesia’,Bulletin of Indonesian Economic Studies,vol.36,no.2,pp.115–38.

Kong,T.,Meng,X.andZhang,D.2009,‘Impactofeconomicslowdownonmigrantworkers’,inR.Garnaut,L.SongandW.T.Woo(eds),China’s New Place in a World in Crisis: Economic, geopolitical and environmental dimensions,ANUE Press and Brookings Institution Press, Canberra and Washington, DC,pp.233–60.

Lewis,W.A.1954,‘Economicdevelopmentwithunlimitedsuppliesoflabour’,Manchester School,vol.22,no.2,pp.1139–91.

Manning,C.2000, ‘Labourmarketadjustment to Indonesia’seconomiccrisis:context, trendsand implications’,Bulletin of Indonesian Economic Studies,vol.36,no.1,pp.105–36.

MinistryofHumanResourcesandSocialSecurity(MoHRSS)2009,Theresponseof China’s employment of rural migrants to the GFC, Series of reports onChina’semploymentstrategiesagainsttheglobalfinancialcrisis,Unpublishedmanuscript.

Ministry of Human Resources and Social Security (MoHRSS) 2010, Aninvestigation on employment demand of enterprises in Spring 2010 andemploymentsituationofruralmigrantsin2009,Unpublishedmanuscript.

NationalBureauofStatistics(NBS)2009,Thetotalnumberofruralmigrants(inChina)was225.42millionbytheendof2008,Pressrelease,NationalBureauofStatistics,Beijing,viewed25March2009,<http://www.cpirc.org.cn/tjsj/tjsj_cy_detail.asp?id=10471>

Ranis,G.,andFei,J.C.H.1961.‘Atheoryofeconomicdevelopment’,American Economic Review,Vol.51No.4:533–65.

World Bank (2009) From poor areas to poor people: China’s evolving poverty reduction agenda: An assessment of poverty and inequality in ChinaWorldBank,WashingtonD.C,ChunlaiChen.

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Part IIIPolicy and Reform: Unfinished Business

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Avoiding economic crashes on China’s road

to prosperity 13 Wing Thye Woo

Introduction

There is a long tradition of predictions of gloom and doom among Chinaeconomists. For example, in the mid 1990s, Nicholas Lardy (1998) of thePetersonInstituteforInternationalEconomicsstartedhighlightingthedefactoinsolvencyoftheChinesebankingsystemwiththeimplicationthatabankrunleadingtofinancial-sectorruinwasastrongpossibilityinthemediumterm.Thetwenty-firstcenturybeganwiththeclaimbyGordonChang(2001)thatChina’simminentaccessiontotheWorldTradeOrganisation(WTO)wouldcausesuchwidespreadunemploymentwithinChina’salreadyalienatedpopulationthatthecountry’seconomicandpoliticalsystemswouldcollapse.

Thesetwodirepredictionshaveturnedouttobewrong.China,infact,accelerateditsannualgrossdomesticproduct(GDP)growthtodouble-digitratesafter2001.Lardywaswrongbecause,whilethebankswereindeedbankrupt,theChinesegovernmentthatownedthemwasnotbankruptandcouldaffordtobailoutthebankswhennecessary.Thefiscalstrengthofthegovernmentmadeitirrationalfor depositors to contemplate a bank run. Chang was wrong because WTOmembershipquickenedthepaceofjobcreationinChinabygreatlyincreasingthevolumeofforeigndirectinvestment(FDI)inflow.WTOmembershipmadeChinamoreattractivetoFDIbecauseitguaranteedtheaccessofChinesegoodstotheUSmarketbyeliminatingtheneedforChinatoreceivedmost-favourednation(MFN)statusannuallyfromtheUSCongress(McKibbinandWoo2003).

Thefactthatthedoomsayershavebeenwrongsofardoesnotmeanthattheirdirepredictionsareguaranteednot tohappen in the future. It alsodoesnotmean that gloom and doom can be ruled out because the doomsayers couldsimplyhavebeenwrongintheirspecificidentificationsofwheretheywouldcomefrom.Thischapter is,first,anassessmentof someof theobstacles thatChinacouldstumbleintoonitsdevelopmentpath;and,second,aproposalforhowtheseobstaclescouldbeovercome.


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The rocky road to prosperity

ThetraditionofforecastinggloomanddoomforChinaisquitesurprisinggivenChina’seconomicperformanceinthepast30yearsand,indeed,itisbecomingmorecommontohearglowinglyoptimisticassessmentsofChina’sfuturethandismissivelypessimisticones.Forexample,JimO’Neilletal.(2005)ofGoldmanSachshavepredictedthatChina’sGDPwillsurpassthatoftheUnitedStatesin2040evenafterassumingthatChina’sGDPgrowthratewillslowsteadilyfromitsaverageannualrateof10percentduring1979–2005to3.8percentduring2030–40.1

AgoodguidetohowoneshouldregardthenewoptimismandthetraditionalpessimismcanbefoundinthediscussionsoftheSixthPlenumoftheSixteenthCentralCommitteeoftheCommunistPartyofChina(CPC)inOctober2006.ThesixthplenumpassedaresolutiontocommittheCPCtoestablishaharmonioussociety by 2020. The obvious implication is that the present major social,economic and political trends within China might not lead to a harmonioussocietyor,atleast,notrapidlyenough.

Among thedisharmonious featuresmentioned in the ‘resolutionsof theCPCCentral Committee on major issues regarding the building of a harmonioussocialistsociety’wereseriousimbalancesinsocialandeconomicdevelopmentacross (and within each of) China’s 31 provinces; worsening population andenvironmentalproblems;grossly inadequatesocialsafetynetsandhealthcaresystems; and serious corruption. The harmonious socialist society wouldencompassademocraticsocietyundertheruleoflaw;asocietybasedonequalityandjustice;anhonestandcaringsociety;astable,vigorousandorderlysociety;andasocietyinwhichhumansliveinharmonywithnature.

China’seconomyduring thepast threedecadescanbe likened toa speedingcar. The CPC leadership in 2006 saw that the car could crash in the futurebecausetherewereseveralhigh-probabilityfailuresthatmightoccurandcauseeconomiccollapse.Tobespecific,therearethreeclassesoffailuresthatcouldoccur:hardwarefailure,softwarefailureandpowersupplyfailure.

A hardware failure refers to the breakdown of an economic mechanism—adevelopmentthatisanalogoustothecollapseofthechassisofacar.Probablehardwarefailuresincludeabankingcrisisthatcausesacreditcrunch,abudgetcrisis that necessitates reductions in important infrastructure and social

1 ForareviewofthedebateonhowtointerpretChina’shighgrowthin1978–2000andwhyChina—unliketheeconomiesof the formerSovietbloc—didnotexperiencearecessionwhen itmade theswitch fromacentrallyplannedeconomytoamarketeconomy,seeSachsandWoo(2000)andWoo(2001).

Avoiding economic crashes on China’s road to prosperity

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expenditure (and possibly generates high inflation and balance-of-paymentsdifficultiesaswell) anda serious slowdown inproductivitygrowth fromtheaccumulationofmicro-inefficienciescreatedbystateintervention.

Asoftware failurereferstoaflawingovernance thatcreatesfrequentwidespreadsocialdisordersthatdisrupteconomy-wideproductionanddiscourageprivateinvestment. This situation is similar to a car crash that results from a fightamongthepeopleinsidethespeedingcar.Softwarefailurescouldcomefromthepresenthigh-growthstrategycreatingenoughinequalityandcorruptiontogenerateseveresocialunrest,andfromtheStatenotbeingresponsiveenoughtorisingsocialexpectations,hencecausingsocialandeconomicdisorder.

A power supply failure refers to the economy being unable to move forwardbecauseithitseithera natural limit oran externally imposed limit—asituationthatisakintothecarrunningoutoffuel(anaturallimit)orintoaroadblockerectedby foreigners (an externally imposed constraint). Examples ofpowersupplyfailuresareanenvironmentalcollapseandacollapseinChina’sexportsbecauseofatradewar.

There are many events within each type of failure that could make China’shighgrowthunsustainable isbeyond the scopeof this chapter.We limit thediscussionheretothosethatseemmostlikelyinJune2010.

Potential hardware failure

Chinawillfacetwopotentialhardwarefailuresintheaftermathoftheglobalfinancialcrisis:aweakeningofthefiscalpositionandaslowdowninproductivitygrowth.Tosee thesourceofourconcern,wehave to recall,first, thenatureof theglobalfinancial crisis and themanner inwhich it impactedonChina;andsecond,thekindofeconomicmechanismsthatwereusedtogeneratethestunning8.7percentGDPgrowthratein2009.

Theglobalfinancial crisisburstonto theworld sceneon15September2008when investment bank Lehman Brothers filed for bankruptcy. This actionsparked a wholesale flight to liquidity that caused a meltdown of financialmarkets globally. This widening financial crash, in turn, became a negative


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feedback loop to the level of aggregate income. GDP growth (year-on-year)turnednegativeinthefourthquarterof2008intheUnitedStates(–1.9percent)andtheUnitedKingdom(–2.1percent).

Thisabruptdecline inGDPof themajoradvancedeconomies translated intoa large, abrupt negative external shock to China that had two components:a negative export shock and a negative inward FDI shock.2 This prolongedcontractionary external impulse hit China at a time when its economy wasalreadyslowingfromthetighteningofmonetarypolicythatwasimplementedimmediatelyaftertheconclusionoftheseventeenthCPCcongress inOctober2007.Intherun-uptothepartycongress,easymonetarypolicyhadsteadilyboostedGDPgrowthfrom10.4percentin2005to11.6percentin2006and13percent in2007.GDPgrowth,whichhadbeenbroughtdownbytightermonetarypolicyto10.4percentinthesecondquarterof2008,fellto9.6percentinthefourthquarterof2008,andthenfurtherto6.1percentinthefirstquarterof2009,undertheadditionalsqueezefromthelargedrop-offinexportandforeigninvestment.

TheChinesegovernmentrespondedwithveryaggressivefiscalandmonetarypolicies to offset the external deflationary policies. It announced in earlyNovember2008thatafiscalstimulusofRMB4trillionwouldbeundertakenin2009–10—anannualstimulusofabout7percentofGDP.Monetaryeasinghasbeenevenmoredramatic,withbroadmoney(M2)increasedby28percentin2009.

Whileconsumerpriceindex(CPI)inflationin2009wasreassuringlylowat–0.7per cent, ‘land prices…doubled in 2009 on a nationwide basis’ (‘China tellsbankstorestrictloanstolocalgovernments’,The New York Times,25February2010).Thevalueofresidentialpropertytransactionsin2009was80percenthigher than in 2008 (‘Marketdefies fear of real estatebubble inChina’, The New York Times,4March2010).3Thefirstquarterof2010sawevenmorerapidincreasesinlandprices,especiallyinthemajorcoastalcities.4InmidApril2010,thegovernmentsoughttostabilisepropertypricesbyimposingrestrictionsonmortgageapplicationstobuysecondandthirdhomes.

Theroaringrealestatemarketandtheuseofnon-marketmeans(forexample,bansonpurchases)totameitaresymptomsofsomedeepeconomicproblemsthat

2 On a year-on-year basis, the growth rate of exports turned abruptly negative (–2.2 per cent) in 2008(11months)andremainednegativethrough2009(11months).ThegrowthrateofFDIalsoturnedabruptlynegative in 2008 (11months)—to–36per cent from35per cent in 2008 (10months); remained negativethrough2009(sevenmonths);andrecoveredtohistoricallylowlevelsin2009(eightmonths)to2010(fourmonths).3 ThearticlealsoreportedthatsomeduplexesinShanghaiweresellingforUS$45millioneach.4 In2009,landpriceshadgoneup200percentinShanghai,400percentinGuangzhouand876percentinWenzhou(‘China:noonehome’,Financial Times,21February2010).


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Chinahastoaddressinordertosustaingrowthoverthelongrun.Specifically,the real estate boom is part of a generalised investment boom unleashed bythe RMB4 trillion stimulus program implemented since November 2008.Thefact that thecentralgovernmentwould fundonlyone-thirdof theproposedexpenditure might prompt one to think of the stimulus program as a workagenda for the government to create the incentives to induce investment toreachthestatedlevel,butsuchaninterpretationwouldbewrong.Thestimulusshould be properly understood as permission by the central government toallowadditionalinvestmentsuptothestatedlevel.

ThisdifferentunderstandingisbasedontherealitythatalargepartofChina’seconomyisstillstatecontrolled5andthatthissegmentpursuesotherobjectivesbesides the ideal of profit maximisation. Because state-controlled enterprises(SCEs)areusuallybailedoutwhentheirinvestmentsturnouttobebasedonover-optimistic projections or are derailed by bad luck, the outcome is thewell-knowninterest-inelasticphenomenonofa‘thirstforinvestment’bySCEsand localgovernments.The state-appointedSCEmanager is always in favourofexpandingthescaleandrangeoftheoperationoftheSCEbecauseityieldsthreemajorbenefits tohimorher:higher likelihoodofpromotionbasedontheprovenability tohandlebigger things;greaterpatronagepower tobuilda political base; and more resources that could potentially be diverted forpersonalgain.Similarly,localgovernmentleadersalsosharetheenthusiasmofSCEmanagersforeconomicgrowthintheiradministrativeregionsforthesamethreereasons.

Wheneverthestate-controlledbanks(SCBs),whichdominateChina’sfinancialsector,extendloanstoaccommodatethehighdemandforinvestmentloansbySCEs and local governments, a ‘liquidity tango’ is generated.The inevitableoutcome of a protracted liquidity tango is high inflation followed by non-performingloans(NPLs).6Thenotableperiodwhensuchliquiditytangoswererare was 1996–2001 when Zhu Rongji was prepared to punish the managersofSCBs severely for the appearanceofnewNPLs.Thekey is thatwhenevera SCB manager feels they are operating under a soft-budget constraint, theyextendloansreadilybecauseascaling-upoflendingbringsthethreebenefitsmentionedpreviously.

At present, the central government has two lines of institutional defence topreventtheliquiditytangofromgettingoutofhandinChina’spartiallyreformed

5 State-controlled firms include state-owned firms and publicly listed firms in which the State and itsintermediariesholdthecontrollingshare.6 SeeWoo (2006) for a more detailed discussion of how the frequent rescue of state firms (also knownas the soft-budget practices of the government) has made the economy inflation prone since economicdecentralisationbeganin1978.


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economy.ThefirstlineisthatalllargeprojectsneedtheapprovaloftheNationalDevelopment and Reform Commission (NDRC; formerly, the State PlanningCommission).Thesecondlineisthatallbanksareassignedcreditquotas.

So, when Premier Wen Jiabao approved the stimulus program and coveredonlyone-thirdofitscost,hewasgivingpermission:1)totheSCEsandlocalgovernmentstoinvestmoreinordertooffsetthespendingslumpintheprivatesector;and2)totheSCBstoextendthenecessaryloanstofundtheapprovedprojects.Hereinliesthemechanismforthesuccessofthestimulusprogram:theuse of capacity-maximising state-controlled production and financial units toboostaggregatedemand.BecausetheSCEsandSCBsareimplementingastate-assignedmission,theirmanagerscannotrightlybeheldresponsibleshouldtheassignedprojectsturnouttobefinancialbustsinthefuture.

Not surprisingly, the public media carries occasional anecdotes about newinvestmentsinindustriesplaguedbyovercapacity(forexample,steel,cementandaluminium), trophy investments (forexample,grandtowncentres,high-speedrailandstatelyadministrativebuildings)andspontaneousprivatisationof project funds (for example, massive purchases of cars by state bodies).7AnothercommonconcernaboutChina’s stimulusprogramwas that theSCBswerechannellingthefloodofliquiditytotheSCEsandneglectingtheincreasedfinancingneedsoftheprivatesectorbroughtonbytheglobalfinancialcrisis.Pressedforworkingcapital,twowell-knownlargeprivatecompanies,Rizhao(asteelfirm)andMengniu(adairy),agreedtobeacquiredbytheirstate-ownedcounterparts.

WhileitisclearthatChina’smassivemacro-stimulusprogramhasbeensuccessfulinwardingoffdeflationfromthenegativeexternalshocks,weseethisprogramascreatingtwopotentialhardwarefailuresinthefuture.

ThefirstisaweakeningofthefuturefiscalpositionoftheState.Manyoftheindustrial and infrastructure investments in 2009 were undertaken by the8000localinvestmentcompaniesestablishedbylocalgovernments.Ithasbeenestimatedthattheloansoftheseinvestmentvehiclesamountedto51percentofGDPin2009.8(Thepresentdebtofthecentralgovernmentamountsto20percentofGDP.)AddinginthelargeloanstotheSCEs,therecentstimulusprogramhasthepotentialofgeneratingahugenumberofNPLs.Itisimportanttosee

7 See,forexample,Forsythe(2009);‘China:noonehome’,Financial Times,21February2010;‘Chinaauditfindsmisuseof funds tied to stimulus’,Financial Chronicle,29December2009,<http://www.mydigitalfc.com/news/china-audit-finds-misuse-funds-tied-stimulus-821>; and ‘China boosts auditors’ power asstimuluspackagespendingpromptscorruptionconcerns’,People’s Daily,21February2010,<http://english.peopledaily.com.cn/90001/90776/90785/6898354.html>8 The51percentfigureisfromcombininginformationinShih(2010),whoreportedthedebtofthecentralgovernmenttobe20percentofGDP,withinformationintheFinancial Times (‘Chinawarnedofgrowing“landloan”threat’,28March2010)thatreportedthecombinedfigurewas71percent.


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thatNPLsarenotjustafinancial-sectorproblem;theyareafiscalproblem.TheUSandUKbailoutsoftheirfinancialsystemsin2008–09makethispointmostclearly.

GivenChina’shistoryof liquidity tangos, it is reasonable toworry thatmostofthebankloanstothestimulusprogramwillendupasNPLs.9TheresultingfinancialcrisiswouldcauseChinatocrashmuchliketheUnitedStatesandtheUnitedKingdomdidin2009unlesstheChinesegovernmentsteppedinagain—asitdidinthe1998–2003periodtorecapitalisethebanks.Suchalarge-scalerecapitalisationwouldinevitablymeanthatstateexpenditureinothercategorieswouldhavetobereduced.10

Thesecondpotentialhardwarefailurethatcouldresultfromthe2009–10macro-stimulusprogram isa slowdown in theproductivitygrowthof theeconomy.Unlessthe2008–10expansionofthestatesector (sometimesoccurringattheexpenseoftheprivatesector)isbalancedbyalargerexpansionintheprivatesector, the post-1949 economic history of China does not give ground foroptimism thatPremierWen’swayof imparting theneededboost to capacityutilisationduringtheglobalfinancialcrisiswillnotbecomeadragonfutureproductivitygrowth(‘CommunistPartyneedstoloosenitsgriponChina’,The New York Times,2March2010).11

Potential software failure

The satisfactory functioning of a market economy requires a wide arrayof regulatory institutions that ranges from straightforward law-and-orderadministrationtocomplicatedlegaladjudication.China’sstrategyofincrementalreformcombinedwith the fact that institutionbuilding is a time-consumingprocess means that many of its regulatory institutions are either absent orineffective.The resulthasbeengovernance failure onmany fronts,with themostwell-knownrecentonesbeingviolationsofthewelfareofconsumersandworkers.

TherehavebeensignificantregulatoryfailuresinkeepingChina’sfoodsupplyandpharmaceuticalproductssafe.Themisuseofchemicalstolowerproduction

9 SomeobservershavepointedoutthattheNPLratiohasstayedlowsincethesecondroundofrecapitalisationin2003and,hence,haveclaimedthattheSCBshaveimprovedtheirinternalincentivesandrisk-assessmentability so much that large NPL ratios are a thing of the past.We, however, think that it is premature topronouncevictoryon state-ownedbank (SOB) reformsbecause the2003–09periodhasbeenoneofhighgrowth.10 See Tong and Woo (2006) for an analytical discussion of the undermining of fiscal stability by theconstantrecapitalisationofSCBs.11 This debate over the growth of the state firms at the expense of private ones is conducted over theheadingof‘guojin mintui’(thestatesectoradvances,andtheprivatesectorwithdraws).


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costs has resulted in the addition of poisonous substitutes to toothpaste(‘China investigates contaminated toothpaste’, The New York Times, 22 May2007; ‘China prohibits poisonous industrial solvent in toothpaste’, The New York Times,12July2007),coughmedicine(‘FromChinatoPanama,atrailofpoisonedmedicine’,The New York Times,6May2007)andanimalfeed(‘Fillerinanimal feed isopensecret inChina’,The New York Times,20April2007;‘Anotherchemicalemergesinpetfoodcase’,The New York Times,9May2007);theapplicationofleadpainttochildren’stoys(‘Asmoretoysarerecalled,thetrailendsinChina’,The New York Times,19June2007;‘Trainwreck’,The New York Times,19June2007;‘Fisher-Pricerecalls1.5mChina-madetoys’,Financial Times,2August2007);12andtheoveruseofantifungalsandantibacterialsinfishfarming(‘FDAcurbssaleof5seafoodsfarmedinChina’,The New York Times,29June2007;‘Aslippery,writhingtradedispute’,The New York Times,3July2007).Derelictionofdutybygovernmentofficialsisthefundamentalreasonforsuchgovernancefailures.Themostwell-knownrecentcasewastheconvictionofZhengXiaoyu,theformerdirectorofChina’sfoodanddrugsafetyagency,foracceptingbribes toapproveproduction licences forpharmaceuticalandfoodcompanies(‘Ex-chiefofChinafoodanddrugunitsentencedtodeathforgraft’,The New York Times,30May2007;‘For2children,banofadrugcametoolate’,The New York Times,13July2007).

Therehavealsobeensignificantregulatoryfailuresinthetreatmentoflabour,especiallyintheareasofoccupationalsafetyandwagepayments.Oneofthemostrecenthorrifyingaccounts involved the forced labourofkidnappedchildrenin thebrickkilnsofShanxi andHenanProvinces (‘China to investigate into“slavelabour”incident’,China Daily,16June2007).13TheofficialChina Dailyreportedthat‘asmanyas1,000childrenmayhavebeensoldintoslavelabourincentralChina’ (‘Chinabrickworkslavechildrenmaynumber1,000’,China Daily,15June2007).Aparentvisitingthebrickkilnsinherquesttofindhersonfoundthatthelocalpolicewerenotonlyunwillingtohelpbutdemandedbribes(‘ReportsofforcedlabourunsettleChina’,The New York Times,16June2007).Inonecase,thesonofthevillagepartysecretaryownedthebrickkiln(‘5Chinesearrestedinenslavementcase’,The New York Times,18June2007).

Perhapsthetwomostdismayingrevelationsfromthenewsreportsonthebrickkilnslaveryarethatthissadstateofaffairshasbeengoingonforadecade14—andthe‘forcedlabourandsexualexploitationhaveincreasedasthetrendin

12 Thefirstarticlealsoreportedtherecallofaghoulishfakeeyeballthatwasfilledwithkeroseneandofaninfant’swristrattlethatpresentedachokinghazard.13 The New York Times (‘Chinaslavescandalbringsresignationcalls’,18June2007)reportedthat‘[t]heworkersenduredprison-likeconfinementwithfiercedogsandbeatings…Releasedworkerswereshownontelevisionwithfesteringwoundsandemaciatedbodies.’14 ThispointwasmadebythepopulartabloidSouthern Metropolis Daily;seeThe New York Times(‘Chinaslavescandalbringsresignationcalls’,18June2007).


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humantraffickinginChinahastakenaturnfortheworst’(‘Moreforcedintoprostitution,labour’,China Daily,27July2007).YinJianzhong,theseniorofficialattheMinistryofPublicSecuritywhoidentifiedtheworseningtrendinhumantrafficking inChina, recognised a reason for thenegativedevelopment tobe‘theloopholesinthelegalandlaboursystems…[Specifically,]theCriminalLawonhumantraffickingprotectswomenandchildrenonlyandleavesoutgrown-upand teenmales. Itdoesn’thaveprovisions forpunishing those traffickingpeopleforforcedlabourorprostitution’(‘Moreforcedintoprostitution,labour’,China Daily, 27 July2007).The fact that such legal loopholes exist supportsourcontentionthatthemaincauseofthegovernancefailuresinChinaisthe‘derelictionofdutybygovernmentofficials’.15

Inadequateinstitutionsofgovernancearenot,however,theonlycauseofsocialtensionsinChina.Thepresenteconomicdevelopmentstrategy,despiteitsabilitytogeneratehighgrowth,alsogenerateshighsocialtensionsbecause,inthepast10years,ithasfailedtoreduceextremepovertyandtoimprovesignificantlytherural–urbanandregionalincomedistributions(Wooetal.2004;Démurgeretal.2002).InanAsianDevelopmentBank(ADB2007)studyofincomeinequalityin 22 Asian countries, in 2004, only Nepal had a Gini coefficient (47.3) thatwashigherthanChina’s(47.3).Meanwhile,in2004,China’sincomeratiooftherichest20percenttothepoorest20percent(11.4)ofthepopulationwasthehighestinAsia—significantlyhigherthanthenexthighestincomeratio(9.5forNepal).ChinaisprobablythemostunequalcountryinAsiatoday.

InthefirstphaseofChina’seconomicdevelopment,theprovisionofmorejobswasenoughtolowerpovertysignificantly.Atpresent,however,manyofthepeoplewhoarestillpoorrequiremorethanjustjobopportunities.Theyfirstneed an infusion of assistance (for example, empowering them with humancapitalthrougheducationandhealthinterventions)inordertobeabletotakeupthesejobopportunities.Effectivegovernanceforequitablegrowthhasnowbecomeevenmorechallenging,sotheprobabilityofimprovingsocialharmonyhasbeendiminished.

Furthermore, the present mode of economic development also generatesimmenseopportunities forembezzlementof stateassets, seizureof farmlandsforindustrialdevelopmentandcorruptionbecauseoftheabsenceofeffectivemechanisms to supervise government employees (Woo 2001). These featurescertainlymakesocialharmonyhardtosustain.

15 ThispointwasmadebytheShanxiGovernor,YuYoujun,whosaid:‘Foralongtime,relevantgovernmentdepartmentsdidlittletoregulateruralworkshops,smallcoalminesandsmallfactories,andtheyarebasicallyoutofcontrolandarenotbeingsupervised…Thederelictionofdutybycivilservantsandthecorruptionofindividualshavemadeitpossibleforillegallabourtoexist,particularlytheabductionsofmigrantworkers,andforcedlabourofchildrenandmentallydisabledpeople.’See‘Fearslingeroverchildslavesatkilns’,South China Morning Post,23June2007.


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The data on social unrest are consistent with the hypothesis of rising socialdisharmony.First,theincidenceofpublicdisorder—labelled‘socialincidents’—hasrisensteadilyfrom8700in1993to32500in1999,andthento74000in2004.Second,theaveragenumberofpeopleinvolvedinmassincidentshasalsorisengreatly—fromeightin1993to50in2004.

Clearly, the number of mass incidents would have been lower if China hadbettergovernance.Therewouldhavebeenmorepre-emptiveeffortsatconflictmediationbythegovernmentandlessabuseofpowerbygovernmentofficialsif the government’s actions had been monitored closely by independentmechanisms—andalsoifthegovernmenthadbeenheldmoreaccountableforitsperformance.

Power supply failure

The two most probable power supply failures that China faces are tradeprotectionismandenvironmentalcrises.Whilewethinkthattradeprotectionismisthelikelierofthetwotocausegrowthfailureinthemediumrun,wewilllimitourselvestosomebriefremarksonthistypeofpowersupplyfailurejustbeforeconcludingthechapterbecausewehaveanalysedthisissueatlengthinWooandXiao(2007)andWoo(2008).

ThepresentmodeofeconomicdevelopmenthasgivenChinathedirtiestairintheworld,ispollutingmoreandmoreofitswaterresourcesandis,possibly,changingtheclimatepatternswithinChina.TherealityisthattheCPC’snewobjectiveoflivinginharmonywithnatureisnotachoicebecausetheMaoistadageof ‘manconqueringnature’ is justasunrealisticascreatingprosperitythroughcentralplanning.ThereisnodoubtthatChina’srapidgrowthinthepast twodecadeshasdonesubstantialdamage to theenvironment (Economy2004).

Water shortages appear to pose the most immediate environmental threat toChina’scontinuedhighgrowth.16Presently,Chinauses67–75percentof the800–900billioncubicmetresofwateravailableannually,andpresenttrendsinwaterconsumptionprojecttheusageratein2030tobe78–100percent(‘Topofficialwarnsofloomingwatercrisis’,South China Morning Post,7November2006).Thepresentwatersituationisalreadyfairlycriticalbecauseoftheunevendistributionofwaterandthelowerthanaveragerainfallinthepast15years.

16 Airpollutionisalsoaseriousproblem.Ofthe20citiesintheworldidentifiedbytheWorldBankashavingthedirtiestair,16areinChina.Itisshockingthatleadandmercurypoisoningaremorecommonthanexpected;see‘China’seconomicmiraclecontainsmercuricthreat’,Financial Times,18December2004;and‘ApoisonspreadsamidChina’sboom’,The Wall Street Journal,30September2006.


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Rightnow,about ‘400ofChina’s660cities facewatershortages,with110ofthemseverely short’ (‘Chinamaybe lefthighanddry’,The Straits Times, 3January2004).17

Theextendedperiodofsemi-droughtinnorthernChinacombinedwitheconomicandpopulationgrowthhavecausedmoreandmorewatertobepumpedfromtheaquifers,leadingthewatertabletodrop3–6metresayear(‘Northerncitiessinkingaswatertablefalls’,South China Morning Post,11August2001;Becker2003).AstudyusingmeasurementsfromsatelliteshasestablishedthatthepartofChinanorthof the thirty-sixthparallelhasbeen ‘sinking at the rate of 2mmayear’(‘NorthernChinasinking…asthesouthrises’,The Straits Times,18March2002).18Specifically,‘Shanghai,Tianjin,andTaiyuanaretheworsthitinChina,witheachsinkingmorethantwometres(6.6feet)sincetheearly1990s’(‘Chinesecities,includingOlympichostBeijing,slowlysinking’,Agence France-Presse,23July2004).TheoverallwatersituationinnorthernChinaisreflectedinthefateoftheYellowRiver,‘whichstarteddryingupeveryfewyearsfrom1972,didsoforincreasingperiodsoftimeoverlongerdistancesinthe1990suntil1997,whenitdriedupforalmosttheentireyearoverastretchofseveralhundredkilometres’ (‘Chinamaybe lefthigh anddry’,The Straits Times, 3January2004).

Watershortagesandtheincreasingpollutionofwaterarenottheonlyseriousenvironmental threats to the economy of northern China19. The desert isexpanding(possibly,atanacceleratingpace)andhumansappeartobethechiefculprits.The State Forestry Administration reported that 28 per cent of thecountry’slandmasswasaffectedbydesertificationin1999and37percentwasaffectedbysoilerosion.Thereport identifiedabout65percentofthedesertas having been created by ‘over-cultivation, overgrazing, deforestation andpoor irrigation practices’ (‘Quarter of land now desert—and man mostly toblame’, South China Morning Post, 30 January 2002). One direct upshot is agreat increase in the frequency of major sandstorms20 that play ‘havoc withaviation in northern China for weeks, cripples high-tech manufacturing andworsensrespiratoryproblemsasfardownstreamasJapan,theKoreanpeninsulaandeventhewesternUnitedStates’(‘Billionsoftreesplanted,andnaryadent

17 TheshortageisreportedtobemostacuteinTaiyuaninShanxiandTianjin(Becker2003).18 According to Becker (2003): ‘Some 60 per cent of the land in Tianjin municipality is plagued bysubsistence.’19 Examples of reports about serious water pollution include: ‘Main rivers facing a “pollution crisis”’,South China Morning Post,6June2003;‘Boomingcitiespollutingscarcewatersupplies’,The Straits Times,18September2003;‘Riversrunblack,andChinesedieofcancer’,The New York Times,12September2004;‘“Cancervillages”payheavypriceforeconomicprogress’,South China Morning Post,8May2006;and‘Rulesignored,toxicsludgesinksChinesevillage’,The New York Times,4September2006.20 ThenumberofmajorsandstormsinChinawasfiveintheperiod1950–59,eightin1960–69,13in1970–79,14in1980–89,23in1990–99,14in2000,26in2001,16in2002and11in2003,accordingtoYinPumin(‘Sands of time running out: desertification continues to swallow up “healthy” land at an alarming rate’,Beijing Review,16June2005).


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inthedesert’,The New York Times,11April2004).IntheassessmentofChenLai,Vice-MinisterofWaterResources: ‘Itwill takenearlyhalf a century forChinatocontroltheerodedlandandrehabilitatetheirdamagedecosystemsinaccordancewithChina’spresenterosion-controlcapabilities’(‘Quarteroflandnowdesert—andmanmostlytoblame’,South China Morning Post,30January2002).

WhilenorthernChinahasbeengettingdrierandexperiencingdesertification,nature—as if in compensation (or in mockery)—has been dousing southernChinawithheavierrains,causingheavyfloodsthathavebroughtconsiderabledeaths and property damage almost every summer since 1998.21 The sadpossibility is that the northern droughts and southern floods might not beindependenteventsbutacombinationcausedbypollutionthatoriginates inChina.Wewillhavemoretosayaboutthispossibilitylater.

Clearly, without water, growth cannot endure. In response to this, thegovernmentbeganimplementationin2002ofMaoZedong’s1952proposalforthreecanalstobebuilttotakewaterfromthesouthtothenorth:aneasterncoastalcanalfromJiangsutoShandongandTianjin,acentralcanalfromHubeitoBeijing andTianjin, and awestern route fromTibet to thenorth-westernprovinces(‘Ambitiouscanalnetworkaimstomeetgrowingneeds’,South China Morning Post,27November2002).Constructionoftheeasterncanal(tobebuiltonapartoftheexistingGrandCanal)startedin2002andofthecentralcanalin2003.Workonthewesterncanalisscheduledtobeginin2010oncompletionofthefirststageofthecentralcanal.

Thismassiveconstructionprojectwillbenotonlytechnicallychallengingbutextremelysensitivepoliticallyandfraughtwithenvironmentalrisks.ThecentralcanalwillhavetotunnelthroughthefootofthehugedykethatcontainstheelevatedYellowRiverandthewesterncanalwillhavetotransportwaterthroughregionssusceptibletofreezing.ThenumberofpeopledisplacedbytheThreeGorgesDamwas1.1millionandthiswater-transferschemeisabiggerproject.Movingpeopleinvoluntarilyiscertainlypotentiallyexplosivepolitically.Theprojectcouldalsobepoliticallyexplosiveontheinternationalfront.Oneplanforthewesterncanalcallsfor‘dammingtheBrahmaputraRiveranddiverting

21 TheNationalDevelopmentandReformCommission(NDRC2007)reported: ‘TheregionaldistributionofprecipitationshowsthatthedecreaseinannualprecipitationwassignificantinmostofnorthernChina,[the]easternpartofthenorth-west,andnorth-easternChina,averaging20–40mm/10a,with[the]decreaseinnorthernChinabeingmostsevere;whileprecipitationsignificantlyincreasedinsouthernChinaandsouth-westernChina,averaging20–60mm/10a…Thefrequencyandintensityofextremeclimate/weathereventsthroughoutChinahaveexperiencedobviouschangesduringthelast50years.Droughtinnorthernandnorth-easternChina,andfloodinthemiddleandlowerreachesoftheYangtzeRiverandsouth-easternChinahavebecomemoresevere.’


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200billioncubicmetresofwaterannuallytofeedtheageingYellowRiver’—ascenariothatisreportedly‘givingsleeplessnightstotheIndiangovernment’(‘China’sriverplanworriesIndia’,Times of India,23October2006).

Many opponents of the water-transfer project have argued that waterconservationcouldgoalongwaytowardsaddressingChina’swaterproblemsbecausecurrentlyatremendousamountofwateriswasted(‘Alertsoundedoverloomingwatershortage’,The Straits Times,10June2004).Themostimportantreason for this inefficient use of water lies in the fact that ‘China’s farmers,factories and householders enjoy some of the cheapest water in the world’(‘WaterwastagewillsoonleaveChinahighanddry’,South China Morning Post,8 March 2006), even though China’s per capita endowment of water is one-quarteroftheworldaverage(‘Alertsoundedoverloomingwatershortage’,The Straits Times,10June2004).

There is,however, theunhappypossibilitythatneither thepricemechanismnor the three canals can solve China’s water problems, making its growthunsustainableunlessthepresentmodeofeconomicdevelopmentisdrasticallyamended.

A reform agenda for avoiding crashes on the road to prosperity

Dealing with potential hardware problems

We identified two potential hardware problems arising from the large doseof SCE–SCB-based macro-stimulus that Prime Minister, Wen Jiabao, hasadministered to maintain full utilisation of production capacity: NPLs thatcouldcauseeithertheSCBstocollapseorafiscalcrisisfromthebailoutoftheSCBs,andlowerproductivitygrowthinthefuturefromthecrowdingoutoftheprivatesectorbythestatesector.China’sinstrumentsofmacro-stimulushavecreatedatrade-offbetweenmaintenanceoffullcapacityutilisationintheshortrunandsustenanceofahighrateofcapacityexpansioninthelongrun.

Our recommendation is that China eliminates this trade-off by replacing itsmacro-stimuluswiththreenewgrowthdriversthatareinterrelated:1)creationofmorenewentrepreneurs;2)urbanisationaccordingtotheprincipleoffuturehomeownership;and3)developmentofamodernfinancialsysteminwhichtheprivatesectorhasagreatlyenhancedrole.

The State can partly offset the expanded state sector by mobilising inlandmigrant workers laid-off from the coastal provinces into an entrepreneurial


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force.Manyofthesemigrantshavesufficientworkexperiencetostarttheirownfactories/workshops to take advantage of the increased cost competitivenessof the inland provinces created by the explosive extension of the nationaltransportationnetworkduringtheglobalfinancialcrisis.Becausetheprimarybarriertotheemergenceofthisgroupofowner-operatorsistheavailabilityofcredit,thegovernmentshouldlegalisesmallandmediumprivatebanks,astheyhavecomparativeadvantageoverthefourlargestatebanksincateringtotheneedsofthesenewentrepreneurs.Thehealthydevelopmentofthenewprivatebankswouldrequirethatthesystemofprudentialsupervisionbestrengthenedandthat interestratesbederegulated.Farmlandshouldalsobeprivatisedsothatthenewbusinessescanhavethecollateraltoaccesscreditfromthenewprivate banks. As most of the migrants are from the western provinces, thegovernmentcouldunleashthisfirstdriverofgrowthinthewesternprovincesonanexperimentalbasis.

The creation of a new large group of private entrepreneurs will bring threemajorbenefits

• expenditurebythisnewgroupwillsubstituteforthepresentmacro-stimulusprograminkeepingaggregatedemandhigh

• privatefirmsarelikelytohavehigherproductivitygrowththanSCBs

• thesesmallandmediumprivateenterpriseswillbemore labour intensivethanSCEs.

The second new growth driver is urbanisation based on the principle ofaffordablefuturehomeownership.Thefastgrowthoftherealestatesector—notonlyrecentlybutinthepastdecade—reflectsnotjustspeculativedemandbutgenuinepent-updemandforhousingandgenuineaccommodationtomeetthehighrateofthejointindustrialisation-urbanisationprocess.22Thebulkofthenewarrivalsfromthecountrysidecannotqualifyforbankmortgages,somanyinvestorshavebeenbuyingmultiplehousingunitstorenttonewarrivalswiththeintentionofraisingtherentsovertimeinlinewiththeincomegrowthoftherenters.Inthissense,muchoftherecenthousingdemandhasbeenspeculative.

WeproposethatChinastudiesthelow-costpublichousingschemesinHongKongandSingaporeandestablishesanationalhousingprogramunderwhichthe new arrivals would rent homes for seven years and then have the firstright to buy these units at a price based on construction costs.This ‘futureownership’formofurbanisationwouldpreventtheproblemofemptyhousing

22 Ifspeculativedemandhadbeentheoverwhelminglydominantcauseofthepropertyboom,houserentswould not have risen substantially (because the speculative investors would tend to rent out their extraunits).Instead,rentinBeijinginMarch2010was19.6percentabovethatinMarch2009;see‘Surveyshowshousepricesstill toohigh’,China Daily,12May2010,<http://www.chinadaily.com.cn/metro/2010-05/12/content_9839054.htm>


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heldforspeculativereasonsescalating intoNPLs.Chinacanaffordamassivepublichousingprogrambecausetheexpensivepartofsuchprogramsinothercountries is thecostof landandnot thecostof the structures—and land inChinaismostlyownedbytheState.23

OurproposedformofurbanisationwillsupportChina’sgrowthinthreeways

• through the maintenance of real estate investment to supply the neededhousingandtohelpmaintaintheexistinglevelofaggregatedemand

• throughtheredirectionofbankloanstonewruralmigrants,withthenewhousingagencyastheintermediary,topreventtheappearanceofNPLs

• thishousingschemewillredistributeincometotheruralmigrants(whichhelps in reducing the threat of software failure), with the positive sideeffectthatconsumptionwillrisetohelpoffsettheeliminationofthemacro-stimulusprogram.

Wenotethatthefirstandsecondnewgrowthdriversaremutuallyreinforcing.Thenewenterprisesoftheformerruralmigrantswouldinevitablybelocatedinorneartownsandcitiestotakeadvantageofinfrastructureandpositivespill-oversfromagglomeration.Wenotethatthemaininstitutionaladjustmentsthatmustbemadetoenabletheworkingofthesecondnewgrowthdriverarethesameasthosethatwouldhelpthedevelopmentofthefirstnewgrowthdriver:privatisationoffarmland,terminationofthehouseholdregistrationsystemandliberalisationofthefinancialsystem.

The third interrelatednewgrowthdriver is the true legalisationofprivatelyowned financial institutions.24 The emergence of a strong small–mediumbankingsectorwouldreducethedominanceoftheSCBsandhencemaketheeconomy less vulnerable to their collapse from potential NPLs.The entry ofprivatebanks(domesticandforeign)willreducetheprobabilitythatanyoneofthebigfourstatebankswouldremaintoobigtofail—andhencereducethesoft-budget protection enjoyed by the now monopoly state banking system.TheprivatisationofsomeunitsoftheSCBs,andtheemergenceoflargedomesticprivatebanks,willalsohelpinstrengtheningthebudgetconstraintsperceivedbythemanagersofSCBs.Thedevelopmentofamodernbankingsystemwithamajorrolefortheprivatesectorwillthenceincreasethequalityofbankloans

23 Itshouldbenotedthathousingconstructionisrelativelylabourintensiveandthathomedecorationishighlylabourintensive.24 Wedonotconsider listedbanks inwhich theStateholds thecontrollingshare (often throughstate-controlledintermediaries—forexample,‘legalpersons’)tobeprivatebanksinthetruesense.


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alongwiththeincreaseinthequantityofbankloans—helpingtoreducetheappearance of NPLs along with market-directed investments replacing themacro-stimulusprogram.25

Dealing with potential software problems

The important realisation about hardcore poverty is that, in today’s China,introducing more of the same economic policies will not produce the samesalubrious results on every front because the development problems havechanged. This was illustrated above with the example that, during the firstphaseofeconomicdevelopment,theprovisionofmorejobs(througheconomicderegulation)wasenoughto lowerpovertysignificantly,whilemorerecentlyjobopportunitiesalonehaveprovedinsufficient.

ComplicatingmattersisthattherehavenotjustbeenrisingexpectationsabouttheperformanceoftheStateinitstraditionalfunctions(forexample,coordinatingwateruse);therearealsonewexpectationsabouttheparticipationoftheStateinsomeadditionalareas(forexample,reducingincomeinequality).Inthisnewsituation, the greater use of democratic procedures, the establishment of anindependent judiciaryandtherestorationofa freepressmightbe inevitableif the CPC is to successfully accommodate the rising social expectations andmediatetheemergingdifferencesinsocialexpectations.

OnemainsourceofrecentsocialunrestinruralChinahasbeentheconversionoffarmlandtoindustrialparkswithoutadequatecompensationforthefarmers.It is interesting therefore that the ‘No. 1 Document’ issued in January 2006jointly by the CPC Central Committee and the State Council pledged to notonly‘stabiliseandregulatethetransferofland-userightsandacceleratelandacquisition reforms’,but ‘expandchannels toexpresspublicopinions in thecountrysideandimprovethemechanismtoresolvesocialconflicts’(‘Newpledgetogivefarmersaloudervoice’,South China Morning Post,30January2007).26

ThedesirebytheHu–Wenleadershiptoimprovetheinstitutionsofgovernanceisalsoborneoutbythe followingreport fromtheSouth China Morning Post aboutwhatPremierWensaidwhenhemetagroupofChinesecitizensinJapaninApril2007:

During30minutesofimprompturemarks,hesaidthekeytopursuingsocialjustice,themainland’smostimportanttask,wasto‘letpeoplebemastersoftheirhousesandmakeeverycadreunderstandthatpowerisinvestedinthembythepeople’…MrWenisknownforbeingcareful

25 Themanagementof state assets and the regulationof thefinancial sector shouldalsobe reformed toeliminatethephenomenonofrepeatedrecapitalisationoftheSCBs.26 TheNo.1Documentdesignationisdesignedtoshowthatthisisthemostimportanttaskinthenewyear.


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aboutwhathesays,whether inpreparedremarksorspeakingoffthecuff.Thefact thathehighlighted, in thepresenceofHongKongandoverseas journalists, the need for political reform is uncharacteristicand interesting…There have been signs that the leadership underPresidentHuJintaoisunder increasingpressuretoundertakedrasticpoliticalreformstoconsolidatetheparty’sgriponpowerandstampoutwidespreadcorruption.(‘Imprompturemarksrevealtheparty’spressureforreforms’,South China Morning Post,16April2007)

WhiletherearereasonablegroundsforananalysttodoubteitherthesincerityofPremierWen’swordsorhisabilitytoactonthem,theanalystcannotdoubtthatPremierWen isat leastaware thatdemocracy isoneway to solvemanyof China’s problems of governance. The embrace of the harmonious societyprogram by the Hu–Wen leadership reveals the CPC’s acknowledgment thatdemocracy,theruleoflaw,areductionincorruption,landreformandimprovedincomedistributionmakeanindivisiblecombinationthatisnecessarytoensurethesocialstabilitythatwillkeeptheeconomyonthehigh-growthpathneededtocatchupwiththeUnitedStates(avisionthatactsasthebedrockoftheCPC’slegitimacytorule).

Warding off software failure is of course much more difficult than wardingoff hardware failure because political reforms lie at the heart of successfulreconfiguration of the software of governance.The modernisation of China’sadministrativesoftwarewillrequiretheadoptionoffreeelections,afreepressandanindependentjudiciary.

Dealing with power supply failure caused by environmental degradation

The general point is that effective policymaking on the environmental frontisaverydifficult taskbecausemuchof thescienceabout theproblemisnotknown.Forexample,thereisnowpersuasiveevidencethatChina’svoluminousemissionsofblackcarbon (particlesof incompletelycombustedcarbon)havecontributedsignificantlytotheshifttoaclimatepatternthatproducesnortherndroughtsandsouthernfloodsofincreasingintensity(Menonetal.2002;Streets2005).The biggest source of what has been called in the popular media the‘Asianbrowncloud’isburningofcoalandbio-fuelsinChinaandIndia.ThislinkbetweenpollutionandwatershortagesfurtherreducesthepossibilitythateitherthepricemechanismorthethreecanalscansolveChina’swaterproblemsunlessthepresentmodeofeconomicdevelopmentisdrasticallyamended.

Chinamustnolongerselectitswaterstrategyanditenergystrategyseparately.Asystemsapproachtopolicymakingisnecessarybecausetheinteractionamongtheoutcomesfromthedifferentsectoralpoliciescangenerateseriousunintended


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environmentaldamage.IfpartoftheshiftinChina’sclimateisintegraltoglobalclimate change, a sustainable development policy would require a completerethinking of the location of population centres and the types of enhancedinternationalcooperationonglobalenvironmentalmanagement.

The uncomfortable reality for China is that unless ecological balance isrestoredwithinthemediumterm,environmentallimitscouldchokeofffurthereconomicgrowth.And theuncomfortable reality for the restof theworld isthat thenegativeconsequencesof large-scaleenvironmentaldamagewithinageographicallylargecountryareseldomconfinedwithinthatcountry’sborders.The continued march of China’s desertification first brought more frequentsandstorms to Beijing and then, beginning in April 2001, sent yellow dustcloudsnotonlyacrosstheseatoJapanandKoreabutacrosstheoceantotheUnited States. China’s environmental management is a concern not only forChina’swelfarebutforglobalwelfare.

Indiscussingtheenvironmentalaspectsofthewater-transferplan,itisimportanttonotethatthereisnowopencontroversyinChinainvolvingakeygovernmentinfrastructureproject—andthiscontroversyisnotlimitedtomembersofthetechnocracy.Theverypublicnatureofthecontroversy—andtheinvolvementofmorethanjustscientists,engineersandeconomistsinit—revealshowveryfarsocialattitudeshaveprogressed.Theimportantpointisthatthischangeinsocial expectationswill require anygovernment inChina to live inharmonywithnature.Anygovernmentwill,however,havegreatdifficultiesindoingsoevenifitwantstobecauseagreengrowthpolicyinvolvesasystemsapproach,andscientificunderstandingofmanyecologicalsubsystemsandthenatureoftheirinteractionsisstillratherincomplete.

TheglobalenvironmentisanimportantareainwhichChinacanhelptobuildaharmoniousworldsystem.27Specifically,ChinashouldbemobilisinginternationalconsensustoformaninternationalresearchconsortiumtodevelopwaystoburncoalcleanlybecauseChinaisnowbuildingapowerstationaweekandhenceisabletofacilitateextensiveexperimentationonprototypeplantstoburncoalcleanly.Furthermore,given thegrowingwater shortages inChina (especiallyinthenorth)andinmanyofitsneighbouringcountries,Chinashouldstartaregional forumonthe jointuseofwater fromtheTibetanPlateaubefore thesituationbecomestoocritical.Chinashouldalsobemobilisinganinternationalscientificresearcheffortonthedesalinationofseawaterfordrinking.Ifglobalcooperationoncleanenergyresearchanddesalinationresearchissuccessful,itwillunleashsustainabledevelopmentinthewholeworld.

27 SeeMcKibbinetal.(2008)foranexampleofanefficientglobalcarbondioxideemissioncompactthatChinaandtherestoftheworldcouldadopt.


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Dealing with power supply failure caused by trade protectionism

Finally, we consider briefly how to reduce the probability of the speedingcar (that is, China) crashing into a roadblock that takes the form of tradeprotectionism. There is no denying that international tensions over China’slargechronictradesurpluseshaveincreasedgreatlysince2004,andhavebeenexacerbatedbytheglobalfinancialcrisis.Chinahasbeenaccusedofmisconductonmanyinternationalfronts—forexample,causingtheglobalfinancialcrisisbyforcingcheaploansonUSconsumers28andengaginginbeggar-thy-neighbourdevaluationsbykeepingafixedrenminbi–USdollarexchangerate(‘WillChinalisten?’,The New York Times,17March2010).

TherootofChina’schroniccurrentaccountsurplusisthatthesumofsavingsbySCEsandtheprivatesectorexceedsthesumoftheirinvestmentexpenditures.This chronic large trade surplus reveals a deep-seated and serious problemin China’s economy: its dysfunctional financial system (Liu and Woo 1994).China generates the current account surplus because of inadequate financialintermediation and the surplus grows over time because the dysfunctionalfinancialsystemfailstopoolriskstoreduceuncertainty-inducedsavingsandfails to provide loans to reduce investment-motivated saving. The optimalsolution to China’s excess saving is to establish an improved intermediationmechanismforcoordinatingprivatesavingsandprivateinvestments.

Itmustbementionedinfairness,however,thatatradeimbalancereflectstheeconomic situation in two countries: China could not have over-saved if theUnitedStateshadnotunder-saved.USprofligacyistobeblamedforthetradetensions just asmuchasChinese thriftiness.Furthermore, asWoo (2008)haspointed out, even if China’s trade balance were zero, the pains of structuraladjustmentandincomeredistributioncausedbytechnologicalinnovationsintheUnitedStates,institutionalchangesintheUnitedStates,globalisationandimmigrationintotheUnitedStateswouldstillbethere—andtheamountofUSworkeranxietygeneratedcollectivelywouldbemuchlargerthantheadditionalworkeranxietygeneratedbythewideningtradedeficit.

ThereductionoftradetensionsbetweentheUnitedStatesandChinawouldbehelpediftheUnitedStatesnowstrengtheneditssocialsafetynetstolowerthecostofchangingjobs.Specifically,theUSCongressshouldspeedupthereductionoffiscalimbalancesandexpandtradeadjustmentprograms—especiallythose

28 Nicholas Lardy has described China as being in a co-dependent relationship with the United Statesinwhich ‘[t]he UnitedStates is the addict.We are addicted to consumption.China is thedealer.They’resupplyingthecreditthatmakesitpossibleforustoover-consume’(‘WinterInstitute:ChinaandUSjoinedatthehip’,Newsrelease,2March2009,FromconferenceatStCloudStateUniversity,Minnesota,27February2009,<http://www.stcloudstate.edu/news/pressreleases/default.asp?storyID=28126>).


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thatupgrade the skills ofyoungerworkers.The importantpoint is thatUS–China trade tensions would be lower if both countries undertook correctivepoliciesratherthanifChinaactedalone.

Apart from what the United States and China can each do independently toreduceinternationaltensionsoverthetradeimbalance,theyshouldalsoworktogethertopreventtheGeneralAgreementonTariffsandTrade(GATT)–WTOfree-traderegimefromweakening.Specifically,ChinahasbenefitedimmenselyfromtheWTOsystem,yetithas,uptothispoint,playedaverypassiveroleinpushingtheDohaRoundofnegotiationsforwardtocompletion.Bydefault,Brazil and India have assumed the leadership of the developing economies’camp in the trade negotiations. According to Susan Schwab, the US TradeRepresentativeat theGroupofFour (G4: theUnitedStates,EuropeanUnion,BrazilandIndia)meetinginPotsdaminJune2007,BrazilandIndiaretreatedfromtheirearlierofferstoreducetheirmanufacturingtariffsinreturnforcutsinagriculturalsubsidesbytheindustrialisedeconomiesbecauseof‘theirfearofgrowingChineseimports’(‘SchwabsurprisedbystanceofIndiaandBrazil’and‘China’sshadowloomsoverDohafailure’,Financial Times,22June2007).

WiththeUnitedStatesweakeninginitsresolvetoprotectthemultilateralfree-tradesystem(Woo2008),ChinashouldnowbecomemoreactiveintheDohaRoundnegotiationstoderegulateworldtradefurther.Sucharolewillbeverymuch in China’s interest because Brazil is now bypassing multilateral tradeliberalisationbyenteringintofree-tradenegotiationswiththeEuropeanUnion.ThefactisthatagrowingnumberofnationssuchasBrazil‘areincreasinglywaryofamultilateraldealbecauseitwouldmandatetariffcuts,exposingthemmoredeeplytolow-costcompetitionfromChina.Instead,theyareseekingbilateraldealswith richcountries that are tailored to the twoparties’needs’ (‘Brazil,otherspushoutsideDohafortradepacts’,The Wall Street Journal,5July2007).ItistimeforChinatoshowthatitisaresponsiblestakeholderbyjoininginthestewardshipofthemultilateralfree-tradesystem.SuchaninternationalstancewouldalsoreducethethreatofthistypeofpowersupplyfailuretoChina’sowngrowth.

Conclusions

Ourassessmentisthattheprobabilitiesofeitherasoftwarefailureorapowersupply failure are higher than the probability of a hardware failure becausethefirst twoareharderproblems todealwith.Formosthardwareproblems,Chinacanlearnfromtheexperiencesoftherestoftheworld,especiallythoseoftherichercountriesinEastAsia,aslongasideologicalconstraintsonmethodsof economic management continue to wither. The 1868 insight of the Meiji


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reformists that success in economic catch-up largely involves willingness toadoptandadaptto‘bestinternationalpractices’willcontinuetoapplytoChinauntilitspercapitaGDPconvergeswiththatofJapanandWesternEurope.

Dealingwithsoftwarefailureisharderthandealingwithhardwarefailurefortwo major reasons.The first is that development policymaking in China hasbecome more challenging because popular expectations of administrativeperformancehaverisendramaticallywithincomegrowthand,moreimportantly,with increasingknowledgeof theoutsideworld.AChinesegovernment thatconsistentlyfailstoproduceresultsinlinewiththeriseinsocialexpectationsrunstheincreasingriskofbeingchallengedbyinternalfactionswithintheCPC,culminatinginanopensplit,witheachsideseekingthesupportofnon-partygroups.

The second reason is that successful reconfiguration of the administrativesoftware requires not just highly developed political skills but favourablecircumstances in the domestic political arena and a benign internationalenvironment—bothofwhicharenormallybeyondthereachofmostpoliticianstomanipulate.Whathappens in the futurewilldependonwhether theCPCis sufficientlyconfidentandpolitically skilfulenough to lead thedemocratictransitionandemergeafterwardsasthemostimportantpoliticalforce.Historytells us that the French and British monarchies reacted very differently topopularrequestsforreformoftheadministrativesoftware—andtheoutcomeswereverydifferentineachcase.ThepracticalissueiswhethertheCPCcandoabetterjobinpoliticaltransitionthantheKuomintangdidinTaiwanduringtheperiod1983–88.

Dealingwithpowersupplyproblemsismuchharderthandealingwithhardwareproblemsbecauseitofteninvolvesworkingonissuesofwhichtheworldhasfew(mostly,no)successfulexperiences(forexample,aglobalcarbondioxideemission pact) or it involves working with powerful foreign partners wheredifferentiation between culturalmisunderstanding (for example, abombastic


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national but nevertheless well-meaning demeanour) and unstated nationalrivalry(forexample,keepingshippinglanesopen)isnoteasy—oritinvolvesworking with both of these difficult conditions. As most solutions to powersupplyfailuresrequireahighdegreeofmobilisationofinternationaleffort—whichChinahashistoricallybeentooweaktoparticipateinmeaningfully—

ChinaandtheothermajorpowerswillneedtoconvergeintheirrethinkingofChina’s responsibilities in theworldeconomybefore there canbe significantcooperationoncommonproblems.29

China’s economy has now become an important shaping force of the globaleconomy and, along with it. Chinese civil society has come to possess moreandmoreofthemiddle-classaspirationscommonintheindustrialisedworld.China’scontinuedhighgrowthnownecessitatesanewdevelopmentstrategythat also emphasises the creation of a harmonious society and a harmoniousworld—andthiswillrequireanimprovementinitsadministrativesoftwareandthesustenanceoftheglobalpowersupply.

References

AsianDevelopmentBank(ADB)2007,Key Indicators: Inequality in Asia,AsianDevelopmentBank,Manila.

Becker, Jasper, 2003, “The death of China’s rivers,” Asian Times Online,August26.

Chang,G.G.2001,The Coming Collapse of China,RandomHouse,NewYork.

Démurger,S.,Sachs,J.D.,Woo,W.T.,Bao,S.,Chang,G.andMellinger,A.2002,‘Geography, economic policy and regional development in China’, Asian Economic Papers,vol.1,no.1(Winter),pp.146–97.

29 AtimelydiscussionaboutChina’sroleinthefutureworldeconomyisfoundinthecollectionofpapersinGarnautetal.(2009)—forexample,Woo(2009).ThepresentdisputebetweenChinaanditsbiggesttradingpartners over its exchange-rate regime illustrates very well the difficulties of handling a power supplyproblem.Theproposed—andhighlycontentious—solutionofasignificantrenminbiappreciationistypicalofthenarrowlyfocusedsolutionsthathavebeenproposedforpowersupplyfailures(forexample,onlybuildingcanalstotransferwaterfromsouthtonorthwhenChinashouldalsoreduceblackcarbonandconcentrateurbanisationinsouthernChina).Specifically,aneconomicallymoreefficient—andpoliticallymoreamicable—solutiontothetradeimbalanceproblemwouldrequire:1)morethanonepolicyinstrumenttobeusedtoreducethetradeimbalance(thatis,notjustappreciationoftherenminbi,but,atleast,liberalisationoftheChinesegovernment’sprocurementpolicyandexportpromotionbytheUnitedStates);2)morethanonepartytoadjustitspolicieswhenthesituationistheproductofpoliciesinatleasttwocountries(thatis,theUnitedStatesandChinamusttakecorrectivepolicies,notjustChina);and3)morethanthepursuitofasinglepolicytargetbutachievementofarangeofmoredirectwelfareobjectivesaswell(thatis,goingbeyondreductioninthesizeofChina’stradesurplustoincludeobjectivessuchasstrengtheningtheWTOsystemofadjudication,andkeepingGDPgrowthrateshighinallcountries).


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Economy, E. C., 2004, The River Runs Black: The environmental challenge to China’s future,CornellUniversityPress,Ithaca,NY.

Forsythe,M.2009,‘IsChina’seconomyspeedingofftherails?’,The New York Times,23December2009.

Garnaut,R.,Song,L.andWoo,W.T.(eds)2009,China’s New Place in a World in Crisis: Economic, geopolitical and environmental dimensions,ANUEPressandBrookingsInstitutionPress,CanberraandWashington,DC.

Lardy,N.R.1998,China’s Unfinished Economic Revolution,BrookingsInstitutionPress,Washington,DC.

Liu, L.-Y. and Woo, W. T. 1994, ‘Saving behavior under imperfect financialmarketsandthecurrentaccountconsequences’,Economic Journal,vol.104,no.424(May),pp.512–27.

McKibbin, W. J. and Woo, W. T. 2003, ‘The consequences of China’s WTOaccessiononitsneighbours’,Asian Economic Papers,vol.2,no.2(Spring/Summer),pp.1–38.

McKibbin,W.J.,Wilcoxen,P.J.andWoo,W.T.2008,‘ChinacangrowandhelppreventthetragedyoftheCO2commons’,inL.SongandW.T.Woo(eds),China’s Dilemma: Economic growth, the environment and climate change,AsiaPacificPressandBrookingsInstitutionPress,CanberraandWashington,DC,pp.190–225.

Menon,S.,Hansen,J.,Nazarenko,L.andLuo,Y.2002,‘ClimateeffectsofblackcarboninChinaandIndia’,Science,vol.297,no.27(September),pp.2250–3.

NationalDevelopmentandReformCommission(NDRC)2007,China’s National Climate Change Programme, June, National Development and ReformCommission,Beijing.

O’Neill,J.,Wilson,D.,Roopa,P.andStupnytska,A.2005,How solid are the BRICs?, Global Economics Paper No. 134, 15 December, Goldman Sachs,NewYork.

Sachs,J.D.andWoo,W.T.2000,‘UnderstandingChina’seconomicperformance’,Journal of Policy Reform,vol.4,no.1,pp.1–50.

Shih, Victor, 2010, “China’s 8,000 Credit Risks,” The Wall Street Journal,February8,2010.

Streets,D.2005,‘BlacksmokeinChinaanditsclimateeffects’,Asian Economic Papers,vol.4,no.2(Spring/Summer),pp.1–23.


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Tong, J. and Woo, W. T. 2006, ‘Keeping fiscal policy sustainable in China’,in R. Garnaut and L. Song (eds), The Turning Point in China’s Economic Development,AsiaPacificPress,Canberra.

Woo,W.T.2001,‘RecentclaimsofChina’seconomicexceptionalism:reflectionsinspired by WTO accession’, China Economic Review, vol. 12, nos 2–3,pp.107–36.

Woo,W.T. 2006, ‘The structural nature of internal and external imbalancesin China’, Journal of Chinese Economic and Business Studies, vol. 4, no. 1(February),pp.1–20.

Woo, W. T. 2008, ‘Understanding the sources of friction in US–China traderelations: the exchange rate debate diverts attention away from optimumadjustment’,Asian Economic Papers,vol.7,no.3(Fall),pp.65–99.

Woo,W.T.2009,‘Chinaandinternationalfinancialreform’,inR.Garnaut,L.SongandW.T.Woo(eds),China’s New Place in a World in Crisis: Economic, geopolitical and environmental dimensions, ANU E Press and BrookingsInstitutionPress,CanberraandWashington,DC,pp.15–32.

Woo,W.T.andXiao,G.2007,‘Facingprotectionismgeneratedbytradedisputes:China’spost-WTOblues’, inR.GarnautandL.Song (eds),China: Linking markets for growth,AsiaPacificPress,Canberra.

Woo,W.T.,Li,S.,Yue,X.,Wu,H.X.andXu,X.2004,The poverty challenge for China in the new millennium,ReporttothePovertyReductionTaskforceoftheMillenniumDevelopmentGoalsProjectof theUnitedNations,UnitedNations,NewYork.

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Rebalancing China’s economic structure 14

Yiping Huang and Bijun Wang

Introduction

ChinesePremier,WenJiabao,warnedinearly2010that‘theChineseeconomyisstillimbalanced,inharmonicandunsustainable’.ThisisnotthefirsttimethatPremierWenhasexpressedconcernsaboutgrowthquality.Hefirstraisedtheissuewhenhetookofficein2003andrepeatedthewarningwhentheeconomyshowedsignsofoverheatingin2007.ItisprobablyfairtoranktransformationofthegrowthmodelasoneofthetoppolicyprioritiesunderWen’sgovernment.

Indeed,despiteitscontinuoussuccessmaintainingstronggrowth,theChineseeconomy has exhibited worsening structural imbalances in recent years.SomeofthegrowthqualityproblemshighlightedbyPremierWenandotherpolicymakersincludetheveryhighinvestmentshareofgrossdomesticproduct(GDP),theverylargecurrentaccountsurplus,inefficientresourceuse,unequalincomedistribution,seriouspollutionandcorruptionamonglocalgovernmentofficials.Iftheseproblemspersist,China’sstrongeconomicgrowthwillprobablynotbesustainable.

ThegovernmenthasundertakenarangeofpolicymeasurestoadjustChina’seconomicstructureduringthepastsevenyears.Forinstance,ithasprovidedlargesubsidiestoagriculturetoboostruralincomeandithastightenedcontrolsover investment projects to reduce overcapacity in certain industries. It hasadjustedexporttaxrebatesandrevaluedthecurrencyinordertoslowexportgrowthandnarrowcurrentaccountsurpluses.IthasrequiredallprovincestolowertheenergyintensityofGDPby20percentduringtheeleventhFive-YearPlantoimproveenergyefficiencyandcurbpollution.Andithasevenadoptedanewstrategytorespondtoglobalclimatechange.

Allthesepolicyefforts,however,havefailedtoreversetheoveralltrendofaworseningeconomicstructure.Between2003and2008,the investmentshareofGDPincreasedwhiletheconsumptionsharefell,thecurrentaccountsurplusbecamelarger,incomedistributionbecamemoreunequalandpollutionprobably


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becamemoreserious.Thesedonotimplythatallpolicyeffortswereineffective;butdeterioratingproblemsofimbalancecertainlyraiseanimportantquestionaboutwhatmoreneedstobedonetoalleviatethegrowingrisks.

Inthischapter,wetakeacloselookattheevolutionofstructuralimbalancesinChinaandtheirpossibleremedies.Wearguethatmostofthepolicymeasuresimplementedsofarhaveaddressedthesymptoms,butnottherootcause.Forinstance, theover-investmentproblemwasprobably causedby the expectedhighreturnstoinvestment.Therefore,unlesstheincentivestructureiscorrected,administrative measures controlling investment projects are unlikely to beeffective.Marxoncesaidthatiftheprofitratewasabove100percent,capitalistswouldbewillingtorisktheirlives.Inthissense,Chineseentrepreneursarenolesslikelythanotherstoprovehimright.

Wefurtherproposethatthefundamentalcauseofstructuralimbalanceliesintheuniquepatternofmarketliberalisationduringthereformperiod:completeliberalisation of product markets but with distortions remaining in factormarkets. Such a reform approach generally represses prices for labour, land,capital, resources and the environment. These distortions have the effect ofsubsidy equivalents for producers, exporters and investors.This is probablywhygrowthhasbeensostronginChina,butexportsandinvestmenthavebeeneven stronger. If our analysis is right, correctionof the structural imbalanceproblemsinChinaisdependentontheliberalisationoffactormarkets.

The remainder of this chapter is organised as follows. The next sectionsummarisesthemajormanifestationsofChina’sstructuralimbalancesandthenreviewswhatthegovernmenthasdonetoalleviatetheseimbalancesinthepastfiveyears.Thenextsectiondiscussestheasymmetricliberalisationofproductandfactormarkets.Subsequently,theeffectsoffactor-marketdistortiononthestructuralimbalanceproblemarepresented,beforesomefinalconclusionsaredrawn.

China’s growing imbalance problems

Structuralimbalanceisabroadandsubjectiveconcept,althoughinternationalexperience provides some useful references. We focus our discussion onimbalanceproblemsinthreebroadareas:sharesofinvestmentandconsumptionin GDP; income distribution among households; income distribution acrosshouseholds, the corporate sector and the government; and current accountimbalances.

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Over-dependence on investment

One of the most widely identified imbalance problems is the rising share ofinvestmentinGDP,whichrosefrom38.2percentin1978to49.3percentin2008.Incontrast,theconsumptionratedecreasedfrom62.1percentto46.1percentduringthesameperiod. In2008,householdconsumptionaccountedforonlyabout36percentofGDP.Thisshareisextraordinarilylowcomparedwithmostdevelopingandindustrialisedcountries.

A high and rising investment share in itself might not be a problem, asinvestmentisanecessarydriverofeconomicgrowth.Averyhighinvestmentshare,however,increasestheriskofexcesscapacityandlowreturns.EastAsianeconomies traditionally have very high investment shares, especially duringperiodsofeconomictake-off.China’scurrentinvestmentshareis,however,highevencomparedwithitsEastAsianneighbours.Duringthepastseveraldecades,onlythreeeconomiesexperiencedabove-40percentinvestmentshares.ThefirstwasSingaporeintheearly1980s—butitssharecollapsedinthemid1980swhenstructuraladjustmentwasforcedonthecountry.TheothertwowereMalaysiaandThailandinthe1990s.Unfortunately,financialcrisisquicklyfollowedinbothcountries.Theseprevious incidentshighlightthepotentialrisksfortheChinese economy should its investment share remain at extraordinarily highlevels.

Wearenotcertainthatthereisanoptimalrangefortheinvestmentshare,sinceit probably varies according to individual economies’ particular conditions.Chenery and Syrquin (1975), however, examined the empirical relationshipbetweenacountry’sconsumptionrateanditspercapitanationalincomeusingdatafrom101countries.Applyingtheempiricalrelationshipimpliedbytheirstudy—knownastheCheneryStandard—wefindthatChina’sinvestmentshareofGDPisroughly20percentagepointshigherthanthebenchmark,whileitsconsumptionrateisabout20percentagepointslower(Figure14.1).

Sources: National Bureau of Statistics (NBS) various years, China Statistical Yearbook, China Statistics Press, Beijing; Chenery, H. and Syrquin, M. 1975,‘Patterns of development, 1950–1970’, Oxford University Press, UK; He, G.2009,AstudyontheunbalancebetweeninvestmentandconsumptionanditsimpactonChina’seconomicgrowth,Doctoraldissertation,HuazhongUniversityofScienceandTechnology.


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Figure 14.1 Comparison of the investment rate and consumption rate between China and the Chenery Standard, 1990–2008

Sources:NationalBureauofStatistics(NBS)variousyears,China Statistical Yearbook,ChinaStatisticsPress,Beijing; Chenery, H. and Syrquin, M. 1975, ‘Patterns of development, 1950–1970’, Oxford UniversityPress,UK;He,G.2009,AstudyontheunbalancebetweeninvestmentandconsumptionanditsimpactonChina’seconomicgrowth,Doctoraldissertation,HuazhongUniversityofScienceandTechnology.

Current account surpluses

The rapid growth of China’s current account surplus is a relatively recentphenomenon.Thesharpestriseinthecurrentaccountsurplusoccurredafter2004.Withinthreeyears,thesurplusjumpedfrom3.5percentofGDP,in2004,tothehighestinhistoryat10.8percentin2007.Thesoaringtrendmoderatedin2008and2009asaresultofseriouslydampenedexternaldemandaffectedbythecurrentglobalfinancialcrisis(Figure14.2).Thesurplusshrankfurtherto3.5percentofGDPduetomuchfastergrowthofimportsthanofexports.Thisfurtherdownwardshiftcould,however,provetobetemporaryintheabsenceofmoredecisivepoliciesforstructuraladjustment.

By definition, the current account surplus is equivalent to the excess of acountry’s savings over its investment. A persistent current account surplusmeansthatChina,asalow-incomeeconomy,hasbeenexportingcapitaltoothercountries throughfinancial intermediaries.This isobviouslyoddsinceChinastillhasmanyareaswhereinvestmentisbadlyneeded.Moreimportantly,mostofthecurrentaccountsurplusendsupasforeignexchangereserves.Returnstosuchinvestment,suchasUSTreasurybonds,arerelativelylow.Ifthecentralbankpaysahigherratefordomesticbillsthentheholdingofforeignexchangereservescouldimplyanetloss.Thisstilldoesnottakeintoaccountexchangeraterisk.


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The current account surplus has recently been closely tied to the renminbi(RMB)exchangeratepolicydebate.AmericanpoliticianshaverepeatedlyarguedthattheRMBissubstantiallyundervaluedandthatChinatakesjobsawayfromtheUnitedStates.China’scurrentaccountsurplusesareoftenusedtoprovide‘hard evidence’ to support this argument. Large current account surplusesalsocauseeconomicproblemsdomestically.Inadditiontoexportingcapitaltorichcountries, the surpluses indicate thedegree towhichChinesegrowth isdependentonexternaldemand.ThiswaspreciselywhyChinesegrowthwasseriouslyaffectedbytheUSsub-primecrisisnearlytwoyearsago.

Figure 14.2 China’s current account balances, 1986–2009 (per cent of GDP)

Source:CEICDataCompany.

ItisimportanttonotethattheincreaseinnetsavingsinChinainrecentyearswastheresultofafasterriseinthesavingrate,notadeclineintheinvestmentrate.Infact,asalreadynoted,theinvestmentraterosebynearly10percentagepointsduringthepastdecade(Figure14.3).Sincetheinvestmentrateisalreadyatsuchahighlevel,itisreasonabletoexpectthatanyeffortstodealwiththelargecurrentaccountsurpluswillhavetotrytoreducethesavingrate.

Income inequality

As the most important result of economic reform, household income hasincreaseddramaticallyduringthepastthreedecades.Rapidincomegrowthhasliftedhundredsofmillionsofpeopleoutofpovertyandthelivingstandardsofruralandurbanresidentshaveimprovedsignificantly.Incomedistributionhas,however, also deteriorated sharply.This change was understandable initiallysince the ‘very equal’ income distribution pattern in the pre-reform perioddid not provide any incentives for hard work. Over time, however, incomeinequalityhasbecomeamajorpoliticalaswellaseconomicconcern.


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PerhapsthemoststrikingmeasureofincomeinequalityistheGinicoefficientamonghouseholds,whichrosefrom0.25in1985to0.47in2008(Figure14.4).The latest reading of the coefficient is among the highest in the world andprobablyindicateshighrisksofsocialandeconomicinstability.

Figure 14.3 China’s saving and investment rate, 1978–2009 (per cent of GDP)

Source:CEICDataCompany.

Figure 14.4 Gini coefficient among households and the urban–rural income gap

Source:NationalBureauofStatistics(NBS)variousyears,China Statistical Yearbook,ChinaStatisticsPress,Beijing.

A relatedproblem is thewideninggapbetween rural andurban income.Atthe beginning of the 1980s, the rural–urban income gap in fact narrowed,sinceagriculturalincomewasboostedbytheimplementationofthehouseholdresponsibilitysysteminthecountrysidewhileurbanreformswereslowtogathermomentum.Overtime,however,thegaphaswidenedsharply.In1981,urban


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incomewasonaverageabouttwotimesthatofruralincome.In2005,thisratioroseto3.2.Onthesurface,thistrendappearstocontradicttheincreasingtrendof rural–urban migration. In reality, it is probably the result of institutionalrestrictionsonmigrationandfasterproductivitygrowthintheurbaneconomy.

Fromtheperspectiveofmacroeconomicimbalance,oneofthemostimportantindicators is the distribution of national income among households, thecorporatesectorandthegovernment.Between1995and2007,thesharesofthecorporatesectorandthegovernmentintotalnationalincomeincreasedsteadily.Asaresult,theincomeshareofhouseholdsdecreasedfrom68percentto50percent(Figure14.5).ThistrendcouldbeimportantforexplainingthedecliningshareofconsumptioninGDP.

Figure 14.5 Proportion of residential, firms’ and government income in primary distribution and the urban–rural income gap

Sources:Bai,C.-EandQian,Z.2009,‘FactorincomeshareinChina:storiesbehindstatistics’,Economic Research Journal[Jing Ji Yan Jiu],vol.3;NationalBureauofStatistics(NBS)variousyears,China Statistical Yearbook,ChinaStatisticsPress,Beijing.

Policy efforts to rebalance the economy

Between 2003 and 2010, the Chinese economy experienced almost two fullcycles.EconomicmomentumacceleratedintheyearsafterChina’saccessiontotheWorldTradeOrganisation(WTO)inlate2001.In2004,theeconomystartedtoshowsignsofoverheating,withtheconsumerpriceindex(CPI)exceedingthe5percentbenchmarkinJulyandAugustofthatyear,althoughitcooledoffquicklyasthegovernmentadoptedvarioustighteningmeasures.In2007,theeconomyenteredanothercycleofoverheating,withtheincreaseintheCPI


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reaching8.7percent inearly2008.Thismomentumwas,however, reversedabruptlybytheglobalfinancialcrisisfrommid2008.Again,inearly2010,theeconomybegantoshowinitialsignsofoverheating.

Whiletheprioritiesofmacroeconomicpoliciesshiftovertime,oneconsistentpolicythemethroughoutthisperiodhasbeenthetransformationofthegrowthmodel.TheChinesegovernmenthasbecomeincreasinglyuncomfortablewiththe growing imbalance problems. PremierWen and his government take theimprovementofthequalityofgrowthasatoppolicypriority,andduringthepastsevenyearstheyhaveadoptedvariousmeasurestoachievethisobjective,including administrative controls, monetary instruments and fiscal tools (seeAppendix14fordetailedpolicymeasuresduringthepastsixyears).

Industrialpolicyhasplayed an important role in thegovernment’s efforts totransformthegrowthmodel.Theideaistopromotehigh-tech,highvalue-addedandenvironmentallyfriendlyindustries.Thishasbeendoneinvariousways,with the most important tools including fiscal subsidies and administrativecontrols. The National Development and Reform Commission (NDRC) is thecoordinatingauthorityforindustrialpolicy.Atthebeginningofeveryyear,itsetsoutplansforinvestmentforthecomingyear.Italsoidentifiestheindustrieswhereexcesscapacityrisksarehigh.

PerhapsthemostpowerfulpolicytooloftheNDRCisitsapprovalandterminationauthority.Forinstance,in2004–05,theNDRCclosedalargesteelplantinJiangsuProvincecalled‘TieBen’andterminatedanother70600investmentprojectsinaneffort to cool the economy.Since2007,when theeconomyshowed initialsignsofoverheating,theNDRChasbeengrantedtheauthoritytoapproveanyinvestmentprojectslargerthanRMB50million.

Inadditiontoitsresponsibilitiesformanagingtheoverallsizeof investment,the NDRC is responsible for optimising the industrial structure. It regularlypublisheslistsofindustrieswithhighovercapacityriskandpromotesinvestmentinother industries. In2009, for instance, theNDRC stoppedapprovingnewprojectsincertainindustries,includingthehydropowerdevelopmentprojecton the Jinsha River and steel industry projects in Shandong Province. TheNDRC also raised the capital requirement in 2005 for investment projects inironandsteel,cement,aluminiumandrealestateandagainin2009forenergy-intensiveindustries.

The government has also made efforts to promote industrial upgrading,suchas localising theproductionof largenuclearpowerequipment in2006,revitalisingtheequipmentmanufacturingindustryin2007,restructuringthe


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telecommunications and airline industries in 2008 and subsidising sales ofelectronics,motorbikes,carsandagriculturalmachineryinthecountrysidein2009.

Creditexpansionisoftenanimportantpolicyinstrumentfortheauthoritiestoregulatemacroeconomicconditions,withthescaleofloansfluctuatingaccordingtoeconomicperformance.Forinstance,aspartoftheeffortcontrollingeconomicoverheating,thePeople’sBankofChina(PBOC)reducedloangrowthfrom21.1percentin2003to9.3percentin2005(Figure14.6).AstheglobalfinancialcrisishittheChineseeconomy,however,thePBOCsignificantlyboostedcreditexpansioninordertosupportgrowth,raisingloangrowthfrom15.9percentin2008 to31.8percent in2009. Indeed, thenew loansextended in2009—RMB9.6trillion—doubledtheannualtargetforthatyear.

Figure 14.6 China’s annual increased loan, 2004–10

Note:Thedatafor2010aretheofficialtargets.


Theauthoritiesfrequentlychangetheircreditpolicies.Forinstance,theStateCouncil published ‘Regulations on strengthening control of investment infixed assets and newly started projects’ in June 2006. This policy requiredthecommercialbankstotightencontrolsoverloanextensionsforinvestmentprojects. Meanwhile, financing demands from strategic emerging industries,smallenterprises,tradeandresidentialconsumptionarethehighestpriorities.Besidetheseareas,loandemandsfromnewlystartedprojects,heavypolluters,heavy energy consumption and resource-related industries, industries withexcesscapacityandrealestateinvestmenthavebeenlistedwithinthescopeofstrictcontrol.

Inadditiontocreditpolicy,thePBOCraisesorlowersthereserverequirementratioandbaseinterestratestoadjustthemonetarypolicyenvironment.Inthe


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wakeoftheglobalfinancialcrisis,thePBOCloweredthereserverequirementfour times to ease liquidity conditions.Thiswas an important factorbehindtheextraordinaryloangrowthduringthatperiod.Ontheotherhand,between2004 and mid 2008, the PBOC continuously raised the reserve requirementratio—from7percentinearly2004to17.5percentinthefirsthalfof2008.

Unlikeothercentralbanksaroundtheworld,thePBOCdoesnottargetaparticularmarket interestrate.Instead, itdirectlyadjuststhebenchmarkinterestrates,suchasone-yearbaselendinganddepositrates.Commercialbanksareallowedtofloat theratesas longastheyobservefloorsfor lendingratesandceilingsfordepositrates.Adjustmentsofinterestrates,though,areoftenlessfrequent,reflectingthepolicymakers’greaterconfidenceinquantitativemeasures.

The government has also adopted a number of other policies to reduce theimbalance problems. For instance, to boost consumption, the authoritiesincreasedspendingonsocialwelfaresystems,includingmedicalinsuranceforruralresidentsandsocialsecurityfundsintheurbanareas.Thelogic isthatdevelopmentofthesocialwelfaresystemscanprobablyreducethehouseholdsavingrateandthereforeincreasetotalconsumption.TheMinistryofFinance(MOF) raised the minimum thresholds for personal income taxes and alsoabolishedagriculturaltaxes.

Tonarrowexternalaccountsurpluses,theMOFhasfrequentlyloweredexporttaxrebatestodiscourageexports.ThePBOCalsoallowedtheRMBtoappreciategraduallyforthreeyearsbetween2005and2008.

Inrecentyears,policymakersbegannewinitiativestodeveloparesource-savingandenvironmentallyfriendlysociety.Theystarted178energy-saving,water-saving and resource-efficient projects.They required all provinces to reduceenergyintensityannuallyby4percentandthedischargeofmajorpollutantsby 2 per cent in 2006. In 2009, the government published a new policy on‘China’sresponsestoclimatechange:policyandaction’,announcinganexplicittargetofreducingthecarbonintensityofGDPby40–45percentby2020.

Asymmetrical market liberalisation

Despitethegovernment’sdeepconcernsanditscontinuousefforts,theimbalanceproblems have worsened steadily in recent years. This is indeed puzzling.Theoretically,therecouldbeonlytwopossibilities:thewrongpolicies,ortherightpolicies,butnotimplementedaggressivelyenough.Inourview,mostofthepolicymeasuresimplementedsofarhavenotdirectlyaddressedtheincentive


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structurethatcausedtheimbalanceproblems—apeculiarincentivestructurethat is associated with China’s unique asymmetrical market liberalisationapproach.Thisapproachhascausedseriousdistortionsinmostfactormarkets.

Product-market liberalisation

Themostfundamentalchangeduringthereformperiodhasbeentheintroductionoffreemarkets.Inretrospect,theintroductionofthemarketsystemincludesat least three dimensions: 1) creating autonomy and incentives at the microlevel; 2) liberalising restrictions inmarkets; and3)building the institutionalinfrastructurenecessaryforamarketeconomy(Huangforthcoming).Ofthese,theliberalisationofmarketsisessential,includingthereintroductionofmarket-determinedpricesandtheliberalisationoftradeingoodsandservices.

Forthesakeofprogressivereform,theinitialdual-trackpricesystemrepresentedthecoexistenceof statepricesalongsidemarketprices.OnepricewassetbytheStateforplannedactivitiesandtheotherwasdeterminedbydemandandsupply in free markets.The dual-track system served an important purposein the reforms: allowing free markets to allocate resources without seriouslyaffecting the groups with vested interests.This dual-track price system wasappliedmainlytograinandproductiongoodsaswellascapitalgoodssuchasforeignexchangeandstock.

Priceliberalisationstartedintheagriculturalsector.Statepurchasepriceswereraisedfromtheendofthe1970sandfreemarketsforagriculturalsurpluseswerealsoreopenedinurbanandruralareas.In1984,themandatorystatepurchaseofgrainwasconvertedtoacontractsystem,partiestowhichwerefarmersandtheState.Themandatorynaturewasnotphasedout,however,until1992.

Theliberalisationofnon-agriculturalpricesstartedwithconsumergoodsandwasthenextendedtoindustrialmaterials.Thecouponsystem,whichwasusedto allocate consumer goods during the central planning system, was phasedoutcompletelyintheearly1990s.Freemarketsformostconsumergoodscameintoexistenceduring the1980s.By the late1990s, transactionsof almostallconsumergoodswerecompletelyliberalisedwithpricesfreelydeterminedbythemarketmechanism.

Distortions of factor markets

Comparedwithproductmarkets,factormarketshavenotyetbeenliberalisedcompletely. From the production function, there are four major sources ofoutput: labour, capital, natural resources and technology. Given technology,pricesfortheotherthreefactorsaredistorted.


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Labour

AbundantandcheaplabourisknownasakeyfactorbehindChina’ssuccessinlabour-intensivemanufacturingexports.Becauseofthesegmentationofruralandurbanlabourmarkets,however,aswellastheunderdevelopmentofsocialwelfaresystems,labourcostsinChinaaredistorted.

Themainsourceoflabour-marketsegmentationistheHouseholdRegistrationSystem, which differentiates agricultural and non-agricultural registeredpermanentresidence,resultingintheformationofaseparatedstructureoftownandcountry.Duringthepre-reformperiod,nolabourmobilitywaspermittedbetweenagriculturalandnon-agriculturalresidences,unlesstherewasspecialapprovalbythegovernment.Thisrestrictionhasbeenloosenedinrecentyearswith the growth of the non-state sector, evidenced by the large number ofmigrantworkersroamingthecities.Attheendof2009,therewereabout150millionmigrantworkersacrossthecountry.

Althoughrestrictionsonrural–urbanmigrationhavebeenloosened,thelocationofanindividual’shouseholdregistrationmakesasignificantdifferenceintermsofpaymentandothersocialwelfarebenefits;evenwhenmigrantworkershavebeenworking in cities foryears, they arenormallynot entitled topensions,medical care and housing subsidies, and their children cannot attend localpublic schools. In short, it isverydifficult for them to settledown.For thisreason,migrantworkers’payissometimesonlyhalfthepayofurbanresidents,eveniftheydothesamejob.

Scepticismaboutdistortedwagecostsderives fromtheargument that labourshouldbecheapgivenChina’smassivesurpluslabourinthecountryside.Thisisnotnecessarilyso.Ifurbanemployersmadesocialwelfarecontributionsfortheirmigrantworkers,theirpayrollscouldrisebyabout35–40percent,whichincludescontributionstopensions(20percentofpayroll),medicalinsurance(6percent),unemploymentbenefits(2percent),workinjuryinsurance(1percent), maternity benefits (0.8 per cent) and housing entitlements (5–10 percent).1IfsocialwelfarepolicieswereimplementedproperlyandtheHouseholdRegistrationSystemwasabolished,migrantworkerswouldbelikelytoreceivesignificantlyhighercompensation.

Capital

Distortionsincapitalmarketsexistintworespects.Domestically,thefinancialsystemremainsrepressed,asevidencedbyhighlyregulatedinterestratesandstate influences on credit allocation, and externally, the currency has beenundervalued.

1 TheseestimatesforatypicalyearwereprovidedtotheauthorbyZhaiFan,aformerofficialofChina’sMinistryofFinance,in2002.


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Generally,market-orientedinterestrateshavebeenintroducedinthewholesalemarket.TheChinainter-bankofferedrate(CHIBOR)wasformedin1996andtheinter-bankmarketwasliberalisedaccordingly;theloanratesanddepositratesforforeigncurrencywereliberalisedin2000and2004,respectively.Worriedabout possible vicious competition among banks, however, the PBOC stillcontrolsRMBdepositandloaninterestratesbysettinganupperlimitfordepositratesandalowerlimitforloanrates,basedontheannouncedbenchmarkrates.

Undersuchregulation,interestratesaredepressed,asinmanyotherdevelopingcountries.From1990to2008,theaverageloananddepositinterestrateswere7.63 per cent and 5.26 per cent, respectively. The average loan and depositinterestrateswereonly5.85percentand2.45percentbetween2000and2008.Theseseemlowforadevelopingcountrywithgreatopportunitiesforproductiveinvestment.Theinterestratehasbecomeincreasinglydistortedsince2000.

Underestimationofthedomesticcostofcapitalisunderscoredbytheexistenceoffinancialrepression(Wang2010).AWorldBankstudysuggeststhatfinancialliberalisationinemergingmarketeconomiesoftenraisesdomesticinterestratesbyacoupleofpercentagepoints(Caprioetal.1994).Thiscouldbeinterpretedasfinancialrepressionreducinginterestratesbyacoupleofpercentagepoints.

Asfortheexchangerate,whenreformsbegan,theofficialRMBexchangerateagainsttheUSdollarwas1.5,whichwasprobablyovervalued.Insubsequentyears, the authorities frequently devalued the currency in order to promoteexports. At the beginning of 1994, the PBOC unified the official and swapmarketexchangeratesat8.7,substantiallydevaluingtheofficialratefrom5.3.Theexchangeratestrengthenedslowlyto8.27attheendof1997.InresponsetotheEastAsianfinancialcrisis,thePBOCadoptedaconventionalpegbyfixingtheexchangerateat8.27.

On21July2005,thePBOCappreciatedthecurrencyby2.1percentandadopteda managed float with reference to a basket of currencies. The RMB showedslowbutsteadyappreciationagainsttheUSdollar,reaching6.84attheendof2008.Withtheexceptionofbriefperiodswhenthecurrencyexperiencedmilddepreciationpressure,thePBOChasgenerallyresistedpressurestoappreciatefaster. Today, most economists believe that the RMB remains undervalued,althoughtheydisagreeonthedegreeofundervaluation(GoldsteinandLardy2008),withthenormalrangeoftheundervaluationestimatedtoliebetween5and50percent(CliveandWilliamson2008).

Natural resources

Natural resources such as land, energy and the environment are importantproductionfactors,buttheirpricesarealsodistorted.InChina,landisownedbytheStateinthecitiesandbythecollectivesinthecountryside.TheLand


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Administration Law, promulgated in 1999, classifies land into agricultural,developmentandunutilisedland.Landtransferfornon-agriculturaluseshastobeapprovedbythegovernment.

In the past, local authorities decided land fees. To attract more investment,theyoftenprovidedconcessionsonland-usefees.Inrecentyears,however,thegovernmenthasturnedtomoremarket-orientedlandtransfermechanisms,suchasauctionsandnegotiations.Thispractice,however,appliesmainlytopropertydevelopment.There isnomarketmechanism fordetermining landprices forindustrialuseanditisstillcommonforthegovernmenttoapplyland-usefees,the average of which is only about 16 per cent of the costs through auction(HuangandTao2010).Manufacturers,therefore,receiveimplicitsubsidiesonlandinputs.

Institutionaldistortionsindomesticenergymarketsarewidespread,althoughthemagnitudeofcostdistortionshasvariedovertheyears.Ofthedifferenttypesofenergyproducts,coalpricesaretheclosesttomarketprices.Electricitytariffsaredifferentforagricultural,industrialandresidentialusesandaresetbytheNDRC,althoughtheauthoritiessometimesholdpublichearingstoimprovethequalityofdecisionmaking.Electricitypriceshavebeenunderupwardpressureinrecentyears,asthecostsofoilandcoalhaverisensignificantly.

Themostvisibleandsometimesmostvolatiledistortionsare inoilproducts.In1998,inanimportantsteptowardsoilpriceliberalisation,theStateCouncilannouncedaformulalinkingdomesticpricestotheweightedaverageofpricesinNewYork,SingaporeandRotterdam.TheNDRCwouldadjustdomesticprices,withacoupleofmonths’delay,iftheinternationalweightedaveragemovedbymorethan8percent.In2000,theNDRCraisedoilpricesseventimesinordertobringdomesticpricesclosertointernationallevels.Wheninternationalpricesmovedsharplyupwards,however,theNDRCwasreluctanttofollowforfearofdisruptingdomesticeconomicgrowth.Forinstance,wheninternationalcrudepricesreachedtheirrecentpeakin2008—atclosetoUS$150abarrel—domesticpricesremainedataboutUS$80abarrel.

The environment is not regarded as a conventional production factor;however,compensationforpollutionshouldbecountedasanintegralpartofproductioncosts.WhileChinahas introduceda seriesofenvironmental lawsandregulations,theproblemisthebiggapbetweentheintentofthesepoliciesandtheirimplementation,asthevariouslevelsofgovernmentcontinuetogiveprioritytoeconomicgrowth.

AccordingtoajointstudybytheNationalBureauofStatistics(NBS)andtheState Agency for Environmental Protection (SAEP), an incomplete count ofthecostsofenvironmentaldamageamountedtoabout3.05percentofGDPin


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2004.Sinceproducersdonotalwaysfullycompensatefortheirdamagetotheenvironment,thisreducesshort-termproductioncostsattheexpenseoflong-termdevelopment.

Crude estimation of factor cost distortions

Whatisthemagnitudeofthesedistortions?Huang(forthcoming)madehisfirstattemptstomeasurefactor-marketdistortionsandfoundthattheyamountedtoRMB2.1trillionin2008—orabout7percentofGDP.Hisestimation,however,wasmadeforonlyoneyear.Inafollow-upstudy,HuangandTao(2010)refinedsomeofthemethodsandextendedtheestimationtoincludenineyearsfrom2000to2008(Table14.1).

Thetaskofestimatingthesedistortionsisquitedifficult,asinmostcasesthereisnoinformationaboutundistortedequilibriumfactorprices.Thepurposeoftheestimation,however,isnottoprovideaccurateestimates,butrathertogetsomeideaofthepossiblemagnitudeofthedistortionsand,moreimportantly,changesintheirimpactovertime.

Despite potential problems, the estimation results reveal some importantpatterns. First, labour-market distortions have in fact grown in recent years,despitelooseningpolicycontrolsandincreasingrural–urbanmigration.Thisisaresultbothoftherisingnumberofmigrantworkersandpersistent,wideningincomegapsbetweenmigrantworkersandurbanworkers.Indeedthestatisticssuggest that while labour demand has increased in recent years, migrantworkers’payhasnotkeptpacewith thatofurbanworkers,especiallywhensocialwelfarebenefitcontributionsaretakenintoaccount.

Table 14.1 Estimated cost distortions in China, 2000–08 (per cent of GDP)

2000 2001 2002 2003 2004 2005 2006 2007 2008

Labour 0 .1 0 .2 0 .8 1 2 2 .4 2 .7 3 .2 3 .6

Capital 4 .1 3 .9 3 .9 3 .8 3 .1 3 3 .1 3 .6 3 .4

Natural resources

4 .3 4 3 .7 4 .4 4 .5 6 6 .4 5 .2 3 .6

Total 8 .5 8 .1 8 .4 9 .2 9 .5 11 .4 12 .2 12 10 .6

Source:HuangandTao(2010),page18.

Second, of all the distortions, capital-market distortions are by far the mostimportant,2contributingabout40percentoftotalcostdistortionsonaverage.Thishelpstoexplainthepersistentproblemofover-investmentinChinaandalso the rapid development of capital-intensive industries despite continuedjob-marketpressures.

2 Natural resource distortions include land distortion, energy distortion and environmental distortion.Comparedwiththethreeelements,aswellaslabourdistortion,capital-marketdistortionsarethelargest.


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Third, natural resource distortions have fluctuated widely over the years,reflecting volatilities in components, energy—especially international oilprices—andthevaryingresponsesoftheChineseauthoritiestothesechanges.China has already adopted a price mechanism that closely tracks changes ininternational energy prices, but the authorities hold down domestic priceswhen international prices surge rapidly. Therefore, energy cost distortionsaresometimesasymmetrical.Wheninternationalpricesare low,thereis littledistortion.Wheninternationalpricesarehigh,distortionsincreaserapidly.

Finally, the aggregate estimates of cost distortions show significant increasessince 2004—consistent with the observation that structural imbalances haveworsenedduringthisperiod.Thetrendsofcontinuousliberalisationandrecentincreasesinthetotalimpactofcostdistortionsarenotnecessarilycontradictory.These trends could arise because of a slower rise in distorted prices thanundistorted prices, despite loosening controls overall. They could also arisebecausethequantityoffactorshasgrownrapidlyeventhoughunitdistortionshave declined.The moderation of the impact of total distortions since 2006,however,suggeststhattheworstoftheimbalanceproblemsarealreadybehindus.

Structural imbalances: consequences of factor-market distortions

Wedonotintendtoanalysethevariousstructural imbalancephenomenaoneby one, since they in fact share the same root cause: asymmetrical marketliberalisationleadstostructuralproblems.

Infact,someeconomistshavealsorealisedthedistortionsonsomeproductionfactors:WangXiaoluregards the lackof social security toberesponsible forrelatively low incomes, andhence, the lowconsumptionof the labour force,ZhangXiangblamestheweaknessinfinancialsystemreformfortheeconomicstructural imbalances, while Xu Xiaonian blames the strict controls on theservicesector.

We,however,thinkitisnotaproblemthatcanbetracedtoasinglemarketorfactor.More importantly, therearedistortions inall factormarketsandsuchdistortionisinfactaproductionsubsidy:labourischeap;capitalischeap;landischeap;energyischeap;producershavefurtherenjoyedtaxexemptions;andtherehasbeennorealchargeforpollution.

Such a production subsidy improves the international competitiveness ofChina’sproductsandpromotesexports,resultingintradesurpluses.Closeto70


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percentofChineseGDPisexternallyoriented(exportsplusimports),comparedwith20–30percent for theUnitedStates andJapan. In fact,our factor-costdistortion estimates provide a reasonably good fit with the current accountbalanceduringthepastnineyears(Figure14.7,bottomright).

Figure 14.7 Estimated cost distortion and structural imbalances

Sources:NationalBureauofStatistics(NBS)variousyears,China Statistical Yearbook,ChinaStatisticsPress,Beijing;CEICData;andauthors’estimation.

Lowcostshavealsostimulatedinvestment.Accordingtotheestimates,capitalwasbyfarthemostimportantitemintotalcostdistortionsduringtheperiodanalysed.Thus, it has been almost impossible for the government to controlthe over-investment problem. The estimated factor-cost distortionfor capitalestimates shows a proper fit with the contribution of secondary industry toGDPgrowth(seeFigure14.7,upperright).Whenpotentialinvestmentreturnsare sohigh, anyNDRC initiatives to slow investment arebound to fail.ThisexplainswhyChinamovedintoheavyindustriessoquicklyintheearlytwenty-firstcenturyeventhoughthegovernmentwasstillhopingtocreatemorejobs.PerhapsitisalsoeasytounderstandwhyurbaninfrastructureissoadvancedinacountrywherepercapitaGDPisonlyslightlyaboveUS$3000.

While cost distortions have been positive for production, investment andexports—that is, they have the effect of subsidy equivalents for producers,exportersand investors—correspondingly, thesedistortionsareequivalent to


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taxesontheownersofthesefactors,mainlyhouseholdsandconsumers.Itcanbeseenthattherisingshareoftheenterprisesector’sincomeinnationalincomehas been accompanied by rising labour-market distortions (see Figure 14.7,upperleft).

Distortedincentiveshavesignificantlyinflatedinvestmentandexportactivities.At the same time, as household income relative to GDP declined over time,consumptionalsoweakenedinevitablyinrelativeterms.Allthesesuggestthatfactor-costdistortionshavebeenafundamentalforcebehindChina’sstructuralimbalances,whichalongsideotherproblemssuchasinefficientresourceuseandpollutioncouldseriouslyaffectChina’sabilitytosustainitsrapidgrowthinthefuture.

Conclusions

Withthereformofitspoliciesandmodernisationofitseconomysincethelate1970s,Chinahasquickly transformed froma large andpoor economy into aglobally influential economic power. Structural risks have, however, alsoincreasedsignificantly.PremierWenandotherseniorleadershaverepeatedlypointed out that the existing growth pattern is unstable, unbalanced andunsustainable.

In fact, thegovernmenthas tried to address theproblemsof growthqualityand structural imbalances—for instance, taking various steps to stimulateconsumption,containinvestmentgrowthandreduceexternalaccountsurpluses.Overall,however,limitedprogresshasbeenmadedespitethesepolicyefforts.OneexplanationisthatChina’sgradualistreformapproachmeansthatchangescanhappenonlyslowly.Meanwhile,asgrowthhasremainedverystrong,thegovernment has been reluctant to do anything drastic to change the courseof theeconomy.More importantly, theparamountvalueof social stability inChinesepolicythinkingprobablyalsodiscouragesanypolicychangethatmightthreatensocialorder.

In order to alleviate the existing structural risks, the authorities need tochange theirpolicycourse. It is critical tounderstand that the root causeofthe imbalances and inefficiency problems is factor-market distortions. Suchdistortions have artificially increased profits from manufacturing productionand quickly turned China into a global manufacturing centre through thesupply of cheap labour, cheap capital, cheap land and cheap resources. Costdistortionshavealsocontributedtooversizedinvestmentandexports.

Therefore,thefundamentalsolutiontodealwiththeimbalanceproblemistoimplementacomprehensivepackageoffactor-marketreforms.Thisessentially


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callsforanendtotheasymmetricalapproachtomarketliberalisation.Steadyliberalisationoffactormarketsandtheeliminationofcostdistortionsshouldbethetopprioritiesforthenextstageofreform.

Infact,theChinesegovernmenthasalreadystarteditsprocessoffactor-marketliberalisation.

Labour-market liberalisation is a fundamental way to stimulate consumptionandsuchliberalisationisalreadyinprogress.ThegovernmenthasplannedtomakenewbreakthroughsinreformingtheHouseholdRegistrationSystemandpropelling urbanisation in 2010. It also intends to extend the social welfaresystemstoallruralresidents.Thecompleteremovalofdistortionsandthereforeofdiscriminationagainstruralworkerswill,however,stilltakesometime.

Thebreakthroughofcapital-marketliberalisationcouldbetheintroductionofmarket-basedinterestandexchangerates.TheCHIBORhasbeenagoodstartingpointfortryingtoformamarket-basedtermstructureforinterestrates.Thefinancial system,however,needs to cater better for theneeds of theprivatesector,whichwillbe thebackboneof theChineseeconomy. Inaddition, theexchangerateregimeshouldatleastbemoreflexible,evenifitisstilltooearlyforanabsolutelyfree-floatingexchangerateregime.

Clearly defined landownership in the countryside could reduce distortionsto landuse.Collectiveownership isvague,creatingroomforcorruptionandhinderingthemodernisationoftheruraleconomy.Inthecities,thegovernmentshould at least stay out of the direct negotiation of land prices and privatepropertydevelopment.

Themarketshoulddetermineenergyprices.Fluctuationsofenergypricescausedifficulties for the economy but international experience suggests that thesecostsaremuchsmallerthanthecostsofinefficiencycausedbypricedistortions.Fromlate2009,theauthoritiesbegantomakeeffortsinadjustingpricesforfuel,gas,electricityandwater.Ifthegovernmentneedstosupportparticulargroupsforspecialreasons,itshouldusefiscalsubsidies,notmessaboutwithprices.

Otherrelatedreformsarealsoneededasasupplementtoabolishcostdistortions.Thestatesectorneedsfurtherreformssoastoshareprofitswithhouseholds.OnewayisfortheStatetocollectmoretaxesfromthestate-ownedenterprises(SOEs) and then redistribute the gains to broader society. More thoroughly,thestate sector shouldgraduallygiveupmuchof itsmonopolypowerorbeprivatised.


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The complete liberalisation of factor markets and the elimination of costdistortions are likely to take years to complete. When completed, they willgenuinelysignalChina’sfulltransitiontoamarketeconomyandwillalsohelplockChina’sgrowthontoamoresustainablepathforthelongrun.

Appendix 14

The Chinese government’s policy to adjust the economic structure

April 2004 – June 2005

ChineserealGDPgrowthacceleratedfrom7.6percentin1999to10percentin2003.Totalfixed-assetinvestmentgrewby43percentduringthefirstquarterof2004.

1) Industrial policy

• reducingagriculturaltaxesforallproductsexcepttobacco

• subsidisinggrainfarmersdirectly

• implementingminimumpurchasepricesforcertaingrainproducts

• raising capital requirements for investment projects in iron and steel,3cement,aluminiumandrealestate.4

2) Land supply

• suspendingtheconversionoffarmlandfornon-farmusesforsixmonths

• tighteningcontrolsoverlandforconstructionpurposes

• reducingatotalof4813developmentzones(2.49millionhectares).

3) Project approval

• closing‘Tie-Ben’steelplantinJiangsuProvince

• nine central government groups inspecting investment projects in steel,cement, aluminium, government office buildings and training centres,urbanfasttrains,golfcourses,conferenceandexhibitioncentres,logisticsparks,largeshoppingcentresanddevelopmentzones

• NDRC terminating 70 600 projects, with total investment of CNY17.3trillion.

3 Raisingtheleastcapitalrequirementratiofrom25percentto40percent.4 Raisingtheleastcapitalrequirementratiofrom20percentto35percent.


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4) Loan controls

• loangrowthslowingfrom21.1percentin2003to12.1percentin2004.

5) Monetary policy

• raisingreserverequirementby0.5percentagepoint,to7.5percent,on25April2004

• increasing one-year base lending rate by 0.27 percentage point to 5.58percenton29October2004,and lendingrates inother termsadjustedaccordingly

• removingceilingsforlendingrates.

6) Environmental protection

• governmentproposaltodeveloparesource-savingsociety

• starting178keyprojectsforenergysaving,watersavingandefficientuseofresources.

June 2005 – June 2006

FromMay2005,thevalueaddedofindustrialproductionbegantodecelerate.Year-on-yeargrowthof industrialprofits slowedbymore than20percentagepoints.Loangrowthalsoweakenedsubstantially.


• abolishing agricultural taxes and taxes for animal husbandry in 28provincesin2005andtheninthewholecountryin2006

• closingalargenumberofcompanieswithhighenergyconsumption,highpollutionandfailingproductionsafetyrequirements

• localising production of certain important products, including largenuclearpowerequipmentandnovel-typecraft

• implementing restructuring measures for 11 industries including steel,coal and cement. Eliminating backward production capacity of 110milliontonnesand1.2milliontonnesincoalandelectrolyticaluminium,respectively.

2) Loan controls

• loangrowthacceleratingfrom9.3percentin2005to15.5percentin2006.


• centralgovernmentrequiringallprovincestoreduceenergyintensityby4percentandthedischargeofmajorpollutantsby2percentin2006(mostfailedintheend)


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• settingupa systemof targets for energyconservationand reductionofpollutantemissions

• conductinganumberofcirculareconomypilots.

April 2006 – June 2008

Again, theeconomyshowedsignsofoverheating.Duringthefirstquarterof2006,realGDPgrowthreached10.2percentandnewloansreachedCNY1.25trillion—morethanhalfoftheannualtarget.


• revitalisingequipmentmanufacturingindustries

• loweringorabolishingexport taxrebates forhighenergyconsumption,highpollutantandresource-intensiveindustries.

2) Project approval

• new policy-tightening controls over new investment projects andconstructionprojectslist

• raisingcapitalrequirementsforcertainconstructionprojects

• central government approval required for all local government projectswithinvestmentofmorethanCNY50million.

3) Loan control

• publishing ‘Regulationsonstrengtheningcontrolof investment infixedassets and newly started projects’ and requiring commercial banks totightencontrolsoverloanextensionforinvestmentprojects.

4) Monetary policy

• raisingthereserverequirementthreetimesandbaselendinganddepositratestwicein2006

• raisingthereserverequirement10timesin2007—to14.5percentattheendoftheyear—andraisingtheone-yearbasedepositratesixtimes,to7.47percentattheendof2007

• raisingthereserverequirementanotherfivetimes—to17.5percentinthefirsthalfof2008.

5) Fiscal policy

• transitioningfromproactivetoneutralfiscalpolicy.



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• closing a large number of ftactories, including 11 200 coalmines, 46.6milliontonnesproductioncapacityofiron,37.5milliontonnesproductioncapacityofsteeland87milliontonnesproductioncapacityofcement

• starting10keyenergy-conservationprojects

• makingabreakthroughincoal-firedpowerplantdesulphurisationproject.

July 2008 – December 2009

Atthebeginningof2008,thegovernmentsetclearpolicygoalsofpreventingoverheatingandavoidinghighinflation;however,theeconomycooledrapidlyinthesecondhalfof2008astheimpactsoftheglobalfinancialcrisishitChina.


• raising export tax rebates seven times5 in2008 and2009, especially forlabour-intensiveproducts

• restructuringtelecommunicationsandairlineindustries

• closingsmallpowergenerators(1669kilowatts)and1054coalmines

• spendingCNY45billiontosubsidisesalesofelectronics,motorbikes,carsandagriculturalmachineryinthecountryside

• reducing50percentofpurchasetaxonsmallcarsandsupportingself-occupationofhousingconsumption

• planning for revitalisation of 10 industries, closing 26 megawatt smallpowergenerators,16.9million tonnesof steelproductioncapacity,74.2milliontonnesofcementproductioncapacity,andsoon

• allocating CNY20 billion to promote 4441 technological transformationprojects

• introducingnewcapitalrequirementsforfixed-assetinvestmentprojects,whichraised5percentagepointsforenergy-intensiveindustries.

2) Project approval

• MinistryofEnvironmentalProtectionstoppedapprovinganumberofnewprojects6on11June2009inordertopreservetheenvironment.

3) Loan controls

• looseningcontrolsovernewloansfromAugust2008,withthetotalofnewloansreachingCNY9.6trillionin2009—almostdoublingtheannualtarget.

5 1August2008;1November2008;1December2008;1January2009;1February2009;1April2009;1June2009.6 IncludingahydropowerdevelopmentprojectontheJinshaRiver,constructionprojectsoftheHuannengandHuadianGroupandsteelindustryprojectsinShandongProvince.


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4) Monetary policy

• loweringreserverequirementsfourtimesandreducingthebaselendingratesfivetimesin2008.

5) Fiscal policy

• announcing CNY4 trillion fiscal stimulus package in October 2008;spending on investment, consumption, imports and exports, real estateandstockmarkets

• public investment reaching CNY923 billion in 2009—an increase ofCNY504billionfromayearearlier.


• continuingeffortsonenergysavingandecologicalprotection,withatotalofCNY42.3billionspentbythecentralgovernmentin2008

• allocatingabudgettosupport2983energy-savingandcirculareconomyprojects

• releasing‘China’sresponsestoclimatechange:policyandaction’

• announcingexplicitlythetargets7andpolicymeasurestocapgreenhousegasemissionsby2020.

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Clive, William R. and John Williams, 2008, “Estimates of the EquilibriumExchangeRateofRenminbi:IsThereaConsensusandIfNot,WhyNot?”,inMorrisGoldsteinandNickLardy(eds.),Debating China’s Exchange Rate Policy,PetersonInstituteofInternational.

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Huang, Y. (forthcoming), ‘China’s great ascendancy and structural risks:consequencesofasymmetricmarket liberalization’,Asian-Pacific Economic Literature.

Huang,YipingandTaoKunyu,2010,“CausesandRemediesofChina’sExternalImbalances”,WorkingPaperSeriesNo.2010002,Beijing:ChinaCenterforEconomicResearch,PekingUniversity.


Wang,X.2010,AnindexoffinancialrepressionforChina,Unpublishednote,ChinaCenterforEconomicResearch,PekingUniversity,Beijing.WingThyeWoo.

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Urbanisation with Chinese characteristics15

Cai Fang and Meiyan Wang

Introduction

Itisuniversallyacknowledgedbyeconomiststhatagriculturalsharesinaggregateoutput and the workforce tend to decline as an economy grows. Economistsagree,however,onlyontheexistenceandinevitabilityofthisphenomenonasaresultofgeneraleconomicgrowth,whilearguingaboutquestionssuchashowthetransformationsofproductionandemploymenthappenduringtheeconomicdevelopmentprocess,whatcharacteriseseachstageofthetransformationandwhat changes are indicative in the transformations. In China, there is littleagreementonthewaythesetransformationstakeplacefromeitheratheoreticaloranempiricalperspective,forthefollowingreasons.

First, the explanations and predictions of development economics vary. Forexample, while Lewis (1954, 1958) considered rural-to-urban migration anintegralpartofdualeconomydevelopmentindevelopingcountries,heinfactassumedthatthisprocesswasaone-waymovement,whereasTodaro(1969)andHarrisandTodaro(1970)vieweditasacircularmovementfollowingarepetitive‘come-and-go’pattern.

Second, there have been dissimilarities with respect to the pattern of thesetransformationsamongcountriesandacrosstime,whichhavemadeitdifficulttodetermineanystylisedfactsaboutthetwotypesoftransformations.WhileJapan, Korea and some other countries accomplished their modernisationthrough massive rural-to-urban migration decades ago, many developingcountries—especiallyinLatinAmericaandEastAsia—havebeentrappedby‘urbandiseases’suchasextremepovertyandslumsinurbanareas.

Third,thechangesinChinahavebeentoofastforscholarsandpractitionerstokeeppacewith.Conventionalwisdom—suchasthenotionofa longstandingandeverlastingexcessivelabourforceinruralareas—preventsobserversfromunderstanding the potential for changing situations in labour demand andsupply.ThisisparticularlyrelevantinChina’scase.


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The reality and dynamics of China’s rural labour shift, and of its turningpoint in particular, can be observed through the theoretical framework ofLewisiandevelopmenteconomics.Equallyimportantistoapplythetheoryofdemographic transition to China to understand the changes in demographicstructurethathavehappenedinthepastdecade.DuetotheimplementationofstrictpopulationcontrolpolicyandsocialandeconomicdevelopmentsinChinainthepastthreedecades,incombinationwithreformandopeningup,rapideconomic growth has been underpinned by a rapid demographic transitionfromhighto lowfertility,andtheconsequent increase inthe labourforceasaproportionofthepopulation.Econometricanalysisshowsthatthedecliningdependenceratiohasaccountedfor26.8percentofpercapitagrossdomesticproduct(GDP)growthduringtheperiod1982–2000(CaiandWang2005).

However,inrecentyearsthemainsourceofgrowthoftheurbanworking-agepopulationhasbeenin-migrationoftherurallabourforce,anditispredictedthatbyabout2015,theout-migratingworking-agepopulationinruralareaswillnotbeabletomeetthedemandfortheworking-agepopulationinurbanareas.Thatis,thetotalworking-agepopulationofthecountryasawholewillstopgrowingbythistimeandbegintoshrinkafterwards.Thedependenceratioofthepopulationwillthenbeginincreasingdramaticallyandtheconventionallyrecogniseddemographicdividendisexpectedtovanish.Thetensionbetweenthis population structural change and strong economic growth has beenreflectedintherecentphenomenaofrisingwagesandashortageofunskilledmigrantworkers.

Setting theLewis turningpoint as amilestoneofdevelopment, a theoreticalandempirical recognitionof theendofanunlimited labour supply inChinacanhelptoidentifythepotentialareasinwhicheffortscanbemadetosustaineconomicgrowthandharmonisethesocietyinthenearfuture.Migrantworkersundoubtedlyareatthecentreofthetheoreticalcognitionandthepolicyfocus.1Inasense,changesinthestatusofmigrantworkerswilldeterminethefuturevisionofeconomicgrowthandsocialstabilityinChina.Inthe20yearsto2030,theconsequencesofChina’sdemographic transitionwillbe further revealed,astheworking-agepopulationstopsgrowingin2015andthetotalpopulationreaches itspeak in2030.ForacountrysuchasChina,whichhasrealised itsrapideconomicgrowththroughfullyutilisinganabundantandcheaplabourforce,thechallengesbroughtaboutbythedemographictransitionhavetobetackledsothecountrycanexploitthepotentialofthedemographicdividendintheshortandmediumrunandtransformitsgrowthpatterninthelongrun.

1 This is truenotonlyforChinabutfor theworld,as is impliedbythefact thatChineseworkerswerechosenas‘PeopleoftheYear2009’byTimemagazine.

Urbanisation with Chinese characteristics

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Thischapterisorganisedasfollows.Thenextsectionexplainstheimplicationsof the Lewis turning point for the labour supply and hence for economicgrowth.Investigatingthetrendsofrural-to-urbanmigrationandmoregenerallabour market changes shows that agriculture no longer serves as a pool ofsurplus labour; rather rural workers’ migration to and settlement in urbanareas has become irreversible and inevitable.The next section discusses theoutdatedpolicyimplicationsoftheTodaroparadoxinthecircumstancesoftheLewis turningpoint.This suggests that there isno reason toexpectacome-and-gopatternofrurallabourmigrationandthattheappropriatepolicychoiceis to push forward with urbanisation by transforming migrant workers intourban residents. The subsequent section shows the urgency and feasibilityof including migrant workers in the urban social security system from theviewpointofgovernmentpolicyorientation.Thechapterconcludeswithsomepolicysuggestions.

The irreversibility of rural–urban migration

Therehasbeenmuchdisagreementaboutwhether(orwhen)Chinahasreached(orwill reach) itsLewis turningpoint (Garnaut andHuang2006;Cai 2008a,2008b;Garnaut2010).Thisisnotallthatsurprisingwhen,accordingtoLewis(1972)andotherauthors(forexample,RanisandFei1961),thereareinfacttwoturningpointsasaconsequenceofdevelopmentinadualeconomy.Theperiodwhen the growth of labour demand exceeds the growth of labour supply—andhencethewagerateofunskilledworkersbeginstorise—isthefirstLewisturningpoint.At thispoint, the agriculturalwage isnotyetdeterminedbythemarginalproductivityoflabour,soaproductivitydifferentialbetweentheagriculturalandmodernsectorsstillexists.Subsequently,thepointatwhichwagesintheagriculturalandmodernsectorsaredeterminedbytheirrespectivemarginal productivities of labour and are equal to each other is the secondLewisturningpoint,whichisreferredtoalsoasthecommercialpoint.Whenaneconomyreachesthelatterpoint,itisnolongeradualeconomy.Thischapterintendstodiscussthefirstofthesetwoturningpoints.

TheLewisturningpointisnot,andshouldnotbe,ablack-and-whitewatersheddistinguishingbetweentwostagesofdevelopment,butisratheratransitionalperiod bridging them—or it can be viewed as the starting point of a newhistoricaltrendinthecourseofeconomicdevelopment(Minami1968).Inthisregard,while2004wasasignificantyearsignallingtheturningpoint,thelongerperiodaround it is the focusof this study. Inwhat follows,weexamine thedifferentcharacteristicsofthelabourmarketbeforeandaftertheturningpoint.


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DuringthestagelongbeforetheLewisturningpoint,sincetherewasalargereservoir of surplus labour in agriculture and the marginal productivity oflabourinthatsectorwasverylow,theshiftofworkersfromagriculturaltonon-agriculturalsectorsdidnotimpactonagriculturalproduction—thatis,labourmigrationatthisstagedidnotcauseasignificantchangeintheproductionmodeinagriculture.Ontheotherhand,becausenon-agriculturalsectorsduringthisstageabsorbed the transferred labour forceonlymarginallyandsporadically,and theurban authorities frequentlydispelledmigrantworkerswhenurbanlabour markets came under pressure (Cai et al. 2001), the agricultural sectorstillservedasapoolofsurpluslabour.WiththearrivaloftheLewisturningpoint,however,circumstanceshaveshownsomefundamentalchanges,whichweexplainasfollows.

First,themethodsofagriculturalproductionhavechangedinresponsetothemassive and unremitting outflow of workers. Such outflow, given its largescale and steady growth, has accelerated agricultural mechanisation andmodernisation and has pushed a transformation of agricultural technologicalchangefrombeingofthelabour-usetypetothelabour-savingtype.Examiningthechangesinagriculturalmechanisationclearlyshowsthistrend.Duringthefirstthreedecadesofeconomicreform,thetotalpowerofagriculturalmachineryhasstrengthened,andevenwiththeenlargedbasethegrowthhasshownnosignofdeclineinrecentyears.Whatismorenotableisthechangedcompositionofdifferentsizedagriculturaltractorsandtractor-towingmachinery.Intheperiod1978–98,whentherewassurpluslabourinagriculture,theannualgrowthinthecapacityoflargeandmedium-sizedtractorswas2percentannually,whilethatofsmall-sizedtractorswas11.3percent.Intheperiod1998–2008,asthemasslabourforceshiftedfromagriculturaltonon-agriculturalsectorsand,asaresult,thereemergedstrongerdemandforlabour-savingtechnologicalchanges,the capacity of large and medium-sized tractors increased by 12.2 per centannuallyandthatofsmall-sizedtractorsdecreasedby5.2percent.Changesinthegrowthratesofdifferentsizesoftractor-towingmachineryshowasimilartrend,withtheannualgrowthrateof largeandmedium-sizedtractor-towingmachineryincreasingfromzeropercentintheperiod1978–98to13.7percentin1998–2008,whereastheannualgrowthrateofsmalltractor-towingmachinerydeclinedfrom12.1percentto6.9percentinthesameperiod.

As a result of falling labour inputs and rising physical capital inputs inproduction,Chineseagriculture’scapital–labourratio—whichisdenotedbytheratioofphysicalinputstolabourinputs—hasrisenrapidlysince2004(Figure15.1). According to the theory of induced technological changes (Hayamiand Ruttan 1980), this labour-saving tendency during the rapid process ofagricultural mechanisation is the natural result of the ultimate abatement ofthe surplus labour force in agriculture. It is hardly surprising that the total


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factorproductivity(TFP)oftheagriculturalsectorhasalsowitnessedarapidriseduringthesameperiod—increasingby38percentbetween1995and2008,withasuddenriseafter2004(Zhao2010).

Figure 15.1 Changes in the ratio of physical to labour inputs in Chinese agriculture

Source:NationalDevelopmentandReformCommissionvariousyears,Compilation of Farm Product Cost-Income Data of China,ChinaStatisticsPress,Beijing.

Second, urban demand for migrant workers has become increasingly rigid.Astheresultofdemographictransition,duringwhichprocesstheurbanagestructurechangesfasterthantheruralagestructure,economicgrowthinurbansectorsdependsheavilyonlaboursupplythroughmigration.Andyet,asshowninTable15.1,whilethetotalnumberofmigrantworkersfromruraltourbanareasforsixmonthsorlongercontinuedtogrowfrom78.5millionin2000to145millionin2009,thegrowthratedecreasedovertime.Inthemeantime,theemploymentofurbanlocalscontinuedtoincrease,anditsgrowthrateremainedconstant. In 2009, nearly one-third of urban employees were rural migrantsand they were dominant in some sectors such as construction. At the sametime,migrantworkerstendtoresideandworkincitiessecularly(Zhangetal.2009).Inanyevent,urbansectorscannolongeraffordaretreatofsuchalargeproportionofthelabourforce.

AccordingtoasurveyconductedbytheNationalBureauofStatistics(NBS)inearly2009,attheendof2008ruralworkersworkinginnon-agriculturalsectorsformorethansixmonthstotalled225million,ofwhich140millionweremigrantworkersacrosstownships,accountingfor62.3percentoftotalfarmers-turned-workers,and85million,or37.7percent,workedinnon-agriculturalsectors


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withinhometownships.Amongmigrantworkers,112millionstillhadfamilymembersinhomevillages,accountingfor79.6percentofallmigrants,while28.6millionmigratedfromhomevillageswiththeirentirefamilies,accountingfor20.4percent(Sheng2009).

Table 15.1 Numbers and growth rates of migrant workers and the urban employed

Year Migrant workers Urban employed

Number(million) Annual growth (%)

Number(million) Annual growth (%)

2001 84 .0 7 .0 239 .4 3 .4

2002 104 .7 24 .7 247 .8 3 .5

2003 113 .9 8 .8 256 .4 3 .5

2004 118 .2 3 .8 264 .8 3 .3

2005 125 .8 6 .4 273 .3 3 .2

2006 132 .1 5 .0 283 .1 3 .6

2007 137 .0 3 .7 293 .5 3 .7

2008 140 .4 2 .5 302 .1 2 .9

2009 145 .0 3 .3 313 .1 3 .6

Source: Data for 2001–08 from: National Bureau of Statistics (NBS) various years, China Statistical Yearbook,ChinaStatisticsPress,Beijing;DepartmentofRuralSurveysvariousyears,China Yearbook of Rural Household Survey,NationalBureauofStatistics,ChinaStatisticsPress,Beijing.Datafor2009fromNationalDevelopmentandReformCommission2010,The Report on the Implementation of the 2009 Plan for National Economic and Social Development and on the 2010 Draft Plan for National Economic and Social Development,TheThirdSessionoftheEleventhNationalPeople’sCongress,Beijing.

The two trends described above have altered the characteristics of labourmigrationaftertheLewisturningpoint.Intheperiodbeforetheturningpoint,thecyclicalchangesofdemandof theurbanandnon-agriculturalsectors forlabouroftenbringaboutareverseriseandfallofthelabourforceengagedinagriculture.Theamountofagriculturalemploymentisnotdeterminedbythesector’sneedpersebutstatisticallyisaresidualtermandthusagriculturestillservesasapoolofsurpluslabour.Aftertheturningpoint,however,fluctuationsin the labour demand of urban and non-agricultural sectors no longer causereverse changes in agricultural employment, because the urban and non-agriculturalsectorsgainthecapacitytoaccommodateshort-termlabourmarketfluctuations.Asaresult,agriculturenolongerprovidesapoolofsurpluslabour.

AsshowninFigure15.2,thecorrelationbetweengrowthratesofnon-agriculturalemploymentandofagriculturalemploymentdiffersstatisticallybeforeandaftertheturning-pointyears.Intheperiodbeforethemid1990s,growthratesofnon-agricultural and agricultural employment showed drastically fluctuating andpositivegrowthrates,becausethe labourforcecontinuedtogrow.Whiletheruralsurpluslabourforcefacedthepressureoftransferandtheconstraintsof


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non-agriculturalemploymentopportunities,thetwoemploymentgrowthratesshowednostablecorrelation.Afterthemid1990s,whilegrowthratesofnon-agriculturalandagriculturalemploymentbecamemorestable,theyalsobecamesignificantly and negatively correlated. During the period 1998–2008, thecorrelationcoefficientbetweenthegrowthrateofnon-agriculturalemploymentand thegrowthrateofoneyear laggedagriculturalemploymentwas–0.748,with declining agricultural employment in most years. The most significantchange happened in 2004 when the high growth rate of non-agriculturalemployment and the negative growth rate of agricultural employment werehighlycorrelated.Inconclusion,whileweconsidertheLewisturningpointtoinfactbeatransitionalperiod,theyear2004isstillindicativeofthatperiodbeginning.

Figure 15.2 Quantitative relationship between agricultural and non-agricultural employment


The end of the ‘Todaro dogma’

Michael Todaro is widely known for his profound research on internalmigrationindevelopingcountries.Hismostinfluentialtheoryistheso-called‘Todaro paradox’ (Todaro 1969; Harris and Todaro 1970). He argues thatit is the differential of expected wages between the rural and urban sectorsthat encourages rural workers to migrate. Since the urban expected wage isadjustedbytheurbanunemploymentrate,theparadoxisthis:effortsmadebythegovernmenttoreducetheunemploymentratewillincreasethedifference


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of expected wages between rural and urban sectors and thus motivate moremigration,whichinturncanleadtomoreunemployment.Afurtherimplicationis that anyeffortsmade to improve the statusofmigrantsworking inurbanareas can encourage more migration, thereby deteriorating the potential formigrants to find employment and residencein urban areas. Accordingly, the‘Todaroparadox’hasbeentranslatedintoa‘Todarodogma’,whichviewslabourmigrationasapatternof ‘comeandgo’,ratherthanofpermanentsettlement,andthustheimplementationofpoliciesaimingtocontrolandevenrestricttheprocessofrural-to-urbanmigrationisregularlyimplied.2

TheTodaroparadox rests on the assumption that there isnounemploymentintheagriculturalsector—namely,thatagricultureisapoolfordepositingthesurpluslabourforce.Correspondingly,theTodarodogmatendstomitigatethesocialriskspotentiallyraisedbylabourmigration,throughbalancingthepushandpull forcesbetween the rural andurban sectors, and especially throughstrengthening the roleof rural areas inabsorbingsurplusworkers.Fromtheviewpoint of economic development, such an assumption is insufficient toconductadynamicanalysis,becauseitfailstotakeintoaccountthefactthattheagriculturalshareofemploymentdeclinesovertimeinthedevelopmentofthedualeconomy.

As mentioned previously, the Chinese economy is already inthe stage ofdevelopment expressedby theLewis turningpoint,which suggests that theTodaroparadoxmightnolongerhold.ThusthereisaneedtorevisethepolicyorientationimpliedbytheTodarodogma.BeforetheLewisturningpointarrived,duringeachperiodwhenurbansectorssufferedacyclicaldownturn,migrantworkers frequently returned to their rural homes and their contracted landprovided themwith shelter and someemployment support.Thatmechanismpreventedfloatingworkersfrombecomingunemployedandhencefallingintoabsolutepoverty.Giventhelackofsocialprotectionformigrantworkers,thishasindeedservedasabufferagainsteconomicandsocialrisks.Onceagriculturedoesnotserveasapoolofsurpluslabour,however,andlabourmigrationnolonger followsa come-and-gopattern, thismechanism for riskalleviationnolongerexists.

The employment adjustment of Chinese migrant workers in the face of theglobal financial crisis resonates with international experience. After a shortbreak during the Chinese New Year period in early 2009, migrant workersimmediately returnedback to theirurban jobs, and through relocation frommanufacturingtoserviceandconstructionsectors,theyachievedcomparativelyfullemployment—somuchsothatamigrantworkershortageoccurredshortly

2 ForanexplanationoftheTodarodogmaandthepolicyimplicationsoftheTodaroparadox,seeTodaro(1985:Ch.9).


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afterwards. This evidently suggests that the management mode of labourmigrationbasedontheTodarodogmaandtheconventionalwisdomofacome-and-gopatternnolongercharacterisethenewstageofdevelopment.

In contrast with the period before the Lewis turning point, when urbangovernments regularly drummed out migrant workers each time their citieshad employment pressure (Cai et al. 2001), during the years 2008–09, ascountermeasures to cope with the negative impacts of the financial crisis onemployment, urban administrators relaxed the restriction on ambulatorypitchmen, which helped migrant workers shift their jobs to the informalservicesectorinthefirstplace.Then,asthegovernment-ledstimulusplanwasimplemented,andsince thestructureof investmenthadbecomemorebiasedtowards infrastructure and services, more and diversified job opportunitieswerecreated(Caietal.2010).

ThisisverysimilartoJapan’sexperienceinthat,afterthearrivalofitsLewisturning point, the massive outflow of rural workers who settled and foundjobsinurbanareasinthe1960shasneverbeenreversed,despiteupsurgesandrecessionsintheurbaneconomysincethen.Duringurbaneconomicdownturnsin the country, workers originating from rural areas have not returned toagriculturalproduction. Instead, incopingwitheachof theeconomiccrises,their employment has been adjusted from the manufacturing to the servicesectorandhasbecomemorediversified.Asaresult,thoseworkershavesettledtobecomeurbanresidents.

Ontheotherhand,Chinesemigrantworkers’willingnessandtendencytoliveandworkpermanently inurbanareascanconflictwith the reality that theylacklegitimateurbanresidentialidentities.Whenurbanenterprisesencounterdifficulties, migrant workers are the first group of employees to be affected.Therefore,whilebeingvulnerableinjobandwagesecurityandinadequatelycovered by social safety nets, they also suffer the worst labour relations.Accordingtoasurveyconductedin2009(Ruetal.2009:7–8),labourdisputecasesacceptedandheardbycourtshadincreasedby30percentinthecountryas awhole andby40 to150per cent in coastalprovinces.Migrantworkersbecame the dominant accusers in those cases, ranging from wage arrears tosocialsecurityentitlements.Thisindicatestheexistenceofsocialriskscausedbyemploymentandincomeinsecurity,ontheonehand,andtheurgentneedforrevisingtheconventionalmodeofregulatingthelabourmarket,ontheother.Thatis,inthenewstageofdevelopmentafterreachingtheLewisturningpoint,urbanisationshouldbedeepenedthroughastrategyoftransformingfarmers-turned-workersintomigrants-turned-residents.

ThemanifestationoftheendoftheTodarodogmaisrapidurbanisation,whichis attributed overwhelmingly to migrant workers becoming secular residents


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in urban areas. Such a rapid urbanisation rate, however, is more statisticalthan material under the unique circumstance of China’s hukou (householdregistration) system.The difference between statistical and real urbanisationsuggeststhatwhilefarmershaveturnedtomigrantworkersandhavecountedasurbanresidents,theyarenotrealcitizensinurbanareas.

In the planning period, when strict hukou control prevented spontaneousmigration, the division of agricultural and non-agricultural hukou identitiesbecameapracticalmethodtodefinewhowerecountedasurbanresidentsandwhowerecountedasruralresidents.Forexample,thesecondandthirdNationalCensuses,conductedin1964and1982,respectively,bothdefinedpeoplewithnon-agriculturalhukouasurbanresidentsandpeoplewithagriculturalhukouasruralresidents.

Withrural-to-urbanmigrationbecomingmoreandmorecommonthroughthereformperiod,andsincehukoureformshavenotkeptpacewiththeexpansionof migration, hukou identity no longer accurately reflects real residence inruralandurbanareas.Inresponsetothis,thefourthNationalCensususedtheconceptof‘usualresidence’todistinguishbetweenruralandurbanresidentsbydefiningpeoplewholefttheirruralhomevillageandlivedinanurbanareaformore thanoneyearasusual residentsof thaturbanarea.After the1990census, theNationalBureauof Statistics adjusted alldatabetween1982 and1990basedon the criterionofone-year residence.ThefifthNationalCensusshortenedpermanentresidencetosixmonths—thatis,thoseruralmigrantswholivedincitiesformorethansixmonthswereconsideredurbanusualresidents,regardless of their place of household registration. As a consequence, thereappearstobealargedifferencebetweentheproportionoftheurbanpopulationandtheproportionofthenon-agriculturalhukoupopulation—adifferenceaslargeas12percentagepointsin2007(Figure15.3).

Due to the fact that a large proportion of the statistically defined urbanpopulationisstillengagedinagriculturalactivity,Chan(2009)claimsthatChina’surbanisation level is overestimated by 10 per cent. Although urbanisationinvolvesashiftfromagriculturaltonon-agriculturalactivities,itismoretypicallycharacterisedbypopulationconcentrationandindustryagglomeration.Hence,the engagement of fractional urban residents in agriculture is not sufficientevidence to conclude that urbanisation is overestimated. Because the hukousystem is a unique institutional arrangement of China’s and there are amplewelfare implicationsbehind it, it ismoremeaningful tounderstandChinese-styleurbanisationwithinthecontextofthehukousystemanditspublicservicecontent.


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Figure 15.3 Usual urban population versus non-agricultural hukou population

Source:NationalBureauof Statistics (NBS)variousyears,China Population and Employment Statistical Yearbook,ChinaStatisticsPress,Beijing.

Thefactthatruralworkerscannowfreelymigratetoandworkincitiessignifiesimportantprogressinreformingthehukousystem—towhichthecurrentlevelofurbanisationcanbelargelyattributed.Inthissense,thepresenturbanisationlevelshouldnotbeconsideredanoverestimate.Accordingly,IdonotagreewiththeargumentsbyChanandBuckingham(2008)thatsuggestthatthecumulativeeffectofthenewroundofhukou reformhasnothingtodowiththeabolitionofthehukou,butmakesmigrationharderthanbefore.Onecanhardlyconcludethat,giventhewidespreademploymentofmigrantworkers inurbansectors,theentitlementsoffreeresidenceinurbanareasand,asaresult,thesubstantialexpansionofmigrantnumbersincities.

The significant increase in the shareof thepopulationwithnon-agriculturalhukou, especially in recent years, is an indication of hukou reform progress.Compared with the period 1990–99, in which the annual growth rate of thenon-agriculturalpopulationsharewas2.3percentandthatoftheurban‘usual’populationsharewas3.1percent,intheperiod1999–2007theannualgrowthrateofthenon-agriculturalpopulationshareincreasedto3.2percentandthatof the urban ‘usual’ population share increased to 3.2 per cent. Both thesegrowthrateswerefastcomparedwiththeworldaverage(Cai2010).However,sincethereisstilladifferencebetweenthetwopopulationgroups—whichisreflectedinthegapofaccesstopublicservicesbetweenfarmers-turned-workersandmigrants-turned-residents—thereisgreatpotentialforfurtherurbanisationthrough narrowing the difference between the ‘usual’ urban population andrealurbanresidents.


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Thisurbanisationpatternisanatypicaloneintermsofequalaccesstopublicservices. Those migrant workers and their accompanying family members,though counted as usual urban residents, are not fully covered by socialsecurityandmorewidelybyotherformsofsocialprotection.Theydonotenjoyequalentitlementstopublicservicessuchassubsidisedhousingandchildren’selementary education.This incomplete urbanisation has depressed the effectofurbanisationoneconomicgrowthandsocialdevelopment.Moreconcretely,becausemigrantworkerswithouturbanresidenceidentitystillconsidertheirrural home as their final destination, they behave like rural residents, whoconsumelessandsavemoreowingtocomparativelylowincomeandthelackofsocialprotection.Atthesametime,urbanconstructiondoesnottake intoaccountmigrants’demandforpublicinfrastructure.Therefore,individualandpublicconsumption,whichwouldhavebecomedemandsourcesforspurringeconomicgrowth,especiallyintheservicesector,havebeenheldback.

Requisite conditions for equalising access to public services

Oneof the changesbrought aboutby theLewis turningpoint ismanifestedinthegovernment’spolicyorientationtowardslabourmigration.TheChinesecentral government has been conceptualised as a typical developmental orentrepreneurialstate(Oi1999;Walder1995),whileChineselocalgovernmentsare seen as being competitive (Herrmann-Pillath and Feng 2004). It is welldocumentedthatunderthedecentralisedfiscalsystem,localgovernmentshavehadstrongincentivestospurlocaleconomicdevelopmentandhavethustriedtoensurethatgovernmentfunctionsinanefficientway.

Local governments have various ways of trying to reach their developmentgoals—from intervention in economic activities to the provision of publicpolicies.Througha‘votewiththeirfeet’model,Tiebout(1956)explainedlocalgovernments’behaviourofprovidingpublicservices,tryingtofinda‘market-type’solutionforpublicgoodsprovision.Thishypothesis implies thatgivenparticularpotentialmigrants’needsandpreferencesforpublicservices,theychoose their destinations based on information available to them on publicservicesprovidedbylocalgovernments.Similarly,bydecidingandadjustinghowtoprovidepublicgoodsandcreatepositiveexternalities,localgovernmentstrytoattractordeterpotentialmigrantsinaccordancewiththeirowndemandandpreferencesforthenumberandcompositionoflocaldwellers.

Although there has been extensive debate about the Tiebout model, thishypothesis does provide a powerful tool for our analysis of the incentivecompatibilityoflocalgovernmentsinmakingpoliciestowardsmigrantworkers,


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as they recognise the increasing importance of migrant workers to localeconomicdevelopment. In thedevelopmentof adual economycharacterisedbyanunlimited supplyof labour, anynumberofworkersdemandedcanbemetwithoutanoticeable increase in thewagerate—namely, the labour forcedoesnotbecomeabottlenecklimitingeconomicgrowth.Therefore,themainarenainwhichlocalgovernments—evenofadevelopmentaltype—intervenein economicdevelopment isnot in labourmarketsbut in attractingphysicalcapitalinflows.

AftertheChineseeconomyreacheditsLewisturningpoint,andlabourshortageshadbegun tooccur regularly,whileemployersbegancompeting forworkersbyincreasingwages,improvingwork-relatedwelfareandworkingconditions,localgovernmentsutilisedvariousmeasurestocreateabetterenvironmentforlocalcitiestoattractworkers.Onenotablepracticeistoincludemigrantworkersundertheumbrellaoflabourmarketinstitutionsandsocialprotection,whichincludesraisingminimumwagestandardsandenhancingthecoverageofsocialsecurityandotherpublicservices.

For example, adjusting the level ofminimumwages is amechanism thathasbeen used frequently in recent years by local governments to intervene inwagesetting.TheminimumwagesschemehasbeenputintopracticesinceTheRegulationonMinimumWagesinEnterpriseswasissuedin1993andtheLabourLaw in 1994. The Labour Law authorised local governments to decide theirstandardsinaccordancewithlocallydifferentiatedstandardsofliving.Earlyoninitsimplementation,minimumwagelevelswerelowandrarelyenhanced,andtheschemewasrarelyappliedtomigrantworkers.Thelevelsofminimumwagesandthe frequencyof theiradjustmentslowly increased,however, in the late1990s,andfurthernoticeablechangeshaveoccurredinthenewcentury.Sincethemigrantlabourshortagebecamewidespreadin2004,thecentralgovernmenthascalledforafrequencyofadjustmentofminimumwagesofnomorethantwoyears.Atthesametime,localgovernments,pressuredbylocallabourshortages,haveleapfroggedtoincreaseminimumwages(Table15.2),whicharenowappliedtomigrantworkersalso.Inthesameperiod,minimumwageshavebeenadjustedinanattempttokeeppacewiththeincreaseinmarketwages.3

3 Cai et al. (2009) depict in detail the trends of increases in migrant workers’ wages, which we take asrepresentativeofmarket-determinedwageratesofunskilledworkers.


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Table 15.2 Adjustments of urban minimum wages (numbers, per cent)

YearNo. of

sampled cities

No. of cities involved in adjustment

Average MWR growth rates of sample cities

Average MWR growth rates of involved cities

1996 129 32 3 .6 (7 .2) 14 .4 (7 .2)

1997 142 80 7 .6 (8 .0) 13 .5 (5 .9)

1998 209 31 2 .4 (6 .4) 15 .9 (7 .7)

1999 227 152 16 .9 (14 .2) 25 .3 (9 .4)

2000 255 79 8 .8 (15 .9) 28 .7 (15 .8)

2001 274 122 9 .2 (16 .8) 20 .7 (20 .0)

2002 286 167 9 .8 (11 .4) 16 .8 (10 .3)

2003 286 77 4 .4 (8 .3) 16 .3 (7 .7)

2004 286 186 15 .6 (16 .6) 24 .0 (14 .9)

2005 286 132 10 .9 (15 .5) 23 .6 (14 .9)

2006 286 253 18 .4 (14 .4) 20 .7 (13 .6)

2007 286 154 10 .8 (14 .3) 20 .0 (13 .9)

2008 286 200 13 .6 (11 .9) 19 .4 (9 .4)

MWRminimumwagerate

Note:Standarddeviationsareinparentheses.

Source: Authors’ calculations based on Institute of Population and Labour Economics n.d., Urban Minimum Wages Database, Institute of Population and Labour Economics, Chinese Academy of SocialSciences,Beijing.

Migrantworkersare,however,stillleftbehindwhenitcomestosocialsecuritycoverage,particularlypensionandunemploymentinsurance.AccordingtotheEmploymentContractLawissuedin2008andotherregulations,migrantworkersareentitledtobeincludedinurbanbasicsocialsecurity.Theparticipationrateofmigrantworkersinsocialsecurityprogramsis,however,ratherlow.AsurveyconductedbytheNBSin2009showsthatonly9.8percentofmigrantworkerslivingincitiesformorethansixmonthsparticipatedinbasicpensionprogramsand3.7percentinunemploymentinsuranceprograms(Sheng2009).Sincethereisnolegalhandicapformigrantworkerstoparticipateinvarioussocialsecurityprograms,thewillingnessofworkersandemployerstojoinrestslargelyoneachscheme’sdesign.Beforeconceptionsofschemedesigncanbedecisivelyaltered,localgovernmentscanfindsomealternativesiftheyarewillingtoexpandthecoverageofpublicservicesinordertoattractmorelabour,andthatcanalsobringforthsocialsecurityreformforthecentralgovernment.Itisthereforeimportanttoconsidertheinteractionbetweentherightconditionsforequalisingmigrantworkers’rightstopublicservicescreatedbythearrivaloftheLewisturningpointandthepracticesofthecentralandlocalgovernmentsinrelatedarenas.

The general concerns about including migrant workers in the urban socialsecuritysystemhavebeenthreefold.First,authoritieshavelongbeenconcerned


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withtheburdenofmigrants’participationontheaffordabilityofsocialsecurityfunds. Second, as for the migrant workers’ and employers’ incentives toparticipate in the programs, the fact that not all social security schemes areportableandtransferableacrossregionshasdeterredmigrantworkersandtheiremployersfromparticipating,sincemigrantworkers’employmentisnotstable.Third, the high contribution rates required have reduced affordability andhencetheincentivesforemployerstoparticipateintheprograms.

Turningtopensions,theconditionsforaninclusivebasicpensionsystemhavemellowed.Thecurrentbasicpensionsystemforurbanenterpriseshastwoparts:socialpoolingandindividualaccounts.Thesystemwasformedin1997andithaslongmixedupthepoolingandindividualaccounts,becausetheinadequacyof social pooling was required to be compensated by individual accountcollection.Thatcausedaproblemofemptyindividualaccounts,andthesystemis indeedapay-as-you-go typewithonlyanominal fullyfundedcomponent.The problem of inadequacy of the social pooling accounts is twofold. First,a huge historic debt was accumulated during the pre-reform period, duringwhichtherewasnoaccumulationforworkers’pensionfunds,sincetheStateguaranteedretirementsupportforallstate-ownedenterprises’employees,whooverwhelminglydominatedurbanemployment.Second,thedependenceratiohasincreasedsincetheinitiationofreformandisexpectedtogrowovertime,accordingtodemographicpredictionsmadebytheUnitedNations(UN2009).

Therehave,however,beensomesignificantchangesinthesysteminrecentyears.First,manyofthe‘middlemen’(thosewhohadnotyetretiredin1997)retiredandwerewellsupportedbythesocialpoolingpension,alongsidewiththe‘oldmen’(thosewhoretiredbefore1997).Thatis,alargeportionofhistoricaldebtisdisappearingastimepasses.Second,asthepilotprogramforbasicpensionsystemreformaimedatsubstantiatingindividualaccountsinLiaoningProvincehasbeencompletedandextendedto11moreprovinces, individualaccountshaveaccumulated,which is reflected in thecurrentpositivebalanceofmoretheRMB700billionintherevenuesandexpendituresofthebasicpensionfund.Third,migrantworkerswhoseagesareconcentratedbetweentwentyandthirtyhavebecomewidelyengagedinurbanactivity,whichsignificantlyreducesthedependenceratiooftheretiredtoworkingpopulation—thatis,migrantworkersnotonlycontribute to socialpooling, theybuilda full individual account iftheycanbeincluded.Withallthesechangesreflectingpositiveimprovementsinthebasicurbanpensionsystem,whenafullerinclusionofmigrantworkersinthesystemcanbereached,thefinancialdifficultiesofthesystemwillnotbeaggravatedbutsubstantiallyeased(CaiandMeng2003).

The lackofportabilityhasbeen thedecisiveconstraintonmigrantworkers’incentivestoparticipateinthebasicpensionsystem.Thebasicpensionfundwasnotbuiltattheprovinciallevelin19provincesanditwasnotevenatthe


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municipal level in some regions until 2007.The low levels of social poolinghaverestrictedtheportabilityofbasicpensionsandpreventedhighlymobilemigrant workers from transferring their pension contributions. As a result,whenamigrantworkerchangeshisworkplace,hehastosurrenderhispensioncontribution; and when labour market shocks happen, a mass of migrantworkersretreatsfromtheprogram.Giventhatonlytheindividualaccumulationbutnotthepooledcontributionisrefundable,neitherthemigrantworkersnortheiremployershavemuchincentivetoparticipate.

In order to tackle this problem, the central government has recently issued‘InterimMeasuresontheTransferofContinuationofBasicPensionforUrbanEnterprises Employees’, which stipulates that all workers who participate inthebasicpensionprogram,whenmigratingacrossprovincialboundaries,willbeguaranteedatransferoftheirindividualandpoolingaccountstotheirnewworkplace.Thisnewregulationprovidesinstitutionallyguaranteedportabilityformigrantworkers’pensionentitlements.

Asmallfractionofmigrantworkershassofarparticipatedintheunemploymentinsurance program.While the Employment Contract Law came into effect in2008—requiring employers to sign contracts with migrant workers so thatthelattercouldbeincludedinvarioussocialsecurityprograms—governmentdepartmentsholdingontotheTodarodogmaandhenceconsideringmigrantworkersahighlymobilegroupofworkershavenothadastrongincentivetoenforcethisregulation.Thatis,theauthoritiesexpectthatsuchhighmobilitymight cause circumstances in which migrant workers contribute less to andbenefit more from the program. As discussed earlier, the Todaro dogma ispreventing an accurate understanding of migrant workers’ real status in thelabourmarket.

Thecurrentunemploymentinsuranceprogramrequiresaminimumcontributionperiod of one year and warrants a period before benefiting of one to twoyears. Migrant workers’ employment features are not incompatible with thisregulation.Accordingtoarecentsurvey(Zhangetal.2009),onlythosemigrantworkerswhoenteredcitiesforlessthanoneyear,andaccountfor11percentofallsamples,changedtheirjobsandcitieswithinayear.Allotherswhomigratedoutofruralareasformorethanoneyearchangedjobsandcitiesofemploymentlessthanoncewithinayear.Andthelongerthemigrantsstayedinacity,theless frequently they changed their jobs or cities (Table 15.3). Furthermore,migrantworkersusuallyacceptlowreservationwagesandlesssatisfyingjobs,sotheytakelesstimetofindanewjobonceencounteringunemployment.Inconclusion,thelabourmarketstatusofmigrantworkerscanperfectlymeettherequirementsoftheminimumtimeofcontributingandthewarrantedtimeofbenefiting.


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Table 15.3 Duration of migrating work and mobility of migrant workers (numbers, per cent)

Years Effective nos of people surveyed

Proportion of total

Numbers of annual job change

Numbers of annual city change

<1 362 11 4 .00 3 .89

1–3 658 20 0 .87 0 .76

3–5 454 14 0 .50 0 .42

5–8 475 15 0 .34 0 .27

>8 1268 39 0 .18 0 .14

Total 3217 100 0 .82 0 .75

Source:Zhang,X.,Tian,M.,Liu,F.,Gao,Y.,Chen,L.andHu,X.2009,Surveyreportofmigrantworkers’pension system, International Conference on Migrant Workers’ Pension System, Ministry of HumanResourcesandSocialSecurity,Beijing,15–16September.

Since2003,therevenueoftheunemploymentinsurancefundhassignificantlyoutweighed the expenditure of the fund, so the balance accumulated toRMB128.8billionby2008,whichwasfivetimesthetotalexpenditureofthesameyear.Asapay-as-you-gotypefund,consecutiveexcessesofrevenueoverexpenditurearenotnecessarilyadvisable,particularlywhenahugesurplushasbeen accumulated. It is such an overrun that causes an asymmetry betweenthe contributions and benefits of potential participants and reduces theincentivetoparticipate.Therefore,itisfeasibletoadjustthecontributionrateofunemploymentinsuranceinordertoenhanceincentivestoparticipateandtoexpandthecoverageoftheprogram.Thisisanexampleofstrengtheningthelevelsofsocialprotectionformigrantworkers.

In fact, as local governments have begun to recognise the need to increasesocialprotection to increasingly scarceworkers, localgovernmentauthoritiesfor labourandsocialsecurityhavetendedtoflexiblyadjustthecontributionrates of various social security programs, which the central government islegallyrequiredtoadjust.Whiletacklingtheglobalfinancialcrisis,thecentralgovernmentintroducedaseriesofemploymentsupportpolicies,whichallowedqualifiedenterprisestopostponetheirpaymentsofsocialsecuritycontributionsandreduceworkers’contributionstosocialsecurityfunds.Takingadvantageof the temporary flexibility, local governments in some regions—especiallythosewherelabourshortageshadbeenstronglyfeltbeforethefinancialcrisisoccurred—increased the social security coverage of migrant workers bydebasingthecontributionratesduringtheperiod.

Moreover, one can observe a host of phenomena that had rarely happenedbeforetheshortageofordinaryworkersbecamewidespreadacrossthecountry.First,localgovernmentsinlabour-migrationdestinationshavetriedtoestablish


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formal coordination mechanisms with their counterparts in labour-sendingregionsinordertohelplocalenterprisessecureastablesupplyoflabour.Second,some municipal governments have relaxed certain criteria—such as the sizeofpurchasedhousing, the lengthof employment contracts andaccumulativeyearsofcontributingtosocialsecurityprograms—formigrantstoobtainurbanhukou. All these efforts have been made mainly by local governments andindicateincentivecompatibilityinpeople-centredurbanisation.

Conclusions

Thecombinationofarapiddemographictransitionfromhightolowfertility,aninstitutionaltransitionfromaplannedtoamarketeconomyandacontinuingtransitionfromadualsocietytoanintegrativeonehascontributedsignificantlytothe‘Chinesemiracle’thathasreceivedworldwideattention.Suchacompressedprocessofsocioeconomicdevelopmentandinstitutionaltransitionprovidesaninteresting case for studies ofdevelopment in adual economy.The fact thatChina’sdevelopmentofadualeconomyispassingthroughtheLewisturningpointhas injectednewlife into theeconomicdevelopment theorycoinedbyArthur Lewis. The application of other relevant paradigms in developmenteconomics to the China case helps us to assess the stage of, and to identifychallengesandopportunitiesfacing,China’ssocioeconomicdevelopment.

As a result of the arrival of the Lewis turning point, migrant workers havebecomeanindispensablesourceof labourforurbansectors—inotherwords,non-agriculturalsectors’demandformigrantworkershasbecomeunvarying,or rigid. Since agriculture no longer provides a pool of surplus labour andlabourmigrationnolongerdemonstratesacome-and-gopattern,thereisaneedfor synchronisationbetweenurbanisation and industrialisation.WhileChinahasurbanisedattheworld’sfastestpaceinrecentdecades,thisspeedcanbeattributedtocountingmigrantsasdefactourbanresidents,wholiveincitiesformorethansixmonthsbuthavenoformalaccesstopublicservicesduetotheirlackoflocalhukou.

Nowthattheexistingexclusivenessofurbanpublicservicesprovisionisrootedinthehukousystem,theextensionofthoseprovisionstomigrantworkersshouldlogicallyinitiatefrom hukousystemreform.Becausemanymunicipalitieshavelittlefinancialcapabilitytocoverallmigrantswithequalprovisionofpublicservices—such as social security, migrant children’s compulsory educationand entrance to higher education and subsidised housing—and while therehas been some hukou reform in some cities, there has not been a significantbreakthroughoverall.The hukousystemis,however,significantonlybecauseofitsaffiliationwithvariousurbanpublicservicesthatfavourresidentswith


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localhukouidentity.Underthecircumstanceoflabourshortage,andinpursuitofattractingandkeepingmigrantworkers,developmental localgovernmentswill change their function to focusmoreon equalpublic servicesprovision.Whennon-hukoumigrantworkersandtheiraccompanyingfamiliescanenjoymore equal rights to urban basic public services, the hukou per se becomeslessmeaningful.Thatis,realhukoureformcanbeembodiedintheprocessoftransformingfarmers-turned-workersintomigrants-turned-residents.

Compared with other developing and transitional countries, in China, thehukousystemisunique.China’sdevelopmentofadualeconomyhasthereforebeencharacterisedbythetransformationoffarmerstourbanworkerswithoutentitlementtopublicservices,particularlyregardingaccesstosocialprotection,whichhasdrivenrapidurbanisationwithChinesecharacteristics.Asreachingthe Lewis turning point brings about a labour shortage, a new round ofurbanisationwithChinesecharacteristicswillbeshiftingtowardstransformingmigrantworkersintoentitledresidents.JustasChina’sdevelopmenthasalreadycreatedthelargestnumberoffarmers-turned-migrantworkersinhumanhistory,itcanalsobeexpectedtocreatethelargestnumberofmigrants-turned-urbanresidentsintheworldinthenexttwodecades.

References

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Cai,F.2010,‘Howmigrantworkerscancontributetourbanization:potentialsofChina’sgrowthinpost-crisisera’,Chinese Journal of Population Science,no.1,pp.2–10.

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Cai, F., Du,Y. andWang, M. 2001, ‘What determines hukou system reform?AcaseofBeijing’,Economic Research Journal,vol.12.


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Cai, F., Wang, D. and Zhang, H. 2010, ‘Employment effectiveness of China’seconomic stimulus package’, China & World Economy, vol.18, no.1,pp.33–46.

Chan,K.W.2009,UrbanizationinChina:whatisthetrueurbanpopulationofChina?WhichisthelargestcityinChina?,Unpublishedmemo.

Chan,K.W.andBuckingham,W.2008,‘IsChinaabolishingtheHukousystem?’,The China Quarterly,vol.195,pp.582–606.

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Indigenous innovation for sustainable growth16

Yanrui Wu

Introduction

After three decades of rapid growth, the Chinese economy is now at thecrossroadsheadingtothenextphaseofdevelopment.WhileChina’seconomicgrowthhas indeedbeenphenomenal, ithasalsobeenresource intensiveandenvironmentallydamaging.Tosustainhighgrowthinthecomingdecades,theroleoftechnologicalprogresshastobeboosted.Technologicalprogresswithinacountrycanbeduetotechnologytransferfromabroadorindigenousinnovation.TheformerhasbeenwidelydiscussedintheliteratureontheChineseeconomy.Forexample,WeiandLiu(2006)examineproductivityspill-oversfromexportsandforeigndirectinvestment(FDI)intheChinesemanufacturingsector,Tian(2007) and Liu et al. (2009) investigate technology spill-overs from FDI andmultinationalcorporationsandKuoandYang(2008)analyseknowledgespill-oversandregionaleconomicgrowth.TheinnovationcapacityandachievementsofindigenousfirmsinChinaare,however,under-documented.1Theobjectiveof this chapter is to examine China’s indigenous innovation capacity and toexplore the potential for innovation to provide a key source of sustainablegrowthinthefuture.ThechapterbeginswithareviewofChina’sinnovationcapacityandachievements.Thisisfollowedbyananalysisofinnovationatthefirmlevel.Subsequently,China’sinnovationisexaminedfromaninternationalperspective, before discussing the implications for sustainable growth in thecountry.

China’s innovation capacity and achievements

Chinahasadoptedanactivescienceandtechnologydevelopmentprogramsincethe foundationof thePeople’sRepublic in1949.Theprogramhas longbeenbiased towards technologicaladvancement indefence-relatedsectors.Science

1 GeneralsurveysofChina’sresearchanddevelopmentsectorsareavailable inGaoandJefferson (2007);OECD (2009); and Zhang et al. (2009). Wei and Liu (2006) and Jin et al. (2008) also cover research anddevelopmentmarginally.


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andtechnologyasimportantsourcesofeconomicgrowthmoregenerallyhavebeenrecognisedandpromotedonlyrecently.This isclearlyenvisaged in thecountry’s‘NationalMediumandLong-termProgramforScienceandTechnologyDevelopment(2006–2020)’releasedinearly2006(hereafter,the‘2020program’).2Theaimofthe2020programistomakeChinaaninnovation-orientedsocietyby2020andoneoftheworld’sleadinginnovatorsinthelongerterm.

ThekeygoalsandprioritiesinChina’sscienceandtechnologydevelopmentinthecomingdecadearedetailedinthe2020programdocument.Accordingtothisdocument,Chinawill:

• give priority to technological development in 11 major sectors such asenergy,waterresourcesandenvironmentalprotectioninthecoming15years

• further improvethenational intellectualpropertyrights (IPR)systemandstrengthentheenforcementofIPRprotectionlawsandregulations

• encourage enterprises to play the key role in innovation through theirinvolvementinstateprojectsandtheprovisionoftaxincentivesandotherfinancialsupport

• boost investment in science and technology; by 2020, China’s researchanddevelopment expenditureswill account for about 2.5per cent of thecountry’sgrossdomesticproduct(GDP)

• by2020,derive60percentormoreofitseconomicgrowthfromtechnologicalprogress; thenumbersofpatentsgranted to and total citationsof journalarticlesbyChinesenationalsareexpectedtoberankedamongthetopfiveintheworld.

To provide an assessment of China’s indigenous innovation capacity, severalindicatorscanbeconsidered.Themostimportantfactorunderlyingindigenousinnovation is research and development spending. Associated with theimplementationofthe2020programhasbeenadramaticincreaseinresearchanddevelopmentexpenditure in recentyears.Forexample,during2005–09,researchanddevelopmentexpendituregrewatanaveragerealrateof19.4percent—twice as fast as the growth of China’s GDP.3 As a result, research anddevelopmentexpenditureasaproportionofGDP(orresearchanddevelopmentintensity)inChinarosefrom0.71percentin1990to1.62percentin2009(Figure16.1).The same figure also illustrates that China’s research and developmentpersonnelincreasedfromabout670000(full-timeequivalent)peoplein1992to1.9millionin2008.Thisgrowthwasparticularlyrapidinrecentyears,withan

2 The2020programwas releasedby theStateCouncil,People’sRepublicofChina,on9February2006(<www.gov.cn>).3 The average growth rate of research and development expenditure is calculated using data from NBS(2009,2010)andYST(2009).

Indigenous innovation for sustainable growth

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averagerateof13.4percentduring2005–08.Inaddition,thenumberoffreshgraduatesinscience,engineeringandmedicineincreasedfrom476110in1995to2.7millionin2008(NBS2009).

Figure 16.1 China’s research and development intensity and personnel, 1990–2009

Sources:NationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChtinaStatisticsPress,Beijing;NationalBureauofStatistics(NBS)2010,2009 Statistical Communiqué of National Economic and Social Development,NationalBureauofStatistics,Beijing;YHT2009,China Statistical Yearbook of High Technology Industry 2009,NationalBureauofStatisticsandMinistryofScienceandTechnology,ChinaStatisticsPress,Beijing.

With the expansion of research and development inputs, China’s innovationcapability and outcomes have increased too. For example, the numbers ofdomestic patent applications and registrations grew from 69 535 and 41 881items in 1995 to 878 000 and 502 000 items in 2009, respectively (Figure16.2).Duringthesameperiod,thenumberofChineseapplicationsforpatentregistrationoffshorealsoincreased—from13510toabout99000items,withthenumberofregisteredpatentsrisingfrom3183to80000(NBS2009;MST2010). Inaddition, it is reportedthat thenumberofpublicationsbyChinesescientistsandengineers increased from65000 to208000between1995and2007.4

There are considerable variations among the Chinese regions. Among the 31administrative regions in China, research and development intensity variedfromlessthan0.5percentinsixregionstomorethan2percentinfourregionsin 2008 (Table 16.1). In terms of human resources, the number of researchanddevelopmentscientistsandengineerspermillionpeoplerangedfrom161

4 Thosenumbersarebasedonthesciencecitationindex(SCI),engineeringindex(EI)andindextoscientificandtechnicalproceedings(ISTP)databases,accordingtoYST(2009).


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inTibet to9833 inBeijing.Table16.1also shows that thenumberofpatentregistrationspermillionpeoplewasbetween32inTibetand1296inShanghaiin2008.Ingeneral,largedisparitiesexistbetweenthecoastalregionsandtherestof thecountry (that is, thecentralandwesternregions).Furthermore, ifthenumberofpatentregistrationsper1000scientistsandengineersisdefinedas an indicator of research and development performance then, in general,provincial-level performance and inputs are positively related—as expectedandasdepictedinFigure16.3.Thefigurealsohighlights,however,twoclearoutliers, with Beijing underperforming and Zhejiang achieving an excellentperformancein2008atleast.

Figure 16.2 Numbers of patents applied for and accepted, 1995–2009

!

0

200

400

600

800

1000

1200

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Year

10

00

pie

ces

Application

Acceptance

Sources:NationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing;NationalBureauofStatistics(NBS)2010,2009 Statistical Communiqué of National Economic and Social Development,NationalBureauofStatistics,Beijing;MinistryofScienceandTechnology(MST)2010,China Science & Technology Statistics,MinistryofScienceandTechnology,Beijing,<www.most.gov.cn>

Table 16.1 China’s regional research and development statistics, 2008

Regions Expenditure over GRP (%)

Scientists and engineers per

million population

Number of patents per million

populationCoastal mean 1 .96 2830 601

Beijing 5 .25 9833 1047

Shanghai 2 .59 4212 1296

Tianjin 2 .45 3293 577

Jiangsu 1 .92 1887 579

Zhejiang 1 .60 2067 1034

Liaoning 1 .41 1538 247

Guangdong 1 .41 2186 650

Shandong 1 .40 1408 283

Fujian 0 .94 1345 220

Hebei 0 .67 535 79

Middle mean 0 .85 731 84


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Hubei 1 .31 1103 147

Anhui 1 .11 655 71

Heilongjiang 1 .04 1168 120

Hunan 1 .01 604 96

Jiangxi 0 .97 540 52

Shanxi 0 .90 974 67

Jilin 0 .82 1085 109

Henan 0 .66 583 97

Guangxi 0 .46 426 46

Hainan 0 .23 172 40

Western mean 0 .81 597 80

Shaanxi 2 .09 1352 117

Sichuan 1 .28 768 164

Chongqing 1 .18 995 170

Gansu 1 .00 593 40

Ningxia 0 .69 694 98

Guizhou 0 .57 257 46

Yunnan 0 .54 357 44

Inner Mongolia 0 .44 647 55

Qinghai 0 .41 377 41

Xinjiang 0 .38 366 70

Tibet 0 .31 161 32

Sources:NationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing;YST(2009).

Innovation at the firm levelChinese enterprises have played an important role in promoting growth inthe country’s innovation capacity. Since the mid 1990s, Chinese enterpriseshavebecometheleadingplayersinresearchanddevelopmentinvestmentandexecution(NBS2009).By2008,theywereaccountingformorethan70percentof the country’s research and development investment and spending (Figure16.4).Thisgrowthisalsoreflectedinthechangingshareofpatentsregisteredbytheenterprisesectorcomparedwiththenationaltotal.Thisshareincreasedfrom12percentin1995to34percentin2008.5TheexpandedroleofChineseenterprises could, however, have led to more market-driven research anddevelopmentinvestment.Thisisreflectedinthemovementoftwoindicators.First,theshareofbasicandappliedresearchexpenditureovertotalresearchanddevelopmentspendingdeclinedfrom32percentin1995to17percentin2008

5 ThosesharefiguresarecalculatedusingChina’spatentdata(NBS2009).


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(NBS2009).Second,theshareof‘invention’patentsovertotaldomesticpatentsregisteredpeakedat25.9percentin2004andhassincefallen,reaching22.7percentin2008(NBS2009).6Thechallengeaheadforpolicymakersistoensurethatmarket-orientedresearchanddevelopmentactivitiesdonotgrowattheexpenseoflong-terminnovationcapacitybuildinginthecountry.

Figure 16.3 China’s research and development intensity and performance, 2008

Note:Researchanddevelopmentefficiencyisdefinedasthenumberofpatentregistrationspermillionscientistsandengineers.

Sources:ResearchanddevelopmentintensityandefficiencyvaluesarecalculatedusingdatafromNationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing;YST2009,China Statistical Yearbook of Science and Technology 2009,NationalBureauofStatisticsandMinistryofScienceandTechnology,ChinaStatisticsPress,Beijing.

Figure 16.4 China’s research and development expenditure shares and sources of funds, 2008

Expendituresshares Sourcesoffund

Source:NationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing.

Intermsofinnovationactivitiesandefforts,heterogeneityexistsacrosssectorsaswellasamongfirms.TheNationalBureauofStatistics(NBS)conductedthefirstnationalsurveyoffirminnovationactivitiesin2007.Detailedinformation

6 Chinesepatentsaregenerallygroupedintothreecategories:inventions,utilitymodelsanddesigns.


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about firm-level innovation activities was collected over a three-year period(2004–06).Thesurveycoveredalllargeandmediumfirmsandasampleofsmallfirms.7Amongthe299995firmssurveyed,therewere2674largefirms(0.9percent), 29 622 medium firms (9.9 per cent) and 267 699 small firms (89.2 percent).Only86342firms—lessthanone-thirdofthetotal—wereinfactengagedininnovationactivities(NBS2008).Accordingtothesurvey,largefirmswerefoundtohavethehighestrate(83.5percent)ofparticipationinresearchanddevelopmentactivities,followedbysmall(25.2percent)andmedium(55.9percent)firms.Attheindustrylevel,thetopfivesectorsintermsofparticipationrates were pharmaceuticals (63.7 per cent), instruments and office machines(60.7 per cent), tobacco (55.2 per cent), communication and other electronicequipment(46.8percent)andspecialmeasuringinstruments(46.5percent).8Allofthesesectorsotherthantobaccobelongtotheso-calledhigh-technologysector.9

Onaverage,innovativefirmsin2006spentabout1.9percentoftheirbusinessincomeon innovation.Thoughthisfigure is larger thanChina’sresearchanddevelopment intensity, there is huge disparity among firms. Large firms onaverage investedabout2.7percentoftheirbusiness incomeonresearchanddevelopment,whichiswellaheadofthemedium(1.8percent)andsmallfirms(1percent)(NBS2008).Thelargeandmediumenterprises(LMEs)asagroupaccountedfor81.1percentoftotalexpenditureoninnovationin2006.Theyalsohadavalueshareof78.7percentintheoutputofnewproducts,whichcouldbeusedasanalternativeindicatorofinnovationoutcome.Forthisreason,moststudiesof innovationatthefirmlevel inChinafocusonLMEs(suchasJeffersonetal.2003;Girmaetal.2009).

Theanalysisbelowprovidesastudyofresearchanddevelopmentdeterminants,strategiesandintensityinChinesefirmsusingpaneldatafor19880LMEsfortheperiod2005–07.10Threedifferentyetrelatedmodelsareestimated.Thesemodelsinturndealwiththreeissues—namely,thedeterminantsofinnovation,thechoiceofresearchanddevelopmentstrategiesandtheintensityofresearchand development spending in Chinese firms. The baseline model can bepresentedasEquation16.1.

7 AccordingtotheofficialEnterpriseClassificationStandardsadoptedin2003,Chinesefirmsaregroupedusingthreecriteria:thenumberofemployees,salerevenueandvalueofassets.Forexample,thenumberofemployeesisabove2000forthelargefirms,between300and2000forthemediumfirmsandbelow300forthesmallfirmsinthemanufacturingsector(<www.stats.gov.cn>).8 ThepercentagefiguresinparenthesesaretheratesofparticipationinresearchanddevelopmentactivitiesaccordingtoNBS(2008).9 TheNationalBureauofStatistics(NBS)releasedacirculartointroducetheCatalogue for High-technology Industrial Statistics ClassificationinJuly2002(<www.stats.org.cn>).10 SeeWu(2010)foramoredetailedpresentationanddiscussion.


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Equation 16.1!

InEquation16.1, *Y isa latentvariable thathasavalueofunityorzero forthe first two models (that is, the determinants of innovation and choice ofresearch and development strategy models) and measures firm-level researchanddevelopmentintensityinthethirdmodel(thatis,theintensityofresearchanddevelopmentspendingmodel).Thelaggedvariables(X)capturetheeffectsof theageandsizeofeachfirm, its levelof liabilityordebtburden, levelofproduction technology, intangible assets and long-term investment. The X-variablesarelaggedoneperiodtoavoidpotentialsimultaneityproblemsinthemodels.Specifically,thesevariables(X)aredefinedasfollows

• AGEissimplytheageofthefirm(yearsinexistence)

• SIZEreflectsthesizeofthefirm,measuredusingthenumberofemployees11

• DEBTmeasuresthedegreeofliability,definedastheratiooftotalliabilityoverthetotalvalueofassets

• TECHcapturestheleveloftechnologyinproduction,measuredbytheratioofthenetvalueofassetsoveremployment(thatis,thecapital–labourratio)

• INTANGreflectswhetherafirmhasintangibleassets(suchaspatents);itisdefinedas1ifthefirmhasintangibleassetsandzerootherwise

• INVEST takes thevalueof1 if afirmhas long-term investmentandzerootherwise.

Other independent variables—namely, the Z variables in Equation 16.1—areintroduced to reflect firms’ productivity performance and exporting status,industryconcentrationandvariationsacrossfirmswithregardtoownership,location,industryandtime.Thesevariables(Z)include

• EFF,whichisanindicatoroffirmefficiency,measuredsimplybythefirms’labourproductivity—thatis,theratioofoutputvalueovertotalemployment

• EXP,whichisabinaryvariableandhasavalueof1ifafirmisengagedinexportingandzerootherwise

• theHerfindahlindex(HERFINDAHL),whichiscomputedtomeasurethelevelofcompetitionorconcentrationofbusinessactivitiesinasector;thecalculation is based on the four-digit classification of Chinese industrialsectors

• four ownership dummy variables, which are included to represent firmsownedorcontrolledthroughmajorityshareholdingbytheState,investors

11 Thereare,ofcourse,othermeasuresoffirmsizesuchastotaloutputvalue,thevalueoftotalsalesandsoon.Thenumberofemployeesischosensothatfewobservationsaredroppedduetomissingdata.


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from Hong Kong, Macau and Taiwan (HMT), foreign investors andshareholders(versusallotherfirms)

• fivedummyvariables,whichcapturevariationsamongfirmslocatedintheareasofBeijing,Shanghai,PearlRiverDelta,thesix‘middle’provinces,thethree north-eastern provinces and western China, with the north-easternprovincesbeingchosenasthereferenceregion12

• 11 sector dummy variables to reflect potential sectoral differences amongthefirms,whicharecategorisedinto12industrysectorsonthebasisoftheofficialStandardIndustryClassification(SIC)grouping.

TheestimationresultsofthethreemodelsarepresentedinTable16.2.Accordingto the results of Model 1, large or old firms are more likely than others toinvest in innovation. Exporters and capital-intensive firms also have higherprobabilitiesofspendingonresearchanddevelopment—asarefirmswithlong-terminvestments,intangibleassetsandbetterperformance(intermsoflabourproductivity).Theprobability of innovation tends to increase over time andthatmore competition increases initially and then reduces theprobabilityofinnovation.Thisisconsistentwithevidencefromothereconomies(Aghionetal.2005;TingvallandPoldahl2006).Firmsthatarelesslikelytoinvestinresearchanddevelopmentareoftenburdenedwithheavydebtorownedbyoffshoreinvestors—inparticular, investors fromHongKong,Macau andTaiwan.ThelatterhavealargepresenceinthePearlRiverDeltaregion.Thisfindingimpliesthatthecountry’sforeigninvestmentpoliciesmightnotbeprovidingincentivesforforeignfirmstoinvestinresearchanddevelopmentinChina.

Table 16.2 Econometric estimation results

Model 1 Model 2 Model 3Variables Coefficients p-values Coefficients p-values Coefficients p-values

Intercept –2 .2088 0.000 –1 .3537 0.000 0 .1013 0.025

AGE 0 .0098 0.000 0 .0087 0.000 0 .0024 0.000

AGE2 –0 .00005 0.000

SIZE 0 .0000 0.051 0 .0000 0.000 0 .0000 0.543

EXP 0 .3319 0.000 0 .2535 0.000 0 .0321 0.000

DEBT –0 .1763 0.000 –0 .2149 0.001 –0 .6026 0.000

TECH 0 .0001 0.000 0 .0000 0.009 0 .0000 0.832

12 Specifically,China’s 31 administrative regions arepartitioned into sixgroups and representedby sixdummy variables: REG1 (Beijing,Tianjin, Hebei and Shandong), REG2 (Shanghai, Jiangsu and Zhejiang),REG3(Guangdong,Fujian,GuangxiandHainan),REG4(Shanxi,Anhui,Jiangxi,Hubei,HunanandHenan),REG5 (Liaoning, Jilin and Heilongjiang) and REG6 (Inner Mongolia, Ningxia, Tibet, Xinjiang, Gansu,Guizhou,Qinghai,Shaanxi,Sichuan,YunnanandChongqing).


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EFF 0 .0000 0.011 0 .0000 0.771 –0 .0001 0.000

INTANG 0 .2223 0.000 0 .1789 0.000 –0 .0358 0.000

INVEST 0 .4580 0.000 0 .3566 0.000 0 .2252 0.000

HERFINDAHL 3 .0130 0.000 2 .6715 0.000 3 .8713 0.000

HERFINDAHL2 –9 .6779 0.000 –8 .3931 0.004

Region dummies yes yes yes

Ownership dummies yes yes yes

Year dummies yes no yes

Seudo-R 0 .1480 0 .0842 0 .6091

Sample size 59640 27102 13446

Notes: Models 1 and 2 are estimated using quadratic hill-climbing optimisation algorithm and quasi-maximumlikelihood(Huber-White)robuststandarderrorsandco-variance.Model3isestimatedusingpanelEGLSwithcross-sectionweightsandWhitecross-sectionstandarderrorsandco-varianceprovidedinEview 6.


Theestimatedcoefficients (notreported in the table)of thedummyvariablesalso show that firms engaged in manufacturing pharmaceuticals, machinery,transport equipment, communication and other electronic equipment aremorelikelythanotherstoinvestininnovation.Theseproductsaremainlyinthehigh-techsectors.Infact,attheaggregatelevel,onaverage,researchanddevelopmentintensityinthehigh-techsectorsismuchhigherthanthenationalaverageof1.4percentin2007(seeFigure16.1).Forexample,thepercentageshare of research anddevelopment expenditure over sectoralvalue added in2007was4.7inpharmaceuticals,15.4inaircraftandspacecraft,6.8inelectronicandtelecommunicationequipment,3.9incomputersandofficeequipmentand6.3inmedicalequipmentandmetermanufacturing(YHT2008).Theestimationresultsalsoimplythatstate-ownedandshareholdingfirmsaremorelikelythanotherstobeinnovators.13Itisalsointerestingtonotethatfirmslocatedinthecentralandwesternregions—inparticular,thewesternregion—aremorelikelythanotherstospendonresearchanddevelopment.Thiscouldreflectthefactthatstate-ownedenterprises(SOEs)playamoreimportantroleintheeconomiesof thecentralandwesternregions—accountingfor25.1percentand30percentoffirmsinthetworegionsrespectively,comparedwithashareof15.6percent in thecoastal area.Thesefindingsabout the roleofSOEs in innovationsuggestthatprivatisationisnotalwaysconducivetoinnovation(atleastbeforeChina’sprivatefirmscanplayamoreprominentroleininnovation).

According to the estimation results of Model 2 in Table 16.2, persistentinnovators—definedasfirmsthatinvestedinresearchanddevelopmenteveryyearduringtheperiodsurveyed—aremorelikelytobeassociatedwithlarge-

13 ThedetailedresultsarereportedinWu(2010).


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scaleproduction,oldageintermsofcommencementdate,exportingstatusandhighcapital–labourratios(orcapital-intensivetechnology).Persistentinnovatorsarealsolikelytohavelong-terminvestmentsorintangibleassets.Wefoundhighindebtednesstobenegativelylinkedwiththeprobabilityofbeingapersistentinnovator(Table16.2).Relativelyefficientfirmsarenotnecessarilymorelikelythanotherstobepersistentinnovators.FirmscontrolledbyinvestorsfromHongKong,MacauandTaiwanorlocatedinthePearlRiverDeltaregionarelesslikelythanotherstobepersistentinnovators.Ingeneral,SOEsandshareholdingfirmsaremorelikelytobepersistentinnovators,asarefirmslocatedinwesternChinaorinvolvedinmanufacturingpharmaceuticals,machinery,transportequipment,communicationandotherelectronicequipment.Theseproductsonceagainareproducedmainlyinthehigh-techsectors,asexpected.

Wefoundthatfirms’researchanddevelopmentintensitywasnegativelyrelatedtotheageofthefirm(Wu2010).Furtheranalysis,however,demonstratesthatfirms’researchanddevelopmentintensityincreases initiallyandthenfallsastheir capital ages (Model3,Table16.2); theestimated turningpoint is about25years.Sincetheaverageageofthefirmsinthesampleis17,mostChineseenterprisesare stillon theupward (left) sideof the inverted-Ushape.As fortherelationshipbetweencompetitionandresearchanddevelopmentintensity,thereisnoevidenceofaninvertedU-shapedrelation,asarguedbyAghionetal. (2005) andTingvall andPoldahl (2006). Instead it is shown inTable 16.2thatresearchanddevelopmentintensityandcompetitionarenegativelyrelated.This supports the argument thatdominantfirms tend tobemore innovativethannon-dominantones(Blundelletal.1995).

ItisfurthershowninTable16.2(Model3)thatfirms’researchanddevelopmentintensityisassociatedpositivelywiththeexistenceoflong-terminvestments,exportingstatus,largesizeandhighcapitalintensity,althoughthelasttwohaveinsignificantcoefficients.Itisalsofoundthatfirms’researchanddevelopmentintensityislinkednegativelywithfirmliability,efficiencyandtheexistenceofintangibleassets.Ifafirmpossessesintangibleassets,itcouldimplythatthefirmiswellestablishedinthefield(withnewproductsorpatents,forinstance)andneedsresearchanddevelopmentinvestmentonlytomaintaintheleadingedge.The negative relationship between efficiency and research and developmentintensityisapuzzle.ItcouldreflecttheroleofSOEsininnovation.ChineseSOEsaregenerallylessefficientthanothers,buttheyarethekeyplayersinresearchanddevelopmentactivitiesinChina.ThisisconsistentwiththepositivesignofthecoefficientofthedummyvariablerepresentingSOEs.Thesefindingsimplythat China is facing a dilemma.While the need for further economic reformcallsforthewithdrawalorprivatisationofSOEs,China’sprivatefirmsarenot


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readytotakeovertheriskybusinessofresearchanddevelopmentinvestment.Thus,asfarasinnovationisconcerned,specificpoliciesarerequiredtohelpthetransitionfromSOEstoprivatefirms.

International perspective

Among theworld’smajor spenderson researchanddevelopment,Chinawasrankedthird in2007—behindonlytheUnitedStatesandJapan(Table16.3).Itshouldbepointedout,however,thatthereisstillalargegapbetweenChinaand the world’s top-two research and development investors. For example,in 2007, China’s total research and development spending was about 28 percentand70percentof that in theUnitedStates andJapan, respectively. Intermsofresearchanddevelopmentintensity,althoughChinaisstillbehindtheworld’stopspenders,itiswellaheadofmajoreconomiesatasimilarstageofdevelopment—asisclearlydemonstratedinFigure16.5.Ifcurrentgrowthinresearchanddevelopmentspendingismaintained,wespeculatethatChinawillfollowtheinnovationpathsofSouthKoreaandJapanandbecomeoneofthemostinnovativecountriesintheworld.

Table 16.3 World’s top five research and development spenders, 2007

Shares (%)

Country

Research and development expenditure (PPP$ billion in 2000 prices) Business Government Others

Research and development personnel (million people)

US 311 .4 66 .2 28 .3 5 .5 1 .426

Japan 124 .6 77 .7 15 .7 6 .7 0 .938

China 87 .1 70 .4 24 .6 5 .1 1 .736

Germany 58 .7 68 .0 27 .8 4 .3 0 .506

France 35 .6 52 .0 38 .2 9 .8 0 .372

United Kingdom

33 .3 46 .5 30 .0 23 .4 0 .349

PPP=purchasingpowerparity

Note:ResearchanddevelopmentpersonnelfiguresfortheUnitedStatesare2006data.

Sources: Research and development expenditure and personnel data are drawn from the OECD onlinedatabase(<www.oecd.org>).


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Figure 16.5 Research and development intensity and per capita GDP of major economies, 2007

Note:ResearchanddevelopmentintensityisthepercentageshareofresearchanddevelopmentexpenditureoverGDPineachcountry.GDPpercapitaisexpressedin2005constantinternationalprices.

Source:WorldBank2010,World Development Indicators,TheWorldBank,Washington,DC.

Furthermore,thecombinedshareofbasicandappliedresearchexpenditureovertotalresearchanddevelopmentspendingmaintainedadecliningtrendinrecentyears.Itwasonly17.2percentin2008,whilethisratioismuchhigherandrisingorrelativelystableovertimeinthemajorindustrialisedeconomies(Figure16.6).Thus,thepatternofChina’sresearchanddevelopmentspendingdeviatesfromtheglobal trendandisbiasedtowards investment in ‘development’research.Asdiscussedabove, this couldhave long-term implications for thecountry’sinnovationcapacitybuilding.For instance,anemergingtrendisthat,amongthepatentsgranted,only22.7percentbelongedtothe‘inventions’categoryin 2008.The structure and quality of China’s research and development arethereforechangingasinvestmentincreasesovertime.

In2006,ChinaforthefirsttimeovertooktheUnitedStatestohavetheworld’slargestnumberofresearchers.14By2008,China’sresearchanddevelopmentsectorhadmorethan1.9millionemployees,ofwhichmorethan84percent(about1.6million)werescientistsandengineers.15Meanwhile,inthesameyear,therewereabout6.1millionstudents,including759000postgraduatestudents,whowereenrolledintheschoolsofscience,engineeringandmedicalsciencesinChineseuniversities (NBS2009).Thus,China’spotential in researchanddevelopmenthumanresourceswillundoubtedlybethelargest intheworldinthecoming

14 ThisisbasedondatafromtheOECDonlinedatabase(<www.oecd.org>).15 These numbers are drawn from the Annual Statistics of Science and Technology, National Bureau ofStatisticsofChina(www.stats.gov.cn).


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decades. The country’s comparative advantage in human resources is alsoreflectedintheresearchanddevelopmentcoststructure.Labourcompensationaccounted for about 25 per cent of total research and development costs in2007, which was much lower than that in many Organisation for EconomicCooperation andDevelopment (OECD) countries suchas Japan (39per cent),SouthKorea(44percent),theUnitedKingdom(48percent),theUnitedStates(57percent),France(57percent)andGermany(60percent)inthesameyear.16ThissuggeststhatChinastillenjoysaconsiderablecomparativeadvantage inlabourcosts.Thereare,however,risksassociatedwithlowcompensationpaidtoscientistsandengineers.Skilledlabourisverymobileintoday’sworldandlowwagescouldmakeChinalesscompetitiveintheinternationaltalentmarket.

Figure 16.6 Research and development spending shares (basic and applied research) in selected economies

Sources:NationalBureauofStatistics(NBS)2009,China Statistical Yearbook 2009,ChinaStatisticsPress,Beijing;OECDonlinedatabase(<www.oecd.org>).

Anotherimportantfactorcloselyrelatedtoinnovationisthedevelopmentofthehigh-techsector.During1996–2007,theaveragerealgrowthrateofvalueaddedinthissectorwas18.7percent,whichwastwiceasfastasthegrowthrateoftheChineseeconomy.Computerandofficeequipmentmanufacturingledthisgrowth,witharealrateofgrowthof28.8percent,followedbytheelectronicand telecommunications equipment sector, with 18.8 per cent, and medicalequipmentandmetermanufacturing,with18percent(Figure16.7).In2008,thehigh-techindustryasagroupamountedto12.9percentoftotalmanufacturingoutputinChina(DPD2009).Thevalueofexportsinthissectorhasachievedanaveragerateofgrowthof44.9percentduring2002–08.17Incomparisonwithmajor high-tech exporters in the world, China has the largest global marketshare(Table16.4).In2007,China’shigh-techsectoralsoaccountedfor29.7percentoftotalmanufacturingexportsfromthecountry.Thisfigureiscompatible

16 LabourcompensationsharesovertotalresearchanddevelopmentcostsareestimatedusingdatafromtheOECDonlinedatabase(<www.oecd.org>).17 ThisisanominalrateofgrowthcalculatedusingdatafromYHT(2008).


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with that in the United States, which is the world’s second-largest exporter,butiswellbehindotherEastAsianeconomiessuchasthePhilippines(68.9percent),Malaysia(51.7percent),Singapore(46.4percent)andSouthKorea(33.4percent)(Table16.4).ItwillbeinterestingtoseewhetherChinaisabletofollowitsAsianneighboursintermsofthedevelopmentofthehigh-technologysector.

Figure 16.7 High-technology sector value added (in 1995 constant prices)

0

50

100

150

200

250

300

350

400

450

500

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Bill

ion

yuan

Year

Pharmaceuticals

Aircraft and spacecraft

Electronic and telecommunication equipments

Computers and office equipments

Medical equipments and meters

Sources:YHT2002,China Statistical Yearbook of High Technology Industry 2002,NationalBureauofStatisticsandMinistryofScienceandTechnology,ChinaStatisticsPress,Beijing;YHT2008,China Statistical Yearbook of High Technology Industry 2008,NationalBureauofStatisticsandMinistryofScienceandTechnology,ChinaStatisticsPress,Beijing.

Table 16.4 High-technology sector exports in selected economies, 2007

Countries Percentage of manufactured exports

World shares (%)

China 29 .7 18 .6

United States 28 .5 12 .7

Germany 14 .2 8 .6

Japan 19 .0 6 .7

South Korea 33 .4 6 .1

Singapore 46 .4 5 .8

France 18 .9 4 .5

Netherlands 25 .7 4 .1

Malaysia 51 .7 3 .6

United Kingdom 19 .5 3 .5

Mexico 17 .1 1 .8

Philippines 68 .9 1 .6

Brazil 11 .9 0 .5

India 5 .3 0 .3

Russian Federation 6 .9 0 .2

Source:WorldBank2010,World Development Indicators,TheWorldBank,Washington,DC.


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Implications for future economic growth

A precise assessment of the contribution of innovation to China’s growthis technically and conceptually challenging. The empirical literature isdominated by growth-accounting exercises and has focused on the analysisof the traditional Solow-type innovation or total factor productivity (TFP)growth.Wu(forthcoming)reviewsmore than70studieswithmore than150estimatesofTFPgrowthratesandfindsthatTFPgrowthonaverageaccountedforaboutone-thirdofChina’seconomicgrowthduringthe1990sandthefirstdecadeof thiscentury.Thesamefigureformore industrialisedeconomies is,however, much higher. For example, according to Dougherty and Jorgenson(1996), productivity growth accounted for 49.8 and 57.6 per cent of outputgrowthduring1960–89inJapanandGermany,respectively.Therefore,thereisconsiderablescopeforimprovementinChina’sproductivitygrowthingeneralandininnovationinparticular.

Themodestcontributionof innovationtoeconomicgrowth in thepast threedecadesisconsistentwiththecountry’sinnovationconditions.Asshownintheprecedingsections,evidenceatthemacroandmicrolevelsillustratesthatthereisstillaconsiderablegapbetweenChinaandtheadvancedeconomiesintermsofinnovationresourcesandcapacity.Chinais,however,catchinguprapidlywithindustrialised economies in terms of its innovation capacity measured usingvariouscriteriasuchasthenumberofpatentsregistered,scientificpublicationsandcitationsandhi-techcommodityexports.Thedrivingforcesforthecatch-upare the increasingresearchanddevelopment inputs incapitalandhumanresources. The catch-up will make it possible for the country to realise itsinnovationpotential,whichwillbevitalforChina’ssustainablegrowthinthecomingdecades.Toreachthisgoal,severalemergingissuesmustberesolvedbyChinesepolicymakers.

First,intermsofaggregateinvestmentinresearchanddevelopment,ChinaisaheadofothercountriesatasimilarstageofdevelopmentandthecountryisalsorapidlycatchingupwithOECDeconomies.Thereare,however,areaswhereChinacoulddomuchbetter.Forexample,China’s researchanddevelopmentintensity in the high-tech sector is lagging behind the major players in theworld(Table16.5).Infourofthefivehigh-techsectors(theexceptionbeingtheaircraftandspacecraftsector),thereisahugegapinresearchanddevelopmentintensity. Even in the aircraft and spacecraft industry, China’s research anddevelopmentintensitywasabouthalfthatinGermany,FranceandtheUnitedKingdomin2007(Table16.5).


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Table 16.5 High-technology sector research and development intensity in selected economies, 2006 (per cent)

Industries China US Japan Germany France United Kingdom

Italy Korea

Manufacturing total

3 .4 10 .2 11 .0 7 .6 9 .9 7 .0 2 .4 9 .3

High-tech sector otal

5 .7 39 .8 28 .9 21 .5 31 .9 26 .6 11 .1 21 .3

Pharmaceuticals 4 .7 46 .2 37 .1 23 .9 33 .4 42 .3 5 .0 6 .3

Aircraft and spacecraft

14 .9 24 .1 11 .5 32 .9 31 .1 31 .1 45 .2 26 .1

Electronic and telecommunication equipment

6 .4 43 .3 13 .4 28 .8 50 .9 23 .9 11 .6 25 .1

Computers and office equipment

3 .8 34 .7 n .a . 14 .9 27 .7 1 .4 8 .4 14 .2

Medical equipment and meters

5 .2 48 .3 31 .9 13 .6 19 .0 7 .8 6 .7 10 .3

n.a.notavailable

Sources: YHT 2008, China Statistical Yearbook of High Technology Industry 2008, National Bureauof Statistics and Ministry of Science andTechnology, China Statistics Press, Beijing;YHT 2009, China Statistical Yearbook of High Technology Industry 2009,NationalBureauofStatisticsandMinistryofScienceandTechnology,ChinaStatisticsPress,Beijing.

Second, with the expansion of research and development activities it isimportant not to neglect the quality of research and development in China.Theprecedingsectionspresentedevidenceof relativedeclines in investmentinbasicandappliedresearchinrecentyears.Thisisalsoreflectedinthesmallshare of ‘invention’ patents among total domestic patents in China. If thistrend continues, China’s long-term capacity in innovation—and hence thesustainabilityofeconomicgrowthinthefuture—couldbecompromised.

Third, the role of privately owned enterprises, including foreign firms, ininnovation should be strengthened through more stringent enforcement ofintellectualpropertyrightsprotectionlawsandregulationsandtheprovisionof incentivesviaappropriate innovationpolicies.Asshown in theprecedingsections,theenterprisesectorplaystheleadingroleininnovationintheworld’smajor economies. Although China’s privately owned firms are expandingrapidly, in terms of innovation, they are lagging behind their state-ownedcounterparts, not to mention privately owned firms in other countries.Thiscould be due to institutional constraints in China such as limited access tofinanceandgovernmentgrantsfornon-SOEs.


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Finally, there is considerable regional disparity in innovation.This not onlycontributes to China’s overall regional disparity, but it is also detrimental tothe diffusion of knowledge and technology within China. There should beinstitutional mechanisms to ensure a more even distribution of innovationresourcesacrosstheChineseregions.

Conclusions

Insummary,Chinahasmadeconsiderableprogress indeveloping indigenousinnovationskillsandcapacityinthepastthreedecades.Thistrendhasbeenstrengthenedthroughtheimplementationofthe2020programofscienceandtechnologydevelopmentsince2006.ItalsolaysthefoundationforthepossibletransformationofChina’seconomicgrowthmodelfromaresource-intensiveonetoaninnovation-orientedmodel.China’sinvestmentininnovationhasalreadygrownrapidly,withinnovationoutcomesexpandingasaconsequence.

An important development in recent years is the expanded role of Chineseenterprises in innovation. Chinese firms are now the dominant investors inresearchanddevelopmentinthecountry.Intermsofinnovation-relatedfirmcharacteristics, however, there is heterogeneity across firms with differentownershipandscaleaswellasindifferentindustriesandlocations.ItisshowninthisstudythatSOEsperformmuchbetter thanforeign-investedfirmsandprivatelyownedChinesefirmsasfarasresearchanddevelopmentpropensityandeffortsareconcerned.ThisisadilemmaforChina.Aseconomicreformdeepens,SOEs are under pressure to privatise. In the meantime, non-SOEs (includingforeignandindigenousprivatefirms)arenotreadytotakerisksassociatedwithresearch and development activities. This situation calls for specific policiesencouragingtheparticipationofnon-statefirmsininnovationandimprovementofthelegalsystemtoprovideeffectiveprotectionofintellectualpropertyrightsinChina.

ThisstudyhasalsodemonstratedthegapbetweenChinaandtheworld’sleadinginnovators.Toclosethegap,Chinesepolicymakerscouldpaymoreattentiontoseveral issues inthecomingdecades.First,whileChina is theworld’s largestexporterofhigh-techproducts,China’sresearchanddevelopmentintensityinthehigh-techsectorislaggingbehindtheworld’smajorplayers.Second,astheroleofenterprisesininnovationisstrengthened,thereisthedangerofneglectingbasicandappliedresearch,whichisvitalforthecountry’sinnovationcapacitybuildinginthelongerterm.Finally,boththequantityandqualityofinnovationinvestmentsandproductsshouldbemonitoredduringtheprocessofeconomictransformation.Growthshouldnotcompromisethequalityofinnovation.


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China’s health system and the next 20 years of reform 17

Ryan Manuel

Introduction

HealthcareinChinaremainsatopicofgreatpopulardiscontent,particularlyinruralareas,despitearaftofrecentreformsandanunprecedentedsplurgeingovernmenthealth spending,The commonphrase ‘kanbing nan, kanbing gui’(seeingadoctorishard,andexpensive)summarisessuccinctlytheissuesfacingmanyChinesecitizenswithregardtohealthcare.

AnalysingthefutureoftheChinesehealthcaresystemrequiressomehistoricalcontext.ThischapterwilldividetheChinesehealthcarereformexperienceintothreedistinctperiods.Thefirstisthecollectiveperiod,definedastheperiod1950–79. Due to its efficient public finance system and ‘step-up, step-down’deliverymechanisms,China’spublichealthsystemwasaworldleaderintermsofitshighlevelsof‘bangforyourbuck’.

The second, post-collectivisation period (approximately 1980–2003) saw theChinese system remain efficient compared with other developing countriesof comparable per capita income. Yet it was highly inequitable in terms ofaccess.TheendofthecollectivewithinChinahasseenaconstantlyhighrateof cost inflation, caused largely by physician-induced demand and the over-prescription of drugs and high-tech services, a disturbingly high level ofinequityofaccessandfallingratesofhealthcaresecurity.Providersandusersalikewereconfrontedwithflawedinstitutionsandincentives.Ruralandurbandifferencesandanineffectivepublicfinancesystemthatreinforces inequitieshaveexacerbatedtheseproblemsandhinderedreform.

Thebeginningofthethirdperiod(2003onwards),alongwiththeintroductionof the Harmonious Society Program, saw considerable debate about how toreformChina’shealthsystem.TheintroductionoftheNewCooperativeMedicalScheme (NCMS) and the beginning of the ‘Cover the countryside’ campaignofpublicfinancein2003alsoledtofargreaterpublicfundsbeingintroduced


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intothehealthcaresystem.Anumberofdemand-sidesocialhealthinsuranceprojectswereintroduced,andthesewillbemajordriversofthenext20yearsofhealthreforminChina.

Thesereformproposalscan,onthewhole,bedividedintotwomajorcamps.The first camp looks largely at using demand-side strategies based on socialhealth insurance schemes to increase the funds available in the system.TheothercampconcentratesonincreasingspendingtodevelopaChinesesystembased on publicly funded outpatient institutions acting as a gatekeeper andreferrertopublichospitals—similartoBritain’sNationalHealthService(NHS).

Eachofthesereformsappeartobeinsufficient.Aninstitutionalmodelrevealssome of the problems facing the Chinese government. Increases in publicspending appear to be unable to change the flawed incentives that exist forindividual providers. Issues remain, stemming from a lack of supervision,coordination and governance that hinder the imposition of social welfareobjectivesfromthecentralgovernment,inspiteoftheadditionofgreaterfunds.Themostrecenthealthplan,releasedin2009,hasmadesomeprogresstowardsresolving the theoretical conundrums facing the Chinese health sector, butleaving structuralproblems.Theeffectivenessof thenext20yearsof reformlooksmostlikelytobedeterminedbyhoweffectivelytheChinesegovernmentaddressesthestructuralproblemsandflawedincentiveshinderingthesystem.

History of the Chinese health sector

There are three distinct phases of healthcare provision in China. The firstphase—built within the socialist planned economy—was characterised bypublicprovisionofhealthservicesatallgovernmentlevelswithpublicfinancinginurbanareasandcommunityfinancinginruralareas(Liu2004:149-156).Thisegalitariansocialmodelusedstronggovernmentstructuresinordertoprovidehealthbenefits.Thecollective(inruralareas)andtheworkunit—ordanwei—inurbanareasbothmadeprovisionsforhealthcarefortheirmembers.Compulsoryhealthinsuranceandprimary-careprovisioncouldbeprovidedthrougheitherthecollectiveorthedanwei.Thissituationprovidedanumberofdifferenttiersoftreatment,which,combinedwiththeinnovativeuseofpart-timedoctorstoprovidelocalisedprimaryhealthcare(Smith1974:429–35),ledtoextraordinaryimprovementsinpopulationhealthmeasurementsacrossChinesesociety.Theseachievementsoccurredinalow-budgetenvironmentandinasocietythatspentadisproportionatelysmallamountofgrossdomesticproduct(GDP)onpublichealth.Muchofthisimprovementwasattributedtotheuseofpreventiveandprimarycareandtothewideentitlementandaccesstohealthcarepresentinthe‘egalitariansocietyperiod’(Liu2004:533).

China’s health system and the next 20 years of reform

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ManyauthorsarguethatthestructuralfeaturesofChina’spublichealthsystemwere instrumental to China’s excellent health outcomes.1 Under this system,village health stations, township health centres (THCs) and county hospitalswereintegratedwithinthethree-tiersystembyaverticaladministrativesystem.Thecountyhealthbureauwasresponsiblefortheperformanceoflocalhealthservices.Itpreparedplansandallocatedtheannualgovernmentbudget.Countyinstitutions supervised township and village facilities and provided referralservices,trainingandhigh-leveltertiarycare.

More importantly, social health insurance schemes organised at the villagelevelfundedmorethan50percentoftotalhealthexpenditures.AtthepeakofpopularityoftheCooperativeMedicalScheme(CMS),itcovered90percentof theruralpopulation.HealthservicesfinancedthroughtheCMSwereableto relyonprepaymentplans.Hence,during thisperiod, theStateplayedanimportantroleinfundingproviders(particularlyatthesecondaryandtertiarylevels),whilethecommuneprovidedmandatorycommunityhealthinsurancetoindividuals.

Figure 17.1 Levels of healthcare provision in pre-1978 rural ChinaSpecialist Hospital(several million patients)

Municipal Hospital(around 1 million patients)

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1 See,forexample,BloomandTang(2000);Liu(2004);andSmith(1974).


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By the mid-1970s, China had established an effective rural health system,supported by institutional arrangements including a network of appropriatefacilities and personnel, social financing of a large proportion of healthexpenditureandmechanismstocoordinateserviceprovidersandtoencouragehealthworkers toact in thecommunity’s interest (Chernichovsky1995).Theincentivesinthisthree-tier,‘step-up,step-down’systemwerehighlyeffective,encouraginghighlevelsofprimarycare.

Similarly, in urban areas an efficiently organised and managed system wasmarried with state funding and a vertical administrative system. Unlike theruralareas,thissystemreliedontheworker’semployer,thedanwei,toorganisehealthcare.Patientshadtopayaverysmallfee;however,thedanweiactedasthemajorpurchaserandproviderofhealthservices.Likethebarefootdoctorsin rural areas, factory workers were given work points for performing basicprimary healthcare tasks and for referring patients upwards when required.Above that level of treatment was a healthcare system staffed with full-timeemployees.

Inbothofthesesystems,majorhospitalsactedasthehighestpointofcareandthepublichealthmechanismsactedasgatekeepersforthesehospitals.Before1980,publichospitalservicefeesweremandatedbythegovernmenttobeatverylowlevels(about20percentofthecosts)andthegovernmentprotectedagainstdeficitsinthehospitalthroughaflexiblegovernmentbudgetinwhichpatientsweresubsidisedforhospitalcare(Jing2004).Hospitalshadnoincentivetoprovideunnecessarycareordrugsthatcouldincreasetheeconomicburdenofpatients,asbudgetaryconstraintswerelargelysoft.

This system laid the foundations for much of China’s modern healthcareinfrastructure.Althoughtodaytherearenofactoryworkersactingasprimary-careproviders,andbarefootdoctorsandvillagehealthstationsarenowprivateproviders,thestructureofthestatesystemandtheexpectationofpatientflowthroughthesystemremainmuchthesameasduringthecollectiveperiod.

The end of communes and socialised medicine

FollowingtherisetopowerofDengXiaoping,Chinadramaticallyshiftedthestructureofitseconomyandtheprovisionofpublicservices.ThefundamentalroleoftheStateitselfchanged.Thischangeinvolvedfargreaterapplicationofcompetitionandavaryingdegreeofdecentralisationtoprovincial, townshipandvillagelevelsofgovernment.Withshiftsinmodelsofgovernance—andthechangesthisledtoinChina’semploymentstructureandtaxationsystem—camea shift in the nature of health services. Social sector development includinghealthcarebecamelowonthepublicpolicyagenda.


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In spite of this—although somewhat unsurprisingly given China’s economicgrowth—the health status of China’s people, measured by broad populationhealth indicators, continuously improved. Life expectancy at birth increasedfrom67.9years in1981to71.8years in2003.From1991to2005, the infantmortalityratefellfrom50.2to19per1000livebirthsandthematernalmortalityratedeclinedfrom88.9to47.7per100000(WHO2009).

Moreover,China’sprimaryhealthcaresystemwas,bypercapitainternationalstandards, relatively comprehensive. The coverage rates of access to safedrinking water, antenatal care, hospital delivery and childhood vaccinationswere99,96,93and95percentforurbanareasand80,86,62and85percentforruralareas,respectively(MinistryofHealth2004).

Inspiteoftheseimprovementsinbroadprimaryhealthobjectives,thisperiodalsosawgrowingdissatisfactionwiththehealthcaresectorwithinChina.Self-reportedmorbidityratesandbedriddendaysincreasedremarkablyfrom1993to2003.2By2003,hospitaldissatisfactionratesinpatientslivinginurbanandruralareasincreasedto61percentand54percent,respectively,comparedwith8percentand14percentin1993(MinistryofHealth2004).Thisdissatisfactionwith the hospital system appeared to be related largely to cost inflation andaccess.

Thisshiftseemedtobetheresultofabroadershiftofstrategy,basedontheChinese government’s acceptance of the principle referred to as the ‘familyresponsibilitysystem’fortheruralsectorinparticular(Saich2003:18-30).Atitsheart,thisprincipleholdsthatthefamilyisthefirstlineofsocialprotection.Asacorollary,thegovernmentbecomesinvolvedonly‘whenthefamilycannottakecareofitsown,andwhengovernmentactioncanbeeffective’(Lin2005:1).Mostimportantly,theburdenofspendingforsocialservicesfalls initiallyontheindividual.

Correspondingwiththeriseinprivatespendingwasaconsiderablefallinpublicspending.Between1978and2004,theannualgrowthrateofhealthexpenditureinChinawas12percent,whichwashigherthanthe9.4percentgrowthofGDP.Despite rapidgrowth inhealthcarecosts, thepercentageofgovernmentspendingasaproportionoftotalhealthexpendituredeclinedfrom32percentin1978to17percentin2004(NBS2005).Intheoverallgovernmentbudget,healthexpenditureaccountedfor2.4percent in1980,decreasing to1.9percentin2004(MinistryofHealth2010).

Thus, before the introduction of the Harmonious Society campaign, China’spublic spending on health care was far lower than that of most developing

2 Basedonthethreenationalhouseholdhealthsurveysdonein1993,1998and2003;seeMinistryofHealth(2004).


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countries (Figure 17.2). This financial structure created significant shortfallsin government funding for healthcare providers. Hospitals were nominallypubliclyfunded,yetneededtoraisesignificantamountsoftheirownrevenue.Theendofthecollectivesawadismantlingofcentralgovernmentsoftbudgets,andin1985 institutionalhealthproviderssuchashospitalshadtosubmittohardbudgetaryconstraints.Thisresultedintherapidreductioninpublicfundsavailable to the system. A World Bank (1997) survey estimated that overallgovernment subsidies to total hospital operating costs amounted to no morethan15percent.Thishashadenormousramificationsforhospitalsanddoctors.

Even nominally fully funded public health institutions have suffered fromseverebudgetshortages.3Atthebeginningofthe1980s,allofthepublichealthinstitutions’revenuewasfromgovernmentbudgets,yetby1992thecontributionfromthegovernmenthaddwindledtoonly35percentof the total revenue.Therestofthebudgetwasmadeupfromservicecharges.Bytheendof1996,thegovernmentbudgetcoveredonly50percentofthecostforbasicsalaries,orsome25percentofthepublichealthinstitutions’totalrevenue(Xu1997).

Theresultwastopushresponsibilityforfundingpublichealthcareontotheindividualduringthispost-collectivisationperiod.

Figure 17.2 Public spending in the post-collectivisation period, 1990–2003

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China’s Public Spending Far Lower Than International Comparisons

Majorquestions,whicharestillbeingaskedtoday,aroseaboutwhetherornottheindividualcouldaffordthislargerburden.The2003ChineseNationalHealthSurveyshowedthatintype-fourruralareasabout68percentofthepopulationreportedthattheyrefusedtoseekmedicalassistanceforreasonsofcost.4Yipand

3 Public health institutions here refers to bodies whose job is solely to provide public goods such asimmunisationsorprimaryhealthmonitoring,asopposed toanormalhospitalorTownshipHealthCentre(THC),whichprovidesamixofpublic,privateandmeritgoods.4 Typefouristhelowestrelativesocioeconomicstatusruralarea.Areasareclassifiedonetofouraccordingtosocioeconomicstratificationusingaverageincomemeasures(MinistryofHealth2004).


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Hsiao’s(2008)retrospectivestudyshowedthat3percentofChinesehouseholdsperannumwerepushedintopovertyduetohealthcarecosts.Moreover,therealfigurescouldbeevenmoredistressing,asmanypeoplefailtoreportillnesseseven to their family due to concerns about the economic burden or a beliefthattheservicesprovidedwillnotbeeffective.Thus,itappearsthattherearemanysituationsinwhichfamiliesarecurrentlynot‘abletotakecareoftheirown’.Worryingly,theincreasednumberofpeoplewhodidnothaveaccesstohealthserviceswasduelargelytoadecreaseintheperceivedaffordabilityofoutpatientcare,whichshouldbethemostaffordablelevelofcare.

Figure 17.3 People declining hospitalisation in the post-collectivisation period, 1990–2003

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TheimpactofthisriseintheamountofpersonalfundsneededtoaccesshealthcarewasexacerbatedbyashortageofinsuranceavailabletoChinesecitizens.Ruralsocialhealthinsurancecoveragedroppedfromabout90percentin1980to10percentin1989(WorldBank1993:28).ThislowcoveragecontinueduntiltheadventoftheNCMSprogram.Likewise,coverageinurbanareasdroppedtoabout2–3percentin1993–95(NBS2006:125,908–9).Thisledtopatientsaccessinghealthcareself-funding.

Theeffectsofthisperiodremaintoday.Muchofthecurrentdebateisshapedbyadesiretoamelioratethenegativeimpactsofthisperiod.

Structural problems

Central to understanding how and why this system developed when it didis an appreciation of the public finance system that funds health, and thisappreciationisalsocrucialforunderstandingthefutureofChinesehealthcarereforms.Thissectionthereforeprovidesabrief introductiontothe impactofpublicfinancemechanismsontheChinesehealthsystem,particularlyduringthispost-collectivisationperiod.


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Figure 17.4 Sources of healthcare spending in the post-collectivisation period, 1990–2003

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Following the end of the communes, a system of fiscal responsibility wasintroduced in the early 1980s, which lasted until 1994 (Wong 2007). Thisreformpertainedmainlytotherelationshipbetweenthecentralandprovincialgovernments. Due to incentives to stimulate local industry, lower-levelgovernmentsfocusedfundsalmostsolelyonlocalindustry.Thisencouragedthehoardingoffundsattheprovinciallevelwhilereinforcingexistingverticalandhorizontalinequalities(Wong20072).Moreover,itledtothenearbankruptcyoftheChineseStateasitstaxrevenuedwindled(WorldBank2005;Wong2007;FockandWong2008)andsocialspendingwithered.

In 1994, a ‘tax-sharing’ system, which formally delineated local and centraltaxes,wasintroduced.Themainaimsofthistaxreformweretostrengthenthecentre’sfinancialpositionandtoseverthedirectlinkbetweentherevenuesofthelocalgovernmentandthoseoftheenterpriseslocatedwithintheirrespectivegeographical jurisdictions. The system theoretically enabled the centralgovernmenttoplayaredistributiverolethroughtheusageoffiscaltransfers,ensuringthatadequatefundswereavailablethroughoutalllevelsoftheChinesepoliticalsystem.

Thissystem,however,failedtosolvetheunderlyingstructuralimbalancesofthe Chinese taxation system. The central government increased its revenuesmorethantwofold(Wong2007:7).Thesegainsinrevenuecame,however,frompassingshortagesinfundingdowntolowerlevels—asshowninFigure17.5.

This is significant for public health as these lower levels of government arethenmandatedtopayforsocialgoods.Figure17.5demonstrateswhichlevelofgovernmentisresponsibleforeachsocialgood.Itclearlyshowsthatdistributionof revenues is not proportional to the allocation of mandates. Each level ofgovernment has therefore been under progressively more pressure to raiserevenuestofundsocialprograms.Thisputsconsiderablepressureonthefinances


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ofsmallercounties.Theinabilitytoraiseruralinformalfeesandcharges(duetothe2002mandateoutlawingruralinformalfeesandcharges)andtheincreaseoftop-down‘matchedfund’transfersfromabovealsoreinforcehorizontalandvertical inequities inspendingtothedetrimentofserviceprovidersat lowerlevels,particularlywithindisadvantagedareas.

Figure 17.5 Changes in tax revenues versus expenditures, 1993–2004 (per cent)

Doctorate Master’s University Junior Secondary High School College School and below

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Gaps in spending power are critical to understanding health care in China.A lack of taxation revenue makes it difficult to fund healthcare providers,healthcare policies or bodies to regulate healthcare provision. As Chou andWang (2009:694) show, government budget deficits have a significant long-run impact on regional healthcare expenditures. An inability to raise fundsimposesaconsiderableconstraintonpublichealthexpenditures.Indeed,ChouandWangarguethat,allotherthingsequalandonaverage,foreveryRMB10millionincreaseinbudgetdeficits,healthexpenditurewillbedecreasedby26.3percent.

Apartfrombeingverticallyunbalancedamongdifferentlevelsofgovernment,China’seconomicgrowthhasalsobeenhorizontallyunbalancedacrossregions,withmuchhighergrowth rates in the coastalprovinces, on thewhole, thanintheinlandprovinces.Withtheshifttothetax-sharingsystemin1994,thedistributionoffiscalresourcescametoresemblemorecloselythatofregionalincomes,reinforcingtheeffectofincomeinequalities.Thus,Liuetal(2009:978-979) note, transfers often reinforce rather than reduce horizontal revenuedisparities.Themoreeconomicallysuccessfulaprovinceis,themorelikelyitistobenefitfromtax-basedtransfermethods.

As a result, effectivedemand forhealth care shifts to thosewho can readilyaffordit,makingcitizensinthefarwealthiercoastalregionsmorelikelytovisitdoctorswhensick(ZhangandKanbur2005:194).Thisshiftindemandhascausedanenormousshortageofsecondaryandtertiary-levelmedicalprofessionalsin


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ruralareas.Largerandbetter-equippedfacilitiescangeneratemoreprofitsandthus pay more bonuses, so there is a strong financial incentive for qualifiedpersonnelindistricthospitalstoleaveforlargercityhospitalsandfortrainedhealthworkersinruralareastoseekemploymentincountyorcityhospitals.Thenegativeimpactofthisontheskillsofdoctorsinruralareasismarked.

Gong et al.’s (1997) study, for example, showed that more than 80 per centofqualifieddoctors sampled fromeightChineseprovinces leftpoor countiesformorelucrativepositionsinurbanfacilities.Asaresult,whileaboutthree-quartersofChinesepeopleliveinruralareas,onlyaboutone-thirdofmedicalprofessionals work there. This, when combined with the higher skill levelspresentinurbanhospitals,makesitdifficultforruralareastoassurethesamequalityofstandardsasthosepresentinurbanareas—asshowninFigure17.6.

Figure 17.6 Urban and rural health profession skills and ratios

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by level of government(%)

Shortagesinskilledstaffhavedeleteriousoutcomesforpatients.Forexample,thelowproportionofhealthworkerstoresidentsinChina’sruralareashasseriousrepercussions.TherecentstudybyLiuetal.(2009)showedtheimpactsofthesestructuralproblemsontheamountsofcoverageinChina’shealthsystem.Therewere significantdifferencesbetweenprovincesandbetweenurbanandruralareas.Onaverage,coverageinurbanareas(61percent)was15percenthigherthaninruralareas.Thislowcoverageisalsoreflectedinpoorhealthoutcomes.Asanexample,widerresearchshowsclearlythatthedensityofhealthworkersphysicians,nursesandmidwivesper1000population)isnegativelycorrelatedwithmaternal,infantandunder-fivemortalityrates(Anandetal.2008;Chenetal.2004).In2005,theinfantmortalityrateinruralareaswas2.4timeshigherthaninurbanareasandthematernalmortalityrateinruralareaswas2.5timesthatoftheurbanpopulation.Anotherstudyofhealthoutcomesshowedthatinpoorerareas,lifeexpectancywasfouryearsshorterthanthecountry’saverage(Liu2004).


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The negative cycle of Chinese health care

The Chinese health system has reacted to these structural problems and hasdeveloped flawed incentives for medical providers. On the supply side, theattempt by the Chinese government to effectively subsidise the provision ofbasicservicesthroughallowingoverchargingonmorecomplexservicesforcesphysicianstochoosebetweentreatingloworhigh-costpatients.Onthedemandside,patientresponsestothissystemindicatethatinsteadofhavinganefficient‘step-up,stepdown’system,theChinesesystemismoreofa‘doughnut’systeminwhichdemandissqueezedtothelowestandhighestrungswithinthesystem.

Theincentivesembeddedinthissystemleadtoaviciouscycle.Averagehospitalbillsarenearlyequaltotheaverageannualruralsalaryandareabouttwo-thirdsthe average urban disposable income (Ministry of Health 2009; NBS 2009).Thesehighmedicalbillsoftencontributedirectlytopoverty.Thus,farmersandworkersalikeavoidhealthcareinstitutions.

Yet healthcare institutions—underfunded by the public purse—also sufferfromrevenueshortages.Theirbeststaffoftenleaveforhigher-levelinstitutions.They have incentives to raise prices, employ more high-tech machinery andoversupplymedicalcare.Yetthen,asnotedabove,poorcitizenshaveanevengreaterdisincentivenottoseekmedicalcare,andthusthecyclecontinues.

This then exacerbates the shortage of effective demand that exists becausepeopleareunabletoaffordhealthcare.Underfundedpublichealthprovidersare forced to charge for poor-quality care or fail to have sufficient supplies.ThismakespatientswhocanaffordhealthcareservicestoleavelowerlevelsofprovidersuchasthoseworkinginavillageclinicorTownshipHealthCentre(THC),andtojoininsteadhigher-levelprovidersofcare,whoaremorehighlytrainedandhavebetterresources.Thesehigher-levelprovidersare,however,alsostretchedforfunds,andthereisalsoanincentivetoobtainextrafundsbyoversupplyingcare,throughsuchmeansasexcessiveover-prescription,over-orderingoftestsandforcedrepeatvisits.

Hence,withintheChinesehealthsystemthereisaparadoxcentredondemand.Many regions suffer acuteproblemsof inadequate supply.Manymore areas,however, suffer fromchronicunder-utilisationdue to loweffectivedemand.5Althoughpeoplewanthealthcare,theycannotaffordit,orwhentheycantheyarepushedupwardstowardscountyandmunicipalproviders.Theseprovidersarenotonlymoreexpensive,theyarelikelytobefurtheraway.

5 Togiveasimplemeasure,theaveragebedoccupancyrateinhospitalsisabout60percent;itisabout40percentinTHCs(MinistryofHealth2009).


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Thispricebarrier affects access tohealth care.Thosewhoareunable topayremain ill, often becoming even more ill, necessitating even more expensivetertiary care.This leads to a dynamic whereby patients, if unable to obtainaccessprovidersasalow-costpatient,returnasahigh-costpatient,leadingtobothaccessandcost-inflationproblems.6

Breaking this cycle through insurance

TheChinesegovernmentannounceditsfirstmajorresponsetotheseproblemsintheearly2000sthroughanumberofdemand-sideinitiativesdesignedtoboosttheoverallcoverageofChinesehealthinsuranceschemes.Theseinitiativesusebasicsocialmedicalinsuranceschemesasacountry-widegovernmentsystemthatwasdesignedtobeathird-partypayerandanewmechanismforfinancinghealthcare.7

The reforms in demand-side policy seek to break the cycle described abovethroughalteringtheeffectivedemandforhealthcare.Byprovidingsubsidised,government-organised social health insurance, the government reduces theriskofcatastrophicmedicalexpensesandtriestomakenecessaryhealthcareaffordablethroughriskpooling.Theaimatinitiationwastoexpandtheprogramsto cover all citizenswithin10years.Although theprograms still donotyetprovideuniversalcoverage,theprogramhasbeenexpandingrapidlyintoruralandurbanareas inChina in thepastfiveyears.Thegovernmenthasalreadyproclaimedthatuniversalcoveragewillbeachievedby2011,andalmostallitstargetsforthecoveragethroughtheNCMSprogramhavesofarbeenachievedaheadoftime.

Although the reimbursement rates differ, urban and rural social healthinsurance(SHI)schemesuseco-contributions.Inruralareas,fundingisdividedbetween the individual, a mandatory local government contribution and amatchingcentralgovernmentcontribution.Asanexample,earlyiterationsoftheNCMSpolicy (2003–05)usedasubsidyofRMB10perperson,anRMB10localgovernmentsubsidyandanRMB10centralgovernmentmatchingsubsidy.Thesubsidieshavebeenprogressively increased throughcentralgovernmentmandatetothepointwheretodaygovernmentsubsidiesareataminimumofRMB80,andtheminimumtotalfundcontributionisRMB120.

6 Liu(2009)hastwogoodrecentexamples,showingthatonlyabouthalfofurbanandalmost60percentofruralpatientswhoweretreatedfortuberculosiscompletedthetreatmentprotocol.Similarly,only12percentand7percentofpatientswithhypertensionlivinginurbanandruralareas,respectively,hadtheirbloodpressureloweredtonormalvaluesasaresultoftreatment.7 Dong(2009:595)hasagoodoverviewofthestrategicimplicationsofthispolicy.


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In urban areas, the Urban Employees’ Healthcare Insurance Scheme (usuallyreferredtoasBasicMedicalInsurance,orBMI)isdesignedtocoverallemployeesandretireesinurbanareas.Itisfinancedbyemployee(2percentoftotalsalary)andemployer(6percentoftotalsalary)contributions.Thelocalgovernmentisabletotop-uptheBMIfundsifrequired;however,itsroleremainsmainlyoneofgovernanceandfundmanagement.Usershavetwoaccounts:theindividualaccountpaysforoutpatientexpenses,emergencyservicesanddrugcosts,whilethesocialpoolingaccount(70percentoftheemployer’scontribution)paysforsomeinpatientcostswithinapredefinedband.Thepatientspayupfrontandarethenreimbursedbythefund.

Urbanresidentswithoutadanweioremployerhadbeenleftuninsuredsincetheabolitionoffreeurbanmedicalservicesinthe1980s.Inthemidtolate2000s,the State Council carried out pilot reforms for a special basic social medicalinsuranceprogramforurbanresidentsthatcoveredthesegroupsin79citiesinChina,whichwasthenexpandedtomorethan300citiesin2007.ThestructureofthisprogramissimilartotheNCMSinthattherearecontributionsfromtheindividualand fromthegovernment.Totalcoverage today isestimated tobeabout40millioncitizens.Itisexpectedthatthisprogramwillbefurtherrolledoutsoon.

Allofthenewsystemsarecatastrophic-eventinsurancefundsthemainaimofwhichistoreimbursepatientsforexpenditurecostsafterinpatientepisodes.InthecaseoftheNCMS,thesefundsprovideanaccountfor‘seriousillnessandmanpowerfees’fortheconsumer,whichispooledintoacooperativemedicalfundatthecountylevel(ZhongguoWeishengBu2006).Theconsumerpaysfortheepisodeandissubsequentlyreimbursedpost-treatmentbythetownship-leveladministrationbody,whichisreimbursedbythecounty-levelCMSfund.The bulk of reimbursement by the NCMS is for inpatient expenses, even incountieswhereoutpatientexpensesarecovered.8

Reform effectiveness

Early evaluations suggest that despite its relatively short life and limitedfinancing, theNCMShas improvedaccess.AnumberofChinesestudiesfindthattheimplementationoftheNCMShasimprovedoverallhealthcareutilisationandaccessandtosomeextenthasreducedthefinancialburdenofdiseasesfortheinsured.AstudyinpilotcountiesinShandongProvincerevealedthattheruralpopulationcoveredbytheNCMShadanaverageof10–15percenthigher

8 A 2006World Bank survey noted that in the 27 counties for which data were available, the share ofreimbursementsaccountedforbyinpatientcarevariedfrom100percentto66percent,dependingonthecoveragemode(Wagstaff2007).


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healthcareutilisation than theuninsured (Jacksonet al 2005). WagstaffandLindelow (2008),utilisinganumberofdata-sets,find that theBMI inurbanareashasincreasedtheutilisationrate.

Anumberofproblemsremain.The inpatient focusof the insuranceschemesmeans that the system of health security is geared towards more expensivetertiary care. The focus on the individual paying upfront and then beingreimbursedencouragesbothadverseselectionandmoralhazard.9

Perhapsmoresignificantarerecentfindingsthattheincidenceofcatastrophicspendingappearstohaveincreasedsincetheintroductionofthedemand-sidereforms.Thus,theearlyassessmentoftheNCMSinparticularseemstoshowanincreaseindemandforservicesduetotheloweringofcoststhroughinsurance.10Yettherealcostofhealthcareitselfcouldstillbeincreasing—incontrastwithpreviousinternationalevidence.11

There is a notable theoretical gap here, which is that a causal relationshipbetweenhealthinsuranceandhealthoutcomesrequireshealthinstitutionstoact as the intermediary.The reason for the distinct increase in cost inflationcouldlieonthesupply-side—thefactthatprovidersinChinaarepaidbyfee-for-serviceandfaceafeeschedulethatstronglyencouragesdemandshiftingtodrugsandhigh-techcareonwhichthemarginsarehigher.12Ifphysiciansandinsuranceusersalreadyfaceflawedincentivesandmorefundsareaddedtothesystem,theextrainflowofpublicfundsintothehealthsystemrunstheriskofmerely fuellingcost inflationrather thanchangingbehaviour ina favourableway.

9 SeeManuel(2008)foramorein-depthdescriptionofthisproblem.10 Formoreontheimpactsofthedemand-sidereforms,seeLeiandLin(2009).11 WagstaffandLindelow’sstudynotedthecasesofVietnamandMexicospecifically.12 LiuandMills(1999)remainstheclassicstudyofthis.


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Demand-side strategies and structural problems

Ifwetreatthedemand-sidereformsasincreasesinfundsthatdonotchangetheincentivesorthestructureofhealthcareprovision,itisreasonabletoassumethatthe structuralproblemsofurban–rural and inter-provincialdivideswill alsocontinue,andhencewewillalsoexpecttoseesimilarlyinequitableoutcomesstemmingfromthesedivides.

There is some research currently emerging on these matters. Yip and Hsiao(2009), using the data from the 2003 Health Services Survey and their owndata,reportthatgovernmentspendinginurbanareasisfivetosixtimeshigherthaninruralareas.Demand-sidespendingdrivesmuchofthis:cityhospitalsabsorbed 50 per cent of supply-side subsidies in 2002 and county hospitals9percent;THCs,incontrast,receivedjust7percent.

Moreover, inherent regressive biases remain within the current demand-sidepolicies.ThecityBasicMedical Insuranceprogram, forexample, isbasedonpaymentsofapercentageofsalary;however,theriskpoolingforthisprogramoccursatthecitylevelratherthanonbroadercountyorprovinciallevels.Thereisnoabilitytotransferresourcesbetweencities.Hence,citieswithadvantageousdemographicorpublichealthendowmentsorwithhighrevenuesareable toprovidemoregeneroussupportpackagesthancitieswithhigheractuarialrisksorlesswell-paidworkers.

This reinforces the fact that spending is often distributed unequallyhorizontallyandvertically.TheNCMSscheme, for example, canalso receiveextracontributionsat thehouseholdor localgovernment’sdiscretion.WorldBankstudiesofthe2005iterationoftheNCMSprogramshowedthetotalNCMSbudgettendedtobehigherthantheRMB50minimummandatedamountperperson(RMB62.9onaverageinasampleof189countiesfrom17provinces),anditvariedconsiderablyonce local incomeandcoveragemodewerefactoredin(Wagstaff2007).Moreeconomicallydevelopedcountiesarethusabletoprovidegreaterfundstothescheme.

Establishingdemand-sidereformsrequirestheinstitutionsrunningthereformstohave sufficient authority and skills for fund collection and risk transfer.13Yet in theNCMSprogramthere isadistinct lackof fundingfor institutionalcapacitybuilding. For example, the centralMinistryofHealthdeclared thatthemanagementcostofpilotcountiespaidbythefinancedepartmentsoflocalgovernmentsin2004wasCNY85million,orapproximatelyCNY1percapita

13 BloomandXingyuan(1997)haveacomprehensiveoverviewofthisneedforcapacityinruralareas;theirsurveyprovidesanextensiveoverviewofthestructureofpaymentinunder-capacityareas.


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(Hu 2004:2). The problem here is that the management costs for the poorercounties are likely to be relatively far more significant, due to their lowerbudgets.Meng(2005)notesthatmanagementcostsaccountfor9.8percent,5.1percentand3percentofbudgetarycostsinthewestern,centralandeasternareas,respectively.Thus,theveryregionsthatneedtheextrarevenuearefarmorelikelytohaveashortfall.Moreover,centralgovernmentregulationsforbidtheuseoffundsfromtheNCMStosupportmanagementcosts.

ThemanifestationofthisprecarioussituationisthatcountygovernmentsoftenbecomemoreunwillingtospendeventhefundstheyhaveraisedthroughtheNCMS.Poorergovernments, concerned aboutbudgetary shortfalls, are likelytocontaincostsandavoidoverspendingthroughdesigningveryconservativeplansthatlimitcoverageandbenefits(Wong2007).

Dependingonwhenmeasurementsweretaken,theminimumleveloffinancingperbeneficiarygenerallyrepresentedonlyaboutone-fifthofaveragepercapitatotal health spending in rural areas.14 Hence, coverage of medical expensestendstobeshallow,manyservicesarenotcoveredorarecoveredonlypartially,deductiblesarehigh,ceilingsarelowandco-insuranceratesarehigh.

It is further revealed by a number of studies that the NCMS has not beeneffectiveinimprovinghealthcareaccessandreducingthefinancialburdenofdisease,asexpected,forthepoor.Comparedwiththehigh-incomeinsured,thelow-income insuredutilised lesshealthcareandreceived lessreimbursementfromtheNCMS(Mao2006).

How structural problems hinder reform

Thecurrentinequitiesinfundingdonotaffectjusttheprovisionofservices;they also affect the incentives for institutions.15The impacts of thedemand-sidereformsoutlinedaboveprovideanexcellentcasestudy.Theadministrativeresponsibilities for the NCMS fund are fairly clearly outlined.16 The centralgovernment—inaquest to improvesocialwelfareandgeneralhealth serviceprovision—commits funds and gives targets to provinces. Provincial-level

14 Zhang(2005:20)uses2004calculations;Wagstaffetal. (2009)makesimilarassumptionsfor2007.Thedata themselves each year are available from <http://www.moh.gov.cn/publicfiles//business/htmlfiles/zwgkzt/pwstj/index.htm>15 This section follows themethodologicalprincipleofWilson (1989) inarguing thatbureaucracies canalsoactasself-interestedunitsandthatthisself-interestisdirectedtoassuringitsownsurvivalthroughthemaintenanceoffunding.16 ThisoutlinecanbefoundinZhongguoWeishengBu(2006);anytranslationsandabbreviationmistakesarethefaultoftheauthorofthischapter.


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responsibilitieslargelyamounttotargetsettingandanalysis,andtheydecidethe relative effectiveness of the counties, as well as exerting influence overannualdecisionsregardingfundallocationandspending.17

CountiesbearmostoftheresponsibilityforthemanagementandadministrationoftheNCMSfunds.They‘outlinethelevelofcooperativemedicalcaretobefunded,setreasonablerebateguidelinesandthencalculatetheceilingpayments,compensation and the proportion of the scope of compensation’ (ZhongguoWeishengbu2006).Countygovernments,however, are allowed to loosely setNCMSreimbursementrangesandcriteriaaccordingto‘fundsraisingandlocalconditions’(ZhongguoWeishengbu2006).

TownshipresponsibilitiescentreontheefficientmanagementoftheTHC,whichisgenerallyconsideredthelynchpinoftheNCMSmodel (Wu2007).Mostofthese responsibilities focus on ensuring supplies of drugs and basic medicalequipmentandthat‘medicalinstitutionsarefunctional’.ThustheTHC,underthemanagementofthetownshipgovernment,isthehubofthedeliverysystem,performingoutreachandconnectingallpreventiveservicesforthetownshipresidentsincludingchildvaccination,diseasecontrol,preventionofinfectiousdisease,maternalandchildhealthandfamilyplanning,whilealsoprovidingalinktomoreadvancedtertiaryservices.THCsreceivenosubsidy,however,fortheservicesoftheirtimeandadministration.FundingtoTHCsisexpectedtocomefromcash-strappedlocalgovernments.Notsurprisingly,theirrelativefundingislowerthanothertiersoftreatment.

PhysiciansinTHCsfaceadifficultsituation.Theydonothavethesamelevelsof training or access to resources and supplies that larger hospitals have inordertotreattheirpatients.Theirenvisagedroleisasagatekeeperandprimaryhealthprovider.UnderthisTHCusagesystem,however,pricestendtobesetbelowcostforsimpleandnon-invasivecareandabovecostformorecomplexcare.Hence,theincentiveforthephysiciansintheTHCistotreatthecomplexpatientsthemselves,inordertogaingreaterrevenue.

Similarly, in a situation in which they face funding shortages, THCadministrators’expectedbehaviourformoredifficultcases is tocontainTHCcostsbyencouragingphysicianstotransferpatientstohospitalsatthecountyormunicipal level.Thisutilisationmode,however,givesTHCs lesser incomefromtheabsenceofmorecomplexcasesthatactasadefactosubsidy.

In this way, the behaviour ofTHC administrators and township governmentofficials is aligned. As the township government officials are measured for

17 Provincialgovernmentsarerequiredto ‘establishCMSessentialdrug list, formulatesurveybasisandanalysehospitaladmissions,fiscalbalancesandfundpayouts’,balancethebooksand‘strivetoimprovethelevelofbenefitforthefarmersoftheSenate’(ZhongguoWeishengbu2006).


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effectivenessthroughensuringthatTHCsdonotbecomebankrupt,theyhaveno incentive to force THC physicians or administrators to attempt to act asgatekeepers.

Forthesystemtowork,thecountygovernmentwouldneedtobeabletoforcethetownshipgovernmentofficialstoinfluencethebehaviouroftheTHC.Yetthecountygovernmenthasverylittleincentivetodothis.Thisisbecausecountygovernmentofficialshaveconflictingincentives.Theperformanceofofficialsismeasured,withsomeprovincialvariations,accordingto

1. whetherornotinstitutionsundertheircommandbecomebankrupt

2. whetherornottheirNCMSfundisfinanciallyviable

3. therateofenrolmentintheNCMSprogram

4. thenumberofstaffworkingonhealthcare

5. generalpublichealthmeasurementsincludingvaccinationsandsoon.

Theinformationasymmetriespresentintreatmentmeanthatmeasurementssuchastreatmentprotocols,prescriptionratesanduseofmedicaltestingareunableto be used to assess the performance of government officials. Unlike healthoutcomes,enrolmentinNCMSismeasuredandcanthusinfluencetheprovincialgovernment’sassessmentofthecountryofficials’performance.Hence,thereisanincentivetomakesurethatallcitizensareenrolled—inspiteoftheschemebeingvoluntary—yet there isno incentive forgovernment administrators totakeaccountofservicedelivery,inspiteofthehealthcaresystembeingpublic.

Moreover, the inability tomeasureoutcomesmeans thatgovernmentofficialsneedtorelyonhospitaladministratorstoensurethatphysiciansbehave inawaythatissociallybeneficial.AlthoughcountyhospitalsandTHCsarepublic,theyhaveincentiveschemessimilartotheprivatesector.Localgovernmentscanprovidesomefundingtohospitalsandprovidethemwithtargetsforspecificpublichealthinterventions,suchasvaccinationtargets.Yet,simultaneously,themajorroleofthehospitalistosurviveinspiteoffundingshortages.

Hospitalsdothisthroughensuringanadequatesupplyofhigh-costtreatmentpatients. More importantly, hospitals have a controlling mechanism over thebehaviourofphysicians through thepaymentofbonuses.Thesebonusesaresupplementarytosalaryandaregenerallynotformallycontracted—oravailableonthepublicrecord.AstudydonebytheWorldBank(2005:43)indicatesthatthereappearstobealinkbetweenhospitalrevenueandphysicianbonuses,butdatatoprovethishypothesishavebeendifficulttoaccess.

Finally,localgovernmentsandhospitals/THCshaveincentivestoincreasethenumberofstaff.Asthebasesalaryofstaffismandatedbycentraldecree,andthere are generally soft budget constraints only, extra staff is useful for the


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hospitals/THCs(whocanusethemtogenerateextrarevenue)orforthelocalgovernment(forwhomtheyareasourceofsupport,powerandinfluence)(Shihetal.2008.Capitalgrantsortargetedtransfersfromthecentralorprovincialgovernment can similarly be used for purchasing or upgrading expensiveequipment, which tends to allow for more complicated revenue-generatingmedicalprocedurestobeperformed.

Patientsarethenforcedtorespondtotheseincentives.Thepatientpaysupfrontandthusthepatientdecideswhichlevelofprovidertovisitaswellasbearingallthefinancialrisk.Thepost-visitrepaymentstructuresoftheNCMSencouragethepatienttobetreatedattheTHClevel.TheTHChasanincentivetotreatthepatientashighratherthanlowcost,andtherearetheusualasymmetriesofinformationproblemspresentinmodelsoffee-for-servicehealthsystems.TheTHCworkersare,however,lessqualifiedthancountyhospitalstaff.18

Patients not only have to ascertain which level of provision is most suitableforthemtobetreatedandpayupfrontforthetreatment,theyaresupposedtodisciplineproviderbehaviour.Theoretically,providing individual consumerswithgreaterfundsallowsthemtohaveameasureofvoice,exitorloyalty.19Yetpatientsareunlikelytohavemuchvoicesinceinformationasymmetrybetweenpatient and doctor makes it difficult for individuals to discipline providersone-on-one.Moreover,aspatientshavenosayintherunningoftheNCMSoritspurchasingbehaviour, theirchoicebecomesoneofexitor loyalty.As themajorityofthehealthsystemispubliclyownedandmanaged,optionsforexitarealsolimited.Hence,itappearsdifficultforindividualstodisciplineproviderbehaviour.

Due to pushing the risks back onto the patient, and not having effective,aligned incentives forbureaucrats, thedemand-sidestrategiesof theChinesegovernmentappeartobeinsufficientontheirown.Thesocialmedicalinsurancesystemdoesnotprovidemechanismsforimprovingflawedincentivesandfailstoameliorateormonitoragencyproblemsbetweenphysicians.Theconflictingincentivesforgovernmentbureaucrats,hospitaladministratorsandphysiciansforcepatientstoattempttonavigate,fundanddisciplinethehealthcaresystemthemselves—aroleforwhichtheyareillequipped.

18 Asdiscussedintheschematicofthecollectivisationperiodsupply,thereisalsoaverylow-levelprivatealternative available to the patient—the village doctor—but as these doctors are unregulated and do notofficiallyaccesspublicfundstheyhavebeenleftoutofthismodelforthesakeofmaintainingreaderinterest.19 Based on Hirschman’s classic characterisation of consumer options for public providers (Hirschman1970:17–37outlinesthemodel).


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Supply-side reforms also hindered by flawed incentives

Significantly,theseconflictingincentivesalsoaffecttheChinesegovernment’sabilitytomakesupply-sidereformstothesystem.Take,forexample,theideaof‘governmentleadership’—asupply-sidetheorythathasgainedconsiderabletractioninthemediaand,accordingtosomereports,withinthegovernmentitself.20Accordingtothistheory,thegovernmentshouldberesponsibleforasmuchofthedevelopmentof‘basichealthcare’aspossible.Publiccommunityhealthcareprovidersat theprimary-care levelwillprovidehighlysubsidisedcare,withasmallco-paymentfromtheusers.Theseprovidersshouldimprovetheir skills through greater, publicly funded training and are expected toalso upgrade the skills of village doctors within the area. At higher tiers oftreatment,publichealthinsuranceschemessuchastheNCMSandBMIshouldbe ‘enhanced’ and this enhanced funding should be used to provide socialhealthinsurancecoverforhospitalisationcosts.

There are two major problems with this proposed strategy of reform. Thefirstrelatestocost.ThetotalrevenueofpublichealthcareprovidersinChinaat thetimewasequal toaboutone-seventhof totalgovernmentexpenditure,and China lacked the fiscal capacity to introduce full supply.21 Rather, thesesupply-side strategies focused on creating a sort of ‘mini-NHS’ system inwhichthegovernmentattemptedtofocusitsspendingoncommunitycentres,includingextensivetrainingprogramstoensuretherewereenoughemployeesforthecentres.Yetthisdoesnotdealwiththeproblemsofwhattodowiththehospitals.Supply-sidereformsthusfarhaveconcentratedonintensifyingtheSHIprogramsinordertodealwith‘non-basiccare’.

Moreover,thisexacerbatestheproblemswithpoorincentivescurrentlyfacedbytheChinesehealthcaresystem.Publichospitalswouldbeabletouseexcessrevenuestopaybonusestostaff.Forthisandotherreasonssuchasprestige,itwouldbehardtoretaincommunityhealthworkersinTHCsortoensurequalityofhealthserviceswithinthisarea.TheconflictinincentivesforTHCs,countyhospitalsandbureaucratsthereforecontinues.

20 Gu (2009:124) has far more on the internal politics of this, although his preference for demand-sidereformsisclear.21 Gu(2009:125)doesthecalculations,basedonMinistryofHealth(2007)andNBS(2007).


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The April 2009 health reforms

PerhapsthebestindicationofhowtheChinesegovernmentseesthenext20yearsofreformcanbeseeninitsmostrecenthealthplan.22Theplan—theOpinionsonDeepeningHealthcareSystemReform(2009–10)—wasadoptedinJanuary2009andreleasedinearlyApril.23Thisplanpromisesto ‘effectivelysolvetheproblemofdifficultandcostlyaccesstohealthcareservices’—aproblem,theplannotes,‘arousesintensepublicconcerns’.

Muchoftheplanappearstobeembracingsupply-sidereformproposals.Fundingstandardsforbasicpublichealthserviceswillbeincreased(‘in2009,theaveragepercapitapublichealthfundingshallbenolessthan15Yuan,andnolessthan20yuanby2011’),withtheexpectationthatthisgreaterfundingbeusedforimprovingpublichealthandgrassrootsservices.Thecentralgovernmentalsoproposestoplacemoredrugsontheessentialmedicinelist.

Over and above this, there appears to be a commitment by the centralgovernment to ‘lead’ healthcare reforms on the supply side. It promises to‘rationallydetermine thepayment criteria fordrugs,healthcare services andmedicalmaterials’; tocheck that the ‘salary levelofhealthcareworkers is inlinewiththeaveragesalarylevelofstaffoflocalpublicinstitutions’;tosetthe‘servicechargesofgrassrootshealthcareinstitutionsaccordingtothecostsafterdeductionofgovernmentsubsidy’;andfinally,toensurethatdrugsare‘soldatzeropricemargin’.Itisthoughtthatthiswillstopdrugrevenuefrombeingthe‘majorcompensationsource’forfundinggrassrootshealthcareinstitutions.Rather,thegovernmentthinksthatitwill‘providerationalsubsidiestoruraldoctorsforprovidingpublichealthservices’.Crucially,localgovernmentswillregulatethecriteriaforthesemeasures.Thereisnomentionofwhichlevelofgovernment will pay the providers themselves, but it is presumed from thechoiceofregulatorybodythatitwillbelocalgovernments.

Onthedemandside,thesubsidyonSHIprogramswillbeincreasedsothatthefundsreachaminimumofRMB120percapitaperannum.Greater focuswillbeputonoutpatientexpensesandthereimbursementrangewillbeincreased.

22 Themostrecentboutofreformwasintendedtobeaseminalreform.ItwasanointedbytheStateCouncilandLiKeqianghimselfledtheproject.Manymultinationalconsultingfirms,foreignandlocaluniversitiesandthinktanksalsoconsultedontheproject.Thefulldetailsofthereformcanbefoundat<http://shs.ndrc.gov.cn/ygjd/ygwj/>23 Thefollowingsectionistakenfromdetailsoftheplan,whichcanbefoundat<http://shs.ndrc.gov.cn/ygjd/ygwj/>Anytranslationmistakesarethefaultoftheauthor.


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The scope and proportion of reimbursement for outpatient expenses will beexpanded. In rural areas, county governments are mandated to reimburse ahigheramountofNCMSfunds.24

The most radical part of the reform is a promise to shift away from publicownership.Thegovernmenthaspledgedtocompensatehealthcarenon-profitorganisationsforany‘grassroots’worktheydo.Ithasalsoencouraged‘qualified’physicianstorunclinicsorestablishtheirownclinicsorpractices.Theenvisagedcompensationmechanism is throughSHI reimbursement, althoughproviderswillbeforcedtosigna‘designatedinsurancecontract’.Similarly,‘effortswillbemade’totransferownershipofpublichospitalstonon-publicinstitutions.

Finally, governance reforms are promised. These reforms include tryingto ‘encourage’ local governments to ‘actively explore effective formats ofseparatinggovernmentagenciesandpublicinstitutions’andtotrytoseparate‘governmentadministrationandbusinessoperations’.Themostsignificantoftheseisamooted‘negotiationmechanismbetweenmedicalinsurancehandlinginstitutions and providers of healthcare services’. This, if done effectively,wouldundoubtedlybeamajorstepforward.

Future paths and conclusions

Overall,however, theChinesegovernmentappears tobecaught inabind inwhichitistryingtodotoomanythingsatonce.Itwishesto‘rationallydeterminethepaymentcriteriafordrugs,healthcareservicesandmedicalmaterials’,yetsimultaneouslycommitsmassiveamountsoffundingtodemand-sideprogramsinwhichindividualsareforcedtonavigateflawedgovernmentincentives.

Clearly,asinsurancecoveragewidensandthefundsdevotedtoinsuranceincrease,theabilitytousethesedemand-sideprogramstoreformthepaymentsystemsofproviderswillalsoincrease.Thecurrentmodel,however,requirestweakinginordertochangethebehaviourofproviders.Theinsurancemechanismwouldbenefitfrommovingfromapost-hocreimbursementmodeltoamorecontractualmodelinwhichinsurancebodiesactasgenuinethird-partypurchasersandinwhichinsurancebodiesareabletousemixed-methodpurchasingtechniques.Anumberof studies inChinaacrossdifferentgeographicalareasandserviceprovidershaveallreportedconsiderableimprovementsinaffordability,accessand patient satisfaction following shifts to mixed-method models (Yip andEggleston2001;YipandEggleston2004;Wangetal.2005;Hsiao2007a,2007b;Wagstaffetal.2009).

24 Thisistheso-called‘85–93rule’,wherebycountygovernmentsaremandatedtoreimbursenolessthan85percentoftheNCMSfundfromtheyearbuttonotreimbursemorethan93percent.


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A shift such as this will also require the Chinese government to clarify itsown political structure and strategy at a number of levels. For example, theresponsibilities for the current insurance schemes at the central governmentlevel itself are divided between the Ministry of Health and the Ministry ofLabour and Social Security. Reform proposals are often bitterly contestedbetweenthesetwoministriesatthecentrallevel.25

ThislackofclarityisaproblemthatreinforcesitselfwithinChina’sgovernancestructurebothhorizontallyandvertically.Forexample,thecentralgovernmentthinks that it will ‘provide rational subsidies to rural doctors for providingpublichealthservices’,yetthelocal(mostprobablycounty)governmentwillregulate the criteria for these measures. The very same local government,however,hasconsiderableincentivestoensurethathospitalsandcommunitycentres—underfundedbythepublicpurseforalengthyperiod—donotgooutofbusiness.Assuch,allowingthecontinuanceofadistortedsysteminwhichproviders are forced to choose between providing low and high-cost healthservicesmakesanysortofreformsdifficult.

Changingthissystemisnotmerelyadministrativelyandfiscallydifficult.Italsorunsparallel torecentpolitical trendsthatpointtothegreatercentralisationof Chinese governance. As Barry Naughton (2010) observed so perceptivelyabout the 2010 National People’s Congress, the current central governmentlinefollowingtheglobalfinancialcrisisistheeffectofwhatWenJiabaocalled‘macro-control’.Macro-controlisdefinedascontinuing

to make use of both market mechanisms and macro-control, that is,at the same time as we keep our reforms oriented toward a marketeconomy,letmarketforcesplaytheirbasicroleinallocatingresources,and stimulate the market’s vitality, we must make best use of thesocialist system’s advantages, which are making decisions efficiently,organizingeffectively,andconcentratingresourcestoaccomplishlargeundertakings.(Wen2010)

It is difficult to see how concentrating resources can accomplish largeimprovementsinhealthcare.Forexample,moregenerousearmarkedtransfersforpublichealthprogramshavebeenmootedfortheprovinciallevelinordertoattempttoreducethehorizontalfiscalinequitiespresentinthecurrentChinesesystem.Yet the current vertical inequities indicate that 50 per cent of theseextra fundswouldbedirected intourbandemand-sideprogramsandwoulddoverylittletochangetheincentivesforbureaucratsandprovidersatlowerlevels.Itishardtoseehowconcentratingresourcesatthecentrallevelwouldnotmerelyreinforcethecurrentflawedincentives.

25 Hsiao(2007b)coversthisatlength.


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Atrulypromisingcourseofreformforthenext20yearsofChinesehealthcarewouldbeashiftawayfrommacro-controltowardswhatwecanterm‘micro-control’.Anyprogramofreformwouldneedtoconsidersupplyanddemand-sideissues.

True supply-side reforms would embrace sector neutrality. The governmentwouldneedtoeliminatethehigh-cost/low-costpatientdistinction,decidetheownershipstatusofhealth institutionsandexaminereformof the incentivesforlocalbureaucrats.Similarly,attemptswouldneedtobemadetosecurefarhigherlevelsoffundingfortownshipandcountygovernmentstoactaseffectivemonitors, measurers and regulators and to secure greater funding for publichealthproviderstoensuremoreefficient‘gatekeeping’.Therewouldneedtobehorizontalandvertical intergovernmentalfiscal reform inorder toamelioratethecurrent incentives forprovidersandpatients tomove tomoredevelopedareas.Finally,therewouldneedtobesomeconcessionsto‘losers’fromthesereforms26—andtheywouldundoubtedlycomeatconsiderablefiscalcostandadministrativedifficulty.

The other option for the next 20 years is to truly embrace demand-sidereform.Makingdemand-side institutionssuchas theBMIorNCMSagenciesaccountabletothepopulationstheyserve(andthatfundthem)wouldcreatehuge incentives for improving service delivery. This would be particularlytrue if these demand-side institutions are allowed to embrace new paymentmechanismsandactivepurchasing.Vitaltothisoccurringwouldbetonotonlyensureuniversalcoverageby2011,asplanned,buttocounteractproblemsofportabilityandinequity.Allowingtransfersbetweencitieswithbasicmedicalinsurance,forexample,wouldbeagoodstart.Betteryetwouldbetocontinueandevenexpandthelargefundingincreasesforthedemand-sideprograms;tomakehealthinsurancepartofasinglecentralgovernmentministry’smandate;tomergeurbanunemployedandruralschemesandensuretheyarealignedwiththeBMIprogram;andfinally,tomakehealthinsurancepackagesfullyportable.

When considering the next 20 years of reform, it is difficult to avoid theproblemsoftoday—andtheseproblemsarefirmlyanchoredbyeventsinthepast.Specifically,inequalitiesinthefiscalandpublicgoodsystemwerelinkedtoinequalityinserviceprovision.Moreover,theintersectionoftheseinequalitiescreatedflawedincentivesthatledtopooreroutcomesforChinesecitizensandthattodayhinderreform.ReformproposalssuchasthemostrecentApril2009planmustnavigatethesameflawedinstitutionsthatbroughtaboutdiscontentwith the health sector. Without attacking these incentives, systemic reformremainshighlydifficult.Assuch, it isdifficultnottofeelsomewhatcautiousaboutthenext20yearsofreform.

26 ThispointwasfirstmadebyEgglestonetal.(2008:163).


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The Chinese central government has, however, shown a considerable, andlaudable, commitment to healthcare spending throughout the past decade.Althoughmuchremainstobedone,amarryingofthiscommitmenttofundingwithacommitmenttoredressingtheflawedincentivesinthesystemcouldhaveadramaticimpactinthenexttwodecades.

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393

agricultural underemployment28,145,244,

260,261 wages9,172,173,321agriculture31,32,41,47–8,172,173,

174,243,263,298,301,303,315,322 aspoolofsurpluslabour12,321,322,

324,326,336anti-dumping213Asia currencies181 economies10,80,184n.19,193–4,

195,201,209,295,355 foreigndirectinvestment(FDI)221–

37,239 trade184,193–215AssociationofSouth-EastAsianNations

(ASEAN)106,141,195,196–204,206,207,209,210,214,234

AssociationofSouth-EastAsianNations(ASEAN)–ChinaFreeTradeAgreement(ACFTA)234

balanceofpayments168n.5,169,179,184,271

bank central,see People’sBankofChina credits46 commercial175,177,178,185,301,

302,314 deposits160 loans274,283 private281–2,283 reserves177,178 state-controlled(SCBs)43,273–4,

275n.10,281,282,283 state-owned(SOBs)275n.9 system269,270,273,283,305‘BeijingConsensus’31,39–41bio-power107,285capital304–5,307,309,311,356 account43,166,168–70,184 accumulation1,23,143,156,157,235 controls9,158,160,164,169,175,

177,179–81,185 cross-borderflows2,158,159,161 flow77n.3,144,157,168,169,221 formation84,221 inflows154,158,160,331 investment42,50,144 outflow48,154,161,296–7 requirement300,312,314,315 returnson182 shortage77n.3 stock12,24,48,79n.6,82n.9,144,

179,180,224,294,303capital-intensivegoods26,33,34capital-intensiveindustry136,142,145,

308,349,351capital–labourratio322,348,351catch-up9,35,144,159,160,163,285,

288,356centrallyplannedeconomy1,270n.1Chinainter-bankofferedrate(CHIBOR)

305,311ChinaInvestmentCompany(CIC)178,179ChineseCommunistParty(CCP)41,44–

51,65,128,147,270climatechange4,5,8,94,99,100,106,

110,112,119,120,278,285,293,302,316

coal ‘clean’286 consumption102–3,107,114,285 dependenceon99 prices118,306 production114,137,139,277n.15,

313,315CoastalDevelopmentStrategy127CommonwealthofIndependentStates

(CIS)8,75,84comparativeadvantage2,3,23,26,30,

33,34,74,82,94,141,235,281,354consumerpriceindex(CPI)158,172,

173n.10,272,299consumption24,27,50,74,156,182–3,

283,295,302,308,310–11,316

Index


394

basket75 domestic4–5,9,27,33,158,330 durablegoods94 efficiency160 household73,295,301,310,315 patterns76 preferences89 private176,213 rate23,295,296 share22,33,293,294,299corruption59,65,66,146,223,227,270,

271,277,284,285,293,311currencyappreciation9,10,34,153,

154–5,156,158,160–1,163,164,165,170,177–8,179,181–5,305,289n.29,302,305

debt159,175,333,348,349,315 government65,178,274 national153 public33,212decentralisation2,53–4,55–60,100,366 fiscal7,42,47,53,273n.6,330decouplingthesis10,193–217democracy39,40,47,51,56,58,65,67,

159,270,284,289democratisation7,51DengXiaoping1,127,128,142,366desertification279,280,286disparity,rural–urban45,212,298,299,

377drought278,280,285EastAsia21,48,79,85,288,295,319 dollar181 economies10,226,230,231,295,355 financialcrisis169,175,222,243,

249,305 trade193–217education2,3,26,27,28,173,213,223,

277,372 compulsory336 expansion35,143 expenditure116,144,156,171 investment30,32,147 overseas157 primary41,43,330 products137,139 provision28,60,65,75 quality30

rural49,156 tertiary144,336electricityconsumption83,85energy73,157,285,342 conservation8,99–120,302,313,

314,315,316 consumption3,99,101,102,113,

114,115,118,119,301,313,314 demand3,107,113 efficiency101–6,110,117,293 intensity3,100,101,102,111,112,

113,115,119,293,302,314 -intensiveproduction3,8,101,111,

117,120,300,301,313,315 pricing3,79n.6,101,120,306,308,

309,311 projects146 reliability8 research286 resources143,305,307n.2,308 -savingtechnologies3,4 supply102 use100,101,103,110–11,112,114,

115,118,119,314environmental amenity94 consequencesofgrowth8,99,101,

341 costs106,116,294,305,306–7 degradation(see also pollution)4,11,

12,99,106,109,270,271,278,279,280,285–6

friendlyindustry4,300 policy8,100,116,285 protection100,117,118,127,313–16,

342 standards103,302 technology4Europe74,84,153n.2,158,159,181n.17EuropeanUnion(EU)57,104,106,107,

115,180,195,196–7,198,199–200,203–4,205,209,210,214,224,288

exchangerate33,163–193,227,287,296,305,311

adjustment156,158 appreciation25,35,155,165,168,

170–4,213 debate9,153

Index

395

fixed34,305 floating43 nominal25,35,213n.10 policy153–61,297 real9,25,35,154–6,163–85,213 regime3,5,289n.29,311 stability155–9 unified41exports10,46,79,82,84,130,193–5,

199,200,201–5,208–10,217,221,228,233,235,341,348,351

agricultural184 capital296,297 commodity23,356 competition213 constraintson164 contraction11,184,208–9,241,247,

250,271,272 costs155 demand20,178,212 disincentives10 distortions310,311 expansion19,34,184 growth23,41,42,45,174,195,196,

210,212,216,293,296 high-technology355–6,358 industrial183 investment316 labour-intensive3,241,304 manufacturing185,196–7,198,199,

200,201,205,215,354,355 merchandise200,207,209–10,211,

212 orientation8,31,34,74,213,226,309 prices34 promotion289n.29,305,309,214 relianceon4,212,214 revenue177 sector157,184,185,213factorinputs94factormarket distortions12,294,303–10 domestic3,217 reform6,12,294,311,312factorprices79n.6Five-YearPlan(eleventh)100,101,115,

118,212–13,217,293‘flyinggeese’model141,142

food136,137,139,243,276 prices29 supply73,275forcedlabour276,277foreigndirectinvestment(FDI)1–2,130,

157,169,216,221,225,272,341 approved175 attracting10,215 barriersto41 inflows10,175,221,222–4,225–30,

232,234–7,239,269 outflows10,229,232,235freeelections11,47,56,57,64,65,66,

285freetrade215,287,288free-tradeagreements(FTAs)214,215,

216,234fueleconomystandards105G20214GDPgrowth1,50,87,91,95,99,101,

116,118,130–1,132,176,226,239,241,269,270,271–2,289n.29,309,312,314,320,342

GeneralAgreementonTariffsandTrade(GATT)287,288

Ginicoefficient48,49,277,298globalisation2,214,287GreatDepression,the60,61,205,206,

213GreatLeapForward41healthcare46,60,75,171 accessto5 expenditure41 interventions277 reform13,49,363–87 rural213 system3,5,270 see also insurance—medicalhomeownership11,281,282HongKong57,58,129,130,141,154,

155,160,169,179,180,195,198,202,204,207,209–10,222,229,233,234,282,284,349,351

HuJintao46,128,284,285hukou (householdregistrationsystem)12,

13,46,163,173,174,258,259,263,328,329,336,337

humancapital3,144,277


396

hydropower107,300,315n.6imports42,79,82,84,153,155,157,

168,194,195,198,199,200,202,203–5,206–7,208,209–10,211,212,216,233,288,296,309,316

competing173,215 components184,185 contraction184 costs161,177 cutting185 demand5 manufacturing198,201,205 rawmaterials231 technology75India79n.8,84,106,108,147,158,179,

180,181,193n.1,198,214,229,230,231,234,280,285,288,356,368

Indonesia106,198,202,207,209–10,222,229,230,231,243,249,368

inequality income5,12,19,23,24,25,33,48,

79–80,142,277,284,297–8,371 regional9,127,132,141,143,144,

146,147,148 social3,34,47,48,271,386informationandcommunication

technology(ICT)196,208,209,210InformationTechnologyAgreement214insurance171,369 medical171,185,243,249,302,304,

364,365,369,374–8,381,382,384–6 retirement171,175,243,249,332 social252 unemployment243,249,332,334,

335 welfare249 workinjury249,304intellectualpropertyrights13,43,227,

342,357,358interestrates9,33,41,43,154,157–8,

159,160,178,182,183,282,302,304–5,311

Japan8,74,75,156,195,234,284,319,327,352,354,357,368

currency154 economicdevelopment21 economy158,159,179,183

energy103 exports196–7,207,208–10,355–6 foreignownership180–1 GDP288,309 Ginicoefficient49 growth2,155,172 Imperial48 imports207 industry141,239n.215 metalintensity84,85,87,89,91,95 pollution279,286 trade198–205,214 vehiclestandards104JiangZemin127labour agricultural11,19,32,213,241–64,

268,260,261,262,304,323,324–9 leavingindustry12–13,19,213,

242,322,323,327,328–30,337 mobility2,5,26,46,141,168,244,

304,334,335 surplus3,6,12,19–35,142,143,145,

147,174,304,321,322,324–6,336landclassification277,282–4,306,312lawofoneprice164,168,184leapfrogging8,75,76,77,79,81,85,88,

92,93,94,95,331legislation CriminalLaw276 EmploymentContractLaw332,334 environmental306 InterimMeasuresontheTransfer

ofContinuationofBasicPensionforUrbanEnterprisesEmployees334

LabourLaw331 LandAdministrationLaw305–6 NewLabourContractLaw241 PropertyLaw43,49 RegulationonMinimumWagesin

Enterprises331 Regulationsonstrengtheningcontrol

ofinvestmentinfixedassetsandnewlystartedprojects301,314

RenewableEnergyLaw108Lewis,Arthur6,20,21,26,87,141Lewisianturningpoint’6,12,142,145,

320–2,324–7,330,331,332,336,337

Index

397

liberalisation2,214,289n.29,308 capitalaccount42 financial41,43,179,283,305 foreigndirectinvestment(FDI)42 market12,294,302–8,311,312 programs1 trade11,30,42,172,215,216,222,

288,302 see also priceliberalisation‘liquiditytango’273,274Macau129,130,349,351MaoZedong278,280marketeconomy1,6,7,12,40–1,43,45,

58,65,66,144,147,159,193,270n.1,275,303,305,312,336,385

markets capital22,179,184,185,304,307,

311 energy306 see also factormarketmetalconsumption73,78,85,88,93,94Mexico180,181,198,355,376n.11migration,rural–urban5,11,12,21,

30,172,241–64,299,304,307,319,321–5,326,328

MinistryofEnvironmentalProtection315MinistryofFinance176n.15,302,304n.1MinistryofHealth377,385MinistryofHumanResourcesandSocial

Security(MoHRSS)242MinistryofLabourandSocialSecurity

385MinistryofPublicSecurity276‘monetarymercantilism’175–7,181NationalBureauofStatistics(NBS)306,

323,332NationalDevelopmentandReform

Commission(NDRC)102,109,117,273,300,306,309,313

NationalPeople’sCongress272,385neoclassicaleconomics7,41,43,44,141,

144neo-liberal39,43NewCountrysideMovement49newlyindustrialisedeconomies(NIEs)

195

non-performingloans(NPLs)273,274,281,282,283

NorthAmericanFree-TradeAgreement(NAFTA)195,196–7,198,199–200,203,204–5

One-ChildPolicy3Open-DoorPolicy1,45,127,142OrganisationforEconomicCooperation

andDevelopment(OECD)60,84,224,354,356

pensions304,332,333–4 see also insurancePeople’sBankofChina(PBOC)154,175–

9,181,182,183,184,185,296,301,302,305

pollution99,280,285,293–4,306,309,310

air278n.16 coal114 industrial8,120,301,313,314 reducing100,101–6,116,118,293,

302,314 vehicleemissions105–6 water278,279population4,10,42,45,48–9,77–8,130,

132,333 ageing3,235 control320 growth25,28,278 migrant246 pressures270 projections32 rural23,365,368–9,376 shiftin87,320 urban2,82,84,328,329–30,373 working-age2,30,32,145,320poverty1,5,21,130,145,146,147,277,

283–4,297,310,319,326,369,372,373,378

priceliberalisation155,303,306 agricultural303privatisation9,13,41,42,45,156,171,

274,282,283,312,351,352,358productivity44,80,94,226,341,348 agricultural29,116,213,244,263,

319,321 capital141


398

catch-up9,160,163–4 gains1,28,87,143–4,153,154–5 growth4,5,11,21,24,35,154,159,

160–1,165–6,168–9,173,184–5,271,275,281,282,356

labour3,23,142,156,165,227,236,321,322,348

raising21,29 urban46,299propertyrights11,42,43protectionism153,183,213–14,278,

286–8purchasingpowerparity(PPP)352recapitalisation274n.9,275,283n.25re-employmentprograms45,49,245n.2,

254n.3regionalimbalances128,270renewableenergy100,106–10,113,118‘RevivetheNortheast’scheme128,143‘RiseoftheCentralRegion’scheme128ruleoflaw7,57,58,60,65–8,270,275,

285rules-of-origin(ROO)215,216Rural–UrbanMigrationinChinaand

Indonesia(RUMiCI)Project11,241–2,244,245,251–2,258

Singapore49,106,141,179,180,195,198,199,202,207,209–10,222,223,229,231,233,234,282,295,306,355

socialunrest11,46,47,48,49,50,51,176,241,271,277,284

soft-budgetconstraint175,273,283,366,368,380

SouthKorea8,48,85,319,352,357,368 economy77n.3 exports207,208,209,355–6 foreigndirectinvestment(FDI)222–3,

229–31 foreignownership179–81 Ginicoefficient49 growth2,155,172 imports210 income80 industry141,215n.15 labourcosts29,354 pollution279,286

steelintensity74,84,87,89,91,93,95 trade195,197,198,199–200,201–4,

214,233,234SovietUnion45,57,58,270n.1specialeconomiczones(SEZs)42,45,222StateCouncil102,146,284,301,306,

342n.2,375,383n.22state-controlledenterprises(SCEs)273,

274,281,282,287State-OwnedAssetsSupervisionand

AdministrationCommission63state-ownedenterprises(SOEs)13,30,

42,45,46,47,49,63,130,143,156,171,175–6,185,273n.5,274,311–12,333,350–2,357–8

statistics agricultural73,139 consumption114 energy100,113–16,119 reliabilityissues8,100,111,113–16,

119steelconsumption77,81,84,87,89,90,

93stimulusprogram50,157,212,272,273–

5,281,282,283,316,327structuraladjustment2,6,34,45,287,

295,296structuralimbalance3,12,293,294,308,

309,310,370subsidies agricultural173n.9,174,288,293 energy120 export12,214,293,294,215,302,

310,314,315Taiwan47,48,80,84,91,95,130,141,

155,169,172,179,180–1,195,197,198,199–200,201,202,207,208,209–10,222,229,230,231–3,234

tariffs agricultural172n.8 import183taxation42,52,54,55,59,61,63,64,

114,116–17,176,227,310,311–12,342,366,370,371–2

exemptions309 reform7,41,370

Index

399

taxes agricultural173n.9,302,306,312,

313,326 arablelandoccupation117 coal101,118 consumption104,116 contract117 corporate42,223 development117 export101,173,183,184,185,293,

302,314,315 income42,116,302 inflation41 property118 resource118 trade183–5 urbanland-use117 vehicleexcise104 vehiclepurchase116,315 see also value-addedtax(VAT)Tax-SharingSystem(TSS)57,62,63,64,

65,67,116,117,118,370,371Todarodogma12,321,325–30,334‘Top1000EnterprisesEnergy

ConservationActionProgram’102,117

totalfactorproductivity(TFP)144,323 growth24,34,144,356townandvillageenterprises(TVEs)41,

46tradesanctions213,214,286transferpayments,intergovernmental5,

53–60,62–4,67,68,370,371,372,381,385

UnitedNations(UN)57,91,92UnitedStates6,33,35,45,58,60,79,80,

84,113,145,183,213,214,352,353,354

consumption94,153,157,287 currency153,154,155,163,181,297 dollarpeg154,161,170,181–2 economy156,157–60,163,164,165,

167,170,181,274,275,285,287 energy103 exchangerate34,153,154,167,287,

305 exports153,355

exportsto208,209–10 foreigndirectinvestment(FDI)224 foreignownership180–1 fueleconomy104 GDP270,271,309 labourcosts29,213 metalintensity80,84,85,87,89,91,

95 pollution279,286 productivity184,212 renewableenergy107–8 trade184,213,269,287,288,289n.29urbanisation2,3,4,11,12,73,78,80,

82,84–5,87,88–9,90,91,153,159,281,282,283,289n.29,311,319–37

value-addedtax(VAT)42,63,108,116,173

WashingtonConsensus31,39–41,43water138,139,278–81,284–6,302,311,

313,342,367 transfer280,281,285,286,289n.29WenJiabao46,153n.2,273,275,281,

284–5,293,300,310,385West–EastGasPipelineproject127West–EastPowerTransmissionProject

127WesternRegionalDevelopmentProgram

(WRDP)127,128,129,141,146windpower107–10,120WorldBank278n.16,377WorldTradeOrganisation(WTO)5,172,

287,289n.29 China’saccessionto20,30,42,45,

101,143,164,166,169,171,172,183,184,221,222,269,299

ZhuRongji273

Documents

China: The Next Twenty Years of Reform and Development · ASEAN Association of South-East Asian Nations BMCDR Beijing Municipal Commission of Development and Reform BMI Basic Medical