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This article was downloaded by: [Universite De Paris 1]On: 04 September 2013, At: 00:46Publisher: RoutledgeInforma Ltd Registered in England and Wales Registered Number:1072954 Registered office: Mortimer House, 37-41 Mortimer Street,London W1T 3JH, UK

The Journal of DevelopmentStudiesPublication details, including instructions forauthors and subscription information:http://www.tandfonline.com/loi/fjds20

Subsidising inequality:Economic reforms, fiscaltransfers and convergenceacross Chinese provincesMartin Raiser aa Chief Economists Office, European Bank forReconstruction and Development, LondonPublished online: 23 Nov 2007.

To cite this article: Martin Raiser (1998) Subsidising inequality: Economicreforms, fiscal transfers and convergence across Chinese provinces, The Journalof Development Studies, 34:3, 1-26, DOI: 10.1080/00220389808422518

To link to this article: http://dx.doi.org/10.1080/00220389808422518

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Subsidising Inequality:Economic Reforms, Fiscal Transfers andConvergence Across Chinese Provinces

MARTIN RAISER

The article investigates per capita income convergence acrossChinese provinces over the 1978-92 period. It confirms previousstudies which find a reduction in inter-regional income inequalityover the course of economic reforms. However, the rate ofconvergence has declined since 1985 as a result of two factors.First, the shift from rural to industrial reforms hasdisproportionately benefited the relatively wealthier coastalprovinces. Second, the system of inter-provincial fiscal transfershas prevented convergence among interior provinces, as transfershave gone to the richer among them. Further fiscaldecentralisation and an acceleration of reforms in the interiorprovinces is thus unlikely to increase regional income inequality.

I. INTRODUCTION

In a vast country such as China, the regional impact of economic reformsnaturally commands high policy interest. As regions may differ accordingto initial conditions such as economic structure, resource endowments, andlevel of development, the outcome of China's transformation processtowards the market is expected to be regionally differentiated. Moreover,one element of the reform process in China has been the reduction of inter-provincial fiscal transfers from the coastal area to the interior. Indeed, in

Martin Raiser, Chief Economists Office, European Bank for Reconstruction and Development,London. This article was written while the author was a research fellow at the Kiel Institute ofWorld Economics, Germany. The views expressed are the sole responsibility of the author and inno way reflect the opinion of either the Kiel Institute or the EBRD. The author thanks ErichGundlach, Peter Nunnenkamp and Rolf J. Langhammer for extensive discussion and twoanonymous referees for comments on an earlier draft. Financial support from the VolkswagenFoundation for the Project 'Decentralisation and Enterprise Reform in China' is gratefullyacknowledged.

The Journal of Development Studies, Vol.34, No.3, February 1998, pp.1-26PUBLISHED BY FRANK CASS, LONDON

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2 THE JOURNAL OF DEVELOPMENT STUDIES

recent years, there has been a growing concern that a widening income gapbetween the prosperous coast and the laggard interior might eventuallycause the break up of the Chinese national state. Such concerns (typicallyassociated with a call for more inter-provincial redistribution) run counterto the theoretical expectation that regional income convergence shouldaccelerate in a country implementing economic reforms as factor marketsimprove and capital starts flowing from richer to poorer areas.

This article presents results that overall confirm the theoreticalexpectation that reforms have led to the convergence of per capita incomesacross Chinese provinces. However, this process has been uneven bothacross time and across regions of China. The article shows that convergencewas more rapid during the early reform phase than after the mid 1980s. Thisrecent slow-down in convergence is due to a combination of two factors; awidening average income gap between the coast and the interior and thepartial reversal of convergence among interior provinces after 1985. Whilefaster growth along the Chinese coast can be explained as a result offavourable structural conditions and rising investment rates, the lack ofincome convergence among interior provinces after 1985 may at least partlybe attributed to the perverse effects of inter-provincial transfers, causingcapital to flow to rich rather than poor provinces. While data imperfectionslimit the policy conclusions that may be drawn from the present analysis,the unexpected impact of fiscal transfers on convergence suggests thatfurther fiscal decentralisation is unlikely to harm the poorest interiorprovinces.

The results of this article are related to a growing body of empiricalliterature on provincial economic development in China during the reformperiod. Hsueh, Rawski and Tsui [J994] and Wu [1995] look at regionalefficiency improvements in state industry, and state industry only, ruralindustry and agriculture respectively. The first source finds a convergenceof efficiency levels in state industry across provinces, indicating thattechnologically backward provinces have moved closer to the productionfrontier with economic reforms. The results in Wu [1995] are moreambiguous, revealing that the convergence of efficiency levels in stateindustry has been confined to the coastal area. In rural industry (which islargely free of state interference) efficiency levels have tended to convergethroughout China, while in agriculture they have diverged. The averageweighted increase in Total Factor Productivity (TFP) has been higher alongthe coast than in the interior, a result that will be supported below. Jian,Sachs and Warner [1996] and Gundlach [1996a] study the convergence ofGross Domestic Product (GDP) per worker across Chinese provinces overthe 1952-1993 and 1978-89 periods respectively. Both find a convergencerate of around two per cent per annum for the whole reform period. Jian,

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ECONOMIC REFORMS . . .AND CONVERGENCE: CHINA 3

Sachs and Warner also show that there was no convergence before the startof reforms in 1978 and that the trend towards income convergence duringthe reform period had stopped by the early 1990s. These results are inaccordance with the present study, although the interpretation differs fromthe one given in this paper, as discussed below.

The article is structured as follows. Section II presents the evidence onregional income convergence in China since 1978. It identifies a slow-downin the rate of convergence for the 1985-92 period and discusses twotheoretical possibilities that could account for this finding. Section IIIexplains the better post 1985 growth performance along the coastalprovinces of China in terms of an increase in investment and higher TFPgrowth. It then estimates convergence rates conditional on investment ratesand structural conditions that might be related to higher TFP growth andfinds evidence for conditional convergence after 1985. Section IV turns tofiscal transfers and their impact on capital flows and investment rates acrossChinese provinces to account for the lack of income convergence amonginterior provinces. Section V concludes and draws some policyimplications.

II. CONVERGENCE IN CHINA SINCE 1978

(1) Measures of ConvergenceThere are two ways to measure the convergence of per capita incomes. Thefirst measure computes the coefficient of variation of per capita or perworker incomes. Thereby, GDP is typically taken as a measure of income,abstracting from transfers from abroad. If the coefficient of variation of percapita or per worker incomes falls over time in a given cross-section ofprovinces or countries, sigma convergence is said to obtain [Sala-i-Martin,1995].' The second measure of convergence is obtained by regressing thegrowth rate of per worker incomes against a constant and its initial level asdefined by equation (1). This yields an estimate of beta convergence.

\nYt - In7o = A - (l - (1)Yt - income per worker at time tYO - initial income per workerA - regression constant equal to ( l -

with Y* = steady incomeP - convergence rate per annum/ time index.Equation (1) is derived from a standard neo-classical growth model. In

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4 THE JOURNAL OF DEVELOPMENT STUDIES

the recent reformulation of this model by Mankiw, Romer and Weil [1992],the level of income is described by a Cobb Douglas production function ofthe form Y=F(K,HK,L,t), where K, HK, L stand for physical capital, humancapital and labour inputs respectively and t represents time. Constantproportions of income Y (sk and sh) are saved and invested in physical andhuman capital and a constant rate of depreciation applies to both types ofcapital. Under these assumptions, the ratio of capital and human capital perworker and with it real income per worker grow at decreasing rates, until theeconomy reaches the so-called 'steady state'. In steady state, the ratios ofphysical and human capital to labour are constant and real income grows atthe (exogenous) rate of technological progress, g. The level of real incomeper worker in steady state depends positively on the savings rates inphysical and human capital and is negatively related to the rate ofdepreciation and the rate of population growth.2 The adjustment path of realincome per worker towards the steady state level is obtained by a linearTaylor approximation of steady state income and leads to the relationship in(1) [Mankiw, Romer and Weil, 1992]?

The sigma and beta measures of convergence are related to each other inthat the existence of beta convergence is a necessary condition for sigmaconvergence. However, it is not a sufficient condition. Because the cross-country evidence for sigma convergence is weak, recent contributions to theneo-classical growth literature have introduced the concept of conditionalconvergence, whereby the estimate of beta in (1) is conditioned by variablesthat control for differences in steady state incomes across countries oreconomic regions. Conditional beta convergence may obtain even in theabsence of sigma convergence [Sala-i-Martin, 1995]. In other words, whilesigma convergence measures the absolute dispersion of incomes, betaconvergence conveys information on the catch-up potential of pooreconomies.

(2) The DataResearchers working on regional economic development in China in principlecan draw on both national and a set of provincial statistics, giving more or lesscomplete coverage of all provinces and autonomous regions from around1978 until 1995. However, complete volumes of regional statistical yearbooksare not easy to obtain outside China. Moreover, data collection methodologiesmay differ and issues of comparability and consistency across provinces arise[Herrmann-Pillath, 1995; Jian, Sachs and Warner, 1996]. The shortcomingsof the original sources have prompted a number of projects aimed at thecompilation of easily accessible and reasonably consistent cross-provincialdata sets. In computing the two convergence measures introduced above, Idraw on two of these secondary sources in particular.4

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ECONOMIC REFORMS . . . A N D CONVERGENCE: CHINA 5

Hsueh, Li and Liu [1993] have provided a comprehensive set ofprovincial statistics drawn from the provincial statistical yearbooks andcovering the period 1949-89. The authors have attempted to use aconsistent methodology in compiling these data, thereby overcoming someof the potential problems of comparability. The disadvantage of this firstsource (referred to as Data 1 below) is that the time period starting with thereforms in 1978 is thereby shortened to only 11 years and more recentdevelopments are not captured. Moreover, as Jian, Sachs and Warner [1996]point out, the data in Hsueh et al. [1993] become increasingly unreliabletowards the end of the 1980s. These authors thus complement the firstsource with data from national sources (the China Statistical Yearbook andthe China Price Statistics Yearbook) in addition to more recent provincialstatistics for the second half of the 1980s and the early 1990s.

While I have not been able to obtain Jian, Sachs and Warner's data-set,Herrmann-Pillath [1995] offers a recent compilation of basic nationalincome and production statistics, retail prices, labour force and populationdata for 1978-92 drawn from the China Statistical Yearbook (SSB, variousissues). National sources also offer the advantage of methodologicalconsistency across provinces. Additionally, accordingly to Herrmann-Pillath [1995], SBB has attempted to correct labour force and populationdata at the province level to take the substantial increase in migration duringthe 1980s into account. When a large number of rural residents left theinterior to work as labourers in the booming coastal cities, such movementswere often not recorded by provincial employment records. However,national records still fail to account for the substantial 'floating population'of temporary migrants that live in the shanty towns of China's metropolitanareas [Herrmann-Pillath, 1995].5

Another potential problem with national data are the reported provincialprice deflators [Jian, 1997]. Herrmann-Pillath has a detailed discussionabout the accuracy of the SSB price data. At least up until the late 1980s,the differences between the two secondary sour...