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Rebalancing China's economic structure

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In Brief

Despite its extraordinary growth performance during the past decades, China’s structural risks have also increased significantly.  Premier Wen and other senior leaders have repeatedly emphasised that the existing growth pattern is unstable, unbalanced and unsustainable.

One of the most widely identified imbalance problems is the rising share of investment in GDP, which increases the risk of excess capacity and low returns.

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A persistent current account surplus means that China, as a low-income economy, has been exporting capital despite domestic investment needs. Most of the current account surplus is held as foreign exchange reserves, which have relatively low returns and are vulnerable to exchange rate risk. In addition, the surpluses indicate the degree to which Chinese growth is dependent on external demand.

Income inequality has also drastically increased.  The Gini coefficient rose from 0.25 in 1985 to 0.47 in 2008, indicating high risks of social and economic instability.

In addition the corporate sector and the government’s share in total national income have increased steadily, resulting in the income share of households decreasing from 68 per cent to 50 per cent. This trend could be important for explaining the declining share of consumption in GDP.

Other growth quality problems include inefficient resource use, serious pollution, and corruption among local government officials.  If these problems persist, China’s strong economic growth will be unsustainable.

Changing the growth model is one of the top policy priorities under Wen’s government, which has already undertaken a range of policy measures to adjust China’s economic structure. For instance, it has taken various steps to stimulate consumption, contain investment growth, reduce overcapacity in certain industries, and reduce external account surpluses.  But overall, limited progress has been made and imbalance problems have worsened steadily in recent years.

What is going wrong?

Theoretically, there are two possibilities: the wrong policies; or the right policies, but not implemented aggressively enough.  In our view, most of the policy measures implemented so far have addressed the symptoms but not the root cause of China’s problems.  For example, the over-investment problem is partly caused by the expected high returns to investment.  Unless the incentive structure is corrected, administrative measures controlling investment projects are unlikely to be effective.

The fundamental cause of structural imbalance lies in the unique pattern of market liberalisation during the reform period: complete liberalisation of product markets but with distortions remaining in factor markets.  Such a reform approach generally represses prices for labour, land, capital, resources, and the environment.  These distortions are effectively subsidy equivalents for producers, exporters and investors.  Such distortions have artificially increased profits for manufacturing production, turning China into a global manufacturing centre through the supply of cheap labour and cheap capital and resources.  Cost distortions have also contributed to oversized investment and exports.  This is probably why growth has been so strong in China, but exports and investment have been even stronger.

In order to alleviate the existing structural risks, the authorities need to change their policy course.  It is critical to understand that the root cause of the imbalances and inefficiency problems is factor-market distortions.  Therefore, the fundamental solution to deal with the imbalance problem is to implement a comprehensive package of factor-market reforms.  This essentially calls for an end to the asymmetrical approach to market liberalisation.  Steady liberalisation of factor markets and the elimination of cost distortions should be top priorities for the next stage of reform.

In specific terms, what should be done?

Labour-market liberalisation is a fundamental way to stimulate consumption.  The government has planned to make new breakthroughs in reforming the Household Registration System and propelling urbanisation in 2010.  It also intends to extend the social welfare systems to all rural residents.  This is a positive step.

Another positive breakthrough could be the introduction of market-based interest and exchange rates.  The China Interbank Offered Rate has been a good starting point for a government trying to form a market-based term structure for interest rates.  But the financial system needs to cater better for the needs of the private sector, which will be the backbone of the Chinese economy.  This means market-based interest rates.  It also means that the the exchange rate regime should be more flexible.

Clearly defined land ownership in the countryside could reduce distortions to land use.  Collective ownership is vague, creating room for corruption and hinders the modernisation of the rural economy.  In the cities, the government should stay out of the direct negotiation of land prices and private property development.

Other related reforms are also needed as a supplement to abolish cost distortions.

For instance, the state sector needs further reforms in order to share profits with households.  One option is for the State to collect more taxes from state-owned enterprises and then redistribute the gains to broader society.  In broader terms, the state sector should gradually give up much of its monopoly power or be privatised.

The complete liberalisation of factor markets and the elimination of cost distortions are likely to take years to complete.  When completed, they will signal China’s full transition to a market economy and will help lock China’s growth onto a more sustainable path.

Yiping Huang is Professor of Economics and Bijun Wang is a PhD candidate at the China Center for Economic Research, Peking University.

 

This essay is a summary of an article published in Ross Garnaut, Jane Golley and Ligang Song (eds): China, The Next 20 Years of Reform and Development.’

2 responses to “Rebalancing China’s economic structure”

  1. I wish the authors would have continued their plain and easy-to-understand style of articulating their ideas as they’ve done in the beginning paragraphs. As soon as the article begins to take on an academic tone, it loses its clarity; and the authors lose the audience. The academic jargon stands in the way.

  2. Leaving the causes of the current economic issues/problems in China aside, some measures could significantly if not greatly diminish the problems.
    For example, allowing the private sector and corporate sector in china to hold and buy and sell foreign currencies will reduce the pressure for the authority to buy them and invest them in low return foreign government bonds. Whatever the private and corporate sectors do is likely to increase the returns. Further, it is likely to reduce the pressure for currency appreciation.
    Another issue relates to the profits and taxes of the SOEs. Rather than tax them more heavily that would distort the market, government should set mechanism for returns of profits, either linked to what the private sector average, or a fixed percentage, then if needed to make some general adjustments to mimic the private sector.
    The private sector and the SOEs should compete on an equal footing in terms of price and taxes. Of course, entry can be a big issue that is should be addressed clearly in terms of development strategies.
    If monopoly is an issue, then anti-monopoly policies should be applied irrespective the targets are private sector or SOEs. SOEs must face effective competition to be efficient enterprises.
    For environmental issues caused by externalities and mispricing, the most efficient and effective way is to use taxes to correct them as opposed to direct administrative measures. The later can be effective but are unlikely to be efficient.

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