(Reprinted from HKCER Letters, Vol.38, May 1996)
China's Transition Economy
and Macroeconomic Stability
Macroeconomic InstabilityIn this talk, I will discuss three issues on the Chinese economy that are currently important: macroeconomic cycles and stabilization, economic disparity across regions, and the sustainability of China's high growth.
Since economic reform began in the late 1970s, China has experienced several macroeconomic cycles. Macroeconomic instability in China arises because the economy is both a developing and a transitional one. As a developing economy, it faces structural changes in many areas such as agriculture and industry, and problems such as regional imbalance and unemployment. All these could lead to inflation and fluctuations in the macroeconomy. Yet, in comparison, a more serious source of instability is the transition from a planned to a market economy. The difficulties faced by other economies going through similar transitions illustrate the disruptiveness. Russia, for example, has suffered 1000 percent inflation annually over the past few years. The transition process involves major income redistribution and conflicts of interests. During the process, problems arise everywhere: in the state sector, the nonstate sector, the old planning system, price liberalization, ownership reform, and so on.
A major problem at the current stage of transition in the Chinese economy is the fact that it is a dual economy with both the state sector and the nonstate sector. The state sector, for the most part, still relies on government control mechanisms which have been in place for some time. The growing nonstate sector, on the other hand, is largely subject to market forces and needs a different set of policy instruments for macroeconomic stability. For example, changes in interest rates can affect behaviour and decision making in the market and the nonstate sector, but will have little effect on the state sector. As borrowers in the state sector have difficulties repaying debt, they will not care much about marginal changes in the interest rates. I am often asked why methods such as price ceilings and quota systems are still used in China. The answer is that when monetary instruments do not work, it is necessary to use conventional policy tools to control credit, expenditures, and investment directly. A dual economy needs dual kinds of policies, which can make macroeconomic stabilization very complicated.
Another feature of the current stage of China's economic transition is that local governments now play a larger role in decision making and spending. This was particularly true in the last investment boom, which consisted mainly of setting up special technology development zones, investment by local governments in infrastructure and other local development programs. In relation to that, there is speculation in the newly established stock and land markets. Also, because of decentralization and the development of capital markets, there is capital flight from inland areas to the coastal areas in order to get higher returns. The interior, less developed regions sometimes argue that they need more investment, but when funds become available people tend to move the money to coastal areas for higher returns. This results in larger regional income disparities.
Unlike market economies in the West where the problems are typically recession and unemployment, China's economy is still expanding. China's main economic problem, on the other hand, is overheating. Government and state sector investment, which is governed by so-called soft budget constraints and is thus easily expandable, still represents a major portion of overall investment. The government had this problem under control in 1992. In 1993, however, it allowed investment to increase for a significant period, causing overheating to occur once again. This led to a long period of inflation which has been difficult to control. Given this recent lesson, the government will probably be more cautious about inflation in the future.
In the next few years, I believe China's situation will be relatively stable. Inflation will probably be lower, partly because of macroeconomic control, but also because increases in food prices (a significant cause of recent inflation) will not be so great. In fact, food prices in China have already reached international levels. China must try to adjust its macroeconomic policy to achieve stabilization and low inflation, and yet maintain the growth necessary for development.
My second topic is the economic disparity among various regions in China. This has been a hot issue in recent years. Regional disparity is an unavoidable element of development and transition process. Development implies a change in the economic map, for example, from agriculture to industry. The transition from a centrally planned to a market economy also causes re-location of resources. In China, regional disparities have become more acute in recent years. The central government has already adopted policies to increase investment and introduce institutional reforms in the interior, less developed regions. However, the past 40 years have shown that the use of investment funds by the central government is not very efficient. New policies are also limited by the central government's budget. The total government budget has declined from over 40 percent of GDP to about 11 percent and, in addition, the central government's share of the total government budget has declined. Regional disparity is a long-term problem that can only be solved by development. The goal should not be to equalize the level of development across regions; it should be to equalize per capita income. However, it will probably prove impossible to move towards the realization of this goal until next century.
One can observe two major positive trends in China at present. Firstly, capital has started to move inward. Also, improvements in central China's infrastructure have led to reductions in transportation costs. Land and labor costs have increased sharply in coastal regions, which help push foreign and domestic investment inward. I expect that the whole Yangtze River region will become a new hot spot for investment.
Secondly, labour is migrating from poor regions to rich cities. Contrary to some arguments, in my opinion this situation remains under control. Movements of the floating population show that people still have ties to their home villages, possibly because they still hold land there. If they cannot find jobs in the cities, they can still go home. This is in contrast to the situation in many other countries, where the urban poor sell their land or means of livelihood before moving, and thus have nowhere to go if they are unemployed in the cities. So far, this has not happened on a large scale in China, even though there are some urban poverty problems. The disparity issue could eventually be solved in the long run with capital moving to the interior and labour moving to the coastal areas.
The final point I would like to address is whether China's current growth is sustainable. China is still enjoying a 10 percent growth rate. How long can this continue? I see several reasons to believe that China's growth is sustainable. First, even though interest rates are low (sometimes negative in real terms), the savings rate is still almost 40 percent of GDP. Second, although foreign investment is not necessarily increasing, new investors continue to appear. If foreign investment remains at the US$30 billion level, it will constitute a major contribution to growth. In 1994, for example, 22 percent of total investment was foreign. Third, due to recent efforts by the central and local governments to improve the infrastructure such as roads, communication, and the energy and raw materials sectors, some bottlenecks in the economy have been removed. This leads to a higher productive capacity and contributes to growth. At the same time, the nonstate sector which contributed more than 60 percent of China? total industrial output last year continues to grow. Similarly, reform in other sectors have been improving efficiency in the use of resources.
Is growth sustainable?
China has experienced not only localized market growth, but also nation-wide market integration. This is a fundamental stabilization factor. Conflicts and differences between regions exist, but there is also a great deal of integration. The more developed regions rely on resources and cheap labour from the less developed regions, while the less developed regions increasingly rely on investment, technology and the labour market of the more developed regions.
I believe that China's high growth rate will last longer than that of other Asian economies such as Japan, Korea, and Taiwan, because China has a much larger source of cheap labour. There may be 300 million rural surplus labourers in China waiting for new jobs. Insufficient education and lack of skills do pose a problem, but in general, employers can continue to pay low wages because the supply of cheap labor is so great.
Although China's transition period is fraught with difficulty, this is normal. We cannot expect to solve all the problems overnight. In the West, market economies took 400 years to grow into developed countries. China has only been at it for 16 years. If China can attain the level of developed market economies in 40 years, that would be an achievement in itself. Problems aside, there are many reasons to remain optimistic.
Professor Fan Gang is Deputy Director of the Economic Research Institute, the Chinese Academy of Social Sciences. He was associated with the Academy since 1982 and had carried out research at Havard University and the National Bureau of Economic Research. The above was an edited version of a talk he presented at the Centre.