A challenge in China

A mammoth OECD study documents the loss of dynamism in the Chinese economy, but predictably asserts, unconvincingly, that more reform can break the stalemate.

AFTER Japan and South Korea, China is arguably Asia's next economic giant. Starting from a base that is relatively egalitarian, in terms of asset and income distribution and created during the years of central planning, it has over the last two-and-a-half decades grown at a remarkable pace within the framework of an increasingly market-friendly regime. Per capita income has increased more than four-fold from $168 in 1980 at 1995 prices to $727 in 1998. Growth over time was indeed uneven with the annualised rate of growth of three-year-average GDP (gross domestic product) figures rising from a little less than 7 per cent in 1982 to a peak of close to 14 per cent in 1985, then falling continuously to less than 6 per cent by 1991, rising again to the above 13 per cent level in 1994 and then falling to less than 8 per cent in 2000. However, the average rate of growth has indeed been high.

This increase in per person incomes has occurred in a period when China has witnessed major reform of its economic policies, starting with reform in the agricultural sector in 1978. Later, beginning in the mid-1980s, China opened its economy to inflows of goods and investment. Though a range of non-tariff barriers remain in place, the average tariff rate on imports has fallen from 40 per cent in the early 1990s to 15 per cent in 2001. Foreign investment flows, which increased from around $1 billion a year to $3.5 billion during the 1980s, mainly as a result of investment in special economic zones (SEZs), jumped to $37.5 billion in 1995 and $40.3 billion in 1999. As a result, during the second half of the 1990s, FDI inflows amounted to over 5 per cent of GDP and accounted for well over 10 per cent of gross capital formation. There does seem to be evidence of a virtuous link between such foreign direct investment (FDI) flows and China's export performance. In the event, China's exposure to trade has grown substantially, with the ratio of imports plus exports to GDP rising from 12 per cent in 1980 to 42 per cent in 2000.

This and other evidence has been collated in a recently released 800-plus page study done by the Organisation for Eco-nomic Cooperation and Development (OECD), titled "China in the World Economy: The Domestic Policy Challenges". As is to be expected, the study uses the link between reform, growing trade dependence and high growth as the basis for two generalisations. First, that if appropriately carried out, a shift from an interventionist to a market-friendly regime, which facilitates international integration, is the best route to high growth. Second, that to overcome the deceleration in growth that China has been recently experiencing, the best strategy would be to intensify the reform effort. Thus, China's commitments as part of its accession to the World Trade Organisation (WTO), which go far beyond what many other middle income countries have adopted, is seen as a positive step forward.

However, while declaring that China's progress during the economic reform era is one of the great success stories of the post-War era, the study points to a number of emerging areas of concern in recent performance. These include the evidence of a loss of dynamism in industry and agriculture, of growing unemployment and of substantial and rising regional disparity. Grain production stagnated in the early- and late 1990s and fell in 2000 to its mid-1990s level. Industrial growth has fallen quite sharply after 1993. The town and village enterprises (TVEs), which were a much-noted source of dynamism in the Chinese economy, are faced with difficulties. This is of significance, since the TVEs were the largest contributor to growth in aggregate GDP and employment from the mid-1980s through the early 1990s, and by 1996 employed 131 million workers, or 28 per cent of the rural workforce. The development of rural enterprises in turn has transformed rural income generation, with more than 40 per cent of rural incomes now coming from non-agricultural activities. Unemployment has been on the rise, which in its starkest form is reflected in the phenomenon of "floating" migrant workers in search of underpaid informal sector employment, estimated at around 100 million. Finally, China's growth during the 1990s has been accompanied by growing inequality among its regions. Growth has been the most rapid in the coastal provinces, followed by provinces in the central region, and least rapid in the western regions.

These trends have generated some degree of scepticism regarding the evidence of rapid growth over a long period in China as well as a degree of disillusionment with the reform process itself. Surprisingly, it is precisely at this time that China has decided to accept extremely tough conditions in terms of trade, foreign investment and financial sector reform as commitments made in return for WTO access. This, many argue, would not merely ensure a qualitative shift in the nature of the economic regime in China, but would accentuate the tendency towards sluggish growth and weakening welfare.

It is that argument that the OECD study seeks to challenge. While admitting that evidence is growing that "the important engines that have driven China's growth in the past have lost their dynamism", the study advances two theses. First, it holds that even though China is even now as open as many WTO members and though the depth and breadth of its WTO accession commitments to increase access to its domestic economy are far greater than those agreed to by previous adherents to the WTO, China's accession constitutes merely an important and much-needed milestone in its reform path rather than a change in direction. Second, in order to reverse the tendency towards loss of dynamism and maximise the benefits of the imminent increase in the openness of its economy, China would have to go farther than its WTO commitments and undertake a set of complementary and far-reaching reforms. The intent of the study is clearly to remake China in the image of the developed capitalist world, if that is possible at all, ostensibly because "to reap the full benefits of further integration in the world economy, the Chinese economy must undergo fundamental adjustments".

THERE have been four elements to the reform in China adopted so far. The process began with reform in the agricultural sector, which displaced the pre-reform commune economy. This was replaced with a household-based system in which individual households that leased land from the collectives were provided autonomy in production decisions. Further, market forces were given a greater role and government intervention in the production, pricing and marketing of most crops, except grain, was substantially reduced.

Second, the government permitted and sought to encourage investments outside the state-owned industrial sector, initially in the TVEs and other collectively owned enterprises, then in foreign funded enterprises and more recently in domestic private enterprises. Third, the government began to liberalise the import and export trade, by reducing tariffs and easing non-tariff barriers on a range of exports. Finally, the government has sought to encourage foreign investment in SEZs and elsewhere.

Each of these, the report argues, contributed significantly to increasing productivity and stimulating income growth. The problem is that more recently their role as stimuli has substantially waned. The waning of the effects of these stimuli is attributed in large part to the fact that the specific form which reform took in each area had positive effects in particular segments of the sector concerned. But once the slack in those segments had been taken up, the persistence of dynamism required not just the intensification of reform in the affected segments, but the extension of reform to other segments and to economy-wide policies. While China's WTO access commitments do involve such an extension, they would be inadequate if the benefits from opening up are to be maximised.

In agriculture, the loss of dynamism is attributed to the fact that there are now binding barriers to increases in agricultural productivity. Fertilizer use is already exceptionally high, pesticide application cannot be increased because of environmental problems, and there is a growing shortage of water in many areas. This, according to the study, implies that agricultural production must diversify away from land-intensive to labour-intensive products such as horticultural ones.

But such diversification is constrained by the grain procurement system maintained for food security reasons, which has ostensibly contributed to growing surpluses, falling prices, reduced rural incomes and constrained rural consumption. This focus on the physical barriers to productivity increase and the policy-induced constraints to diversification because of the emphasis on grain production is not just overstated, but tends to underplay some of the consequences of agricultural reform for welfare and growth. Thus, according to some observers the phenomenon of "floating" migrant workers is in large measure the result of a loss of the institutional ability to mobilise and utilise labour resources, which was a characteristic feature of the commune system of production. An example of such utilisation was the pooling of off-season labour resources in building rural infrastructure. The collapse of the latter not only affected employment adversely, but resulted in the neglect of the maintenance and strengthening of communal infrastructural facilities, with adverse consequences for productivity. But a perspective which has as its prior the view that Chinese reform was positive but inadequate, inevitably ignores such questions.

Consider also the puzzle as to why rural unemployment has increased despite the success of the TVEs. The growth of such enterprises in the rural as opposed to the urban areas was partly because of the opportunity to sustain ancillary activity and contract work at extremely low labour costs that excess labour resources in rural areas provided. Temporarily at least, the government's decision to encourage TVEs as a part of the process of "growing out of the plan" worked because it facilitated the rural outsourcing of such activities, to sustain low-cost production, including for export markets. As a result, the new system appeared to be a better way of absorbing rural surplus labour. However, evidence to the contrary is growing. The demand for such outsourcing was inadequate to absorb in full the growing rural labour surplus.

Further, such employment tended to be unevenly distributed. Such industries have developed mostly in the coastal provinces and are reportedly much less visible in the interior provinces, especially in the western part of the country. More recently, there are signs of stagnation and decline in the TVE sector, with employment in rural enterprises falling by close to 2.5 million since 1996.

Glossing over all this, the OECD study asserts that the worsening of the performance of the TVEs is due to fundamental structural problems. These include financial problems, operating inefficiencies and loss of competitiveness owing to distance from infrastructure. Hence, "even under optimistic assumptions about how much their performance can be improved, REs (rural enterprises) are unlikely to be able to take up more than a fraction of the rural workers who will need to find jobs outside the agricultural sector."

WHAT then is the answer? Urban industry does not offer much of an alternative. The study points out: "As in agriculture, the dynamism to industry imparted by structural shifts seems to be weakening. Industry financial performance has deteriorated sharply since the early 1990s. Profits fell to nearly zero in 1998, with more than one-third of enterprises making losses, and despite noticeable improvement during 1999-2001, financial performance remains weak in many sectors. Growth in industry employment and capital spending has declined markedly. The deterioration has been pervasive and not simply confined to SOEs. The performance of collective enterprises has worsened nearly as much as that of SOEs; and the SME sector generally is in particularly dire straits."

With foreign investment flows into China already far in excess of other developing countries, and with a predominant share of it coming from Hong Kong, Taiwan and other Asian countries with ethnic Chinese populations, it is unlikely that this sector can even sustain its growth, let alone help employ the unemployed. In the event, we are likely to see a worsening of the unemployment situation, because even the high growth associated with the unusual combination of more than two decades of rapid expansion accompanied by persisting and even growing unemployment in the Chinese economy is no more a reality.

Given all this, it should be obvious that this is hardly the point in time when Chinese producers should be subjected to increasing competition from imports and state-owned enterprises should be restructured through downsizing or outright closure. But these are inevitable consequences of China's WTO accession commitments, rendering the argument that this wide-ranging commitment is an appropriate deepening of reform questionable. But the study advances that argument by attributing poor industry performance to inefficiency resulting from wrong investment decisions and protection and cost ineffectiveness because of social burdens imposed on them. Even if this were true, reform in a period when international competition is expected to increase would only result in closure. And given the dependence of many local industries on the SOEs, the process is likely to be cumulative.

The difficulty is that the OECD economists are not even satisfied with the extent of reform implied by WTO commitments. The study argues: "In China's present situation, the outcomes of particular reforms depend increasingly on the interaction among measures taken by the economy's key actors - government, enterprises, workers, and the financial system - acting in markets whose functioning is shaped by key framework conditions such as competition, property rights, and corporate governance. Rather than emphasising particular sectors, reforms now need to focus more on economy-wide policies to promote more efficient allocation of resources and to bolster the effectiveness of markets."

TWO areas in which the extension of reform is emphasised is the financial sector and macroeconomic policy. Lamenting that the financial sector is still dominantly state-owned, the report argues that credit is inefficiently allocated, with state-owned enterprises obtaining the bulk of funding to ensure that they operate with soft budget constraints. This is indeed true since hitherto the role of credit in the Chinese system was as a means to realise targeted production as per plan. If in the name of bank restructuring state-owned enterprises are to be now starved of funds, leading to the collapse of such enterprises, the banks themselves would not be able to survive unless they are recapitalised by the state. As the study notes: "In a proximate sense, the ongoing problems of financial institutions reflect the poor condition of their enterprise customers. A severe vicious circle has developed. Poor enterprise performance contributes to bank non-performing loans and lowers bank profits by eliminating much of their core market."

Banks after all cannot restore the health of real economy enterprises. That has to be the result of appropriate corporate restructuring and counter-cyclical macroeconomic policies. But with customs duty reductions and the tax rationalisation associated with reform having reduced the revenues of the state substantially, the manoeuvrability of the state is already substantially circumscribed. Though "official figures suggest that China's fiscal position is healthy and that there is ample scope for fiscal expansion", this picture is misleading because it is widely acknowledged that the government will need to take on debt obligations not yet explicitly recognised. The main obligation, the funds needed to restore solvency to financial system, could more than double the government debt ratio initially."

Given these factors, the challenge in China is to restore the room for manoeuvre of the state so that it can restore some dynamism to the system. This would require reducing rather than increasing China's integration into the world system. But though its own analysis points in that direction, the OECD, given the predilections of its member governments to obtaining a foothold in the large, even if stagnating, Chinese market, is forced to argue to the contrary.