Lecture Note

The Structural and Institutional Dimensions of China’s Economic

Transformation

Dr. Xiao Gengxiaogeng@hku.hk

www.econ.hku.hk/~xiaogeng

What is special about China?

– China’s size• Labor force is larger than the employment in all developed economies• GDP at Purchasing Power Parity is second only to U.S.• GDP at current price is 1/4 of Japan and 1/10 of US• Global market share of some manufacturing products as high as 50%-80%

– China is young and maturing• China’s population profile is similar to Japan’s in 1975, with working age

population as much as 70%, the highest in the world, compared to 60% for other less developed and 67% for more developed economies

– China is opening up• Capital is moving to China through FDI, competing not with China but

among foreign investors• Hong Kong and western economic institutions are replicated in China with

help from large numbers of returning overseas Chinese students

– China is catching up by learning from the miracles of Japan and other Asian dragons, except that China has a very big pool of skilled labor and well educated engineers

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Economics of Unlimited Supply of Labour

• “Economic development with unlimited supply of labor” (W. Arthur Lewis 1954)– The non-capitalistic traditional sector provides a reservoir for

unlimited supply of labor• At a fixed urban wage slightly higher than the subsistence rural

wage• Migration of labor to modern sector is checked partly by urban

unemployment

– The capitalistic modern sector is able to generate profits and net savings for investment in capital to sustain growth

• In Great Britain, net savings increased from 5% before 1780 to 7% in early 1800s, and 12% around 1870

• Similar rises of net savings in U.S. between 1840s and 1890s• Similar changes since World War II for many developing countries

• Lewis model is highly relevant to China and its implications to China and the world not fully appreciated

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China’s Surplus Labour

• The scale and speed of China’s draw of labor from the traditional sector to modern capitalistic sector are unprecedented– In 1820, Western Europe and its Offshoots had a

population only about 150 million– From 1870 to 1998, net migration to Western Offshoots

amounted to about 60 million– Since 1978, China has created 150 million new non-farm

jobs for its farmers– Number of Chinese with income less than $1 fell by 150

million from 1990 to 1999

• But China still needs to create 150 million new jobs in the future decades for its remaining unemployed or under-employed rural labor force

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• Transaction costs– Costs of inadequate institutions and incentives– They are man-made costs that hinders mutually beneficial

trade– Hong Kong and Singapore have maintained their

competitiveness because of their low transaction costs, which more than offset their high factor costs

• WTO will reduce artificially created transaction costs in China because its rules target specifically on the following services sectors:– Distribution and producer services– Telecommunication– Law and accounting services– Banking and financial services

Competitiveness= 1 / (transaction costs + factor costs)

Global Foreign Direct InvestmentFDI Inflows 1979-2001

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Year

US

D M

illio

ns

United States

Asia and the Pacific

China

All developing countries minus China

Source: World Investment Report, 2002

China’s FDI and Export: Concentratedin Nine Coastal Provinces

Region Population

(%) GDP (%) FDI (%) Trade (%)

GDP per capita (US$)

China Total 100.0 100.0 100.0 100.0 1,008

Top 9 Provinces by FDI 31.7 51.8 84.6 89.4 1,647

E.China (Shanghai, Zhejiang, Jiangsu) 10.6 19.9 28.9 29.2 1,882 S.China (Guangdong, Fujian) 8.8 14.0 34.2 40.9 1,600 N.China (Beijing, Tianjin, Liaoning, Shandong) 12.2 17.9 21.4 19.2 1,477

Middle 12 Provinces by FDI 49.9 37.4 13.6 7.7 756 Bottom 10 Provinces by FDI 17.7 10.8 1.8 2.9 614

Concentration of Trade and FDI in China's Coastal Provinces

Source: Statistical Yearbook of China, 2002.

China’s Impact on Global Relative Prices

• China is changing global relative prices– Deflation in manufacturing products– Inflation in knowledge, raw materials, energy, advanced

services, including premier tourist services• China is not causing a global deflation

– Its share of global export is only 5%!– China’s export of net savings is trivial to the global

economy (Global deflation requires large net export of savings!)

• The growth of one fifth of global population– Will trigger a global change towards more competitive

production and higher living standards for rich and poor

• China is not alone in changing global relative prices– Add India, the rest of Asia, and the rest of developing or

transition economies that are growing rapidly now

• Reactions to the global relative price change as China joins the world market:– Expected returns on past investment need to be adjusted– Shareholders need to absorb residual losses & sunk cost– Producers need to adjust strategies– Consumers are enjoying cheaper and better products– Economies need to re-position themselves properly in the

value chain, with China as a new partner• What is happening now?

– China and Aisa gains market shares in exports and FDI mainly at the expense of mature economies

– Hong Kong, Taiwan, Korea, MNCs and other Asian economies are all doing well on economic integration with China, lowering costs and gaining competitiveness

Reactions from the Rest of the World

China and its Asian Neighbours:Gaining Export Market

1990 2000 Gain/Loss

World 100.0% 100.0%

Developed countries 80.4% 69.4% -11.0%

Developing countries 17.5% 27.4% 9.9%

Asia 12.6% 19.9% 7.3%

China 1.9% 4.7% 2.8%

Asia-Six* 9.1% 12.2% 3.1%

Other Asia 1.6% 2.9% 1.3%

Source: WTO; *Asia six: Taiwan, Hong Kong, Korea, Malaysia, Singapore, and Thailand; Significant re-exports excluded.

Share in World Exports of Manufactures 1990 and 2000

China’s Impact on Global Consumption

• China’s demand for energy and raw materials is rising rapidly with its booming economy

– China turned from net exports to net imports of crude oil, growing at a rate of about 10 million tons a year since 1995

– China’s share of world oil consumption to rise from 3.5% in 1990 to 6% in 2000 and above 8% by 2020

– The share of crude materials in China’s imports rose from 8% in 1985 to 18% in 2000

• Products made in China with parts and designs from elsewhere are spreading the middle class lifestyle to developing countries

– Significant improvement in the quality and affordability of toys and daily necessities

– Sophisticated products such as motor cycles, DVDs and fashion clothes affordable for people in developing economies

• Chinese tourists start to appear in major tourist attractions around the world

Surplus Savings in China and Asia

• Even China has become a net exporter of capital – China run Current Account surplus in 17 out of 22 years since 1982,

including last 10 years, accumulating a surplus of US$170 bn or about 13.7% of GDP

– Accumulated capital flight since 1982 through the Errors & Omission term in Balance of Payment is about $140 bn or 12.1% of GDP

– Official foreign exchange reserves at $316 bn or 25.5% of GDP– Non-official holding of foreign assets at $260 bn or 22.5% of GDP

• China’s surplus deposits are huge– China’s banking deposits increased from 30% to 180% of GDP over last two

decades with money supply growing about twice as fast as nominal GDP– About 20% to 30% of deposits have difficult to find investment outlets, and

have to be absorbed by government bonds and spent on the New Deal type projects

• The puzzle: co-existence of both surplus capital and labor– This is a problem not only for China but also for Asia as a whole– Japan and newly industrialized Asian economies have large surplus savings

while other parts of Asia have large amount of surplus labor

Why does not surplus capital hire surplus labour?

• Bottleneck in Asia’s domestic financial system– State banks not active nor effective in screening good projects– Domestic stock markets still need to be improved to serve the

best companies and investors

• Some alternatives from external financial services helpful but far from enough– Foreign banks, FDI and MNCs provide financing services outside

of the domestic financial system but only for large projects and high value added services

– Off-shore financial markets such as in Hong Kong and Singapore provide some alternative services with much higher costs

• The property rights premium of international investment swap– China and other Asian governments give good protection of

property rights for foreign invested assets– U.S. and other mature markets provide good protection of

property rights for Asia’s savings, such as through the stable value and return from investing in U.S. bonds

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• Efficient and timely distribution networks – With effective supply chain management that can guide China’s

manufacturing sector

– Can sell Made-in-China products to anywhere in the world

• Efficient and safe banks– With low levels of non-performing loans

– Strong capacity in channeling savings to quality investment

• Efficient and robust capital markets – Complement the banks in intermediating savings and

investment

– Facilitate corporate restructuring and corporate governance

– Manage risks at individual, corporate, and national level

China’s Most Wanted List:Distribution network, Banks, & Capital Markets

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• Efficient and reliable accounting services– Make, protect and enforce contracts– Provide reliable information

• Trusted and credible legal system– Protect and fine-tune property rights– Reduce corruption– Cultivate credit culture

China’s Most Wanted List:Accounting and Legal System

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Early Easy Growth Phase

• China, like other East Asian economies, started with many advantages:

– Low wage and surplus labour

– Stable political environment with educated elite

– High savings rate and prudent fiscal management

– Demographic endowment of young labour force

– Declining trade barriers opened up export opportunities

– Opening up to FDI brought new technology and managerial skills, which improved overall productivity and growth

• But future growth period faces many obstacles: – Burden of NPLs

– Corruption

– Unemployment, and

– Threat of protectionism (eg pressure to revalue currency)

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Too Much Risks Concentrated in Banks (% of GDP)

Remark: *1999 figureSources: FIBV, CEIC, Bloomberg, various central banks and government websites

Bank Assets Equity Market Bond Market1998 2001 1998 2001 19982001

China 139 160 25 45 12 28Hong Kong 214 215 206 313 32 28India 69 133 24 26 21 28Japan 145 139 64 55 101 153Korea 233 233 35 46 53 67Singapore 220 243 112 135 20 41Taiwan 226 262 97 104 41 20Thailand 176 134 30 32 23 39

Germany 273 155 51 58 97 90US 65 63 158 136 141 148

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Weak Financial System DestroysWealth and Property Rights

• Hard-earned wealth from exports can be destroyed without protection of property rights

Strong Real Sector Wealth CreationWeak Financial Sector Wealth Destruction irony of super Asian household savers who cannot afford to spend

– “Finance for Growth” bias created a weak financial system that destroyed considerable wealth accumulated by successful export drive

– Asian crisis cost the crisis economies more than 50% of GDP to clean up

– As long as structural issues and policy bias are not addressed, more NPLs to come

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Progress on SOE Reforms• SOEs as independent legal entities• Increase of managerial autonomy• Contracting for profit-sharing• Monitoring by the State and the Party• Transformation of SOEs into corporations• Grasping the large and letting go the small• Severing the link b/w state and labor• Changing the relation b/w banks and SOEs• State as shareholder under mixed ownership

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The problem of state-owned enterprises and state banks

• Privatization of profits and assets.

• Socialization of losses and liabilities.

• Asset-liability imbalance in the state sector troika of enterprises, banks, and budget. LiabilitiesAssets

How to deal with negative net value of assets by the State

• Printing money inflation.

• Borrowing now rising national debts.

• Selling assets not enough for liabilities.

• Financial austerity unemployment and deflation.

• Selling national treasure politically unacceptable.

• Increasing the net value of SOE assets need fundamental reform of SOEs.

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Unlimited liabilities SOEs and potential financial system risks

• Concentration of state control Concentration of state assets Concentration of state liabilities Increase of net state liabilities Potential for financial system risks.

• Private ownership of capital “surplus value”.

• Concentrated state ownership of assets negative net value of assets.

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Why has not yet financial crisis happened in China?

• The necessary condition for financial crisis: large and increasing net liabilities for private and/or state firms and banks (e.g. bad loans).

• The sufficient condition for financial crisis: the public loses confidence in the financial system (e.g. bank-run or currency run).

• China has met the necessary condition but not yet the sufficient condition.

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China has maintained public confidence in its financial system

• Central bank as effective inflation fighter.• Central bank as credible lender of last resort.• RMB not convertible on capital account.• Significant trade surplus in recent years.• Large FDI inflows since 1993.• Large foreign exchange reserves.• Low external debt.• Low share of short-term external debt.

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Will China be able to avoid financial crisis in near future?

• China’s backwardness implies potential for catching up.

• Low factor costs of labor, land (for non-agriculture development), and domestic capital (due to high rate of savings).

• high transaction costs (often hidden and entirely human-created barriers for doing mutually beneficial exchange and production).

• Reform of SOEs and state banks crucial for reducing transaction costs and financial system risks.

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High transaction costs of restructuring ownership and control

• The judges and the legal system in China are not yet able to fine-tune and enforce property rights and contracts independently according to social justice and economic efficiency.

• The ownership and control of SOEs and banks are necessarily fragmented when the State is their sole or majority owner.

• Cost-effective financial services for buying and selling firms and banks are not yet developed.

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How to reduce transaction costs in China? Learn from Hong Kong!

• The State needs to understand the tradeoff b/w state control and return to state assets.

• Best to limit the State’s equity interest in any commercial businesses to less than 30%.

• Expand capital markets by listing the best firms regardless of their ownership, location, industry, etc.

• Make Hong Kong’s efficient financial services available to investors and businesses in China or replicate these services in China.

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The State as a passive & non-majority shareholder under mixed ownership

Diversification

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State as a passive & non-majority shareholder: The case of Hong Kong• Hong Kong government’s intervention in the stock

market amid the Asian financial crisis made it a passive & non-majority shareholder with about 10% shares of all the listed blue-chip companies in Hong Kong.

• Hong Kong government had capital gains of significant amount as the market index almost doubled since its intervention.

• Hong Kong government did not try any interventions in the management of those blue-chip companies.

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High risks of state bank lending• Risks of lending to SOEs are concentrated in the state

banks due to a lack of financing by equity, bond and private and foreign banks.

• To avoid corruption charges, the managers of the state banks may work hard on expanding lending to private firms.

• The moral hazard problem of excessive lending during boom and excessive tightening of credit during recession may be more serious in state banks than in private banks because of bureaucratic practices at the state banks.

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How to rescue China’s state banks? The mainstream approach

• Reduce the state banks’ tax burden.• Lower capital reserve requirements.• Re-capitalize by issuing government bonds.• Transfer of bad assets to new asset

management companies.• Transform debt into equity at SOEs.• Issue equity for state banks.• Allow entry of new domestic banks.• Allow entry of foreign banks.

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Learn from Hong Kong again: Opening RMB lending business to foreign banks

• Understand the difference b/w lending and deposit-taking.

• Open RMB lending business immediately to best foreign banks.

• Keep deposit-taking monopoly for the state banks for a while during the transition.

• Let foreign banks borrow short and long-term funds from the state banks through the inter-bank markets.

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Three Stages of China’s Reform• Stage 1: Post-war nation-building

– In post-war reconstruction, key policy focus was on closed economy, central planning and efficient usage of state assets + building basic industries and agricultural infrastructure to raise China from basic poverty. Bureaucracy had low corruption because of strong moral revulsion against pre-war corruption and relatively low level of market activities

• Stage 2: Opening up and catching up– Since 1978, policy shifted towards using market forces to catch up in

technology, production, marketing, consumption and knowledge, particularly through opening up to external trade, FDI and liberalizing ownership to private rights. Combination of labour mobility, efficient new capital investments in “hard infrastructure” led to high productivity gains and growth, but corruption and grey market activities rose due to unclear property rights

• Stage 3: Modernisation of institutions– By 2000, efficient hard infrastructure already exist in cities like Shanghai,

Beijing, and Guangzhou, well connected to global economy – But, huge losses through inefficiencies and corruption are building up losses

in financial system. Unless robust PRI is built, China’s apparent high growth will be wasted in a fragile financial system