A challenge in China

["Ulhas Joglekar" <joglekarulhas@xxxxxxxxxxx>]

Frontline
Volume 19 - Issue 07, Mar. 30 - Apr. 12, 2002

A challenge in China

C.P.Chandrasekhar

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 Economic 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.

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