EC330 Economies of Transition

What factors have been responsible for Chinas rapid economic growth over the past quarter of a century?
Thomas Tovell This essay will explain as to can be attributed to Chinas rapid economic growth over the past quarter century, then conclude on Chinas future growth. Economic reasoning is mainly used, with political and social less significantly.

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In 1978, two years after the death of Mao Zedong, China had the tenth largest economy in the world, with GDP equalling approximately US$150 billion, or 6 percent of the USAs GDP at the time. Yet by 2005, Chinas economy had grown to US$2.2 trillion or 17.6 percent of the USAs GDP, becoming the fourth largest in the world behind the USAs US$12.5 trillion, Japans US$4.5 trillion and Germanys US$2.4 trillion. (Jefferson et al, 2007).

Since the start of economic reform in 1979, China has maintained a GDP growth rate of approximately 9 percent per year. To understand how China has reached its current rate of economic development and what its outlook as a world economic power looks like, we first need to present a brief retrospective on its recent economic history.

Morrisons (2006) account tells how in China, during the 1950s, most industry was nationalised. At the same time, all farms and private land were collectivised into large rural communes. To move the country towards rapid industrialisation, the Chinese government undertook large scale investment programs during the 1960s and 1970s. By 1978, of industrial output was carried out by state-run enterprises. Private investments were virtually non-existent at this time. The main goal of the government was to turn Chinas economy into a relatively self-sufficient one. Imports were limited to capital goods which could not be obtained domestically.

This form of government intervention left the Chinese economy stagnant and inefficient, as there was little incentive for private enterprise or investment. Price and manufacturing controls further impeded the economy of the time. Coupled with the political and social disruption of the Cultural Revolution, there was little net growth in Chinas GDP over many years. The standard of living of most Chinese citizens fell behind that of many other developing countries.

The reformist leader, Deng Xiaoping, came to power in 1978 and economic reform

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began in earnest in 1979. The Chinese government hoped that gradual reform would lead to significant economic growth and better the lives of its citizens. We see that its prognosis was correct (Morrison, 2006). One of the first reforms of the Chinese government was to allow farmers to keep and sell part of their produce in the private sector. It also established four special economic zones along the coast to attract foreign investment wishing to take advantage of the lower labour costs in China. Their aim was to stimulate high technology imports to China and encourage exports (Morrison, 2006).

The process of economic decentralisation had begun. Economic control over various programs was transferred to local governments in the Chinese provinces, who were authorised to perform and compete based on the principles of open competition. Coastal regions and certain cities where designated as development zones, authorised to trade freely and given fiscal incentives to attract foreign investment. Price controls over a number of goods were gradually diminished (Morrison, 2006).

Theories which explain economic growth in China tend to consider the economic reforms as the largest contributing factor. For example, Woo (1994) considers the creation of private enterprise in each sector of the economy and a high savings rate fundamental in the case for Chinas growth. Other conditions favouring growth include a large under-employed workforce willing to work for relatively low wages; a cultural tradition of discipline, quickly adapting to the new system rules and the historical background. Qian (2000, 2003) attributes the successful reform to the adoption of non-orthodox economic policies. For this author, the key to Chinas economic growth were government incentives and the growth of free trade.

According to Holz (2008), the most significant economic reforms occurred at the beginning of the 1990s, with the removal of price controls and freeing of internal trade, as well as further foreign investments. However, if these were the only factors explaining Chinas economic growth, it wouldnt be possible to explain how the country has maintained its high growth rates even after the economic reforms and transition phase was over. Some economists believe that China still receives the benefits from transition to this day. To them, the transition process is not complete yet, bearing in mind that the Chinese government still exerts control over various

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economic aspects of the country and there is still the possibility for an open economy and potential for larger foreign investment in several areas.

According to Morrison (2006), Chinas economic growth can be attributed to two factors: large-scale investments financed by domestic savings and foreign investments; and a rapid growth in productivity. The economic reforms have increased economic efficiency and the capacity to acquire resources necessary for the growth in agricultural and industrial output. The benefits to productivity were due to the reallocation of resources in sectors that, before, were state-run, such as agriculture, commerce and the service sector.

The factors mentioned by Holz (2008) are: a) Structural changes: China shifted from being an agricultural country to transform itself into a highly productive industrial country and a significant exporter. b) Catching up: Meaning that technological innovation developed abroad can be acquired through the importation of industrial equipment, for example through foreign investment in the economy. c) Price equalisation: According to this theory, in a country whose labour costs are lower when compared to its capital, this will favour large growth in the labour markets. The resulting reduction in unemployment directly increases productivity. The growth of demand for skilled and specialised labour results in wage increases which is generally accompanied by growth in industrial output. For Holz (2008), these three factors are fundamental to the economic growth in China.

For Denninghaus (2009), one of the factors which strongly contributed to the economic growth of China was Deng Xiaopings agricultural reforms, which began in 3

1979. The country was in need of change after 30 years of planned economy under Mao Zedong. This transition based itself on pragmatism and experimentation. Moving on, from Denninghaus (2009), we see that the agricultural reforms and the opening-up of the countrys economy to commerce and foreign investments were the base for an economic reform package which guided the Chinese economy on market demand. The fact that these reforms were implemented gradually contributes significantly to avoid economic crises in the first stages of these reforms, as well as being easier to increase economic consumption after the success of several big harvests.

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In this context, another important factor was the growth in the export sector. The promotion of exportation is considered an important instrument for economic growth, particularly in developing countries. As Chinas recent history has shown us, a developing country can promote its economic growth by specialising its human capital and its goods. Through development strategies aimed at exports, a country can increase its productivity, use its resources more efficiently and increase its technological innovation. As the developing countrys economy expands, it tends to integrate itself better into international markets, which in turn, facilitates further economic growth (Chen et al, 2000).

There were also generally favourable conditions for Chinas growth. A relatively large amount of decentralisation, the quality and quantity of human capital were other fundamental factors. Denninghaus (2009, p. 8), concluded that China is an impressive example of a developing country with a difficult past, catapulting itself amongst the ranks of the biggest economies in the world in an extremely short period of time. All these factors were further helped along with growing globalisation around the world, increasing the demand for Chinese goods further.

It is also important to study the Chinese financial system to better understand its economic growth. According to Allen et al (2004), the four most important financial resources for all businesses in China, in terms of fixed asset investments, are: domestic bank loans, firms self-fundraising, state budgets and foreign investment. Until now, self-funding and bank loans have been the most important sources of financing. Loans provide a large number of funds for businesses and make up a large

part of firms total financing. For example, state-run enterprises owe 25 percent of its funding through bank loans.

Allen et al (2004) studied the relationship between Chinas financial system and its economic growth. Being one of the economies with the fastest growth in the world, China differs itself from other socialist countries. Although its judicial and financial systems developed relatively slowly, its economy grew significantly. The authors believe that a system of alternative mechanisms helps in sustaining the growth in the

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private sector, and are excellent substitutes for the standardised corporate governing mechanisms and other traditional means of finance.

Currently, one of the largest difficulties faced by the Chinese government is in stimulating internal consumption. Internal consumption grew during the economic reforms, but has been falling since 2000. In 2005, internal consumption comprised only 38 percent of Chinas GDP, the smallest participation rate among the largest world economies. In the USA, internal consumption accounted for 70 percent of GDP in the same year. In England, it was 60 percent and in India, 61 percent. Even Japan, known for its citizens frugality, had internal consumption of 57 percent of its GDP in 2005 (Lardy, 2007).

Promoting domestic demand as a means to economic expansion implies that internal and/or governmental consumption grow along with growth in exports and investments. Policies to promote consumption can base themselves on reducing taxes and changes and letting the exchange rate rise so as to make imports cheaper, thus benefitting the population. In many economies, the governments use fiscal policy to increase internal consumption, but in China fiscal measures are not effective because taxation is already low (Lardy, 2007).

If cuts in import taxes do not have the potential to lead to a significant increase in consumption, the alternative is to increase government spending to favour domestic demand. Investing in education, health-care, well-being and social care can contribute indirectly to economic growth. These investments are necessary in China, which currently spends only 3 percent of its GDP on public services for its citizens (Lardy, 2007). 5

Economists state that significant structural reforms are needed to maintain Chinas rate of economic growth. In these changes needed, we can identify: 1) State-run enterprises correspond to one-third of total industrial production. It is believed that more than half of these are running deficits and being maintained by state bank subsidies. Governmental support to firms which do not see financial returns could be invested into more efficient and lucrative firms. 2) The banking system faces difficulties due to its obligation to provide

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financial support to state-run enterprises instead of its lending being based solely on market assessments. The Chinese banking system is regulated and controlled by the central government. The government then determines which state-run banks make low-interest loans to state-run enterprises. Without these subsidies, these businesses would probably become bankrupt. For this reason, the Chinese government puts restrictions on foreign competition in the banking sector. Corruption is also a serious problem as a large part of these loans are given for political means and not exclusively financial. Fixing the exchange rate to overvalue to currency also has its detractors abroad, meaning imports from China are more expensive. Changing this practice is necessary to make the Chinese banking system more efficient. 3) There is a clear necessity to reduce pollution and political corruption, as well as increasing the populations salaries and equate rural salaries to urban ones (wages paid in large urban centres are much larger to rural wages, leading to a large social inequality). China is not a signatory for many international cooperation treaties to reduce carbon emissions and other pollutants. This is because such laws are seen to put a brake on further economic growth, leading to restrictions to industrial production. For this reason, 16 out of 20 of the most polluted cities in the world are located in China. Further, 300 million people living in rural areas drink dirty and unsuitable water, or rather, water contaminated by agricultural and industrial waste.

In all the problems presented in China, the ones which could most affect its economic growth are corruption and financial speculation. Many successful Chinese businesses succeed not just by their own merit, but also by governmental influences and political connections. Many foreign companies find it difficult to do business in China because its systems can be inconsistent or not transparent enough. Also, intellectual property rights are unprotected due to China missing an independent judicial system. The lack 6

of law enforcement in China limits the efficient allocation of goods and services in the economy.

In the current world recession, the Chinas primary trading partners are going through financial difficulties, forcing them to reduce their imports. This is putting pressure on the Chinese government to further to amend its policies for economic growth. This is necessary if China is to maintain its higher rate of growth and so bring other benefits to the population: greater equality between rural and urban populations, greater

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purchasing power for consumers, better public health services, and cleaner air and drinking water.

From this project we can conclude that the main factors that lead China to rapid economic growth were: 1. cheap labour; 2. agricultural reform leading to opening up the economy to foreign investors; 3. government policy; 4. foreign investment in technology; 5. investments in education, particularly industrial methods teaching.

Other factors that explain Chinas economic growth are: domestic demand, privatisation of state-run enterprises and international demand for Chinese goods, especially from the USA. Through the reforms mentioned, China has shifted from a largely agricultural based economy to a more industrial one, while sill remaining mainly agricultural. This means there is still scope for further growth. From Dennninghaus (2009:8), we finish this project with: China is an impressive example of a developing country with a difficult past, catapulting itself amongst the ranks of the biggest economies in the world in an extremely short period of time.

References

ALLEN, Franklin; QIAN, Jun; QIAN, Meijun. Law, finance and economic growth in China. Journal of Financial Economics, volume 77, issue I, July 2005, pages 57116. 7

CHEN, Baizhu; FENG, Yi. Determinants of economic growth in China: Private enterprise, education, and openness. China Economic Review 11 (2000), 1-15.

DENNINGHAUS, Marie. What factors have been responsible for Chinas rapid economic growth over the past quarter of a century? EC330 Term Paper 2008/ 2009. Available at: www.essex.ac.uk/economics/eesj/aut-

09/Denninghaus_Marie_EC330.pdf.

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JEFFERSON, Gary H.; HU, Albert G. Z.; SU, Jian. The Sources and Sustainability of Chinas Economic Growth. Published in 2007. Available at:

en.scientificcommons.org/33363152.

HOLZ, Carsten A. Chinas Economic Growth 19782025: What We Know Today About Chinas Economic Growth Tomorrow. World Development Vol. 36, No. 10, pp. 16651691, 2008.

LARDY, Nicholas R. China: Rebalancing Economic Growth. Chapter 1 from: The China Balance Sheet in 2007 and Beyond. Washington D.C.: Peterson Institute for International Economics, May 2007.

MORRISON, Wayne. Chinas Economic Conditions. In: CRS Issue Brief for Congress. Published in 2006. Available at:

http://www.fas.org/sgp/crs/row/IB98014.pdf.

QIAN, Yingyi (2000). The Process of Chinas Market Transition (19781998): The Evolutionary, Historical, and Comparative Perspectives. Journal of Institutional and Theoretical Economics, 156(1), 151171.

QIAN, Yingyi (2003). How Reform Worked in China. In D. Rodrik (Ed.). Search of prosperity: Analytic narratives on economic growth (pp. 297333). Princeton, NJ: Princeton University Press.

WANG, Yan; YAO, Yudong. Sources of China's economic growth 19521999: incorporating human capital accumulation. China Economic Review, volume 14, issue 1, 2003, pages 32-52.

WOO, W. T. (1994). The Art of Reforming Centrally Planned Economies: Comparing China, Poland, and Russia. Journal of Comparative Economics, 18(3), 276308.

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