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Changing Chinaˇ¦s path
to growth
By Michael Spence
China is poised to begin its transition from middle-income to developed-country
status. Relatively few economies (five to be precise, all in Asia: Japan, South
Korea, Taiwan, Hong Kong and Singapore) have successfully managed this
transition while sustaining high growth rates. No country of Chinaˇ¦s size and
diversity has ever done so.
Chinaˇ¦s 12th Five-Year Plan, adopted last month, provides the road map it will
follow. Yet it is not really a plan; rather, it is a coherent interconnected set
of policy priorities to support the economyˇ¦s structural evolution ˇX and thus to
maintain rapid growth ˇX over the period of the plan and beyond. So a great deal
is at stake, both internally and externally. Growth in the worldˇ¦s emerging
economies now depends on China, the main export partner for a growing list of
major economies, including Japan, South Korea, India and Brazil.
There are at least five important interconnected transitions embedded in Chinaˇ¦s
new plan: Changing the economyˇ¦s growth model or supply side structure, because
as labor costs rise, global market shares become large enough to limit expansion
and advanced countriesˇ¦ growth momentum slows for an unknown period of time;
rebalancing demand, from investment and exports to domestic consumption;
accommodating a rapidly urbanizing population and ensuring that incentives are
structured to bring about as orderly a process of social change as possible;
building the institutions necessary for achieving inclusiveness and equal
opportunity; and finally, assuming international responsibility for stability,
growth and sustainability, including tackling climate change.
The challenge for China is implementation, which means reform and systemic
change. International experience suggests that the balance between planning and
markets shifts toward markets as countries become richer. The structural
evolution that underpins growth will increasingly be driven by market
opportunities and entrepreneurial initiative. A huge number of new businesses
need to be created.
To support this shift, much is required. Labor-intensive industries in the
tradable sector must be allowed to decline. Many companies may survive, but only
by moving to different parts of the global economy or up the value-added chain
domestically: up or out. A rising nominal and real exchange rate can propel
structural change; a weak--currency policy is a trap.
The financial sector must be developed to create more savings options and to
supply credit and equity capital efficiently to new and growing businesses,
which China needs in order to attract the rural population to cities. Many of
these jobs will be in the domestic, urban, non-tradable service sector.
However, urbanization faces another obstacle: the hukou system of residency
permits, which restricts mobility and bars migrants from becoming full-status
urban citizens. Chinese officialsˇ¦ reluctance to eliminate hukou quickly
reflects their observation of the social consequences of rapid or unbalanced
urbanization.
As the scope of the private sector expands, legal structures and policies that
support competition, entry and exit, market openness, intellectual property and
social safety nets will also be needed. The move to higher-value-added links of
domestic and global supply chains will require more effective education and
expanded investment in the economyˇ¦s intellectual and technological
underpinnings. The balance between technology imports and domestic innovation
will continue to shift toward the latter.
The Chinese public sector has a huge balance sheet and includes major equity
positions in state-owned enterprises (SOEs), which account for more than half of
net fixed assets and one-third of profits in the corporate sector. In all
countries, these assets should be held in trust for citizens and deployed in
pursuit of economic and social development. China has an exemplary record in
this area. Unlike most countries, China has not struggled to get public-sector
investment up to levels that support sustained high growth.
However, there are issues. Investments are justified and support economic and
social development when they have high private and social returns. Elements of
the investment portfolio in the public sector and the SOEs are beginning to fail
this test.
To be fair, given the legacy costs of SOEs (stemming from their responsibilities
for social services and insurance), together with their financial distress in
the 1990s, it made sense for a while to let them keep their retained earnings
and not place additional claims on them through the government budget.
This is no longer the case. If reinvested income from SOEs is not subject to a
high return criterion, growth will eventually slow. The portion that falls short
needs to be redirected to higher-return investments in either the public or
private sector, to household income or to essential public services and social
insurance.
The SOEs compete in product and labor markets with the private sector, but less
so in capital markets. While wages and incomes are rising and appear to have
broken the iron grip of the surplus labor pool, the growth pattern requires this
structural demand-side shift toward more disposable income, greater government
consumption and high-return investment.
It is suspected that consumption will increase. Properly recycled savings,
including corporate profits, could go back mainly into high-return public or
private-sector investments. Both contribute to aggregate domestic demand and the
structural shifts on the supply side will be driven by the ˇ§rightˇ¨ mix of
aggregate demand, with the low-return component on the investment side removed.
Thus, the new Five-Year Planˇ¦s goal is to recompose (not expand) aggregate
demand in order to sustain growth and avoid the -diminishing-returns trap that
is the principal risk of Chinaˇ¦s current investment pattern. Changing that
pattern will require a restructured financial system that allocates savings
efficiently, based on fiscal and capital-market discipline and
corporate-governance reform. Designing that system will be an important part of
achieving the high-return investment and expanded consumption that Chinese
leaders want ˇX and that Chinaˇ¦s economy needs.
Michael Spence is a professor of economics at the Stern School of Business, New
York University, and a senior fellow at the Hoover Institution, Stanford
University.
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