Economic Survey of China 2005: Key challenges for the Chinese economy

 

The following OECD assessment and recommendations summarise Chapter 1 of the  Economic Survey of China 2005 published on 16 September 2005.

Economic growth has been rapid

The pace of economic change in China has been extremely rapid since the start of economic reforms just over 25 years ago. Economic growth has averaged 9½ per cent over the past two decades and seems likely to continue at that pace for some time. Such an increase in output represents one of the most sustained and rapid economic transformations seen in the world economy in the past 50 years. It has delivered higher incomes and a substantial reduction of those living in absolute poverty. The size of the economy, when measured at market prices, now exceeds that of a number of major European economies and may be exceeded by only three OECD member countries in five years’ time. While average incomes are still below those in other middle income countries, there are large parts of the country that have reached the income levels seen in some developed East Asian countries just one generation ago and are proceeding along a similar rapid catch-up path. Many industries have become completely integrated into the world supply chain and, on current trends, China could become the largest exporter in the world by the beginning of the next decade. Underlying this growth there has been a profound evolution of economic policies that has transformed the efficiency of enterprises.

 



 helped by profound changes in economic policies,

This extraordinary economic performance has been driven by changes in government economic policy that have progressively given greater rein to market forces. The transformation started in the agricultural sector more than two decades ago and was extended progressively to industry and large parts of the service sector, so that price regulation was essentially dismantled by 2000. While price controls were being abolished, the government introduced a pioneering company law that for the first time permitted private individuals to own limited liability corporations. The government also rigorously enforced a number of competition laws in order to unify the internal market, while the business environment was further sharpened by allowing foreign direct investment in the country, reducing tariffs, abolishing the state export trading monopoly and ending multiple exchange rates. The momentum towards a freer economy has continued this decade with membership of the World Trade Organisation resulting in the standardisation of a large number of its laws and regulations and the prospect of further tariff reductions. In addition, fundamental changes were made to the constitution in 2004, stressing the role of the non-state sector in supporting economic activity in the country and protecting private property from arbitrary seizure. In 2005, regulations that prevented privately-owned companies entering a number of sectors of the economy, such as infrastructure, public utilities and financial services were abolished. Overall, these changes have permitted the emergence of a powerful private sector in the economy.



reform of the state-owned sector,

The government has also introduced wide ranging reforms into the state-owned sector that dominated the economy in the early 1990s. State-owned enterprises have been transformed into corporations with a formal legal business structure and many have been listed on stock exchanges that were created in the early 1990s. Since 1998, a policy of letting small enterprises go and restructuring large companies has been successfully pursued, with the number of state-controlled industrial enterprises falling by over one half in the following five years. Employment contracts were made more flexible, leading to job reductions in the industrial sector of over 14 million in the five years to 2003. This process was aided by the creation of unemployment and welfare programmes that transferred the burden of compensating redundant workers from enterprises to the state. Finally, in 2003, the government rationalised its control over state-controlled enterprises further by creating an agency charged with exercising the government's ownership rights and boosting the performance of these enterprises.

and rapid growth of physical and human capital.

These reforms have improved the framework for mobilising the resources generated by one of the highest rates of savings in any economy – the gross saving rate approaches half of GDP – generating a particularly rapid increase in the capital stock, although such estimates can only be approximate since there are no official estimates either of the capital stock or of constant price estimates of expenditure components of GDP, the absence of which complicates interpretation of economic trends. Investment has, in part, served to raise the assets available to each worker in the business sector, so boosting the annual growth of labour productivity to 8½ per cent in 2003. It has also been used to create an increasingly urban society – a movement that has gone in step with a flow of people from the land into the service and manufacturing sectors of the economy. Since workers in agriculture have low productivity, such a movement has boosted growth considerably.

In parallel with the growth of physical assets, the government has pursued a policy of raising the education qualifications of young people. It launched a programme to give all children nine years’ education, moving recently to ensure that all rural areas achieve this goal by 2006. Higher education has also been transformed. In the five year period to 2003, the number of students joining higher education courses has risen by 3½ times, with a strong emphasis on technical subjects. As a result of these policy initiatives, the average quality of the labour force has also been improving significantly, with new entrants to the labour force having almost three times as many years of schooling as those who are retiring. Finally, government initiatives have freed the urban labour market, with the wages for educated staff being pushed up by the growing influence of a market economy.

Strong medium-term growth requires a stable macroeconomic environment

The growing importance of the private sector puts a premium on the maintenance of a stable macro-economic environment – notably in the area of prices. Fiscal policy has been run in a stabilising fashion. The overall fiscal position is sound, and has allowed scope for counter-cyclical management: expenditure and deficits were allowed to expand in 1998, when external developments threatened to reduce the pace of economic expansion; and deficits were reduced, while expenditure was kept under control when revenues surged beyond budget expectations in 2004. Yet, the past decade has seen considerable volatility in the inflation rate, almost 8 times that in the United States and 4 times that in Western Europe. The annual rate of inflation, when measured by the GDP deflator, has moved from 6% in 1996, to slight deflation in 2002, before rebounding again in 2003 and 2004 and still registered a rate of 4½ per cent in the first half of 2005, though the consumer price index has slowed to a greater extent at the beginning of 2005 due to its high food content.

that would be best achieved with a more flexible exchange rate.

Such fluctuations suggest that domestic monetary policy has not always been successful in maintaining low and stable inflation. Rather, the existence of a relatively fixed rate of exchange against the dollar has exposed the economy to inflationary or deflationary impulses stemming from fluctuations in the effective exchange rate of the dollar. In the current cycle, the combination of a rising current account surplus and foreign direct investment inflows has led to a need to purchase dollar assets to stabilise the exchange rate. The Chinese authorities have been able to sterilise much of this inflow through changes in reserve ratios, open market operations and window guidance to restrain the growth of bank lending without raising interest rates. However, given that inflows amounted to 12½ per cent of GDP in 2004 and, in line with experience in other countries, central bank sales of securities may eventually disturb the portfolio balance of the private sector, putting upward pressure on interest rates. Although there are strict controls on capital inflows, there is a likelihood that, with increasing trade flows, the capital account may become increasingly porous and responsive to any such increase in interest rates, increasing the pressure for sterilisation. Moreover, reliance on window guidance to limit bank lending goes against the government’s policy of increasing the use of market-based instruments to control monetary developments. Indeed, in line with this policy, the authorities have started to develop foreign exchange and derivative markets that would allow a redistribution of risks stemming from exchange rate fluctuations. Overall, a policy of allowing greater flexibility in the exchange rate would allow the authorities to guard against the risk of any further increase in inflation in both product and asset markets, to more easily adapt monetary policy to domestic concerns and to allow market forces to determine bank interest rates to a greater extent. The July 2005 revaluation of the currency, together with the associated change in the exchange rate arrangements, represents a step in this direction.


 

Reductions in geographic income dispersion are needed

Increased fiscal transfers have helped lessen some of the inequalities in economic development but need to be complemented by further liberalisation of the labour market. Since 1999, polices have been in place to boost infrastructure and education spending in the poorest, western areas of the country with the objective of providing the conditions for faster growth. Programmes are also in place to reduce taxation and illegal fees in rural areas, so boosting incomes. Such programmes could be usefully complemented by efforts to create a national, or at least provincial, labour market. At the moment, it is difficult for workers and their families to permanently change their place of residence. Even for a temporary move, many permits are required and many local services, such as education and health are either not available to migrants or only available on unfavourable terms. Moreover, if a rural person moves permanently to a city, his rural landholdings are forfeited without compensation. The government has been reducing restrictions on movement but further relaxations would tend to reduce rural-urban income differentials.

and could be helped by a faster pace of urbanisation

Migration will bring increased urbanisation that will need to be managed carefully. At present, Chinese cities are more equally sized than those in other economies. Considerable gains in productivity might be achieved with larger cities and recent government reports have highlighted the benefit of creating three major agglomeration hubs, as well as a number of city belts on the coast and major rivers. However, policies with regard to land ownership tend to militate for relatively extensive urban development, as cities and towns retain most of the funds from the sale of land leases, leading the central government to curb excessive development during the current upswing. Following extensive privatisation during the past decade, a residential housing market has emerged, with the owner occupation rate approaching 70% in urban areas. Nonetheless, the short length of commercial and residential leases (40 and 70 years, respectively) may constitute a barrier to effective improvement of land, as property on the land reverts to the state at the end of a lease. In 2003, new legislation gave farmers the right to a 30 year lease on their land, but this law has not yet been fully implemented. Moreover, leased land may be subject to redistribution when household size changes. Longer leases might improve incentives for rational land-use.

In sum, the very wide urban-rural income differences mean that large-scale migration will continue one way or another. On the positive side, continued urbanisation will contribute to growth, and also to reduced inequality. But managing the process is complex and requires simultaneous reform in several areas: reduction in regulated barriers to migration; land-law reforms to underpin a more efficient urbanisation process; changes in fiscal relations among levels of government (particularly within provinces) to assure an adequate funding of health and education spending for the newly urbanised population; as well as proper incentives for urban governments to allocate resources to these ends.

that can be achieved without sacrificing the environment.

Increased urbanisation and economic activity has taken place in the context of an environment that is subject to a high level of pollution. Government policies have been successful in containing the level of pollution but, even so, five of the ten most polluted cities in the world are in China. Investments under the 9th and 10th five year plans have improved pollution control. Indeed, the quantity of sulphur emissions rose only 5% between 1993 and 2003, despite GDP more than doubling in the same period. The upswing in emissions in the recent business cycle suggests that it will be a significant challenge to ensure that environmental measures and energy policies are sufficiently forceful to lower pollution levels markedly. New legislation, introduced in 2003, has strengthened the use of economic instruments by markedly increasing penalties paid for the emission of air and water pollutants. As yet, though, few old power stations are fitted with anti-pollution equipment and the level of pollution, both for air and water, remains high. The key to ensuring further improvements in air quality, which currently imposes a welfare cost estimated to lie between 3% and 8% of GDP, will be the effective enforcement of laws by local environmental bureaux and ensuring that pollution emissions from major sites are carefully monitored.

Overall, a sound strategy for development is in place.

A marked evolution in economic polices over the past two decades has led to a long period of sustained economic expansion. National income has been doubling every 8 years and this has been reflected in the reduction of the poverty rate to much lower levels. Indeed, by some accounts, over half of the reduction in absolute poverty in the world between 1980 and 2000 occurred in China. At the other end of the scale, average incomes in major coastal areas are on a similar development path to that seen in other East Asian countries one generation ago. Considerable challenges face the economy, not the least of which is a rapid increase in the age of the population, but continued evolution of economic policies, especially in the areas of the allocation of capital, labour mobility, urbanisation and the creation of a improved framework for the development of the private sector of the economy, should ensure that this development momentum is sustained.

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