The OECD Observer
January 1999, No. 215

 

China: A World Economic Leader?
By Colm Foy and Angus Maddison

 

China’s great history is a checkered one, but its economic performance since 1978 has been impressive. Though still essentially poor, it could, according to certain measurements, overtake the United States as the world’s largest economy in the next 20 years.(This article is based extensively on the Development Centre book, China’s economic performance in the Long Run, by Angus Maddison, 1998, http://www.oecd.org/scripts/publications/bookshop/redirect.asp?411997101P1)

In terms of both population and GDP, China was the largest economy on the planet until the early 19th century. Indeed, China’s existence as a definable political and economic entity predates virtually all other countries. Its bureaucracy was already a profession by the 10th century, and it already had access to printing. The base of China’s prosperity and stability was intensive and efficient agriculture, nurtured by a centralised political system which depended on it for its income. But because it relied on the force of tradition, rather than military or feudal might, to maintain order, its vast territory became an easy target for outside colonial powers. In short, the Chinese system was to find itself no match for the entrepreneurial prowess and military forces of Europe and Japan.

By the time of the First Republic in 1911, imperial China was in ruins: the social system was in collapse; central authority had evaporated; the most lucrative parts of the economy were in the hands of foreigners; and significant areas of territory had been lost. Thereafter, the situation became more and more chaotic, culminating in the country’s military collapse under the weight of the Japanese invasion and the Second World War.

When the Chinese Communist Party came to power in 1949 it restored central control under the People’s Republic. National unity with economic independence was its priority. From 1952 to 1978, GDP measured by value in purchasing power parities was multiplied by three, while per capita income increased by 80%. The economy’s structure was transformed and industry’s share of GDP rose from 10% to 35%. Inputs of labour and physical capital rose dramatically and the quality of human capital was improved.

However, China’s politics still leaned towards autarky. Though the communist party was socialist in the Marxist tradition, it was fiercely independent of the Soviet Union and deeply suspicious of the Soviet domination of the socialist camp. This led the government to hunt for a unique Chinese way of resolving political and social problems, ultimately provoking the Sino-Soviet split and disastrous economic experiments, such as the Great Leap Forward, which were designed as short cuts to industrialisation, and political errors, the most destructive of which was the Cultural Revolution.

Another of the weaknesses of the People’s Republic was its early belief in economies of scale. People’s communes with workforces averaging 6,700 were created in 1958 out of 130 million family farms, with a disastrous effect on agricultural production. The size of the production unit was reduced three years later to 30 workers. The experience was the same in industry and services. Resource allocation was entirely government-directed and China’s isolation from the world economy deprived it of innovation and caused consumer interests to be neglected. Isolation—chosen vis-à-vis the Soviets, imposed by the United States—did not help. It led to economic stagnation, whereas 1950-73 proved to be a remarkable period of growth for the world economy and for OECD countries in particular. In China by 1978 the average firm had 11 times more workers than in Japan. Only after isolation was ended and reforms begun in 1978 would Chinese growth take off dramatically.

 

From Reform to Growth

The temptation to compare China’s reform performance with that of the former Soviet Union has been too strong for commentators to resist, but some of these comparisons have been ill-founded. The Soviet economy operated at a higher level of income and was much more industrialised by the time perestroika got under way. China, by contrast, was still a predominantly rural country; huge as the state enterprises were, they still employed a minority of the population and surplus labour was to be found in the rural areas. Moreover, the communist party remained the sole political power in the country and its territorial integrity has been maintained since the start of reform in 1978, whereas the former Soviet Union split into its constituent parts and finally collapsed.

The main difference with Russia of course is in the progress made in improving the economy. Since 1978 major policy changes in China have succeeded in generating substantially higher growth in per capita income. There has been a modest increase in the growth of capital stock, but the major reason for the improvement was better use of resources and substantial growth of total factor productivity.

There were several forces which contributed to the greater efficiency and higher productivity growth of the Chinese economy. Peasants regained control and management of their land. The average production unit became the farm household employing 1.4 people on less than half a hectare. There were better prices for farmers, and easier access to markets. The result was a large improvement in incentives and productivity.

Another force was the huge expansion of small-scale industry, particularly in rural areas. The average size of state enterprise did not change, but in the non-state sector it fell from an average of 112 to 8 persons, so the overall average fell from 175 to 14 employees per firm. Productivity growth was much faster in the non-state sector, which has lower labour costs, virtually no social charges and a much smaller and more efficient use of capital.

The rigid monopoly of the government over foreign trade and the policy of autarky were abandoned after 1978. Foreign trade decisions were decentralised. Between 1980 and 1997 there was a five-fold devaluation of the yuan. Special economic zones, such as Shenzhen, were created not as free trade areas as is often believed, but as windows of new opportunity and bridges for co-operation between China and foreign investors. In response to the greater yielding to market forces, competition emerged, resource allocation was improved and consumer satisfaction was increased. The volume of foreign trade rose by 13.5% a year and China’s share of world trade increased from 0.8% to 3%. There was a significant inflow of foreign direct investment, particularly after 1992.

The success of Chinese policy making is reflected in per capita incomes, which rose by 6% a year from 1978 to 1995. That was faster than any other Asian country except Korea, and very much better than the 1.5% a year in the European Union and the United States, and six times as fast as the world average. China’s per capita GDP, in 1990 international dollars adjusted for PPP, rose from a quarter to a half of the world average level to stand at $2,653 by 1995. Its share of world GDP increased from 5% to 10%, and it became the world’s second biggest economy, again measured in PPP terms, after the United States. The big questions are whether this catch-up process can last and, if so, for how long.

 

Catching Up with the United States?

It has become popular, if unrealistic, to speak of levels of growth of around 10%. This is understandable, in a sense; Chinese official figures, upon which most other estimates are based, do show such rates of growth. However, the Chinese national accounting system is based upon old Soviet methods, essentially relying on output reports from enterprises and production units in the countryside. This method is crude and unsound, and can be used to provide only part of the calculation. When standard OECD accounting procedures are employed to evaluate China’s GDP growth in purchasing power parity terms, however, it can be shown to have been lower, though still strong, at 7.5% per year since 1978.

For China to reach an overall level GDP equal to the United States, the world’s largest economy, an annual rate of growth of some 5.5% would be required up until about 2015. On past performance, this would appear to be perfectly possible, particularly if China’s leadership continues to allow the economy to adapt itself to the requirements of international competition. This implies continued improvements in the efficiency of human and physical capital allocation; further embracing foreign technology and adapting it to the country’s special needs; and allowing identification and implementation of comparative advantages.

The economy remains handicapped by an excessive number of loss-making state enterprises which will either have to be reformed or closed. In the former Soviet Union and in other economies in transition from command to market economy, this process has caused hardship and political instability. China will have to tackle certain problems carefully, particularly that of unemployment, since state-sector employment currently offers social benefits such as health care and housing upon which workers depend given the absence of state-wide systems. Suppression of jobs would thus have serious social consequences.

Linked to the problem of inefficiency in state enterprises is the need to reform the banking and financial system. During the early stages of opening up the economy, the Chinese monetary authorities were unable to control the financial system’s development. This contributed to inflationary pressures and inefficient allocation of savings. While the banking system, which is propping up inefficient state enterprises through the bad loans it has made to them, remains under state control, a parallel system of non-banking financial intermediaries (NBFIs) has evolved which provides financing for the non-state sector by using a proportion of private savings. These NBFIs—trust and investment companies, urban credit co-operatives—have helped to satisfy enterprises’ needs for investment loans and have benefited from transfers from the state banks which use them for their specialised knowledge. The result has been excessive credit creation. Reforms in 1994 went some way to remedy the situation, but this mix still needs to be reconciled and the non-bank financial intermediaries will have to become real competitors of the banks through a wide-ranging rationalisation and renewal of the entire financial system.

Finally, the weak fiscal position of central government must be strengthened. Current relations between the central and regional governments for tax-raising purposes will have to be clarified and the tax base widened to replace the current use of extra-budgetary income.

On the whole, as we enter the 21st century, China remains a poor country. This makes high growth rates, of course, easier to achieve, but it also means that per capita incomes have a long way to go to reach those of the United States and other major OECD countries. Per capita GDP rose by an average annual rate of 6% from 1978 to 1995; it can be expected to grow by a more modest (but still honourable) 4.5% between now and 2015. That increase will bring China up to somewhere around the world average, but still well below the OECD average and to only one-fifth of the US figure. With 5.5% overall GDP growth in the same period, China would account for 17% of world GDP, giving the country a much greater weight in the global economy. This implies growth in Chinese exports, but also corresponding increases in imports which would stimulate the world economy generally. Despite the current difficulties in Asia’s normally dynamic economies, the region as a whole can be expected to recover and assume growing importance in the world economy over the medium term. Provided it continues to open up to the world economy, China will have a key role to play in determining the pace and form of that recovery.

 

OECD Bibliography

Angus Maddison, China’s Economic Performance in the Long Run, 1998
(http://www.oecd.org/scripts/publications/bookshop/redirect.asp?411997101P1)

Fan Gang, Maria Rosa Lunati and David O’Connor, Labour Market Aspects of State Enterprise Reform in China, 1998

Colm Foy, Francis Harrigan and David O’Connor, The Future of Asia in the World Economy, 1998 (also available in Chinese)
(http://www.oecd.org/scripts/publications/bookshop/redirect.asp?411998041P1)

Ren Ruoen, China’s Economic Performance in an International Perspective, 1997
(http://www.oecd.org/scripts/publications/bookshop/redirect.asp?411997101P1)

Éric Girardin, Banking Sector Reform and Credit Control in China, 1997
(http://www.oecd.org/scripts/publications/bookshop/redirect.asp?411997111P1)

Jean-Jacques Laffont and Claudia Senik-Leygonie, Price Controls and the Economics of Institutions in China, 1997
(http://www.oecd.org/scripts/publications/bookshop/redirect.asp?411997061P1)

Kiichiro Fukasaku, David Wall and Mingyuan Wu, China’s Long March to an Open Economy, 1994.
(http://www.oecd.org/scripts/publications/bookshop/redirect.asp?411994131P1)