The long march to modern China

Today is the 60th anniversary of the founding of the People's Republic of China. The traditional Chinese calendar, which was first used in the third century before Christ, is a sexagenary system. In lay terms, 60 year cycles are a big deal.

Prior to Deng Xiaoping's inspired decision to pursue economic openness in 1978, the economy progressed in fits and starts, with periods of moderate development success interspersed by major setbacks driven by profound policy errors.

The major theme was to redirect resources towards heavy industry through major distortions in the allocation system. Actual rates of growth for this era are still hotly disputed. Official data claims growth of 6.5 per cent on average for this era (4.3 per cent per capita), which is widely considered to be an overestimate. A consensus of the alternative measures puts growth just shy of 5 per cent, with per capita growth around 2¾ per cent.

The autarkic nature of the pre-1978 economy and the emphasis on heavy industry produced relatively high investment and manufacturing shares prior to the high growth era. That is a major point of differentiation with other East Asian economies. But the low quality of the capital stock, its low level per worker and inefficiency of resource allocation kept productivity levels low. In the 1950s state owned enterprises (SOEs) produced 99 per cent of industrial output. Chinese output per worker was about 5 per cent of US levels in the early 1950s and it was basically stagnant at that relative level through the 1960s and 1970s. Today the SOE share is less than 10 per cent. Productivity has risen to 14 per cent of the US level, with ample catch-up still to come.

In sharp contrast to the transition economies of Eastern Europe, who went for 'Big Bang' reform, China decided to adopt an incremental strategy. The gradualist and pragmatic approach to reform is encapsulated in four quotes separated by two and half millennia. The first and second are from Deng Xiaoping: "It does not matter whether a cat is black or white as long as it catches mice” and we will "cross the river by grasping the stones”. The third and the fourth are both from Confucius: "It does not matter how slowly you go so long as you do not stop” and "Study the past if you would define the future”. China studied the mistakes and successes that occurred elsewhere and adopted a pragmatic mix of policies. They have avoided the most egregious errors of others, have moved at a pace mostly of their own choosing and garnered a good deal of success along the way.

The resource intensity of activity has risen enormously. Steel output per head has risen at a compound annual rate of 12.9 per cent over the sixty years. However, it was only in the early years of the current decade that China moved beyond self-sufficiency in the supply of most key materials, sparking a commodity super cycle in the process. And yet, steel use per head is still just one third of the peak levels reached by Japan and Korea in their respective industrialisation drives.

China's high investment share has been funded by extremely high rates of domestic savings, with financial repression playing a role. While household savings are very high by international standards, it has been China's corporate savings rate that has truly distinguished it from its international peers over the last ten years or so.

China's share of world merchandise exports has grown seven-fold to upwards of 9 per cent. This trend, alongside huge domestic market share gains at the expense of manufactured imports, has accommodated a long run shift from modest external deficits in the 1980s and early 1990s to the largest external surpluses (and accumulation of FX reserves) that the world has ever known. The accession to the WTO in 2001 accelerated this shift, with foreign firms ploughing into coastal manufacturing. China has been an immense long run beneficiary of foreign capital inflow, with more than 3.2 per cent of current world GDP having been absorbed in a net sense since 1980. As a consequence foreign firms now account for three fifths of China's trade flows.

The period since 1978 is roughly divided into the 1980s era of 'reform without losers' and the 1990s era of 'reform with losers'. The latter period saw the shattering of the 'iron rice bowl' welfare system that built up around SOEs due to the mass unemployment that arose in the mid-1990s bust. Jobs in SOEs shrank by an average of 4.4 million in the ten years to 2007, giving birth to the 8 per cent official growth target that was deemed sufficient to create enough private sector jobs to offset both this supply and to keep up with new entrants.

The first half of the 1990s saw an inflationary boom/bust cycle that encouraged the leadership to seek the stability of a fixed exchange rate from 1994. The required real exchange depreciation worked through a pronounced fall in the price level. Legacy bad loans from this era and the Asian crisis forced major recapitalisations of the banking system in the early 2000s, while China has been both lauded (1998) and criticised (2003 on-going) internationally for the rigidity of its exchange rate regime over this period.

The financial system has been undergoing reform since the early 1980s, when the current big four state banks were carved out of the People's Bank and the latter was given operational autonomy from the Finance Ministry. However, the sector is still a backwater, with administratively determined floor and ceiling interest rates, heavy controls on portfolio capital flow and undeveloped fund management, inter-bank, bond and foreign exchange markets. The financial system will be a work in progress for the foreseeable future.

In order for China to rebalance its economy the catalogue of reforms is long. The unequal nature of broadly defined income distribution (between capital and labour, between private actors and the state, between regions and between households) is the central difficulty to be addressed. The pivot point is the government's revenue share. At just over 20 per cent of GDP it is too low. Raise that to 30 per cent of GDP, at the expense of the heavily subsidised state owned enterprise sector (thereby lowering net corporate savings), would fund a credible universal social safety net, thereby lowering net household savings. Together with a more efficient financial system, such reforms can be expected to catalyse the required structural adjustments. Policy moves in these directions are underway. Their logic is compelling.

#1 stat of the 60 year cycle: China has grown its population by 786 million between 1949 and today, despite the introduction of a family planning policy in 1979. The urban share has risen from 11 per cent to 46 per cent.

This column was originally published as Westpac Banking Corporation's Phat Dragon column.