The Chinese Growth Miracle

Background — Comparison

• See GDP per capita increase rapidly since 1980s.

• By 1950, China was one of the poorest countries in the world — accounting for less than 5% of the world GDP, and its GDP per capita at 21% of the world average GDP per capita.

• Compare this with 1820 when China was essentially a middle-income country — with its global GDP share (33%) almost equal to its global population share (37%). By 1920, its GDP per capita was 90% of the global average GDP per capita.

• The secular economic decline from 1820 to 1950 began to reverse afterwards especially after the 1978 deep economic reform.

• By 2015 China’s share in global GDP and population both stood at about 20%, and its GDP per capita is 16% higher than the global average.

→ Average economic growth is now 9.5% and stable

Relevance of China’s experience in understanding development I

• Democracy is neither a necessary nor a sufficient condition for economic growth. The same is true about authoritarianism.

• The fact that China is a very large country means it is almost impossible to establish a centralized absolute rule even if the political elite may want to do so.

• Instead, the Chinese government created contingent institutions that:

a) would keep local leaders incentivized to put in place growth-promoting policies, and

b) keep the country together while implementing profound reform (such that the transition to a market economy would be peaceful and efficient)

Relevance of China’s experience in understanding development II

The Chinese growth experience is also unique in the following ways:

• Unlike other transition economies (countries that transitioned to a mixed economy from a communist regime), China followed a gradual approach to economic reform.

• Managed its transition without major disruption in economic growth.

• And achieved rapid economic growth without a major political reform.

Highlights of the Chinese economic reform program:

• The reform started in 1978

• Started with deregulation of markets (undoing central planning)

• Allowed for greater private sector participation and privatization of state-owned enterprises.

• Included agricultural reform:

  • Land reform (equalize land ownership)

  • Remove collective farming

• Industrial policy: subsidies, tax holidays, and exchange rate policies.

• Export-oriented industrialization

More Highlights of the economic reform:

What does “muddling through” mean? What was the best example of this?

• The Chinese approach to economic reform can be characterized as “muddling through” as compared to the radical approach (shock) in other East European communist bloc countries.

• Best example of this was the dual-track price reform that involved:

  • Liberalization of consumer prices at the beginning of the reform (1978)

  • Retain state controlled prices for key production inputs: Coal, oil, and steel

  • Market determined prices for other production inputs.

  • Incentivize managers of state-owned enterprises to increase productivity:

    • Producers of key inputs can only sell in the open market once they fulfill the quota imposed on them at gov’t set prices.

    • Buyers can purchase key inputs at market prices once their quotas are used up.

• The reason for this gradual approach to reform is to avoid the disruption of the production process, which could lead to hyperinflation (as experienced in other transition economies).

Why was China more successful in their transition compared to Russia?

• They used a gradual approach to reform rather than shocking the system.

• See a gradual reduction in the share of State Owned Enterprises (SOEs) and a rising share of the private sector.

• See evidence of structural change (shares of GDP in three sectors increases for industry and services, and decreases in agriculture) and strong manufacturing sector.

What are the main 8 economic & political factors that contributed to the Chinese growth miracle?

1. Conducive Initial Conditions

2. High Saving and Investment Rate

3. Macroeconomic Stability

4. Fiscal Decentralization

5. The Promotion Tournament

6. Institutions and Institutional Change

7. The Role of the State

8. Export-Led Growth

The Economics of the Chinese Growth Miracle

1. Conducive Initial Conditions

Discuss the three economic conditions

1. High human capital (education and health outcome): Although China was poorer than India by the late 1970s, its literacy rate and life expectancy were higher than that of India because of the communist party’s effort to expand education and health services in a more equitable way.

2. Low inequality: This was achieved largely through expropriation of the assets of rich farmers in rural areas and capital owners in cities during the communist revolution. While this is clearly a wrong approach to achieving a more equal society, it turned out to be beneficial once the economy started to grow in the post-reform period.

3. Strong manufacturing base: China’s manufacturing before the 1978 reform was built around capital-intensive heavy industries that were poorly managed by state-owned enterprises. However, the sheer size of the sector (at about 40% of GDP) allowed China to cultivate an army of well-trained manufacturing workers and technicians. After the 1978 reform, this manufacturing workforce was readily available for the growing labor-intensive and export-oriented manufacturing that was globally competitive.

The Economics of the Chinese Growth Miracle

2. High Savings and Investment Rate

• Even before the 1978 reform, China had one of the highest saving rates in the world. This was largely forced savings achieved through a number of communist policies.

• The saving rate continued to rise after the reform (reaching 50% in 2010), suggesting that its rapid post-reform growth is largely investment driven.

• However, intensive investment activities allowed Chinese firms to import the latest technologies embedded in modern machinery and equipment from abroad.

The Economics of the Chinese Growth Miracle

3. Macroeconomic Stability

• China has avoided macroeconomic instability that rocked many transition economies.

• This is partly through its dual-track pricing policy, fiscal discipline, and better agricultural productivity that kept food prices lower.

The Political Economy of the Chinese Growth Model

4. Fiscal Decentralization

Why is China unique among transition economies?

What was their reform to incentivize provincial leaders to promote growth?

Where does the bulk of government spending happen?

• China is unique among transition economies in having a highly decentralized fiscal regime in a highly politically centralized setting.

• Through a series of fiscal reforms, the communist party established separate revenue sharing arrangements with each province that would allow provinces to keep a significant portion of the revenue they generate.

• This incentivized provincial and local leaders to promote growth and increase revenue. This allowed each province to implement economic policies that are best suited to its socioeconomic conditions.

• This reduced the risk of systemic (national) policy failure as provinces adopted different approaches rather than implementing the same model.

• Since the central gov’t keeps about 50% of total revenue, it used a fiscal transfer program to disperse a large portion of its revenue to local provinces based on adherence to its national development plans and priorities

Summary of Chinese Fiscal Federalism: the bulk of gov’t spending happens at the local level.

The Political Economy of the Chinese Growth Miracle

5. The Promotion Tournament

How was the government able to incentivize local leaders to implement growth promoting policies?

• A major challenge for communist countries is how to incentivize local leaders (who are appointed rather than elected) to implement growth promoting policies.

• The answer lies in part with the Chinese bureaucracy being inspired by the Confucian doctrine that emphasizes meritocracy; leaders need to be well educated and capable to serve in government, but also bear the responsibility of taking care of the people (problem solving).

• Moreover, young leaders joining the CCP have to demonstrate governance and problem-solving capabilities at the local level before they can be promoted to higher offices (this could take 20 years or more of dedicated service and loyalty).

• Since the number of positions declines as one moves up the ladder, it creates a promotion tournament incentivizing local leaders to outperform their rivals (in terms of economic growth, tax revenue, employment, social stability, etc).

The Political Economy of the Chinese Growth Miracle

6. Institutions and Institutional Change

What does China’s peaceful and efficient transition to a market economy without political reform tell us about their institutions?

Why did the political elite implement economic reforms? What two things did the CCP do?

• How China managed a peaceful and efficient transition to a market economy without political reform raises questions about the role of institutions.

• The reason why the political elite (the CCP) decided to implement economic reforms is because they were facing legitimacy crisis internally (because of the poor performance of the economy during 1950-1978) and the realization that neighboring countries in the region were outperforming China.

• The promote growth without jeopardizing its own political future, the CCP did two things:

1. Follow a gradual approach to economic reform, and

2. Implement contingent institutions: these refer to arrangements that would help solve an immediate problem but do not necessarily become permanent fixtures of the country’s institutions.

• Examples of contingent institutions include the dual-track pricing system and Township Enterprises.

The Political Economy of the Chinese Growth Miracle

7. The Role of the State

Why is the CCP often characterized as a Developmental State?

What institutional reforms did they adopt?

• The CCP is often characterized as a Developmental State — taking an active role in resource allocation across key sectors, building human capital and infrastructure, and investing in technology.

• This was made possible through institutional reforms that include:

1. Eliminating personal cult and heavy reliance on a single (supreme) leader — to avoid erratic policy choices.

2. Introducing collective leadership through the Standing Committee of the CCP (involving deliberations).

3. Putting term limit and mandatory retirement for top leaders.

• The fact that the CCP has basically eliminated its political rivals (during the revolution) means it can focus on growth promoting policies without fear of political challenge.

• Since the CCP has also achieved a more equal society by the end of the 1970s (by dispossessing the landowning and capitalist class), it can focus on growth without having to worry about redistribution. [Relate this with Acemoglu et al. (2005) discussion on the inseparability of the efficiency and redistribution implications of policy reform.]

8. Export-led Growth

What two transitions facilitated China’s export-led growth?

• Joining the WTO in 2001 allowed China to increase its exports rapidly (but that wasn’t the only factor).

• This export-led growth was facilitated by two transitions (double transition hypothesis):

1. Demographic transition: achieved through a strict family planning policy. This led to a reduction in the age-dependency ratio (those below 15 and above 65 as a share of the population in the 15-65 age group). The decline in age-dependency ratio has two implications: an increase in the labor force and domestic savings rate.

2. Rural-urban migration: the urban based industrialization benefited from a continuous supply of labor from rural areas. This transition keeps wages low for Chinese manufacturers, helping them compete internationally, while creating better employment opportunities for agricultural workers.

• Another factor for China’s successful export-led growth is the increasing technological sophistication of its exports partly based on the use of domestic technology.

China’s domestic and global imbalance problems can be summarized into the following three puzzles:

Puzzle 1: The share of household income in national income has declined since 1996 although per-capita income has increased.

Puzzle 2: The national savings rate has increased dramatically since 2000. The household saving rate has increased despite the declining share of household income in national income; the size of corporate savings has become as large as the size of household savings although the corporate savings rate has remained constant; and the government saving rate has remained higher than the household saving rate in most years.

Puzzle 3: China has become a net international capital provider although returns to capital in the country are higher than in most other countries.