Looking into the economic future is a popular pastime at the end of the year, but the accurate forecasting of long term economic prospects is notoriously difficult. Over 30 years ago few economists were prepared to predict that China would open up and successfully reform its economy. Professor Steven N S Cheung was probably the only one to do so in his book Will China Go Capitalist? But I am not aware of any economist who was able to foresee that within three short decades China would overtake Japan to become the world’s second largest economy , grow at about 10% annually, and unsettle, if not exactly threaten, the world’s largest economy, the US.

GDP (bn) GDP per capita
USA 14,624 47,132
China 6,044 4,283
Japan 5,391 42,325
South Korea 986 20,165
Mexico 1,004 9,243

Note: All figures are from the IMF for 2010 in US$.

What has China done right in the past 30 years to lift itself out of the ranks of the very poor and bring about the greatest post-World War II economic miracle? Will this be enough for China to achieve a per capita income that will allow it to join the ranks of high income economies, like say South Korea? Or will China remain a middle income country like Mexico?

Put simply China’s success can be traced to its willingness to substantially largely decentralize economic decision-making. The decentralization of political decision-making, however, has been more limited, but there has been progress especially at the grass roots level insofar as where economic activities are concerned. This economic success has bestowed enormous political legitimacy upon the state, although not necessarily everyone has been entirely happy with the process, or the outcome.

The decentralization of economic decision-making has succeeded in spurring rapid economic growth even in the presence of an inefficient financial system, the lack of rule of law, poorly protected contractual and property rights, and the presence of continuing rigidities in the labor market. The idea that markets can perform economic miracles even while resting on unsound foundations, and even while working imperfectly, has been clearly demonstrated in China. Indeed, China’s experience suggests that it is not entirely necessary for a country that starts from a highly distorted economic condition and at a very low income level to achieve some very significant progress without well operating markets.

In reflecting upon the cautious and negative attitudes of many economists 30 years ago, I believe they were too eager to criticize the failures of imperfectly operating markets. They neglected to appreciate that the operation of the markets during Britain’s economic growth spurt, some 200 years ago, was not ideal either: economies were hugely distorted by government regulations, and the rule of law was still immature. But, by the standards of the time, huge economic progress was made which ushered in the Age of the Industrial Revolution. Our modern-day naysayers had not studied their economic history.

A good way of characterizing China’s economic progress is to consider its decision to allow some 200 to 300 million people to leave agriculture and the rural sector and join the various industries springing up in the urban coastal regions. This freedom to migrate, to leave the communes, and take charge of their own lives has fueled China’s market-driven growth. A considerable portion of these jobs were provided by the opening of the economy, which created the opportunity to export overseas and attract foreign direct investments. These activities in turn led to the growth of domestic demand as the economy expanded. The globalization and expansion of the world economy in the 30 years before the Great Recession facilitated China’s entry into the world market. As we know this entry was helped in the beginning by the expertise of many Hong Kong businessmen.

Can China continue to make good progress in future in light of the global recession?  Or will its imperfect market institutions impede its growth now?

Two economists, Timothy Kehoe and Kim Ruhl, have recently drawn attention to the experience of Mexico. In the decade that followed the severe economic crisis of 1982-85, the Mexican government implemented a series of market-oriented reforms that culminated in the implementation of the North American Free Trade Agreement (NAFTA), in 1994. These included fiscal reforms, privatization of state firms, and the opening of the economy to trade and foreign investment.

In spite of this, Mexico’s economic growth since 1985 has been modest. Real GDP per capita grew at an annual rate of 1.8% from 1990-2000. This growth rate is disappointing compared with China’s annual rates of 9%.  Both countries adopted essentially the same changes in economic policy but with different outcomes. Kehoe and Ruhl found that these outcomes can be explained by differences in productivity, but what is the basis of this discrepancy?

The scale of trade and foreign investment inflows as shares of GDP, in Mexico and China, respectively, are of the same magnitude.  Both countries suffer from an inefficient financial system, the lack of a rule of law, poorly protected contractual and property rights, and the presence of continuing rigidities in the labor market. The degree of openness and the presence of weak market institutions are common factors in both countries and cannot account for the discrepancies in performance between them.

Trade and FDI Inflows in GDP in 2009
China Mexico
Trade 44.5% 52.9%
FDI Inflows 2.00% 1.45%

 

Mexico was not a democracy until the mid-1990s and so these differences cannot be blamed on political institutions either, at least not for the decade 1985-1995, when the benefits of the reform should have been most prominent.

A number of studies of productivity growth in China have documented huge gains in the manufacturing sector following reform. These gains have typically been the result of (1) the entry of new high productivity firms and the exit of low ones due to greater competition, (2) the establishment of a more level playing field for private efficient firms as subsidies to the state owned sector was cut in preparation for accession to the WTO, and (3) growing foreign direct investment from more efficient foreign firms. Other studies of Mexican manufacturing industries have also found large increases in productivity arising from trade and foreign investment. China’s industry sector as a share of GDP was 48.6% in 2009 and is larger than that the corresponding figure of 34.5% in Mexico. This would help explain why growth in China is faster than in Mexico to some extent, but it cannot provide a full explanation given the very large differences in growth rates between the two countries.

GDP Composition by Sector in 2009
China Mexico
Agriculture 10.9% 4.1%
Industry 48.6% 34.5%
Services 40.5% 61.3%

 

In the rest of the economy, Mexico suffers from a lack of competition in sectors like petroleum extraction, electricity, telecommunications, and transportation. But China also lacks competition in these areas. The state reorganized many of these industries into large companies in anticipation of accession to WTO, as preparation against competition from the entry of foreign firms.

The puzzle of why China’s productivity has grown faster than Mexico’s therefore appears to be unexplained as the two nations have much in common and whatever differences there may be, they are not large enough.

An intriguing yet simple answer has been available all along. Studies by Stephen Parente and Edward Prescott (2002) and William Lewis (2004) provide a simple explanation of why Mexico is trapped in middle income status. In fact the arguments are well known to those who have studied economic development in the past 60 years. A rich nation is one that is productive in all three sectors of the economy – agriculture, industry, and services. A poor nation has low productivity in all three sectors.  In a world of rich and poor nations, the poor ones will be able to develop if they adopt the more advanced technologies from the rest of the world.  Failure to do so can be blamed on government policies and institutions, like monopolies, that impede their adoption. To catch up with the rich nations it is necessary for the poor nations to reform and open their economies on a sustained basis.

For over a century the US economy has been the leader in terms of productivity through its ability to advance the world’s technology frontier. This applies to almost all areas. It has produced a record of growth since 1900 of a sustained 2% annual growth of GDP per working-age person, with the exception of the period impacted by the Great Depression during 1929-39 (see Chart 1). It is likely that this rate of growth reflects what is achievable by an economy at the frontier of knowledge given the underlying economic institutions it has and the policies it adopts. Obviously it is easier for an economy to grow faster than the world leader when it is behind, and the further one is behind the faster one can potentially catch up, but as this economy catches up then the rate of growth tends to level off. This occurred in Western Europe in the early 1970s, and again in Japan in the early 1990s.

Nations that are behind the US can catch up if they are willing to open their economies to trade and foreign investment allowing them to benefit from adopting the best available technology. Achieving this demands a reform of the domestic economy which will provide the necessary infrastructure and policies for markets to function properly. It is often easier to achieve this in manufacturing than in services.  A casual examination of the history of our own economy confirms that at almost all times our manufacturing industries have been far more open and competitive than our services, even today.

Nations that have been unwilling to open up to trade and foreign investment have remained at the bottom of the heap. After World War II many nations adopted import substitution policies and stayed poor as their industries have remained uncompetitive and unproductive. These include many of the countries in South America, Africa, and Asia. The exceptions were Japan, the Four Asian Dragons, and later many nations in Southeast Asia. These nations have moved ahead because they favored openness and market oriented reforms. In so doing they have industrialized their economies and benefitted from adopting the best available technologies from around the globe.

Some middle income nations have remained at this level despite opening up their manufacturing sector, because they have failed subsequently to extend this openness to their services sector.  While their governments have embraced policies to promote trade and have welcomed foreign investment in manufacturing they have adopted a different attitude for their services sector. As a consequence, competition is limited in this area and productivity has remained low. Countries like Mexico are productive in manufacturing, but not in services and are therefore trapped in the middle income range. They are unable to break through to rich income status. Thirty years ago China was poor, but it has now progressed to the lower ranges of middle income countries where it will remain while catching up. But will it manage to break through to the next stage?

Opening up services is more difficult than manufacturing. Trade in services has always suffered from more protectionist barriers than trade in goods. And high value added services are particularly sensitive to, and will be adversely affected by, the lethal combination of an inefficient financial system, the lack of a rule of law, poorly protected contractual and property rights, and the presence of rigidities in the labor market for professional and other services. Catching up means essentially further reforms to improve the functioning of competitive markets, remove trade and regulatory barriers, remove monopolies, and strengthen the soft infrastructure that supports free competitive markets. These will be not easy because of the political resistance from entrenched special interests.

Given that China is still very much behind the US, there is much scope for development which will allow it to expand at a very rapid rate. That the Chinese economy was probably severely distorted and overly-regulated probably also helped it to grow faster after opening up and reforming. Since China’s economy remains distorted and over-regulated there will be considerable scope for fast growth catching up as distortions and regulations are removed.  Mexico is not enjoying the same rapid catch-up growth because after experiencing this during the period prior to 1981 it stopped reforming its institutions and continue to push pro-competition policies to the rest of the economy. Today it is growing at a rate that is similar to the US trend rate of 2%. But Mexico is still far behind the US and therefore can resume catch-up growth. But to do so would require further economic reforms, especially in the service sector, which will eliminate barriers to growth and promote competition.

If China fails to sustain its reform efforts then, like Mexico, its growth rate might slow down once its catch-up growth dividend has been spent, relegating it to the middle income group of countries. As a large nation it will still be among the major powers in the world, as President Hu Jin Tao’s recent trip to the US demonstrates, but that is not enough for the Chinese people to secure the highest possible standard of living. Steven N S Cheung’s call 30 years ago has been proven correct so far. This is quite an achievement for him and for China. If China proves him correct for another 30 more years then he would indeed be remembered in the halls of economics together with Ronald Coase.

References:

Steven N S Cheung, Will China Go Capitalist? Hobart Paperbacks, Institute of Economic Affairs, 1982.

Timothy Kehoe and Kim Ruhl, Why Have Economic Reforms in Mexico Not Generated Growth? Research Department Staff Report 453, Federal Reserve Bank of Minneapolis, 2010

William Lewis, The Power of Productivity: Wealth, Poverty, and the Threat to Global Stability, University of Chicago Press, 2004

Stephen Parente and Edward Prescott, Barriers to Riches, MIT Press, 2002

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