Doing Business with China

Overview

Li Shantong, Development Research Centre of the State Council

Since the beginning of China's economic reforms and its opening to the outside world, China's economy has achieved unprecedented rapid growth. From 1978 to 2000 average annual GDP growth was 9.5 per cent, thanks to China's stable environment for development and the deepening of global economic integration. China's fast growth can mainly be attributed to a rapid increase in capital investment and improved productivity. Five years from now the international political and economic situation may be volatile, but the general international environment and pattern of development will support China's continuing economic development. Although China faces a variety of developmental issues, the policy environment will continue to favour rapid economic growth. Based on the trend to changes in investment, productivity and labour supply, China's economy will still be able to maintain a relatively high growth rate, with annual average GDP growth above 7.5 per cent. The key to achieving such rapid economic growth is the continuation of the strategic restructuring of the economy. This is being driven, on the one hand, by reforms and the opening to the outside world and, on the other, by technological progress.

Taking a long- term perspective on economic growth, the momentum is determined by both quantitative and qualitative improvements in productivity, capital and labour. Before looking ahead at economic growth in five years, one must look back at the sources of China's economic growth over the past 20 years.

Since 1978, rapid capital accumulation and improvements in productivity are the major factors explaining China's rapid economic growth. Increases in the overall labour supply have played a relatively small role in fuelling economic growth, although the impact of the reallocation of labour resources should not be altogether ignored. A substantial body of research on China's economic growth from 1978 to 1997 confirms that capital input accounts for nearly 60 per cent of China's economic growth in this period; improvements in productivity represent 30 per cent of growth, while the expansion of aggregate labour supply represents only 12 per cent of growth.

This investment has been increasing at a high rate. Since the outset of reforms and opening to the outside world, China's investment rate has remained at around 35 per cent of GDP. The investment rate in about half of the years from 1978 to 2000 was close to or above 40 per cent. This high investment rate can be in part explained by the fast-growing income of the Chinese people and their high propensity to save. From 1980 to 2000, total bank savings rose from 160 billion renminbi to 12 trillion renminbi, of which private savings grew from 40 billion renminbi, or 25 per cent of total savings, to 6.4 trillion renminbi, or 52 per cent of total savings. Another factor supporting rising investment was the large inflow of foreign investment as a result of preferential foreign investment policies. From 1979 to 2000, China received a total of US$518.9 billion in foreign investment.

Productivity has also improved. In the past 20 years or so, China has been able to improve productivity largely as a result of the following factors:

• Technological progress has increased the output associated with a given amount of capital.

• The rise in the level of education in the workforce has increased per capita output.

• Market reforms have contributed to a rational flow of resources, particularly of labour resources, across different sectors. At the micro level, this has made enterprises more profit-focused.

• The inflow of foreign investment has not only compensated for the limited domestic supply of capital and increased total investment, but has been accompanied by advanced foreign technologies and management expertise. All of these have helped Chinese enterprises to improve their competitiveness in both domestic and international markets.

Our research suggests that improvements in productivity since the beginning of reforms in the late 1970s can mostly be explained by two factors. The first of these factors, the more effective allocation of resources, is at the macro level. The second factor, which is at the micro level, is the increased efficiency of individual enterprises as a result of market reforms, technological progress and the spillover effect of foreign investment and foreign trade. Technological progress is, however, not the key contributing factor for improved productivity. The reallocation of labour across industrial sectors and different regions is considered a more important source of growth. Large-scale migration of labour from the agricultural sector to secondary and tertiary industries has fuelled the rapid growth of the economy, given the relatively higher level of efficiency of the industrial sector.

China's economic growth over the next five years hinges on whether the relatively high rate of investment can be sustained and productivity levels improved further. Our analysis of these factors supports the conclusion that China's economy will be able to maintain a relatively high rate of growth over the coming five years, despite signs of a decline in the rate of growth in recent years, from 14.2 per cent growth in 1992 down to 7.3 per cent in 2001.

Our research also confirms that China will maintain a relatively high investment rate and that productivity will be improved further. First, the investment rate in the next five years is expected to stay at the current level of between 35 to 40 per cent. There have been quite a few precedents of other regional economies sustaining both high levels of savings and investments. Taiwan Province, Japan and South Korea, for example, have experienced long periods of maintaining high savings and investment rates.

A sustained increase in household income will also contribute to a high rate of growth in household savings. Although the aging of the population will have some impact, the relatively strong propensity of Chinese households to save is not expected to change. Moreover, China's stable political and economic environment, as well as its huge market potential, will continue to remain attractive to foreign investors. The formalization and transparency of foreign investment policies after China's entry into the World Trade Organization will strengthen foreign investors' confidence in mainland China. Therefore, in the long run, the inflow of foreign investment will maintain the momentum of rapid growth.

Second, China's labour supply in the next five years is expected to grow on average by 1.2 per cent per year, which will satisfy the demand for labour implied by such levels of economic growth. With rising levels of education and urbanization, the quality of the labour force will be continuously improving. The accumulation of human capital will thus play a greater role in supporting economic growth than it has in the past.

Third, the implementation of the government strategy of 'transforming the country through science and education' will enhance the country's overall capacity for technological innovation while at the same time raising the general quality of the workforce. The policy of opening to the outside world will continue to attract foreign investment, encourage the inflow of advanced technology and introduce management expertise. As a developing and technologically backward country, China will, by embracing learning and innovation, unleash its huge potential for technological progress. The level by which technological progress will support economic growth is expected to maintain or exceed the levels of the past 20 years.

Fourth, China's industrialization is not yet complete. The 'dual structure' in the economy is still largely pervasive. The mobility of resources, especially human resources, across different sectors, such as labour migration from agricultural to non-agricultural industries, will lead to further improvements in productivity and to growth in aggregate national output. Fifth, the improvement in the market economy regime and the further expansion and deepening of the policy of opening to the outside world will result in fiercer competition among enterprises, and hence to improvements in all economic activity.

In an economy that not too long ago experienced product shortages and where product supply is now in relative surplus due to structural problems, changes on the demand side, in addition to those on the supply side, will have an influence on the rate of economic development. Our analysis of demand side factors indicates that China's high rate of growth in the coming five years will not be impeded by constraints on the demand side. However, the following priorities remain:

• First, the level of development and of people's standard of living in China needs to be greatly improved. According to the World Bank's World Development Report 2002 , China's gross national income (GNI) per capita was US$840, which represents only about 16.3 per cent of the world average and 3.1 per cent of the average in high-income countries. Even by the measurement of purchasing power parity (PPP), China's per capita GNI in 2000 was only US$3,940 dollars, representing 53.6 per cent of the world average or 14.4 per cent of the average for high- income countries . In 1998, as measured by PPP, daily consumption for 18.5 per cent of China's population amounted to less than US$1, while for a further 53.7 per cent of the population it was less than US$2.

• Second, China needs to construct more large-scale infrastructure. The average rate of infrastructure per person (or the infrastructure per square kilometre) is far below the world average. In the next 15 years and beyond, a great deal of effort will be directed toward the development of infrastructure, such as roadways and railways, electric utilities and communications infrastructure. In 1997, Chinese people consumed the equivalent of 907 kilograms per person of petroleum, while the per capita consumption of electricity amounted to 714 kilowatt-hours. The world average consumption in these categories for the same year was 1,692 kilograms and 2,053 kilowatt-hours respectively.

• Third, traditional industries should be reformed and expanded. China's traditional industries are technologically backward and not competitive, and require reconstruction on the basis of new and high technologies. In terms of productivity per person, the output of some traditional industries, such as food processing, is not as high as it should be, and needs to be raised. Accordingly, the transformation of traditional industries should focus on the upgrading of existing projects with new and high technologies on the one hand, and on the construction of new projects employing new and high technologies on the other. Both will require large-scale investment.

• Fourth, a great effort needs to be made to develop high-tech industries. In general, hi-tech industries are capital intensive , and the development of such industries will also require a large amount of investment.

• Fifth, urbanization needs to be further promoted and intensified. In 1999, the level of urbanization in China was 32 per cent, compared with a world average in the same year of 46 per cent urbanization. The average rate of urbanization in middle-income countries was 50 per cent and in high-income countries it was 77 per cent. The expected massive migration of agricultural population into urban areas will bring about a huge growth in aggregate demand. On the one hand, such migration will generate great demand for urban infrastructure, which will in turn drive the growth in the demand for investment. On the other hand, the migration of the farming population into urban areas will lead to urbanized consumer behaviour, which will also boost the growth in demand.

• Sixth, China needs to rapidly develop its service industry. Since the start of reforms and the opening of China to the outside world, the service industry has experienced rapid growth. However, the service industry is on the whole still quite backward. Traditional service industries that are quite mature in the developed countries, such as finance, insurance, accounting and legal services are insufficiently developed in China and are far from being able to satisfy the needs of economic development. Newer areas of the services industry in China are lagging even further behind. A rapid development of China's service industry will satisfy the population's growing demand for services arising from an improved standard of living. At the same time, this will address the requirements of structural changes to the economy and the upgrading of the industrial structure. As such, the development of the Chinese service sector may well be a new source of economic growth, generating a large number of job opportunities which will mitigate the pressures associated with structural changes to the workforce.

On the basis of the above analysis, we have elaborated two scenarios for the future growth of the Chinese economy in the next five years, employing a dynamic computable general equilibrium (CGE) model as a simulation tool. The first scenario assumes that past growth performance will be sustained to realise a relatively high rate of growth. The second scenario is of low growth, and emphasizes possible sources of a slowdown as a result of identified risks and challenges in the future course of China's economic development.

In the first or higher growth scenario, the average annual rate of growth in China's economy between 2001 to 2005 will be 8.1 per cent, whereas in the low growth scenario, the average annual rate of GDP growth will be 6.9 per cent in the same period. We contend that the current slowdown in the growth rate of China's economy is mainly the result of structural factors. To tap into China's growth potential, there are two critical issues that need to be solved from the demand side, one of which is how to raise people's spending in order to turn potential demand into real demand, and the other is how to eliminate bottlenecks in investment growth. From the supply side, however, the critical issue is how to raise the efficiency of resource allocation.

In the tenth Five Year Plan period China will adopt a series of policy measures aimed at facilitating strategic adjustments to the economic structure, increasing the growth in personal income and enabling the two driving forces of the economy: the policy of reform and opening to the outside world on the one hand and, on the other, technological progress. We have good reason to believe that China is able to realize rapid economic growth in the next five years.

^[*] This chapter was originally written in Chinese and translated by Li Yong.