Understanding China

China has accomplished a remarkable feat in transforming itself from one of the poorest countries in the world into the second largest economy in just thirty years. Growing at an average of an impressive 9.6 per cent per annum since market-oriented reforms began in 1979 which transformed the previously centrally planned economy, China has not only doubled its GDP and income every seven to eight years, it has also lifted 660 million people (or one-tenth of the world’s population) out of abject poverty. With its 1.3 billion people accounting for one-fifth of the global population, China’s economic growth has begun to shape the world and yet the determinants of its successful development are far from established or well-understood.

China, like other large countries, has fairly unique economic drivers. It is a transition economy that has dismantled most, but not all, of its state-owned enterprises and banks. It is also a developing country where half of its population is rural and in large parts agrarian;  agriculture, even in decline as a share of GDP, accounted for 40 per cent of rural employment in 2010. China is also an open economy whose trade-to-GDP ratio was about 70 per cent in the 2000s, making it substantially more globally integrated than other comparable-sized open economies, such as the UK (37 per cent). It also does not fit well into the studies of institutions and growth, as China remains a Communist state dominated by the Chinese Communist Party.  

As a result, it is not surprising that the rule of law and other market-supporting institutions, such as private property protection, are weak, as there is no independent judiciary, giving rise to the so-called ‘China paradox’ where the country has grown well despite not having a well-developed set of institutions. China’s economic growth is therefore in many respects both impressive and puzzling. It is also, like any other rapidly growing economies, not assured of sustaining such economic growth.

Structured thinking

To better understand the Chinese puzzle it is important to realise that the structure of the economy is as important as the standard growth factors. And the best view of the structure is from the microeconomic perspective of firms and households. Data at the household and firm level are more reliable than the aggregate statistics, and can shed light on the details of the key growth drivers.

Whether it has to do with reforming the state-owned enterprises or dismantling the allocated labour market or promoting exports, structural change modifies the traditional drivers of economic growth. An example is that China is not an industrializing country; it was already industrialized in the centrally planned period before 1979, well before the start of the reform period. It is the re-industrialisation process of upgrading obsolete machines and factories into more advanced ones that explains much of the continuing capital accumulation that has accounted for about half of its economic growth. In other words, China’s growth can be explained by the standard economic models, but with additional features that are specific to its unusual institutional context.

Another example is that neoclassical growth models emphasise factor accumulation of labour and capital as determinative of the steady state of the economy (the level of output given the people and savings of the country) while technology and productivity growth increase the rate of growth. In China’s case, productivity is not only driven by technology but also by factor re-allocation; for example, the structural change of labour migrating from state-owned to private industries. The process of factor reallocation exists within the industrial sector, so it is not just captured by the urbanisation and industrialisation processes described by the Lewis model and others which explain how developing countries grow. It is but one feature of the complex background of China being both a transition and a developing economy. This is also why total factor productivity (or TFP) growth is often difficult to interpret because this measure covers both technological as well as one-off productivity improvements, such as those related to privatisation (moving capital from state-owned to private ownership), which are all counted as part of the residual in growth estimations that is considered TFP.

Fuzzy openness

In terms of endogenous growth models including human capital, the Chinese experience is more straightforward, with the exception that the iron rice bowl means that the lifetime employment system prevented the relatively good levels of educational attainment and skills from being rewarded and also impeded labour mobility that reduced the matching of productive workers to the most appropriate jobs. As a result, human capital models which consider only the standard measures of educational levels will miss the allocative improvements from labour market reforms that finally rewarded human capital and contributed to China’s impressive economic growth. Those improvements are captured in microeconomic studies of the returns to human capital and the changes occurring at the level of the changing labour market.

Moreover, China’s context further confounds straightforward interpretations of the theories that link ‘openness’ to the global economy with economic growth. These explanations centre on the positive correlation between greater opening and faster development. The mechanisms include how the experience of exporting and accessing global markets can induce competitiveness improvements, as well as ‘learning’ from foreign investors with more advanced technology and know-how. It would enable a developing country like China to ‘catch up’ in its growth rate if it can imitate the existing technology embodied in foreign capital, the classical avenue through which countries achieve convergence in their growth rates according to the Solow growth model.

Again, the theories require adapting to China, as they do for many other countries. China is an open economy but exercises elements of control that prevents direct competition in its domestic economy and utilises a policy toward foreign direct investment (FDI) that furthers its own active industrial policies to develop domestic companies. As such, the simple openness measure that underpins the models of openness and growth do not fully capture the nature of China’s ‘open-door’ policy that introduced market-oriented reforms in the external sector first in 1978, which then accelerated after 1992.

Restrictions of its exchange rate and capital account while seeking technology transfers from FDI mean that several metrics are needed to calibrate the influence of opening on growth. For instance, FDI supplemented domestic investment, accounting for as much as one-third of all investment, at the start of the reform period when China was a poor country with a low rate of household saving of only 10 per cent of GDP. Foreign direct investment was also thought to be a source of productivity improvement, particularly via the Chinese–foreign joint venture policy that required transfers of technology to the Chinese partner as a condition of approval to produce in China. Furthermore, estimating those FDI spillovers requires firm-level data to estimate productivity. The joint ventures and other foreign-invested enterprises (FIEs) were also explicitly geared toward exports. They were initially located in Special Economic Zones (SEZs), which were created as export-processing zones that were similar to the export-oriented growth models of its East Asian neighbours.

China thus became integrated with East Asia, as it joined regional and global production chains, and eventually became the world’s largest trader. The focus on exports and the fixed exchange rate plus the restrictions on the other side of the balance of payments for a high saving economy, though, contributed to large current account surpluses by the 2000s at a time when the United States became a large deficit country. By the late 2000s, China formed part of the global macroeconomic imbalances where the surplus countries (China, Asia, and the Middle East oil exporters) and the main deficit country (the United States) experienced growing and seemingly unsustainable imbalances. Therefore, analysing China as an export-led growth model would explain only part of its success and also misplace China amongst the theories which are geared towards small, open economies like those in East Asia. The global imbalances and other aspects of the ‘China effect’ (impact on global prices) point to the need to examine China as a large, open economy that affects the global terms of trade in order to understand the role of openness in its economic growth.

Shoulder to shoulder

The other part of technological progress derives from innovation. Technology in endogenous growth models is generated by a knowledge production function and not treated as an exogenous shock in that innovation is created by researchers within the model. This also applies to China particularly as it increased its focus on patents and investment in R&D since the mid-1990s. Endogenous growth theories, including some variants of the human capital models, attempt to explain why some countries innovate and develop technologies that underpin a sustained rate of economic growth that is not subject to the usual diminishing returns. In other words, knowledge builds upon knowledge (the so-called ‘standing on shoulders’ effect) generating increasing returns, and unlike factor accumulation that is subject to decreasing returns per unit of investment.

These models have been applied to the United States in particular which has been not only the world’s largest economy but also the standard setter for the technological frontier. However, there has only been limited empirical support – indeed, Stanford’s Charles Jones found that a larger number of US researchers does not increase innovation or growth. For China, where researchers and scientific personnel are numerous, this strand of theories can potentially help explain its sustained rate of growth, although being farther from the technology frontier means that it may be a phenomenon of the 2000s rather than earlier in the reform period.

The application of the institutions and growth theories to China is perhaps among the most complex. The predominant view is that market-supporting institutions (those which protect property rights and provide contracting security) and an effective rule of law support and can thus drive strong economic growth. China is generally not included in the studies that argue for a causal relationship whereby good institutions lead to growth, as it does not have a colonial past with which to establish the exogeneity of its institutions. In this methodology, specific instruments related to colonial history are relied upon to address the reverse causality relationship whereby countries that grow well could develop good institutions rather than vice versa. Nevertheless, China has been measured against the rule of law and legal origins studies and found to be a paradox in having a weak legal system but strong economic growth. This genre of models was proposed to try and explain why some countries grow faster than others, as existing growth theories did not seem able to account fully for the differential growth of countries in the post-Second World War period.

However, China as an ‘outlier’ requires a closer examination as to how markets were enabled given the poor formal legal system. Specifically, the informal institutional reforms of the various ‘dual track’ policies that created a market alongside an administered track were important when applied to agriculture and the state-owned enterprises (SOEs), but these ‘institutional innovations’ were seemingly sufficient to instil incentives short of formal law-based reforms. But even in terms of legal protection, China’s adoption of laws in some key respects was not too dissimilar to that of the United States at a similar stage of economic development. The institutional theories of growth therefore apply to China, but its precepts again need to be modified to consider the effective role played by incremental legal and institutional improvements. This is particularly important when examining the development of the crucial private sector, which had been stymied by the preferential policies towards state-owned enterprises even after the mid-1990s reforms significantly reduced state ownership.

The role of informal institutions such as social capital also cannot be overlooked. Entrepreneurship relied on social networks or guanxi to overcome the lack of well-developed legal and financial systems. It is also the case that the cultural proclivity towards inter-personal relationships meant that social capital played a key part in understanding the development of self-employment and the impressive rise of the private sector. Measuring and quantifying social capital requires detailed individual and household level surveys rather than aggregate-level studies.

Leveling the field

Finally, to sustain its growth for another thirty years, which is an aim of China’s, will require not only technological and human capital improvements, but also reform of its rule of law, the role of the state, and the rebalancing of its economy. Rebalancing the economy will involve boosting domestic demand (consumption, investment, government spending) to grow more quickly than exports, shifting toward services (including non-tradable areas) and away from agriculture, increasing urbanisation to increase rural incomes, and permitting greater external sector liberalisation, including the internationalisation of the renminbi (RMB). To achieve these aims will also require examining the role of the state in China and the legal system. The retention of large SOEs and the increasingly perceived ‘non-level playing field’ for both foreign and domestic private firms raises doubts as to the efficiency of China’s markets and thus its ability to overcome the ‘middle-income country trap,’ whereby countries start to slow after reaching upper-middle income levels. For China to realise its potential as an economic superpower requires reforms of both the microeconomic drivers of productivity as well as significant transformation of the structure of its economy.

There are understandable concerns about the nature of China’s macroeconomic statistics available to address these key questions. But its micro-level data are superior. Due to the decades of central planning that accounted for most households including in rural areas and the continuing close surveillance of its large and medium-sized enterprises (defined as those with 5 million RMB and above in revenue), household and firm-level data are closely checked and yield more satisfactory results than those generated by aggregate statistics alone. The need to understand the micro foundations of macroeconomics is prevalent in the economic discipline in any case. Where macro patterns are seen, it requires a finer analysis of household and firm behaviour to interpret aggregate trends, such as why labour reallocation has ceased to be as important as a productivity driver by the 2000s, or why the savings rate increased during the reform period, that are premised on analysing the behaviour of households and firms. It is the same for China as for other economies.

China’s context, though unique, does not imply that economic growth models do not explain its success in the reform period. Rather, its being a transitioning and developing country that is following an export-oriented growth strategy whilst adopting rapid legal reforms must temper any direct application of the theories. Understanding these elements will identify the theories that can best explain China’s growth since 1979.

London Business School