China became an economic giant of the world thanks to an extraordinary transition in the last four decades, but it is only now there is new light on the price it has had to pay for its success.
In 2018, China celebrated the 40th anniversary of transition from a planned economy to a market economy. And it was an astounding success. In 1978, the country was a closed suspended to the world. It was a poor country, if not among the world’s poorest. Its per capita was less than a third of even sub-Saharan African nations. Over 80 per cent of its people lived in the rural areas, as many were living below the international poverty line and China had a closed economy where trade made less than 10 per cent of its GDP.
The reasons for Chihna’s success and the cost of the stupendous growth are part of a new analysis by Professor Justin Yifu Lin, formerly Senior Vice President and Chief Economist of the World Bank, 2008-2012, is Dean of Institute of New Structural Economics, Dean of Institute of South-South Cooperation and Development, and Professor and Honorary Dean of National School of Development (NSD) at Peking University. The analysis is excerpted from the book, China and the West, edited by a Columbia University professor, Jan Svejnar, and Lin.
But in the last 40 years, the annual GDP growth rate was 9.4 per cent on average and trade grew at an average rate of 14.8 per cent. In no time, China was the world’s second largest economy overtaking Japan. It was the largest exporter, beating Germany. It even overtook the USA to become the largest economy, measured by ‘purchasing power parity’, and the largest trading economy.
China could boast of having taken around 700 million citizens out of poverty. While several big economies suffered economic collapses periodically, China remained immune to financial crises. By 2019, China’s per capita GDP reached $10,400 and may cross $12,700 to become a high-income country by 2025. If this is achieved, China would be only the third country after South Korea and Taiwan to transform from low-income to high-income economy “among nearly 200 developing economies after World War II”.
China was among several socialist countries that embarked upon economic transformation, but it alone tasted success. Lin’s analysis puts it in perspective: “Other socialist countries and many developing countries followed the Washington Consensus of privatization, marketization and liberalization, inspired by neoliberalism. This strategy derived from the argument that socialist countries and other developing countries had not done well because excessive government intervention caused misallocations of resources. This argument led to the recommendation that, to improve their economic performance, these socialist and developing countries should immediately remove all distortions and end government interventions, so as to allow markets to function.”
But these economies realised the problems after starting out on the new path. “Even after the privatization, governments continued to subsidize (large-scale industries) to stay in operation. As a result, whether it was for reasons of social stability, basic needs or national defense, after the privatization, liberalization and marketization, the government reintroduced new types of subsidies and distortions. These distortions were yet more inappropriate and even more inefficient than the explicit subsidies and protections that had been swept away.”
However, China did not fall into this trap and adopted a pragmatic approach. The professor explains: “The government provided transitory protection and subsidies to the existing sectors to maintain stability. However, the Chinese government also liberalized and facilitated entry into new labor-intensive and small-scale traditional industries, which were consistent with China’s comparative advantages. In the past, the government discriminated and repressed those sectors. To make those labor-intensive industries competitive, China also needed to provide adequate infrastructure and a good business environment. The infrastructure in China was extremely poor when the transition started. Although it was desirable to improve infrastructure for the whole nation, the Chinese government lacked financial resources to do so, and so it set up special economic zones (SEZs), industrial parks and export processing zones, improving infrastructure in a limited number of areas. China’s business environment was also very poor due to the distortions needed to protect existing industries.”
As a result, on the face of it, China remained a stable country, achieving dynamic growth figures. Its exports increased rapidly over the years and it came to be known as the world’s manufacturing giant. Until, of course, the Covid pandemic struck, but that is another story.
What price did China pay for its unprecedented success? “In addition to environmental degradation and food safety issues, which have attracted many public complaints and are the results of rapid industrialization and lack of appropriate regulations, the main issue during the transition is widespread corruption and the worsening of income disparities. Before 1978, China had a rather disciplined and clean bureaucratic system and an equalitarian society. According to the Corruption Perception Index published by Transparency International, China ranked No. 79 among all the 176 countries or territories in 2016.”
The negatives are attributed by economics experts to China’s “dual-track transition strategy”. At one level, “the government provided transitory protection and subsidies to the nonviable state-owned enterprises (SOEs) in the old, capital-intensive sectors to maintain stability”. At another, it “liberalized and facilitated the entry to the new, labor-intensive sectors which were consistent with China’s comparative advantages to achieve dynamic growth”.
Professor Lin points out that one of the most important “costs of investment and operation for the old capital-intensive sectors was the cost of capital”. Before the transition in 1978, the “government used fiscal appropriation to pay for investments and cover working capital, so SOEs did not have to bear any cost for capital. After the transition, the fiscal appropriation was replaced by bank loans”. The Chinese government set up four large state banks and a stock market to meet the capital needs of large enterprises and to “subsidize SOEs, the interest rates and capital costs were artificially repressed”.
So, how did the transition impact China? The research shows: “When the transition started, almost all firms in China were state-owned. With the dual-track transition, private-owned firms grew and some of them become large enough to get access to bank loans or list in the equity market. As interest rates and capital costs were artificially repressed, whoever could borrow from the banks or list in the stock market were therefore subsidized. These subsidies were paid for by the low returns to savings in the banks or in the stock market made by individual households. Those people providing the funds were poorer than the owners of the large firms they financed. The subsidization of the operation of the rich’s firms by poorer people was one reason for increasing income disparities. Moreover, the access to bank loans and equity market generated rents, leading to bribery and corruption of the officials who control the access.”
The analysis argues that in addition, some natural monopoly industries, such as power and telecommunication, were operated by state-owned enterprises and the government “liberalized the entry to those industries gradually”, adding that “those monopoly rents were also sources of inequality and corruption”.
Prof Lin’s analysis says that “competitive industries can be profitable, accumulate capital and engage in processes of industrial upgrading that tap into the potential advantage of backwardness, enabling them to grow much faster than high-income countries, maintaining growth rates of 7 percent or more for several decades, as in the case of China in the last four decades”. A careful liberalization of entry into new sectors, of a country’s comparative advantages and of government facilitation of growth in those sectors, “can allow it to grow dynamically and preserve stability while preparing the ground for the removal of the distortions”. A pragmatic approach to “step-by-step development, according to a country’s evolving comparative advantage, is of great value to developing countries”.