from Follow the Money

How to explain China’s success?

June 14, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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If China were growing slowly, there would be no shortage of potential explanations.

Free labor market in China? Not even close. The household permit system is an enormous impediment to free labor mobility within the renminbi currency union. And China has its share of linguistic differences as well.

A free internal market in goods? Sort of. But local authorities often seem to try to rig local markets to favor local producers. There is no shortage of what Europeans call "state aid" at the local level.

A functioning equity market? Not really. Set aside the fact that China’s domestic stock markets are in a deep slump. Stock market slumps happen everywhere. There is little other evidence of functioning equity markets. Firms raised very little capital on the stock market over the past couple of years. And most listed firms are controlled by the state. There certainly is no market for corporate control.

A market-based banking system? Not really. Deposit rates are capped at very low levels to protect the financial health of the banking system. Lending rates are no longer controlled, but the quantity of loans that the banks can offer certainly is. Credit is certainly not allocated in an open market. The four biggest banks are all owned by the central government; the fast growing joint stock commercial banks are generally owned by local authorities.

A free market in land? Not at all. China is still a communist country. Land is the property of everyone, or no one ...

An economist looking for distortions that might inhibit economic growth would have no trouble finding them. The puzzle: despite all these distortions, China has grown very rapidly. And it still is.

What does this tell us?

It seems that there are four potential explanations for China’s growth.

1) State intervention in the economy (or certain forms of state intervention at certain stages in the development process) is less of an impediment that is often argued.

That is the lesson Putin seems to have drawn. And it is not just Putin. Joe Stiglitz argues that China’s success demonstrates the limits of "Washington Consensus" politics. And it is not just left-leaning economists either. There are plenty of other defenders of Chinese intervention -- at least in certain markets -- outside of China.

Foreign businessmen operating in China generally don’t object to massive government intervention to keep the RMB from rising (It should be noted that many economists also support various forms of exchange rate pegs, though not necessarily pegs designed to keep a country’s currency undervalued for an extended period of time). I don’t hear real estate developers here in the US complaining about the intervention by foreign governments in US credit markets (all the bonds purchased with growing dollar reserves), intervention that is contributing to low interest rates and the real estate boom. State intervention certainly helps some even if hurts others. In China, state intervention often seems to help at least certain types of business at the expense of Chinese labor, and other interests inside China.

2) China’s markets are far more flexible than they seem.

Internal migration is controlled in theory but not in practice, so China has its own "undocumented" internal migrants, migrants who cannot generally work in the state sector and thus are available for private employment. In addition to the formal banking system, informal networks help growing private firms obtain credit.

3) High savings rates and high investment rates can overcome a multitude of other sins.

In a macroeconomic sense, China is defined above all by very high rates of domestic savings and domestic investment (something it shares with other Asian "tiger" economies). Domestic savings per se does not always lead to domestic investment -- high levels of savings can be used to build up bank accounts abroad. But in China -- and elsewhere in Asia -- domestic savings generally has been used to finance high levels of domestic investment. Moreover, a history of macroeconomic stability means most savings are kept in local currency denominated bank accounts -- a huge advantage.

4) High savings, high investment rates and undervalued exchange rate can overcome other sins.

The undervalued exchange rate creates an incentive for domestic firms to test themselves in foreign markets, and foreign firms to use the country as a base for production to serve their home markets. In the process they bring access to key distribution networks, and needed technology and know-how. An undervalued exchange rate that keeps local labor "cheap" on a global scale is in effect the bribe the country pays to attract foreign expertise.

Personally, I suspect high savings rates and high investment rates are the most important factors. Avoiding major currency overvaluations is also important -- though I am not sure China’s current undervaluation (explanation 4) is as necessary as many argue.

The biggest question -- implicitly raised by Guy de Jonquieres in today’s Financial Times, though he focuses more on other Asian economies -- is whether China’s current model is sustainable. My strong sense is that the answer is no. 30% y/y export growth implies that China’s exports would more than double every three years. $600b in exports becomes $1300b in 2007, and $2800 b in 2010. I suspect China now has become big enough that it needs to contribute to global (consumption) demand, not just global supply. How and when that transition will come, however, remains a huge question.

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