Demystifying the Chinese Economy

On April 3^rd, 2012, Justin Yifu Lin, Chief Economist and Senior Vice President of the World Bank, gave an honorary lecture at the HSE as part of the XIII April International Academic Conference on Economic and Social Development.

Justin Yifu Lin has held the position of the Chief Economist and Senior Vice President of the World Bank since June 2008. Mr. Lin guides the Bank’s intellectual leadership and plays a key role in shaping the economic research agenda of the institution. Prior to joining the Bank, Mr. Lin served for 15 years as Founding Director and Professor of the China Centre for Economic Research (CCER) at Peking University. Mr. Lin received his PhD in economics from the University of Chicago in 1986 and is the author of 18 books, including The China Miracle: Development Strategy and Economic Reform and Economic Development and Transition: Thought, Strategy, and Viability. He has published more than 100 articles in international journals and collected volumes on history, development, and transition.

In his lecture Justin Yifu Lin tried to unveil the reasons and circumstances of the Chinese economic miracle and to give some prospects for the future of the Chinese economy.

32 years have passed since China began its transition from a planned to a market-oriented economy.  In 1979 it was a poor country with a per capita income of US$182, less than one-third of the average in Sub-Saharan African countries. Since then, China’s average annual GDP growth has been 9.9 percent. Its trade-to-GDP ratio has reached 65 percent and is the highest among the world’s large economies. In 2009 China overtook Japan as the world’s second largest economy and replaced Germany as the world’s largest exporter of merchandise. China’s achievements look miraculous and many researchers have attempted to analyze and explain this extraordinary experience.

Justin Yifu Lin has recently published a book entitled Demystifying the Chinese Economy. In that book he tried to answer some questions related to the Chinese economic phenomenon, and in his speech he discussed those questions and gave his answers.

Why has it been possible for China to achieve such an extraordinary performance during its transition?

A rapid increase in per capita income is a modern phenomenon. Per capita income in Europe took 1,400 years to double before the 18th century, about 70 years in the 19th century, and 35 years thereafter. Sustained growth in any economy is based on technological innovation. A developing country such as China, which started its modernization drive in 1949, has the advantage of ‘playing catch up’ in its pursuit of technological innovation and structural transformation. While for developed countries innovation means invention, which is costly and risky, for developing countries innovation means imitation: a country which is a latecomer to this process can borrow technology, industry, and institutions from advanced countries at low risk and costs.

After the transition was initiated by Deng Xiaoping in 1979, China adopted a strategy of opening-up and started to tap the potential of importing what the rest of the world knows and exporting what the world wants. This is demonstrated by the rapid growth in its international trade, the dramatic increase in its trade dependence ratio, and the large inflows of foreign direct investment. The exploitation of the advantage of being behind has allowed China to emerge as the world’s workshop and to achieve an extraordinary economic growth by reducing the costs of innovation, industrial upgrading, and social and economic transformation.

Why was it impossible before?

Justin Yifu Lin claims that after the revolution in 1949, China was too ambitious as a socialist country and adopted the wrong development strategy. The Chinese social and political elites prioritized the development of large, heavy, advanced industries. China was eager to catch up with Britain and the US in the shortest possible time. But at that time the country was a low-income agrarian economy. To achieve its strategic goal, the Chinese government needed to protect priority industries by giving firms in those sectors a monopoly and by subsidizing them through various price distortions. These price distortions created shortages, and the government was obliged to use administrative measures to mobilize and allocate resources directly to nonviable firms. These interventions enabled China to quickly establish modern advanced industries, test nuclear bombs and launch satellites. But economic efficiency was low, and the growth before 1979 was driven mainly by an increase in input.

Why did most other transition economies fail to achieve a similar performance?

Most developing countries in both the socialist and the non-socialist camps adopted a development strategy oriented toward heavy industry and import substitution. To implement this strategy, many developing countries introduced distortions and government interventions like those in China.

This strategy made it possible to establish some modern industries and achieve investment-led growth from the 1950s to the 1970s. Stagnation and frequent social and economic crises began to beset most developing countries by the 1970s and 1980s, while liberalization from excessive state intervention became a trend in the 1980s and 1990s. But without governmental protection, firms in the priority sectors would have collapsed, causing a contraction of GDP, a surge in unemployment, and acute social disorder. To avoid those consequences, many governments continued to subsidize nonviable firms through other, less efficient subsidies and protections. Transition and developing countries thus had even poorer growth performance in the 1980s and 1990s than in the 1960s and 1970s.

Compared with other developing countries, China adopted a pragmatic, gradual, dual-track approach. The government first improved incentives and productivity by allowing workers in the collective farms and state-owned firms to be residual claimants and to set the prices for selling at the market after delivering their quota obligations to the state at fixed prices. At the same time, the government continued to provide necessary protections to nonviable firms in priority sectors and simultaneously, liberalized the entry of private enterprises, joint ventures, and foreign direct investment in labor-intensive sectors.

This transition strategy allowed China both to maintain stability by avoiding the collapse of old priority industries and to achieve dynamic growth by tapping the advantage of backwardness in the industrial upgrading process.

What costs did China pay for its extraordinary success?

The gradual, dual-track approach to transition is a double-edge sword. While it enables China to achieve enviable stability and growth in the transition process, it also brings with it a number of structural problems, particularly disparities in income distribution, consumption and savings, and external accounts.

Major remaining distortions include the concentration of financial services in the four large state-owned banks, the almost zero royalty on natural resources, and the monopoly of major service industries, including telecommunication, power, and banking. Those distortions have contributed to the stability in China’s transition process. They have also contributed to rising income disparity and other imbalances in the economy.

Therefore, it is imperative for China to address its structural imbalances by removing the remaining distortions in the finance, natural resources and service sectors so as to complete the transition to a well-functioning market economy.

How can China sustain a similar dynamic growth in the coming decades?

Mr. Lin is very optimistic regarding the sustainability of China’s success. First, China can continue to enjoy the advantage of backwardness before closing the gap: there is still a large technological gap between China and advanced industrialized countries. Second, China has the potential to achieve another 20 years of 8 percent growth. If China maintains this rate, by 2030 China’s per capita income measured in purchasing power parity may reach about 50 percent of the U.S. per capita income.

As a middle-income country, China has the potential to be a technology leader due to its large domestic market. With foresight, China will be able to gradually shift from absorbing existing technology to becoming an indigenous innovator of new technology to drive its growth

Can other developing countries achieve a similar economic performance?

According to Mr. Lin, every developing country has the opportunity to accelerate its growth if it knows how to develop its industries according to its comparative advantage at each level of development and if it can tap the advantage of backwardness in its technological innovation and structural transformation. In the reform process it is desirable for a developing country to remove various distortions of incentives to improve productivity and at the same time adopt a dual-track approach, providing some transitory protections to nonviable firms to maintain stability, but liberalizing entry into sectors in which the country has comparative advantages.

The audience was very active during the ‘questions and answers’ session after Mr. Lin’s lecture. One of the first questions was on whether the ‘advantage of backwardness’ approach is applicable only for Asian economies. The World Bank’s chief economist responded with some examples of non-Asian countries which have successfully exploited their advantage of backwardness.  Poland and Slovenia adopted a gradual, dual-track approach similar to that of China and achieved outstanding performance during their transitions. Mauritius adopted a similar approach in the 1970s and became Africa’s success story. Ireland was the poorest country in Western Europe in early 1990s and has achieved miraculous success in 20 years.

Several questions were related to the cultural factor of success. Justin Yifu Lin does not consider culture as a decisive factor in economic development. He gave an example of how Confucianism was always blamed for China’s backwardness before transition, and how many people now say that Confucianism is the success factor today. Confucianism has existed for centuries, but what has been changing is the economic policy.

One of the important questions for the Russian audience was related to natural resources and their role in economic development. China’s competitive advantage is labour-intensive industries, but what advantages do resource-intensive industries have? Mr. Lin said that resource-intensive industries can be a competitive advantage, if the resources are used for simultaneous development of the manufacturing sector. The World Bank’s chief economist spoke of the USA as a good example. Only diversification of the economy and development of both resource-intensive and non-resource sectors can result in successful performance.

Evgeniy Yasin, Academic Supervisor of the HSE, said that although he did not ask any questions, he received a huge number of answers. He was happy to see the high level of openness in Mr. Lin’s arguments which is still unusual for Chinese researchers. Evgeniy Yasin was impressed with Mr. Lin’s knowledge and open style of communication and expressed his desire to continue communicating in order to get more information and analysis about what is going on in the Chinese economy.

Maria Pustovoyt, specially for the HSE News Service