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China Embraces the MarketEconomic Analytical Unit

China Embraces the Market

Executive Summary

Since economic reforms began in 1978, China's economy has undergone radical structural change. The reforms have been bold: freeing up prices, abolishing virtually all production and trade planning, effectively privatising agriculture and allowing the non-state sector to now produce over two thirds of industrial output. But the economy is still only about half way in its transition from a centrally planned to a market economy. Difficult reforms are still on-going, in particular developing the legal, administrative and regulatory framework which supports a modern economy. This process will take at least a decade and probably longer. Until complete, China will be a challenging and sometimes complex environment in which to do business, for both local and foreign enterprises. Even so, the internationalisation of the economy has been remarkable, with the ratio of trade to Gross National Product growing from 10 per cent in 1978 to 36 per cent in 1996. China's increasing inter-dependence with the world's trade and investment systems is perhaps the most striking phenomenon of China's recent development. As a consequence, China is an active participant in all multilateral financial institutions and regional forums such as APEC.

The Dynamic Chinese Economy

If as is expected, the present direction and momentum of policy reforms are maintained, China's output by around 2020 will exceed the USA's. Even so, China's per capita income still will be that of a middle income, developing country. Due to greatly improved economic policies and relative political stability, China's economy has maintained real average annual growth of about 8 per cent since 1978, making it one of the fastest growing economies in the world over this period. Despite continuous population growth, real per capita GDP increased 250 per cent between 1978 and 1994, or 6 per cent per year. On these facts alone many Australian firms will wish to trade and invest in China, even before the business environment becomes more predictable.

Economic historians estimate that China's economy was the largest in the world until the late 19th century. By 1949, it had been overtaken by the USA, UK and USSR. In 1997, its economy is again second only to the USA's, when measured in terms of domestic purchasing power. If the USA maintains its growth at 3 per cent, its average over the last 15 to 20 years, and China grows at 7 per cent per year, slightly less than its post 1978 average, China's total domestic purchasing power will overtake that of the USA by 2020.1

On the other hand, China's per capita income is still very low. The World Bank estimates that 350 million people still live below the poverty level ($1 per day). Labour productivity is among one of the lowest in the world, only slightly ahead of India's, and only 10 per cent of the USA's. This indicates both the economy's enormous development needs and its growth potential, if it applies modern technologies in agriculture, industry and services. It also indicates the vast scope for growth as China closes this productivity gap with the more developed economies. All these factors will produce immense trade and investment opportunities, as well as a need for significant capital flows into China.

The inevitable tensions between the immense economic opportunities in China and the constraints on development, including infrastructure and skilled labour shortages, and the difficulty of doing business while legal and institutional frameworks are still developing, form a major theme of this report and the implications it draws.

Sources of Economic Growth

Since 1978 economic growth has been driven by the more efficient allocation of resources in most sectors of the economy as central planning has been replaced by a more market oriented approach in which international trade and investment have been significant. The high savings rate, high investment levels and rapid expansion of the urban labour force provide the necessary supplies of capital and labour to underpin this growth. The long term sustainability of economic growth will depend on continuing success in macro- and microeconomic reforms, accelerating structural change within agriculture and industry, and further integration into the world economy.

Political Environment

While the post-Deng era may see the emergence of leadership rivalries, there is likely to be broad commitment to continued economic reform and continued integration into the world economy. Economic reform has delivered strong growth and tangible benefits. The leadership also recognises that the economy needs to maintain relatively rapid growth to avoid widespread unemployment and possible social disruption.

Compared with the prospects for the economy, which appear to be moving in a reasonably predictable direction, future political structures are more difficult to judge. Political and institutional structures at lower levels of government are becoming more prominent with the reallocation of resources under China's dual taxation and revenue distribution systems. While leadership challenges in the post-Deng era could affect political structures, authority will reside with the Communist Party. As in other countries, individuals and institutions will continue to seek to increase their authority, but the collective leadership now in place is likely to be maintained and to guide the transition to a 'socialist market economy'.

Strengthening Market Institution

Market-based transactions now dominate the Chinese economy, with over 90 per cent of retail prices and 80 per cent of producer and agricultural prices determined by the market. Competition has intensified considerably in internal markets, rapidly reducing the level and divergence of profit rates between industries and provinces. The Government has also progressed considerably in developing the necessary legal and regulatory infrastructure, introducing many of the basic commercial laws and regulations essential in a modern market economy.

However, building such institutions and training the people to operate them are massive tasks. Consequently, many problems remain regarding the implementation of regulations and enforcement of laws. Individuals and firms can face difficulties in obtaining legal redress. Although a private legal profession is rapidly emerging, much of the judiciary is still poorly trained and in some cases, insufficiently independent. The protection of intellectual property rights also remains a problem for many foreign investors as well as local inventors.

Administrative reform, which is also crucial to sustaining the economic reform program, has gathered momentum since the early 1990s. Reforms have attempted to resolve conflicts of law, tackle official corruption and provide reviews of administrative decision-making. However, both foreign investors and local residents still encounter problems in obtaining efficient and impartial administrative decisions. These types of problem will probably take at least a generation to resolve, as younger, better educated, and eventually better paid, administrators assume positions of authority. Encouragingly, this change-over is already starting in the central Government and more advanced provincial ministries.

Macroeconomic Policy Developments

In the past two to three years, the pace of reform in macroeconomic management has increased. The central Government is moving steadily from direct intervention and quantitative controls over the macroeconomy to greater reliance on the indirect fiscal and monetary policy instruments used in market economies. The central Government's direct control over the economy via output planning and price fixing virtually disappeared with economic reform. Furthermore, its fiscal authority declined when it decentralised fiscal powers to the provinces in the 1980s. Consequently, the central Government was increasingly forced to rely on direct controls over bank lending via the credit plan, to influence overall growth and inflation. However, after the major reforms flagged by the Third Plenum of the Party's Fourteenth Central Committee in 1994, the pace of macroeconomic management reform accelerated. The Government now employs monetary instruments such as bond issues to finance the budget deficit; open market operations and reserve deposit requirements to manage excess bank liquidity; and flexible interest rates in the interbank credit market to provide for a more market driven interest rate structure. Recently, monetary authorities successfully engineered a Œsoft landing' moderating growth and reducing inflation from the unsustainable levels of 1993 and 1994. In 1996, inflation was reduced to 6 per cent and real growth was just under 10 per cent. These results were achieved by the use of monetary instruments, credit allocation controls over state investment and administrative controls over some prices. Previously, authorities only succeeded in reducing inflation by severe contractions of credit and growth.

Lack of progress in solving the problems of the ailing state owned enterprises, SOEs, constrains faster macroeconomic management reform and limits efficiency gains. The central Government is unwilling to relinquish control over interest rates to a fully independent People's Bank of China, mainly because of concern about the negative impact of higher interest rates on marginally viable SOEs. In any case, higher interest rates would not necessarily restrain SOEs' demand for credit. Many enterprises are not yet forced to accept responsibility for their borrowing decisions, although this is changing and more enterprises are now forced into bankruptcy. Until interest rates can be used to control demand for credit and the banks can determine lending on a wholly commercial basis, the monetary authorities will retain some quantitative credit controls to achieve monetary targets and to control inflation. Slow SOE reform is also impeding banking system reform. The state banks cannot operate on a fully commercial basis until methods are found to reduce and eventually eliminate their massive backlog of non-performing loans. Bad debts are mounting as more SOEs suffer losses and this situation will not improve until different levels of government take firmer action to force the pace of SOE reform.

Further strengthening of the central Government's taxation capacity would enable fiscal policy to operate more effectively. This would allow for greater revenue generation and more equitable revenue sharing, providing all levels of government with increased capacity to fund social welfare policies. It would also relieve the banking system of some of its quasi-fiscal responsibilities, such as subsidising SOEs, infrastructure projects and agriculture, and enable a more efficient balance between fiscal and monetary policy in overall macroeconomic management.

Rapid Growth In International Trade

The Chinese economy has become increasingly integrated into the world economy. China rapidly emerged from its pre reform autarky to become the world's tenth largest trading nation by 1996, accounting for more than 3 per cent of world trade. While the share of labour intensive exports has grown at a phenomenal pace during the reform period, and now represents 55 per cent of exports, this trend appears to have peaked and the share of capital intensive exports has now reached 30 per cent of exports. Nevertheless, in absolute terms, labour intensive exports should continue to grow strongly for several decades providing that foreign and domestic investment move to lower cost hinterland provinces. This shift in investment is now beginning to gain momentum. With economic reform, China's trade is now closely aligned with its comparative advantage, with industries like processed food, in which China is increasingly competitive, producing a growing share of exports.

Healthy Growth In Australia-China Trade

Australia-China bilateral trade has grown twice as rapidly as Australia's average trade growth in the past decade. Australia's exports to China grew almost 13 per cent per year from 1987 to 1995 compared to about 8 per cent per year for Australian exports overall, while Australian imports from China grew by 24 per cent, and overall imports grew at 8 per cent. This trend should continue as a result of the natural complementarity and increasing internationalisation of the Australian and Chinese economies, and rapid economic growth in China.

Australia's export performance in China has been very successful in the past decade, with our trade share in China's market since 1988 approximately twice the level that would be expected by trade complementarity. While China holds a growing share of Australia's import market, it is still only 20 per cent higher than would be expected by the complementarity of China's exports and Australia's imports. Australia's crude share of China's imports has declined mainly as a result of the changing commodity composition of China's imports, away from primary commodities and towards capital goods and components used in the burgeoning contract trade. Nevertheless in 1996, Australia's agricultural exports to China rose 90 per cent over 1995, reaching US$1.37 billion and making Australia the second largest agricultural commodity supplier to China after the USA.

Reform of the Trade Regime

The trade regime has been significantly decentralised and liberalised since 1978. The pre reform system of trade planning has been dismantled and over 5 000 foreign trade corporations and over 200 000 large domestic and foreign enterprises now have trading rights. Foreign funded enterprises, including joint ventures and wholly foreign-owned firms, now play a prominent role in China's trade. In the first eleven months of 1996, they were responsible for 41 per cent of total export trade and 53 per cent of imports.

However, published tariff rates and non-tariff barriers remain high by international standards. While weighted average tariffs have declined from 32 to 19 per cent between 1992 and 1996 and will drop to 15 per cent by 2000, this is still the highest in East Asia. By comparison, Australia's weighted average tariff is 4 per cent. Licensing covers 25 per cent of imports, and covers a number of major items of importance to Australia such as wheat, wool, and other agricultural and raw materials. However, many imports actually enter duty-free or at much lower duties due to the extensive duty drawback scheme for exporters, as well as weak and inconsistent tariff collection procedures. For these reasons, tariff revenue represented only 4 per cent of the value of imports in 1994.

Foreign Exchange Regime

The dual exchange rate system, which complicated foreign investment and trade and distorted incentives for exporters, was successfully unified in January 1994. Foreign exchange controls were lifted progressively, and in November 1996, China achieved full currency convertibility on the current account. This means that the renminbi is now convertible for all trade related transactions, loan repayments, and profit remittance in goods and services. Foreign funded enterprises are now able to buy and sell foreign exchange at designated banks, as domestic enterprises have done since 1994. Unification has been very successful. Foreign exchange reserves have soared since the 1994 reforms, and in early 1997, they exceeded US$105 million. However, the Government's management of the exchange rate to keep the renminbi reasonably stable despite high current and capital account inflows has put significant upward pressure on the authorities' money supply growth targets and has required the central bank to wind back its loans to the banking sector.

China's WTO Entry

China's accession to the World Trade Organisation has been a drawn out process due to the complexity and lack of transparency of many of the controls remaining in China's trade regime. WTO membership would greatly benefit China's economy, increasing the certainty of its trade access to member countries and raising the efficiency of domestic industries. China's membership would also provide more modest but still significant benefits for the world economy as a whole. Modelling undertaken for this report indicates that WTO membership could deliver China a 4.6 per cent rise in GNP by 2020 and also increase Australia's GNP by 1.8 per cent. These benefits will arise largely from the productivity enhancing effects of trade liberalisation.

Australia has been an active participant in China's WTO accession working parties and through AusAID, is providing training to key Ministry of Foreign Trade and Economic Cooperation officials on WTO issues. Increased political commitment to trade reform in 1997 may accelerate the process of China's WTO entry.

Foreign Investment and the Internationalisation of the Economy

Since 1979, foreign investment has played a critical role in internationalising China's economy and trade, introducing capital, technology and management and marketing skills, and instigating microeconomic reform. In addition to large investors, thousands of small and medium sized companies, particularly involving overseas Chinese have invested in China over the last decade, making a major contribution to output, employment and export growth. Hong Kong alone provided 60 per cent of the US$167 billion in foreign direct investment accumulated to the end of 1995, although US$25 billion to 30 billion of this should probably be deducted to account for Œround-tripping', that is, Chinese capital going offshore and re-entering as foreign investment to benefit from incentives. Australia is China's thirteenth largest source of utilised foreign direct investment, with 2 500 direct investment projects in a variety of fields. Australia is also one of China's leading investment destinations.

Foreign direct investment is growing fastest along China's eastern seaboard. However, companies are increasingly looking inland for lower costs, less intense competition, proximity to raw material inputs and attractive incentives. As infrastructure improves, foreign direct investment in regional China could expand rapidly.

Important lessons for investors, their partners and Chinese officials emerge from interviews and case studies. Briefly, investors should have realistic expectations, understand and appreciate cross-cultural differences and, especially, understand and convey effectively mutual expectations. Most foreign investors have a strong commitment to China, but lament that the operating environment remains complex and opaque. They would like to see greater commercial transparency, predictability and freedom, and less red tape. At the same time, the large multinationals that the central and local governments wish to attract into infrastructure, manufacturing and services, answer to demanding and cautious boards and shareholders who often require faster returns, more accountability and less risk than the China market can currently offer. Notwithstanding these considerations, foreign direct investment has been particularly strong over the last five years. The rate of growth of investment is likely to slow but still remain at relatively high levels. China's success in the long term in continuing to attract and keep foreign funds will depend largely on how it addresses major issues related to the business operating environment and how it responds to investment liberalisation moves throughout the Asian region.

Infrastructure Constraints and Environmental Management

Insufficient investment in infrastructure development in the past, combined with instances of inadequate project planning, management and coordination, have burdened the economy with a backlog of unfinished projects and facilities unable to cope with the rapid increase in demand. The transport and power sectors are subject to the most serious shortfalls. Indeed, analysts estimate that transport bottlenecks alone subtract one percentage point per year from GDP growth. While China is one of the world's largest electricity generators, about 20 per cent of power is lost due to the inefficient grid, causing frequent power outages.

Infrastructure service provision is growing most rapidly in civil aviation and telecommunications as these projects like airports and telecommunications are prestigious and/or offer high rates of return. Projects involving high outlays with low, prolonged returns, such as roads, railways and environmental projects proceed more slowly. Also, projects that cross administrative jurisdictions, as most infrastructure and environmental projects do, often are slowed by bureaucratic processes and internal rivalries.

Under the Ninth Five-Year Plan (1996-2000), China plans to invest US$300 billion in infrastructure development, and hopes to attract $45 billion (15 per cent) of this from foreign commercial lenders and direct investors. Some Australian companies, however, have indicated in interviews that their willingness to invest will depend on a considerable improvement in the highly complex, opaque and frequently inconsistent operating environment. They require a clearer delineation of how risks will be borne and shared. They are observing progress in negotiations in the power sector, where longstanding issues such as effective caps on returns, are being addressed. Notwithstanding the impediments to investing, US and European companies seem to be making strategic decisions to be in China.

Rapid industrial growth is taking a heavy toll on the environment, raising concerns over the sustainability of projected industrial growth rates. Beijing, Shenyang, Xi'an, Shanghai and Guangzhou were among the world's 10 most polluted cities in 1995. The authorities now recognise the seriousness of the problem. However, central government directives are not always implemented locally, especially if they adversely affect large SOE employers. Despite this, authorities have significantly reduced air and water pollution in some of the worst affected areas. With many major waterways not meeting water quality standards and with serious water shortages a prospect, the Government is taking drastic measures, including closing some of the worst polluters.

Foreign companies are normally allowed to bid only for foreign funded environmental projects. Nevertheless, many opportunities are emerging for Australian firms in clean energy, water treatment, sustainable agriculture, coal washing and others.

Growth and Disparities in China's Regions

All regions have benefitted from China's rapid economic growth, achieving growth rates that compare with the fastest growing economies in East Asia. However, the coastal provinces have grown more quickly than those in the hinterland because they are more integrated into the international economy, with more liberal policy environments and better infrastructure endowments, particularly transport links. The coastal region is also more export-oriented, producing almost 85 per cent of exports, attracting almost 90 per cent of foreign investment and having a much higher proportion, 80 per cent, of output produced by the more dynamic non-state sector. Both capital and labour productivity are higher in the coastal region than in the central and western regions, attracting higher levels of investment, much of which is from the retained earnings of the non-state sector enterprises. The hinterland is more dependent on SOEs for production and bank loans for investment. The divergence of regional growth rates has accelerated in recent years as the pace of economic reforms has increased.

Per capita income, industrial production and retail sales in the coastal region are more than double those of the hinterland and the gap is widening. While these disparities are an inevitable aspect of rapid growth, indicating opportunities yet to be fully developed, at the same time they create a major policy dilemma for the Government. While the coastal region has led market-oriented economic reforms, driving overall economic growth, increasing regional divergence has the potential to create social and political tensions.

Regional variation in cost structures is a major source of opportunity for local and foreign investors seeking lower cost production bases outside the main early growth areas on the coast. The inwards movement of foreign and local investment is already underway but the Government will need to make massive infrastructure investments in the hinterland. Ideally this should involve significant inter-regional fiscal redistribution, to ensure growth is sustained, but as noted earlier, improvements in tax collection will be a prerequisite. Failing these improvements, governments at various levels will be forced to rely increasingly on private investment in infrastructure.

Three key areas will be the focus of rapid growth and will continue to attract the bulk of foreign investment in the next decade: the Pearl River Delta in Guangdong province; the Yangtze River Delta stretching inland along the Yangtze from Shanghai; and the Bohai Ring encompassing Tianjin and the developed coastal cities in Shandong, Hebei and Liaoning. Together, these three areas produce 33 per cent of total national GDP with only 3.3 per cent of the total land area and 14 per cent of the population.

Major Decisions Confront Agriculture

The decollectivisation of agriculture produced record-breaking growth in grain output in the early 1980s, finally ending the endemic food shortages experienced since the 1950s and providing the preconditions for China's urban and industrial reforms in the mid 1980s. Despite many problems, agricultural output has expanded strongly throughout the reform period.

While administrative controls remain on strategic crops, such as grain and cotton, market forces are steadily causing Chinese agriculture to shift towards its comparative advantage. Income maximising farmers are increasingly reallocating their land, labour and capital to more profitable crops, or to non-agricultural activities. While this trend is increasing grain imports, it is also stimulating a rapid growth in higher value, non-grain agricultural exports, and has made China into a significant net food exporter in recent years. Estimates of required grain imports by 2010 vary greatly, from 136 million metric tons to 15 million metric tons, with a recent intermediate estimate of 64 million metric tons appearing more realistic. This compares with 1996 grain imports of about 10 million tons.

Although the Government is reluctant to relinquish its grain self-sufficiency policy, because of its fears about food security, the rising cost of achieving this objective will produce a major dilemma for it. China's agricultural policy-making is therefore at a crucial juncture: it can either opt for internationally competitive agriculture based on its comparative advantage, or protect selected agricultural sectors and meet the significant costs this will impose on the economy. Most of the costs of enforcing grain self-sufficiency will fall on low income farmers and grain producing provinces. As domestic prices of many major agricultural commodities have risen close to international levels, it is crucial a decision is made to internationalise agriculture before prices climb higher, and it becomes politically difficult to wind them back.

The Ailing SOEs

Reform of the SOEs is the key to many other crucial reforms in the banking system, macroeconomic management and the trade regime. However, progress has been slow due to political concerns about the impact on urban employment and stability. The performance of the sector has steadily deteriorated during the 1980s and 1990s as it faced increasing competition from the dynamic non-state sector and imports. Almost half the SOEs were reporting losses in 1996, with the value of losses up 45 per cent, to ¥ 65 billion (US$7.8 billion). These losses offset all profit and tax payments SOEs made, so that the sector as a whole made losses in 1996 for the first time since 1949. Thus the state received no return for its massive investment in SOEs.

Despite many attempts to reform SOEs to improve their performance, many are effectively immune from bankruptcy and their costs are inflated by overstaffing, and generous salary and social service packages for workers. In many instances their initiative is constrained by a lack of clear delineation of property rights, inadequate incentives for managers and bureaucratic intervention. The World Bank estimates that the SOEs' social service payments for pensions, housing and health equalled SOE losses. Therefore, all the value added produced by SOEs, including the profits that should have gone to the State as the owner of SOE assets, were consumed by SOE workers, either as wages, bonuses or enterprise provided services.

However, the central and more progressive provincial governments now appear more determined to tackle this issue, and are restricting bank credit for some loss-makers. Under the policy of Œgrasping the big and enlivening the small', medium and small sized SOEs can be leased, sold to workers, joint ventured, merged or privatised. One thousand large SOEs are being recapitalised and groomed to form future conglomerates, on the Korean chaebol model.

As the State still employs about 70 per cent of urban employers, the Government has been wary of wholesale rationalisation of the SOEs, for fear of the social and political consequences. However, the rapidly growing non-state sector is successfully absorbing many redundant SOE workers, even in north eastern provinces like Lioaning, increasing the Government's confidence that continued reform and downsizing of SOE workforces is feasible. This process of rationalisation should intensify over the coming period.

The Dynamic Non-State Sector

The non-state sector now produces two thirds of industrial output and somewhat more of total national output, including largely privatised agriculture and the heavily privatised personal services sector. This sector is generally highly market oriented and competitive; enterprises can and often do go bankrupt. Its structure is also changing rapidly, reflecting the strength of market forces operating within it. Urban collectives, arguably the least market oriented element of the sector, have lost market share in the first half of the 1990s, dropping from 15 to 10 per cent of industrial output. On the other hand, the share of the more dynamic township and village industries, owned by rural local authorities, groups of individuals and private entrepreneurs, is still growing rapidly, increasing from 20 to 30 per cent of industrial output between 1990 and 1994. Local private and foreign funded enterprises have grown even faster, doubling and trebling their shares, now respectively producing 12 and 14 per cent of industrial output.

The non-state sector dominates light industry and has generated about three quarters of total export growth since 1978. It also produces over 80 per cent of industrial output in the coastal provinces. In fact, the preeminence of the non-state sector in these provinces is one of the main sources of dynamism of the coastal region. In the past, the non-state sector has confronted discriminatory tax and other policies; it still has some concerns regarding security of property rights, government interference and access to the banking system. However, the leadership increasingly accepts the essential contribution of the non-state sector to creating employment and raising incomes. Legal and regulatory reforms and political developments in the 1990s have greatly improved the position of non-state sector firms, and been the main cause of the sector's dramatic growth this decade.

Labour Markets and Migration

While labour markets have become much more flexible since 1978, many constraints still remain. The hukou (household registration system) has been considerably relaxed, enabling up to about 100 million rural workers to find jobs in urban areas by early 1997. The numbers of migrants are still rising rapidly with analysts estimating that at least a further 100 million surplus rural workers are seeking to move to more productive jobs outside agriculture, many of which will be in urban areas.

Despite the introduction of bonuses and the greater use of contract labour, productivity growth in SOEs is well below that in the non-state sector and analysts believe up to 30 per cent of SOE workers are surplus. Mobility of SOE workers is still low due to the continued provision of many services by enterprises and inadequate service delivery in the community. Nevertheless, SOEs had made 7.5 million of their workers redundant.

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