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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 Åsoft 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 Åround-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 Å grasping 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.