China Trade Information

China: Coming to Grips with the New Global Player

Horst Siebert 

Kiel Institute for the World Economy, Germany, and SAIS Bologna Centre, 

Johns Hopkins University, Italy

2007-07-11

1. INTRODUCTION 

The transformation of the centrally planned economies of Central and Eastern Europe in the 1990s took place in a disheartening valley of tears. In the reforms that started around 1989, Poland, Hungary and the then still united Czech and Slovak Republics lost roughly 20 per cent of their GDP. In Russia, where the reforms began in 1991 rather than 1989, the plunge amounted to more than 40 per cent. East German industrial production collapsed to one-third of its former level. The cause of this J-style transformation curve lay in several phenomena: firms’products were no longer competitive under the new conditions, the existing capital stock became obsolete and had to be rebuilt in a time-consuming process, human capital had to adjust and the institutional vacuum of how property rights would be defined and which line of economic policy would be followed implied uncertainty for a long time. 

By contrast, China experienced no such J-style transformation curve.1 Since the Deng Xiaoping reforms commencing in 1978 it has enjoyed high average annual GDP growth rates of nearly ten per cent for the last 25 years. In US dollars, it is now a 2.2 trillion economy with a GDP larger than the UK (data for 2005); the preliminary figure for the GDP of 2006 is US$2.3 trillion.2 It accounts for five per cent of world GDP, representing the world’s fourth largest economy. 

The author appreciates critical comments from David Greenaway, Bert Hofman, Mike Plummer and Richard Pomfret. He is also grateful for the collection of data and the preparation of tables and figures by his research assistants Mark Bousfield, Szilard Erhart, Alexander Schratz and Michael Trinkus. 

1，Of course, the initial conditions and the process of transformation were very different in China and in Eastern Europe. Nevertheless, a similar economic problem had to be solved. 

2， If not stated otherwise, all data are from the World Bank’s Country Fact Sheet on China (World Bank, 2006a), the World Development Report 2007 (World Bank, 2006b) and the Quarterly Updates (World Bank Office, Beijing, 2006a, 2006b and 2007). Note that the recent data of different institutions are not always consistent. 

 @ 2007 The Author， Journal compilation . 2007 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA 893 

Viewed in GDP per capita, however, output is still low. Per capita gross national income at current market prices (GNI) in 2005 stood at US$1,740, somewhat lower than the average for low- and middle-income countries (US$1,918) and four per cent of the US level.3 According to this measure, China ranks 128th in the world economy.4 World Bank data indicate that 16.6 per cent of the population live below one US (PPP) dollarper day (data for 2001). (All data refer to Mainland China, excluding Hong Kong.) 

A word of caution is in order with respect to the statistical data that underlie this analysis (Holz, 2006). In spite of the fact that the data are subject to review by international organisations, distortions may occur because local and regional politicians have an incentive to massage the statistically measured results in their favour. For instance, data were heavily distorted in Central and Eastern Europe prior to the fall of the Iron Curtain. Moreover, statistical revision of data ex-post is common for statistical offices of industrialised countries. It would not be surprising if, under conditions of high growth and stark structural change, revisions occur in the future. The last revision of data in December 2005 by the National Bureau of Statistics, covering the period since 1993, has brought a downward revision of data on the relative share of investment and an upward revision on prices, consumption demand and the relative share of the service sector (World Bank Office, Beijing, 2006a). The revision of data relates only to the production side of macroeconomic accounting; revision of the expenditure side is still pending. As a consequence, available data of the macroeconomic accounts on the production and expenditure side are not always consistent with each other. 

2. THE DRIVERS OF GROWTH 

Growth has been spread evenly over the last two and half decades with high average annual real GDP growth rates of nearly ten per cent per decade (Table 1); the preliminary figure for 2006 is 10.7 per cent. However, quarterly growth rates show high volatility. GDP per capita has risen by an average annual real rate of about eight per cent since 1978 (IMF, 2006a), real wages have also increased by eight per cent (since 1987).5 According to World Bank estimates, poverty was reduced for 422 million people in the period 1981¨C2001, using the criterion of one US dollar per day income. The two main drivers of growth were exports and investment. 

3，In purchasing power parity China’s GNI amounts to US$8.6 trillion, nearly 70 per cent of the US GNI of US$12.4 trillion and 14 per cent of the world’s GNI of US$60.6 trillion (2005). Relative to current market prices, purchasing power parity is an indicator of welfare. It can be seen as denoting economic or even political power. 

4， Rank 107 in purchasing power parity (World Bank World Development Indicators, July 2006). 

5，Calculated with nominal wage increases (ILO, 2006) adjusted with the consumer price index (IMF, 2006a). 

　

a. Exports as a Stimulus for Growth 

Exports are a major driver of economic growth in China, amounting to 35 per cent of GDP (2005). This figure relates to exports from Mainland China, excluding exports from Hong Kong. Note, however, that some of Mainland China¡¯s exports are shipped through Hong Kong; therefore adding Hong Kong exports to mainland exports would mean double counting. This high export share is unusual since large countries normally have a much lower export share. The trade account had a surplus of 4.4 per cent of GDP in 2005, the current account surplus stood at 

7.1 per cent of GDP. China has a world market share of 6.8 per cent, measured in terms of merchandise trade (2005). 

Chinese exports have risen in real terms at the rapid rate of 12.4 per cent since 1980, while world merchandise exports expanded at 4.9 per cent in the same period; in the period 1995¨C2005 exports rose at a much greater pace of 19.7 per cent (World Bank, 2006a). Rising exports pulled up the economy. They induced production, investment and employment.6 

Nearly all exports represent merchandise exports, i.e. exports in goods (excluding services). Almost all merchandise exports are produced in the manufacturing sector (91 per cent, 2004).7 Yet whilst China is considered to be the manufacturing workshop of the world, it is astonishing that its exports consist not only of low-technology products. Almost one-third of its merchandise exports (30 per cent) are high-technology exports. In this respect, China is playing ball in the same league as Japan (24), Korea (33), the Netherlands (29), the United Kingdom (24) and the United States (32) according to the World Bank classification (2004; World Bank, 2006b). Although China’s high-technology exports rely on considerable high-technology imports and the issue of delineating high-technology exports may play a role, China’s export basket is seen to be moving up-market into higher value goods (World Bank Office, Beijing, 2006b). WTO membership (since 2001) has improved China’s export conditions by securing access to foreign markets. It also reinforced international investors confidence and made China a favourable destination for foreign investment. The country, however, has to respect and implement WTO-consistent institutional arrangements in intellectual property rights, safeguards procedures and standards. This may affect some of its export- and import-competing sectors negatively. 

6， Note that in order to determine the increase in real terms, i.e. in the volume of exports, nominal export figures, given in renminbi, have to be corrected by a price deflator. Usually, the trade deflator for goods published by the Customs Administration is applied. 

7，On a vent for surplus explanation of Chinese exports see Fu and Balasubramanyam (2005). On the role of FDI, see below. 

The increase in China¡¯s trade volume is not unprecedented. Except for the year 2005, it remains below the performance shown by other Asian export achievers, like Japan and the newly industrialising Asian economies ¨C Korea and the other three tigers. Setting an index of 1 for China¡¯s 1978 export volume and comparing it to an export index of Japan with exports in 1955 set equal to 1, the rise in China’s real exports in the period 1979¨C2004 remained below the expansion of Japanese exports (Figure 1). A similar result holds for Korea with the base year at 1965 and the four tigers (Hong Kong, Korea, Singapore and Taiwan) at 1966 (Prasad, 2004, Fig. 2.3). Note, however, that since the mid-1990s China’s exports exhibit high growth rates, outpacing those of Japan. In 2005, we can no longer claim that China remains within the export pattern shown by Japan. 

Note: a Deflated by the US GDP deflator and indexed, basis year 1955 = 1 for Japan and 1978 = 1 for China.

Source for data: WTO, WTO Online Statistical Database, February 2007 (for merchanidise trade). IMF,International Financial Statistics, Online Database, February 2007 (for the US price deflator). Own calculations.

b. Investment ¨C The Other Driver 

Even after the 2005 downward revision of the data for investment, gross capital formation (previously estimated at over 40 per cent), is still high at 38.7 per cent of GDP (2004), but closer to values witnessed during the buoyant years of other Asian tigers. Annual average growth rates of gross capital formation equalled 

10.6 per cent in the period 1980¨C2005 (Table 1). Foreign direct investment plays an important role in investment (see below). Among the other components of GDP on the expenditure side, household final consumption accounts for 48.5 per cent and general government final consumption for 10.2 per cent (2004; data for the expenditure side are not yet revised).8 Gross national savings for 2004 and 2005 are estimated at 43 and 47 per cent of GDP respectively (IMF, 2006b, Table 1). Households save close to 30 per cent of their disposable income; firms account for the other part of gross national savings. The difference between the share of savings and investment in GDP, the savings-investment gap, reflects the current account surplus. Note that data from the World Bank and the IMF may differ and may stem from a different time period; furthermore, consistency of data between the expenditure side of GDP and the production side may also be relevant. Capital accumulation means that new firms are born, new technologies are embodied in new machines, new products are introduced into the product set of the economy and the economy is restructured. Learning-by-doing processes are driven by exports and investment. Capital accumulation and total factor productivity growth contributed about 4.5 percentage points each to the GDP growth rate of about ten per cent in the early 2000s, with about one percentage point coming from employment growth (IMF, 2005a, Figure in Box 1, p. 12). Another approach assigns 7.8 percentage points to labour productivity growth in the period 1993¨C 2004 of which 2.7 percentage points are attributed to a total factor productivity increase and a 5.1 percentage points rise to a higher capital-labour ratio (Kuijs and Wang, 2005, Table 1). Marginal capital productivity is at about 13 per cent, after about 16 per cent in the 1990s.9 Labour productivity in terms of GDP per worker increased at an annual average of between seven and eight per cent in the early 2000s, with productivity growth coming half from capital intensity and half from total factor productivity (ibid.). 

8，Total government spending amounts to 19.2 per cent of GDP (2005). This includes public investment which is contained in the investment share of 38.7 per cent. 

9， A rough measure of capital productivity is given by relating the increase in GDP in a year (growth rate times output) to annual investment of the previous year (investment share times GDP). For 2005, this yields a value for marginal productivity of 29 per cent. 

The information on the decline in the marginal productivity of capital is supported by data on an increase in the incremental capital-output ratio, i.e. the investment needed per additional unit of output, which has risen from 3 in the 1980s to 4.5 in the early 1990s. Another estimate indicates that the incremental capital-output ratio has increased from 3.3 in the first half of the 1990s to 4.9 after 2001 (McKinsey Global Institute, 2006). More capital is needed to produce additional output.10 These data can be interpreted in three ways. First, they reflect a move down the marginal productivity curve of capital to less productive uses; this tendency iscounterbalanced by technological progress shifting the marginal productivity curve outward. 

Second, the data may be seen to indicate inefficient investment, for instance in the state-owned firms. It also highlights the fact that a functioning capital market that allocates savings to investment efficiently does not exist. Self-financing, financing through informal family networks and intermediation by the state-owned banks cannot match an efficient equity market. Third, they might indicate signs of over-investment in several sectors, creating a distortion in the economy that will have to be painfully corrected in the future. When over-expansion is corrected, output will fall and unemployment will rise. A reason behind overheating is the high money and credit growth. 

c. Sectoral Change, Migration of Labour and Shift of Growth Clusters 

In the process of economic growth, China underwent stark changes in the structure of the production side of its GDP. Agriculture declined from a 28.4 per cent share of GDP in 1985 to 13.1 per cent in 2004 (World Bank, 2006a). Industry expanded its share of 43.1 per cent in GDP in 1985 to 46.2 per cent in 2004. Earlier, non-revised data had estimated the share of industry to be at 52.9 in 2004. The share of the service sector increased from 28.5 per cent in 1985 to 40.7 per cent in 2004, previously estimated at only 31.9 per cent. In terms of employment, the primary sector declined from 68.7 per cent of total employment in 1980 to 50.0 in 2002 (non-revised data), whereas the secondary sector increased from 18.2 per cent to 21.4 per cent and the tertiary sector from 13.1 per cent to 28.6 per cent in the same period (Prasad, 2004, p. 55). 

Strong growth tends to be unbalanced among the regions. High dynamics prevail in the urban centres, especially those of the coastal regions, whereas the west and north are not growing as strongly. There is a stark divide between the urban centres and the countryside as well as between coastal regions and the interior. 

10，Note that empirical figures for the marginal capital-output ratio are not simply the inverse of marginal capital productivity. The empirical variables are delineated differently for the two concepts, for instance as one additional unit of output or as the additional output of a year. 

Migration of rural workers to the booming coastal cities and movement of the growth centres inward will continue to ease this structural problem over time. Regional disparity is the key cause of labour migration. The coastal growth poles offering higher wages attract workers from the interior of the country. It is estimated that the number of rural labour migrants rose to around 60 million in 2000, 94 million in 2002, and 114 million in 2003 (Huang and Zhan, 2005). 

China has seen a north- and westward migration of its growth clusters. Starting in the coastal regions of the South, economic dynamics have spread to the other regions, at first through backward linkages by stimulating the production of intermediate inputs at lower costs. This helped raise wages in the interior and integrate rural workers into the industrial process. Eventually, the growth clusters themselves started to migrate to the West as capital targeted new and unexploited investment opportunities. 

d. Entrepreneurship 

An important condition for growth is the entrepreneurial spirit of the Chinese. Historically, they have been traders, and they enjoy accumulating family wealth. These characteristics together with the traditional value orientation represent powerful incentives for effort and entrepreneurship and are a sturdy basis for bottom-up processes of individuals and municipalities; they encourage economic agents ¨C the entrepreneurs ¨C to organise new combinations in the factors of production in the sense of Schumpeter. The Chinese seem to have been waiting for the Deng Xiaoping reforms, ready to exploit the options created and to embrace capitalism in spite of the Communist Party’s official philosophy. The reforms brought a period of positive surprises not unlike the Erhard reforms in West Germany in 1948. It is no wonder that, according to a survey conducted by the University of Maryland, the Chinese now show a larger acceptance of the market economy than the three large continental countries of Europe.11 

3. STRUCTURAL ISSUES 

a. State-owned Enterprises 

Unlike in the transformation of post-communist countries in Central and Eastern Europe, China¡¯s restructuring strategy was not to deal with the state-owned firms head-on but to circumvent their restructuring simply by letting new economic activities develop outside the government-controlled sector. In this way, the state-owned firms lost importance. This approach was one of many reasons why the J-curve effect with its accompanying valley of tears and decline in GDP, experienced by the post-communist countries of Central and Eastern Europe, were prevented. 

11， According to a survey of the Centre for International and Security Studies of the University of Maryland (World Public Opinion.Org) from 11 January, 2006, 74 per cent of the Chinese population support the market economy, compared to 36 per cent in France. 

Although exact data are not available, state-owned enterprises now account for less than one-third of GDP (2005; Economist, 2006). They do not include municipal firms that are counted as private. Another source quotes 38 per cent of GDP for state-owned firms (Pei, 2006). The bulk of the non-state sector are municipal enterprises. There are only 40 private firms among the 1,520 companies listed on domestic and foreign exchanges (ibid.). The state remains the monopolist or dominant player in the most important sectors, namely in steel, automobiles, energy, transportation and in the banking and telecommunication service sectors. In the past, state-owned enterprises made losses and these losses were covered by credits from state-owned banks which were under pressure from local politicians to provide financial support to them. Eventually, the loans became non-performing. 

State-owned enterprises needed to be restructured or given up. Unemployment ensued and the unemployed lacked insurance coverage against being without a job; moreover, people then no longer had insurance in the case of illness and during old age. Actually, on average, state-owned enterprises are profitable. 

b. The Banking Sector 

Banks are state-owned. This applies to the four big state-owned commercial banks as well as to twelve joint-stock commercial banks, city and rural cooperative banks, other banks and asset management companies. All financial institutions are spin-offs of the People’s Bank of China, which was the only bank in China until 1979. Other spin-offs are governmental policy banks and regulating agencies for banking, securities and insurance. Three of the state-owned commercial banks have been partly privatised through initial public offerings, with the state (and the state-owned management companies) still holding about 70 to 80 per cent of ownership. For instance, 17 per cent of the shares of the Industrial and Commercial Bank of China (ICBC), the largest of the four state-owned banks, were introduced to trade in Hong Kong and Shanghai in the largest worldwide initial public offering ever in October 2006, making this institution the fifth largest bank with a market capitalisation of US$147 billion. In addition, 8.5 per cent of the assets are held by Goldman Sachs, Allianz and American Express. State-owned banks have chosen strategic partners (IMF, 2006b, Table 9).12 The initial public offering of the Agricultural Bank of China is pending.13 Asset management companies are the vehicles through which the government exercises its ownership rights vis-a-vis the four state-owned commercial banks. Each asset management company is responsible for one of the four state-owned commercial banks. 

12， HSBC holds 19.9 per cent of the smaller Bank of Communication.

13, The other two state-owned commercial banks are the Bank of China and China Construction Bank.

China’s banking system is fragile. Asset quality is poor and capitalisation of banks is low. Government intervention in the banking system is massive. Banks are not competitive by international standards. Liquidity of the banking system is high due to monetary policy, banks hold excessive reserves, inter-bank interest rates are low and credits are expanding strongly. Fully functioning bond and equity markets that could allocate savings to investment more efficiently than bank intermediation have not yet been developed. Moreover, bank intermediation is subject to political influence and competes with informal financing; more than half of investment is self-financed. Investing savings abroad is not a permitted option for savers. Banking deposits are the main form of savings.14 That is why poor asset quality, low capitalisation and the fragility of the banking systems are crucial to the further development of China. Chinese savers seem confident in state-owned banks. If the depositors lost their confidence, a severe risk for a stable growth process in China would arise. Thus it is essential that bank failures leading to a bank run be prevented. 

Non-performing loans, resulting from the political pressure on banks to provide credit to inefficient state-owned enterprises, represent a major risk. The stock of the banking system’s non-performing loans was estimated at about 40 per cent of GDP in 2004 (Blanchard and Giavazzi, 2005). Other sources approximate the percentage of total bad loans in GDP to 21 and — with a higher legacy — to 56 (Roubini and Setser, 2005, Tables 1 and 2). Another source estimates the percentage of non-performing loans to GDP for the total financial system, including the asset management companies at 36 per cent in 2003–2004 (Garcia-Herrero et al., 2005). The proportion of non-performing loans to GDP fell in 2005 (IMF, 2006b, p. 22). However, the stock of non-performing loans is still estimated at 25 per cent of GDP at year end 2005, including eight per cent for asset management companies (IMF, 2006b, p. 40). 

In the past, the government has had to recapitalise the state banks with sizeable amounts from time to time. In 1998, the government spent US$32.6 billion (about 3.5 per cent of GDP) in order to save the four then wholly state-owned commercial banks (Prasad, 2004). In 1999¨C2000 the government injected about US$169.1 billion or 14 per cent of GDP via state-owned asset management companies into the financial sector in order to clear the balance sheet of the state-owned commercial banks (ibid.). Bad loans of this magnitude were taken off the banking system’s books in 1999 and given to four asset management companies (Roubini and Setser, 2005). In 2003, US$45 billion or about four per cent of GDP were used for the same purpose. The People’s Bank of China transferred the amount to holding companies in order to recapitalise two of the four state-owned banks (China Construction Bank and the Bank of China). The banks will not convert these assets into renminbi but rather retain them as international reserves. This signifies an increase in the central bank¡¯s balance sheet risk. In 2005, a sum of US$15 billion was given to the Industrial and Commercial Bank of China and US$30 billion transferred to its asset management company. Chinese press reports indicate that a capital injection of US$100 billion will be needed to prepare the Agricultural Bank of China (with 24 per cent of its loans non-performing) for an initial public offering. Problems with non-performing loans also exist in rural credit cooperatives and smaller city commercial banks. 

14, In principle, with the WTO opening of the Chinese banking system in 2007 foreign banks should be allowed to offer non-Chinese financial assets. 

China makes use of its international reserves to clean up its banks’ balance sheets. Astonishingly, China’s reserves relative to GDP amount to a proportion not too different from that of the non-performing loans of the state-dominated financial system relative to GDP. Viewed this way, the international reserves represent an insurance against a future failure of the banking system, and this view mitigates against condemning China’s accumulation of international currency reserves. 

An alternative to pursuing this piecemeal approach of periodically cleaning up the banks’balance sheets would be an explicit policy of improving the risk management of banks, thus strengthening the banking system. This would entail removing non-performing loans from the system and preventing new ones from arising. However, this policy conflicts with the still important role of loss-making state-owned enterprises and the Party¡¯s pressure at the local level. Another option would be to follow a good bank¨Cbad bank policy as Japan did in its crisis in the 1990s, and to funnel all the losses into one or several institutions (which the government would have to recapitalise from time to time). Finally, capital markets reliant on equity capital have to be developed in order to reduce the intermediating role of the banking system. 

Initial public offerings can be seen as a device to improve the efficiency of the banking systems, since they exert pressure on the Chinese banks to become competitive. As of 2007, China will have to admit foreign banks in accordance with its WTO commitment. In principle, Chinese banks must be competitive by then, or at least the majority of them. However, foreign banks are limited in many ways. They are only allowed to open one branch per year. Foreign ownership of Chinese banks is restricted to 25 per cent; ownership of a single investor is limited to 20 per cent. The WTO requirement to open its banking industry also does not imply that the capital account will be fully liberalised (see below). State-owned firms are given preference on credits from state-owned banks, and this implies unproductive use. Even if banks were advised by the central government to learn to make money, the local Party leader is likely to continue to pressure the banker into providing credit to the state-owned enterprises. 

4. MONETARY, FISCAL AND EXCHANGE RATE POLICY 

a. Money Supply and Inflation 

China experienced high inflation rates in the 1980s and 1990s. For instance, the change in the consumer price index was 19 per cent in 1988 and reached its peak of 24.2 per cent in 1994. Inflation rates also were extremely volatile. Whereas the inflation rate was at 18.3 per cent in 1989, only one year later it had fallen to a comparatively low 3.1 per cent. The price level declined in the context of the Asian financial crisis with .0.8 per cent in 1998 and .1.4 per cent in 1999. Compared to the 1980s, inflationary pressure stemming from a considerable increase in the money supply and strong credit expansion has been tempered in the past few years. Consumer price inflation, driven mainly by food prices, was between 0.26 per cent (in 2000) and 4.00 per cent (in 2004), being 1.8 per cent in 2005 after having been negative with ¨C0.8 per cent in 2002. Recent inflation rates are also far less volatile than those of 15 years ago. The money supply (broad money according to the IMF definition) rose in the range of 14.0 per cent to 19.6 per cent in the period 2000¨C2005 (IMF, 2006b, Table 4). Credit to non-state sectors expanded in a volatile fashion in the same period with rates fluctuating between 2.1 (2001) and 26.5 per cent (2002). Lower inflation rates and better monetary policy result from the recognition that rising consumer prices contributed to the social unrest that culminated in Tiananmen Square in 1989. Inflation pressures may arise in the future, for instance when wage demands of workers surface, when environmental costs are felt, when energy becomes more expensive or when other constraints materialise. 

An independent monetary policy is complicated by high current and capital account surpluses since they increase outside money. The Chinese Central Bank —the People’s Bank of China— purchases foreign exchange and accumulates reserves (see below). Given the high twin surpluses, it is necessary to sterilise monetary expansion; the People’s Bank of China sells sterilisation bonds to the state-owned banks. From 2003 to 2004 the stock of sterilisation papers increased by about 265 per cent, from 2004 to 2005 it increased by about 88 per cent or US$117 billion — reaching a value of US$250 billion for the overall stock of bonds.15  However, this vast increase covers only slightly more than half of the increase in reserves. Not all of the outside money can be sterilised; thus there is an increase in liquidity showing up in low inter-bank interest rates and the strong expansion of credits. 

b. Fiscal Policy 

Unlike in Latin American countries, public spending and public budget deficits are not big issues in China. General government final consumption expenditure stood at 10.2 per cent of GDP (2004). This does not include government spending for investment or the expenditures of state-owned firms. The public budget deficit was in the range of 1¨C3 per cent of GDP in the period 1999¨C2005, for instance it stood at 1.2 per cent of GDP in 2005. Fiscal policy was slightly expansionary. Subsidies to state-owned enterprises make up about one per cent of GDP. Official public debt stands at about 18 per cent of GDP (2005; IMF, 2006b, Annex I). 

15, For other data see Roubini and Setser (2005). 

Although this is low compared to other Asian economies (and especially relative to Latin American countries), implicit liabilities of the state are higher, including for instance the non-performing loans of the banking system. Explicit and implicit debt are estimated at 45 per cent of GDP (IMF, 2006b). Total debt would rise sharply if a tax-financed system of social insurance with payments for human health services and pensions were developed, if the rural-urban divide mandated additional government expenditures to keep social unrest from exploding and, eventually, if environmental degradation were to be addressed. Moreover, centre-local fiscal relations are crucial. The central government provides transfers to local governments. Local authorities borrow through public enterprises, thus circumventing the formal ban on direct borrowing. 

c. Balance of Payments 

China has enjoyed a surplus both in the current account and in the capital and financial account for many years. It uses the twin surpluses to accumulate reserves (Table 2). In 2006, the surplus of the current account stood at US$230 billion and that of the capital account (including errors and omissions) at US$17 billion. This translates into an increase of reserves of US$247 billion. Total reserves equal US$1,066 billion, roughly 43 per cent of estimated GDP (with a ten per cent real growth rate assumed for 2006). They were 37 per cent of GDP in 2005. In 2005, the current account surplus stood at US$161 billion and the capital and financial account had a surplus of US$63 billion, now excluding errors and omissions. In 2003, US$45 billion were used to recapitalise the banking system. When these are subtracted, the current account and the capital and financial account surplus of US$143.7 billion is reduced to US$98.7 billion. 

With respect to the trade surplus, the accumulation of reserves can be seen as swapping Chinese export goods for US Treasuries and other papers. It is feared that China might use its reserves strategically to boost the value of the renminbi and to depreciate the US dollar. However, it would have to accept a sizeable loss of its accumulated international reserves. Moreover, China would be limited in its use of its reserves for this purpose, given the fragility of the banking system. 

The capital and financial account includes foreign direct investment and portfolio flows. In 2005, capital net inflows of US$68 billion were in foreign direct investment (3.6 per cent of GDP and about eight per cent of gross capital formation); the preliminary figure for 2006 is estimated at US$63 billion. In 2004, FDI stood at US$53 billion and in 2003 at US$47 billion. In the period 2000¨C2005, the average (net) FDI inflow was US$48.3 billion, in the 1990s it averaged US$26 billion and in the 1980s US$1.4 billion (IMF, 2006a). In addition to the ample supply of domestic capital due to the high savings rate, China succeeds in attracting foreign capital, and very often this also includes access to modern technology, management and foreign markets. Hence, FDI is an important basis for stimulating export. 

Notes: 

a Includes counterpart transaction to valuation changes. 

b Accumulated reserves in a specific year are not identical to the additions of a period plus the reserves of the previous year due to exchange rate changes. 

c 2003 figure includes the counterpart transaction to the US$45 billion of foreign exchange reserves used for bank recapitalisation. With this figure, the capital and financial balance would show a surplus of US$143.7 billion. 

d Includes bank capitalisation and foreign exchange swaps, estimated at US$28.8 billion. 

e Including errors and omissions. 

f Forecast. 

Source for data: 1990¨C2005: IMF, International Financial Statistics, Online Database, February 2007; Forecasts: World Bank Office, Quarterly Update, February 2007. Own calculation. 

Foreign invested enterprises are estimated to account for over 50 per cent of China’s exports (Whalley and Xin, 2006). Some economists question the need for such a high capital inflow. However, eight per cent of gross capital formation through FDI does not seem extraordinarily high. 

In its early stages of reform, China’s open-door policy for foreign direct investment used joint ventures between foreign investors, i.e. multinationals and state-owned enterprises. Now whole ownership of firms by foreign investors is allowed. Foreign owners can buy out their Chinese partners. However, looking at property rights for land and at the need for permits, it may remain advisable to have a Chinese partner (see below). Meanwhile, China’s new strategy includes foreign direct investment abroad. Its outward FDI in 2005 amounted to US$11.3 billion (IMF, 2006b, Table 2); it was used to acquire foreign enterprises and create Chinese multinationals. 

d. Severe Macroeconomic Distortions 

Using the macroeconomic conditions in other economies as a frame of reference, China exhibits stark distortions. The twin surpluses in the balance of payments amounting to ten per cent of GDP in the years 2005 and 2006 highlight the fact that China massively accumulates foreign reserves that will lose value when the renminbi appreciates in the future. It does not trade import goods for its export goods, but it exchanges exports for a stimulation of its economy. Swapping export goods for international currencies and economic stimulation will have its price later on, when the misallocation between sectors must be corrected. Gross national saving at 47 per cent of GDP (2005) keeps consumption low, with households postponing their consumption due to the uncertainty of not having insurance coverage against health hazards and for old age. While there is a sizeable investment gap between savings and investment, there are strong signs of over-investment in the economy which also will have to be corrected eventually. Monetary conditions support these distortions. 

e. Capital Account Controls 

Capital flows are controlled. Though current account convertibility has existed since 1996, the capital account has not been liberalised. In April 2006, permission for selected domestic institutional investors to make transactions outside China was introduced; private citizens can now buy foreign currency up to 20,000 US dollars rather than 6,000 US dollars per year. Only authorised institutions are allowed to perform transactions in foreign currency. China is following a cautious and gradualist approach to capital account liberalisation, taking into consideration the fragility of its banking system. The Asian crisis in 1997 and other currency disruptions, like the financial crisis in Sweden in 1992, have proven the risk of liberalising the capital account when the banking sector is not sufficiently robust, i.e. when it is not adequately regulated to withstand shocks and when banks have too much leeway in extending credits. Finally, a controlled foreign exchange rate is not consistent with a liberalised capital account. From the point of view of the sequencing of liberalisation, it is reasonable first to make the foreign exchange rate more flexible and then to liberalise the capital account in a second step. It would be risky to introduce resident convertibility immediately and fully. Market participants hedging political risks would then place their savings abroad looking for higher rates of return and a diversified risk. This is why introducing mutual funds for residents is discussed as an option in order to absorb the savings of Chinese households, including those of entrepreneurs (see ab
ove). 

f. Exchange Rate Policy 

The exchange rate of a country in transition towards a market economy can be expected to go through two phases. In the first phase, the transformation process and opening up for trade, including a sizeable reduction in import tariffs, put the export sector and exchange rate under pressure, which devalues the currency. In the second phase, when the competitiveness of exports has been established, appreciation is likely. These two phases can be observed in China. 

Throughout the 1980s and the early 1990s, the nominal and the real effective exchange rate of the renminbi depreciated sharply. The nominal rate (renminbi to the US dollar) depreciated from 1.5 in 1980 to 8.6 in 1994 (Figure 2). The real effective exchange rate index (which is the index of the inverse of the IMF¡¯s real exchange rate index) rose from 33.3 in January 1980 to 167 in June 1993, with February of the year 2000 set equal to 100 (in contrast to the index used by the IMF, an increase in this index denotes a real depreciation). From 1994 to 1998, the renminbi appreciated nominally relative to the US dollar, i.e. the renminbi/dollar rate fell. It then was held steady at 8.28 until 2004. Since 2005, the renminbi has appreciated by 5.6 per cent to a rate of 7.81 in December 2006. This looks like a soft crawling peg to the US dollar. In real terms, the renminbi appreciated from 1993 to 2001, then depreciated unsteadily until November 2006. Note that the high volatility of the inflation rate translates into an instability of the real exchange rate. Thus the low inflation rate since 

Note: a Monthly values.

Source: IMF, International Financial Statistics, February 2007. Own calculation. 

2000 is a factor behind the real depreciation of the renminbi since 2001. The revision of the macroeconomic data in December 2005 to reflect a larger share of services and higher prices in services implied a ten percentage point real appreciation relative to the previously estimated real exchange rate (World Bank Office, Beijing, 2006a). 

China has followed a policy of pegging the renminbi, attempting to keep it more or less steady or changing only slowly. For instance, during the Asian financial crisis in 1997, China kept the nominal rate to the US dollar constant.16 Effective from 21 June, 2005, the renminbi is no longer tied to the US dollar alone, but to a basket consisting of the US dollar, the euro, the yen and the Korean won. In addition, the Singapore dollar, British pound, Malaysian ringgit, Australian dollar, Russian rouble, Thai baht and Canadian dollar are taken into consideration. The weights of the currencies in the basket are not disclosed by the Chinese central bank; they are supposed to reflect the importance of China’s trading partners. Disclosure of the weights would allow speculators to guess where the renminbi might be in the future and when the central bank is likely to intervene. In practice, each day trading on the spot market starts with a central parity of the renminbi to the US dollar determined by the weighted average of 15 market makers appointed by the People¡¯s Bank of China rather than beginning with the closing price of the previous day. Intra-day movements are constrained by a band of 0.3 per cent on both sides. China¡¯s medium-term strategy seems to consist in achieving a greater mix and better return for its high international currency reserves.17 Such a reorientation would benefit the euro and put the US dollar under pressure. 

g. Is the Renminbi Undervalued? 

Since China keeps the exchange rate under tight control rather than letting it float, the question as to whether the renminbi is undervalued arises. The presumption is that a floating renminbi would automatically appreciate more than it has done of late.18 

16， The real exchange rate appreciated due to the fact that the other Asian currencies depreciated heavily relative to the US dollar and consequently also to the renminbi. 

17， China does not disclose the composition of its reserves. 

18， Instead of looking at market forces in determining the exchange rate, one may judge the exchange rate in terms of policy costs, especially opportunity costs in future periods. In this approach, an undervaluation of the renminbi is seen as having the advantage for China to stimulate exports and to be a strong impulse for investment and growth and at the same time a vehicle for structural change. The disadvantage lies in a higher inflation rate since inflation is imported with an undervalued currency. Moreover, the sector structure would be distorted in favour of the export industry. Adjustment costs could arise in having to correct this distorted allocation later on. Furthermore, an under-valuation means higher renminbi prices for agricultural products since these products are quoted in US dollars and China is a price taker. This in turn implies a lower real income of industrial workers. Imports of natural resources (oil, copper, cotton) become more expensive. Finally, a future depreciation of the reserves’currency, especially the US dollar, would mean that the value of accumulated reserves would be partially lost. Moreover, the renminbi value of the state’s bank capital (denominated in US dollars) falls; the banks’ capital to asset ratio is reduced (Roubini and Setser, 2005). Of course an undervalued currency has negative effects on China¡¯s immediate competitors, among them Pakistan, Egypt and the Maghreb states, and import-substitute sectors in the industrial countries. 

However, it is not perfectly clear in which direction a flexible renminbi would go. Determining the correct exchange rate is a tricky issue; after all, it is a counter-factual question. Economic forces pull the exchange rate in different directions. Some forces clearly work in favour of an appreciation. Following the trade flow view of the exchange rate and taking a long-run view, an increase in labour productivity and improved access to foreign markets generate pressures for an appreciation. Reducing regulations that impede imports works in favour of a depreciation. More importantly, the high current account surpluses of 7.1 per cent of GDP in 2005 and 8.7 per cent in 2006 clearly suggest an appreciation of the renminbi. In this debate, it is argued that the problem of the US current account deficit can be solved by an appreciation of the renminbi. However, the US’s 2004 bilateral trade deficit with China only amounts to US$80 billion (and US$111 billion including Hong Kong); the figure is not too different from the US’s other bilateral deficits with the EU (US$102 billion), Japan (US$78 billion) and the oil-exporting countries. Data refer to merchandise trade only. For the years 2002¨C2005, China’s annual average bilateral surplus with the US stood at US$73 billion. In the year 2005 with an unusually high Chinese current account surplus, China¡¯s bilateral merchandise trade surplus with the US is reported at US$114.2 billion (WTO, 2006b). We do not yet know whether this figure is an outlier or whether it indicates a trend. In any case, looking at the US current account deficit of US$800 billion in 2005, the data indicate that a unilateral nominal appreciation of the renminbi by China would not solve the US problem. It would be a different story, if most of the Asian currencies would appreciate together with the renminbi.19 Admittedly, different data are used in this debate; the US claims a bilateral deficit with China: US$201.6 billion (US Congressional Research Service, 2006).20 The main reason for the different figures lies in whether US trade with China includes Hong Kong. 

Following the capital flow view of the exchange rate, labour productivity growth and China’s improved access to other countries¡¯ markets also operate in favour of an appreciation, making China more attractive for foreign capital. This would also hold if a more reliable rule of law were introduced. Other factors, however, would work in favour of a depreciation, among them a too high inflation rate (representing a real appreciation but requiring a nominal depreciation) and a liberalisation of the capital account. Thus, resident convertibility with a future outflow of domestic savings would increase demand for US dollars, euros and other currencies and would imply an increased supply of the renminbi, dragging its value down. Consequently, the existing capital controls for residents imply an overvalued renminbi, i.e. the renminbi would depreciate strongly with a liberalised capital account. In terms of macroeconomic equilibrium, high unemployment can be interpreted to indicate that internal equilibrium is not fully established, indicating the need to depreciate. Similarly, a greater weight put on social policies will depreciate the currency. 

19, The bilateral US current account deficit with Asia (including Hong Kong but excluding Mainland China) is estimated at US$341 billion (2004). If China appreciates, it stimulates Asian exports to China and allows the Asian countries to appreciate their currencies vis-¨¤-vis the US dollar and uncouple somewhat from the Asian US dollar standard. 

20, Note that China has a sizeable bilateral deficit with Asia of about US$70 billion in 2005. This by itself would require a depreciation of the renminbi if one were to follow the bilateral view. 

Combining the trade flow and capital flow view, the accumulation of reserves clearly points in the direction of an appreciation. However, insofar as the reserves are used as an insurance against the fragility of the banking system, this remains a different matter. 

Economic models run into difficulties in accommodating all of these and other factors, including expectations. Applying the approach used by Wang (2004) to determine the medium-term path of the real exchange rate, one might conclude that the renminbi was not substantially undervalued in the period 1980-2003 (Wang, 2004, p. 25). Funke and Rahn (2005) draw the same conclusion for the period 1985-2002. Existing studies come up with a wide range of estimates of under-valuation, ranging from zero to nearly 50 per cent (Dunaway and Li, 2005). Different methods used, diverse explanatory variables included and instability in the empirical underlying economic functions in a rapidly growing development country are reasons for the difference in estimates. To sum up, the twin deficits point to an appreciation of the renminbi instead of the real depreciation that has occurred since 1992; however, the case made for the size of the existing undervaluation is not as strong as some American economists suggest.21 We would know better if China followed the advice of the IMF and allowed more flexibility in the exchange rate; and China itself would be informed of the extent to which the exchange rate distorts its economy. 

5. PROPERTY RIGHTS 

Establishing property rights is crucial in transforming a communist, centrally planned society into a market economy. They set incentives for the economic agents to produce, invest, innovate, save and provide work effort. In an approach different from the transformation countries in Central and Eastern Europe, China has developed its property rights step by step. They come in the form of land-use rights, ownership titles of firms and residential titles. Land-use rights are at the core; even firms need them. Although property rights grant the right to use land, run firms, construct, sell and use buildings and own apartments, all these rights are subject to control by collective authorities, most importantly collectives, municipalities and the Communist Party. Property rights are far different from their interpretation in market economies. 

21, Compare, for instance, Bergsten (2006) who estimates the under-valuation of the renminbi against all currencies at 20-40 per cent. 

Land-use rights for individual farmers (outside the collective) were introduced in the Deng Xiaoping reforms. With these reforms and prices for some crops being freed, agricultural output rose considerably. Land-use rights are leases on the use of land. They are granted for 30 years. Rural land is owned and administered by the collectives.22 According to the Land Management Law of 1998, a contract between the collective landowner (i.e. the collectives) and the private farm household defines the rights and duties of both parties (Article 14). Article 13 of the Constitution, amended in 2004, defines ‘citizens’lawful private property as inviolable’.23 Land-use rights are granted by political decision; they were given to those who worked on the land; party connections may have played a role. The total number of land-lease contracts is more or less rationed; there is no first-hand market for land-use rights. However, a thin secondary market for land-use rights exists; it was constitutionalised in 1988 (deLisle, 2004). Farmers can rent out the land with permission, paying a fee to the collective administration. Extension of the land use may be possible. 

Land-use rights do not comprise full ownership. Land cannot be sold, nor can it be mortgaged. Farmers do not enjoy capital gains on their land; ultimately, they may have no interest to invest in their land when this land may have to be returned to the government. Thus, disincentive problems similar to those known from Mexico’s edijo arrangement might arise. Given that farmers cannot negotiate directly with locating firms and developers, they cannot use the proceeds from selling land for investment in firms, for moving to the city or for financing their retirement. Not permitting the marketisation of rural land impedes rural poverty reduction and hinders structural change. Moreover, agricultural firms cannot optimise the inputs in their production process since there is no primary market for ownership of that input. 

Although land readjustments are restricted (Article 14), farmers are not protected when the land is allocated to expanding firms or when it is needed for residential construction. Compensation, if any, is low; for rural land it is at about one-tenth of the market value. About 34 million farmers lost their land-lease contracts in the period 1987¨C2001 (Lindbeck, 2006). De facto local bureaucrats have ultimate control and ownership of rural land. This holds in spite of the formal introduction of private property by the People’s Party Congress in March 2007. China’s land-lease approach represents a combination of private use (so far for a limited time period) and public ownership. 

22, It is unclear what the term collective means ¨C People’s Communes, production brigades or production groups. 

23, The article also states: ¡®The State may, in the public interest and in accordance with law, expropriate or requisition private property for its use and shall make compensation for the private property expropriated or requisitioned’. 

Firm ownership comes in different forms. Under conditions controlled by the party, land can be used for industrial purposes. As a first step, municipalities were allowed to set up firms (township and village enterprises). Nevertheless, township and village enterprises, representing collectives, remain under the control of local officials and several supervisory bodies. As a second step, private-public partnerships were allowed and as a third step private ownership was introduced. State-owned enterprises were privatised; this includes turning them into township and village firms. Foreigners, including multinationals, can own enterprises. Whereas firms own the physical assets they use for production (including the machines and the buildings), enterprise ownership is linked to the ownership of land and thus hinges on the permission of party officials. Urban land is administered by municipalities. Sons and daughters of the political elite have had privileged access to land that was used to open up firms. Private ownership of firms depends on which sectors of the economy are at stake and it also varies with provinces and localities. Public ownership prevails in sectors where government is the dominant producer, for instance in energy, transportation and telecommunication. The relationship between asset ownership and land-use rights is far from clear. If an entrepreneur has good connections with the local or provincial government, land-use rights may de facto not be limited in time. When there is a change in leadership, this contract may be void. The relationship of the former political leader and the current leader is crucial. The local or provincial government has the right to take over a property whenever it likes; there is no way to prevent this. In one major case, an entrepreneur was expropriated because it was claimed that he did not possess a land-use title, even though the shares of his firm had already been transacted in Wall Street (Dole, 2003). The formal recognition of the ownership of enterprises by the People’s Party Congress in March 2007 gives asset ownership more protection. 

Residential ownership refers to the ownership of buildings, including private apartments. With the permission of the political authorities, it is possible to convert agricultural land into residential use for individuals. In contrast to rural land, most urban housing is now privately owned; residential leases run for 70 years (some for 50 or 40 years). Property owners elect their landlord committees in order to protect their property against local party politicians. 

Property rights are far from being clearly defined; nor are they strong. They are in constant flux and opaque. Property rights can be bequeathed (within the limited period they are granted) and they may be extended by local political decisions; however, a property right seems to exist only so long as it is justified by economic success. The characteristics of Chinese property rights are that they have simply followed whatever is needed for high growth. Property rights are rarely respected when an expanding firm needs new location space, when a private investor constructs new residential structures or when the government pursues an infrastructure project. A pay compensation requirement with respect to real estate was introduced into the constitution in 2004. Implementation of the property rights system and of individual claim procedures are, however, far from being established. Compensation is controlled by the state. Corruption is prevalent, the court system is in development, legal advice is scarce. The rule of law is one of China¡¯s institutional deficits. A clear bankruptcy law that would allow to sort out property claims in the event of bankruptcy so far did not exit, either; the revised bankruptcy law, effective June 2007, attempts to partly remedy this situation. It has to be seen to what extent the formal recognition of private property rights through the People¡¯s Party Congress in March 2007 will give more certainty to the private ownership of assets, i.e. enterprises and real estate, while land remains in public ownership. 

This form of mushy and adjustable property right may be appropriate for the Chinese situation in which everything is in flux. These adaptable property rights do seem to create enough certainty for people to invest in the initial period of Chinese transformation, when expected yields are high. The widening of the market in China and the opportunity to have the whole world economy for the absorption of Chinese products overcompensated the risk arising from property right uncertainty. Moreover, improvement in governance relative to the Mao TseDong period and later on is seen as a substitute for property rights (Keefer, 2007). Property rights, however, are likely not to be sufficient later on, when yields become somewhat lower; lower expected yields require more certainty. The approach to property rights is also affected by the process of transforming a communist society in which property rights are not supposed to exist. Apparently, there are ideological constraints to creating property rights. For instance, establishing a rural landowning class would undo the Mao reforms in which rural landowners were expropriated; quite a few of them were executed. A crucial constraint is that establishing new rights does not jeopardise the position of the Party. Note, however, that President Jiang Zemin’s ‘Three Represents’ doctrine calls for the inclusion of the entrepreneurial class- usually property owners ¨C into the Communist Party. 

With respect to intellectual property, China accepted the obligation to honour these rights upon its entry into the WTO. Its laws and regulations must be amended to conform with the ‘Agreement on Trade-related Aspects of Intellectual Property’(TRIPs). This applies to patents, trademarks and copyrights, including production technologies, fashion and audio and video products. It requires that the Chinese government forcefully combats product piracy. 

6. POLICY ISSUES IN THE FUTURE 

The crucial issue for the future is whether China¡¯s growth process of the last 25 years is sustainable. Normal processes, structural weaknesses, newly arising restraints, such as inadequate social security, and institutional deficits may lead to a slower pace of growth. 

a. Normal Brakes in the Process of Growth and Structural Weaknesses 

Quite a few factors point towards continued strong growth. The high savings rate, facilitating strong capital accumulation, entrepreneurship, the migration of growth clusters into the interior, surplus labour, the expansion of the real estate and construction sector and, above all, exports will all be positive factors. The prospects for growth depend crucially on whether China can maintain the pace of its capital accumulation, the increase in total factor productivity by a continuous stream of original innovations and high rates of export expansion. With respect to exports as the main stimulus, China is seeking to move out of its position of low-cost producer by pushing into high-value lines of production and investing in research. China has three times as many graduates in the natural sciences and in engineering than the US. This approach of moving up the technological ladder takes some pressure off other labour-intensive exporters affected negatively by China¡¯s success, for instance Bangladesh. China may further expand its role as a hub, outsourcing the production of part of its intermediate inputs to partners in Asia. With a strong increase in income per capita, intra-sector trade with the developed countries will gain importance, and this will lessen the strain felt in the industrialised OECD countries. The risk of being cut off from its markets through protectionism by the industrialised countries then becomes less likely. 

Conversely, normal processes will tend to reduce growth in the future. Real wages will rise more sharply than in the past as soon as the pool of rural surplus labour is exhausted and wages are no longer supported by productivity growth at previous levels. Although the excess of rural workers is estimated at 150 million and about 10 million new workers have joined the workforce each year in the past, eventually labour will become scarcer. China¡¯s appetite for energy and raw materials will drive up prices of important inputs, making production more expensive; China bidding for these resources on international markets will raise world market prices.24 To mitigate congestion, more resources will have to be invested in infrastructure projects which tend to have lower capital productivity than investment in the private sector. Markets in all these areas are not fully established; consequently a smooth adjustment process to changes in the degree of scarcity is unlikely. Ageing will also affect the growth rate downward. 

More importantly, structural issues and bottlenecks represent constraints to the growth process. Whilst among the structural problems already discussed, capital losses of state-owned firms are likely slowly to lose importance, the fragility of the banking sector may prove a more severe problem. Other weaknesses will come to the fore. China will have to pay more attention to accidents at the workplace and in industrial production, for instance in the chemical industry. Moreover, environmental constraints will make themselves increasingly felt. Toxic industrial dumping in the countryside has to be halted; toxic dumps have to be amended. Air and water pollution, and the deterioration of the soil become less and less acceptable with rising per capita income. They cause social costs in terms of serious health damage. All these factors will increase the costs of production. Moreover, China as an international player will eventually want to be part of multilateral solutions to global environmental problems such as reducing CO2 emissions. 

24， China’s share in world consumption is about eight per cent for petroleum, 27 per cent for cotton and 17 per cent for wheat (Siebert, 2007). 

Energy efficiency has to be increased. Retail gasoline prices are still lower than those in the US. Cheap energy helps to keep inflation in check, but distorts energy use. China’s oil demand is projected by the Energy Information Administration to more than double and reach 14.2 million barrels per day by 2025, with net imports of 10.9 million barrels per day. Furthermore, China is both the largest consumer and producer of coal in the world. China faces major energy-related environmental problems. According to the World Health Organisation, seven out of the ten most polluted cities in the world are in China. 

It may be argued that all these bottlenecks can be overcome with a technocratic approach and with social engineering. However, more resources must be diverted towards these bottlenecks, and the capital spent on these issues will have lower productivity, implying a lower growth rate. In any case, falsely low scarcity prices for land, capital, energy and the environment have to be corrected through institutional changes. 

b. Social Policy Constraints 

Issues of social protection have not been a major concern in Chinese growth policy. Unemployment, which has increased due to the restructuring of state-owned firms, is high, given the high GDP growth rate. The urban unemployment rate is estimated at about five per cent (Prasad, 2004, p. 52). Although generous unemployment insurance has been introduced for the urban unemployed protecting about 105 million (Lindbeck, 2006, p. 55), other workers are not shielded against unemployment. Protection against health hazards and old-age pension insurance has not been developed, the level of social protection in China being similar to that of the European countries 100 years ago. With the decline of state-owned enterprises, which provided safe jobs and human services insurance, a mixed system has developed where, for instance, part of the health costs are covered by firms, but a large part is self-paid. In 1988, 44.1 per cent of health costs in the cities are estimated to have been self-paid. In the countryside the percentage is much higher at 87.4 per cent (Blanchard and Giavazzi, 2005, Table 10). The inadequate insurance arrangements for health and old age are one of the reasons for high savings. The private savings needed as a substitute for insurance are inferior in terms of efficiency relative to an insurance solution. Health insurance, for instance, can be provided more efficiently, if a large number of people with different health risks are insured. Apparently, China has alternative options to following the European social model. However, whichever model is chosen, the need to develop a social insurance system is likely to put a burden on the public budget, increase debt and require higher taxes. 

The growing inequality in income distribution and rural-urban divide represent a severe risk for the power of the Communist Party. Discontent among farmers due to relatively low income, the high costs of human health services, insufficient pensions in old age and the arbitrary decisions of bureaucrats with respect to land-use rights and local levies may lead to social unrest in the countryside which, traditionally, has played an important role in political changes in China. Massive lay-offs in the rust belt, toxic industrial dumping affecting farming, fishing and water, and industrial accidents may add to the unrest. Social upheaval could threaten the ruling Party. That is why rulers fear the Latin-Americanisation of the country and why they have announced the target of a Harmonious Society. After all, China lacks profound experience in social problem-solving, compared, for instance, to India. 

c. Distorted Resource-extensive Growth 

China’s growth is unbalanced in many ways: exports and investment instead of consumption, foreign direct investment from abroad instead of financing from domestic savings, inflationary risk through money and credit expansion instead of price-level stability, production and investment instead of social protection, pollution in favour of production instead of environmental protection and stimulation of urban centres instead of improvement in the rural areas. It can be argued that such unbalanced growth is a normal vehicle to obtain high growth rates; that is simply the price to be paid for this growth. However, imbalances imply serious adjustment costs in the future and the risk of a crisis. The strong expansion of the export sector will require sectoral readjustment later on, the investment boom may have to be corrected at high costs, the real estate boom may end in a bubble that bursts and a banking crisis may have a serious impact on the real side of the economy. 

According to this view, China has followed an inefficient, resource-demanding or even resource-destroying growth path with many distortions. Factoring-in these distortions, the GDP growth rate may actually be lower than measured statistically, say at 7.5 per cent per year.25 That is why some economists plead for another growth strategy with fewer distortions (Blanchard and Giavazzi, 2005; and Roubini and Setser, 2005). It seems likely that the normal brakes and constraints mentioned will affect the growth rate. Barring political crises, a lower growth rate of, say, six per cent annually in the next 20 years is more realistic. Such a scenario is more likely since China¡¯s growth is a catching-up process in which, so far, imitation plays a major role. Such processes lose steam over time. It would be a different story if China were able to move to the technological frontier of the world itself and was not dependent on the imitation of Western technological solutions. 

25，See sources quoted in Lindbeck (2006, p. 25). 

d. Institutional Deficits 

Besides normal brakes and constraints, China’s weak institutional arrangements could affect growth dynamics. It is now well established that institutions are an important factor in economic growth. The institutional deficits may well be more relevant for the sustainability of China¡¯s growth process than the economic bottlenecks. 

An efficient economic system requires a reliable institutional framework since most decisions of economic agents need a long-run orientation. When rules and institutional frameworks for economic decisions are lacking, bureaucratic structures, informal relationships, family networks or networks of friends take their place. 

While informal networks lend some stability to the system, without reliable rules conditions for economic agents become arbitrary in many respects; agents then are at the mercy of bureaucrats and Party officials. Those who have the power to decide can hand out favours, usually in return for compensation. Corruption is the unavoidable outcome. The rule of law, therefore, is a necessary requirement for a sustained growth process. 

Individual economic freedom is a necessary condition for growth. This requires that the Party define a decision space for the private sector, guaranteeing economic freedom. An important aspect of the rule of law is that rights are given to private firms and households and that the holders of these rights can enforce them. This calls for corruption to be pushed back and it mandates clearer property rights. In addition, the Communist Party must desist from intervening in administrative and court decisions. Rules must be stable in order to be credible. To respect human dignity goes beyond the demand for economic freedom. All these requirements may limit the power of the Party. 

The actual Chinese system of governance has been described as neo-Leninist, blending one-party rule and state control of key sectors of the economy with the market mechanism and an open economy (Pei, 2006). Patronage secures support from key constituents, including the bureaucracy, the military and the business community. The question remains open whether or not economic freedom will start a process in which citizens eventually demand political freedom. The relationship between economic freedom and political freedom, i.e. democracy, seems asymmetrical. 

Whereas democracy is accompanied by economic freedom (Friedman, 1982), economic freedom does not necessarily entail political freedom. A major aspect could be that economic agents will insist on the right to elect those who make the laws governing economic freedom. After all, market capitalism separates economic and political power and this may put political power on the defensive. The biggest challenge for China may then well be the demand for democracy. Whether or not this political demand for democracy will be forcefully articulated in China in the future cannot realistically be answered at this stage. One possibility is that the Chinese derive an immense happiness from being and becoming rich and will be satisfied (for a long time) with a situation in which the Communist Party just lets them get rich. Then economic freedom is all there is. In this scenario, the government remains more or less authoritarian. Another possibility is that the Communist Party will introduce some cautious steps towards decentralised democratic procedures, for instance letting mayors be elected on a decentralised level. Among the political leaders there is a fear that the Communist Party will fall apart and the country break up. For the Party, the disintegration of the Soviet Union serves as a negative example besides the Latin-Americanisation of social issues. The result may be a cautious attempt of controlled capitalism, which may then serve as a prototype for other countries, for instance the Arab oil countries and some developing countries. The least likely case is the third possibility, a full move towards democracy, Western style. 

Economic fundamentals may impact on the political system and vice versa. Thus, in generating Chinese multinationals, the issue arises of how China¡¯s products are viewed outside China and whether their image includes the characteristics of freedom. Social inequality may lead to political unrest. Lower growth rates may put the political system into question, and political turmoil may jeopardise the economic growth dynamics of the past. An unstable China, for instance with growing unrest of the rural population, will represent a threat to the world. Political rulers may then be tempted to play with nationalist sentiment to bolster legitimacy. 

e. Hard or Soft Landing? 

Excluding political disruption, for instance a confrontation between China and the United States, a scenario for the next 25 years might be described as follows:26 China’s GDP expands at a rate of 6.0 per cent per year, the US’s at 2.5 per cent. The world grows at 3.5 per cent. Using the revised GDP data, putting China at Taiwan may be a bone of contention in international relations in the future, especially when China is becoming more powerful economically and will be challenging the leading economic and political position of the US. 

5.0 per cent of world GDP and the US at 28.1 per cent (in 2005), China will be at 9.1 per cent of world GDP in 2030, the US at 22.0 per cent, using market prices. Thus, in 25 years China would represent 41.0 per cent of the US GDP, compared to 17.9 per cent in 2005. The economic core of the world economy is slowly but steadily moving towards China. Of course, such calculations invite questions. Economic growth knows booms and busts, and a constant growth rate is unlikely, even in a stable political environment. The process of growth may follow a different pattern. A hard landing in the form of a crisis in China cannot be excluded. Such a crisis may come from the banking system, should depositors lose confidence and a bank run occur. A crisis may arise from the real side of the economy, if overinvestment and a distorted capital stock force major readjustment. It may also appear if the world economy moves into a slump and Chinese exports have to compete with other countries in a situation of global oversupply and excess production capacity. This could then feed into a capital flow reversal with FDI no longer flowing in; eventually a currency crisis may arise. Furthermore, a crisis could emerge from an energy price shock, for instance if an oil price shock cuts China off from its needed energy inputs. Global warming puts China under pressure, possibly inducing it to continue its path of heavy pollution but at the same time following an isolated approach with many international frictions. Last but not least, a political crisis could spill over into the economy. With China now a major global player, a crisis there would have a severe impact on the Asian countries and on the world economy. 

7. CONCLUSIONS 

In contrast to the centrally planned economies of Central and Eastern Europe in the 1990s, whose transformation in the 1990s cost 20 to 40 per cent of GDP, China did not experience a J-type transformation curve. Since the Deng Xiaoping reforms it has enjoyed high average annual GDP growth rates of nearly ten per cent. It now is the world¡¯s fourth largest economy, accounting for five per cent of world GDP with a world market share of 6.8 per cent. Ruling out political disruptions, China may produce about ten per cent of the world’s GDP in 2030, the US being at about double that percentage. 

. Exports (at 35 per cent of GDP) and investment (at 39 per cent of GDP) have been the two driving forces for growth. Loss-making state-owned firms, an inefficient use of savings and a fragile banking system represent structural weaknesses. 

. China uses the large surpluses in its current and capital account to accumulate international reserves, standing at 43 per cent of its GDP. The international reserves have been drawn on to recapitalise the fragile banking system from time to time. With non-performing loans at 25 per cent of GDP, reserves can be interpreted as an insurance against a future bank failure. 

. The exchange rate and capital flows are controlled. The high current account surplus of 7.1 per cent of GDP in 2005 and the inflow of FDI suggest a nominal appreciation of the renminbi. However, a liberalisation of the capital account would encourage the Chinese to export their savings to be protected in old age and hedge against political risk. This would devalue the renminbi. Its under-valuation therefore hinges on the controlled capital account. We would be better informed on this if China followed the advice of the IMF and allowed more flexibility in the exchange rate; China would also be informed to what extent the exchange rate distorts its economy. 

. Property rights, crucial in the transformation of a communist economy, come in the form o
f land-use rights, ownership titles of firms and residential titles. They are in a flux, opaque and are only valid as long as they are justified by economic success. All these rights are subject to control by collective authorities, most importantly municipalities and the Communist Party. They are de facto revoked when a more promising use of land is in sight. 

. Besides structural weaknesses, normal brakes in the growth process and new constraints will slow the growth rate in the coming decades. Amongst these constraints count higher degrees of energy scarcity, more safety in the workplace, environmental degradation and social security insurance. The distorted growth process will have to be corrected. The Communist Party is concerned that social policy issues may lead to a Latin-Americanisation, and therefore introduced the goal of a Harmonious Society. 

. Institutional deficits, for instance the lack of the rule of law, may be more relevant for the future process of growth than economic constraints, which can be dealt with by a technocratic approach. It is an open question as to whether economic freedom will start a process in which citizens eventually demand political freedom. One possible answer is that the Chinese derive an immense happiness from being and becoming rich and will be satisfied with a situation in which the political Party just lets them get rich. 

. A future crisis in China cannot be ruled out. It may come from the banking system, should depositors lose confidence, causing a bank run. Or it may appear if over-investment and a distorted capital stock force a major readjustment, if the world economy moves into a slump and Chinese exports have to compete with other countries in a situation of excess production capacity, or if an energy price shock cuts China off from its needed energy inputs. Global warming may put China under pressure, possibly inducing it to continue its path of heavy pollution but at the same time following an isolated approach with many international frictions. Last but not least, a political crisis could spill over to the economy. 

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