Growing like China: understanding the puzzle of China's economic transition

In this short audio from VoxEU.org Fabrizio Zilibotti talks to Viv Davies about Zilibotti's award-winning paper ‘Growing Like China’ (co-authored with Zheng Song, Kjetil Storesletten and Yikai Wang) that addresses the puzzle of the combination of high growth and high return to capital in China with a growing foreign surplus. They also discuss pensions and demographic transition in China, factors that are driving the country’s growth and the country’s future role in the global economy.

Weather and revolting peasants

Over history it would seem possible that weather shocks, which effect food supply, could affect the probability of peasant revolts. When food is in short supply peasants are more likely to revolt. While such a hypothesis may seem reasonable, is there any evidence to back it up? Thanks to a new article in The Economic Journal there is. At least for China.

I use data covering 267 prefectures over four centuries to investigate two questions about historical China. To what extent did weather shocks cause civil conflict? And to what extent did the historical introduction of (drought resistant) sweet potatoes mitigate these effects? I find that before the introduction of sweet potatoes, exceptional droughts increased the probability of peasant revolts by around 0.7 percentage points, which translates into a revolt probability in drought years that is more than twice the average revolt probability. After the introduction of sweet potatoes, exceptional droughts only increased the probability of peasant revolts by around 0.2 percentage points.

The article is Weather Shocks, Sweet Potatoes and Peasant Revolts in Historical China by Ruixue Jia.

Sometimes common sense does make sense.

Freedom in ideas matters

In their recent book, "How China Became Capitalist," Ronald Coase and Ning Wang argue that the market in ideas matters for the future well-being of China. Coase and Wang deplore China's lack of a free market for ideas and the damage that this has wrought on universities and on the Chinese economy's capacity to innovate.

But just how bad are the controls on academics in China's universities? A part answer to this question may be reflected in this recent posting on Greg Mankiw's blog:

A professor in China brings this story to my attention:

A renowned professor has confirmed online rumours that his peers will decide whether he will be expelled from China's most eminent university after he made a series of remarks in favour of free speech and constitutional governance.

Economics professor Xia Yeliang of Peking University was told by his department that his fate would be decided by a faculty vote, he told the South China Morning Post on Monday.

"They told me it's because of all the things I have said and written," Xia said. "They have threatened me before, but this is the first time they will vote on my expulsion."

My correspondent says that the vote will likely take place in September. He also reports that this is not an isolated incidence. He writes, "Though you may not be aware, there is a quiet crack down currently under way in China with other professors being removed for similar offenses....I can tell you from my personal experience here, most Chinese faculty at PKU and other elite Chinese institutions having been educated at top schools in the US are appalled but are quite fearful to speak out."

There are some very obvious issues here about the role of academics in Chinese society - "critic and conscience of society" in New Zealand terms - and for the freedom of speech but if Coase and Ning are right then the effects of such repression could go further than just the social and political spheres, it could negatively effect the future growth of the Chinese economy. Growth that in recent times has resulted in millions of people being raised out of poverty. Anything which retards the enormous potential for future growth that the Chinese economy has must be of concern to anyone who is worried about the well-being of the many millions of people who are still poor in China today.

EconTalk this week

Now this is super cool!

Nobel Laureate Ronald Coase of the University of Chicago talks with EconTalk host Russ Roberts about his career, the current state of economics, and the Chinese economy. Coase, born in 1910, reflects on his youth, his two great papers, "The Nature of the Firm" and "The Problem of Social Cost". At the end of conversation he discusses his new book on China, How China Became Capitalist (co-authored with Ning Wang), and the future of the Chinese and world economies.

More Coase

From the University of Chicago comes another short video: "How China Became Capitalist: A Conversation Between Ronald H. Coase and Ning Wang".

How China Became Capitalist is the new book by Ronald Coase and Ning Wang, an assistant professor at Arizona State University's School of Politics and Global Studies. It traces the market transformation China has experienced over the past 35 years and argues that China's market transformation flourished without much help from Beijing—contrary to its leadership's claims—but the free flow of ideas has faltered. Until that changes, China will never reach its full potential.

How China made its great leap forward

What is most surprising about this article, which is from the Wall Street Journal, is that it is based on the book "How China Became Capitalist", by Ronald Coase and Ning Wang, which is due out this month. The notable thing is that Coase is of course the 101 year old Nobel laureate in economics. If I'm still working and writing books at 101 I will be bloody impressed!

Coase and Wang open their WSJ article by noting

China's post-Mao market transformation is one of the most dramatic and momentous events of our time. It has lifted hundreds of millions out of extreme poverty, freed one fifth of humanity from ideological radicalism, revived one of the oldest civilizations, and inspired all of us to explore the benevolence of the market.

But they then say,

Yet capitalism as currently practiced in China suffers a severe failing: the lack of a marketplace for ideas. China's market transformation flourished at the ground level without much help from Beijing—contrary to its leadership's claims. But the free flow of ideas has faltered. Until that changes, China will never reach its full potential.

and add

In the years to come, China will continue to forge its own path, but it needs to address its lack of a marketplace for ideas if it hopes to continue to prosper. An unrestricted flow of ideas is a precondition for the growth of knowledge, the most critical factor in any innovative and sustainable economy. "Made in China" is now found everywhere in the world. But few Western consumers remember any Chinese brand names. The British Industrial Revolution two centuries ago introduced many new products and created new industries. China's industrial revolution is far less innovative.

The active exchange of thoughts and information also offers an indispensable foundation for social harmony. It is not a panacea; nothing can free us once and for all from ignorance and falsehood. But the free flow of ideas engenders repeated criticism and continuous improvement. It also cultivates respect and tolerance, which are effective antidotes to the bigotry and false doctrines that can threaten the foundation of any society.

One thing that economists note is that cities exhibit "agglomeration effects"; having lots of people close to one another helps create new ideas and helps to find new way to use current ideas. In short, big cities lead to lots of big ideas. China has big cities, huge cities, but if Coase and Wang are to be believed not much in the way of new ideas. So something must be missing, and for China that something may be freedom from state control. Markets in ideas, if not for goods and services, are still largely missing from China due to state regulation. Coase and Wang point out that

When China started reforming itself more than three decades ago, Deng rightly stressed the "emancipation of the mind" as a prerequisite. But that has yet to happen. It's time for China to embrace not just the market, but the marketplace of ideas.

Can China’s growth lower welfare in developed countries?

This question is asked by Julian di Giovanni, Andrei Levchenko and Jing Zhang in a posting at VoxEU.org. The late Nobel Laureate Paul Samuelson argued that if China's productivity growth accelerates in areas where it does not currently have a comparative advantage – notably the service sector – developed countries may suffer. The VoxEU column presents a multi-country, multi-sector model, and reaches the opposite conclusion: the world, including developed countries, is far better off when China’s growth favours its current comparative disadvantage sectors.

In developed countries, and New Zealand, a common concern is that China's growth will be biased towards sectors in which the developed world currently has a comparative advantage. In a two-country setting, a well-known theoretical result is that a country can experience welfare losses when its trading partner becomes more similar in relative technology. Paul Samuelson brought up this theoretical possibility for the growth of China in particular back in 2004, and thus it is referred to here as the Samuelson conjecture.

A recent study (di Giovanni et al 2012) evaluates this conjecture in a calibrated quantitative model of the world economy. The analysis employs the productivity estimates recently developed by Levchenko and Zhang (2011) for a sample of 19 manufacturing sectors and 75 economies that includes China along with a variety of countries representing all continents and a wide range of income levels and other characteristics. di Giovanni et al embed these productivity estimates within a quantitative multi-country, multi-sector model with a number of realistic features, such as multiple factors of production, an explicit non-traded sector, the full specification of input-output linkages between the sectors, and both inter- and intra-industry trade, among others.

di Giovanni, Levchenko and Zhang write,

To evaluate the importance of China’s sectoral pattern of growth for global welfare, we simulate two counterfactual growth scenarios starting from the present day. In the first, China’s productivity growth rate in each sector is identical, and equal to the average productivity growth we estimate for China between the 1990s and the 2000s, which is 14% (ie an average of 1.32% per annum). In this ‘balanced’ growth scenario, China’s comparative advantage compared with the rest of the world remains unchanged. In the second scenario China’s comparative disadvantage sectors grow disproportionally faster. Specifically, in the ‘unbalanced’ counterfactual China’s relative productivity differences with respect to the world frontier are eliminated, and China’s productivity in every sector becomes a constant ratio of the world frontier. By design, the average productivity in China is the same in the two counterfactuals. What differs is the relative productivities across sectors.

The results are striking. The mean welfare gains (the percentage change in real consumption) from the unbalanced growth in China, 0.42% in our sample of 74 countries, are some 40 times larger than the mean gains in the balanced scenario, which are nearly nil at 0.01%. This pattern holds for every region and broad country group. Importantly, the large majority of countries that become more similar to China in the unbalanced growth scenario -- most prominently the US and the rest of the OECD -- still gain much more from unbalanced growth in China compared to balanced growth.

Thus, when evaluated quantitatively the welfare impact of China’s growth on the rest of the world turns out to be the opposite of what had been conjectured by Samuelson (2004). We develop an explanation for this quantitative result in a simplified multi-country analytical model.

We show that the Samuelson (2004) result, obtained in a two-country, two-good model does not survive in a setting with more than two countries. Greater similarity in China’s relative sectoral technology to that of the United States per se does not necessarily lower welfare in the US. Rather, what drives welfare changes in the US is how (dis)similar China becomes to an appropriately input-and-trade-cost-weighted average productivity of the United States and all other countries serving the US market.

Thus, what matters for global welfare is not China’s similarity to any individual country, but its similarity to the world weighted-average productivity (although the theoretically correct weights will differ from country to country because of trade costs). Closer inspection reveals that China’s current productivity is relatively high in sectors -- such as Wearing Apparel -- that are ‘common’, in the sense that many countries also have high productivity in those sectors. By contrast, China’s comparative disadvantage sectors -- such as Office, Accounting, and Computing Machinery -- are ‘scarce’, in the sense that not many other countries are close to the global productivity frontier in those sectors. This regularity is very strong in the data: the correlation between China’s relative productivity in a sector and the average productivity in that sector in the rest of the world is 0.86. Put another way, China’s pattern of sectoral productivity is actually fairly similar to the world average. Thus, while balanced growth in China keeps it similar to the typical country, unbalanced growth actually makes it more different. Consistent with theory, our quantitative results imply that the rest of the world would find it more valuable for China to experience productivity growth in the scarce sectors -- by a large margin.

• di Giovanni, Julian, Andrei A Levchenko, and Jing Zhang (2012), “The Global Welfare Impact of China: Trade Integration and Technological Change”, IMF Working Paper 12/79.
• Levchenko, Andrei A and Jing Zhang (2011), “The Evolution of Comparative Advantage: Measurement and Welfare Implications,” NBER Working Paper No. 16806.
• Samuelson, Paul A (2004), “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization”, Journal of Economic Perspectives 18(3): 135–46.

Real versus nominal

In this case its real versus nominal exchange rates. Much has been written about China’s currency manipulation policies and why its bad policy. But most of the anti-Chinese rhetoric has been written as if its the nominal exchange rate that’s important. But what’s happening to the real rate?

At his blog economist Ed Dolan looks at this issue. He writes,

[...] what really matters for US-China competitiveness is not the nominal exchange rate, but the real exchange rate. The simplest way to calculate the rate of real appreciation of the yuan against the dollar is to add the inflation differential between the two countries to the rate of nominal appreciation. Recently, inflation in China has been running about 3 percentage points higher than in the United States, depending on what price index you apply. That implies a rate of real appreciation of about 8 percent per year. Such a rate is enough to wipe out a 20 percent undervaluation in less than 3 years or a 40 percent undervaluation in less than 5 years. That’s change you can start to believe in.

There’s more to the story than that, however. What really matters for jobs and competitiveness is not consumer price inflation, but the rate of change of unit labor costs. (Unit labor costs are wage rates adjusted for changes in productivity.) A recent study from the Boston Consulting Group suggests that Chinese unit labor costs will grow at about 8.5 percent per year over the next five years. Meanwhile, U.S. unit labor costs in manufacturing, where the head-to-head competition for jobs lies, have been on a steady downward trend, because productivity growth has been strong and wage increases moderate. The most recent data, which show a tiny upturn, are the first increase in 10 quarters.

Conservatively speaking, then, it appears that over the past couple of years, the real exchange rate of the yuan, deflated by unit labor costs, has been appreciating against the dollar at a rate of something like 15 percent per year. Even if the U.S. unit labor cost trend flattens out, a continued 10 percent rate of appreciation appears likely.

Let’s remember that back in the spring of 2010, when the Chinese were still holding firm to their peg of 6.82 yuan to the dollar, the maximum demand being made by American China-bashers was a 40 percent revaluation. In the fifteen months have elapsed since the peg was abandoned, a third, maybe even half, of the gap has vanished. At the rate things are going, the yuan will reach parity against the dollar, measured by unit labor costs, about two years from now, possibly sooner.

So lets keep it real.

Given all of this, What are we to make of the recent U.S. moves to counter the Chinese manipulation of its currency?

The bottom line? The Senate’s latest assault on Chinese currency manipulation makes no sense at all. Its economic goals will already have been reached long before the tortured procedures it calls for could ever work themselves out. The bill is a blatant play for ephemeral domestic political gain at the risk of unneeded diplomatic conflict. We can only hope that the legislation will die in the House, or if it passes there, that it will be vetoed by the White House, and if so, that any attempted override falls short. Thank goodness for checks and balances.

In other words the politicians make no real sense, again.

A devalued renminbi makes wealthier Americans

A point Don Boudreaux makes in this article at U.S. News & World Report‘s “Debate Club”. We should add that it makes for wealthier New Zealanders as well. Boudreaux writes,

The U.S. government should not respond to China's allegedly undervalued renminbi by raising taxes on Americans who buy imports.

The lower the value of the renminbi the wealthier it makes Americans. Ultimately, the goal of trade is to import goods and services. Exports are a cost; they're the price paid for imports. By keeping the value of its currency low, Beijing enables Americans to stretch our dollars farther. This results in significant improvements in living standards.

University of Chicago economist Christian Broda explains, "In U.S. stores, prices of consumer goods have fallen the most in sectors where Chinese presence has increased the most." Prof. Broda also finds that the benefits of low-priced Chinese goods flow disproportionately to poor Americans, dampening the effects of income disparities. Low-priced consumer goods are good for Americans regardless of why the prices are low.

Boudreaux conitnues by pointing out the effects of a globalised supply chain.

A higher-value renminbi (as opposed to threatened U.S. tariffs) won't necessarily achieve the hoped-for rise in the prices Americans pay for Chinese goods. Supply chains today are global, so many of the components that Chinese manufacturers use are imported into China from elsewhere. If the value of the renminbi rises, Chinese producers' costs of acquiring these components decrease. The resulting fall in Chinese production costs enables producers there to cut prices. Lower prices of Chinese finished products would offset, perhaps significantly, the higher prices Americans would pay even with a higher-valued renminbi.

Basically an "artificially low renminbi" means China is making the rest of the world wealthier at its own expense. Why are we complaining?

$123,000,000,000,000 question

Will China's economy be worth $123 trillion by 2040? The Nobel Prize winning economist Robert Fogel says yes. In the journal Foreign Policy he writes,

In 2040, the Chinese economy will reach $123 trillion, or nearly three times the economic output of the entire globe in 2000. China's per capita income will hit $85,000, more than double the forecast for the European Union, and also much higher than that of India and Japan. In other words, the average Chinese megacity dweller will be living twice as well as the average Frenchman when China goes from a poor country in 2000 to a superrich country in 2040. Although it will not have overtaken the United States in per capita wealth, according to my forecasts, China's share of global GDP -- 40 percent -- will dwarf that of the United States (14 percent) and the European Union (5 percent) 30 years from now. This is what economic hegemony will look like.

A big call, but not one I would argue is necessarily wrong. China has been growing fast and will continues to do so. But there are problems ahead: rising income inequality, potential social unrest, territorial disputes, fuel scarcity, water shortages, environmental pollution, and a still-rickety banking system, for example.

For Fogel there are five main reasons for thinking China can overcome these problems and become a world economic superpower.

The first essential factor that is often overlooked: the enormous investment China is making in education. More educated workers are much more productive workers. (As I have reported elsewhere, U.S. data indicate that college-educated workers are three times as productive, and a high school graduate is 1.8 times as productive, as a worker with less than a ninth-grade education.) In China, high school and college enrollments are rising steeply due to significant state investment. In 1998, then-President Jiang Zemin called for a massive increase in enrollment in higher education. At the time, just 3.4 million students were enrolled in China's colleges and universities. The response was swift: Over the next four years, enrollment in higher education increased 165 percent, and the number of Chinese studying abroad rose 152 percent. Between 2000 and 2004, university enrollment continued to rise steeply, by about 50 percent. I forecast that China will be able to increase its high school enrollment rate to the neighborhood of 100 percent and the college rate to about 50 percent over the next generation, which would by itself add more than 6 percentage points to the country's annual economic growth rate. These targets for higher education are not out of reach. It should be remembered that several Western European countries saw college enrollment rates climb from about 25 to 50 percent in just the last two decades of the 20th century. [...]

The second thing many underestimate when making projections for China's economy is the continued role of the rural sector. When we imagine the future, we tend to picture Shanghai high-rises and Guangdong factories, but changes afoot in the Chinese countryside have made it an underappreciated economic engine. In analyzing economic growth, it is useful to divide an economy into three sectors: agriculture, services, and industry. Over the quarter-century between 1978 and 2003, the growth of labor productivity in China has been high in each of these sectors, averaging about 6 percent annually. The level of output per worker has been much higher in industry and services, and those sectors have received the most analysis and attention. (I estimate that China's rapid urbanization, which shifts workers to industry and services, added 3 percentage points to the annual national growth rate.) However, productivity is increasing even for those who remain in rural areas. In 2009, about 55 percent of China's population, or 700 million people, still lived in the countryside. That large rural sector is responsible for about a third of Chinese economic growth today, and it will not disappear in the next 30 years.

Third, though it's a common refrain that Chinese data are flawed or deliberately inflated in key ways, Chinese statisticians may well be underestimating economic progress. This is especially true in the service sector because small firms often don't report their numbers to the government and officials often fail to adequately account for improvements in the quality of output. In the United States as well as China, official estimates of GDP badly underestimate national growth if they do not take into account improvements in services such as education and health care. (Most great advances in these areas aren't fully counted in GDP because the values of these sectors are measured by inputs instead of by output. An hour of a doctor's time is considered no more valuable today than an hour of a doctor's time was before the age of antibiotics and modern surgery.) Other countries have a similar national accounting problem, but the rapid growth of China's service sector makes the underestimation more pronounced.

Fourth, and most surprising to some, the Chinese political system is likely not what you think. Although outside observers often assume that Beijing is always at the helm, most economic reforms, including the most successful ones, have been locally driven and overseen. And though China most certainly is not an open democracy, there's more criticism and debate in upper echelons of policymaking than many realize. Unchecked mandates can of course lead to disaster, but there's a reason Beijing has avoided any repeats of the Great Leap Forward in recent years. [...]

Finally, people don't give enough credit to China's long-repressed consumerist tendencies. In many ways, China is the most capitalist country in the world right now. In the big Chinese cities, living standards and per capita income are at the level of countries the World Bank would deem "high middle income," already higher, for example, than that of the Czech Republic. In those cities there is already a high standard of living, and even alongside the vaunted Chinese propensity for saving, a clear and growing affinity for acquiring clothes, electronics, fast food, automobiles -- all a glimpse into China's future. Indeed, the government has made the judgment that increasing domestic consumption will be critical to China's economy, and a host of domestic policies now aim to increase Chinese consumers' appetite for acquisitions.