LOOKING INWARD FOR GROWTH
University of Western Australia
DISCUSSION PAPER 12.04
Looking Inward for Growth*
University of Western Australia and
Centre for Applied Macroeconomic Analysis (CAMA)
Research School of Economics
Australian National University
DISCUSSION PAPER 12.04
China, growth, fiscal policy, oligopoly, price caps, privatisation
D43, D58, E62, L13, L43
Export led growth has been very effective in transforming China’s economy and establishing a large high-saving middle class. Notwithstanding political opposition from trading partners, this growth strategy has also offered the rest of the world an improved terms of trade and cheaper finance. Yet it is believed by China’s government that this convenient strategy has run its course and the transition has begun to a model that “looks inward” for growth, to be driven by expanding consumption and home investment. This paper uses a numerical model of the Chinese economy with oligopoly behaviour to examine the available “inward” sources of transformative growth along with the policies needed to exploit them. Success will require the redistribution of the considerable rents now accruing to connections of key state owned enterprises, suggesting the potential for political resistance and the yet-avoidable possibility that China could fall into a “middle income trap”.
* Funding for the research described in this paper is from Australian Research Council Discovery Grant No. DP0557885. It was conducted in part during visits to the China Center for Economic Research (CCER) at Peking University. Special thanks are due to Feng LU and Ling HUANG at Peking University for many constructive conversations on the topic and to Peter Dixon, Yew-Kwang NG, James Giesecke, Yuanfang LI, Miaojie YU, Yongxiang BU and to other participants at lively CCER and CoPS seminars. Research assistance was provided by Pingkun HSU at the ANU, Liu LIU at the CCER and at the UWA Business School by Ying ZHANG and Tsun Se CHEONG.Looking Inward for Growth
There is wide agreement outside China, and more recent concurrence inside, that China’s growth will, and should, be increasingly underpinned by rising home consumption rather than exports.1 The foreign viewpoint is notwithstanding the considerable contributions of China’s export-led growth to improvements in the foreign terms of trade and to cheaper financing of investment and government spending. The dominant political force behind this view seems to be concern over declining overall economic performance, at least compared with China, comparatively high unemployment and the very visible nature of manufacturing “offshoring”.2
Yet the global gains conferred by China’s growth are fragile and the Chinese regime that has produced them faces potentially destabilising threats from within and without. For this reason there looms the “middle income trap” widely ascribed to other developing regions (World Bank 2010). The poor performance of trading partner economies clearly weighs on China’s government, as does foreign political hostility to continued export led growth. Internally, there has been a tightening of labour markets, foreshadowing a Lewis “turning point” that would mark a natural end to export led growth.3 In addition, there are reasons why increased public investment and the fostering of increased private consumption are of considerable political value at present. The high environmental costs of China’s manufacturing expansion have yet to be fully covered and there is increased income inequality, associated with rents in the state-owned sector that will be politically difficult to unwind (Tyers and Lu 2008, Riedel 2011). This inequality coincides with socioeconomic stratification in China’s periphery, which has precipitated increased class, ethnic and regional conflicts.
Middle income “slowdowns” in developing countries that have heretofore grown strongly out of poverty are the subject of expanding interest (Easterly 2001; Eichengreen et al. 2011). The focus is the distinction between “natural” slowdown in the convergence process as poorer countries approach full industrialisation, which is due to diminishing returns to physical and human capital and diminished “catch-up” investment incentives (Lucas 2009), and premature stagnation due to powerful vested interests that oppose economic the policy reforms needed for the final catch-up phase (Haber et al. 2008; Riedel 2011). The sense in which the slowdown is considered a “trap” derives from a divergence of collective interests from those of the leadership group, with the latter associated with rent extraction (corruption) that peaks at middle levels of real per capita income.
So where are the rents and the vested interests that could retard China’s future growth and does “turning inward” exacerbate the risk of an associate slowdown? The financial sector is one location. Very high saving challenges this sector to allocate efficiently across investment opportunities. The many weaknesses in this process, stemming in part from the protection of state owned financial institutions, have already received considerable attention (Riedel 2007; Walter and Howie 2011). Yet the potential gains from further industrial reform that reduces rents in protected corners of the economy extend well beyond the financial sector to include comparatively protected and state-owned heavy manufacturing and services. Industrial reforms have penetrated these sectors less because of their political sensitivity. If such reforms are required for inward focussed growth then there will be political difficulty achieving it. Yet such reforms offer an effective replacement of export led growth that is also transformative of China’s economic structure and its labour force.
Alternative approaches to inward-focussed growth are explored in this paper, including increased government spending, further pure privatisation, the fragmentation of state-owned enterprises, price cap regulation and foreign direct investment in heavy manufacturing and services. Their economic implications are assessed using a mathematical model of the Chinese economy that captures the behaviour of oligopoly state-owned oligopolies and the impacts of further industrial reform. The greatest potential for inwardly-generated growth is shown to rest, as expected, with further industrial reform in heavy manufacturing and services. The simulation results suggest the best prospects for further growth are to attack rents with tighter price cap regulation and to advance services productivity through FDI. The first of these will be resisted by those currently enjoying the rents and the second presses against the desire on the part of China’s government to protect services from foreign ownership.
The next section reviews the relative merits of export led growth, develops the reasoning behind the choice to turn inward in China’s case and discusses the sources of internally generated transformative growth. In Section 3, the particular structure of China’s economy is reviewed along with the associated sensitivity of its overall performance to its real exchange rate. Section 4 offers a description of the model used and the construction of its database. Section 5 compares inward-sourced growth scenarios and Section 6 concludes.
2. The Turn Away from Export Led Growth
Economic development is primarily about shifting the population from low labour productivity farming to urban employment where the availability of physical capital ensures higher income and more efficient access to essential services. This requires rural-urban migration and, at least initially, basic (mainly primary) education and training. These conditions supply a workforce suitable for light manufacturing. If the protection of property rights and the export infrastructure facilities are sufficient, the availability of adequately trained workers then attracts capital that is supplied from both domestic saving and foreign direct investment (FDI). In the “East Asian model”, much of the migration from rural areas goes into manufacturing, though some goes to construction and other services, which also expand.4 In a final phase, the transition from middle level to very high real per capita income requires further education and training suited to the growth of sophisticated services.
The merits of export led growth
The growth in the local supply of light manufactures that occurs in the early stage in the East Asian model is more than can meet local demand. Comparative advantage in light manufacturing is realised via openness to trade and so the home labour force is transformed by exporting. As it turns out, this transformation is also beneficial to already-industrialised trading partners. This is because the resulting change in the international terms of trade is positive for them – light manufactured imports are cheaper and skill-intensive durable (consumer and capital) goods, which they export, are in higher demand. Moreover, since the opening of such developing economies in this way supplies additional low-skill labour to the integrated global economy, FDI opportunities are abundant and savers in industrialised countries earn higher returns. Idiosyncratically, the East Asian model has also offered high saving households and firms which have supplied excess saving to the global economy. This has financed investment and government expenditures in the industrialised economies in ways that have enhanced their growth.5
The choice to look inward
Variations on the East Asian model have been the dominant basis for catch-up by poorer countries and regions for more than a century (Dooley et al. 2004). Then why should the Chinese choose to “look inward” now? The reasons are manyfold. First, it is inevitable that China will cease to depend on labour intensive exports and move its production up the chain of sophistication in the manner of Japan, the Republic of Korea and its regions in Taiwan and Hong Kong before it. This generally coincides with a slowdown in the rate of rural to urban migration and some acceleration in the rate of rise in real wages – the “turning point” of Lewis (1955). The ardent debate over the proximity of this turning point notwithstanding, the most carefully considered evidence suggests it may still be some way off (Cai 2010; Golley and Meng 2011). It is nonetheless true that demographic changes associated with China’s one child policy have accelerated it, and labour costs have indeed grown more sharply in recent years. Even though this pattern of labour force tightening is smooth, the associated transition to slower growth can be abrupt and destructive, as in the case of Japan in the late 1980s,6 and so it is possible the Chinese government seeks to ensure a smooth transition.
A second important reason is that growth has slowed in the regions to which China’s exports are directed. This raises the prospect that the terms of trade might shift more rapidly against it if exports continue to be pushed out at the current rate and so a smaller proportion of the benefits from export led growth would accrue to China.7 Third is political pressure from destination regions against China’s current account surpluses of the past decade, the perceived unfairness of Chinese policy and the loss of trading partner employment in manufacturing. Political attacks on Chinese exports, and anti-Chinese xenophobia in general, are the more likely when the movement of vast numbers of Chinese workers into the modern sector is perceived as being associated with the unemployment of a tenth of workers in Western Europe and the US. This association has high level backing in policy debates, particularly in the US (Bernanke 2006; Krugman 2010).
The Western backlash is essentially mercantilist and much of it is directed at China’s exchange rate. The perception in the US that countries like China use “exchange rate protection”, stems from the role of the US dollar as the reserve currency and the difficulty the US faces when a lack of competitiveness would justify a depreciation against others. In the 1980s, this ire had been directed against Japan, leading to the Plaza Accord and a large and destructive appreciation of the Yen (Goval and McKinnon 2003; Hamada and Okada 2009), and ultimately to the US Exchange Rates and International Economic Policy Coordination Act of 1988, which formalised the US “defence” against currency manipulators. Poverty, and its associated low wages, are seen in US policy debates as an unfair trade advantage rather than a problem that is solved by expanded trade. The fact that the underlying real exchange rate of China against the US has appreciated substantially since 2004 and continues to appreciate seems to have been missed in the American literature (Tyers and Zhang 2011).
Finally, China is constantly criticised for its lack of political rights and for its treatment of unhappy minorities such as the Tibetans and the Hui zu. This criticism is sometimes justified but often it stems from fear of China as a potential strategic opponent and a sense that the advocacy of additional political and religious rights might weaken it in such a competition. These external criticisms of the Chinese state and its policies, while occasionally well intentioned, are too often xenophobic and made in ignorance or disregard of the considerable benefits of Chinese growth for the West. Within China, however, inequality has become a major political issue and the “turn inward”, via expanded public investment, has also been justified as a means of redirecting the fruits of growth to lagging regions and to the rural sector in general (Wen 2011).
Inward sources of growth
Given the apparent success of China’s surge in public investment during the global recession in 2008-9 the government is surely tempted to think of expanded government activity as an inward source of future growth. And it is common for governments of developing countries to undersupply public goods that are foundations for growth. In China’s case these include the facilities and regulatory institutions to support basic and higher education, transport and telecommunications infrastructure, retirement insurance, health insurance and environmental protection. Compared with other developing countries, China is in the fortunate situation of having implemented a sensible tax law in 1994 that is accessing an increasing share of all its economic activity. This means that central government tax revenue is rising faster than GDP and it was this that allowed the substantial increase in public investment in 2009 without a large increase in the fiscal deficit (Jia and Liu 2009). So a rise in government activity will clearly continue to contribute to China’s GDP. It is unclear, however, to what extent if any this expanded government activity will foster sustainable productivity growth.
An important and yet untapped source of further growth is in the extension of industrial reforms to heavy manufacturing and services. State owned firms in these sectors have been relatively protected and significant foreign ownership shares have been prevented. One consequence of this is that these firms, supplying as they do essential materials and services to an economy that is expanding rapidly, courtesy of the more competitive light manufacturing export sector, have been extremely profitable (Lu et al. 2008). At the same time these firms have returned little in the way of dividends to the central government and so their profits have not been distributed to their public owners. Instead, these profits have been reinvested. Consequently, the decision to save or consume from this component of national income has been denied households, contributing substantially to China’s extraordinary saving, amounting to more than half its GDP.8
Substantial potential future growth lies in the redistribution of these rents, which would make Chinese intermediate products cheaper and foster overall output growth while at the same time raise private consumption. A number of approaches are possible, some of which are already being tried.
Pure privatisation: this would return the profits of SOEs to private households and foster consumption, raising domestic demand for China’s goods and services,
SOE fragmentation: this would force more competition between firms and thus reduce mark-ups, and
Tighter regulation of SOE pricing: this could, at least in theory, force firms to price at their average costs, eliminating rents altogether and reducing the price level.
These alternatives are examined in the analysis to be discussed in subsequent sections.
3. China’s Structure, Performance and its Real Exchange Rate
The implications of a turn inward ride rather importantly on consequent changes in China’s underlying real exchange rate, or its level of global competitiveness. This special sensitivity stems from its economic structure, as summarised in Table 1. Four patterns stand out:
the great majority of non-agricultural employment is in the export-oriented light manufacturing sector – indeed, employment in this sector exceeds that in agriculture,
the light manufacturing sector dominates China’s exports,
2) this sector is relatively competitive – price mark-ups are low and so pure or economic profits make up only a small share of total revenue, and
3) the SOE-dominated energy, metals and services sectors are less labour-intensive and at the same time they are oligopolistic, generating substantial rents.
Since exporting firms are highly competitive, generate little pure profit and carry most of the new or “modern sector” employment, future employment performance is very sensitive to the relativities between home wages and export prices, and hence to China’s real exchange rate.
Yet the inward-looking policy changes that could contribute most to enlarging China’s economy all have implications for the real exchange rate. Consider, first, the case of government expansion. There are several mechanisms by which expanded government expenditure tends to appreciate the real exchange rate.
The Mundell-Fleming effect
Increased government borrowing raises home yields and induces financial inflow (Fleming 1962, Mundell 1963). The net effect is to raise demand for home relative to (more elastically supplied) foreign products and services and hence to appreciate the real exchange rate.
The non-traded good demand effect
This recognises that governments concentrate their spending on non-traded services and so their expansion changes the composition of aggregate demand toward more inelastically supplied home products, driving up their relative price and hence the real exchange rate.9
The oligopoly rent effect
Increased government spending raises home demand for home products, reducing the exported share of the average firm’s output. Because foreign demand is the most elastic, this reduces the elasticity of demand faced by oligopoly firms, which then raise their mark-ups. And since these firms reside mainly in the protected heavy manufacturing and largely non-traded services sectors, such price rises appreciate the real exchange rate by raising the relative prices of non-traded services and by increasing costs faced by the competitive export sector (Tyers and Lu 2008). A way of thinking of this is that the excess profits are achieved by supplying less output and so the oligopoly firms reduce productivity in the largely non-traded sectors of the economy.
In assessing fiscal expansions, the negative effect on the real exchange rate is commonly seen as being more than offset by the resulting expansion in aggregate demand. A key mechanism for this is that the increase in government dissaving reduces the national saving rate, at least temporarily, requiring the failure of Ricardian equivalence. Because reduced national saving contracts the leakage of expenditure abroad, which in China takes the form of foreign reserve accumulation, the current account surplus is reduced and more Chinese expenditure falls on the home relative to the foreign economy. This has the effect of either inducing a home inflation or arresting a deflation. If the latter, it stabilises the relationship between nominal wages and the price level and hence maintains the steady state level of employment. Just such a short run approach to government spending in China is taken by Tyers and Huang (2009). In this study the focus is on transformative sources of growth that operate in the long run and so the expansion of government to be considered here is long run in orientation and therefore tax financed.
Returning to the oligopoly pricing effect on the real exchange rate, the alternative of further industrial reform is also considered here. To the extent that this reduces oligopoly mark-ups it will tend to depreciate the real exchange rate and thereby preserve the competitiveness of China’s export manufacturing sector. The further alternative of FDI in Chinese services offers increased services productivity. This also would depreciate the real exchange rate by reducing the relative price of non-traded products. To quantify the effects of these on China’s overall economic performance, a complete model of the Chinese economy is offered.
4. An Oligopoly Model of the Chinese Economy
To capture the behaviour of the oligopolistic SOEs, a comparative static macroeconomic model of the Chinese economy is used that embodies a multi-industry structure in which all industries are treated as oligopolies, with firms in each industry supplying differentiated products and interacting on prices.10 The model is described in detail by Tyers (2012b) and in appendices to Tyers and Lu (2008). A short summary of the relevant elements is offered here.
The model has neoclassical foundations with final consumption, intermediate demand and the demands created by a capital goods sector treated as in most economy-wide models, with nested CES preferences.11 Government expenditure is an exogenous policy variable but it is subdivided across goods and services also via nested CES systems and government revenue stems from a tax system that includes both direct (income) taxes levied separately on labour and capital income and indirect taxes including those on consumption, imports and exports.12 The level of total investment placing demands on the capital goods sector has Q-like behaviour, being influenced positively by home rates of return on installed capital and negatively by a financing rate obtainable from an open “bond market” in which home and foreign bonds are differentiated to represent China’s capital controls. Savings are sourced from the collective household at a constant rate and from corporations at industry-specific rates on the assumption that corporate saving (retained earnings) in SOEs depends on the magnitudes of pure (economic) profits earned. Foreign direct investment and official foreign reserve accumulation are both represented, to complete China’s external financial accounts.13
The departure from convention arises with the way production is specified to account explicitly for oligopoly. Firms in each industry supply differentiated products. They carry product-variety-specific fixed costs and interact on prices. Cobb-Douglas production technology drives variable costs so that average variable costs are constant if factor and intermediate product prices do not change but average total cost declines with output.14 Firms charge a mark-up over average variable cost which they choose strategically. Their capacity to push their price beyond their average variable costs without being undercut by existing competitors then determines the level of any pure profits and, in the long run, the potential for entry by new firms.
Thus, each firm in industry i is regarded as producing a unique variety of its product and it faces a downward-sloping demand curve with elasticity εi (< 0). The optimal mark-up is then:
where is the firm’s product price, is its average variable cost and is the elasticity of demand it faces. Firms choose their optimal price by taking account of the price-setting behaviour of other firms. A conjectural variations parameter in industry i is then defined as the influence of any individual firm k, on the price of firm j. For this parameter the non-collusive (Nash) oligopoly implies a zero value, while for a perfect cartel, it has the value unity. Although level of price collusion between firms is not readily estimated, it is calibrated for each industry in China from prior knowledge of mark-ups and elasticities of demand.
Critical to model’s behaviour is that the product of each industry has exposure to five different sources of demand. The elasticity of demand faced by firms in industry i, εi, is therefore dependent on the elasticities of demand in these five markets, as well as the shares of the home product in each. They are final demand (F), investment demand (V), intermediate demand (I), export demand (X) and government demand (G). For industry i, the elasticity that applies to (19), above, is a composite of the elasticities of all five sources of demand.15
where denotes the volume share of the home product in market i for each source of demand j. These share parameters are fully endogenous in the model.
Thus, the strategic behaviour of firms, and hence the economic cost of oligopolies, is affected by collusive behaviour on the one hand and the composition of the source of demands faced by firms on the other, both of which act through the average elasticity of varietal demand. Thus, when economic shocks change the composition of demand, they also change the average elasticity of demand faced by firms. When this falls, oligopoly firms raise their mark-ups and extract increased rents. Of course, rent extraction depends on costs, and importantly on fixed costs. If there is entry into an industry fixed costs rise with the number of firms, raising average total costs and hence the mark-up required to break even.
The scope of the model is detailed in Table 2. The economy modelled is “almost small”, implying that it has no power to influence border prices of its imports but its exports are differentiated from competing products abroad and hence face finite-elastic demand. The consumer price index is constructed as a composite Cobb-Douglas-CES index of post-consumption-tax home product and post-tariff import prices, derived from the aggregate household’s expenditure function. This formulation of the CPI aids in the analysis of welfare impacts. Because collective utility is also defined as a Cobb-Douglas combination of the volumes of consumption by generic product, proportional changes in overall economic welfare correspond with those in real GNP.
The quantity of domestically-owned physical capital is fixed both in the short and long runs, so that changes in the total capital stock affect the foreign ownership share and hence the level of income repatriated abroad. In the experiments to be presented a long run closure is used throughout.16 Physical capital is homogeneous and fully mobile between industries, though claims on home and foreign capital are differentiated and so there is a wedge between the home and domestic bond yields (interest rates) that stems the differentiation of these financial assets (due, say, to the retention of inward and outward capital controls) combined with endogenous reserve management policy. All real unit factor rewards are flexible and domestic factor supplies are fixed. A fixed oligopoly structure is retained, assuming SOEs are protected from competitive entry and are prevented from exiting if losses are incurred. Consistent with China’s heretofore fiscal conservatism, the base fiscal deficit is held constant with exogenous expenditure changes covered by endogenous changes in tax rates.