The rise and robustness of economic freedom in china

by
Rod TYERS

University of Western Australia, and

Research School of Economics

Australian National University

January 2012

Discussion Paper 12.02

Abstract

The performance of the Chinese economy since Deng Xiaoping’s and Jiang Zemin’s changes to the core philosophy of the Chinese Communist Party (CCP) is unprecedented for a country so large and could be seen as contrary to Popper’s central idea that liberal democracy is essential to peaceful transitions toward prosperity. It is argued in this chapter that this growth surge is due to the separation of economic from political freedoms and to increased liberalism toward the former. In modern China, however, these freedoms depend on political institutions that are fragile and so its growth cannot be yet regarded as robust. Indeed, interdependent as they are with the general level of development, Chinese economic freedoms are under threat from abroad and from the perceived necessity to depart from “export led” growth to a model driven by expanding consumption and home investment. Political and economic obstacles stand in the way of continued strong growth following this change of policy direction and a failure to deliver could cause a second shift in the core philosophy of the CCP and a future path on which both economic and political freedoms are lessened. While “soft resolutions” are available, they depend on the recognition abroad that global economic performance now depends importantly on continued economic growth in China.

Key words:

China, economic freedom, economic growth, oligopoly, price caps, privatisation

D43, D58, E62, L13, L43

Central to Karl Popper’s (1945) thesis is the idea that liberal democracy is the only form of government allowing institutional evolution that raises welfare without destructive transitions involving violence or bloodshed. The wider East Asian experience might be seen as offering support to this idea, since the emergence of economic prosperity in many Asian economies has been accompanied by the evolution of their political systems toward liberal democracy. The same cannot be said for the totalitarian Asian states, however, of which China is the most significant. In those a distinction is made between economic and political freedoms, with great advances in liberalism toward the former accompanying spectacular economic gains.

This distinction between economic and political freedoms is encouraged by the rhetoric of the modern Chinese Communist Party (CCP) and, indeed, by China’s recent history. While it is not correct to deny any evolution of China’s political system in favour of individual freedoms,¹ the expansion in economic freedoms accorded the Chinese people after 1978 was immense by any measure. The economic policy reforms introduced by Deng Xiaoping’s administration centred on such dicta as "economic development is the centre of party work" and "it always stands to reason to develop the economy faster". He transformed the CCP from one centred on class struggle to a vehicle for economic growth. Seeing the latter as the desired end, his philosophy was pragmatic, as suggested by many of his oft cited quotes, including “It doesn't matter if a cat is black or white, so long as it catches mice” and, in response to criticism that a key consequence was the more rapid enrichment of some than others, “poverty is not socialism; to be rich is glorious” and “let some people get rich first”.²

This transformation of the role of the CCP from an instrument for class struggle into a vehicle for economic growth was cemented into party and national policy by Jiang Zemin, whose theory of the “three represents”, written into China’s state constitution in 2003, sees the CCP as central to the delivery of growth and development. The resulting dispensation of Chinese economic freedoms, including private ownership and production, freedom to trade and move and freedom to borrow and lend have transformed the Chinese economy from a highly populated but isolated poor country in the Maoist era to one of the most important drivers of global economic performance today. Since the CCP take-over in 1949, real per capita income in China has grown ten-fold, with the great majority of that being achieved since the Deng Xiaoping reforms.³ But this has not been merely a gain for China and its people. The rest of the world economy has also benefited from an associated improvement in its terms of trade and cheaper credit that has, in turn, fostered investment and growth (Harris et al. 2011; Robertson and Xu 2010).

Yet these gains, both in China and the rest of the world, are fragile and the Chinese regime that has produced them faces potentially destabilising threats from within and without. For this reason, the “middle income trap” widely touted abroad (World Bank 2010), looms. Within China there are high environmental costs which will require substantial public investment to rectify. There is also increased income inequality, associated with considerable rents in the state-owned sector, which will be politically difficult to unwind (Tyers 2012). This inequality also coincides with ethnic socioeconomic stratification in China’s periphery, which has precipitated increased class, ethnic and regional conflicts. Outside China, threats include the global financial crisis and its aftermath, engendering slower export growth. Equally, if not more important, and of more durable significance, is political xenophobia toward the Chinese in the Western democracies. China’s political system is seen as denying basic human rights by some, its large government and defence forces are seen as a strategic threat by others and still others see its economic policies as antithetical to Western interests.⁴ Such voices ignore the immense benefits enjoyed by the average Chinese on the one hand and by the West on the other. For the West these benefits include the substantial lowering of the cost of manufactured consumption and intermediate goods and the reduced cost of credit, both of which tend increasingly to be taken for granted.⁵

This chapter examines the role of economic freedoms in China in the creation and dissemination of these global benefits and the robustness of the system that delivers them. The next section discusses the economic freedoms themselves and the institutions on which they rely. Section 3 offers a short history of the evolution of economic policy in China and its reliance to date on export led growth, while Section 4 discusses the challenges to continued export led growth and the case for a change in China’s growth strategy. The associated risks to continued economic freedom in China are discussed in Section 5. Finally, Section 6 suggests some possible “soft landings” via which economic freedoms and their associated benefits might be sustained.

The key economic freedoms offer only a component of the broad principles of “liberty” defined by Mill (1848, 1959) but it is one closer to Mill’s (1907) subsequent reconsideration. Clearly it is a component that the Chinese have shown has the power to unleash great improvements in private economic welfare. It includes 1) the ownership of the fruits of production, 2) control over the disposition of their labour by individual workers, 3) ownership of physical capital, 4) freedom to trade products and to supply or rent factors of production (own labour and physical capital), which implies private choice of job or place of work, 5) freedom to borrow and lend, and hence to accumulate private wealth. These freedoms are not simply dispensed by the enactment of laws, however. They require active maintenance by the state and this necessitates that resources be committed to the defence of assigned property rights, implying secure national borders and reliable domestic policing. But even this is not sufficient. Property rights are of little purpose unless they, or products that stem from them, can be freely traded. This requires that the state also enforce 1) commercial laws that support contract, corporate governance, patent rights and competition rules, 2) product and service standards that maintain quality and thereby reduce risks associated with trading. In addition, no product, service or primary factor markets can function without a maintained infrastructure. Telecommunications ensure that product and trading information can be exchanged and that products, financial assets and factors of production can be transported. Finally, since the exploitation of private property rights is privately risky, it is facilitated by bankruptcy laws that protect individual investors and a social safety net that ensures access to survival income and health services when ventures fail.⁶

Of course, the source of all these essentials to the underwriting of economic freedoms is economic development. All of them are weakened by widespread poverty. Critically, economic development requires a securely integrated state supporting integrated markets for its goods and services. There is little doubt that tribalism, and divided polities in general, including the extreme of civil wars, lead to poor and ineffective governance, and in particular poor economic policy. These lead to politically destabilising policy bias and therefore interference in economic freedoms, and to non-facilitating corruption, thus preventing or retarding development (North 1990 and Haber et al. 2008). More than this, however, is the more basic idea of Locke (1821), that a successfully liberal society requires that citizens share fundamental beliefs and philosophy. This, in turn, requires shared commitments to common public goods, such as the handshake as implicit contract, courtesy in transport and public places and, in general, the widespread acceptance of and commitment to the “do unto others” rule.⁷

3. China Looking Back

The last successful China-wide regime was in the 18 Century, during the heyday of the Qing Dynasty. For the time, China’s product and service markets were integrated and the state conferred considerable economic freedoms (Gelber 2007). During the 19^thth century, however, this integration diminished under colonial influence, with regional warlords buttressed by concessions to different colonial powers. This segmentation continued until WW II notwithstanding the formation of the Republic of China in 1912 with Sun Yatsen as its first president. Following WW II a civil war ensued that was won by the communist forces led by Mao Zedong in 1949. Thus commenced 27 years of totalitarian rule under a regime motivated by “Marxist Lenninist Mao Zedong thought”, implying a political regime oriented to class struggle and favouring the China’s numerically dominant rural peasantry, as distinct from Marx’s industrial proletariat.

The focus of Mao’s CCP was continuing revolution and class struggle. All production, including farming, was collectivised and no private ownership of the means of production was permitted. This, and the security paranoia common to such totalitarian states, suppressed entrepreneurial initiative. Frequent purges were seen as necessary to the maintenance of the power hierarchy and the ideological focus but these were economically disruptive, causing loss of experienced managerial leadership at all levels. A lack of free debate over economic policy made possible the national implementation of a number of ultimately destructive ideas, including the disastrous “great leap forward” – a failed attempt at rural-centred industrialisation. The subsequent “cultural revolution” saw a frenzied nation-wide purging of Chinese society’s intellectuals and professionals, again weakening human capital growth and economic management, further setting back China’s overall economic growth.

China’s economy did grow during this period, however, though the extent of this growth is difficult to measure and controversial (Robertson 2011). The mechanisms were two-fold. First, Mao’s preoccupation with the power of the state, and hence its precedence over individual welfare, led to his view that population expansion should be encouraged. Of course, while this expanded China’s real GDP, it slowed real per capita income growth (Golley and Tyers 2011). Second, China’s totalitarian state, like that of the Soviet Union, was able to save and accumulate physical capital collectively, though it did this with less success than in the Soviet case in the same period.

Deng Xiaoping, Jiang Zemin and the rise of economic freedom

Following the death of Mao there was a weak political transition, while purges took place of the “gang of four” which had dominated policy during his final years. By 1978, the new regime of the pragmatist Deng Xiaoping had emerged. He was a survivor of the “Long March”, a victim of the “cultural revolution” and a prisoner of the “gang of four” but nonetheless irrepressible (Vogel 2011). He saw the inefficiencies of state capitalism constraining collective progress and he decided that development and growth should be the primary mission of the CCP. To this end he sought to harness individual initiative and opportunity. This led, for example, to the rural “responsibility system” that transformed Chinese agriculture by returning some economic freedoms to individual farmers and to the establishment of “special economic zones” that boosted private manufacturing investment and employment. In association, there was a general opening of domestic merchandise markets to private enterprise, foreign investment and international trade.

At the same time, Deng rejected Mao’s view that population growth was beneficial and so the encouragement of large families was ended, to be replaced by the draconian “one child policy”. While this denied one fundamental freedom (the choice of one’s family size) it greatly slowed China’s population growth and contributed to the resurgence of growth in real per capita income. The mechanisms were twofold. First and most important was the raising of the capital to labour ratio and hence labour productivity. Second, and much discussed, was the subsequent decline in the number of dependent young people and hence the rise in China’s labour force relative to its dependent population – referred to as the “demographic dividend” (Bloom and Williamson 1998, Golley and Tyers 2011).

Deng Xiaoping was followed as Chinese leader by Jiang Zemin, a pragmatist of similar philosophy. His theory of the “three represents” sees the CCP as "a faithful representative of the requirements in the development of advanced productive forces in China, the orientation of the advanced culture in China, and the fundamental interests of the broadest masses of the people in China."⁸ The "Represents" were adopted at the 16th Party Congress in November 2002 and written into the Party Constitution. In March 2003, the National People's Congress decided to have them included in the State Constitution. With this, the transformation of China’s political approach to economic policy, from one stressing inequality and the power of the peasantry to one fostering overall growth, was complete.

Of particular importance at the outset was the responsibility system in Chinese agriculture, at the time the dominant sector of its economy. It gave farmers ownership of their product and the right to sell at the best attainable prices. To achieve this it was necessary to legalise private markets for agricultural produce. Farmers were required to yield to the state a proportion of their output at state prices but were then permitted to sell any remainder on the private markets. The result was a very considerable increase in output and overall productivity which was the more important for the overall economy because of the comparative size of its agricultural sector. Then, from 1979 emerged the “special economic zones”, constructed around China’s most crowded Southern cities. This began the accommodation of surplus urban and, most importantly, rural labour in foreign invested private and semi-private manufacturing. A further boost to productivity resulted and the zones were so successful that the policies that made them special were eventually broadened to the coastal provinces and thence to the country as a whole.

In 1994, China’s exchange rate was unified and the policy of maintaining a fixed de facto US dollar peg initiated. This greatly reduced financial uncertainty and fostered foreign investment, commencing China’s modern growth surge. At the same time Chinese law was being reformed, among other things to protect property rights over physical and financial capital, and a new tax system was implemented that included by income and consumption taxation. Soon after, stock markets were opened in Shanghai and Shenzen, broadening the array of options available to China’s ardent savers, albeit initially with heavily regulated share ownership as between domestic and foreign residents and tight restrictions on the issue of equity by state owned corporations.

Most important in China’s recent past was its accession to membership of the World Trade Organisation (WTO), which was concluded in 2001. The Chinese state thereby conceded some sovereignty over trade and related policies, further boosting investor confidence and thereby raising China’s overall, and foreign direct, investment. This ushered in a period of truly extraordinary economic growth with annual real expansions in GDP exceeding 10 per cent for several years. This acceleration in China’s growth since the 1990s is clear from Figure 1. A complicating factor during this period, however, was a substantial rise in China’s current account surplus, to about a tenth of its GDP.⁹ This is explained by the fact that China’s total domestic saving exceeds its investment by this proportion, and this is due to several factors that act in concert.

First, China’s very large saving rate sees more than half of its GDP set aside each year. This is not merely because rapid recent expansions leave households seeing their “permanent incomes” as well surpassed, remembering poorer times and fearing a return to them once the boom passes. It is also because the state owned enterprises, which were unprofitable in the 1990s, have since become very profitable and that their earnings are not repatriated to the public but rather passed directly to financial markets as investment. Second, an almost as extraordinary 45 per cent of GDP is invested and it is unlikely that many high returning projects remain to justify an increase in this proportion. Public investment has increased since the global financial crisis but this is not a sustainable solution to the problem which, ultimately, requires further industrial reforms (Azziz and Cui 2007; Tyers and Lu 2008; Kuijs 2006, 2007).¹⁰

Recent events

Since the 1990s the rise in China’s current account surplus has raised bilateral imbalances as political issues in the US and Europe. As firms based in those countries have relocated their labour intensive manufacturing to China, their levels of manufacturing employment have declined. Even though the resulting trade has benefited both regions, it has raised structural unemployment, at least temporarily. Since the Chinese don’t vote in European or US elections, they are ready political scapegoats. Much of the blame has centred on China’s exchange rate policy, whereby it is suggested that China is artificially cheapening its products so as to raise exports and reduce imports. This confuses the true origin of China’s current account surplus, which it is shown above depends on its saving relative to its investment. In the end, the issue is China’s high saving rate, but even this serves to cheapen credit in the rest of the world and, more directly, to pay for US national debt. In any case, pressure from abroad for China to appreciate heightened in the 2000s and has remained strong since.

In 2005 some flexibility was introduced into the nominal exchange rate regime. This aided a real appreciation upwards of 30% to 2008, though the underlying force behind this appears to have been increasing Chinese labour costs (Tyers and Zhang 2010, Jacob 2011). Although this flexibility was suspended in 2008, the appreciating trend has continued since. The global financial crisis of 2008 buffeted the Chinese economy, on which the main effect was to reduce demand for its exports by almost a third. For two years China was faced with a structural unemployment problem of its own, which was solved by the return of some workers to agriculture and the diversion of government spending to additional public infrastructure projects. More recently, under pressure from Europe, the US and international institutions, the Chinese government has decided to “look inward for growth” and so rely less on exports. This policy stance has become a new CCP orthodoxy (Jia and Liu 2009, Yi 2011).

4. The Challenge to Export Led Growth

Economic development is primarily about raising the proportion of the population in the “middle class”. For countries that start poor and primarily rural, 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, that then attracts capital that is supplied from domestic saving and foreign direct investment (FDI).¹¹ Some of the migration to urban areas goes into construction and other services, which expand, but the transition to very high real per capita income is part of a second stage that then requires further education and training suited to the growth of sophisticated services.

This development strategy requires relatively free trade since the growth in the local supply of light manufactures that occurs in the early stage is more than can meet local demand. Such developing countries realise their comparative advantage in light manufacturing and so transform their home labour forces by exporting. As it turns out, this transformation of developing countries is also beneficial to those that are already industrialised. 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, Asian development has also offered high saving households and firms which have offered excess saving to the global economy. This has financed investment and government expenditures in the industrialised economies in ways that have enhanced their growth.¹²

This convenient and successful pattern of expanded interdependence has been the 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 graduate to industrialised status and therefore cease to depend on labour intensive exports 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 an acceleration in the rate of rise in real wages – the “turning point” of Lewis (1955). The proximity of this transition in the Chinese case is the subject of ardent debate (Garnaut 2010; Golley and Meng 2011), though it is probably still some way off. It is nonetheless true that demographic changes associated with China’s one child policy will accelerate it, and labour costs have indeed grown more sharply in recent years (Tyers and Zhang 2011). The transition to slower growth can be abrupt and destructive, as in the case of Japan (Tyers 2011), and so the Chinese might be wise to plan their transition early.

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.¹³ Third, and more likely to be of significant influence, is political pressure from destination regions against China’s current account surplus and its effects on manufacturing employment abroad. Associated 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; Bergsten et al. 2008; Lardy 2006; Krugman 2010). That this unemployment has more to do with domestic policy misjudgements, plays poorly in the West.

The Western backlash is essentially mercantilist and much of it, including Krugman’s many published comments, is directed at China’s exchange rate policy. 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 it 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; Obstfeld 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 be missed (Tyers and Zhang 2011). Thus, the combination of high level browbeating on macroeconomic policy and threats of retaliation must surely have had an impact on Chinese policy choice.

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.¹⁴ 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.