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Another Look at China’s 12th 5-Year Plan

China - Hong Kong Nexus Again

Prof Y C Richard Wong

The University of Hong Kong

17 October 2011

Fulbright Visiting Scholar 2011 Presentation

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The Distribution of World GDP 1978 & 2009

1978 2009

Source : UNSD Statistical Databases

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Super Growth Forecasts

• Citi Investment: (assumed 5% per capita growth rate in a growth convergence model) China in 2040 dominant economy $58 trillion (PPP) ; US $31 trillion (PPP) in 2040. By 2050 India dominant economy.

• Subramanian (FA): (assumed growth rate 7%) China in 2030 dominant economy with 20% world’s GDP; 15% for US; per capita GDP at $33,000 will be half of US.

• Robert Fogel: China will produce $123 trillion GDP by 2040 assuming an average annual growth rate of about 10.8 percent a year for more than 30 years

• Fogel: "Beijing has proven quite adept in tackling problems it has set out to address."

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Danny Quah’s Economic Centre of Gravity, 1980-2007 (in black) and Extrapolated to 2050 (in red)

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China Opens and Reforms

• Sustained opening and reform for 30 years• High growth and high frequency fluctuations• China’s 12th 5-Year Plan• Role of pre-conditions• Logic and criticisms of the Chinese approach• De-collectivization and de-centralization

– Fiscal role of provincial and local governments• Reforms incomplete and need for rebalancing• Will high growth continue for another 30 years? • Hong Kong’s role?

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Fast Growth High Freq-Amp Fluctuations

• Average Real GDP growth rate was 10.8%• 4 big economic cycles (peak-peak in 8 years)• Is there a unified explanation for 30 years of fast growth

and high frequency-high amplitude fluctuations

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China – GDP by Industry

Source : CEIC

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Highlights of China’s 12th 5-Year Plan

• China wants to sustain 7% growth by stimulating domestic demand

• Urbanization rate to rise 4% to reach 51.5%, create 45 million jobs in urban areas

• Price stability, 5% unemployment rate• Promote private consumption• Minimum wage to rise by 13% p.a. • Pensions schemes to cover all rural residents and 357

million urban residents• Construct 36 million low-income homes• Service sector to account for 47% of GDP up 4%

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• Coastal regions to turn from “world’s factory” to hubs of R&D, high-end manufacturing and service sector

• Foreign investment welcomed in modern agriculture, high-tech and environment protection industries

• Breakthrough in emerging strategic industries. Value-added output to account for 8% of GDP

• R&D expenditure to account for 2.2 %of GDP• 3.3 patents per 10,000 persons

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Favorable Revolutionary Pre-Conditions

• Landlord class destroyed (Olson institutional sclerosis hypothesis)

• Leninist party and state apparatus survived (Huntington political institutionalization hypothesis)– Rebuilding the party and state through rehabilitation of old

cadres• Successes in East Asia and the role of Hong Kong

– Ideas on benefits of markets, openness and globalization– Spearhead economic opening – Built institutional infrastructure for trade and investment– An offshore international financial center– Re-build civil society

• Mao’s Cultural Revolution had severely weakened the bureaucracy and becomes a plus factor

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Policy Choices

• Social and economic damage and turmoil of the Great Leap Forward and Cultural Revolution presented some obvious policy choices at the beginning– Facts not ideology gained ascendancy– Reversing egalitarianism Deng: “Let some get rich first”– Huge gains to be reaped from investing in obviously neglected

sectors, i.e., economic distortions from the past era– De-collectivization and De-centralization left open some room for

markets to rapidly develop

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Assumed “Logic” of the Chinese Model

• A gradualist step by step ad hoc approach more or less controlled from the top, but no blue print

• Experimentation to reduce political risk• False starts and backtracking• Followed path of least resistance• Consolidation of achievements and articulation of

goals for the next stage as a pragmatic strategy to keep reform alive

• Some called it “crossing the river by feeling the pebbles in the water.”

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Critics of Gradualist Transformation

• Process may be stalled as opponents have time to stiffen their resistance

• Gradualist meant inevitably partial reforms and inconsistencies that become future obstacles to reform or even chaos and paralysis

• (Merton Miller: changing from driving of the left hand side of the road to the right hand side; neighborhood by neighborhood)

• How can transition be made without convulsive threats to the authority of the state

• Momentum would be lost and rampant growth of corruption

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Logic of Stalinist Planning

• Stalinist strategy was a heavy industry first strategy• Work against a poor country’s comparative advantage by

emphasizing capital intensive sectors when labor is abundant

• Adopting the command economy and state ownership therefore provided a compelling institutional logic

• It was not Oscar Lange’s rational socialist calculation • Price controls were pervasive and supervised by layers

and silos of bureaucracy• Widespread shortages were managed through full scale

rationing • Agricultural collectivization necessary to extract surplus

and peasants must not be allowed to exit

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Dismantling Stalinist Planning

• Reversing the Stalinist command economy:– Shifting from heavy to light industries – De-collectivizing agriculture – Allowing rural to urban migration to support growth of light

manufacturing and services (Landlords were no longer obstacles)

– Outsourcing state provided services– Outsourcing non-business services from state owned

enterprises– Empowering provincial and local officials as the instrument

to affect change

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Employment Distribution by Sector 1952-2010

Source : China Statistical Yearbook 2011

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Dismantling Stalinist Bureaucracy

• Attempts at decentralizing decision making powers lead to chaos, recentralizing decisions recreated the bureaucratic status quo– (Role of provincial and local government officials in

promoting growth)– (Privatized or outsourced many peripheral state services to

quasi-monopoly “SPVs”; retaining influence, less control and market driven)

– (State employees became entrepreneurs and joined the private economy; staff quarters became quasi private assets)

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Fiscal institutions and government behavior

• Role of provincial and local governments• Greater fiscal decentralization in China than in the US

– Only about one-third of government spending done by the central government in China

– Provincial and local governments play an important role in the Chinese economy

– In comparison two-thirds done by federal government in the US

• Pre-1994 and post-1994 period dividing line due to tax reforms and banking reforms

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Fiscal Federalism: Chinese Style

• Local governments commonly credited with some of the key successes and key failures of the economic reforms– A key success: explosive entry of collectively owned

Township Village Enterprises– Key problems

• Trade barriers• Poor access to education in rural areas• Stagnation of incomes in agriculture• Instability in land markets

• How do we best explain these outcomes, given the incentives faced by local officials?

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Alternate Tiebout and Exit-Voice Models • Two possible alternates:

– Voice: from central government rather than from voters (obvious limitations)

– Exit: of economic activity rather than of people (due to hukou system), causing loss in tax revenue (firm centered not citizens)

• Provincial and local government policy choices:• Spending on public services aiding

– Firms– Farmers– Households

• Allocation of bank loans (prior to 1994)• Allocation of land

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Behavior Pre-1994

• Efficient incentives to invests capital in collective firms– Local governments the residual claimant– Firms operated in a competitive national market

• Neglect of agriculture– Tax rate is higher on industry, so gain from shifting activity

from agriculture to industry– Lowering the marginal product of farmers lowers the cost of

labor in industry, raising profits of collective firms• Opposition to entry of private firms

– Receive only tax payments, instead of the full profits received from collectives

– Control over land can prevent most entry– But side-payments can induce support for these firms

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Behavior Pre-1994

• Public services– Efficient provision of services and infrastructure to

collective firms– Minimal services to agriculture, unless can charge high

enough user fees– In general, no services (education, housing, health) to

households unless they pay the full cost – Education raises future excise tax payments by firms, but

may risk future exit from the jurisdiction

• Officials have a short horizon; can’t legally sell position – With fixed pool of local funds available for new investment,

incentive is to make investments with a quick payoff

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Major Policy Changes Around 1994

• Major changes in tax structure VAT introduced• Bank loans (in principle) now controlled by banks rather

than local governments• Privatization of smaller state-owned firms, and implicit

central support for entry of new private firms• Introduction in 1998 of the right to sell lease-holds on

land• Recently, elimination of taxes on agriculture

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Provision of Services Post-1994

• Favor firms with higher tax payments per worker– Favor capital-intensive firms

– Favor firms facing higher VAT rate

– Weaker incentives, though, than before 1994

• Continue to neglect agriculture, particularly after end of agricultural taxes

• Limit shift of land to industry – to keep land prices high – to keep required compensation to farmers low

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Provision of Services Post-1994

• Implications of short time horizon of officials– Prefer sale to lease of land– Prefer rapid sale of land. – One explanation for sales now in spite of rapid increases

in land prices

• Still no incentives to provide services to households without sufficient user fees

• In particular reluctance to finance tuition-free education.• In order to implement tuition-free education, central

government in the end forced to cover full cost. But local governments may divert funds.

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Provision of Services Post-1994

• Government responses to migration pressures– Migrants increase tax base but can create extra costs for

public services

– Governments have incentive to discourage entry (encourage exit) of migrants that are net recipients, but encourage entry of migrants who are net contributors to budget

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Voice from Central Government

• Promotions under control of central government – Means for central government to exercise influence

– In practice, information poor, limiting direct oversight to egregious cases

– Threat also weak for most officials, given that most future assignments close substitutes

– Tenure length too short for making long-term investments in social services, education, health, housing for low income households

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What additional incentives result?

• Promotion may be positively correlated with future tax revenue for higher levels of government– Current tax payments to central government– Growth rate in tax payments

• Local officials favor sectors facing a high central tax rate because of promotion incentives so they favor high-end industries

• Business profits taxes and even property taxes on businesses play little role in other countries because competition drives down these taxes, but in China they play a central role in driving local economic policy

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Local Taxes and Migration

• With little migration competition among localities will undermine: – taxation of business income– VAT paid based on local production, since compete for

industries paying VAT• Taxation of employment income can be made

independent of the industry one works in if it is based on consumption, e.g., retail sales tax or a consumption-based VAT – This runs counter to pressures for a progressive income

tax

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Competition for migrants

• Localities will seek to attract residents who are net tax payers,– Provide better services to richer households, and poorer

services to net recipients

– Reallocate more land, in order to raise wage rates and lower residential rents

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Re-understanding the 12th 5-Year Plan

• Financial incentives do seem to matter for government officials– Help explain striking initial success of collective firms– But also help explain continuing neglect of agriculture and

education, leading to growing inequality.• The current design of these incentives is a potential

threat to future growth, especially if the creation of a coastal region with high-end industries falters due to destructive competition among localities

• Many aspects of the 12th 5-Year plan are better understood as a reflection of the political demands and present incentives of provincial and local governments

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Re-balancing the Chinese Economy

• Stimulating consumption is key to addressing the imbalances it faces internally and externally

• Most critical internal imbalance is the heavy reliance on investment growth, especially capital-intensive SOEs

• Resources will then be transferred to households and labor-intensive SMEs

• Raising consumption, lowers savings, and lowers the current account surplus

• Raising real interest rates is a positive move• Raising real wages is a positive move• Raising RMB is a positive move; but a “forced” move can

be countered domestically by an expansion of credit at lower real rates and would be a negative outcome

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Can Consumption be Stimulated?

• Most critical imbalance is the heavy reliance on an investment driven growth model (A Stalinist legacy that still haunts China 30 years after reform)

• Private consumption’s share of GDP is now 35%, and investment’s share is 40%

• In part this reflects the legacy effects of the not totally dismantled Stalinist institutions in the form of ministries and the state owned enterprises

• To bring Chinese consumption in 5 years up to 40% it would need to grow by 10% each year assuming a 7% annual GDP growth rate

• To bring Chinese consumption in 20 years up to 50% it would need to grow by 9% each year assuming a 7% annual GDP growth rate

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China : Consumption vs Investment

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Another Miracle is Needed

• Consumption must grow much faster than GDP for rebalancing

• The fiscal incentives for cooperation between central and local authorities are not in place

• Households when faced with a high growth rate of income, but few opportunities to invest their savings to yield a return to match the high growth rate will have to save even more

• Low consumption and high savings/investments is of course the other side of the equation reflecting large current account surpluses

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THANK YOU