Structural change in China:
Privatization and transition from industry to services
Veronica Strøm
Master of Philosophy in Economics
Department of Economics
University of Oslo
10 November 2016
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Structural change in China:Privatization and transition from industry to services
Veronica Strøm
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c© Veronica Strøm, 10 November 2016
Structural change in China:
Privatization and transition from industry to services
http://www.duo.uio.no/
Publisher: Reprosentralen, University of Oslo
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Preface
This thesis represents the end of the 5-year program of Master of Philosophy in
Economics at the Department of Economics at the University of Oslo. The past
five years have been inspiring and challenging. The topic of this thesis is a result
of a semester spent at the Fudan University the Fall 2014.
The work on this thesis has been both enlightening and demanding. Several
people deserve to be mentioned. First of all, I would like to thank my supervisor
Yikai Wang, for excellent guidance throughout this project, and for sharing his
knowledge of the Chinese economy. His helpful comments, ideas for extensions
and structure have been invaluable.
I would also like to thank my fellow students over the past five years for making
the time at Blindern memorable.
Lastly, I could not have completed this project without the endless support and
motivation from my parents and sister. I love you.
Any remaining mistakes are my responsibility.
Veronica Strøm
10 November 2016
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Abstract
With a fall in real GDP growth in recent years, China is about to
enter the next stage of its structural transformation. The existence of a
dominating state sector impede the transformation. This thesis highlights
the two structural changes in China; privatization in the manufacturing
sector and the transition from the secondary to the tertiary industry. The
major works in the literature on structural change and growth in China
are reviewed and discussed. A general growth theory of the transition from
industry to services is reviewed and applied to China. The factor market
distortions harm private firms development and strengthen the power of
monopolistic state firms. Introducing a policy in favor the monopolistic
state firms in the manufacturing sector, speed up the transition toward the
tertiary industry. With sufficient support of the development of private
firms, a structural change toward the tertiary industry slows down the
privatization process in manufacturing.
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Contents
1 Introduction 1
2 Economic reforms and growth accounting 3
2.1 State sector reforms and economic trend . . . . . . . . . . . . . . . 3
2.1.1 First stage of transition . . . . . . . . . . . . . . . . . . . . 3
2.1.2 Second stage of transition . . . . . . . . . . . . . . . . . . . 5
2.2 Contribution to growth . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2.1 Costs of the state sector . . . . . . . . . . . . . . . . . . . . 9
3 The state and private firms in the manufacturing sector 10
3.1 "Growing like China" . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.1.1 The model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.1.2 Slowdown of the privatization process . . . . . . . . . . . . . 16
3.2 The horizontal structure framework . . . . . . . . . . . . . . . . . . 21
3.2.1 State sector monopoly . . . . . . . . . . . . . . . . . . . . . 21
3.3 The vertical structure framework . . . . . . . . . . . . . . . . . . . 23
3.3.1 Labor abundance and wages . . . . . . . . . . . . . . . . . . 24
3.3.2 Globalization & International trade . . . . . . . . . . . . . . 25
4 From industry to services 26
4.1 Industry level trends . . . . . . . . . . . . . . . . . . . . . . . . . . 28
4.2 A theory of structural change . . . . . . . . . . . . . . . . . . . . . 28
4.3 The implications for China . . . . . . . . . . . . . . . . . . . . . . . 30
4.3.1 Income levels . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.3.2 Factor market distortions . . . . . . . . . . . . . . . . . . . 32
4.3.3 Technological catch-up . . . . . . . . . . . . . . . . . . . . . 33
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5 Combining the structural changes 35
5.1 Monopolistic state firms and industry-to-services . . . . . . . . . . . 36
5.2 Structural change in demand and private firms expansion . . . . . . 38
6 Conclusion 40
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List of Tables
1 Simple growth accounting . . . . . . . . . . . . . . . . . . . . . . . 7
2 Characteristics of selected manufacturing sectors in China. . . . . . 18
List of Figures
1 Employment share of private firms in manufacturing sector. . . . . 15
2 The secondary and tertiary industry’s percentage contribution to
GDP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3 Direction map: The dynamics of how state firm monopoly power
in the manufacturing sector increase the speed of transition from
industry to services. . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4 Direction map: The dynamics at which a structural change in
demand affect the employment share of private firms in the
aggregate economy and in the manufacturing sector. . . . . . . . . . 38
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1 Introduction
China has experienced an unprecedented economic growth since the first reforms
and opening up in 1978. The average growth in real GDP has been well above
9 percent in the last three decades. In recent years however, there are signs of a
growth slowdown in China. Between 2011 and 2012, the real GDP growth rate
fell from 9.5 to 7.9 percent, and has continued to fall in the years after (IMF
2016). With the slowdown in growth, it has become more evident that China is
about to enter the next stage in its structural transformation from the secondary
to the tertiary industry. This is also confirmed by the current level of GDP per
capita. A higher contribution of the tertiary industry to economic growth calls for
massive restructures in resources across industries and sectors, and a shift in the
expenditure shares of final consumption.
Compared to other developed economies once at the same stage of development,
China stands out because of its large and dominating state sector. The state firms
play a significant role in the economy. Because of their close ties with the central
government, the state firms benefit from preferential access to resources. This has
led to severe distortions in the capital and labor markets. The central government
consistently distorts the factor market to keep both the economic and political
power safely within the state sector. As a result, the state firms prevent the growth
and expansion of private firms in the competitive parts of the economy.
A large state sector thus inhibits the realization of China’s potential GDP, and
also impedes the structural change towards the tertiary industry. It is therefore
not given that the Chinese transition toward the tertiary industry will follow the
same trend as for example that experience by the United States. The structural
transition highly depends on a more efficient allocation of resources at sectoral
level. Thus, in order to understand the transition toward the tertiary industry in
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China, we must first understand the structural change at sectoral level.
The structural change from the complete dominance of the state sector toward
privatization started with the economic reforms in 1978. The reforms of the state
owned firms have been a key driver for the growth process, gradually allowing
more private firms. Over time, this privatization process has accelerated. But the
state sector still dominates important parts of the economy, especially within the
manufacturing sector.
In this thesis, I review and discuss the existing literature on structural change
and growth in China. I address three questions: What has been the true driver
of China’s economic growth since the 1990s; the state or private firms? How do
they coexist within the manufacturing sector? And, how do the existence of the
dominating state sector affect the speed of transition towards the tertiary industry?
The thesis contributes to the existing literature in that it includes a discussion of
how the two structural changes, the privatization process in the manufacturing
sector and the transition from the secondary to the tertiary industry, affect each
other.
Given that China is at an early stage of the transition toward the tertiary industry,
the available literature on this subject is limited. The state-private relationship
in the secondary industry is on the other hand well documented. I present the
theoretical framework by Z. Song et al. 2011, which capture China’s transition
toward a market economy. Its predictions fits well with the empirical evidence
of the manufacturing sector in the first three decades after 1978. I discuss a
complementary theory by X. Li et al. 2015 of China’s state capitalism which
emerged after 1998. I also review a general growth theory by Boppart 2014, and
apply and discuss its implications on China.
The thesis is structured as follows: Section 2 reviews the development of state
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sector reforms in China, and discusses the contribution of productivity growth
and resource allocation to growth over time. Section 3 explores the relationship
between state and private firms in the manufacturing sector in China. I review a
theory of transition toward a market economy and discuss the observed trend in the
employment share in the manufacturing sector. I then discuss how monopolistic
state firms affect the development of the private sector. Section 4 reviews a theory
of structural transition from industry to services, and discusses its implication
on China. Section 5 discusses how the two structural changes state-private and
industry-to-services can affect each other. Section 6 concludes.
2 Economic reforms and growth accounting
Important for China’s economic growth since the 1980s is the gradual adoption of
market-oriented reforms. The acceleration of reforms in the 1990s increased the
transformation towards a market economy. Massive reallocation of resources was
instrumental for this transition. In Section 2.1 I briefly present the development
of the state firms reforms and the following privatization process. In Section 2.2
the contributions of the state and private sector to output growth over time is
discussed in the light of the finding of Brandt and Zhu 2010.
2.1 State sector reforms and economic trend
2.1.1 First stage of transition
The first economic reform in China was introduced in 1978. A large share of
employment and almost all new investments in the non-agricultural sector was in
the state sector. In the 1980s, decentralization of authority and resources led to
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massive transfers of labor out of agriculture. This was absorbed by the private,
non-agricultural sector, which had relatively high productivity growth compared
to the state sector. In the mid-1980s, more than 70 percent of non-agricultural
labor was employed in the private sector. The decentralization of banks and a few
financial institutions also allowed credit to private businesses. This led to a sharp
rise in the return to capital in the private sector.
In 1992, a new stage of economic reforms was introduced. The 1980s had been filled
with macroeconomic imbalances and political instability (Storesletten and Zilibotti
2014). The need for an acceleration of the economic reforms was emphasised by
Deng Xiaoping during his famous Southern Tour in 1992.
A new national objective was endorsed, the socialist market economy. Private
firms was now seen as important components to the socialist market economy
rather than a complement to the state sector (Isachsen 2012). This started the
gradual transition toward state sector downsizing and an acceptance of a moderate
amount of privatization.
The new reform quickly removed the barriers to the existence of private businesses.
A larger share of investments was directed to the private sector. Between 1992
and 1994, the private sectors share of non-agricultural fixed investments rose from
30 to 42 percent (Brandt & Zhu, 2010).
The state firms faced increasing competition from the privately owned firms.
Between 1978 and 1993, the rise in private sector investment share reduced state
sector’s share of net industrial output from 80 to 59 percent (Li et al., 2015). The
deregulating reforms after 1992 led to further large losses for the state firms as
they were outperformed by the more productive private firms.
After the reforms in 1992, many state firms therefore gradually exited from the
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competitive industries. Unprofitable and inefficient state firms were forced to
restructure or close down. Small state firms in selected provinces were allowed to
privatize.
Although the central government slowly tolerated the development of private firms,
there still was a lack of encouragement and support for the private sector. During
the 1990s, resources and macroeconomic control were again recentralized. The rise
in investments to the private sector came to a halt.
The central government maintained the control of the medium and large state
firms, which went through a managerial reform rather than privatization. The
medium and large state firms became owned rather than operated by the central
government (Brandt and Rawski 2008). This gave local government officials more
decision-making authority.
2.1.2 Second stage of transition
The state sector reform gained momentum in 1997. Now the reform also covered
the medium and large state firms. Private businesses were finally encouraged,
and the legal status of private ownership was formally endorsed in 1999 (Li et al.,
2015). Most of the privatization and restructure of state firms therefore took place
after the late 1990s.
Between 1998 and 2000, the government launched a battle to restructure the state
sector, a policy famously known as "grasp the large, let go of the small". The
policy was to merge and restructure the profitable state firms and continue the
privatization of unprofitable small and medium-sized state firms. The close down
of unprofitable state firms after 1998 led to a sharp drop in the employment share
of state firms in the non-agricultural sector. The decline of the state sector further
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reduced state firms’ share of industrial output, from 50 percent to 30 percent
between 1998 and 2005 (Hsieh and Z. M. Song 2015).
The merge of the profitable state firms led to large state firms that became
dominant in strategically important sectors, such as transportation, telecommunication,
electronics, energy and military equipment. In this way, the central government
maintained its control of the important parts of the economy, while the private
sector operated in the free market.
2.2 Contribution to growth
The growth accounting exercise by Brandt & Zhu (2010) emphasize how productivity
growth and the allocation of resources have contributed to Chinese growth over
time. They find productivity growth in the private, non-agricultural sector as the
most important source of China’s GDP growth since 1978. This is confirmed by
Cheremukhin et al. 2015, which identify productivity growth in the private sector
in manufacturing as the key contributor to GDP growth. The reallocation of labor
within the non-agricultural sector, from state to private, also accounts for a large
share of China’s GDP growth.
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Table 1: Simple growth accounting
Year 1978-1988 1988-1998 1998-2007
Aggregate
Output per worker 6.77 6.40 9.79
Capital per worker 2.58 3.35 5.21
TFP 4.19 3.05 4.58
Non-agricultural
Output per worker 2.52 5.28 8.65
Capital per worker -0.30 2.69 4.27
TFP 2.81 2.59 4.38
Non-state
Output per worker 3.91 6.40 8.39
Capital per worker -2.39 3.23 4.21
TFP 6.30 3.17 4.18
State
Output per worker 3.32 3.69 11.06
Capital per worker 2.62 3.74 6.88
TFP 0.70 -0.05 4.19
Source: Brandt &Zhu (2010).
Brandt & Zhu (2010) use a three-sector model to quantify the sources behind
China’s GDP growth after 1978. Table 1 shows the contribution of capital
deepening and productivity (TFP) growth to the annual growth rate in real output
per worker, separated into three subperiod between 1978 and 2007. The table
provide results for the aggregate economy, the non-agricultural sector, and at
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sectoral level within non-agriculture.
Table 1 shows that the rate of growth of the aggregate real output per worker
increased substantially in the last subperiod, to impressive 9.8 percent per annum.
This increase is a result of faster capital accumulation and productivity growth
than in the two earlier subperiods. Capital per worker grow by 5.2 percent annually
in the last subperiod, and the growth in capital per worker contributes by 53
percent to total growth.
In the non-agricultural sector, output per worker grow at a lower rate than at the
aggregate level in all three subperiods. This is a result of both lower productivity
growth and lower growth in capital per worker. The negative contribution of
capital deepening in the first subperiod is due to the massive transfers of labor
out of agriculture. Productivity growth account for all the growth in output per
worker in this period. In the two last subperiods, the growth in output per worker
increase with the rapid growth in capital accumulation.
Comparing the state and non-state sector, the evidence reveals a significant
difference in the contribution of productivity and capital deepening to growth
in output per worker. In the first subperiod, the two sectors grow at fairly
similar rates in terms of real output per worker. The non-state sector grow by 3.9
percent and the state sector by 3.3 percent. However, high productivity growth
in the non-state sector is offset by a negative contribution of capital per worker,
while capital deepening account for the growth in the state sector. In the second
subperiod, the rapid growth in the non-state sector is caused by capital deepening
and still high growth in productivity. This is consistent with the rising share of
investments directed to the private sector in the early 1990s.
The growth in the state sector do not take off before in the last subperiod.
Consistent with the massive restructures and layoffs after 1998, the capital-labor
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ratio in state sector is significantly higher than in the two previous subperiods.
This emphasize the state sectors reliance on capital accumulation for growth. The
state sector’s productivity growth become comparable to that in the non-state
sector in the last subperiod. This reflects the mergers of profitable state firms
after 1998, and the privatization of unprofitable state firms.
The difference in productivity growth between the state and non-state sector is
especially evident when aggregated over the whole period. Between 1978 and 2007,
productivity in the non-state sector grew at an annual rate of 4.56 percent while
productivity in the state sector rose at a rate of 1.52 percent each year (Brandt &
Zhu, 2010).
2.2.1 Costs of the state sector
In addition to trace out the sources of growth, the growth accounting exercise is
beneficial in that it also emphasize the distortions in the allocation of resources
between state and private sector. Aggregate investments in China since the early
1990s have been very high, between 30 and 40 percent of GDP. Table 1 shows that
in the last subperiod, the capital-labor ratio grew more rapidly in the state sector
than in the non-state sector, at 6.9 and 4.2 percent respectively. This reflects
the fact that the majority of aggregate investments in the economy were directed
to the state sector. In fact, with an employment share of only 13 percent in
2007, more than 53 percent of all resources for investments in the non-agricultural
sector were directed to the state sector (Brandt & Zhu, 2010). An explanation for
unequal distribution of investment resources is that the state firms benefit from
easier access to bank loans and subsidies from the government.
Moreover, the state firms reliance of investments for growth has led to a return to
capital close to zero in the state sector (Brandt & Zhu, 2010). If capital was allowed
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to allocate freely, the share of capital going to the state sector would decline. The
higher productivity level in the non-state sector imply that more resources should
be allocated to this sector. In fact, Brandt &Zhu (2010) argue that had more
capital been allocated to the non-state sector, China could have achieved almost
the same growth performance without any increase in the aggregate investment
rate.
The state sector’s wage premium is also a result of the severe distortions of capital.
The wage premium exist because the state sector need to employ a sufficient share
of the workers in the non-agricultural sector. The share of capital allocated to
the state sector is increasing both in the state sector’s employment share and the
wage premium. As a result, the distortions in the allocation of capital supports
the distortions in the labor market (Brandt & Zhu, 2010).
3 The state and private firms in the manufacturing sector
In section 2 we saw that there still exist significant gains from further reallocation
of resources between the state and the private sectors, especially of capital. This
section analyse the coexistence of the state and private firms in the manufacturing
sector in China. A theory of economic transition by Song et al. (2011) is presented.
Reallocation of resources within the manufacturing sector is the driving force in
this benchmark model. The theory suggest a transition toward market economy,
and predicts that the state firms are forced out of the manufacturing sector.
This is in stark contrast to the observed evidence. A thorough discussion of the
observed trend in the employment share in the manufacturing sector follows. In
the second part of this section, I present the extension of the benchmark model
and a complementary theory by Li et al. (2015) where the state firms are granted
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monopoly power. This is followed by a discussion of how the monopolistic feature
of state firms in the manufacturing sector obstruct the economic growth.
3.1 "Growing like China"
Song et al. (2011) predicts that starting from a steady state with severe distortions
in the allocation of resources, an economic reform trigger a transition that
gradually force the state firms out of the manufacturing sector. At the beginning of
the economic reform, the existence of a labor market wedge between the state and
private sector ensure that there is no employment in the private sector (Storesletten
& Zilibotti, 2014). The economic reform increase the competitive pressure and
force the state firms out of the manufacturing sector.
The theory emphasise the wedge in the return to capital between the state and
private firms. Distortions in the capital market prevents private firms from attract
production resources from the state firms. The private firms must rely on private
savings and retained earning to finance their investments. Hence, the growth
potential of private firms are limited by their savings.
Firms can choose between modes of production. The private firms delegate
authority in contrast to the state firms whose authority is centralized. As a result,
the private firms attain a higher labor productivity. If the private firms have
sufficiently high savings, or in the absence of the financial market imperfections,
the private firms will therefore outgrow the state firms.
3.1.1 The model
The model capture the evolution of the economy during the transition.
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Households
The economy is populated by overlapping generations with agents that live in
two periods. The young agents work and live off savings when old. Preferences
are for simplicity characterized by a standard logarithmic utility function, Ut =
log(c1t) + βlog(c2t+1), where β is the discount factor. All young agents save a
fraction β1+β of their income (Storesletten & Zilibotti, 2014). The population
grows at an exogenous rate, ν. In each period of time, there exist a measure of
Nt workers and µNt entrepreneurs, i.e., agents with no entrepreneurial skills and
agents with entrepreneurial skills, respectively. Skills are transmitted from parents
to children. The private firms are owned by old entrepreneurs that hire their own
children as managers.
Technology
The state and private firms produce the same consumption goods. The technology
of the two types of firms are1:
yFt = kαFt(AtnFt)1−α and yEt = kαEt(χAtnEt)1−α,
where y is output, and k and n denote the capital and labor input, respectively. Atis the technology parameter that grow at an exogenous rate z: At+1 = (1 + z)At.
χ > 1 represents the higher labor productivity in the private firms relative to state
firms from more effective monitoring of managers in private firms.
The lending rate to domestic state firms is given by Rl. State firms profit
maximization implies that Rl equals the marginal product of capital and wage
equals the marginal product of labor,
wt = (1− α)( αRl
)α
1−αAt. (1)
1Where "E-firms" and "F-firms" are the equivalent of private and state firms, respectively.
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Banks do not lend capital to private firms. The banking sector is competitive,
equalizing the return on deposits, lending rate to state firms and the bank’s
return on domestic capital and foreign bond, that is, Rd = Rl = R, respectively
(Storesletten & Zilibotti, 2014).
The private firms are owned by entrepreneurs that hire managers to run their
firms. The managers are given a compensation, mt, on top of workers wage, wt.
The compensation is subject to a no-stealing incentive-compatibility constraint
mt≥ ψyEt, for some ψ ∈ (0, 1). The constraint is binding in equilibrium if and
only if mt > wt. The value of a private firm with capital stock kEt is given by the
solution to the following problem:
Ξ(kEt) = maxmt,nEt
{(kEt)α(χAtnEt)1−α −mt − (1 + ω)wtnEt
}, (2)
subject to the incentive constraint (which is binding, implied by the optimal
contract) and the state firms equilibrium wage in (1). ω > 0 is the labor market
wedge.
The employment share of a private firm is found by taking the first order condition
with respect to nEt and substituting in the equilibrium wage in (1),
nEt =(1− ψ
1 + ωχ) 1α(Rl
α
) 11−α kEt
χAt. (3)
This imply that employment in private firms is linear in their capital stock. The
value of the private firm is found by inserting the incentive constraint and the
private employment share (3) into (2), and is given by
Ξ(kEt) =(1− ψ
1 + ωχ) 1α
χ1−αα RlkEt ≡ ρEkEt. (4)
We can see that the value of the private firm is proportional to its capital
stock. Moreover, the rate of return to capital invested in the private firm is
constant ρE ≡(
1−ψ1−ωχ
) 1α
χ1−αα Rl. The firm-level results hold at the aggregate
level (Storesletten & Zilibotti, 2014).
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Economic transition
The economic transition is triggered by a shock to the economy. An economic
reform lower the labor wedge, ω, which lead private firms to set up firms and hire
workers and managers. Capital starts to accumulate in the private firms.
The transition hinges on the fact that young managers find it optimal to invest in
the private firms and do not invest their savings in bank deposits, i.e., ρE > Rl.
They invest their savings in the private firms if and only if
χ
1 + ω>( 1
1− ψ) 1
1−α . (5)
This is a necessary condition for the economic transition to take off. Labor
productivity χ in the private firms must be sufficiently high and the labor wedge
ω sufficiently low, given ψ.
The transitional equilibrium is described as2; Given KEt and At, the equilibrium
dynamics of total capital and employment of E firms during transition are given
by KEt+1/KEt = 1 + γ and NEt+1/NEt = (1 + γ)/(1 + z), respectively, where
(1 + γ) = β
1 + β
ψ
1− ψρEα. (6)
For E-firms’ share to grow over the transition, it is necessary that (1+γ)/(1+z) >
1 + ν. The speed of transition is increasing in β and χ and is decreasing in
ω (Storesletten & Zilibotti, 2014). Investments in the private firms are higher
the higher the propensity to save for young agents and the higher is the labor
productivity in the private firms, which speed up the transition. A higher wedge
has the opposite effect.
The transitional dynamics in the economy is illustrated in Figure 7 in Song et
al. (2011). During the transition, aggregate GDP grow due to better resource2Lemma 2 by Song et al. (2011).
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allocation from the low-productive state firms to the high-productive private
firms. The private firms’ employment share increases during the transition. The
transition ends when all workers are employed by private firms. The difference in
return to capital between state and private firms, ρE > Rl, prevails throughout
the transition because the return to capital in both types of firms are constant.
The average return to capital in the economy rise. The share of the capital stock
going to the private firms increases. With the high return to capital and increasing
employment share, the private firms have a lower capital-labor ratio than the state
firms. Lastly, the wage per worker remains constant.
Source: Storesletten and Zilibotti 2014.
Figure 1: Employment share of private firms in manufacturing sector.
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3.1.2 Slowdown of the privatization process
Song et al. (2011) provide a comprehensive description of the empirical
observations of the development of the manufacturing sector. The predictions
of the theory fit well with their empirical findings. The manufacturing sector
has experienced increased return to capital and higher wage growth than output
growth. Private firms have both higher return to capital and lower capital-labor
ratio than state firms (Song et al., 2011).
The theory also fits well with the development of Chinese private firms in the 1990s.
Brandt & Zhu (2010) document the reduction in the state sector wage premium.
The theory captures the closedown of unprofitable state firms and the reallocation
of labor from the less productive state firms to the high-productive private firms
during the 1990s. This explains the gradual rise in the employment share of the
private sector within the manufacturing sector. Figure 1 shows how the deepening
of the privatization process starting in 1998 further led to an acceleration of private
sector employment in the 2000s.
But in contrast to the theory, the observations in Figure 1 shows a slowdown of the
privatization process after 2008, and even a slight decline after 2010. This suggests
that the theory is not sufficient to explain the development of the employment
shares in the manufacturing sector after 1998. Possible explanations for the
observed slowdown are productivity growth within the state sector, higher private
labor costs, the government’s dependence on supports from state workers and the
use of state firms as financial instruments.
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Productivity growth
Because the rate of productivity growth is exogenous, the model do not capture
the rise in aggregate productivity level in the state sector after 1998. The rapid
growth in productivity within the state sector after 1998 is evident from Table 1.
Productivity growth in the state sector rose rapidly from the second subperiod to
the third subperiod. After 1998, productivity grew at a rate of 4.2 percent in both
the state and private sector.
The higher productivity level in the state sector may imply that the gains from
privatization within the manufacturing sector were eventually exhausted in the
late 2000s (Molnar and Chalaux 2015 & Chansomphou and Ichihashi 2013). Hsieh
& Song (2015) document that the transformation of the state sector led to a
convergence of labor productivity in the state firms to that of the private firms.
They further emphasize the difference in the productivity level between the exiting
and the entering state firms. In general, the state firms established after 1998 were
large and with a labor productivity similar to that of the private firms. Thus,
over time, the state sector has grown to include mainly large and efficient firms.
These state firms dominate the strategically important industries the government
want to control. As a result, the privatization of state firms stagnated in the late
2000s.
Labor costs
Another explanation for the observed slowdown in the privatization process is
the rise in private sector labor costs, which makes it less attractive to privatize
state firms. Table 2 shows the change in unit labor costs, defined as the ratio
of wage to value added per worker, in industries with high employment size. In
17
Table 2: Characteristics of selected manufacturing sectors in China.
Source: H. Li et al. 2012.
18
the period between 2007 and 2010, Column (5) and (6) show that the unit labor
costs in the labor intensive industries rose relatively more than in the capital
intensive industries, such as transport equipment and basic iron and steel. The
labor intensive industries are operated by privately owned firms. This suggests
that the labor costs in the private sector rose relatively more than that of the
state firms.
In addition, by comparing Column (2) and (3), the labor intensive industries are
more engaged in exports than the capital intensive industries. With rising labor
costs, China’s comparative advantage among other low cost Asian countries is
reduced. This implies that the private firms engaged in international trade has
become less competitive internationally. Moreover, foreign private firms are also
moving their production out of China due to the rise in in Chinese labor costs (The
Economist Mar 2015). This suggests that the privatization process have stagnated
because private firms have retreated from the manufacturing sector and not only
by a decline in the number of state firms being privatized. This effect is further
amplified by the drop in foreign demand due to the trade slow down after the
Great Financial Crisis in 2008.
Elite supporter base
A politically motivated explanation suggests that the employment share of the
private firms grew too large during the 2000s. In a theory formalized by Wang
2016, the central government is run by a political elite which control the economy.
This elite depends heavily on its supporter base, made up by workers in the state
sector. Hence, a sufficient share of the total labor force must be employed in the
state firms.
Consistent with this theory, the elite’s supporter base was gradually lowered during
19
the 2000s as the private firms attracted more workers. In Figure 1, the employment
share of private firms started to level off in 2009, which suggests that the supporter
base was lowered to a critical level around this period. According to the theory,
the elite would at this point start to limit private firms’ access to capital, which
depress the development of private firms. Limiting private firms’ access to capital
further lower the expansion of the private sector. Consequently, the employment
share of private firms levels off. Resource shortage in the private sector imposed by
the government may thus explain the stagnation of the privatization process.
In fact, this theory suggests that the manufacturing sector never will be privatized
as long as the political system is not disrupted. This is in stark contrast to the
predictions of the theoretical model outlined in Section 3.1.
Financial instrument
A related explanation is that the central government use the state sector as a
financial instrument (Wen and Wu 2014). In normal times, the state firms are
profit maximizing enterprises just like the private firms. But in a recession, like in
the aftermath of the Great Financial Crisis in 2008, the government over-invest in
the state firms to boost production.
In 2008, the government introduced huge stimulus packages to offset the lower
foreign demand. These investments were directed to the large state firms. The
private firms, on the other hand, suffered from a reduction in demand, which likely
forced private firms to lay off workers. The state firms were then forced to absorb
the unemployed labor to prevent an additional drop in domestic demand and a
potential rise in poverty. This suggests a transfer of workers from the private to
the state firms after 2008, causing the slowdown of the privatization process.
20
3.2 The horizontal structure framework
The benchmark model by Song et al. (2011) is extended to a two-sectoral
environment. In contrast to the benchmark model, the driving force of this
two-sectoral model is productivity differences between state and private firms.
The manufacturing sector is separated into a labor intensive industry and a capital
intensive industry. The transition now have two possible steady state outcomes:
(i) full privatization in both production industries, an (ii) the private firms operate
in the labor intensive industry and the capital intensive industry is monopolized
by the state firms. Next is a brief review of the transitional dynamics leading to
the two outcomes, and focus on the monopolistic outcome (ii).
3.2.1 State sector monopoly
In the two-sector model, the state and private firms produce differentiated
intermediate goods used in the production of a final consumption good,
Yt =(ϕ(Y t
k)σ−1σ + (Y t
l)σ−1σ
) σσ−1
. (7)
k and l represents capital and labor intensive intermediate goods and the elasticity
of substitution between the two goods is σ > 1. The capital intensive good is
produced without labor.
At the beginning of the transition, state and private firms operate in both types
of industries. Because the private firms are high-productive, market forces drive
the state firms out of business in the labor intensive industries. The efficiency
of the private firms increase during the transition. Given that the productivity
improvements are sufficiently large, the private firms turn to the capital intensive
industries. At this stage of the transition, both state and private firms invest in
the capital intensive industries. When the transition ends, the state firms are also
21
forced out of the capital intensive industries. Hence, outcome (i) of the transition
is realized.
The (ii) outcome emerge if the productivity improvements in the private firms
are not large enough. The private firms will never take over the capital intensive
industries. At this stage of the transition, there still exist state firms that are
active in the production of the labor intensive good, although the share of state
firms in this industry is declining. As outcome (ii) is realized, the state firms
gain market power in the capital intensive industries. The economy now consist of
two sectors; a competitive sector and a monopolized sector. The more productive
private firms operate in the competitive labor intensive industries, while the capital
intensive industries are monopolized by large state firms. The model predicts that
the power of the monopolized state firms is strengthened along with the retreat
of state firms in the labor intensive sector and as the productivity of the labor
intensive industries increase.
This last result rely on the fact that the elasticity of substitution across the
intermediate goods is strictly greater than unity, σ > 1. A simplified version
of this horizontal structure is formalized by Li et al. (2015). They argue that with
a sufficiently high elasticity of substitution, σ ≥ 2, the power of the monopolistic
state firms is in fact weakened by productivity growth in the private firms. Thus,
within this simplified environment, without capital, the relative price effect decide
the direction of demand for the monopolistic goods. Applied to the monopolistic
outcome (ii), if the elasticity of substitution is sufficiently high, this may harm the
power of the monopolist.
But, given the monopolistic state firms preferential access to external capital,
the state firms will never be forced out of the manufacturing sector. Despite
productivity differentials, the power of the monopoly is held up by persistently high
22
investments in the state sector. In this way, the central government can maintain
its control in strategically important industries. But the severe distortions in the
factor markets is sustained. The existence of the state monopolies is thus an
obstacle to the realization of the economy’s potential GDP.
3.3 The vertical structure framework
An alternative framework for the coexistence of the private firms and the
monopolistic state firms is a model of "State Capitalism" provided by Li et al.
(2015). In this framework the production industries are separated into upstream
and downstream industries. The upstream industries consist of large monopolies
owned by the state and operated by the elite class, and only private firms are
active in the competitive downstream industries. The upstream industries produce
an intermediate good used in the production of a final consumption good in the
downstream industries.
Compared to the horizontal structure, the vertical structure is more consistent
with the observed feature of firms in the Chinese manufacturing sector. The
upstream firms control the strategically important industries such as energy,
telecommunication and transportation, which are relatively more capital intensive
consistent with Table 2. Whereas the liberalized downstream industries such as
manufacturing of commodities and catering on the other hand, are labor intensive
and open for competition between private firms.
In this framework, the monopolized state firms benefit from productivity improvements
in the private firms through the vertical structure mechanism. Holding the monopoly
markup constant, the upstream state firms extract rent from the downstream
private firms through two channels. First, the higher productivity of private firms
23
in the downstream industries lower the price of the downstream goods. This
increase the demand for both types of goods. Moreover, productivity improvements
in the private firms increase the price of the upstream intermediate goods. In
contrast to the theory above, factor markets in this economy are competitive.
The rental rate on capital is equalized across state and private firms. When
productivity in the private firms increase, the rental rate on capital is driven up
trough the general equilibrium effect. This lead to higher production costs for the
monopolistic state firms, which increase the price of the upstream intermediate
goods as the markup is unchanged. This increase the profit per unit of sale for the
monopolistic state firms.
3.3.1 Labor abundance and wages
However, during the process of structural change, the monopolistic feature of
the upstream industries may eventually be an obstacle for economic growth and
development. At the early stage of a transition, labor abundance lead to a less
rapid growth in wages which keep the labor costs in both downstream and upstream
industries down. Factor accumulation together with productivity improvements
in the private firms, increase competition in the downstream industries. The
downstream private industries expands. The monopolised state firms benefit
disproportionately from this expansion, and the profitability of the state firms
increase without any improvements in the productivity.
At some point along the transition however, all excess labor is absorbed into the
manufacturing sector. In the case of China, this imply that the massive transfer
of unskilled labor from the agricultural industry is fully absorbed. The labor force
have reached a peak and wages increase (The Economist Jan 2013). Before the
labor force reached the peak, the abundance of labor ensured that wages were
24
sufficiently low to offset the markup cost for the intermediate input. After the
peak on the other hand, wages rise rapidly because labor is scarce.
The downstream industries are competitive, to cover the rising labor costs they can
increase the price on the downstream goods only marginally. If the monopolistic
state firms do not reduce their markup, the rise in labor costs force the price of
the intermediate goods upwards. This increase the production costs for the private
firms further. Consequently, this inhibit the expansion and development of private
firms in the downstream industries. This in turn also hurt the monopolistic state
firms in the upstream industries themselves. Ultimately, the effect on GDP growth
is negative and lead to a slow down of the structural transition.
3.3.2 Globalization & International trade
In Table 2 we saw that within the manufacturing sector, the labor intensive
industries are more involved in exports than the relatively more capital intensive
industries. In the international market, China has had a comparative advantage
in the production of cheap and labor intensive goods. Translated into the vertical
structure framework, the downstream private industries produce tradable goods
and are major exporters (H. Li et al. 2012). More precisely, the demand for the
downstream goods is both domestic and foreign. Hence, trade openness raise the
aggregate demand for downstream goods.
Given labor abundance, the inclusion of trade globalization enables the monopolised
state firms to extract more rents. The foreign demand lead to an expansion
of the downstream private firms, which increase the demand for the upstream
non-tradable intermediate goods. In isolation, this lead to higher monopoly profit
and total GDP than in autarky.
25
The comparative advantage of the downstream private industries depends heavily
on domestic labor costs. With rising labor costs, the country become more
vulnerable to international competition because goods prices adjusts. Especially
given the existence of similar developing countries with low(er) labor costs in
Asia. To offset the negative effect from lower foreign demand, the monopoly must
sufficiently improve productivity.
In this sense, trade openness is a double-edge sword for the monopolised state
firms in the upstream industries. For the downstream industries to remain
internationally competitive, the monopolistic state firms must either lower or even
eliminate the monopoly markup, which will weaken the power of the monopolistic
state firms. If on the other hand elimination of the markup is insufficient, the
upstream industries must improve their productivity. If they fail to do this, this
hurt the development of the private firms which again hurt the monopolistic state
firms themselves. Hence, trade globalization may potentially amplify the negative
effect the monopolistic upstream industries have on total GDP and structural
change.
4 From industry to services
This section discuss how a structural change in expenditures can determine the
speed of transition from the secondary to the tertiary industry in China. Boppart
2014 shows that structural changes are driven by rising income levels and changes
in the relative price for goods and services. The direction of the relative price
effect depends on the growth of resources across production sectors. In China,
the distortions in the allocation of capital and labor can thus limit the speed of
transition toward the tertiary industry.
26
3035
4045
5055
6065
70
%
1990 1995 2000 2005 2010 2015Year
Secondary Tertiary
Source: China Statistical Yearbook 2015.
Figure 2: The secondary and tertiary industry’s percentage contribution to GDP.
27
4.1 Industry level trends
Figure 2 shows that during the 1990s, the distortions in the allocation of capital
kept the secondary industry’s share of GDP substantially higher than that of the
tertiary industry. In the 1990s, high investments in the secondary industry was
the main contributor to GDP growth. With the state sector reform in 1998, the
productivity of the aggregate economy rose. Higher productivity growth increased
the tertiary industry’s contribution to GDP in the early 2000s. This could have
started a transition toward a more dominating tertiary industry.
Instead, in the 2000s investments in the secondary industry increased further and
the industry grew. Figure 2 shows that the secondary industry was the main
contributor to GDP in the decade that followed. The high investments slowed
down the transition toward the tertiary industry by strangling the development of
private firms in the service sector. As a result, the service sector, which is the main
sector within the tertiary industry, is relatively underdeveloped given China’s level
of GDP per capita (Nabar and Yan 2013). In other word, China has enormous
potential in the expansion of the service sector.
4.2 A theory of structural change
Boppart (2014) addresses the structural transition from industry to services. In
relation to China, a benefit of this theory is that it focus on the transitional
dynamics at the sectoral level, with balanced growth at the aggregate. It analyzes
the income and substitution components in relation to structural change. Applied
to the Chinese economy, this theory help explain how rising income levels in the
demand side of the economy trigger the transition.
Moreover, the theory emphasize the connection between a change in the demand
28
structure and changes in the production side of the economy. A change in the
demand structure translates to the production side. A shift in demand affect the
flow of resources across production sector, which affects the relative price between
goods and services. Hence, this link help to captures the effect from distortions
in the Chinese factor markets on relative prices, which influence the speed of
transition.
The theory predicts that a rise in income levels led to an increase the demand for
services relative to goods. This is followed by a structural change in the production
side of the economy, where two production sectors produce either goods or services.
The sector producing services grow at a higher rate relative to the goods sector in
terms of available resources:
g∗KG≤ g∗
K ≤ g∗KS
(t) and g∗LG≤ n ≤ g∗
LS(t), ∀t.
g∗K and n are the growth rates of the aggregate capital stock and labor force in the
economy, respectively. The growth rate of capital and labor in the service sector is
denoted by S and the goods sector by G. Along the competitive equilibrium path,
the allocation of capital and labor to the service sector grow at a higher rate than
the aggregate capital stock and the labor force. The aggregate capital stock and
the labor force grow at higher rates than capital and labor allocated to the goods
sector.
The structural change in demand lead to a structural change in production.
Because more resources flow to the service sector relative to the goods sector, the
service sector expands. This amplify the transition toward the tertiary industry.
The relative growth rates of capital and labor between the two sectors determine
the speed of the transition from industry to services. The higher the growth rate
of resources allocated to the service sector relative to the goods sector, the faster
the transition.
29
Further, the sector that experience a relative price increase grows in terms of
expenditure shares. The relative price between goods and services is determined
by the productivity level in each sector. The relationship between productivity
growth and the growth in prices is given by
g∗PG− g∗
PS= gS − gG.
With relatively less resources allocated to the goods sector, productivity growth
is higher in the goods sector than in service sector, gS < gG. This implies that
the price of goods decline at a relatively higher rate than the price of services,
g∗PG
< g∗PS.
The relatively higher price of services imply that the expenditure share devoted to
goods declines, g∗ηG≤ 0. It declines at a constant rate over time. This does however
not mean that the demand for goods drop to zero in absolute terms. Because
goods are necessities, there will always be a demand for goods. The reduction in
the expenditure share devoted to goods is simply a result of the relatively lower
price on goods, and the higher demand for services, defined as luxuries, as income
levels rise.
The share of expenditure devoted to services increase over time. In the long-run,
the theory predicts that the service sector is indeed the dominating consumption
sector.
4.3 The implications for China
Given the predictions of this general growth theory, what are the implications for
China?
30
4.3.1 Income levels
Rising aggregate income levels is crucial for the structural change. In China,
the whole population has benefitted from growth over the last decades. The fast
growth has been accompanied by a rapidly growing middle-income class as well as
rise in the top 10 percent income, and the level of absolute poverty has declined
(Storesletten & Zilibotti, 2014). Data from the World bank shows than in 2011,
the Chinese GDP per capita, evaluated at purchasing power parity (PPP), rose
above $10,000. This is by some argued to be a threshold at which industry’s share
of GDP starts to decline (Naughton 2007).
With a rise in aggregate income levels in China, the share of services in
consumption expenditure will increase. Empirical evidence from the United States
shows how the share of total consumption expenditures spent on goods has declined
since the 1950s, along with rising aggregate income levels. The quantity of services
relative to goods consumed in the United States increased until the 1990s (Boppart,
2014). According to the World Bank, the level of GDP per capita, evaluated at
current U.S. dollars, in China in 2011 was comparable to that of the United States
in 1970. Thus, if China is following a similar trend in expenditure shares as
the United States, China may experience a sharp increase in the consumption of
services over the next decades.
But Chinese growth has also been accompanied by an increase of income inequality
(Storesletten & Zilibotti, 2014). This could potentially dampen the shift in demand
towards services. However, Boppart (2014) uncover that the demand for goods
in United States declined also for poorer households. Even though the poorer
households exhibits a larger expenditure share of goods than richer households,
the trend in the demand for goods is identical across all income levels. This
implies that the rise in aggregate income levels in China may indeed be sufficient
31
to trigger a structural change in demand.
4.3.2 Factor market distortions
With a relative decline in the demand for goods, the theory implies that the flow of
capital and labor towards the service sector rises. Applied to China, this prediction
is complicated by the severe distortions in the factor markets.
Capital
The financial frictions obstruct the free flow of capital across production sectors.
As a result, a change in the demand structure may not be sufficient to affect
the flow of capital in the direction of the service sector. The distortions in the
allocation of capital may potentially affect the relative growth rates of capital. If
the distortions are sufficiently severe, the flow of capital may go in the opposite
direction than the theory predicts: gcKG > gKc ≥ gcKS . Even with a higher demand
for services relative to goods in China, capital allocated to the service sector may
grow at a lower rate than the aggregate capital stock. This limits the expansion
of the service sector, and thus slow down the speed of transition.
Labor
The direction of the flow of labor in China fits better with the theory. The
Chinese service sector is relatively more labor intensive than the goods sector.
Labor allocated to the service sector is indeed growing at a higher rate than labor
allocated to the goods sector. Given the stark difference in factor intensities in
production, a change in the demand structure could potentially increase the rate
at which labor is allocated to the service sector.
32
However, there exist potential barriers to the flow of labor. For example, consistent
with the theory by Wang (2016), the central government may depend on the
support from its workers to maintain its control. A sufficient share of the labor
force would then be employed in the goods sector. This limits the amount of labor
that can flow freely between the production sectors. It will eventually hurt the
expansion of the labor intensive service sector.
Productivity
The most important determinant for the speed of transition, however, is the
relative productivity growth between the production sectors. The misallocation
of capital pose a serious threat to the productivity growth in the goods sector.
The state firms operating in the goods sector benefit from preferential access to
finances. This inhibit the reallocation of capital out from the goods sector. With
better access to capital, the state firms in the goods sector have less incentives
to improve productivity. This implies that the goods price decline relatively less.
Because the relative price change between goods and services is lower, this slows
down the growth in the expenditure shares devoted to services. Consequently, the
speed of transition towards the tertiary industry is significantly reduced.
4.3.3 Technological catch-up
Despite the negative effects of factor market frictions, there are factors beyond
the scope of the theory by Boppart (2014) that may affect the transition. China
has an enormous potential in technological catch-up. China’s productivity level,
in both state and privately owned firms, lags far behind that of the United States,
which is the world’s leading nation for technology and innovation.
33
As a latecomer, China has an advantage in that it can adopt technologies
already available abroad. The mere adoption of these technologies would increase
the productivity level in China. Because the technologies already exist, the
productivity growth will be very high and the time it takes to catch-up to some
given threshold will be shorter. In other words, China has the potential to narrow
the productivity gap with the United States in a relatively short period of time.
If China successfully adopt and implement the available technologies, this could
lead to an acceleration of economic growth.
Symmetric adoption
The introduction of new technologies in the economy have the potential to increase
the aggregate productivity growth. If all firms and sectors have equal access
to the new technologies, the absolute productivity level in the economy would
increase. But the relative gap in the growth rates of productivity between the
production sectors would be unchanged. Thus, because the distortions in the
factor markets still prevails, the effect on the relative price between goods and
services is maintained. The symmetric adoption of technologies do not affect the
relative growth rates of productivity, and thus have no effect on the relative prices.
In isolation, the introduction of new technologies have no effect on the speed of
transition.
Asymmetric adoption
The adoption of technologies may be costly. The technologies may be expensive,
the installation time-consuming and the high-technological production may require
high skilled workers that demand high wages. Being financially integrated, the
goods sector would then have a comparative advantage in the adoption of the
34
technologies. This could offset the negative effects from capital distortions.
However, if the goods sector consist of monopolistic state firms, the goods price
may not decline. The rent-seeking feature of the state firms in the goods sector
thus implies a marginal effect on the speed of transition at the most.
Being credit constrained, the service sector would be relatively slower in the
implementation of the new technologies. But as the costs of technologies diminish
over time, and the service sector would eventually also adopt the technologies.
This trigger the expansion of new markets in the service sector that have enormous
growth potential, such as e-commerse. The transition would accelerate. Although
it takes longer time, the transition toward the tertiary industry grow more rapidly
once the technologies are implemented in the service sector.
5 Combining the structural changes
This section analyse how the two separate structural changes, the privatization
process in the manufacturing sector and the transition from industry to services,
affect each other. I first discuss how a policy favoring the state firms in the
manufacturing sector lead to a faster transition toward the tertiary industry.
Secondly, with the policy introduced, I discuss how a change in the demand
structure toward services lead to a reduction in the employment share of private
firms in the manufacturing sector.
I assume a more market-oriented reform is implemented (Leutert 2016), which
sufficiently supports the development of the service sector. This lead to a
better allocation of resources between the manufacturing sector and the service
sector. The central government being concerned about both political and economic
stability, control the strategically important sectors in the economy. Its control
35
is maintained through the monopolistic state firms in the manufacturing sector.
The state firms, often referred to as the backbone of the economy, dominate the
manufacturing sector.
State Monopoly
Speed of transition
Flow of K&L to Ser.
P-firms in Manuf.
Figure 3: Direction map: The dynamics of how state firm monopoly power in the
manufacturing sector increase the speed of transition from industry to services.
5.1 Monopolistic state firms and industry-to-services
A policy that strengthens the power of the monopolistic state firms in the
manufacturing sector can speed up the transition from industry to services. The
dynamics are illustrated in Figure 3. Both the monopolistic state firms and the
private firms operate in the manufacturing sector. As in the horizontal structure
framework discussed in Section 3, the monopolistic state firms is active in both
the labor and capital intensive industries, while the private firms operate in the
labor intensive industries only.
36
The reason for the introduction of the policy is twofold. The government wants
to strengthen its control in the important part of the economy, this is ensured
by increased competitiveness of the monopolistic state firms. In addition, as a
financial instrument, the monopolistic state firms are instrumental in boosting
production during a recession. A strong state sector is important to avoid financial
crisis. In normal times, they should act as profit maximizing firms just like the
private firms (Wen & Wu, 2014).
The policy thus demand the monopolistic state firms to become more efficient. The
rise in productivity level come from further restructures and mergers of existing
state firms. More power is also delegated to lower level, which increase state firms’
incentives to improve productivity. The power of the monopolistic state firms are
now strengthened by both productivity improvements in the private firms and
also by productivity growth within the state firms themselves. Consequently, the
introduction of the policy increase the unequal position of the state and private
firm in the manufacturing sector.
Eventually, the more efficient monopolistic state firms impede the development
of private firms in the manufacturing sector. Despite being more productive, the
private firms cannot compete with the monopolistic state firms. The monopolistic
state firms benefit from both higher productivity level and preferential access to
capital, meaning that they have resources to undergo temporary losses. The price
of the monopolistic good is effectively lower than the privately produced good. The
private firms are actively forced out of business in the manufacturing sector.
In the manufacturing sector, the government now concentrates on developing the
strategically and economically important state firms without the disturbance from
the competitive private firms. Therefore, the government support the development
of private firms in the services sector. The support includes a greater flow of
37
both capital and labor allocated to the service sector. This allow private firms to
establish businesses in new markets within the service sector.
Being high-productive and labor intensive, the private firms have enormous
potential to expand in the service sector. The development of private firms flourish.
Ultimately, the policy speed up the transition toward the tertiary industry.
Demand Ser.
Private firms Manuf. State firms Manuf.
Capital and labor Ser.
Private firms Ser.
Private/state-ratio
Productivity Manuf.
Wage rate Manuf.
Capital and Labor Manuf.
Figure 4: Direction map: The dynamics at which a structural change in demand
affect the employment share of private firms in the aggregate economy and in the
manufacturing sector.
5.2 Structural change in demand and private firms expansion
The government can also strengthen its control in the manufacturing sector
without having to monopolize the state firms. The government can promote private
38
firms development in the service sector by carefully ease the capital restrictions.
This increase the flow of capital allocated to the service sector. A change in the
demand structure towards services will amplify this process.
In Figure 4, the left hand side illustrate the dynamics at which private firms retreat
from the manufacturing sector when there is a structural change in demand. A
shift in demand toward services lead to a larger flow of resources allocated to the
service sector. This is because the government encourages the development of
the service sector. With more capital and labor directed to the service sector,
production of services is more attractive for the labor intensive private firms.
Private entrepreneurs establish businesses in the service sector. Competition lead
to a fast expansion of the markets within the sector. As a result, the share of labor
employed in private firms increase.
Within the manufacturing sector, however, the dynamics are more complicated.
The right hand side of Figure 4 illustrate the dynamics within the manufacturing
sector. Less resources are directed to the manufacturing sector. This force all
firms within the manufacturing sector to improve productivity. The higher growth
in productivity eventually increase the wage rate. This change the composition of
state and private firms in the manufacturing sector.
The wage rate increase because the rise in productivity is accompanied by a shift
in what products the workers in the manufacturing sector produce (Romei Apr
2011). The majority of the goods produced in the manufacturing sector are
exported. When productivity improves, the production of low-technological goods
such as textiles and wearing apparel for exports is reduced. A larger proportion
of production is devoted to high-technological goods, such as computer parts and
telecommunication equipment (Romei, 2011). The shift involve a change away
from the production of low value-added goods that depend on abundant and
39
cheap labor. As production becomes deeper involved in high value-added goods,
more skilled workers are required, and higher educated workers demand higher
wages.
The shift in production harm the private firms relatively more than the state
firms. The private firms are involved in the production of the low-technological
goods. With the shift in production, the profit of private firms are restrained
by two forces. First, the redirection of labor out of the manufacturing sector.
Despite higher productivity, this inhibit the expansion of the labor intensive private
firms. Secondly, the higher labor costs prevents the establishment of private firms
in the high-technological industries. Hence, the private firms retreat from the
manufacturing sector.
Because the government supports the development of the service sector, the
transition from industry to services is amplified by a structural change in the
manufacturing sector. This ends the privatization process in the manufacturing
sector, but increase private firms’ share of total employment in the economy.
Hence, the government can strengthen its control in the manufacturing sector
without having to monopolize the state firms.
6 Conclusion
This thesis reviews and discusses the existing literature on structural change and
growth in China, and discuss how the privatization process in the manufacturing
sector and the transition from secondary to tertiary industry affect each other.
Productivity growth in the private sector has been the most important driver of
economic growth. But the emergence of large monopolistic state firms inhibit the
development of the private sector and threatens the realization of the economy’s
40
potential GDP. The distortions in the allocation of capital and labor between
state and private firms inhibit the structural change from industry to services in
China.
The introduction of a policy favoring the monopolistic state firms slows down
the privatization process in the manufacturing sector and increase the speed of
transition toward the tertiary industry. A structural change in demand toward
the tertiary industry slows down the privatization process in the manufacturing
sector, given sufficient governmental support of private firms development. Hence,
the speed of transition towards the tertiary industry is amplified by a slowdown
of the privatization process.
The future development of the Chinese economy calls for further state sector
reforms that allow market forces to play a greater role. Boosting competition
is important for the development of private firms in the service sector, and also
to offset the slowdown in domestic growth. Implementation of new technologies
can be instrumental for growth in the future. But a key challenge for state sector
reforms in the future is in deciding when and how to allow market forces play a
larger role.
Lastly, given the observed reduction in private employment share in the manufacturing
sector, further empirical research on the existence of state and private firm in the
secondary industry could reveal if this slowdown is temporary or will prevail in the
long-run. Unfortunately, obtaining Chinese firm-level data from is very difficult.
It is therefore beyond the scope of this thesis.
41
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