China – an important component in the global economy

18. Aug 2008

Christer Ljungwall Assistant Professor, Department of Marketing and Strategy, Stockholm School of Economics and guest researcher, China Center for Economic Research (CCER) ([email protected])


China’s development suggest that the global economy no longer can ignore China’s internal development. The country is most likely to affect the international development for a long period. This is irrespective of whether the direction of development is positive or heads-off in a more turbulent manner.

An adventure

Almost five years have passed since I was invited to conduct my research on China’s economy at the prestigious China Center for Economic Research at Peking University. I had finished my dissertation in economics a year earlier and the timing was perfect. Since then, my work has been a combination of academic challenges and a private adventure. I have met hundreds of people from all over China and from the most different backgrounds. I have the privilege to work with some of China’s best economists, while teaching and supervising students provides new perspectives on the younger generation of Chinese citizens. New impressions comes in plenty!

My personal view on the Chinese development have been gradually changed during my stay in the country. My analysis is now based on a combination of economic theory and empirical studies mixed with knowledge of internal processes and experiences from the Chinese society. In my view, the Olympic Games is not in any way conclusive for the Chinese economic development. The ‘risk factors’ remains regardless of the games and what can cause serious trouble will not simply go away by itself.

Overtime, I am cautiously positive with respect to China’s future. It would, however, be a big mistake to view the current relative stability as a guarantee that the Chinese economy – and the Chinese society in general – is immune to severe crises.

A fascinating development

China’s radical change has fascinated the world for 30 years[1]. Although a number of changes took place already a few years earlier, the reforms formally begun in late 1978. At that time, the Chinese economic structure was plagued by a strictly planned economy and confronted by huge problems; productivity levels were extremely low and the allocation of resources were mismatched – by it self largely as a result of the Great Leap Forward and the Cultural Revolution. In order to maintain stability the Chinese leadership took a decisive decision to reform the economy and improve the standard of living for its citizens. It is worth noting that reforms, by definition, did not come as a result of immediate political or economic crises.

The early reforms

Domestically, early reforms was a combination of improved incentive structures in the agricultural sector, the well-known household responsibility system, and changes in the monetary and fiscal systems. Principally, control of the means of production and incomes was transferred from the central government to provincial governments. As a result households and newly established private enterprises experienced rapidly increasing incomes[2].

Initially, the deregulation of prices within the industry took the form of a dual price system, that is a system in which a number of goods were given an artificial (i.e., lower) price, while other goods – mainly processed goods – were priced according to the market. This means that those parts of the country who was rich in natural resources, mainly Central and Western regions, subsidies industries and hence the economic development in coastal provinces. The price of input goods were set at artificially low levels, while the processed goods were sold at prevailing market prices.

Internationally the reforms lead China into a completely new era, at least in modern times, as domestic reforms were matched by increased openness to the global economy. The most pronounced reforms to open-up China to the global economy can be summarized as:

– decentralizing of trade including geographic prioritization, symbolized by the special economic zones and cities with less restrictions towards international trade and investments.

– prioritization of key industries.

– membership in the World Trade Organization (WTO).

Generally speaking, there has been a rapid shift away from a relatively closed economy with state control of the means of production and allocation of resources towards a situation with increased focus on the individual. Market based allocation of resources, privatization and market based pricing constitute major elements in the economy. The pace of change has been very high and involved structural changes as well as increased levels of production.

Increased aggregated production volumes has also led to a decisive shift in the composition of GDP away from agriculture towards industry and services; consumption patterns and the distribution of the economic surplus has changed. Although the statistics tell the story, there is more to it: Xu and Ljungwall (2008) show that China’s service industry is underestimated and point out that its share of GDP is in the interval 45 percent to 55 percent in 2006 (compared to 39 percent reported by the official statistics). The exercise shows that China’s GDP is 9 percent to 32 percent larger than given by official calculations.

The opportunities created by economic reforms has attracted investors from all over the world to China, which has made the country the second largest recipient of foreign direct investment (FDI). International trade has reached impressive levels and the aggregated economy – with a few exceptions – has developed with relative stability. China’s GDP increased by 11,9 percent to RMB 24,66 trillion (USD 3,46 trillion) in 2007. The highest GDP growth in 13 years. Measured in USD, the Chinese economy is now the fourth largest in the world only after the USA, Japan, and Germany[3].

At the same time, China’s economy is currently confronted by rapidly increasing general price levels. Population growth, however, is less than one percent per year. Huge differences in term of standard of living and per capita incomes are also evident, in particular between urban and rural areas. However, these differences aside, there is no doubt that the absolute majority of the Chinese population has benefited from the economic expansion. In the 17 years between 1978 and 1995 more than 200 million people were lifted out of absolute poverty. Definitely, most people in China is better off today than 30, 20 or even 10 years ago.

China has entered the international scene and has gained a considerable influence outside its borders. The country has become a global concern and its domestic development – turbulent or not – is an important component of the global economy.

China’s future

China’s fut
ure development, however, is not only discussed in positive terms. It is clear that the opinions concerning the contents and speed of reform as well as its general results differ widely among politicians, researchers and the general public – both inside China and internationally. The costs of reform, for example in terms of environmental degradation are gigantic, and the problem of huge differences in the standard of living and per capita incomes is hard to solve in the short run. The financial system lacks thorough reforms and rests upon fragile foundations; state-owned companies (SOEs) are loaded with hidden problems of enormous proportions; and the society in general is facing severe corruption and is soiled by vested interests.

The opinions stretches over a wide area from unreserved pessimism via an arbitrary view on the development to a fear of a rising superpower with unclear ambitions in international politics.

To answer the questions what China will look like in 10, 20 or 30 years may seem relevant from a number of perspectives such as how the European Union (EU) should relate to China. Such an analysis, however, is heavily burdened by unsure assumptions.

One argument in favor of a continued positive development is that the Chinese economic development follows a pattern with distinct resemblance in modern development -and trade theory: structural changes, catching-up, and factor price equalization. China fits well these three criteria, which in this context points at similarities with the early developments of Japan, South-Korea, and Taiwan. There are, of course, differences – not the least in terms of the national and international conditions prevailing in respective countries at different times. At the same time, nothing indicates that these differences should be systematic with respect to their affect on economic growth in China. Corresponding pattern of development may very well be applied to China in the future.

It should be pointed out, however, that these three factors not only are dependent on one another, but also stand in close relation the prevailing domestic and international conditions. A pattern of development similar to that of other Asian countries is applicable also to China but, perhaps with the major difference that China develops at an unprecedented pace and that the absolute size of the Chinese economy to a larger extent affects the global economy than does its predecessors.

No guarantees for continued high economic growth

The prerequisites for China’s economy to grow and develop in the previously mentioned direction rests upon a number of important assumptions such that existing problems are solved without hindrance and that coming problems are properly dealt with as they appear. Examples of obvious areas that need immediate attention is China’s inefficient financial system and its link to loss-making SOEs, corruption, capital leakage (for example from state-owned pension funds), differences in income levels and the standard of living between urban and rural areas, environmental degradation, and a rapidly changing political environment.

Without doubt, it must be clear to anyone of us that China’s rapid economic expansion and overall structural change cannot be guaranteed. The gradual reform strategy that so far has proven successful is now increasingly questioned from the perspective of sustainability – this is, not the least, evident by the insufficient reforms of China’s financial system.

Weaknesses in China’s financial system

The financial system plays a decisive role in a dynamic economy and, hence are further reforms and widening absolutely necessary. A failure in this area will, by definition, put a halt to China’s economic development. This, in turn, will bring serious consequences to the global economy.

There are two major argument in favor of such a development. The first rests upon previous experiences in other countries that financial systems from time to time undergo different stages of instability and turbulence – such as the sub-prime crisis in the US, the world’s most dynamic and transparent economy. The second rests upon the fact that China’s financial system generally is known to be fragile, filled with vested interests and political interference.

The financial system is, next to the legislating sector, the part of a country’s economy in which political interference and foot-dragging of political decisions have the highest affect. Despite sweeping reforms of China’s financial system there remains huge problems, in particular within the state-owned banks.

Government interventions in the capital market, such as capital injections to restructure state-owned banks, a deliberate strategy to keep insolvent financial institutions afloat, maintaining state monopolies etc., has created a skewed incentive structure among Chinese banks and other financial institutions. The same procedures prevail among SOEs as well as in the relationship between SOEs and state-owned banks.

The number of new loans has expanded rapidly in the past five yeas, thus increasing the probability of a new wave of bad loans and – perhaps more importantly an increasing number of bankruptcies[4]. In 2006, the share of fixed-asset investment in GDP reached above 50 percent – a historically high level – in connection to the banks financing a large number of investments in the real estate sector and increased industrial production capacity. We can already observe an increasing number of ‘bad-loans’ reports from the banks – often originating in the real estate sector – while at the same time excess capacity within certain industries indicate that a potential slowdown in economic activities, or increasing interest rates, will put severe financial pressure on firms. The latter is most evident among SOEs, which for a long time have enjoyed subsidized credits by the government.

Despite tough measures by the China Banking Regulating Committee, the average capital-ratio among Chinese state-owned banks is a mere 8 percent – significantly lower than in other Asian economies, while at the same time Chinese state-owned banks report significantly lower profits. To this can be added that investments in China generally is relatively inefficient as compared to, for example, India.

High inflation – a real threat

The high inflation rate in the Chinese economy depends on a combination of factors: high rates of fixed investment, an increasing number of new loans, a large trade surplus, increasing cost of production due to higher world prices for raw material and other input goods, increasing nominal wages, and of course higher prices on food. Behind these factors, however, is one major economic event – the rapidly increasing money supply.

As a matter of fact – and despite repeated actions such as increased interest rates and reserve-ratios – the Chinese central bank has not succeeded in slowing down the rapidly growing money supply in the last 18 months. The reserve-ratio was raised 10 times in 2007 while at the same time the interest rate was upward adjusted six times, all with the purpose of limiting overall liquidity in the economy. As it turns out, the Chinese economy has experienced a lowering of the real interest rate despite increasing nominal interest rates – indeed an interesting paradox.

According to official statistics released by the central bank, M2 reached RMB 42,1 trillion by the end of February 2008 – a growth rate equal to 17,5 percent compared with the same period a year earlier. Simple facts like this point at a continued strong liquidity in the Chinese economy. It is difficult to escape rapid price increases under such circumstances! At the same time, it is difficult for the central bank to efficiently sterilize the rapidly increasing inflow of foreign currenc
y. Interventions in the exchange market by the central bank, i.e., the purchase of USD and selling of RMB with the purpose to control the rate of appreciation of RMB, has also supported an increasing money supply leading to higher rates of inflation. Contributing to the inflationary pressure is also the natural inflow of foreign capital to China – largely due to interest rate differentials between China and rest of the world. China will definitely experience further price increases! It is also the case that the current macro-economic situation with high economic growth rates and inflationary pressure in the Chinese domestic economy, and a US and Europe on the edge of recession places the Chinese central bank and thus the central government in a difficult situation.

Lessons learnt from the late 1980s and early 1990s tells us that high rates of inflation in the Chinese economy leads to lower rates of real economic growth. Today, the situation is much more complex than in the 1980s or 1990s. A continued austere monetary policy and restrictive credit policies strikes hard against SOEs and sectors of the economy with a high level of private entrepreneurs, such as real estate developers. This can lead to devastating effects for Chinese banks. This would most certainly bring out the ‘dust under the carpet’ and, hence lead to even higher levels of money supply[5]. The result is rapidly increasing rates of inflation which, in turn, would have an immediate and negative effect on the average Chinese household through lowered purchase power and decreasing wealth. This may very well lead to social unrest.

One measure to prevent non-performing loans from reaching uncontrollable levels and lowering the costs in case of financial crisis is to widen and deepen the financial system, among other things, by establishing private banks on a large scale. A conclusive step in this direction was taken on May 11 this year.

In summary, my view of the Chinese economic development is cautiously positive. It would, however, be a big mistake to view the current relative stability as a guarantee that the Chinese economy – and the Chinese society in general – is immune to severe crises


Lin, Y., F. Cai. And Z. Li (2003). The China miracle: Development strategy and economic reform. The Chinese University Press, Hong Kong.

Nanto, D.K. and R. Shina (2001). ‘China: a major economic power’. Post-Communist Economies, Vol.13, No. 3.

Qian, Y. (2000). ‘The process of China’s market transition (1978-1998): The evolutionary, Historical and comparative perspectives’. Journal of Institutional and Theoretical Economics, Vol. 156.

State Statistical Bureau (2007). China Statistical Yearbook. China Statistical Publishing House.

Xu, D-q. and C. Ljungwall (2008). ‘What is the real size of China’s economy?’ China Economic Journal, Vol. 1, No. 1, Februray.

Xu, G. and C. Ljungwall (2008). ‘Business cycle accounting in China and India’. Forthcoming CCER working paper.

Xu, D-q. and C. Ljungwall (2008). ‘Dust Under the Carpet’. CCER report.

[1] This article is a brief overview of China’s economic development since 1978, including a discussion of the country’s near future. For a detailed overview of the most important segment of China’s reform, please see, for example: Lin et al., 2003; Qian, 2000.[2] The central government still controls means of production and incomes from a number of sectors in the economy.[3]According to calculations by CIA (2008).[4] Ernst & Young, 2005, estimated bad loans in the Chinese banking system to be in the range of USD 900 – 920 billion.[5] See ‘Dust under the carpet’, Xu och Ljungwall (2008).