Information about Asia and the Pacific Asia y el Pacífico

I Overview

Eswar Prasad
Published Date:
June 2004
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Information about Asia and the Pacific Asia y el Pacífico
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Eswar Prasad and Thomas Rumbaugh 

China’s transformation into a dynamic private-sector-led economy and its integration into the global economy have been among the most dramatic economic developments of recent decades. Indeed, China’s growth performance over the last two decades has been spectacular, with GDP growth averaging almost 8 percent. China now ranks as the sixth largest economy in the world (at market exchange rates). The expansion of China’s role in the world trading system has been no less remarkable, with its overall share in world trade rising from less than 1 percent in 1979 to about 6 percent in 2003.

There are strong prospects that China’s rapid economic growth and trade expansion could be sustained well into the future. However, a number of macroeconomic and structural vulnerabilities need to be addressed for this potential to be fully realized. Given the size and complexity of the Chinese economy, many of these reform challenges are interrelated. China’s traditional approach to reform has been incremental (Box 1.1) but, in view of its rapid opening up to the world economy, a more concerted and multifaceted approach to the reform process will be crucial to maintain rapid growth and manage the challenges associated with the process of global integration. This Occasional Paper provides an overview of some of the key aspects of China’s recent growth and integration with the global economy and discusses some of the main policy challenges that lie ahead.

Rapidly Expanding International Trade

The expansion of its international trade has been a particularly noteworthy aspect of China’s rising prominence in the world economy. China’s exports and imports have grown at an average rate of 15 percent each year since 1979, compared with a 7 percent annual expansion of world trade over the same period. This process has been facilitated by trade reforms and the general opening of the economy that have led to a surge in foreign direct investment (FDI) and increased integration with the global trading system. Interestingly, as discussed in Section II, the rapid expansion of China’s trade thus far is not unprecedented in either its scope or speed. Other Asian economies such as Japan, Korea, and the newly industrialized emerging economies of Asia were able to maintain even higher export growth rates, on average, for about a 30-year period. This international experience implies that China could maintain relatively strong export growth for a number of years. Given China’s large population and still substantial development potential (as reflected by its current per capita income of only $1,060), China could have a bigger impact on the global economy than the other economies mentioned above.

China’s trade expansion in part reflects greater specialization in production within the Asian region, with China now serving as the final processing and assembly platform for a large quantity of imports going from other Asian countries to Western countries through China (see Prasad and Rumbaugh, 2003). These changes have resulted in a shift in China’s bilateral trade balances, with its increasing trade surpluses with Western industrial countries being offset by rising trade deficits with many Asian countries. Reflecting its growing prominence and rising appetite for imports (including for meeting domestic demand), China has been an important source of growth for the world economy during the recent global slowdown. During 2001–03, China accounted for about 24 percent of world growth (using purchasing-power-parity-based GDP). China’s imports are growing rapidly from all trading partners and it is now the third largest importer of developing countries’ exports after the United States and the European Union. China has even contributed to the recent strength in world commodity prices; it is now the world’s largest importer of copper and steel, and among the largest importers of other raw materials, including iron ore and aluminum.

While China’s integration into the global trading system is likely to benefit both the global and regional economies, there will no doubt be some short-run distributional effects across countries. The countries most likely to benefit from the expansion of China’s trade include exporters of capital-and resource-intensive products, while countries that specialize in labor-intensive exports similar to those of China will have to undergo significant adjustments to increased competition from China. Trade expansion will also pose some domestic challenges within China itself. Expanding trade could increase regional income disparities, while foreign competition could aggravate social pressures arising from job dislocation and rising unemployment.

Box 1.1.China’s Approach to Economic Reform

For three decades after the 1949 revolution, China followed a policy of socialist economic development based primarily on the centrally directed allocation of resources through administrative means. By the late 1970s, this approach was increasingly recognized as being untenable and unsustainable, and an overhaul of the economic system was initiated.

China’s approach to economic reform has been gradual and incremental, without any detailed “blueprint” guiding the process. This incremental approach is best depicted in a metaphor attributed to Deng Xiaoping as “crossing the river by feeling the stones under the feet” and is still applicable to many of the reforms being carried out by China today.

This incremental approach has been characterized by the following features. First, reforms tend to be undertaken first on a pilot or experimental basis in some localities before they are applied to the whole country. In the view of the authorities, this minimizes disruptions to the economy, allows deficient policies to be modified based on experience, and provides time to build the necessary institutions for full implementation. Second, another strategy frequently employed has been the use of intermediate mechanisms to smooth the transition to a market-oriented economy. One example of this is the setting up of Special Economic Zones in the early 1980s as a way of gradually introducing foreign capital and technology. Finally, the Chinese leadership has consistently tried to preserve the socialist character of the economy while introducing market-oriented reforms. For example, even though policies have been conducive to the rapid growth of the nonstate sector, state enterprise reform has been gradual with no signs of a mass privatization strategy for large and medium-sized enterprises as pursued by other transition economies.

Economic reform since the late 1970s can roughly be divided into five phases.1 In the first phase (1978–84), the organization of farming was decentralized to the household level, agricultural prices were raised, and some state-owned enterprises were allowed to retain profits as an incentive for good performance. The success of the rural reforms encouraged the authorities to introduce further reforms to the urban industrial sectors in a second phase (1984–88), including some liberalization in enterprise pricing and wage setting, introduction of enterprise taxation, and breakup of the monobank system. Fourteen major cities in the coastal areas were also opened up to foreign trade and investment.

The third (1988–91) and fourth (1992–1997) phases continued the reform process, but were also characterized by the lack of effective institutions and instruments for macroeconomic management. Inflation increased considerably after price liberalization and, in the third phase, the authorities recentralized many price controls and administered sharp contractionary policies to control double-digit inflation, This was effective in stabilizing prices but also produced a sharp slowing in the economy, mounting losses in state-owned enterprises, and rapid increases in interenterprise debt that threatened to further destabilize the macroeconomic situation. In the fourth phase, stimulative policies returned, leading the economy into another growth cycle.

More fundamentally, however, the highlight of the fourth phase was in 1992, when the Communist Party formally embraced Deng Xiaoping’s view that the market system was not incompatible with the ideals of socialism and called for the establishment of a socialist market economy. This provided essential political support for major decisions to restructure the role and function of government, as well as the development of plans to speed up enterprise, financial, and social reforms and set the stage for a more fundamental “globalization” of the Chinese economy, in a fifth phase (1998 to present). This most recent phase has been characterized by a broader and more general opening up of the economy, including more broad-based trade liberalization and comprehensive commitments in the context of accession to the World Trade Organization to open the agricultural and services sectors of the economy.

1 For a further description of the earlier reform periods see Bell, Khor, and Kochhar (1993) and Tseng and others (1994).

Price Dynamics

As a result of increased integration with the global economy and continued domestic price liberalization, prices in China are increasingly market determined and traded goods’ prices have achieved substantial convergence with international prices. Even though not all prices in China are market determined, understanding the causes of variations in aggregate prices is important for domestic macroeconomic policy management. Characteristic of the challenges of modeling inflation dynamics in China, it has experienced two recent episodes of mild deflation (1998–2000 and 2001–02) despite sustained high output growth.

The analysis in Section III suggests that supply-related factors have been key determinants of recent price dynamics in China, especially during the recent deflationary episodes. Some of the supply factors are transitory, including the declines in commodity prices at the beginning of each of these episodes and restraints on administrative price increases. There are also longer-term factors on the supply side, such as productivity gains from strong investment, a series of tariff reductions, state enterprise reform, and adoption of new technologies that continue to exert significant downward pressures on prices. As discussed further below, a large labor surplus in rural areas and excess capacity in some state enterprises are also acting to keep costs and prices down. On the other hand, strong growth of monetary aggregates has supported price increases, particularly in 2003.

Real Exchange Rate Fluctuations

A great deal of recent debate has focused attention on China’s exchange rate regime. China maintains a de facto fixed exchange rate regime, with the renminbi linked to the U.S. dollar within a narrow trading band. China’s strong export growth, expanding market shares in major trading partner countries, and rapid accumulation of reserves have raised questions about whether the renminbi’s link to the U.S. dollar may have resulted in an undervaluation of the currency. However, estimating a currency’s “equilibrium exchange rate” is a very complicated matter, with the difficulties greatly compounded in the case of a developing country like China that is undergoing substantial structural change. Indeed, as the analysis in Section IV shows, existing techniques provide a very wide range of estimates of the equilibrium exchange rate from a medium-term perspective, and each of these estimates is in turn sensitive to various assumptions.

The analysis also shows how different sources of shocks could affect the medium-term path of the exchange rate. The currency’s value will be inexorably linked to the ongoing structural reforms of the economy, and will reflect further opening of domestic markets to foreign goods and services in line with World Trade Organization (WTO) commitments. Moreover, the medium-term movement of the exchange rate will depend on the nature and pace of liberalization of capital controls. Thus, discussions about attaining a particular level of the exchange rate may be less productive than focusing on the broader benefits of exchange rate flexibility for China.

Fiscal Policy

As the economy opens up, domestic macroeconomic policies will have a prominent role in reducing vulnerability to external shocks. For an economy with a tightly managed exchange rate, fiscal policy is therefore of considerable importance. With relatively low explicit government debt (26 percent of GDP) and a modest budget deficit (3 percent of GDP), China clearly does not face immediate concerns of fiscal sustainability. However, as discussed in Section V, the government faces a number of possible future obligations associated with potential losses in the state-dominated banking system, the future funding requirements of the pension system, and rising expenditure pressures, especially for education, health, and other social programs. Resolving the substantial quasi-fiscal liabilities poses a significant medium-term challenge. This challenge could increase substantially if macroeconomic conditions, especially growth, were to become less favorable or if structural reforms were not forceful enough to prevent the accumulation of new contingent liabilities. This highlights the urgency of undertaking structural reforms since many of these liabilities could otherwise pose an even greater burden in the future.

Another aspect of the public finances that is relevant to macroeconomic outcomes is related to intergovernmental fiscal relations. The 1994 fiscal decentralization reforms succeeded in raising government revenue and in increasing the share going to the central government, and appear to have been effective in stimulating growth at the provincial level. However, this growth has been unbalanced and income disparities across provinces have widened over time. Center-local fiscal relations have not been effective in reducing these disparities, especially since the transfer mechanism from the center to the provinces is not sufficiently progressive. Furthermore, the resources available to provinces, especially the poorer ones, have not kept pace with their rising expenditure mandates. This has led subnational governments to rely on indirect sources of financing and the associated creation of implicit liabilities at the local level poses significant fiscal risks. Section VI discusses the decentralization reforms and their effects, and reviews the main challenges that lie ahead in improving the structure of intergovernmental fiscal relations.

Banking System Reform

Financial intermediation in China occurs mainly through the banking system. State-owned banks dominate the banking system and are the main official source of financing for companies, since the stock market is relatively thin and there is no corporate bond market. Banks have a crucial role in intermediating the substantial amount of private saving in China, which is estimated to be around one-third of total household income. Bank lending has supported the high level of investment growth, which has made an important contribution to China’s growth performance in recent years. Stability of the banking system is therefore crucial for promoting sustained growth. Section VII discusses the financial sector reforms that have been undertaken recently and highlights the remaining challenges. The urgency of financial sector reforms has increased as domestic banks will need to be prepared to face intense competition when, under WTO accession commitments, the financial sector is opened up to foreign banks in 2006.


Many of the inefficiencies in the Chinese economy are ultimately manifested in labor market outcomes. Unemployment and “underemployment” of a significant portion of the rural population remain pressing concerns as the economy adjusts to the effects of state-owned enterprise (SOE) reforms and WTO accession. Section VIII surveys recent labor market developments and indicates that, even with strong output growth, the unemployment problem is in fact likely to worsen over the next few years due to restructuring in the rural and state enterprise sectors. How soon the unemployment problem will be brought under control will depend in large part on the degree to which the reforms described earlier are undertaken. To mitigate social pressures as labor is shifted from agriculture to other parts of the economy and from the state sector to the private sector, further progress will be needed in strengthening the social safety net, including the pension system, unemployment insurance, health care, and the minimum living allowance. Needless to say, these measures will have fiscal implications as well, again reflecting the interconnectedness of required reforms on various fronts.

The Outlook

China’s economy has good potential for sustained robust growth over the medium term, based on its attractiveness as a destination for FDI, a high domestic saving rate, underlying improvements in productivity stemming from reduced barriers to both internal and external trade, and significant surplus labor. But fulfilling its potential for high growth and continued integration with the global economy will depend largely on successful management of the diverse set of financial and social risks that China faces. This, in turn, will depend crucially on the pace and effectiveness of core macroeconomic and structural reforms. Implementing a broad and concerted reform agenda, and doing so in an expeditious manner, is indeed the crucial challenge facing Chinese policymakers.

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