Why China must change ?

Spring 2011: China has become one of the world’s largest economies over the past few decades and has the potential to move into the ranks of the world’s developed nations. However, this will only happen, says Linda Yueh, China continues to institute changes in the institutional protections provided to businesses.

The story of China’s impressive economic growth since the end of the 1970s, which propelled it from one of the poorest countries in the world to its current status as the world’s third-largest economy, is one that has intrigued me for many years. The history of China’s transformation seemed worth careful investigation to determine what lessons it could provide to other emerging nations.

My research has revealed that the impressive transformation that took place was an informal one, a set of gradual developments that moved China from a centrally planned to a more market-oriented economy. As a result of what I learned, I wrote The Economy of China (Edward Elgar Publishing, 2010) in which I explain Chinese economic growth by emphasising just how important the role of institutional reform was in its transformation. To do that, I had to provide an overview of all the main sectors of the economy and examine each sector by looking at institutional changes, policies and directives from the early stages of the reforms.

Rather informal

Because so many of the institutional changes in the transformation have been rather informal, the Chinese were able to incentivise agricultural output without privatising land. The changes were not the kind of institutional transformation that you see in other economies in transition; in those, privatisation and liberalisation were the norm. Basically, when you look at the reforms still needed if China is to grow into a sustainable major economy, many more formal institutional changes will be needed. In other words, while you can incentivise farmers to produce output by giving them return from their labour, if you want to establish domestic demand and prevent the volatility associated with global exports, you need to make formal reforms in interest rates, create a social welfare system and allow capital account outflows.

Nonetheless, what has happened in China demonstrates that, if a government sets a permissive regime, a lot of market-driven entrepreneurial activity actually starts from the grass roots. China ‘allowed’ market segments to develop, and that was enough to inspire entrepreneurs to begin to develop new industries and create new markets. Informality, in fact, can lead to formality: one of the more surprising things I have discovered was the extent to which this informal, entrepreneurial institutional arrangement gave way to increasingly formal institutional reforms. In the past decade, for example (and for the first time), both a property law — an explicit market-supporting institution that defines and protects private property rights — and a contract law for individuals were put in place.

Looking to the West?

The change in legal protections for businesses is just one of the shifts China has made that emulates the practices that mark Western economies. For example, today private firms in China can become limited liability partnerships, and they can be listed on the stock exchange. The changes that already have taken place have supported productivity growth in China in the past decade. In fact, industrial output averaged about 23 per cent in the past decade (per annum, in real terms), but it was only half that in the 1980s and 1990s when Chinese growth already was robust.

To continue its spectacular growth, though, China will have to move toward a market much more clearly defined by formal legal and regulatory institutional structures, because it is such an important globally integrated economy. And, if it is able to do that, then it has the potential of transforming itself from a lower-middle-income country to an upper-middle-income country over the next decade or so.

It is important for China to be aware that, once an economy hits this middle-income threshold, its growth rate slows because the initial catch-up phase ends. So, for instance, in order for productivity to increase (which it must in order to sustain the next stage of growth), China must protect innovation; and that implies much better intellectual property rights protection.

Moving forward, I think China will have to pay more attention to what we in the West take for granted as supporting the market in advanced economies — transparent regulation, executive rule of law, efficient dispute resolution and security of transactions.

By comparison

Another interesting way to look at China is to compare the similarities and differences in what is happening there to what has taken place in other nations that are in a similar stage of growth, most notably India and Russia. For example, China had institutions dominated by the state, just as the former Soviet Union had; and those institutions had to be gradually dismantled, while at the same time China had to incentivise the usual development processes. However, the comparison to the replacement of communism by capitalism in Russia is not relevant; because when communism fell there in 1989, it was quickly replaced by the privatisation of all state-owned industries. The change in China was different; it was an informal, slow process — and it began a decade earlier.

The comparisons made to what has happened in India lie mainly in the fact that they’re both huge countries — over one billion people; but it is important to keep in mind the many differences between the two. The main one is that China has had to dismantle state-owned enterprises, which was not the case when India began its upward path after gaining independence from Great Britain. Another key difference is in the labour forces in the two nations. While China has developed a reasonably skilled large labour force through its focus on education, India has failed to do so, concentrating more on preserving the status quo in terms of class — and without a large skilled labour force it is hard to industrialise.

China’s future

Looking ahead to the next five years, I am cautiously optimistic about what is likely to happen in China. After all, so much of Chinese growth has occurred within the complicated context of state ownership with quite a lot of restrictions on the free market — restrictions on everything from China’s banking system to managing the business cycles to the ability to meet the expectations of foreign investors. What will make a difference is how business evolves as economic and legal reforms rapidly increase during the 21st century.