China and the world of tomorrow

Linda Yueh, currently a visiting professor at London Business School, is a media commentator and contributor to Bloomberg TV News. She is a fellow in economics at Oxford University where she serves as the Director of the China Growth Centre and has spent time as an international corporate lawyer practising in New York, Beijing and Hong Kong.

Her latest book, The Economy of China (Edward Elgar Publishing) was released in May 2010. Stuart Crainer discusses her current research into the developments that have been taking place in China and the pace and impact of what is happening there.

The Economy of China is basically the story of China and its economic development since 1979, a period in which China became a hallmark in the global economy. Its impressive economic growth propelled it from being one of the poorest countries in the world to becoming its second largest economy, and it did this through an informal transition from a centrally planned to a more market-oriented economy.

My goal was to explain Chinese economic growth by emphasising just how important the role of institutional reform was in its transformation, which meant providing an overview of all the main sectors of the economy and examining each sector by looking at institutional changes, policies and directives from the early stages of the reforms to the challenges of the present day.

Because so many of the institutional changes were rather informal, the Chinese were able to incentivise agricultural output without privatising land, for instance. It wasn't the kind of institutional transformation that you saw in other economies in transition, where privatisation and liberalisation were the norm. Instead, in China the change was gradual.

Basically though, when you look at the reforms still needed if China is to grow into a sustainable major economy, more formal institutional changes will be needed. In other words, while you can incentivise farmers to produce output by giving them returns from their labour, if you want to establish domestic demand and prevent the volatility associated with global exports, you need to make reforms in interest rates, create a social welfare system and allow capital account outflows. And these measures are, by definition, much more formal.

This is what surprises quite a lot of people because there is a perception that policy and great management are required for the kind of success that China has had, and these factors are definitely part of that success.

I think, however, that what China demonstrates is that if a government sets a permissive regime, a lot of market-driven entrepreneurial activity actually starts from the grassroots. China allowed the market segment to develop, and that was enough to inspire entrepreneurs to begin to develop new industries and create new markets.

Probably one of the more surprising things was the extent to which this informal institutional arrangement gave way to increasingly formal institutional reforms. In the last decade, for example (and for the first time), both a property law, which is an explicit market supporting institution that defines and protects private property rights, and a contract law for individuals were put in place.

Yes, exactly, because one common perception was that there wasn't a rule of law in China so therefore you couldn't have a sustainable market. And while what developed was not a perfect rule of law, quite a lot of the formal institutional protections were extended by the 2000s.

For example, private firms could become limited liability partnerships, and private firms could list on the stock exchange. The proof is in the pudding: those changes have supported productivity growth in China in the past decade that was even higher than what it was in previous decades. In fact, industrial output averaged about 23 per cent in the last decade (per annum, in real terms), but it was only half that in the 1980s and 1990s when Chinese growth already was robust.

I think China is facing many challenges. It has 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's able to do that, then it has the potential of transforming itself from what it is currently, which is a lower middle-income country, to an upper-middle-income country over the next decade or so.

At the same time, it is important to be aware that once an economy hits this middle-income threshold, its growth rate slows because the initial catch-up phase ends. For instance, if you want productivity to increase (which has to sustain the next stage of growth), you have to protect innovation, and that implies much better intellectual property rights protection.

Yes, absolutely. I think they have to pay more attention to what we in the West take for granted as supporting the market in advanced economies — transparent regulation, effective rule of law, efficient dispute resolution and security of transactions.

This is not an uncommon step for developing countries. It's just that China had institutions dominated by the state, just like 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 as well.

When it comes to Russia, the comparison to the replacement of communism by capitalism is interesting because when communism fell in Russia in 1989, it was quickly replaced by the privatisation of all state-owned industries. The change in China, as I mentioned earlier, was an informal, slow process — and it began a decade earlier.

The similarity to India lies mainly in the fact that they're both such big countries — over one billion people; but it is important to keep in mind that there are many differences between the two. The main one is that China has had to gradually dismantle state-owned enterprises, which is very different than the challenges that India faced when it began its upward path after gaining independence from Great Britain.

The Indian economy has seemingly turned a corner, which can be dated to a move towards embracing greater global integration. For example, it joined the World Trade Organisation when it formed in 1995, which enabled it to integrate its services sector and that has helped to diversify the Indian economy. As a result, Indian growth, at the moment, is approaching Chinese rates, growing 8.8 per cent in the second quarter, which is substantially higher than the 6 per cent it grew at over the previous 15 years or so.

But whether or not that's sustainable depends a great deal on its ability to continue diversification — that is, can India sustain a bigger industrial sector and a more diversified services sector which create jobs?

To do that, India will require some very difficult reforms involving boosting human capital, such as improving the educational system. Thus, while India has tremendous potential, it also faces the enormous challenge of industrialising sufficiently to create employment.

The key point is that India still hasn't developed a reasonably skilled, large labour force the way China has; and without that, it's hard to industrialise. While industry is a relatively small share of GDP relative to services and agriculture, a country needs to it create a wider base of jobs. If a country doesn't create jobs, people have no incentive to go and acquire education in order to get a job. It's quite a chicken and egg problem.

I visit quite often; for example, I was there in January 2010 working on giving advice on the country's 12th Five Year Plan, and I was there the following May and June for conferences debating how China can rebalance its economy.

Not directly, but it was perhaps the first international seminar the Chinese government's top policy body had ever held on the Five Year Plans, and they invited three international experts to give them advice on the 12th Five Year Plan. I was one of them.

I'm optimistic, but cautious. That's because I see a number of significant downside risks. After all, so much of Chinese growth has occurred within this very complicated context of state ownership with quite a lot of restrictions on the free market — restrictions on everything from its banking system to managing the business cycles to the ability to meet the expectations of foreign investors.

All these factors give me some cause for concern. So, I see China's underlying fundamental growth potential to be very positive, but I also see the number of challenges that it faces as it tries to lift average incomes significantly above $3,000 per capita, which is what it is at the moment.

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