Challenges to China’s Policy: Structural Change

Comparative Economic Studies, 2013, 55, (721–736) © 2013 ACES. All rights reserved. 0888-7233/13

www.palgrave-journals.com/ces

Regular Article

Challenges to China’s Policy: Structural Change HELMUT WAGNER Department of Economics, FernUniversität in Hagen, Universitätsstr. 41, Hagen 58084, Germany. E-mail: [email protected]

This paper focuses on the challenges China is confronted with in the context of structural change. It first shows that the service sector in China is ‘relatively small’ compared with other developed and developing countries in their historical context of structural change. Then it discusses – against the background of the experiences of former emerging economies that have, in the meantime, progressed towards ‘developed’ economies – why the service sector in China has to change. Afterwards it analyzes the challenges that China is confronted with in relation to ongoing structural change. Finally it draws some policy implications and then concludes. Comparative Economic Studies (2013) 55, 721–736. doi:10.1057/ces.2013.22; published online 1 August 2013

Keywords: structural change, growth dynamics, economic development, China JEL Classification: O1, O4, O5, P5

INTRODUCTION China is confronted with major challenges in the context of structural change. Here, we understand the term ‘structural change’ as changes in the relative importance of the agricultural, manufacturing and service sectors, measured either in terms of value added or employment.1 The structural change literature provides impressive evidence that this process usually goes along That is, structural change is here analyzed in the framework of the ‘three-sector-hypothesis’ that has a very long tradition (see, eg, Fisher, 1939, 1952; Clark, 1957; Fourastié, 1949/1969). Alternative descriptions of these three sectors are primary, secondary and tertiary. 1

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with an increasing share of services in GDP and in employment (see, eg, Fuchs, 1968; Kuznets, 1971; Maddison, 1989, 1995, 2007a; Kongsamut et al., 2001). China still has, in comparison with other countries at similar stages of development, a low share of services in GDP and in employment. This paper argues that this will (or has to) change for both economic and socio-political reasons. It also stresses that the implications for the economic and the political system of China are significant. The paper is structured as follows. The next section ‘The service sector in China in comparison’ shows that the service sector in China is ‘relatively small’ compared with other developed and developing countries in their historical context of structural change. The subsequent section ‘Why the service sector in China has to change’ discusses – against the background of the experiences of former emerging economies that have, in the meantime, progressed towards ‘developed’ economies – why the service sector in China has to change. The penultimate section ‘Challenges China is confronted with in the context of ongoing structural change’ analyzes the challenges that China is confronted with in relation to ongoing structural change. The final section ‘Implications and conclusions’ draws some policy implications and then concludes.

THE SERVICE SECTOR IN CHINA IN COMPARISON Recent studies have argued that the service sector is relatively (or ‘too’) small in China compared with countries that underwent ‘traditional’ structural change patterns (see, eg, Australian Government, 2005; Blanchard and Giavazzi, 2006; Li and Zhang, 2008; Zheng et al., 2010). Indeed, if one compares the sector structure in China with that in developed economies (OECD), and also emerging economies such as India, as shown in Figures 1–3, one can see that the service sector in China is relatively small. Figure 1 delineates the structural patterns in China since 1960; it shows that the industrial sector is dominant over the last few decades. The typical structural patterns of the OECD-countries (today’s advanced industrial economies) since 1870 are presented in Figure 2. Figure 2 shows that, measured in current prices, the service sector always (at least since 1870) ‘dominated’ the industrial sector in the OECD-countries. If measured by employment shares, the service sector ‘dominated’ or surpassed the industrial sector in the OECD-countries before 1900 (see Figure A1 in the Appendix). As we can see from Figures 1 and 2, the sector structure in China has developed very differently than in the average OECD country. Figure 3 shows that this is also true if we compare China with another large emerging market economy, namely India, as in India, like in the OECD-countries (in their Comparative Economic Studies

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Industry Services

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Figure 1: China: Value added (% of GDP) Data Source: The World Bank, World Databank, World Development Indicators

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Figure 2: OECD-countries: GDP by sector (%), current prices Data Source: Maddison (1989, p. 20)

early stages of development), the service sector share is higher than the industrial sector share (see also Kotwal et al., 2011). Indeed, against the background of these stylized facts, it becomes apparent that the service sector in China is relatively small and thus expandable. We will consider some arguments or interpretations that can explain the particular characteristics of structural changes in China. Over the past few decades, China has engaged in a huge program of industrialization and development. The speed of industrialization has been driven, on the one hand, by a politically-controlled liberalization Comparative Economic Studies

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Figure 3: India: Value added (% of GDP) Data Source: The World Bank, World Databank, World Development Indicators

process2 and, on the other hand, by targeted subsidies to industrial stateowned companies partly financed by forced savings. Chinese companies have received a wide range of subsidies from the government, such as tax exemptions, cash grants, discounted raw materials, water, power and land. Beyond that, state-owned banks have been pressured to lend to sectors favored by policymakers. Against this background, in the 1990s and early 2000s China became the world’s workbench (reflecting a ‘division of work between the nations’) as there were huge offshoring investments mainly in manufacturing.3 This explains part of the strong dependence of the Chinese economy on investment. (The political side of this process will be explained in more detail in the section ‘Implications and Conclusions’ below.) We have seen that China is unusual (by comparison to India and OECD) with respect to its previous structural pattern. However, China is not unique in managing to create a large industrial sector (and thus a smaller service sector) for a relatively extended period of time. This can be seen by looking at the structural change pattern of Germany. Figure 44 and Figure A2 in the 2 This process began after the post-1978 reforms in China; see Wagner (1981), Chow (2007) and Xu (2011) for details on the early period of reform. The first wave of reforms mainly affected the agricultural sector. The second wave of reforms in the 1980s and 1990s primarily concerned the industrial and service sectors, property rights and institutions (see Maddison, 2007b), whereas in the late 1990s and 2000s the banking and finance sector and international economic relations were involved. 3 See, for example, Xu (2011). In the 1990s, many of these foreign direct investments were implemented in the so-called ‘Special Economic Zones’ (see ibid). 4 Figure 4 is in constant prices (no data with current prices for the late 19th and early 20th century Germany have been available). Nonetheless, Figure A2 in the Appendix (which is in current prices) supports the above hypothesis.

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Agriculture Industry Services

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5 18 0/5 55 4 18 /5 6 9 18 0/6 6 4 18 5/6 7 9 18 0/7 7 4 18 5/7 8 9 18 0/8 8 4 18 5/8 9 9 18 0/9 9 4 19 5/9 0 9 19 0/0 0 4 19 5/0 1 9 19 0/1 2 3 19 5/2 3 9 19 0/3 5 4 19 0/5 55 4 /5 9

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Figure 4: Germany: GDP by sector (%), constant 1913 prices Data Source: Hoffman (1965, p. 33), own calculations. Figure includes war breaks

Appendix reveal that Germany was similar to China with respect to the dominant share of the industrial sector. The industrial sector in Germany dominated the service sector for more than 100 years (see Figure A3 in the Appendix for presentation in sector-employment measurement).5 This shows that a country can sustain a dominant industrial sector for a very long time without losing its competitiveness within the world economy. Although it is normal that the size of the service sector differs across countries (even with the same development stage) because of socio-politicoeconomic reasons,6 there are convincing arguments for the hypothesis that China is under pressure to change its economic/sectoral structure in order to stabilize its economy. This will be explained in the next section.

WHY THE SERVICE SECTOR IN CHINA HAS TO CHANGE As mentioned in the introduction, structural change is a common aspect of development. That is, the service sector becomes dominant over other sectors, measured either in terms of value added or employment. There are three common explanations of this structural change: (a) income elasticity of 5 Of course, there is a caveat insofar as one has to be careful with different dates for comparisons, for example, of late 19th and early 20th century Germany to late 20th century China. 6 One might here also refer to countries in Eastern Europe, some of which have also had a small service sector over a long period of time. These Eastern European countries shared a specific characteristic with China (at least before 1990), namely a communist planning system that has largely determined their structural change process.

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services demand, (b) Baumol’s cost disease and (c) the costs of industrialization that force countries/governments to foster tertiarization. (a) Because of the high income elasticity of services demand, it can be expected that a country like China with a rising income level will soon show a higher private demand for services. (b) ‘Baumol’s cost disease’ is associated with structural change. Baumol and Bowen (1965, 1966) indicated that some sectors of the economy are subject to an increase in labor costs as they tend not to benefit from increased efficiency. Despite all kinds of technological advances, health-care and other public services like education, municipal administration and garbage collection suffer from this cost disease. Therefore, there will be cost differences between sectors – with high costs in the service sector – that, under certain circumstances, will imply a reallocation of labor toward the service sector, as shown by Baumol (1967) and Ngai and Pissarides (2007). (c) There are political economy reasons for structural change. The costs of industrialization, after a while, tend to induce governments to take measures favoring tertiarization.7

In many emerging economies, the process of industrialization has tended to create increasing inequalities in income distribution, together with high macroeconomic imbalances and volatilities.8 These inequalities, imbalances and volatilities have regularly led to complaints and revolts in the poorer part of the population, so endangering the legitimacy or acceptance of the economic and political systems (depending upon the conflict culture or mentality of a country or society). Therefore, to prevent further revolts and to stabilize their systems, governments eventually aim for a fairer distribution of income by introducing institutional reforms such as higher minimum wages, investment in a health-care system and in social security, unemployment insurance and so on. Furthermore, when the macroeconomic imbalances also include an increase in unemployment, governments (in some countries) try to create employment directly by expanding their share of production and, in turn, their workforce. Thus, if necessary, the government sector expands and plays the role of employer.9 These institutional 7 There are numerous references hereto in the literature of social and economic history, particularly of the emergence of the social or welfare state in Europe and elsewhere (eg, Eichenhofer, 2007, Kaufmann, 2003, Castles et al. (eds), 2012). 8 See, eg, Brenner et al. (1991). See also Steckel and Floud (1997), Szreter (1997), Kniivilä (2007), Rosenbloom and Stutes (2008) and Jankowska et al. (2012). Imbalances and volatilities here refer mainly to current account imbalances and ‘price imbalances and volatilities’ incorporated in inflation episodes and asset-price booms and busts. 9 This might also be seen as a specific background element of ‘Wagner’s Law’ (Wagner, 1892).

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reforms in the welfare system and social policy have strengthened the tertiary sector. These experiences also resemble China’s present development: the country’s industrial growth (its phase of industrialization) over the past two decades that has been driven mainly by the growth in world trade and the international division of labor brought about by globalization. Nevertheless, the service sector has been increasing for three decades already (see Figure 1) and will continue to grow in China for the political economy reasons mentioned above. By 2011, the service sector in China was already responsible for 43% of economic output. This was only 3 percentage points less than the secondary sector (46%) (See National Bureau of Statistics of China, 2012, p. 5). This developing tertiarization was partly a by-product of the industrialization process and partly was triggered by the attempt of the communist government in China to react to social – internal and external – tensions over rising income inequalities (see, eg, OECD, 2011, pp. 15–16) and macroeconomic imbalances10 created during the industrialization process. Moreover, the Chinese government will continue to react in such a way to these imbalances. That is, the service sector (including private as well as state services) will expand even more in the near future, as the communist government in China is forced (because of these tensions) to create a fairer distribution of income and a reduction of external imbalances.11 The 12th Five-Year Plan (2011–2015), as well as the previous 11th Plan, has already prioritized the development of services in order to put more people to work by making economic growth more labor-intense and strengthening consumption over exports and investment. The very high savings rate will come down and wages will increase (through the introduction of higher minimum wages). Higher state expenditures on education,12 to establish a health-care system and other welfare system components,13 have 10 These include current account imbalances as well as ‘price imbalances’ such as inflation and asset-price booms. See IMF (2011). 11 This also has been recognized by the Chinese political leaders. Recently, China’s Premier Wen Jiabao has said that ‘there are structural problems in China’s economy that cause unsteady, unbalanced, uncoordinated and unsustainable development’ (see Time 18 June 2012, p. 37). 12 The Chinese population is still not educated enough overall to develop a service sector along Western lines (see, eg, OECD, 2011). Higher expenditure on education is necessary for providing complex, knowledge-intensive services. Low levels of education in many parts of China account for inequalities in income distribution between the Eastern urban areas and the Western rural areas. In the latter, knowledge-intensive services lack highly skilled staff. Even in the Eastern parts of China, knowledge-intensive corporate services in areas such as advertising or IT are still underdeveloped (Gallagher et al., 2009). 13 Since 2003, China’s rural health insurance scheme has risen to 97% (starting from 3% in 2003; see Economist 8 September 2012, p. 20). To date, however, welfare in China has been more like an affirmative action or investment in manpower. However, this should change soon because of the pressures highlighted above in this section.

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also been added to the agenda. Last but not least, a further revaluation of the yuan (to reduce the price of imports) is planned to rebalance the so far exportdriven economy toward more imports and domestic consumption.14 All this will further foster the development of the service sector (private as well as state services). Revaluation could also resolve the currency dispute with the United States and raise levels of competitive pressure to force domestic industrial enterprises to improve efficiency. This may even lead to more outsourcing to other (even less developed) countries and thus increase the relative weight of the service sector against manufacturing industry, leading to new jobs in the service sector. Overall, a main element (or hope) in rebalancing the economy and thereby strengthening the service sector will be to make China less susceptible to fluctuations and crises in the global economy and thus to stabilize the path of economic growth. Ageing will also favor structural rebalancing in China as the elderly tend to spend relatively more on services.15 The pattern of industry within the tertiary sector will even change, shifting the balance further toward consumer services (particularly those produced in the state administrative, health and leisure sectors). This will reduce the productivity of the service sector, with consequences for economic growth.16 Last but not least, it could be argued that the industrial sector may soon become less important (relative to the service sector) in China, as manufacturing offshoring to China may become less attractive for the industrial countries as wages – and other – costs continue to rise so much in China. At any rate, there is currently a tendency towards significant rise of wage costs in China, which reduces its attractiveness as an offshoring location. Against the backdrop of fierce locational competition in the context of globalization, this should reduce offshoring investments in China and thus the share of the industrial sector there. (For a more specific discussion of this point, see the section ‘Challenges China is Confronted with in the Context of Ongoing Structural Change’ below.) The question is how fast the structural change process happens. At this point, one has to consider that a specific characteristic of today’s world appears 14

In fact, the yuan has already been strengthening vis-a-vis the dollar for quite a while now. See Stijepic and Wagner (2012). This is particularly the case if the social security system is small or less developed. Alternatively, the society will have to provide more social services to the growing number of elderly. China has one of the largest ageing populations of the emerging countries (see Wagner, 2012). However, other Asian countries, like Hong Kong, Singapore and South Korea, also are ageing faster than other countries (see UN Population Division). By 2030, over half of the world’s elderly will live in Asia (excluding Japan). 16 As will be argued in the section ‘Challenges China is Confronted with in the Context of Ongoing Structural Change’, the shift towards services, and in particular consumer services, will reduce economic growth. 15

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to be that, driven by intensified competition in the context of the globalization process, the stepwise transition from the dominance of one sector to the other occurs or has occurred faster than in earlier times. That is to say, the structural change tends to develop faster (towards tertiarization) in times of globalization.17

CHALLENGES CHINA IS CONFRONTED WITH IN THE CONTEXT OF ONGOING STRUCTURAL CHANGE This ongoing structural change toward tertiarization will have important (micro- and macroeconomic, as well as non-economic) implications for the respective countries. In the case of China, tertiarization will likely lead to transitory unemployment of certain labor providers particularly in the tradable sector18 and thus migration.19 Even more importantly, it may also lead to (a) a decrease in economic growth, (b) a decrease in the current account surplus and foreign reserves, and even to (c) inflationary pressures. (i) To reiterate, industrialization tends to go along with institutional reforms in the welfare system and social policy that strengthens the tertiary sector, in particular consumer services. This will tend to reduce the economic growth rate in the respective countries.20 The reason is that some activities in the tertiary sector have lower levels of productivity compared with those in the industrial sector. Most notably, the growing activities in welfare and social policy (including those in the state administration, health and education sectors) are characterized by relatively low levels of productivity, whereas the knowledge-intensive corporate services have had higher levels. Furthermore, the activities in the state sector have lower levels of productivity compared with those in the private sector (see also Duarte and Restuccia, 2010 and Baumol et al., 1985). Therefore, this government-driven process of welfare system expansion, which aims to diminish income inequalities and macroeconomic imbalances 17

See hereto, eg, Welfens (1999). Nevertheless, there are large differences in patterns and speed of structural change across countries and regions (see, eg, McMillan and Rodrik, 2011). A major driver for such a faster development of structural change, in the case of China, is knowledge externalities incorporated within foreign direct investments (organized in China predominantly as ‘joint ventures’ with domestic enterprises over the past two decades). 18 These job losses may partly be offset by job creation in the non-tradable sector that, however, is likely to be slower and will evolve only with a time lag (see Guo and N’Diaye, 2009). 19 On the theory of the correlation between sectoral shocks and unemployment see, for example, Lilien (1982); Brainard and Cutler (1993); Mills et al. (1996); De Loo (2000); Basile et al. (2011). 20 See also Eichengreen, Park and Shin (2011) on the slowing down of rapidly growing economies like China. Comparative Economic Studies

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and thus to counteract the danger of a systemic legitimacy crisis, will reduce the overall/average productivity growth in the economy. Eventually, with advancing development, the economic growth rate will decline. (ii) The intended rebalancing of the economy and the associated strengthening of consumption over exports and investment as a growth driver (also favored by the 12th Five-Year Plan of the Chinese government21) will reduce China’s current account surplus through increased imports and reduced savings. Consequently, the stock of China’s foreign reserves will decrease, and because of declining savings the growth rate will decline too. Moreover, tertiarization (a shift to the service sector) requires – and is facilitated by – a real appreciation of the exchange rate and structural reforms to raise productivity in the non-tradable sector.22 (iii) Tertiarization may even lead to an inflationary pressure in China if the government tries to reduce the differences in income differentials across sectors in order to prevent social unrest (as argued above in the section ‘Why the service sector in China has to change’). The reasons are the following: productivity growth in the service sector, particularly in the rising consumer service sector, is lower than the productivity growth in the industrial sector. Hence, wage increases should be lower in the service sector from a market point of view. However, if the Chinese government tries to reduce or minimize the differences in income differentials across sectors by improving the relative income conditions of the so far worsedispositioned income groups of the service sector, growth rates of wages in the service sector will tend to converge toward those of the industrial sector despite lower sectoral productivity growth in the service sector. This may end up in inflationary pressure when the share of the service sector increases.

As argued above, rising wages and production costs in general tend to drive some offshoring investments out of China toward other, still cheaper, emerging economies. However, this decrease in offshoring should be rather small (see again Germany as an example). Wages are only one component of locational competition. Other similarly relevant elements are tax burdens, the quality of labor, rule of law, political and administrational governance, and the quality or reliability of supply chains. In addition, the sheer size of the domestic market is a strong argument for further (albeit lower) offshoring investments in a location like China even when wages there increase. 21

For specifics of the 12th Five-Year Plan, see APCO (2010). This could also be seen as a lesson from Japan’s experience of the 1980s (see N’Diaye, 2010, pp. 15–16). However, as sometimes argued (see, eg, McKinnon, 2006), an appreciation of the Chinese exchange rate, in turn, might drive the economy toward deflation and a liquidity trap. 22

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IMPLICATIONS AND CONCLUSIONS We argued in this paper that China’s service sector is relatively small, compared with other countries. Thus, when comparing China’s structural change pattern with that of the typical OECD country (with a longer history of structural change), one can conclude that China’s service sector is indeed relatively small. However, it needs to be considered that China is in a process of transition from a developing toward an industrial country and was, two decades ago, still a very poor country.23 Nonetheless, the assertion that China has a relatively small service sector is corroborated when comparison is made with other recently poor emerging market economies such as India. In the section ‘The service sector in China in comparison’, we briefly explained why the service sector is still relatively small in China. To be more specific, one has to emphasize that over the past decades China has been a country with a communist political system and a state-planning (‘socialist market’) economy. This fact has also affected the process of structural change up to now. Over several decades, the communist party in China has engaged in a huge program of industrialization and development. The communist governments in China prioritized the development of industry during the past decades by providing very favorable prices for industrial products and subsidizing state-owned enterprises through export subsidies and import controls. In addition, the process of industrialization was favored by the kind of offshoring that China, from the mid-1980s onwards, received from developed countries that chose China as their workbench (see Wagner, 2012).24 This drove China towards strong industrialization and hindered earlier or faster tertiarization. In the meantime, the service sector has already caught up with the industrial sector in importance over the past three decades.25 This shift toward services will likely progress for the three reasons discussed here: (a) the high income elasticity of services demand, (b) Baumol’s cost disease and (c) the social costs associated with industrialization that will force the Chinese governments to foster (further) tertiarization. 23 In 1978, China was a poor and primarily agrarian economy. Per capita GDP in PPPs was then lower than in India. Only in 1992 did China overtake India in terms of GDP per capita, and in succeeding years widened the gap between the two countries. 24 The Chinese government under Deng Xiaoping regarded foreign trade as an important source of investment funds and modern technology. Therefore, it relaxed restrictions on commercial flows and legalized foreign investment by permitting and encouraging joint ventures with foreign enterprises. 25 One has here, however, to take into account that the overall employment share of services in China ‘is highly concentrated in below-average productive sectors such as retail trade and other community and personal services’ (DeVries et al., 2012, p. 219).

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This tertiarization process will, however, pose serious challenges for the economy and politics in China. The main challenges of tertiarization and rebalancing of the Chinese economy will be, as outlined above: (a) a decrease in economic growth, (b) a decrease in current account surplus and foreign reserves and, perhaps, (c) inflationary pressures. In the medium to long term, China should adjust to the typical structural development pattern. This, however, can still take quite a while, as the example of Germany has shown, a country where the industrial sector dominated the service sector for about 100 years. However, it is to be expected that the adjustment to the ‘typical’ structural change will happen in China sooner, compared with Germany, because of the pressure of globalization. Against the background of the above-described challenges of tertiarization and rebalancing of the economy, China’s leadership should soon start or intensify preparations for these challenges (see, eg, Gallagher et al., 2009; Deer and Song, 2012).

Acknowledgements My thanks go to Denis Stijepic for his excellent research assistance and to three anonymous referees and the editor, Paul Wachtel, for their comments.

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APPENDIX

70 60 50 40 30 20 Agriculture

10

Industry Services

0 1870

1900

1950

1980

1987

Figure A1: OECD-countries: Employment by sector (%) Data Source: Maddison (1989, p. 20)

Figure A2: Germany: GDP by sector (%), 1950–1990, current prices Data Source: Statistisches Bundesamt

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736 70 60 50 40 30 20 10

Agriculture Industry Services

0 1870

1913

Figure A3: Germany: Employment by sector (%) Data Source: Maddison (1995, p. 39)

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1950

1992