Demystifying the Chinese Economy

WASHINGTON, DC – China had an advanced and prosperous civilization for millennia until the eighteenth century, but then degenerated into a very poor country for 150 years. Now it has resurged to become the world’s most dynamic economy since launching its transition to a market economy in 1979. What drove these fateful changes? In my recent book Demystifying the Chinese Economy, I argue that, for any country at any time, the foundation for sustained growth is technological innovation. Prior to the Industrial Revolution, craftsmen and farmers were the main source of innovation. With the largest population in the world, China was a leader in technological innovation and economic development throughout most of its history because it had a large pool of craftsmen and farmers. The Industrial Revolution accelerated the pace of Western progress by replacing experience-based technological innovation with controlled experiments conducted by scientists and engineers in laboratories. This paradigm shift marked the coming of modern economic growth, and contributed to the global economy’s “Great Divergence.” China failed to undergo a similar shift, owing primarily to its civil-service examination system, which emphasized the memorization of Confucian classics and provided little incentive for elites to learn mathematics and science. The Great Divergence had a silver lining: developing countries could use technology transfers from advanced countries to achieve a faster rate of economic growth than the countries that were at the industrial vanguard. But China failed to exploit this benefit of backwardness until the transition from a command economy began in earnest. In the wake of the communist takeover in 1949, Mao Zedong and other political leaders hoped to reverse China’s backwardness quickly, adopting a big push to build advanced capital-intensive industries. This strategy enabled China to test nuclear bombs in the 1960’s and launch satellites in the 1970’s. But China was still a poor, agrarian economy; it held no comparative advantage in capital-intensive industries. Firms in those industries were not viable in an open, competitive market. Their survival required government protection, subsidies, and administrative directives. These measures helped China establish modern, advanced industries, but resources were misallocated and incentives distorted. Economic performance was poor. Haste made waste. When China’s market transition started in 1979, Deng Xiaoping adopted a pragmatic, dual-track approach, rather than the “Washington Consensus” formula of rapid privatization and trade liberalization. On the one hand, the government continued to provide transitory protection to firms in priority sectors; on the other, it liberalized the entry of private enterprises and foreign direct investment into the labor-intensive sectors that were consistent with China’s comparative advantage but were repressed in the past. This approach enabled China to achieve stability and dynamic growth simultaneously. Indeed, the benefits of backwardness have been breathtaking: 9.9% average annual GDP growth and 16.3% annual trade growth over the past 32 years – a stellar achievement that holds valuable lessons for other developing countries. Now China is the world’s largest exporter and its second largest economy, and more than 600 million people were pulled out of poverty. Yet China’s success has not come without cost. Income disparities have widened, owing in part to the continuation of distortionary policies in various sectors, including the domination of China’s four large state-owned banks, the near-zero royalty on mining, and monopolies in major industries, including telecommunications, power, and financial services. Because such distortions (a legacy of the dual-track transition) result in income disparities, they ultimately repress domestic consumption and contribute to China’s trade imbalance. Those imbalances will remain until China completes its market transition. I am confident that, notwithstanding the headwinds blowing from the eurozone crisis and the slump in demand worldwide, China can continue its dynamic growth. In 2008, China’s per capita income stood at 21% of the US level (measured in purchasing power parity), and was similar to Japan’s per capita income in 1951, South Korea’s in 1977, and Taiwan’s in 1975. Annual GDP growth averaged 9.2% in Japan from 1951 to 1971, 7.6% in South Korea from 1977 to 1997, and 8.3% in Taiwan from 1975 to 1995. Given the similarities between these economies’ experience and China’s post-1979 development strategy, it is likely that China can maintain 8% growth in the coming two decades. Some may think that the performance of a country as unique as China, with more than 1.3 billion people, cannot be replicated. I disagree. Every developing country can have similar opportunities to sustain rapid growth for several decades and reduce poverty dramatically if it exploits the benefits of backwardness, imports technology from advanced countries, and upgrades its industries. Simply put, there is no substitute for understanding comparative advantage. Justin Yifu Lin, Chief Economist and Senior Vice President for Development Economics at the World Bank, founded the China Center for Economic Research at Peking University. His latest book is Demystifying the Chinese Economy (Cambridge University Press.). Copyright: Project Syndicate, 2011.