Zhou Xiaochuan - Experience and Lesson from China’s Gradual Reforms
Bank Chief Economist Francois Bourguignon opened the event with an introduction of Zhou Xiaochuan, Governor, People’s Bank of China on his country’s experiences with economic reforms since the late 1970’s. Zhou came to speak on April 26th at the Bank’s ongoing Practitioners in Development Lecture Series. Bourguignon said China’s economic success has been astounding over recent decades. Bank estimates suggest 400 million people have been lifted out of poverty. Since the 1970’s, its GDP has increased five times, and growth is expected to double during the next decade. Growth and poverty reduction has been attributed to liberalization of agricultural prices and expanded rural production. Increased foreign direct investments and exports have also fueled growth. China’s success if forcing the Bank to re-examine its development models, Bourguignon said. Yet at the same time, China’s model does not adhere to the transparency stressed by international financial institutions. State banks have played a prominent role in the reform efforts.
Zhou said his talk would compare China’s transition with other emerging market economies. A centrally planned market economy is far different than an open market economy, he noted. In theory, open market economies have no cross sectoral subsidies. Redistribution is done, if at all, by fiscal policy to support a specific development goal. The main priority for centrally planned economies was industrialization and keeping a strong military industry. It was a highly distorted model, Zhou admitted. In China, agricultural production was subsidizing industries. Subsidization of military production also occurred. A radical correction by policy makers would have made inefficient sectors insolvent, causing significant unemployment, lowering GDP, and reducing the savings rate. Redistribution was necessary, but needed to be done careful to avoid social and economic instability. A gradual correction allowed reduction of discriminatory policies against the agricultural sector and exporters that existed, but subsidies for highway construction was not eliminated immediately.
The first key reform issue was addressing exports. Central market economies were operating with Mutually Economic Assistance (CMEA) models of trading within a small group of other centrally planned economies. But this was not advantageous to the smaller economies in the CMEA. But when economies opened for trade, many sectors kept their old production models. This put these sectors at a trading disadvantage with Western competitors. Consumers also became enamored with Western goods. As these centrally planned economies opened for trade, their external trade levels initially declined. Zhou showed data from the former Soviet Union and Eastern European countries. Similar trends were experience in real output during the 1990’s. Unemployment rose sharply as inefficient sectors and businesses struggled within the new system. China’s experience was vastly different as the implementation of reforms before the 1990s was well under way. Zhou then described some of the aspects of China’s trade with countries on its borders.
Reforming the financial sector required additional financial resources as well as some sequencing. First, policy makers liberalized the prices of agricultural goods. There was a strong concern that the reforms did not create suffering among the public, as the government feared that its economic policies would lose support. So subsidies were maintain and only gradually phased out. Some of these subsidies included tax reductions and exemptions. Zhou acknowledge there were some problems regarding tax collection due to corruption, and as subsidies and exemption increased, tax revenues declined from 28% of GDP to 10%. More capital was needed to enact the reforms, so the government encourage commercial banks to lower their lending rates to the business sector at high leverage rates. Banks were also asked to support state-owned enterprises (SOEs) to help maintain production and employment levels and allow them to transition with the reforms. Efforts were initiated in the 1980s to develop a stock market, which was hindered by poor accounting standards. These steps made it easier for the government to maintain stability with its reforms during the early stages. Work continued on building discipline and confidence in the capital market.
Zhou noted that the observed results from these reforms during the 1990s suggested economic and export growth was maintained, as was income and savings rates. On the negative side, there was capital market distortions with low standards, scandals, significant investor concern, and delays in transparency. SOEs had mixed success with the reforms as their percentage of GDP declined during the decade. One-third failed, one-third succeeded, and the others remain in transition. He suggested that shock therapy enacted in the transition economies was radically different than reforms enacted in China, and he made some comparisons. The Asian financial crisis of the late 1990s was a wake-up call for the Chinese, Zhou suggested, and spurred the government to change its banking credit culture. A key question is how to solve nonperformance loans (NPLs), and Zhou said the reforms provided the growth generation necessary to produce the fiscal resources to address this important issue.
The enactment of a stock market began with a debate as to whether establish rules first or begin practicing first. Accounting standards needed to be established, as well as rules on disclosure and corporate governance. Supervision needed to be developed to watch for fraud and price manipulation. In the later part of the 1990s, policy makers looked closely to developing sound regulatory policies. As of today, the Chinese stock market has 1,300 listed companies and a daily trading volume of $US 2.5 billion. In total market capitalization, China compares quite favorably with the transition economies.
Zhou called China’s reforms a process of partial design and partial compromise. Shock therapy was assiduously avoided, but undue support was given to sustaining SOEs. In retrospect, many now believe the reforms would have performed better if tax reform had come earlier, and banking reforms had been enacted immediately following the Asian financial crisis. An important remaining concern is pension liability. China’s aging population is placing further pressure on the country’s financial resources.
Fred Bergsten, Director of the Institute of International Economics, provided the first commentary of Zhou’s speech. Bergsten suggested China’s opening to trade was the most dramatic story of it reform process, because its rejection of globalization and trade during the 19th century led to economic mediocrity in the next century. By contrast, the current Chinese leadership is determined to lead in this era of globalization. Exports account for more than 50% of China’s GDP. He cited research by Bank economists David Dollar and Aart Kray that suggested a causal relationship between increases in globalization and increases in economic development and growth, which is symbolized best by China’s growth. He called trade protection measures currently contemplated by the US government as potentially tragic. He called the US trade deficit with China as overstated, but that there were real problems in the international trade regime. Bergsten also suggested that the Chinese economy may be overheating, which could escalate into hyper-inflation. Capital inflows have contributed to this problem. Adjusting the exchange rate can address both problems. Much of the capital inflows are speculation on the Chinese currency, and a revaluation would slow the inflows and reduce the overheating. For example, when the US dollar becomes overvalued, it leads to large trade deficits and promotes US protectionist policies.
Montek Ahluwalia, Director of the IMF’s Independent Evaluation Office, provided the second commentary. He said one could think of China as a country in transition or a low-income country experiencing rapid growth. The lessons drawn can be different depending on one’s perspective. He noted the juxtaposition of China’s policy of gradualism when compared to its dramatic growth over two decades. India’s perspective on China, Ahluwalia said, was that it was determined course taken early on. He noted that China invests 40% of its GDP, and this was a factor in its 8% annual growth. India is carefully monitoring how China is handling the financial sector and NPLs. To achieve efficiency in the banking system, it must be privatized, Ahluwalia said. China has a very high public banking sector, which raises questions about the long term objectives of Chinese policy makers. Another area of important area for further inquiry is the liberalization of capital outflows.
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