The PRC's Development Path and the Current Economic Crisis

The current economic crisis is not only a short-run shock to the PRC economy, but also a challenge to the PRC's development path. The PRC has been growing rapidly since its initiation of the open-door policy in 1978, and the significant growth in PRC has greatly benefited from its low labor costs which contributes the relatively low prices of its products. Low labor cost is primarily guaranteed by the labor market reform and mostly responsible for the export-oriented development strategy in PRC. However, several potential problems are derived from the unbalanced growth path PRC has been following during the past three decades. These problems were hidden by the fast export-driven growth of GDP, especially during the high-growth years of 2001–2007, but they are seen explicitly in face of the current crisis. The unbalanced growth path has been accompanied by the process of marketization reform, and led to “dual imbalances,” both internal and external,¹ which, if unadjusted, would undermine sustainable economic growth.²

The internal imbalance, depicted as a decreasing share of consumption in GDP and investment and export driven growth, is fundamentally related to the growing income inequality. As illustrated in Figure 1, the national Gini coefficient has been increasing from 1980 to 2002, and reached around 0.45 in 2002. Though the Gini coefficient with cost-of-living adjustment is lower, a trend of increase is still revealed. And according to Li's recent estimation, the national Gini coefficient is approximately 0.48 in 2007.³ The disparity between rural and urban income in the PRC, measured by Gini coefficients, has also steadily increased (Figure 1 [ PDF 33.5KB | 1 page ]). It is worth noting that whereas income disparity within cities has tended to increase, for the nation as a whole, income disparity has fluctuated, some caused by the decrease in the urban–rural income gap, especially the decrease of such disparity around the mid-1990s (Figure 2 [ PDF 30KB | 1 page ]).

Widening income disparity is detrimental to economic growth and would bring about several consequences. First of all, as inequality rises, domestic consumption demand may grow more slowly. Under the law of diminishing marginal propensity of consumption, the rich, at the upper end of income distribution, income inequality reduces demand in a way that the rich tend to save more and consume less. For the poor, precautionary saving increases with the rise in income risks during the process of marketization. Chamon and Prasad (2008) attribute the rise in the PRC's saving ratio since 1995 to precautionary motives and underdevelopment of financial markets. As both the rich and the poor save, the saving ratio of households is higher in the PRC compared with other countries.

Figure 3 [ PDF 32KB | 1 page ] depicts the share of household consumption in GDP from 1978 to 2007, which has dramatically declined. In 1978, the share of household consumption in GDP was 48.8%. However, this share has been declining continuously since then and fell to about 35.5% in 2007. Despite the comparatively high public investment in PRC, this continuous decline in household consumption is still not enough to be compensated, and therefore, it leads to slow growth in aggregate domestic demand. It is noteworthy that high investment growth, including government investment, increases domestic demand in short run, but in medium and long run it results in over-capacity of production that needs being absorbed by external demand. As can be inferred from the gross domestic production identity, given low domestic demand and overcapacity of production, net exports are the only way to achieve high GDP growth. The upward trend in the investment-GDP ratio is shown in Figure 3 [ PDF 32KB | 1 page ]. Low domestic demand, accompanied by the high production capabilities of PRC enterprises, leads to a secular increase in exports. Statistics also suggests that compared to other economies of the similar scale, the trade dependency ratio, i.e. the sum of export and import divided by GDP, is particularly high in PRC which contradicts the general rule that trade dependency ratio is generally lower in larger economies. The trade dependency ratio in the PRC was as high as 66% in 2006, compared with 20–30% in other economies of similar scale.

Given the current system of foreign exchange in PRC, nearly all trade surpluses, foreign direct investment inflows, and remittances from abroad should be exchanged into yuan (CNY) at the banks. Therefore, the central bank needs to issue a corresponding amount of CNY to absorb foreign currency inflows that are thereby transformed into foreign exchange reserves. This increased liquidity, especially the liquidity resulting from international trade surpluses, was one of the reasons for both the high inflation and capital markets bubble, before the PRC economy was shocked by the crisis in the fall of 2008.

In addition, large income inequality also mirrors the development pattern of the PRC economy which is highly reliant on low labor costs. The low labor costs in the PRC labor market can be accounted by three reasons. The first is the large-scale influx of rural labor into cities since the mid-1990s. This urbanization process met the needs of globalization and the reallocation of labor-intensive industries from developed economies to PRC. Though rural-urban migration restrictions were loosened in the mid-1980s, actual large-scale rural-to-urban migration emerged only in mid-1990s. Throughout 1994 to 2004, the rise in wages of migrant workers was quite limited.⁴ Secondly, massive numbers of redundant workers were laid off from state-owned-enterprises (SOE) as a result of labor market reform during 1996 and 2000. This has led to more severe competition in the labor market, and thus imposed downward pressure on wages. Finally, low labor costs are also a result of inadequate protection of labor, especially for migrant workers and laid-off workers from SOEs. Many workers did not have contracts with employers in the private sector, so they did not receive social security, and so the labor costs of production were lowered. Fiscal decentralization and yardstick competition between local governments are primarily responsible for the poor labor protection, because local governments concentrate on economic growth, through attracting both domestic and foreign investment, while the interests of labor are overlooked. Therefore, when the forces of urbanization meets globalization in the PRC, labor's market power is weakened, because capital can move easily across countries and regions, while the supply of labor is sufficient and labor mobility is less free than capital. This is the basic reason why labor's share in national income has declined since 1996, which will be shown later on.

With low labor costs, enterprises do not have adequate incentive to innovate, as we have observed in the PRC. Although the country has claimed to follow an innovation-based development path, enterprises are reluctant to put their revenues into research and development, because innovation is almost always costly and risky. With inexpensive labor, enterprises maintain an emphasis on low costs, along with a low technology level, and consequently inadequate innovation. This development pattern limits firms' demand for high-skilled workers. Accordingly, the employment pressure of university graduates can partly be explained by the low wages of migrant workers in the PRC.

Apart from the internal imbalance, the PRC economy also has an external imbalance due to the unbalanced growth path. The external imbalance is associated with low labor costs, which were not completely established until the mid-1990s. Low labor costs, together with an undervalued CNY since 1994, constitutes the comparative advantages of Chinese products in overseas markets, and has led to rising exports as well as the huge amount of foreign currency reserves in the PRC. According to a Morgan Stanley estimate cited in The Economist (2007), although wages of PRC workers rose from 2000 to 2006, increases in labor productivity were much larger. Therefore, the actual labor cost per unit of products declined significantly. In addition, empirical studies have also come to a consensus about the PRC's comparative advantage in exports, especially in labor-intensive products which illustrate the Heckscher-Ohlin approach. For example, using international trade data of the PRC and the world, Yue and Hua (2002) calculate the revealed comparative advantage (RCA) index of Chinese products. Their calculations confirm that from 1980 to 2000, the comparative advantage of the PRC has largely shifted from resource-intensive products to labor-intensive ones, and international trade has accentuated this trend. Having benefited from this comparative advantage, increases in PRC exports have been enormous, which is shown in Figure 4 [ PDF 30.6KB | 1 page ]. Imports have also grown in the same period, but not as rapidly as exports. It could be seen from Figure 5 [ PDF 30.6KB | 1 page ] that net exports fluctuated around zero before 1994, but since then, exports have persistently exceeded imports. As a result, foreign exchange reserves have also risen steadily since 1994, especially in recent years, (see Figure 6 [ PDF 29.1KB | 1 page ].) Foreign exchange reserves in March 2009 reached 1,953.74 billion US dollars (US$), which is equivalent to almost one half of the country's total GDP. Although PRC entrepreneurs claim that their exports to other countries are inexpensive mainly because of low labor costs and high productivity, rising international trade conflicts have also been seen between PRC and other countries. According to Stevenson (2007), the number of anti-dumping investigations the PRC has been the focus of ranked first of all the countries in the world. During the first half of year 2007, there were as many as 18 anti-dumping investigations against the PRC, which accounted for 30% of all anti-dumping investigations in the world (Stevenson, 2007). Furthermore, the rapid increase in foreign exchange reserves is also responsible for the PRC's holding of US assets. At the end of December 2008, the State Administration of Foreign Exchange (SAFE), part of the People's Bank of China (PBoC), managed close to US$2.1 trillion: US$1.95 trillion in formal reserves and between US$108 and US$158 billion in “other foreign assets.” The PRC's state banks and the China Investment Corporation (CIC), PRC's sovereign wealth fund, together manage another US$250 billion or so. This puts the PRC's total holdings of foreign assets at over US$2.3 trillion. That is over 50% of the PRC's gross domestic product (GDP), or roughly US$2,000 per Chinese inhabitant (Setser and Pandey 2009).

Such internal and external imbalances in the PRC, and the international imbalance between the PRC and the US, however, are reasonable to some extent, as long as labor productivity in the US can be continuously enhanced. The savings ratio in the US began to decline in the mid-1980s when the US began its rapid growth of information technology and labor productivity. Labor productivity increased more rapidly after 1995, and high productivity was an essential stimulus for economic growth in the US. With the increase in productivity, workers' wages would tend to rise. When the expectation of an increase in future income is formed, to smooth consumption and maximize life-time utility, individuals would borrow to consume at present. Moreover, the highly developed capital market in the US has further encouraged this trend. Industrializing countries, like the PRC, have accumulated huge trade surpluses since the middle of the 1990s. Their purchases of US bonds and other US assets have contributed to the appreciation of these assets. In this way, these countries, including the PRC, have in essence shared the rapid growth of the US economy. However, one vital threat to the continuance of this imbalance is the question of to what extent the appreciation of US assets is related to the real rise in US productivity. If productivity growth can be sustained, high returns could be attained from the holding of US assets, and there would not be a significant departure of the “paper” economy from the real economy. Otherwise, risks may accrue to the point that adjustments would have to be made. The ongoing crisis is an opportunity for the PRC to make overdue internal policy changes, leading to a structural adjustment, so that domestic demand would increase and reduce the dependence on exports. As shown in Figure 7 [ PDF 98.4KB | 1 page ], since the third quarter of 2008, the growth rates of both exports and imports on a yearly basis have declined tremendously, and even fell to below zero after November 2008.

The economic shock has also resulted in unemployment. As Yin, the Human Resources and Social Security Minister, has announced, the current employment situation is disconcerting.⁵ The first point is that the number of new urban jobs has declined dramatically. The urban unemployment rate has risen and reached the highest level of the past three years. Second, finding a new job is becoming more difficult for migrant workers, and many among them have lost their jobs. Since September 2008, employment, especially in the export-led manufacturing sector in the Pearl River Delta and the Yangtze River Delta, has fallen dramatically. Many factories were shut down during the crisis. Surviving enterprises also cut their employment, or asked their workers to take a “long vacation”. Most of the factory employees are migrant workers (Mingong) from inland rural areas. Many lost their jobs and went back to their hometown in the second half of 2008, especially after September. According to the survey results released by the Ministry of Human Resources and Social Security, there were over 130 million migrant workers at the end of 2008. 60% of them returned home for the 2009 Spring Festival, 10 percentage points higher than the previous year. 20 million migrant workers are seeking new jobs in 2009. Compared to the year before, the number of enterprises that plan to hire in the month after the Spring Festival dropped by 12%. The overall number of vacancies was 10% lower.⁶ During the annual meeting of the People's Congress in March, the Ministry of Human Resources and Social Security announced that about half of the migrant workers returned home during the Spring Festival, among whom 80% returned to cities after the festival. 45 million of those migrant workers have found jobs, while 11 million are still unemployed.

The economic crisis has also greatly increased employment pressure on college graduates. According to the estimate of the Ministry of Education, the number of college graduates was 4.95 million in 2007, of which 1 million are unemployed. In 2008, the number of graduates rose to 5.6 million, of which 1.5 million are unemployed. In 2009, 6.1 million have graduated, which is 8.9% more than 2008. To alleviate the employment pressure, PRC has enlarged the enrollment of graduate students by 5% in 2009. The number of new job opportunities in central government-owned-enterprises for college graduates has also doubled. The central government will continue to call for graduate students to work as rural village officials. More positions would also be provided to graduates who would like to participate in education, agriculture, medical service, and poverty reduction.

Based on the average employment elasticity to GDP ratio during 2001 to 2007, as is shown in Table 1 [ PDF 88.4KB | 1 page ], if GDP in the secondary and tertiary industries grows by 6%, then employment would increase by 8.57 million. Assuming that agriculture does not create more employment, and that the total urban labor force grows by 11 million, as in 2008,⁷ 2.4 million more people will be unemployed. This is almost the number of unemployed receiving unemployment insurance from the government at the end of 2008.⁸ In other words, if the rate of GDP growth is 6%, the unemployment rate may double. However, if a GDP growth rate of 8% could be maintained in the PRC, 11.4 million new jobs would be created in the secondary and tertiary industries. Thus, the current unemployment rate may remain almost unchanged. This explains why PRC has set 8% as its goal of economic growth for 2009.

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