The rise and robustness of economic freedom in china

The Risks to Economic Freedom in China

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5. The Risks to Economic Freedom in China

Economic freedoms and the development they have fostered are precarious in China because they are the gift of a totalitarian political regime that has supported them while they have been advantageous to the CCP. The regime could, more readily than a liberal democracy, shift its strategy again, as abruptly as it did in 1978. It could foster a shift toward more liberal democracy, as appears to be occurring at the village level (Wang 2012), but a slowing of growth and the rising inequality anticipated by Deng Xiaoping’s opponents could also cause a shift in the opposite direction - toward a new class struggle. The circumstances under which it would consider this therefore warrant consideration and it is argued here that the slower growth due to stem from the choice to “look inward” could be an early trigger.

The middle income trap and slowdown literature

There is increasing interest in middle income “slowdowns” by developing countries that have heretofore grown strongly out of poverty (World Bank 2010; Eichengreen et al. 2011). This literature is concerned with the distinguishing the “natural” slowdown in the convergence process as poorer countries approach full industrialisation, which is due to diminishing returns to physical and human capital and diminished “catch-up” investment incentives (Lucas 2011), from political vested interests in opposing economic policy reforms needed for the final catch-up phase (Riedel 2011). The sense in which the slowdown is considered a “trap” derives from a divergence of collective interests from those of the leadership group, with the latter associated with rent extraction (corruption) that peaks at middle levels of real per capita income. If the final phase of convergence is seen as requiring more dispersion of power to control the corruption and release the rents then there are important implications for China.

So where are the rents and the vested interests that could retard China’s future growth? The financial sector is one location. Very high saving challenges this sector to allocate that saving across investment opportunities efficiently. The many weaknesses in this process, stemming in part from the protection of state owned financial institutions, have already received considerable attention (Riedel 2007; Walter and Howie 2011). Yet the potential gains from further industrial reform that reduces rents in protected corners of the economy extend well beyond the financial sector. To quantify this, in a separate study I have used a mathematical model of the Chinese economy to examine the sources of future Chinese growth (Tyers 2012).

Numerical simulations on “looking inward for growth”

The simulations are comparative static and indicative, though they derive from a database representative of ca 2005. Importantly, the model used captures the oligopolistic structure of the Chinese economy of that period, as summarised in Table 1, and it incorporates oligopolistic pricing behaviour throughout the economy. What is clear from China’s economic structure is that the agricultural and export light manufacturing sectors are relatively competitive, with few rents to physical capital. The more protected heavy manufacturing and services sectors, on the other hand, have high rents, half the nation’s value added and almost half of total employment.

Continued export led growth is simulated by a further rise to agricultural labour productivity and, via FDI, to total factor productivity in the light manufacturing export sector, combined with an arbitrarily low increase in an exogenous real production wage. Workers continue to be released by agriculture and expansion is substantial as expected. The results are included in Table 2, which also includes a simulation of the same shocks except that the Lewis turning point is past and the supply of production labour is fixed. Growth then stems from the productivity changes alone and is much reduced. The real production wage rises faster, however, and there is a reduction in the current account surplus due to a decline in pure profits in the protected sectors (in effect, a gain by workers at the expense of capital) and hence a decline in corporate saving. The table also shows the effects of one of the proposed mechanisms for new growth – further expansion of government activity. Consumption tax financing causes overall economic activity to rise modestly but the protected heavy manufacturing and services sectors, and hence capital income, are the principal beneficiaries, with households and workers worse off. If the government expansion is financed from company tax the net effects on overall economic activity are still small. Expanded government activity, by itself, is therefore not shown to be a significant source of future Chinese growth.

The greatest potential for inwardly-generated growth rests with industrial reform, which applies to both heavy manufacturing and services, including financial services. This has numerous dimensions. One is pure privatisation, which ensures that all after-tax company income accrues to households and so can be allocated by them to saving (Tyers and Lu 2008). By itself, as indicated in the first column of Table 3, this reduces national saving and the current account surplus. Other than this, however, the simulations suggest that privatisation generates no substantial growth.15 Another industrial policy reform that has been popular is to retain the proportion of state ownership but to force price competition by fragmenting SOEs. The problem with this approach is that, while it does induce more competitive pricing, it raises fixed costs substantially, and the simulations show that the latter effect dominates the former, yielding no positive growth.

Substantial growth is available, however, from directly attacking the rents accruing to SOEs by regulating their pricing with a view to forcing them to price at average cost. There has been considerable success from this in the industrial countries and the simulations show that the effect is to reduce costs in industries whose products are used throughout the economy and hence to expand economic activity substantially. The export sector is a substantial beneficiary from this and, aside from the overall expansion it offers, the associated redistribution is away from capital owners toward workers. Yet this very desirable result requires the redistribution of very considerable rents currently accruing to China’s industrial elite. It is politically difficult for the reasons made clear by Riedel (2011). The final simulation offered in Table 3 shows the effect of productivity growth in the expanding services sector on overall performance. Not only is the growth effect considerable, but it also offers a step toward the convergence of the Chinese economy with the industrialised West. As Table 3 indicates, the simulation yields substantially higher real wages the result of which is a redistribution of industrial output and exports in favour of heavier manufacturing. The Chinese economy continues to open but it is much more reliant than before on intra-industry trade with the West, in the manner of the US and Western Europe.

The difficult politics of internally generated growth

For substantial further growth to be found from looking inward, China will need to combine other elements of industrial reform with a more ardent regulatory attack on oligopoly rents. This will be difficult politically, as will the other key element of further growth, namely substantial productivity growth in the primarily state-owned services sector. Achieving this will require levels of FDI in services that parallel those in Chinese manufacturing. Heretofore, the CCP has opposed foreign ownership in key services and heavy manufacturing industries. Allowing such FDI will also be very difficult politically.

The inward search for continued growth is therefore a key threat to economic performance and hence to the attitude toward economic freedoms of the CCP. At the same time, the rise of domestic inequality and its associated class and ethnic conflict will keep the CCP under pressure. This pressure will continue to be exacerbated by the Western clamour for human rights in general and Western public sympathies with minority opponents of the CCP. Should these pressures cause the CCP to choose yet another refocus toward class struggle, economic freedoms in China will be restricted and economic stagnation looms, against the interests of the average Chinese and the of the global economy.

6. Soft Resolutions

One natural force toward the resolution of the conflicts, due on the one hand to rising domestic inequality, and on the other, to the current account surplus, is the approach of the Lewis turning point. Its arrival will see accelerated real wage growth and hence the fruits of further growth will be less concentrated and, since this will raise the share of total income available to households, the corporate share of saving should fall. This, in turn should reduce the overall saving rate and the current account surplus. It will, of course, bring with it the need for costly adjustments since, as shown in the previous section, growth will slow and the supply of labour to the heretofore efficient and relatively competitive light manufacturing sector will gradually dry up. Moreover, the net benefits from China’s growth that accrue to the global economy will also decline. Yet if, as some believe (Garnaut 2010), this transition is imminent, the silver lining it brings will be reduced political pressure on the CCP from at home and abroad and hence less incentive to abandon economic freedoms as a means of advancing both the party and the nation.

Even if the Lewis transition is imminent, there remains the matter of an orderly economic transition. Both the Republic of Korea and Taiwan made orderly economic transitions away from dependence on the transformation of their labour forces and labour intensive exports. Political transformations toward liberal democracy also occurred in both, commencing as their urban middle classes assumed numerical majorities. Of course, they were helped in this by the stimulus associated with China’s own growth surge. Japan’s initial transition was orderly, surviving the oil and commodity crises of the 1970s, but it was subsequently disrupted by policy errors during the 1980s and early 1990s. Japan’s comparatively liberal democracy could not chart those waters effectively even with the growth of China on its doorstep. Now China must do so, but without the external stimulus associated with a growth surge in a large near neighbour.

To find further substantial growth, the CCP must dig deep and produce industrial reforms that reduce the rents that currently concentrate economic gains while at the same time welcoming FDI into its hitherto protected services sectors. This will be a tall order politically. Yet China’s governments since the early 1980s have faced constant political and economic challenges and they have thus far muddled through effectively. There is reason to expect that the next Chinese government will do similarly. The fundamentals behind Chinese growth to date seem sound and the obstacles to continued transformation are known to the government and its branches (Economist 2011). Yet there has never been a full year recession in three decades and the political response to a significant slowdown of the type the Western democracies have weathered on numerous occasions remains uncharted.

As Riedel (2007) indicates, the main challenges take the form of the need for improved governance, a stronger social safety net and improved environmental protection but most of all it needs financial reform to facilitate the flow of China’s considerable saving into productive domestic investment. The external clamour for greater consumption, however, is essentially xenophobic - tantamount to demands that the Chinese should invest less and have their economy perform more poorly. A strong Chinese economy and a smooth economic transition is in the global collective interest and it will require that Western political pressure is restrained. At the same time, the Chinese are in a better position to learn from the Japanese experience and resist external pressure for economic policy changes that are not beneficial domestically. With a modicum of good fortune the CCP will hang on to DenXiaoping and Jiang Zemin theory for long enough to allow its smooth economic transition and the establishment of a dominant middle class. Thereafter, the stage is set for an associated political transition that will confer on the Chinese people the remainder of the freedoms that Popper’s tome advocates.


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Figure 1: Fruits of Economic Freedoms - China’s Relative Growth
Real GDP per worker (PPP $, log scale)

Source: Robertson (2011).

Table 1: Structure of the Chinese Economysta

Per cent

Value added share of GDP

Share of total production employment

Share of total exports

Pure profit share of gross revenue






Petroleum, coal, metals





Light manufacturing















a Pure profits are calculated from national statistics estimates of accounting profits, deducting required returns to service industry specific prime rates. Here they are presented gross of tax and corporate saving and as shares of total revenue.

Source: Model database, derived from Dimaranan and McDougall (2002), and an updating of the national data to 2005, as described in Tyers (2012).

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