Deepak Lal: Walking on two legs

THE CHINESE ECONOMIC MIRACLE: I

I visited China in October after a gap of five years. I found it transformed.

As in the other economic miracles I have personally witnessed in my life time""Japan in the early 1960s, and South Korea in the early 1970s""the pace of change is breathtaking, as its scale, given China's size.

Its most visible physical manifestation is the change in the physical landscape, with construction in the intervening period leaving few familiar landmarks.

There is a verve and energy, particularly amongst the young, which seems boundless. For me, the major symbol of the change was a visit to a Communist shrine in Shanghai: the traditional house where the Chinese Communist party was founded.

In the mid 1990s, it was still surrounded with traditional houses and drab "socialist" housing.

When I visited it last autumn, it looked forlorn in a little street off a large pedestrian mall containing every symbol of decadent Western capitalism: Starbucks, McDonalds, Pizza Hut, Kentucky Fried Chicken, French restaurants, karaoke bars and elegant shops with every Western brand in stock.

The mall was filled with the burgeoning new affluent Chinese middle class. I wondered what those old Communists looking down from their Marxist heaven would make of this capitalist paradise that their successors have created.

Perhaps Dr Manmohan Singh should give free passage to the indigenous Communists and Leftists tormenting his government to visit this Chinese Communist shrine and the economic miracle surrounding it.

So how has this come about? Can the miracle be sustained? What are the lessons for India? And in the race for growth of the two emerging Asian giants who is likely to win: the tortoise or the hare? These are the questions I will explore in this and the next two columns.

China's movement from the plan to the market began with Deng Tsao Ping's retreat from the collectivisation of agriculture in 1978 with the introduction of the household responsibility system.

This in effect restored, all but in name, privately run and owned family farms. This reversal of policy was the pragmatic response to the deep economic and social crisis caused by Mao's collectivisation, Great Leap Forward and the Cultural Revolution.

The peasant's response was stupendous. Agricultural output, which had grown at 2.9 per cent p.a between 1952 and 1978, grew at 7.6 per cent p.a. from 1978 to 1984 (Justin Lin, American Economic Review, March 1992).

The large increase in farm incomes led to a rapid rise in savings, from below 5 per cent of GDP from the 1950s to the mid 70s, to nearly 34 per cent in 1994.

The rise in savings was also fostered by China's forced demographic transition with its one-child policy, which reduced the dependency ratio (the number of the old and young to workers) and thus""on the lines of the life cycle theory of savings""to a rise in the savings rate (see F Modigliani and S L Cao, Journal of Economic Literature, March 2004).

The crucial difference between China and Russia in their transitions from the plan to the market lay in their initial conditions. Russia and Eastern Europe had about 90 per cent of their labour force in state-owned industrial enterprises, whilst most of the labour force in China (80 per cent) was in agriculture.

For Russia and Eastern Europe the only route to a more efficient private market economy was a "big bang" dismantling of the state-owned industrial enterprises.

China could, through its own rural big bang, immediately convert the majority of state employees into private owner operators, and see a rise in output rather than the losses experienced by Russia, leaving time for a gradual reform of its inefficient state-owned industrial enterprises.

A momentous unintended consequence of the privatisation of agriculture was the initiation of a boom in small-scale non-farm rural enterprises. This began with Deng's injunction that it was virtuous to be rich. The local party officials took this to heart, becoming directors and managers of township and village enterprises (TVEs).

With the rise in farm incomes the pent-up demand for manufactured goods and housing was met by these TVEs. Collectively owned but run as profit-making capitalist enterprises, they provided the local authorities extra budgetary resources and their officials legal opportunities to become rich.

Unlike the state enterprises, they did not carry any welfare responsibilities and were free to hire and fire the abundant local labour in a completely free labour market.

With Deng's creation of the special economic zones in China's southern rim in the early 1980s, these TVEs and later individually owned private firms became the spearhead of a Dickensian capitalism which, using the cheap labour in the Chinese countryside with foreign technology, self financing from household savings and enterprise profits, and (some) foreign capital, became the processing centre for manufactured goods in the world.

This labour-intensive industrialisation is now spreading inland along the Yangtze.

Total employment in TVEs rose from 28 million in 1978 to 60 million in 1996. There was dramatic growth in individually owned enterprises, rising from nothing in 1978 to 4 million in 1984, and 23 million in 1996, employing 76 million people.

They have been the motor of China's spectacular labour-intensive industrialisation. Angus Maddison (in his Chinese Economic Performance in the Long Run) estimates that real value added in this new small-scale sector rose by about 22 per cent a year from 1978 to 1994. It has made China the workshop of the world.

These spin-offs from the privatisation of agriculture were aided by the massive buildup of infrastructure by the state. Labour-intensive export industries were further helped by domestic price reforms, and one of the largest unilateral liberalisations of foreign trade in history. Today, most relative prices in China (unlike India) are closely aligned to world prices. Chinese exports have exploded, growing eightfold between 1978 and 1995.

By 2003 China was the world's third-largest trading country, when its trade increased by over $200 billion""twice the level of India's total trade in 2002.

Its share of global trade is six times that of India's (N Lardy, IMF-NCAER "Tale of Two Giants" conference, November 2003).

As its non-state sector grew, China undertook a gradual reform of its state-owned industrial enterprises. Most were set up, as in India, under the unviable heavy industry-biased industrialisation strategy.

In the reform period, they have been kept alive to avoid losses in output and employment, till the dynamic non-state sector is large enough to absorb the labour their closure would release.

Today 70 per cent of manufacturing output is produced in the non-state sector, even though 70 per cent of all fixed assets and 80 per cent of working capital is still in the state sector.

Most state firms are making losses, worsened by the "social" welfare burden they continue to carry. Worried about the social disorder entailed in their wholesale closure, the Chinese government has to tread warily.

Closing the worst loss-making units has reduced state employment from 109 million in 1995 to 70 million in 2002, of which 10 million are in manufacturing.

The rest have been kept alive by subsidies through the banking system. The consequent debauching of the financial system and inefficient uses of massive domestic savings pose serious problems for China's economic future, taken up in my next column.