The Region

Progress and Peril in China's Modern Economy

The past 25 years have seen dramatic economic transformation, but major challenges remain.

Chun Chang - Associate Professor of Finance, Carlson School

Published December 1, 2003  |  December 2003 issue

China Images To risk stating the obvious, China today is a major force on the world economic scene, and its prominence is likely to grow in coming decades. But China's rapid evolution from a relatively poor and isolated nation into one of the world's preeminent market powers is not widely understood. This article presents a broad outline of China's transformation over the past 25 years and also describes some of the important challenges that now face the country as it seeks to secure its hard-won economic gains and expand upon them.

Seeds of reform

The seeds of China's economic growth were planted in December 1978, two years after the death of Mao Zedong cleared the way for change. At a pivotal central committee meeting of the Chinese Communist Party, Vice Premier Deng Xiaoping established his authority and called for reform of the Chinese economy. Deng and like-minded reformers adopted policies to open the Chinese economy both to market forces and to foreign influence. These policies included efforts to expand rural income and reduce central planning, but perhaps the most visible economic reform was the creation of special economic zones.

The zones, established in villages in southeast China in the 1980s, were an experiment in market economics. Foreign investors in the zones—primarily from Hong Kong, Taiwan and other Southeast Asian nations—were given exemptions from all taxes and from the regulations that hampered regular businesses in China. And while initial investments were modest, the zones grew quickly and demonstrated the capacity of free markets and foreign investors to unleash dynamic growth. Several hundred millions of dollars poured in; fishing villages became midsized cities; market forces worked.

In addition to the special economic zones, China's leaders eliminated many price controls in the Chinese economy and reformed land ownership so that farms, rather than being operated as collectives, were effectively privatized. Farmers were given the power to decide what to grow and where to sell it.

These reforms led to rapid economic growth and significant structural change during the 1980s. Foreign direct investment, for example, grew from $916 million in 1983 to $3.5 billion in 1990. Rural per capita real income doubled. China became self-sufficient in grain production. And both agricultural and industrial output grew at roughly 10 percent each year, a considerable improvement over previous decades. But there were problems as well.

Lacking a fully developed legal system, and without the other checks and balances inherent in competitive markets, China's economic reforms and the coexistence of planned and market sectors also gave rise to inflation and corruption. Absent the political and institutional infrastructure needed to support a market system, it was easy for those with personal or political connections to control newly created markets. Competition didn't exist in most markets, so prices climbed for many products, especially food and other agricultural goods.

To an international audience, the most obvious manifestation of these problems was the uprising at Tiananmen Square in 1989. While Westerners tended to perceive the protest as a student-led push for political reform and greater democracy, the true popular support for the uprising had more to do with the general public's dissatisfaction over the adverse consequences of economic reforms—in particular, rapidly rising prices for basic commodities.

Conservative forces in the Chinese government cracked down politically and economically after the Tiananmen uprising, and for several years economic reform was halted. But in 1992, Deng sought to preserve his legacy as a reformer by going on a tour of the special economic zones in southern China.

A second wave

The southern tour enabled Deng to highlight the success stories of his economic liberalization policies. And following the tour, he launched a second wave of economic reforms (though conservatives in the government continued to restrict political freedoms). In this second stage, foreign investors were no longer required to set up joint ventures with Chinese companies, but could create wholly owned subsidiaries and were permitted to enter sectors of the economy previously declared off-limits. In the countryside, local township-village enterprises were allowed to privatize. And price controls again were eased.

In the wake of these new reforms, foreign investment soared and the economy grew rapidly. But inflation also reemerged. By 1994, prices were rising at an annual rate of nearly 22 percent. And having learned from the 1980s, economic leaders acted quickly to temper inflation by ordering banks not to issue credit, by raising interest rates and also by reinstituting some price controls. Growth slowed to single-digit annual increases as did inflation. Indeed, by 1998 price levels actually began to fall. China's leaders had successfully managed what many view as "a soft landing" (see table).

A Soft-Landing: Growth and Inflation,
1994-2001

Year

GDP Growth Rate

Inflation Rate

1994

   12.6%

  21.7%

1995

 10.5

14.8

1996

 9.7

 6.0

1997

 8.8

 0.8

1998

 7.8

 -0.8 

1999

 7.3

 -1.3 

2000

 8.0

  0.4

2001

 7.2

  0.7

Source: Statistical Yearbook of China, various issues


The Asian financial crisis of 1997 also helped to shrink economic growth and inflation, as investors from Hong Kong, Taiwan and South Korea reduced their foreign direct investment in China. It should be noted that during that crisis, many outsiders thought the Chinese currency was overvalued and predicted China would devalue the yuan—ironically some of the same outsiders today think the Chinese yuan is undervalued and should be revalued—but to its credit, China resisted the pressure. By maintaining the yuan's value, China helped stabilize the economies of Hong Kong and other Asian nations, and ultimately helped to resolve the Asian financial crisis.

Reforms continue

Deng died in 1997 with his legacy secure. Economic reform continued. The major policy adopted in September 1997 by the 15th National Congress of the Chinese Communist Party was a commitment to reform and/or privatize state-owned enterprises, the large government-owned businesses that for decades had held monopolies over steel, coal, shipbuilding and other heavy industries. The SOEs are widely criticized for their inefficient production and management methods—at least half of them lose money every year—but they also employ vast numbers of people, and their privatization inevitably creates substantial unemployment. By some estimates, China's SOEs have already shed 41 million jobs. Their reform, therefore, has been a slow and difficult process.

Related to reform of the SOEs is a growing recognition that China's financial sector needs to be overhauled. State-owned commercial banks (SOCBs) have high levels of nonperforming loans; they're inefficient at allocating savings to productive investment opportunities; and like SOEs, they employ more people than necessary.

A move that will bring pressure on China to reform its financial sector was its agreement in December 2001, after 15 years of negotiations, to join the World Trade Organization. As part of its accession to WTO membership, China committed to open up its financial service industry to foreign banks and investors by 2007.

Progress at risk

By many measures, China has undergone dramatic change in the 25 years since Deng planted the seeds of reform at the 11th Party Congress. The nation's gross domestic product (GDP) is eight times what it was. It is now one of the world's largest trading economies, with six times the share of global trade that it had in 1978. And with nearly $53 billion in investment inflows in 2002, it is now the world's top destination for foreign direct investment. There is no question that living standards have improved for most of China's people, and while its political system is still a "monopoly," the economy is becoming, for all intents and purposes, a market economy.

But major challenges remain and if they aren't met soon, the undeniable improvements that China has enjoyed in recent decades will be at risk. First among these is growing inequality, between urban and rural areas and within urban areas themselves. The growing prospect of mass unemployment could well exacerbate this inequality. A second significant problem is a potential banking crisis, due to the high proportion of bad loans. And a third major challenge is the hard process of reforming China's 300,000 SOEs, an effort that involves 100 million workers and one-third of China's GDP. Each of these difficulties is intimidating in its own right; their resolution is even more daunting because they are deeply intertwined.

Reform of state-owned enterprises

While China's leadership has made a commitment to privatize a large proportion of SOEs, they've had limited success in doing so. The main obstacle, as stated previously, is that as SOEs privatize, millions will lose their jobs. Given China's already substantial level of unemployment, political leaders are reluctant to further deepen joblessness, even if continuing to support SOEs means overcapacity and inefficiency.

A potential banking crisis

China's SOEs have been kept afloat with loans from the SOCBs, an unsustainable situation given the unprofitability of most SOEs. According to some estimates, Chinese bad bank loans are as high as 40 percent of the nation's GDP. (For context, bad bank loans during the U.S. savings and loan crisis represented just 2 percent of U.S. GDP.) But SOCBs cannot force SOEs to pay back their loans—indeed, they've continued to lend to them—without causing their collapse and the inevitable political crisis that would ensue. (While the high level of nonperforming loans held by SOCBs would ordinarily lead to bank collapse, the pressure has been relieved to some degree by the monopoly that state banks hold on the savings deposits of Chinese households.)

Reforming the financial sector will be difficult, partly for political reasons but also because many managers of Chinese banks have relatively little training. It's possible that with China's entry into the WTO, SOCBs will be forced through competitive pressure to enhance their employees' skills and rationalize their lending practices.

Inequality and unemployment

While the official unemployment rate in China is under 4 percent, the Ministry of Labor admits that if it accounted for underemployment and for rural migrants living in cities but not counted in the urban workforce, the rate would be closer to 11.5 percent. But even that is most likely an underestimate.

Rural unemployment, though difficult to measure, has led to high levels of migration from rural to urban areas, exacerbating unemployment in cities and inequality within urban areas. It's estimated that between 65 million and 130 million migrant workers have moved off farms into China's cities. These people are usually given the worst jobs in cities and often treated as second-class citizens. Without good jobs for lower-skilled people, inequality within cities is extremely high, and this has led to great tensions between rich and poor.

Inequality is even more extreme between rural and urban areas. China's economic growth has been largely concentrated in the country's coastal provinces and its largest cities, rather than in the rural areas that are home to two-thirds of China's people. Indeed, it is estimated that 300 million Chinese, most of them in the countryside, still live on under $1 a day, while entrepreneurial success has brought great wealth to a tiny minority concentrated in China's largest cities. While the central government has taken some measures recently to build infrastructure and redistribute wealth to rural regions, many inland areas remain much as they were 30 or even 100 years ago.

This rural-urban inequality causes deep tensions nationally, especially as citizens in rural areas become more aware of the living standards in urban areas. China's leadership has openly admitted that inequality is a major problem, but giving the rural population equal rights would require a very substantial wealth transfer, something that may not be politically feasible. Nevertheless, the strain generated by inequality within China is an issue that cannot be ignored indefinitely.

In sum, China has undergone major economic transformation over the past 25 years. GDP growth has been extraordinary by any standard; international trade and foreign investment have soared; and living standards are significantly higher for many Chinese. But the nation continues to face significant challenges that, if not soon addressed, threaten to weaken or even reverse China's impressive economic progress.

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