The Development of China's Export Performance

By Javier Silva-Ruete
Alternate Executive Director of the IMF for the Constituency of Argentina, Bolivia, Chile, Paraguay, Peru, and Uruguay

At a Conference at the Central Reserve Bank of Peru
Lima, Peru, March 7, 2006

The purpose of this presentation is to discuss, from both the multilateral agency viewpoint and on the basis of my own experience, the main aspects of the remarkable development China has recorded in its export sector in the past few decades, the challenges the country must address in the medium term in order to ensure balanced and sustained economic growth, and the possibilities China's development raises for Latin America.

Part I - China's Integration in the Global Economy

Introduction

Since the end of the 1970s, the Chinese economy has been expanding dramatically with an average annual growth rate of 9 percent. Capital formation, which has been fuelled by high domestic savings rates, has been equally notable and is now estimated to be 50 percent of GDP, according to the latest IMF figures. Annual inflation meanwhile remained steady at around 1 percent between 1996 and 2003, a period which was also characterized by periods of deflation despite the rapid expansion of the economy.

The expansion of China's participation in international trade has been one of the most outstanding features of the country's economic development. Chinese exports rose on average 5.7 percent in the 1980s, 12.4 percent in the 1990s, and 20.3 percent between 2000 and 2003. By 2003, China's export growth rate was seven times higher than the export growth rate recorded by the world as a whole. Foreign direct investment has also soared, and currently over a billion dollars in FDI are invested in China each week.

Thanks to this remarkable economic growth, China no longer belongs to the group of low-income developing countries in the world and, since the end of the 1970s, some 400 million people have been lifted out of poverty.

I personally received a strong impression of economic expansion during my visits to the coastal cities of China, where trade and industry seem to be thriving at every turn. This impression is reinforced by the sound work ethos displayed by the Chinese people.

Chinese Economic Reform

Three transformations underpin China's recent economic development: the transformation from a centrally-planned to a market-oriented economy; the transformation from an agriculturally-based to a manufacturing- and services-based economy; and the transformation from a closed to an open economy.

Three factors have played a significant role in this transformation process:

a. Initial conditions that favored growth: When the reform process was started, China had one of the largest populations in the world, a low-wage labor market, and a production force whose social indicators were more on a par with those of middle-income nations. The sheer size, as well as the location, of the country played a strategic role, as did its potential economic advantages in terms of generating public goods, economies of scale, and production and transport agglomerates, and the positive influence of the economies of its East Asian neighbors.

b. Structural reforms: The fact that the State had traditionally formulated strategic development policies and been a major presence in all aspects of the country's economic and social life made it possible to implement the reforms in a disciplined manner. The first great reform took place at the end of the 1970s with the "quasi-privatization" of communal farming, which introduced private incentives aimed at boosting productivity and GDP. This was followed by a policy which allowed rural households to invest their savings in local businesses, manufacturing and transport, which gave rise to the so-called "town and village enterprises". The ensuing trade liberalization reforms included opening up an export-oriented processing segment, implementing a unilateral trade liberalization process and joining the World Trade Organization (WTO). In the initial stages, foreign direct investment was limited to the special export zones, but restrictions on this kind of investment were subsequently gradually lifted. State-owned enterprises were only slightly affected by the reform process at first, but increasingly as of 1988. The aim was to introduce incentive schemes and use financial consolidation and privatization as means of improving efficiency and competitiveness. Other notable features of the reform process include the removal of red tape, the opening of the financial markets, and fiscal reform.

c. Implementation strategy: The Chinese authorities have drawn up their policy proposals within a long-term vision, according to which, sustained high growth rates must be attained so that both labor and jobs can be redirected towards market-oriented activities. Ambitious central and local-level objectives aimed at promoting the continuous improvement of the country's position in the international economy have also been established. China's strategy is thus based on maintaining macroeconomic stability, as well as vigorous investment growth, a proactive industry and technology policy, and access to domestic credit, and, notably, ensuring a tangible improvement in education. The Chinese authorities pragmatically chose to implement this reform process gradually in several progressive stages. This has been referred to as the practice of the "art of dualism" inasmuch as market reforms are being implemented in step with the "old regime". Compensation programs have also been set up to soften the impact of the reforms on the so-called "losers" in the process.

China's Participation in the World's Main Export Markets

China has experienced a trade boom, especially in the last two decades. Chinese exports have grown from US$25 billion in 1984 to US$383 billion in 2003, which represents a jump from 1.5 percent to 5.8 percent in its share in world exports. The table below shows the evolution of China's participation in the world's main export markets.

China's Participation in the World's Main Export Markets (Chinese Imports/Total Imports)

1970

1980

1990

1995

2000

2002

2003

Japan

1.4%

3.1%

5.1%

10.7%

14.5%

18.3%

18.5%

USA

0.0%

0.5%

3.2%

6.3%

8.6%

11.1%

12.5%

EU

0.6%

0.7%

2.0%

3.8%

6.2%

7.5%

8.9%


Characteristics of China's Trade Performance

China's export activities can be described as highly dynamic and diversified. In 1987, approximately a quarter of China's exports could be classified as products that were in high demand worldwide. By 2002, this figure had risen to 60 percent, in other words, to the same proportion as that recorded by the United States' exports. Export concentration indicators show that China's export supply is highly diverse compared to that of other countries. Furthermore, current trends in the composition of Chinese exports suggest that their technological content is increasing. In other words, they are gradually shifting from relatively simple manufactured goods towards more sophisticated products. Almost 90 percent of Chinese exports in the mid 1980s consisted of primary products or manufactured items that were based on natural resources or used low technology. By 2002, this figure had dropped to 50 percent, while the percentage of high-tech exports had risen from less than 5 percent to 30 percent over the same period.

Part II - Challenges in the Medium Term

Challenges and Risks (1)

China's economic reforms have been impressive, but dealing with structural problems often generates new problems and challenges in the medium term:

a. "Soft Landing": One of the first challenges, within the context of the need to redress the imbalances in the global economy, is to ensure a soft landing for the Chinese economy from its current high levels of growth. The IMF stresses that China needs to be on the alert for any surges in lending and investment. It recommends policies be implemented to use open market transactions to reduce the excess liquidity in the banking system and suggests that the Chinese authorities consider the application of other policies, such as interest rate hikes and legal reserve increases, to guarantee that this is achieved. The IMF places particular emphasis on the need to improve credit supervision and strengthen prudential regulation so that credit growth can be kept under control and the stability of the financial system duly maintained.

b. Monetary policy and exchange policy: The IMF also points out that Chinese monetary policy could improve noticeably if the central bank were granted more discretionary power to set interest rates. In the last two years, increases in the trade surplus and significant inflows of foreign capital have led to a large accumulation of international reserves, which has further complicated monetary policy handling. In this respect, the IMF has welcomed the changes introduced into the Chinese exchange rate system as a significant step towards making this system more flexible. Although it is difficult to define an "equilibrium" exchange rate for China, the IMF firmly maintains that a more flexible exchange rate, and not just a revaluation, must be adopted if China is to increase the independence of its monetary policy and shield its economy against external shocks. The IMF mainly stresses that it is in China's interest to increase the flexibility of its exchange rate and that although the international community as a whole is responsible for correcting the imbalances in the global economy, a more flexible exchange system in China would contribute to that correction process both directly (by lowering its external surplus) and indirectly (by encouraging other Asian economies to do the same).

Risks and Challenges (2)

In order to guarantee the soundness of the Chinese economy in the medium term, consolidate its integration in the global economy, improve living standards and income levels, and ensure those improvements are evenly distributed throughout the country, the IMF recommends that improvements be made to the country's macroeconomic framework and that structural reforms continue to be implemented, especially in public finances, the financial sector, and state-owned enterprises.

a. Fiscal Policy: The IMF welcomes the medium-term fiscal consolidation plans that have been drawn up to guarantee fiscal sustainability and develop the country's capacity to satisfy future spending needs. It also recommends that China continue to lower its fiscal income target, starting in 2006, and to save any income obtained above that target with a view to helping curb the growth of domestic demand. There has been a gradual shift in public spending priorities towards social projects. The IMF supports this reorientation of China's public spending policy as it will help check investment growth and reduce the deficit in health care and education in the country. The IMF also points out that the country's fiscal consolidation efforts need to be accompanied by improvements in the structure of its public finances: mainly the adoption of a revised budget classification system, the expansion of the coverage of the Treasury's sole account, and tax reforms. Efforts must also be made to correct the imbalances in the country's subnational finances. The clarification of responsibilities and the creation of a regulated system for transfers are particularly important in this respect.

b. Investment sustainability. High levels of investment such as those recorded in China are, at first, a boon for an emerging economy, given that most countries of this kind have abundant labor but little capital. One of the obvious advantages of investment growth is the infrastructure improvements that can be undertaken as a result, especially in comparison with other countries that have a similar level of development. One worrying trend, however, is that, in recent years, investment growth has been concentrated in a few sectors only, namely, the aluminum, automobile, cement, real estate and steel sectors. Investment levels have risen over 50 percent in some of these sectors. Although growth in demand has been high, there is a risk that high investment growth rates, when driven by cheap credit and overoptimistic expectations, will at some point generate considerable slack in the economy. The IMF points out that the fact that the expansion of fixed investment in China has been the main driving force behind the country's economic growth since 2001 poses significant risks: a large portion of that investment could end up being unproductive from a long-term perspective. In the short term, any kind of investment can raise GDP, but this does not necessarily constitute a sensible use of resources. Furthermore, over investment in short run could trigger drops in prices and profits, which could in turn lead to swollen nonperforming loan portfolios burdening the banking system. China's basic problem is that the high savings rates that are fuelling the rapid growth in investment in the country are generating low returns due to weaknesses in the rate patterns that hold the system together. In specific terms, providing enterprises, especially state-owned enterprises, with cheap capital requires low lending rates. In order to keep the banking system profitable, however, borrowing rates also need to keep low. Maintaining economically unviable state-owned enterprises afloat by supporting them through the banking system therefore generates high implicit costs.

c. The financial system reform: I will now focus on a topic that the IMF considers to be particularly important: the reform of the financial system. The Chinese authorities have already acknowledged that reforming the financial system should be a key tool for ensuring sustainable growth. The decision to have the financial system intermediate China's huge savings effectively and channel them towards productive investments will have enormous repercussions for the country's long-term growth. The reform of the state banking sector must be awarded top priority in these efforts as the Chinese stock market is relatively underdeveloped and banks still dominate financial activity in the country. Attention must therefore also be paid to the development of other areas of the financial system so that companies and households have more savings and financing options. Also, more competition needs to be generated in the financial system to speed up the reform process. Fortunately, certain progress has already been made in improving banking supervision. The creation of the Banking Regulatory Commission at the beginning of 2003 and its mandate to improve the regulation and supervision of the banking system marked the starting point of banking reform in China. Injections of capital into three of the main banks have improved their balances, and their capitalization levels are improving by international standards. Strategic foreign partners are beginning to be admitted, which is expected to enhance technical innovation and improve governability in the system. The Chinese banking system is, however, enormous: it has hundreds of thousands of employees and dozens of thousands of branches, even in remote areas. This makes the reform process a huge logistical challenge. More importantly, it still remains to be seen how fast the banks can be induced to reform their lending practices (which for many years were directed by the State), operate according to strictly commercial criteria, and incorporate the principles of feasibility and risk into their projects. There is a crucial, fundamental relationship between banking system reform and monetary policy. A commercially-oriented banking system would ensure more efficient resource allocation in the country. This in turn would force banks to respond to market measures aimed at influencing the levels of economic activity. Short-term interest rates are one of the instruments typically used for this purpose in market economies. An independent monetary policy, however, requires exchange rate flexibility. So far, despite the fact that the controls imposed on capital have, to a certain extent, isolated the monetary system, the independence of monetary policy in China has remained limited. This has forced the monetary authorities to resort to non-market measures to control investment and credit growth. These may have been effective in the short term, but they have distorted the country's monetary transmission mechanism. Furthermore, the central bank has incurred heavy costs by having to sterilize large flows of capital.

d. State-owned enterprises: State-owned enterprises are becoming more market-oriented thanks to management restructuring efforts and a greater participation of foreign capital. Significant reforms still need to be undertaken, however, to ensure the viability of these enterprises in the medium term. Enhancing the role of the Commission for the Supervision and Administration of State Assets and establishing the obligation to pay dividends to the government would help channel state-owned enterprise management efforts towards improving the net worth of these enterprises.

Part III - China and Latin America

China and Latin America

In the words of a recent IDB report, Latin America needs to analyze the four dimensions of China's emergence as a major player in world markets:

a. China the success story: The Chinese experience offers some important lessons for Latin America. In the mid 1950s, Latin America's per capita income was growing faster than China's and somewhat slower than the rest of East Asia. However, Latin America's dynamism faltered in the 1960s and 1970s, exactly when East Asia began gathering steam driven by export-led industrialization. Later, China began following the policies of its successful neighbors. Over the next two decades, the gap widened between Latin America and East Asia. The important point of this story is how East Asia has managed to lift most of its people out of poverty and Latin America has consistently failed to resume growth and reduce poverty.

b. China the market: Latin America is well positioned in various respects. First, as aggregate consumption in China rises with growth in national income, Latin America is in a good position to supply the Chinese market with agricultural products, processed food and drink, as well as services like tourism. Second, China is an attractive and large domestic market for Latin American investors, and a potential source of FDI for Latin American industry. In the past two decades, there have been an increasing number of bilateral trade linkages between China and Latin America. Efforts to forge closer economic ties with China so as to benefit from ever-growing Chinese demand have already borne fruit, with some Latin American countries becoming important suppliers to the Chinese market. Although the majority of these exports today consist of raw materials and commodities, China could start absorbing higher value-added products as the country's incomes and consumption rise. The demand for more sophisticated and more varied products is also likely to increase, and as a result, bilateral trade could also become marked by more intra-industry commerce. In this context, it would not be farfetched to imagine that a free trade agreement or an economic complementation agreement with China might be on the agenda in the next few years.

c. China the competitor: China has had the attention of most of the world because of its emergence from autarky and into the global economy, its continental scale, and its extraordinary economic growth and transformation. Several factors are behind the rise in China's competitiveness. First, China's endowment structure gives it huge comparative and competitive advantages in labor-intensive goods. Second, although China's record on education is mixed, primary education in the country is constantly improving, an increasing drive to expand tertiary education (especially in science and engineering) is underway, and it has a large force of college graduates (1.3 million a year). Third, in the area of innovation, China shows signs of fast progress and potential. China leads Latin America in the numbers of R&D researchers, patent applications, and total R&D expenditures as a percent of GDP. Fourth, a substantial part of Chinese investment has been in infrastructure which, under a stable macroeconomic environment, is believed to promote growth and competitiveness by reducing costs of production, opening opportunities to diversification, providing access to knowledge and raising the returns to labor by improving health and reducing time in non-productive activities.

Lessons for Latin America

The China phenomenon has raised concerns over current and future competition everywhere in Latin America. Even though the effects of China's emergence vary across countries, two issues are clear. First, Latin America must treat China's emergence as a "wakeup call" to rethink its development policy in order to build on its strengths and address its weaknesses. Second, Latin America does not face this challenge unarmed. Fortunately, during the reform process the region amassed or reinforced several important economic and non-economic assets on which it can draw, most notably the progress it has made in economic stabilization. Two areas, equality and government, remain weaknesses, however, and should be the focus of further development. Finally, it is always useful to insist on the importance of (i) education at all levels, not only by distributing more resources but implementing policies that upgrade curricula and improve information about future job opportunities; and (ii) innovation activities that generate significant externalities that benefit firms located in the vicinity of the original innovation. In this respect, policy should shift the attention to promoting demand-driven innovation; support universities and research centers (to complement private R&D), and aim for collaborative innovation activities in potential clusters.



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