China’s economy has expanded by leaps at extraordinary rates. It has done so by relying on markets, price signals and a highly unorthodox set of institutions. Although the country did not depend on global markets at the early stages of its growth, China’s growth was fuelled and sustained by the world market opportunities, starting the mid-1980s. The share of exports in GDP rose from virtually nothing in the 1960s to close to 30% in 2003, a rate of increase that is much larger than what has been experienced elsewhere in the world. Also, inward direct foreign investment has risen from close to zero in the early 1980s to around 5% of GDP. With this, China has become one of the world’s biggest trading powers, accounting for 6% of global trade flow.
China achieved global integration by: dismantling quantitative restrictions on imports, reducing import tariffs and their dispersion, making the currency convertible for current account transactions, eliminating bureaucratic red tape and other impediments to direct foreign investment, improving customs procedures, and establishing the rule of law. The country opened up gradually and reforms trailed behind growth by at least a decade. While monopoly state trading was liberalized in the late 1970s, a complex and highly restrictive set of tariffs, non-tariff barriers, and licenses were imposed. These were not relaxed until the early 1990s.
China’s export growth was not achieved through trade openness and free market forces alone.
The penalizing effect of export production tariffs that averaged around 40% in the 1990s was neutralized through duty drawbacks and other incentives for export oriented investment projects. Foreign investors were given requirements to form joint ventures, transfer technology to local partners, and source their inputs locally.
China’s export bundle is that of a country with an income-per-capita level that is three times higher. It has managed to exploit advanced, high-productivity products that one would not normally expect a poor, labor abundant country to produce and export. China’s experience shows that it not how much you export, but what you export that matters. In addition, China’s industrial structure has been shaped by policies of promotion and protection, just as in the cases of earlier East Asian tigers.
The indeterminacy of comparative advantage
The principle of comparative advantage states that trade patterns are determined by how production costs in a country differ from those in the rest of the world. These differences are associated with differences in productivity levels across industries or to differences in relative factor endowments across countries. Entrepreneurs observe costs directly and make their investment decisions accordingly.
However, in a poor developing country, investors who wish to invest in new non-traditional activities face uncertainty about the costs of operation. The risks from uncertainty are shouldered by early entrants into new industries. If they are successful, later entrants can emulate them and earn accordingly. If they fail, they pay the full cost of their failure. Because of this, market forces generate little investments in new activities (self-discovery). With this, low-income countries produce only a few high productivity goods and they earn incomes that are lower than they would otherwise be.
To measure this, Hausmann and Rodrik (2003) developed an indicator that measures the productivity level associated with a country’s export basket, EXPY[1]. After plotting EXPY against per-capita GDP for 1992, it was observed that EXPY is strongly correlated with per-capita income. This implies that rich countries export goods that other rich countries export. Also, China’s exports were associated with an income level that is more than six times higher than China’s per-capita GDP at the time.
However, some countries do not lie along this regression line; EXPY cannot be explained by per-capita income alone. Human capital and institutional quality cannot provide a better explanation either. Idiosyncratic features seem to have China with an inordinately high level of EXPY.
China has experienced the most rapid rate of growth in the sophistication of its exports since 1992. But in spite of this, some argue that their electronic products are low-cost, high-volume products with not much technological sophistication. Even so, what is surprising is that China was able to export electronic products; other countries with similar factor endowments were not able to do this.
It is not how much but what you export that matters
The scatter plot between EXPY and growth over the period 1992-2003 shows that there is a robust relationship between the initial level of a country’s EXPY and the subsequent rate of economic growth experienced by that country[2]. A doubling of the productivity level of a country’s exports results in an increase in its overall per-capita GDP growth of around 6%. This means that if China had exported only goods that other countries like it tend to export, it would not have grown as much.
EXPY is a potent force for growth because once investors discover a number of high productivity exportables, other investors are drawn in and the economy’s resources are pulled from lower productivity activities to higher productivity activities. Productivity diffusion then ensues within the economy as the productivity gains associated with producing a set of sophisticated exportables is spread around the economy and labor moves across industries and across space toward higher productivity exportable activities.
China’s exportables have been increasing, but not as rapidly as overall income. If much of its growth is due to the pattern of convergence that was observed, China might experience a significant growth slowdown in the future. To maintain its previous growth rates in the future, the country will have to discover new products to sell on world markets.
Consumer Electronics: the roots of success
On top of low labor and materials costs, China’s success in consumer electronics is based on its ability to make a productivity jump. The country evolved from being just an assembler of components. Production was integrated backwards and the supply chain was moved to where the assembly is undertaken.
China’s openness to foreign investment and its willingness to create special economic zones facilitated this evolution because foreign investors are the ones who both dominate exports and bring the necessary technology. China has welcomed foreign companies to foster domestic capabilities. It has endorsed policies that will ensure technology transfer and encourage strong domestic players. The country initially relied on state-owned champions, but later on, foreign investors were required to enter into joint ventures with domestic firms while the domestic market was protected to attract market-seeking investors. Weak enforcement of intellectual protection enabled domestic producers to imitate and recreate foreign technologies. Also, industrial clusters in particular areas of the country were created after localities were given substantial freedoms to make their own policies of stimulation and support.
With this, domestic firms played a significant role in China. Joint ventures between foreign firms and domestic entities dominated the economy. With a strong domestic producer base, imported technologies were diffused and domestic supply chains were created. And even if some Chinese companies have failed due to low productivity, low technology absorption and lack of coordination, the government still tried new approaches.
Under the self-discovery model, a country only needs a few successes. Once a small number of high-productivity activities are identified, they pull resources in from lower productivity activities. In these circumstances, lack of coordination can be an advantage as it allows different things to be tried and for successes in one region to be copied elsewhere. In addition, the hesitant, gradual, often conflicting manner in which policies have been formulated and implemented in China may have presented a more suitable environment for entrepreneurial experimentation and cost discovery.
Implications
First, Chinese policymakers must understand the fundamental underpinnings of its export performance and its economic success better. China’s growth was not driven solely by comparative advantage or free markets. Rather, growth was fuelled by exporting products that are more sophisticated than what would be normally expected. Government policies helped nurture domestic capabilities in consumer electronics and other advanced areas that would most likely not have developed in their absence.
Secondly, it is important to emphasize that what matters for China’s future growth is not the volume of exports or its relation to GDP, but the “quality” of these exports. China sells products that are associated with a productivity level that is much higher than a country at its level of income. The economically relevant question for sustainability is not whether trade-GDP can keep on rising, but whether China will manage to discover and develop higher-income products over time, and continue to fuel its growth thereby.
Lastly, future economic performance must be supported by industrial policies. The appropriate role for industrial policy is to address market incompleteness by subsidizing investments in new products. Good industrial policy withdraws support from failed projects, so that resources are not wasted by unproductive activities. The appropriate criterion of success for industrial policy is not that “only winners should be picked” but that “losers should be let go”.
Moving forward, Chinese policy makers are challenged to design the appropriate institutional structure that fosters an experimental, carrot-and-stick approach to industrial policy. They must enact policies that are suited to the local context – institutional models that are based on Chinese realities.
Source:
Rodrik, Dani, “What’s So Special About China’s Exports?” CEPR Discussion Papers 5484, C.E.P.R. Discussion Papers (January 2006).
[1] EXPY is calculated by first computing PRODY, the weighted average of the incomes of the countries exporting a commodity, where the weights are the revealed comparative advantage of each country in that commodity and then getting the weighted average of the PRODY for each country , where the weights are the share of each commodity in that country’s total exports.
[2] To test whether causality goes from EXPY to growth and not the other way around, an instrumental variable approach is used, where population was located as an exogenous variable that influences growth only through the impact it has on EXPY.
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