Five reasons why China has the most interesting economy in the world

By John Knight

China is not only soon likely to have the largest economy in the world but it also has the most fascinating because of the challenges that it has successfully met and the challenges that lie ahead for this semi-industrialised economy.

(1)   China made a successful transition towards a market economy.

In 1978, China had a centrally-planned command economy dominated by state ownership in the cities and people’s communes in the countryside. Incomes were very low and there was much economic inefficiency, reflecting the lack of economic incentives and of markets. The new leadership, wishing to avoid discontent and restore political legitimacy, embarked on a process of economic reform, starting with the dissolution of the communes. Reflecting the determination of the Communist Party to stay in power, China’s reforms were gradual — unlike those in the Soviet Union, where ‘big bang’ economic transition was accompanied by political transition. China’s reform process was one of cumulative causation: each reform led on to the next. For the first 15 years it had to be ‘reform without losers’, in order to overcome vested interests. However, the success of the early reforms emboldened the reform coalition from the mid-1990s onwards to marketise and privatise the economy on many fronts. The reform process has been remarkably successful but it would be misleading to say that China now has a fully marketised economy. It remains a semi-marketised economy, in which the government continues to play a major role, for instance through the power of the remaining state-owned enterprises and the state’s domination of the financial system.

(2)   China has remarkable economic growth.

China’s economy has grown by an average of 10% per annum for more than three decades. Although a few other countries (such as Japan, South Korea, and Taiwan) managed to grow nearly as fast for some time, they were unable to sustain their growth. China’s growth rate has indeed been remarkable. Rising incomes have taken more than 300 million people out of ‘dollar a day’ poverty. Research shows that the high rate of capital accumulation was very important for rapid growth — the share of investment in GDP rose to over 40%. Growth was assisted by the ready supply of surplus labour from the rural areas and by the policy emphasis placed on primary and secondary schooling. Productivity growth benefited hugely through the dramatic structural transformation of the economy from low-productivity to high-productivity activities — from agriculture to industry, from the state sector to the private sector, and from production for the home market to production for export. This previously closed economy was able through trade to specialise according to its comparative advantage in producing labour-intensive manufactures, so becoming the ‘workshop of the world’.

(3)   China is experiencing a remarkable rise in inequality.

Egalitarianism had been central to the command economy: such inequality as then existed was across regions of this huge country and between rural and urban areas. ‘Brain workers’ received no more pay than ‘hand workers’. The restoration of economic incentives and the creation of markets inevitably raised the inequality of incomes. For instance, as market forces increased the relative wages of educated and skilled workers, so wage inequality grew. However, some of the increase in inequality could not easily be justified by improved efficiency. For instance, bias in policies helped to increase regional inequality and also the rural-urban divide: by the late 2000s the ratio of household income per capita in urban and rural areas exceeded three to one. Moreover, the system of governance enabled well-placed or well-connected people to make fortunes. China’s ‘Gini coefficient’ (an aggregate measure of income inequality in a country) is now as high as 0.5, so making China the most unequal country in Asia. Will China’s income inequality continue to rise? There are two reasons why it might have peaked. Government is now concerned to reduce inequality, seeing it as a threat to social instability. The rapid growth of the economy has created an impending shortage of (previously abundant) labour from the rural areas: scarcity might bid up the market wages of unskilled labour generally and so reduce inequality from below.

(4)   China has a successful but fragile political economy.

China has centralised political governance but decentralised economic governance. This gives rise to what economists call a ‘principal-agent problem’: how to ensure that the many economic decision-makers pursue the objectives of the centre. The centre has used its control of appointments and promotions and its powers of patronage to secure its primary objective: the achievement of rapid economic growth. It has created a successful ‘developmental state’, and it is this which underlies China’s remarkable economic success. However, the system of governance gives rises to problems of accountability and of corruption. Rapid economic growth, pursued in order to avoid social instability, has produced a dramatic transformation of China’s society that has created new sources of social instability. China’s economic growth will inevitably slow down gradually over the decades as the economy matures and as resources, including labour, become more fully employed. However, it is the threat of social instability or of a serious financial crash that might bring China’s rapid growth to a premature end.

(5)   China encounters a puzzle of stagnant life satisfaction.

Various time series measures of life satisfaction are available for China. With household incomes rising rapidly, we would expect that life satisfaction (or happiness, or subjective well-being) also rose for the majority of Chinese people. Yet the average score of life satisfaction was no higher in 2010 than it had been in 1990. How can this puzzle be explained? Research suggests that life satisfaction in China is influenced by much more than simply people’s income levels. It depends also on their income relative to the income of the people with whom they compare themselves, and general prosperity has meant that relative incomes have not risen. It also depends on people’s sense of security — and insecurity grew as economic reform created millions of redundancies and the social security system was dismantled. China has experienced ‘the greatest migration in human history’ as over 100 million rural migrants have come to work in the cities. The migrants’ average happiness is lower even than that of those who remained in the rural areas. This is probably due to the discrimination they experience in the cities but also to the fact that they change their reference groups from the village to the city, where they are among the poorest. Subjective well-being is adversely affected also by growing perceptions of corruption and environmental degradation. In the last few years government has increasingly recognised that economic growth cannot be its only objective, and that policies to create a ‘harmonious society’ deserve more attention.

John Knight is emeritus professor of economics and emeritus fellow of St Edmund Hall in the University of Oxford. He has conducted research on China’s economy for over twenty years. Oxford University Press has published three of his (co-authored) books on China: The Rural-urban Divide: Economic Disparities and Interactions in China (1999), Towards a Labour Market in China (2005), and China’s Remarkable Economic Growth (2012). He is the author of “Inequality in China: An Overview” in the World Bank Research Observer, which is included in a special virtual issue from Oxford Journals.

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Image credit: New constructed buildings at Shenzen China. © tekinturkdogan via iStockphoto.