China's Entry Into the World Trade Organization (Routledge Studies in the Growth Economies of Asia)

China's Entry to the WTO The future of China’s modernisation is dependent on the reactions of the rest of the world to...

Author: Peter Drysdale

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China's Entry to the WTO

The future of China’s modernisation is dependent on the reactions of the rest of the world to China’s economic growth. China’s membership of the World Trade Organisation (WTO) is a crucial part of this process. This volume provides a detailed, up-to-date analysis of the strategic issues and policy options of China’s accession to the WTO. It explains why China needs the WTO and why the WTO needs China. Quantitative analysis demonstrates how tariff reduction resulting from China’s accession to the WTO will benefit the Chinese economy as well as the rest of the world. The book argues that there is no single trade policy initiative likely to result in larger gains in international trade in the foreseeable future than China’s accession to the WTO. Featuring contributions from an international selection of leading economists and China experts, this book is a timely and valuable addition to the literature on international trade, China and Asian economics. Peter Drysdale is one of Australia’s foremost authorities on Australia’s international trade and economic diplomacy. He is Executive Director of the Australia-Japan Research Centre (AJRC) in the Asia Pacific School of Economics and Management and Professor of Economics in the Research School of Pacific and Asian Studies at the Australian National University. He is responsible for an Australia-wide research program on economic relations with Japan and the Asia Pacific, involving research cooperation with economists in economies throughout the Asia Pacific region. Ligang Song is a specialist in applied international trade studies, the Chinese economy and the Asia Pacific economy. Dr Song is Director of the China Economy and Business Program and a Fellow at the Australia-Japan Research Centre in Asia Pacific School of Economics and Management and the Research School of Pacific and Asian Studies.

Routledge Curzon Studies in the Growth Economies of Asia 1 The Changing Capital Markets of East Asia Edited by Ky Cao 2 Financial Reform in China Edited by On Kit Tam 3 Women and Industrialization in Asia Edited by Susan Horton 4 Japan's Trade Policy Action or reaction? Yumiko Mikanagi 5 The Japanese Election System Three analytical perspectives Junichiro Wada 6 The Economics of the Latecomers Catching-up, Technology transfer and institutions in Germany, Japan and South Korea Jang-Sup Shin 7 Industrialization in Malaysia Import substitution and infant industry performance Rokiah Alavi 8 Economic Development in Twentieth Century East Asia The international context Edited by Aiko Ikeo 9 The Politics of Economic Development in Indonesia Contending perspectives Edited by Ian Chalmers and Vedi Hadiz 10 Studies in the Economic History of the Pacific Rim Edited by Sally M.Miller, A.J.H. Latham and Dennis O.Flynn 11 Workers and the State in New Order Indonesia Vedi R.Hadiz 12 The Japanese Foreign Exchange Market Beate Reszat 13 Exchange Rate Policies in Emerging Asian Countries Edited by Stefan Collignon, Jean Pisani-Ferry and Yung Chul Park 14 Chinese Firms and Technology in the Reform Era

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Yizheng Shi 15 Japanese Views on Economic Development Diverse paths to the market Kenichi Ohno and Izumi Ohno 16 Technological Capabilities and Export Success in Asia Edited by Dieter Ernst, Tom Ganiatsos and Lynn Mytelka 17 Trade and Investment in China The European experience Edited by Roger Strange, Jim Slater and Limin Wang 18 Technology and Innovation in Japan Policy and management for the 21st century Edited by Martin Hemmert and Christian Oberländer 19 Trade Policy Issues in Asian Development Prema-chandra Athukorala 20 Economic Integration in the Asia Pacific Region Ippei Yamazawa 21 Japan's War Economy Edited by Erich Pauer 22 Industrial Technology Development in Malaysia Industry and firm studies Edited by K.S.Jomo, Greg Felker and Rajah Rasiah 23 Technology, Competitiveness and the State Malaysia’s industrial technology policies Edited by K.S.Jomo and Greg Felker 24 Corporatism and Korean Capitalism Edited by Dennis L.McNamara 25 Japanese Science Samuel Coleman 26 Capital and Labour in Japan The functions of two factor markets Toshiaki Tachibanaki and Atsuhiro Taki 27 Asia Pacific Dynamism 1550±2000 Edited by A.J.H.Latham and Heita Kawakatsu 28 The Political Economy of Development and Environment in Korea Jae- Yong Chung and Richard J.Kirkby

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29 Japanese Economics and Economists since 1945 Edited by Aiko Ikeo 30 China's Entry to the WTO Edited by Peter Drysdale and Ligang Song

China's Entry to the WTO Strategic issues and quantitative assessments Edited by

Peter Drysdale and Ligang Song

LONDON AND NEW YORK

First published 2000 by Routledge 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 RoutledgeCurzon is an imprint of the Taylor & Francis Group This edition published in the Taylor & Francis e-Library, 2005. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” © 2000 Editorial matter and selection, Peter Drysdale and Ligang Song; individual chapters, the respective contributors All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloging in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data China’s entry to the WTO: strategic issues and quantitative assessments/edited by Peter Drysdale and Ligang Song. Includes bibliographical references and index. 1. World Trade Organization—China. 2. China—Commercial policy. I. Drysdale, Peter. II. Song, Ligang. HF1385.C48 2000 382 .92 0951–dc21 ISBN 0-203-39822-X Master e-book ISBN

ISBN 0-203-39954-4 (Adobe eReader Format) ISBN 0-415-24101-4 (Print Edition)

Contents

List of figures

ix

List of tables

xi

list of contributors Preface

xiii xv

1

China’s entry to the WTO: An overview Peter Drysdale and Ligang Song

1

2

China and the future of the international trading system Ross Garnaut and Yiping Huang

7

3

Economic reform and development strategy in China Justin Yifu Lin

30

4

The WTO and China’s trade strategies in the 1990s Yang Shengming

53

5

Trade liberalisation and development of China’s foreign trade Ligang Song

66

6

Agricultural policy adjustment in the process of trade liberalisation Wen Hai

86

7

The implications of China’s membership of the WTO for industrial transformation Peter Drysdale

99

8

China’s entry to the WTO: a general equilibrium analysis of the recent tariff reductions Xiao-guang Zhang

120

9

China and the WTO: tariff offers, exemptions and welfare implications Christian F.BachWill Martin and Jennifer A.Stevens Spatz

139

China’s trade liberalisation and structural adjustments for the world economy Feng Lei and Yiping Huang

158

10

viii

11

China’s textile and clothing exports in the post Uruguay round Zhong Chuanshui and Yongzheng Yang

173

12

Rapid economic growth in China: implications for the world economy Warwick J.McKibbin and Yiping Huang

192

Abbreviations

214

Index

216

Figures

2.1 Growth rates of GDP and trade in China, 1978–96 2.2 Fluctuations in China’s net exports through business cycles, 1978–96 2.3 Changing share of some East Asian economies in world total labourintensive manufactured exports, 1965–96 2.4 Shares of labour-intensive goods in total exports: world and some East Asian economies, 1965–93 2.5 China’s net imports of cotton and world cotton prices, 1972–94 2.6 China’s shares in world and selected countries’ labour-intensive manufactured imports, 1978–93 2.7 China’s shares in world and selected countries’ imports of textiles and clothing, 1978–93 2.8 China’s shares in world and selected countries’ total imports, 1978– 93 2.9 China’s share in the former USSR’s imports and exports, 1978–95 3.1 Economic growth and inflation in China, 1978–98 3.2 Effects of HIODS on industrial structure in China 5.1 Contributions of exports to economic growth, 1990–98 5.2 China’s nominal and real exchange rate (vs the United States) and export growth rate, 1980–97 5.3 China’s import trade, 1978–97 5.4 Real growth rates of industrial output, 1978–97 5.5 China and East Asian global integration (trade/ GDP), 1980–95 7.1 China’s tariff reductions 7.2 Share of labour-intensive goods in total exports, world and the East Asian economies 1965–96 7.3 Changing shares of some East Asian economies in world labourintensive manufactured exports, 1965–96 8.1 Current production structure 8.2 Database structure 12.1 Growth rate of GDP and trade in China, 1978–95 12.2 World real GDP growth, 1991–2016 12.3 Chinese real GDP and GNP, 1990–2020 12.4 Chinese foreign trade, 1990–2020 12.5 World real GDP, 1990–2020

8 12 14 16 20 22 22 23 23 31 37 68 73 73 73 80 105 113 113 124 127 193 207 208 208 209

x

12.6 World real GNP, 1990–2020 12.7 World current accounts, 1990–2020

209 210

Tables

2.1 East Asian economies’ shares in world merchandise trade, 1960– 2010 2.2 Shares of developing countries and China in world and OECD country imports of manufactured products, 1996 2.3 China’s exports and imports by groups of commodities, 1978, 1980, 1985, 1990 and 1996 2.4 China, many regional economies, 1992 2.5 Destinations of exports and sources of imports in China, 1980, 1985, 1990, 1995 and 1996 2.6 Indexes of intra-industry trade for China and Japan, 1970, 1980 and 1990 3.1 Sector shares of state capital construction investment 3.2 Sector composition 3.3 Growth rate of output and total factor productivity 4.1 Overall tariff rate in China, 1992–96 4.2 Volume of imports and exports in China, 1978–96 4.3 Foreign trade dependence in China, 1978–96 5.1 Shares of China’s imports, exports and total trade in GDP, 1978–98 5.2 Share of goods sold at prices fixed by the state, 1978–93 5.3 Geographical distribution of China’s exports and imports, 1980, 1990 and 1996 5.4 Revealed comparative advantage indices (exports), China and comparators, 1980–96 5.5 Changing commodity shares of selected labour-intensive goods, 1980, 1985, 1990 and 1996 5.6 Growth rate of exports for labour-intensive goods and total exports 5.7 Contribution of different firms to China’s foreign trade, 1994 5.8 Export regression analysis for China’s exports, 1986–97 5.9 Proportion of manufactured goods and labour-intensive goods in imports from East Asian economies by developed countries, 1980, 1985, 1990 and 1996 A5.1 Time-series data used in the analysis, 1986–97 6.1 Annual price changes, 1978–94 6.2 International price comparison of major agricultural product prices A6.1 Effects of exogenous changes on the relative agricultural price B6.1 Changes in factor endowments on relative returns to factors

10 11 14 17 22 25 34 35 40 56 59 59 67 70 72 73 74 76 78 79 81 84 88 89 96 96

xii

7.1 Total trade of Greater China (China and Hong Kong) and its share of world trade 7.2 China’s geographic trade structure, 1970–96 7.3 Constant market share analysis of China’s export performance in world markets, 1985–96 8.1 Gross output and gross domestic product by sector in China, 1994 8.2 China’s macroeconomic indicators, 1992 and 1994 8.3 Values of exports and imports and import tariff rates in China, 1994 8.4 China’s recent import tariff reductions, 1996 and 1997 8.5 Simulation effects on aggregate indicators 8.6 Simulation effects on sectoral indicators 8.7 Simulation effects on the government budget 9.1 Tariff rates for product groups 9.2 Import-weighted tariff rates by region 9.3 Effect on China’s output in 2005 following various shocks 9.4 Effect on real incomes in different countries/regions, 2005 9.5 Effect on welfare of improving the representation of the disaggregated tariff set in a single-region, static setting 10.1 Regions and industries of applied version of GTAP model 10.2 Three sets of experiments of trade liberalisation 10.3 Changes in output—Simulation I 10.4 Overall assessment—Simulation I 10.5 Changes in outputs—Simulation II 10.6 Overall assessment—Simulation II 10.7 Changes in outputs—Simulation III 10.8 Overall assessment—Simulation III 11.1 China’s exports of textiles and clothing 11.2 Tariff reductions by selected developing economies 11.3 Projected changes in factor endowments and real GDP, 1992–2005 11.4 The impact of the Uruguay Round trade liberalisation, 2005 11.5 Projected cumulative changes in production in selected developing economies, 1992–2005 11.6 Projected cumulative changes in exports in selected developing economies, 1992–2005 12.1 Economy-wide growth in China: selected studies 12.2 China’s total factor productivity for G-cubed sectors: selected studies 12.3 Overview of the G-CUBED model 12.4 Baseline assumptions

102 107 111 128 129 130 132 133 134 135 142 143 151 152 154 160 162 163 165 166 166 168 168 174 180 183 185 187 187 197 198 199 208

Contributors

Editors PETER DRYSDALE is one of Australia’s foremost authorities on Australia’s international trade and economic diplomacy. He is a professor in the Asia Pacific School of Economic Management and Executive Director of the Australia-Japan Research Centre, Australian National University. He is a member of the Order of Australia. LIGANG SONG is Fellow and Director of the China Economy and Business Program at the Asia Pacific School of Economics and Management, Australian National University. He has a joint appointment with the Renmin University in Beijing. Contributors CHRISTIAN F.BACH is Associate Professor at the Royal Danish Agricultural University, Denmark. Ross GARNAUT is Professor and Director of the Asia Pacific School of Management, Australian National University. FENG LEI is Research Fellow and Deputy Director of the Department of International Trade at the Institute of Finance and Trade Economics at the Chinese Academy of Social Sciences. YIPING HUANG is Fellow at the Department of Economics, Research School of Pacific and Asian Studies, Australian National University. WEN HAI is Professor and Deputy Director of the China Centre for Economic Research at Peking University. JUSTIN YIFU LIN is Professor and Director of the China Centre for Economic Research at Peking University. WARWICK J.McKIBBIN is Professor of Economics at the Research School of Pacific and Asian Studies, Australian National University and at the Brookings Institutions, Washington, DC. WILL MARTIN is senior economist in the Development Research Group, World Bank. JENNIFER A.STEVENS SPATZ is Export Credit Manager at Weyerhaeuser Company, Tacoma, Washington.

xiv

YANG SHENGMING is Professor at the Institute of Finance and Trade Economics at the Chinese Academy of Social Sciences. YONGZHENG YANG is Fellow at the National Centre for Development Studies, Australian National University. XIAO-GUANG ZHANG is Lecturer at the Department of Economics, University of Melbourne. ZHONG CHUANSHUI is a trade official at the Ministry of Foreign Trade and Economic Cooperation, Beijing, China.

Preface

In 1993, the Australia-Japan Research Centre at the Australian National University (ANU) and two key economic institutes of the Chinese Academy of Social Sciences (CASS) initiated a collaborative research project on China’s accession to the General Agreement on Tariffs and Trade (GATT), now the World Trade Organisation (WTO). The project involved other institutions in China and the region including the China Centre for Economic Research at Beijing University, the Department of International Economics at Renmin University and the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) and Tokyo and Hitotsubashi universities in Japan. Four conferences were organised, one in Beijing, two in Canberra and one in Tokyo. This book is the product of these conferences and the research programs that were their foundations. The project also involved a program under which scholars and trade officials from China came to Canberra for research and training with scholars at the Australian National University. Some of the joint chapters in the volume reflect this research collaboration. We are grateful to Pamela Hewitt for editorial work and bringing the volume together and to Minni Reis for her careful work in typesetting the manuscript. Marilyn Popp, David Duke and other staff at the AustraliaJapan Research Centre gave excellent assistance at all stages of the project. We hope that the volume will contribute to understanding of the significance and impact on China and the rest of the world of China’s entry to the world trade body. Peter Drysdale, Ligang Song Canberra, July 2000

1 China's entry to the WTO An overview Peter Drysdale and Ligang Song

BACKGROUND When Prime Minister Zhu Rongji visited the United States in April 1999, the long-running negotiations on China’s accession to the WTO gained new momentum. With political commitment on both sides and the hope that the issue could be resolved towards the end of the year before the start of the new round of multilateral trade negotiations, negotiation teams from both sides intensified their effort to strike a deal within the year. Significant progress was made by both sides on a broad range of market access and protocol issues, paving the way for China’s accession to the WTO. On 15 November 1999, Chinese negotiators signed an historic agreement with the United States on China’s accession. The agreement included significant concessions on market access issues, including tariff levels, telecommunications, internet, autos, banking/insurance, agriculture, distribution, audio-visual, and travel and tourism. The agreement paved the way for China’s accession to the WTO some time in 2000 and will rekindle a new wave of economic and trade liberalisation in China. There is now broad consensus from a wide range of political and business circles in both China and other member countries that China needs the WTO as much as the WTO needs China. China certainly has much to gain from further opening of its economy to foreign competition. Even the mounting pressure to deal with the domestic adjustment costs of current restructuring, from the slowdown of the Chinese economy and the negative impact of the East Asian financial crisis, do not qualify the imperative of entry. Quite the reverse. China’s entry to the WTO represents a grand strategy to ease the burden of reform, because commitment to deeper reform and liberalisation associated with entry will not only boost efficiency, but also foreign investor confidence in Chinese economy at a time when it is desperately needed. Clearly the benefits to the rest of the world—including the United States— will also be very large. Manufacturing exporters, particularly from industrialised countries, will benefit from China’s substantial tariff reductions. Firms specialising in financial and legal services such as banks, insurance companies

2 CHINA’S ENTRY TO THE WTO

and law firms will gain more access to the Chinese market. Foreign investors will be more confident in making investment decisions under a more transparent and rules-based trading system in China. In addition, the WTO will be made more representative by institutionalising China into the world trading system. Indeed, there is no single trade policy initiative likely to result in larger gains in international trade in the foreseeable future than China’s accession to the WTO. This volume provides evidence in support of this view. STRATEGIC ISSUES AND POLICY CHOICES China’s rapid, internationally-oriented economic growth is a major challenge to the international trade and economic system because of China’s size, rapid growth, skewed resource endowments and tendency to economic instability. In Chapter 2, Garnaut and Huang make the point that China can best answer that challenge through unequivocal commitment to reform, commitment to the eventual goal of free trade and commitment to application of the rules of the international trading system. The concentration of Chinese exports and imports in a relatively narrow range of commodities has the potential to aggravate adjustment in the rest of the world to changes in Chinese trade—both in advanced industrial economies with labourintensive import-competing industries, and in competing labour-abundant developing economies seeking to rely on international markets for exports of similar goods. Yet, Garnaut and Huang argue the world economy is now large enough and open enough to absorb the growth of China’s trade and share the gains from trade growth. Success in meeting the challenge will increase the gains from trade— obviously for China, but also for the rest of the world. Failure will lead to corrosion of the open international system and, in the end, lead to a retreat from the rules-based system, with major consequences for internationally-oriented growth in China, East Asia and beyond. Putting the reform in China in an historical context, in Chapter 3 Lin, discusses the relationship between economic reform and development strategy in China. Lin provides a theoretical explanation of how the current problems encountered in the process of reform can be traced back to the old inwardoriented, heavy-industry-oriented development strategy. Lin argues that the economic problems before the reform were rooted in the heavy industry-oriented development strategy, which neglected the comparative advantage of the Chinese economy. The achievements of reform are attributable to better utilisation of comparative advantage, while the problems emerging after the reform arose from an incomplete shift in development strategies. The way to achieve rapid, sustained growth in the Chinese economy hinges on a complete shift from the anti-comparative-advantage heavy industry-oriented development strategy to a development strategy that relies on the comparative advantage of the Chinese economy.

AN OVERVIEW 3

Yang discusses China’s trade policy issues in the 1990s in the context of its accession to the WTO in Chapter 4. A review of trade reform in the early 1990s indicates that China has made a number of important breakthroughs in meeting the requirements for entering the WTO. They include the establishment of the legal basis for foreign trade, deeper reform of both export and import systems, including trading company and trade administration reform, drastic tariff reductions and exchange rate system reform. Progress has also been made in broadening market access for both foreign investments and imports during this period. Based on these achievements, Yang points out that conditions are now ripe for China to be admitted into the WTO as a developing country. Yang argues that if China’s accession to the WTO occurs sooner, the international trade rules will play a role as a reference point in China’s reform and a benchmark in formulating China’s trade law and regulations. This will benefit China and the world as a whole. The trade agenda for the late 1990s spelled out by Yang is challenging. It includes reduction of tariffs to the level of developing countries, market access for agricultural products and services and controlled convertibility of the capital account. Song explores the relationship between trade liberalisation and rapid trade growth during the reform period in Chapter 5 and lists the benefits to the Chinese economy from open trade. He calculates that exports contributed two percentage points to the average real GDP growth of 10 per cent during the period 1990–98. His estimates imply that the future growth of China’s exports will continue to rely on strong world demand as well as further improvement in productivity and competitiveness of the economy on the other. In the face of the East Asian financial crisis, there will be increasing pressure for China to upgrade its industrial structure, produce high valued-added and high quality products and further diversify its trade structure. Song concludes that further reforms are needed to enhance competition, reduce protection in the form of non-tariff barriers and increase the transparency of China’s trading system, particularly its import controls. A key to resolving the financial crisis in East Asia and to a more sustainable pattern for the development of foreign trade in the regional economies lies in a deepening reform and trade liberalisation program in these economies. Hai touches on the important issue of agricultural policy reform in the process of trade liberalisation in Chapter 6. Observing that both relative and absolute agricultural prices in China have reached or surpassed international levels, Hai concludes that rapid economic growth has reduced comparative advantage in agriculture. He argues that the trend towards a loss of comparative advantage in agriculture will not be reversed as long as China remains a fast-growing economy with a labour-intensive agricultural sector. The Chinese government faces a difficult choice, between following a policy of agricultural protection for the sake of income distribution for farmers and continuous trade liberalisation in the agricultural sector in conformity with WTO rules and regulations.


To balance the act, the most important policy adjustment at this point is to meet the requirement of market access. This would require China gradu ally to remove the quantitative restrictions on agricultural trade and abolish the state monopoly in grain trade. The key to improving domestic income distribution is to increase agricultural productivity and competitiveness by increasing agricultural investment and changing the factor structure of agricultural production. Diversification of farmers’ income by developing off-farm production such as rural industries is another policy choice. Drysdale addresses two key questions with regard to China’s accession to the WTO in Chapter 7. Why is entry to the WTO so important to China’s continuing commitment to reform and liberalisation and to sustaining the success of the last two decades? And why is accommodating China’s entry on terms which define an end point to China’s achievement of equal status within the WTO so important to China’s major economic partners and the international trading system more generally? Drysdale proceeds to explore the corollary question of the impact of WTO entry on the choice of trade policy strategy in China, and the relationship between trade policy strategy and the reform process. He goes on to examine Chinese competitiveness in international markets and the implications of changing competitiveness for trade and industrial transformation, providing a basis for comment on the appropriate direction of industrial policy. Drysdale makes the point that the liberalisation of trade policy associated with accession to the WTO in effect forces the pace of reform in many areas, such as in the management of the state enterprise sector, and financial and foreign exchange markets. Accession to the WTO, with its commitment to ongoing liberalisation, entrenches these reforms and helps to maintain their momentum. The alternative would be a loss of momentum and misdirection of the process of reform and industrial transformation. Drysdale concludes that WTO accession offers an important opportunity to reinforce the pace of trade and economic reform. The protocols of accession must allow time for China to adjust its policies to the full application of WTO rules and to define the principal elements in the schedule of adjustment, if accession is to secure China’s reform objectives at the same time as satisfy China’s major economic partners that the momentum to full marketisation will be maintained. IMPACTS OF TRADE LIBERALISATION: QUANTITATIVE ASSESSMENTS In meeting the requirements of WTO, a series of tariff reductions has been carried out by the Chinese government in the past decade. Zhang’s quantitative analysis in Chapter 8 addresses the following question: What impact would further large-scale tariff cuts and domestic market liberalisation have on the Chinese economy? Using a computable general equilibrium (CGE) model technique, Zhang presents the results of a short-run simulation of China’s recent tariff reductions. The tariff cut is projected to depreciate the real exchange rate,

AN OVERVIEW 5

increase the domestic price of imports and reduce the cost of domestically produced goods. Exports will increase while imports contract initially. The reduction in domestic costs relative to world prices caused by the tariff cuts significantly increases export profitability. The model also projects that the expansionary effects in the export sector (mainly concentrated in manufactured products) more than outweigh the contraction in the import competing sector. Thus, both employment and the trade surplus are expected to rise. The simulation results also show that there is a marginal decline in government net real revenue as a result of tariff cuts. The decline in revenue from the external sector is largely compensated by possible increases in revenues from the growth of real domestic output, which is projected to have a positive growth. The predictions of the model provide quantitative evidence of the beneficial effects of tariff reductions overall. A traditional computable general equilibrium assessment of the gains from liberalisation in China typically leaves out two important features: the effect of variation in the disaggregated tariff information and the effect of tariff exemptions. By applying procedures to capture both these effects and building upon the recent literature on trade restriction measures, Bach, Martin and Stevens Spatz use a standard CGE approach to evaluate the effects of China entering the WTO in Chapter 9. Their results confirm the very large welfare gains to China from the unilateral liberalisation extended by China in the context of its negotiations for accession to the WTO and from the reductions in protection negotiated in the Uruguay Round. China’s major trading partners are also estimated to benefit substantially from China’s liberalisation. Large gains accrue to major trading partners such as Hong Kong, the United States and Canada, Japan, the European Union, the Republic of Korea and Taiwan. Relatively small losses are estimated for economies such as Indonesia and South Asia, which compete relatively directly with China in the production of some export goods. To analyse the implications of China’s trade reform for structural change and welfare in China and the rest of the world, Feng and Huang presented their quantitative results using the GTAP model in Chapter 10. They find that China gains the most from its own liberalisation. They also point out that economic benefits are also accompanied by significant adjustment costs. In particular some sectors, including agriculture, will contract. This leads to two policy choices if China is to maintain its self-sufficient food strategy: one is to raise the productivity of food production and the other is to distort incentive structures in favour of food protection. The former requires substantial investment in agricultural technology and infrastructure and the latter implies a significant misallocation of resources and welfare losses. According to these simulation results, structural adjustment for other countries, especially NIEs, is likely to be concentrated in the textile/clothing sector. However, they argue that those economies in which the most significant adjustments occurred in relation to liberalisation in China are precisely the ones


that will derive large gains from the adjustments. The key for those countries in reaping the gains is to participate actively in the liberalisation process, which is likely to magnify the gains and ease the adjustment task. Broader trade liberalisation with APEC will thus benefit China as well as other regional economies. Zhong and Yang, in Chapter 11, focus on analysing China’s textile and clothing exports in the post Uruguay Round. The opportunities for textile and clothing exports lie in the prospect that China can secure the abolition of Multifibre Arrangement (MFA) quotas on its products and secure substantial benefits to its textile and clothing sector. The challenge is that if quotas continue to apply to China after the phasing-out of the MFA, the competitiveness of Chinese textile and clothing exports will suffer vis-à-vis its competitors and its market share in North America and the European Union will be reduced. Zhong and Yang argue that early entry to the WTO will give China greater opportunity to secure the benefits of the Agreement on Textiles and Clothing (ATC) but much will depend on what is to be included in China’s accession protocol. Demand-side uncertainties aside, they argue that the key to the sustained growth of textile and clothing exports has been economic reform. Trade liberalisation will not only strengthen China’s bargaining power in countering anti-dumping measures and subsidy charges, but more importantly it will improve the efficiency of China’s textile and clothing sector. Phasing out domestic WTOinconsistent policies and increases in the cost of raw materials, especially cotton, will level the playing field for exports. Zhong and Yang also note that the phasing out of the MFA will provide a one-off boost to exports in the next decade or so, but this is unlikely to reverse long-term trends in structural change. Economic reforms starting from 1979 have brought huge changes to the Chinese economy, particularly through rapid economic growth during the reform period. What are the implications for the world economy of China’s rapid economic growth? This is the question addressed in Chapter 12 by McKibbin and Huang through the application of the dynamic general equilibrium model (G-CUBED). The model captures not only the composition of the direct trade impact of development in the Chinese economy but also the implications of endogenous financial capital on macroeconomic adjustment in the world economy. The chapter projects average GDP growth in China of 6.7 per cent from 1991 to 1999, 5.2 per cent from 2000 to 2009 and 4.3 per cent from 2010 to 2019. The simulation results show that there are substantial gains for the rest of the world from productivity improvement in the Chinese economy. There are benefits to the rest of the world from higher Chinese demand for foreign goods, as well as effects on foreign production as capital is reallocated from less productive uses outside China into sectors within China with higher rates of return. But it is not just a one-way story of China’s impact on the world economy. McKibbin and Huang establish that the sustainability of China’s economic growth is also dependent on the reactions of the rest of the world towards the emerging Chinese economy.

2 China and the future of the internationaltrading system Ross Garnaut and Yiping Huang

ACCOMMODATING CHINA Alongside implementation of the Uruguay Round, the accommodation of sustained, rapid, internationally-oriented growth in China is the greatest challenge facing the trading system over the next decade. Success will increase the gains from trade—obviously for China, but also for the rest of the world and for most, if not all, of its economies. Failure will lead to corrosion of the open international system, well beyond the rules governing China’s interaction with the rest of the world. The investment of effort in the accommodation of internationally-oriented growth in China is important and potentially rewarding for three reasons: first, China is a large economy, whose production and trade are rapidly becoming larger; second, its relative resource endowments are very different from an average of the rest of the world; and, third, remnants of central planning make China a potentially unstable participant in international exchange. China’s emergence as a major player in the world economy will be reflected in rapid increases in its share of world imports and exports, concentrated disproportionately in a fairly narrow range of markets. This is mostly a source of gain for China’s international partners, except those which happen to be highly competitive with China in exports or imports. The main costs of China’s growth to outsiders, usually short-term and transitional, is adjustment. But viewed analytically, the adjustment challenge to the international community is of modest scale despite China’s size—proportionately no larger than that associated with the trade growth of Japan until the 1960s or the newly industrialising economies (NIEs) in the 1970s.1 If adjustment to the emergence of China is achieved within clear and stable rules, it will be both as smooth and as difficult as adjustment to the rise of Japan and the NIEs. One danger, however, is that the size and political weight of China will lead to perceptions of competition with an emerging China in the zero-sum context that is common in security studies but alien to economic analysis. This could interact with resistance to adjustment to weaken international rules as they apply to China, therefore weakening the international system more generally.


A BIG COUNTRY The Chinese economy has roughly five times its output of goods and services since reform began in 1978. Real growth rates have averaged 10 per cent, and foreign trade has grown even more rapidly (Figure 2.1). When China’s income is measured in a manner comparable to other developing economies (Garnaut and Ma 1993a), China is already a middle-income country, the world’s fourth largest after the United States, Japan and Germany. China’s share in world GDP rose from 0.92 per cent in 1978 to 3.48 per cent in 1996. Summers and Heston (1991) sought to measure real purchasing power, and calculated that China’s per capita income was US $2,300 in 1988. On these estimates China’s total GDP in 1988 (US $2,500 billion) was half that of the United States (US $4,490 billion) and substantially larger than Japan (US $1,560 billion) and West Germany (US $803 billion). We expect China’s growth to continue to be highly variable, on the pattern of recent years, but to maintain something like the average of the reform years for the (imperfectly) foreseeable future. If China grows at an annual rate of 8.5 per cent and all of the rest of the world at 4 per cent (the latter unrealistically high for the old industrial economies), in the year 2000 China’s GDP, measured on a basis similar to other developing countries, and underestimating purchasing power in the usual manner for developing countries, will be 40 per cent larger than Germany’s and Figure 2.1 Growth rates of GDP and trade in China, 1978–96 (per cent)

Notes. Trade includes exports and imports of commodities and non-factor services. Growth rates of both trade and GDP are calculated from their values at constant prices in Chinese currency (yuan). Source. International Economic Databank, Australian National University. Data compiled from World Bank statistics; SSB (1986–93); Asia-Pacific Economic Group (1994).

40 per cent smaller than Japan’s. It will represent 11 per cent of world GDP.

CHINA AND THE FUTURE OF THE INTERNATIONAL TRADING SYSTEM 9

Total trade has grown faster than GDP in the reform period, at an average rate of 16.74 per cent in 1978–96 (Figure 2.1). The share of exports in GDP rose from 6.19 per cent in 1978 to 18.52 per cent in 1996.2 China’s share of world exports rose from less than 1 per cent in 1978 to 3.07 per cent in 1996. Nevertheless, China’s current export-GDP share is much lower than other East Asian developing countries, and it is low even in comparison with large economies such as the United States and Japan. There is a question about whether Chinese trade will continue to grow so much more rapidly than output. China’s size and diversity of resource endowments, and the separation of a vast inland population from opportunities for low-cost participation in an international division of labour argue that its trade share of output will remain below that of other economies. The relatively large difference between relative resource endowments in China and the rest of the world, the relatively low transactions cost of trade within an extensive Chinese community abroad, the concentration of the most rapid growth among perhaps 400 million people in coastal regions, and the extraordinarily high cost of internal trade and specialisation for coastal communities argue that trade shares will be high. The reduction of currently high official barriers to international trade, both in China and abroad, will tend to raise trade shares. The reduction of currently extraordinarily high barriers to internal trade will have some effect in the opposite direction—although rather less in the context of increasingly fine specialisation in production and intra-industry trade. Lau (1994) predicts that the export ratio will fall in future, because the world economy will not be able to adjust to continued rapid increases in Chinese exports and because there will be opportunities for increasing the relative importance of internal trade. Lau’s view implies a sharp and large break from the past relationship between trade and growth in China in the reform era, and from the pattern in other East Asian developing countries. Our own assessment is that, within an effective, rules-based international trading system, and with continued trade liberalisation under the framework of the Uruguay Round settlement, China’s foreign trade will continue to grow more rapidly than output, although the average trade growth rate of the reform era so far might reasonably be considered an upper limit to future growth. If China’s exports expand at the average rate of the reform period so far, its share of world trade in goods and non-factor services will rise from about 1.7 per cent in 1990 to 3.6 per cent in 2000, and to 6.6 per cent in 2010 (Table 2.1). On balance, this seems a reasonable prospect. A higher rate of growth of exports is a possibility, but a number of factors will work against it, as discussed later. How difficult will it be for the world economy to accommodate the scale of growth in China’s output and trade that seems likely or possible to the years 2000 and 2010? How will the dimension of the required adjustment compare with that of the expansion of Japanese output and trade in the 1960s, and the NIEs in the 1970s?


Table 2.1 East Asian economies’ shares in world merchandise trade, 1960–2010 (per cent)

Note: China’s shares in 2000 and 2010 are projections based on growth rates in the reform period. Source: International Economic Databank, Australian National University. Data compiled from the World Bank’s World Tables.

It is true that China’s economy is considerably larger than Japan’s three decades ago or that of the NIEs two decades ago. But the world economy is now two or three times as large as in the 1960s, and considerably more integrated across international borders, and China’s production is likely to remain less export-oriented than Japan’s, and obviously much less so than the NIEs’. Table 2.2 presents projections of China’s share of world trade, on the reasonable assumption that China’s exports will continue to grow at the rate of the reform era. More arbitrarily, world trade is projected also to increase at the average of the past fifteen years. The resulting increase in China’s share of world trade In the 1990s is similar to that experienced by the NIEs in the 1980s. The projected increase in China’s trade share in the decade to 2000 is less than that of Japan in the 1960s, and the projected increase in the following decade is less than that of the NIEs in the 1980s. A rapid and large increase in the Chinese trade share is in prospect, but we can take comfort from the fact that proportionately similar structural changes have been achieved before. China’s trade share in 2010 is similar to Japan’s share in 1980 and much lower than the NIEs’ share in 1990. Not only is world output and trade much larger now, but now a substantial part of the adjustment can be carried by other East Asian economies, which are more flexible than the old industrial econo mies of North America and Europe. The growth of Japanese trade in the 1960s and the NIEs in the 1970s was accompanied by the proliferation of exceptions to the liberal international trading rules: the voluntary export constraints—including the Multifibre Arrangement (MFA)—and other ‘grey area measures’ that were among the major reasons why a multilateral negotiation in the form of the Uruguay Round had become necessary by the 1980s. It would be unfortunate for the international system if


Table 2.2 Shares of developing countries and China in world and OECD country imports of manufactured products, 1996 (per cent)

Source: International Economic Databank, Australian National University. Data compiled from United Nations trade statistics; World Bank (1996).

the rise in Chinese output and trade were accompanied by a similar proliferation of exceptions. The rest of the world’s adjustment to China’s growth will be eased by the fact that, over time, imports will expand more or less as rapidly as exports. From 1978 to 1996, while China’s exports and real GDP grew on average at 16.9 per cent and 9.9 per cent, respectively, imports grew at an annual rate of 16.6 per cent. While there are large short-term fluctuations in China’s current account and net exports, there is no general tendency towards surplus (Figure 2.1). This is not very different from Japan in the 1960s and the NIEs in the 1970s—tensions associated with these economies’ tendencies towards large current account surpluses came later. The instability in China’s trade balance, described in Figure 2.2, itself is a potential source of adjustment problems in the rest of the world, especially if contraction of economic activity and net imports coincides with recession in the rest of the world. There has been a fortuitous correlation between the Chinese and international business cycles over the past decade, most fortunately in the


Figure 2.2 Fluctuations in China’s net exports through business cycles, 1978–96

Source: International Economic Databank, Australian National University. Data compiled from the World Bank’s World Tables; SSB, China Statistical Yearbook, various issues.

coincidence between China’s boom and recession in the OECD countries in the early 1990s. The periods of large increase in Chinese net exports have tended to coincide with economic expansion in OECD economies, notably through the period of Chinese macroeconomic contraction around 1989. Among other things, the fortunate timing of the Chinese boom in the early 1990s helped to maintain growth in the other East Asian developing economies through the OECD recession. There is no reason to expect the fortunate inverse relationship between the Chinese and international cycles to continue. The possibility that future periods of sharp increases in Chinese net exports might coincide with international recession and so exacerbate international adjustment problems and trade tensions adds to the importance of domestic reforms to promote stability in the Chinese macroeconomic system (Garnaut and Ma 1993b). SECTORAL EFFECTS Viewed as an integrated, unified economy, China, relative to those parts of the world economy that participate intensively in an international division of labour, has a relative abundance of (especially unskilled) labour and a relative scarcity of agricultural land and other natural resources (Garnaut and Anderson 1980; Garnaut 1989). This is true most strongly for the coastal provinces, which have been most deeply involved in international trade and have experienced the most rapid growth. China’s trade specialisation in the early stages of rapid,


internationally-oriented growth has followed closely that of other densely populated East Asian economies, with a strong and increasing focus on labourintensive exports, and imports of capital goods and a range of natural resourcebased products. The resulting concentration of Chinese exports and imports in a relatively narrow range of commodities has the potential to exacerbate adjustment problems in the rest of the world—in advanced industrial economies with labour-intensive import-competing industries, and in competing labourabundant developing economies seeking to rely on international markets for agricultural and mineral products. China’s foreign trade structure has shifted significantly in recent years in line with its relative resource endowment (Table 2.3). Before reform, China’s exports were dominated by agricultural-intensive products, whose share has fallen rapidly since 1978. The share of mineral-intensive products has fallen sharply since the mid-1980s. The share of labour-intensive manufactured goods rose rapidly, in 1992 reaching 56 per cent, or four times these commodities’ shares of world trade. Textiles and clothing alone accounted for an extraordinary 40 per cent of Chinese exports in 1992, or almost six times their share of total world trade—despite severe restriction on exports to North America and Western Europe with the MFA. By 1996 China supplied about 3.06 per cent of world exports. China’s position in world markets was larger than this only in a limited range of labour-intensive products, notably clothing (22 per cent) and textiles (9 per cent) (Table 2.2). The concentration of China’s exports in a relatively narrow range of labourintensive exports is more marked than in most other East Asian economies at similar stages of development. The rest of the world’s adjustment to expansion of Chinese labour-intensive exports has been facilitated by its coincidence with rapid falls in the shares of Japan (especially up to 1986) and the NIEs (after 1983). By 1996 China’s share of world exports of labour-intensive products was close to that of the four NIEs, but at 50 per cent still well below the NIEs’ peak in the mid-1980s. The increase in China’s share coincided with a rapid increase (on a smaller scale) of Southeast Asia’s role in world trade (Figure 2.3). East Asia’s total share of world exports of labour-intensive products has risen hardly at all since 1984; rising Chinese and other ASEAN shares have been balanced by declines elsewhere in Japan and the NIEs. There is now some anxiety in lower-income Southeast Asian economies in the early stage of internationally-oriented growth that continued rapid expansion of Chinese labour-intensive exports will crowd out their own opportunities. Certainly, the competition is severe, especially in textiles and clothing, where it will intensify in North America with the removal of the MFA constraints on Chinese export expansion as the Uruguay Round is implemented over the next decade. The World Bank (1993) notes that shares of European Community, Japanese and North American imports of clothing from developing countries in total


Table 2.3 China’s exports and imports by groups of commodities, 1978, 1980, 1985, 1990 and 1996 (per cent)

Note: The shares of the four groups do not sum to 100 per cent. Source: International Economic Databank, Australian National University. Data compiled from United Nations trade statistics.

consumption were 19.1, 27.9 and 13.1 per cent, respectively, in 1988. The respective shares of imports from China were 1.6, 3.0 and 3.4 per cent. The World Bank projects future shares on the assumptions that China’s exports will continue to grow at about 15 per cent per annum, and other developing countries at Korea’s growth rate between 1980 and 1990, and that apparent consumption of clothing will continue to expand at the rate of the past decade. The Bank projects the shares of clothing imports from developing countries and from China in 1988 to be, respectively, 23.5 per cent and 1.9 per cent for the European Community, 34.3 per cent and 3.8 per cent for North America and 16.1 per cent and 4.2 per cent for Japan. Comparison of these data with Table 2.3 shows immediately that China’s shares of exports from developing countries grew through 1988–92 at a rate well in excess of the World Bank projections. If China’s and the world’s exports of all labour-intensive manufactured goods continued to grow at their rates of the 1980s (23 and 9 per cent, respectively), by the year 2000 China would account for 34 per cent of the world’s exports of these products. This is roughly the same as the combined shares of Japan and the NIEs in the mid-1980s, and would be achieved over a period during which these exports from Japan and the NIEs fell to very low levels (Figure 2.4). Nevertheless, China’s exports of labour-intensive goods would be growing so rapidly that growth in South-east Asian and other developing countries taken as a whole would be limited, or else the increased competitiveness of developing countries as a whole would need to force an increased role for labour-intensive


Figure 2.3 Changing share of some East Asian economies in world total labour-intensive manufactured exports, 1965–96 (per cent)

Source: International Economic Databank, Australian National University. Data compiled from United Nations trade statistics.

products in world trade, with exports growing more rapidly than consumption. The latter response would continue the pattern observed since rapid exportoriented industrialisation emerged in China and the lower-income economies of Southeast Asia became entrenched in the first half of the 1980s (Figure 2.4). Chinese export expansion at this rate on this scale would reduce opportunities for other relatively labour-abundant economies embarking on export-oriented industrialisation strategies—Indonesia, India, Bangladesh, Vietnam and the Philippines among others—If it remained concentrated strongly in simple products. But is this likely to be the case? The regional diversity of China’s relative resource endowments, and a history of heavy public investment, including in education—relevant to comparative advantage in more sophisticated production and therefore support for early diversification of exports—suggest qualifications to first impressions. China is not an integrated economy with a per capita income a bit above US $1,000. Rather, it is a set of provincial and regional economies, with widely differing resource endowments and comparative advantages and separated by high resistances to trade and factor flows. Table 2.4 makes one aspect of the point at a provincial level. The dynamic southeast coastal economies—from Hainan and Guangdong around to Shanghai and Jiangsu, with a total population over 300 million—have per capita incomes well into the range of middle-income economies. The richer and more dynamic parts of this region are already experiencing labour shortages, rising labour costs, and pressure to transform production and exports into more sophisticated and capital-intensive activities.


Figure 2.4 Shares of labour-intensive goods in total exports: world and some East Asian economies, 1965–93 (per cent)

Source: International Economic Databank, Australian National University. Data compiled from United Nations trade statistics.

Over the next decade, many of the opportunities for the sale of labourintensive products from lower-income inland economies, with per capita incomes closer to Indonesia’s and, perhaps, India’s and Vietnam’s, will come from the provision of labour-intensive products to dynamic coastal provinces undergoing structural change. Coastal regions, for their part, will upgrade specialisation into more sophisticated versions of old products, and more capitalintensive processes and goods and services. Parts of coastal China will support industrialisation of inland China through structural change in trade and production in much the same way as structural transformation of the NIEs supported export-oriented growth in China in the 1980s. It is noteworthy that the share of capital-intensive goods in China’s total exports also started to rise after the mid-1980s. At the disaggregated commodity level, exports of some capital-intensive goods indeed experienced dramatic expansion both in relative (to total exports) and absolute terms in the 1980s. Exports of telecommunications equipment accounted for 4.0 and 4.6 per cent of total exports in 1990 and 1996. Similarly, the shares of domestic electric equipment exports were also 0.5 per cent in 1990 and 1.6 per cent in 1996. Other commodities such as office machines, electric power machines, watches and clocks, and sound recorders are now among the top twenty largest exporting commodities (SITC 3-digit statistics). This suggests that China is quickly accumulating the physical and human capital to produce some capital-intensive products at internationally competitive costs. One explanation is that some parts of China are already relatively capital-abundant, as discussed in the preceding paragraphs. Another is that some ‘capital-intensive’ goods are produced labour-


Table 2.4 China, many regional economies, 1992

Source: Per capita income on a comparable basis, according to Garnaut and Ma (1993).

intensively in China. Another important factor is that in the thirty years of central planning, there was a huge investment in capital-intensive and technology-intensive industries. Although these investments, including in human capital, represented a misallocation of resources, once the capital was sunk, it was the source of comparative advantage at the margin in producing some capitalintensive and technology-intensive manufactured goods. The space industry, including satellite launching, is an example.


These signs of China’s rising competitiveness in some technology-intensive manufactured goods may indicate that, given its size and history, the pattern of export specialisation in China may be more complicated than in other East Asian economies. More generally, China’s comparative advantage will shift from labourintensive industry to capital-intensive and technology-intensive industries as physical and human capital accumulate and labour costs rise in the process of economic development. This has been illustrated in the experiences of Japan and the NIEs (Figure 2.4). Japan in the 1960s and Taiwan and Korea in the 1970s all had a period of rapid expansion of labour-intensive manufactured exports. After that, electronic industries replaced textile industries, becoming the leading industry of the economy. Japan’s share in the world’s total exports of labourintensive manufactured goods started to decline from 15 per cent at the beginning of the 1970s to below 5 per cent in 1996, while its share of total exports still increased from 7 per cent to 10 per cent in 1992 and fell down to 8 per cent in 1996. The share of the NIEs in world labour-intensive manufactured exports increased steadily from 5 per cent in the mid-1960s to more than 20 per cent in the mid-1980s and then fell to about 12 per cent in 1996, while their share in total world exports continued to increase from 1 per cent in 1965 to 8 per cent in 1996. The increasing shares of total exports in later stages (after 1968 in the case of Japan and after 1984 in the case of the NIEs) were contributed mainly by export expansion of capital-intensive manufactured goods. Evolving from labour-intensive to capital-intensive and technology-intensive manufacturing will be easier for China because of its historical investment in human capital relevant to technologically sophisticated industry. This will accelerate the emergence of new export sectors and smooth the path of structural change as labour-intensive industries lose competitiveness. The special features of China, including its size and diversity, will cause capital intensification to take an unusual form. China will remain a competitive supplier of labour-intensive products for a longer period of internationallyoriented growth than other East Asian economies, as it will take several more decades of rapid growth for labour to become scarce and expensive throughout this big country. It will, of course, lose competitiveness in the simplest, most labour-intensive products more quickly the more effective are growth-enhancing reforms in lower-income countries, most notably in South Asia. At the same time, it will emerge as an important supplier of more sophisticated products at a relatively early date. The result is likely to be a more diverse export pattern, emerging relatively early in the growth process, with more of China’s exports being focused on the deeper world markets for more technologically sophisticated products. This will ease the problems of competition for other low-income countries. Developing countries will share the opportunities to expand exports to China itself. This has already been important for many agricultural and mineral products. China’s growth will deepen world markets, too, for a range of


manufactured commodities in which some developing countries have revealed comparative advantage. In the larger world market associated with the emergence of China, there will be more opportunities for gains from trade through fine specialisation in production. This will place a premium on flexibility and capacity to transform production through rapid expansion of activities that have proved their international competitiveness. China’s size means that its trade liberalisation, economic expansion or structural change have the capacity to affect prices on world markets. Certainly, internationally-oriented growth in China has depressed to some extent the terms of trade of competing developing countries. In addition to secular tendencies of these kinds, fluctuations in Chinese imports and exports of particular commodities can lead to instability in world prices. The point can be made by reference to cotton. Basically, China seeks selfsufficiency. But it also actively participates in the international market because there are changes in domestic demand and supply, for example with seasonal conditions affecting yield. Therefore, in some years, as between 1986 and 1988, China exported about 500–750,000 tonnes of cotton a year to the world market, while in some other years, as in 1980 and 1981, it imported about 80,000 tonnes a year. In some years China was the world’s largest importer and in some the largest exporter, adding one important unstable factor to existing cotton market fluctuations. Cotton prices tended to be low when China’s net imports were low (or net exports were high), and high when China’s net imports were high (Figure 2.5). China is the world’s largest producer and consumer of many commodities, including a wide range of simple manufactured goods and industrial raw materials (coal, cotton, grain, steel and wool), so that normal fluctuations in Chinese supply or demand inevitably have a substantial effect on world markets. These effects have been exacerbated by policy instability in China in the partially reformed economy of the past fifteen years, especially in relation to industrial inputs. Fluctuations in Chinese supply and demand have their greatest impact in commodities in which international markets are separated from major domestic markets by quantitative restrictions and other controls, so that the international market is simply a residual market, potentially highly volatile in response to relatively small fluctuations in net exports from a major economy. The impact of fluctuations in Chinese net exports in world market prices for particular commodities has already been a source of international concern. The effects of the expansion of Chinese wool imports in the mid-1980s, followed by a sudden contraction in 1989 and 1990, provides an example with dramatic relevance to Australia. If this is not to lead to demands for special restrictions on Chinese participation in international markets, China and its trading partners will be wise to search systematically for cost-effective means of minimising these effects. One is the general internationalisation of markets, with the removal of quantitative restraints on trade, whether they be imposed in China or abroad. This will have the effect of extending the market to cover more of world produc


Figure 2.5 China’s net imports of cotton and world cotton prices, 1972–94

Source: International Economic Databank, Australian National University. Data compiled from FAO statistics: ABARE(1992).

tion and trade, reducing the impact of fluctuations of any given size in China’s net exports. A larger world market will be a more stable world market. A second means is trade and industry reform in China, to remove arbitrary changes in policy that introduce artificial fluctuations in supply and demand for particular products. Instability in markets for commodities in which China is a major player also adds to the reasons for giving priority to reform designed to reduce macroeconomic instability within China. WHOSE ADJUSTMENT? There has been some discussion in old industrial economies in recent years of the effects of rapid expansion of trade with labour-abundant China on advanced economies’ employment levels and full employment wage rates (Forsyth 1993; Krugman and Lawrence 1993; McDougall and Tyers 1993). In reality, trade expansion with the old industrial economies has been less rapid and has entailed less adjustment than in East Asia. Adjustments in East Asian economies following China’s expansion will be greater than the rest of the world’s for three reasons. First, these economies all maintain relatively open economies for manufactured goods, so that changes in the international markets will be quickly transmitted to these economies. Second, East Asian economies are separated from China by relatively low resistances to trade, on account of proximity and a range of factors affecting transaction costs. Third, some of these economies, especially Korea and Taiwan, have large sectors which are directly competitive with emerging sectors of the Chinese economy. Their existing labour-intensive industries will be affected by China’s rising market share.


The world’s most dramatic example of structural adjustment associated with the expansion of trade with China is Hong Kong. Only a decade ago, Hong Kong strongly specialised in exports of labour-intensive manufactured goods. It had a large manufacturing sector, employing about 1.1 million people. Increased confidence in Hong Kong-China economic relations following China’s commitment to economic reform, and the SinoBritish agreement of 1984 led to rapid transfer into China of virtually all of the labour-intensive end of Hong Kong’s manufacturing. Employment in manufacturing had fallen to less than half a million by mid-1994. But far from the dismal outcomes for labour in the high-income country predicted by the factor price equalisation theorem, and now finding their ways into popular discussion in the West, full employment was maintained through the adjustment, and real wages rose dramatically. Hong Kong is now re-specialised internationally, particularly in the export of highvalue services, notably to China. This year for the first time its per capita income will exceed Britain’s and Australia’s. Beyond Hong Kong, the most rapid expansion of trade with an emerging China, and of structural change to accommodate the characteristics of an emerging China’s trade, has been in other neighbouring Northeast Asian economies, and then in the wider Western Pacific region, and the wider Pacific area. Table 2.5 makes the point. North America has grown rapidly as a trading partner since the establishment of full diplomatic relations, catching up the ground lost in earlier times of political tension and distance. In the main labour-intensive commodities, too, neighbouring East Asian countries have borne the largest weight of adjustment to China’s emergence as a major trading economy. The difference in China’s share of various markets can be seen in Figures 2.6, 2.7, 2.8 and 2.9. China’s share of other East Asian imports is around four times larger than in ‘other OECD’ markets for labourintensive goods. The difference is greatest with textiles and clothing, due in large part to the artificial constraints of the MFA in North America and Western Europe. The MFA’s effects in artificially reducing China’s market share can be observed in Figure 2.7. China in 1992 accounted for over 40 per cent of clothing imports into OECD countries that are not participants as importers in the MFA (Australia, New Zealand and Japan), but only 17 per cent in North America and 7 per cent in the European Community. There will be some more ‘catching up’ in the North Atlantic’s adjustment to China’s trade expansion with the dismantling of the MFA as the Uruguay Round is implemented. This is the region that has felt most threatened by the expansion of China’s trade, and the additional adjustment associated with removal of the MFA will exacerbate perceptions of an adjustment problem in the North Atlantic, and, no doubt, strengthen pressures for ‘safeguards’ to constrain China’s trade. One advantage that the world economy has in accommodating new participants now, relative to the 1960s and 1970s, is the increased number of internationally-oriented economies that are now sharing the adjustment burden


Table 2.5 Destinations of exports and sources of imports in China, 1980, 1985, 1990, 1995 and 1996 (US$ million, per cent)

Note: Shares for the NIEs in China’s total exports and imports reported under the year 1993 are actually 1992 numbers, because the calculated shares dropped to an unbelievable extent. indicating some serious data problems in the database. Source: International Economic Databank, Australian National University. Data compiled from the International Monetary Fund’s Direction of Trade statistics.

and the gains from trade. China has emerged rapidly as an important trading partner of Russia since the collapse of socialism (Figure 2.9). This is an important source of gains for each, and if Russia (and its neighbours in the west and east) are able to establish a stable basis for economic growth in the years ahead, this will ease to some extent the adjustment in the rest of the world associated with the expansion of China’s trade. It is noteworthy that the economies that have adjusted most to the new Chinese trade opportunities are those most inclined to perceive the opportunities above the threats: Hong Kong, Taiwan, Korea, the rest of the Western Pacific, followed by North America and Western Europe. There is in their experiences a hint that special measures to inhibit trade expansion and economic adjustment artificially are not helpful to the political economy of adjustment to new opportunities.


Figure 2.6 China’s shares in world and selected countries’ labour-intensive manufactured imports, 1978–93 (per cent)

Note: 1993 numbers are preliminary estimates. Source: International Economic Databank, Australian National University. Data compiled from World Bank statistics; Asia-Pacific Economics Group (1994).

CHINA AND JAPAN The accommodation of China’s internationally-oriented growth is complicated by its timing, in a period of disillusionment with the liberal multilateral system in the North Atlantic and tension in US trade relations with East Asia, particularly Japan. Tensions in US-Japan trade relations in the late 1980s and early 1990s were overlaid by popular perceptions that in the aftermath of the Cold War, economic rivalry between Japan and the United States would have political significance. Japan was identified by some scholars in the United States as having characteristics that made it a poor citizen of the world economy: a chronic surplus in current payments; low intra-industry trade; low shares of manufactured goods in total imports; and low levels of inward direct foreign investment. Trade with China will become as contentious as was trade with Japan. The adjustment challenge will be as large as that to the emergence of Japan at a similar stage of economic development. The overlay of political rivalry will be as great, or larger, as awareness grows of China’s real economic size, and given China’s political self-confidence and ambitions for military modernisation. China will do much better on the tests of good international economic citizenship that have been concocted artificially for Japan. Intra-industry trade is larger and increases more rapidly (Table 2.6), the current account and net exports fluctuate around zero in the reform era, manufactured goods dominate imports and direct foreign investment is now being committed in China at a rate without precedent in East Asia or the developing world. This will not protect China from


Figure 2.7 China’s shares in world and selected countries’ imports of textiles and clothing, 1978–93 (per cent)

Source: International Economic Databank, Australian National University. Data compiled from World Bank statistics.

criticism: the political economy of trade policy and protectionism places modest value on logical consistency. The differences between China and Japan on these and some other points of public concern, however, will make it less likely that tensions in US relations separately with Japan and China will be made less tractable by their merging into a general ‘East Asian’ problem. WHAT RULES? WTO membership negotiation provides China and the international community with a rare opportunity to set some basic principles governing trade relations between the two sides. An appropriate settlement of China’s WTO membership and the related agreement will not only increase China’s confidence in further opening up its economy and participating more actively in international trade, but can also lay out some clear constraints on China’s behaviour and push it towards further reform. To achieve this, it is important to have a correct perspective on the gains and losses from China’s WTO membership and trade reform. China realises the benefits of trade reform and participation in international exchange. But there are many occasions when it has been inclined to accept constraints on reform that are damaging both to itself and its trading partners, notably in the cases of agriculture and motor vehicles. On the international side, it is also crucial to be aware of the current state of China’s institutional setting and the adjustment costs it may have to incur in transition.


Figure 2.8 China’s shares in world and selected countries’ total imports, 1978–93 (per cent)

Source: International Economic Databank, Australian National University. Data compiled from World Bank statistics.

One key problem in the negotiation of China’s membership is whether China should join the WTO as a developing or a developed country. What real difference does this make? According to current WTO rules, developing countries are exempt from some of the trade disciplines. As a low-income country, the member can maintain certain quantitative restrictions, on grounds such as food security or an infant industry. Another difference, following the Uruguay Round settlement, is that developed countries are required to reduce their domestic agricultural support by 36 per cent within six years of implementation, while developing countries are only required to reduce it by 24 per cent and virtually no reform is required for least developed countries with per capita incomes of less than US $1,000. These concessions, however, would not contribute positively to China’s welfare. This has been demonstrated by the experiences of other East Asian economies and reinforced by China’s experience of unilateral trade liberalisation during the whole reform period. The adjustment problems and costs to China of movement to the new regime must be considered. The international community has to be aware that China has in the past reform period pursued a gradual approach to economic reform. While there are some shortcomings in this approach, it helps the government to accumulate experience during the process and to limit adverse consequences like instability and fluctuations. Whether China joins the WTO as a developed country or as a developing country may not be of crucial importance to the trading relationship between


Figure 2.9 China’s share in the former USSR’s imports and exports, 1978–95 (per cent)

Source: International Economic Databank, Australian National University. Data compiled from World Bank statistics. Table 2.6 Indexes of intra-industry trade for China and Japan, 1970, 1980 and 1990

Source: International Economic Databank. Australian National University. Data compiled from the United Nations Trade Statistics; Drysdale and Gamaut (1993). Calculated at 4digit level.

China and the international community. The key to the problem was for both sides to work out an announced trade policy agenda for China. A realistic solution, therefore, was for China to join the WTO as a developing country, especially considering its current income level and its institutional framework, but to make unilateral commitments to further reforms aimed at the achievement of conditions similar to those for developed country members within a finite period. Commitment to movement in the short term to a developed country regime for some commodities assists China’s acceptance in the international community.


The 1997 Uruguay Round trade negotiation provided a favourable environment for China to deliver further reforms. First, the phasing out of the MFA supported faster growth of China’s exports of textile and clothing products in the North American and Western European markets. Second, the world economy embarked on agricultural reform, reversing the trend of the 1980s. This will have some positive effects on China’s agricultural policy choices—which are among the key issues in the membership negotiation. Moreover, the expected rises in international agricultural prices following implementation of the settlements may increase China’s confidence in the internationalisation of its agricultural sector as the adjustment costs are expected to be low. The significance of the Uruguay Round negotiation goes beyond issues in specific sectors. Phasing out of the MFA, for instance, will help China’s overall trade reform. As confidence in its exchange earnings rises, China will find it easier to abolish some of its trade restrictions, which have been motivated by anxiety about access to foreign exchange. Beyond the global economic organisations like the WTO, the Asia Pacific Economic Cooperation (APEC) forums provide an important framework through which China can interact with the wider international community. In particular, trade and investment facilitation and credible commitment to eventual free trade within the Asia Pacific region have the capacity to increase confidence in China and among its trading partners that the exchange opportunities in the international community are a secure basis for China’s future development. THE CHALLENGE China’s rapid, internationally-oriented economic growth is a major challenge to the international economy and trading system, because of China’s size, rapid growth, skewed relative resource endowments and tendencies to instability. In scale and structural implications, however, the challenge is no greater than that which has already been (imperfectly) met in the rise of Japan and the NIEs. There will be assertions in other economies affected by China’s growth that China’s trade expansion is reducing the opportunities of others, reducing labour returns elsewhere, disrupting the international system, and that China is denying to others reasonable gains from access to its own markets. This is a management challenge for China. It can best answer that challenge through unequivocal commitment to reform, to the eventual goal of free trade for itself and the international community, and to application of the rules of the international system. China will be wise to stay ahead of international pressure, linking liberalisation at the border to its domestic reform. If the rest of the world supports China’s entry into the world trading system under the general rules, as strengthened by the Uruguay Round, the widening of the international market will increase potential gains from specialisation and trade, and for some commodities this is likely to lead to greater stability in international prices. The large scale of China’s exports will depress relative


prices for some commodities, and increase the importance of flexibility in other developing economies seeking internationally-oriented growth. The main downside to the international system from the emergence of China as a major trading economy will materialise if the rest of the world baulks at the adjustment task, and seeks to manage closely the scale and content of interaction with China. Such a response would lead quickly to a decline of Chinese confidence about deep integration into the world economy. The prospects of China’s ability to integrate sectors which were the subject of special commitments to self-sufficiency in Maoist times into the international market would decline at a critical time. Political competition would overlay trade relations between China and the largest external economies, especially the United States. The end point would be retreat from the rules-based system, with major consequences for internationally-oriented growth in China, East Asia and beyond. NOTES 1 In this chapter, NIEs include Hong Kong, Singapore, Taiwan and Korea.

REFERENCES Drysdale, Peter and Ross Garnaut (1993) ‘The Pacific: An application of a general theory of economic integration’, in C.Fred Bergsten and M.Norland, eds, Pacific Dynamism and the International Economic System, Washington, DC: Institute for International Economics, in association with the Pacific Trade and Development Conference Secretariat, ANU. Forsyth, Peter (1993) ‘Trade patterns and labour demand: International influences on wages and unemployment in Australia’, paper presented to the conference Unemployment: Causes, Costs and Solutions, 16–7 February 1993, ANU and Department of Employment, Education and Training, Canberra. Garnaut, Ross (1989) Australia and the Northeast Asian Ascendancy, Canberra: Australian Government Publishing Service, Garnaut, Ross and Kym Anderson (1980) ‘ASEAN export specialisation and the evolution of comparative advantage in the Western Pacific region’, in Ross Garnaut, ed., ASEAN in a Changing Pacific and World Economy, Canberra: ANU Press. Garnaut, Ross and Guonan Ma (1993a) ‘How rich is China: Evidence from the food economy’, Australian Journal of Chinese Affairs (30):121–46. —— and Guonan Ma (1993b) ‘Economic growth and stability in China’, Journal of Asian Economics, 1(4):5–24. Krugman, Paul R. and R.Z.Lawrence (1993) ‘Trade, jobs, and wages’ NBER Working Papers 4478. Lau, L. (1994) ‘The Chinese economy in the twenty-first century’, paper presented at the international conference on The Market Economy and China, Beijing, China. McDougall, R. and R.Tyres (1993) ‘Developing country expansion and factor markets in Industrial countries’, presented at the special session on GTAP applications,


International Trade Research Consortium Annual Meeting, San Diego, California, 12–14 December. World Bank (1993) CHINA Foreign Trade Reform: Meeting the challenge of the 1990s, report no. 11568-CHA, Washington, DC. Yuan, G. (1999) ‘Nonperforming debts of the state-owned enterprises in China’, paper presented at the 11th Annual Conference of the Association for Chinese Economic Studies, 15–16 July 1999, Melbourne.

3 Economic reform and development strategy in China Justin Yifu Lin

INTRODUCTION After the socialist revolution in 1949, China, like other socialist and many other developing countries at that time, adopted an inward-looking heavy-industryoriented development strategy (HIODS). The HIODS enabled rapid transformation of the structure of domestic production in the Chinese economy, with industrial income expanding from 12.6 per cent of total national income in 1949 to 46.8 per cent in 1978. Despite rapid industrialisation, the living standard of Chinese people increased only slightly. Between 1952 and 1978, real per capita consumption increased by 77 per cent, equivalent to an annual growth rate of 2.2 per cent. Compared with the remarkable economic development in other East Asian economies, China’s performance was disappointing. Frustrated by their inability to achieve a substantial improvement in the welfare of the Chinese people after thirty years of socialist revolution, the veteran leaders who had been purged during the Cultural Revolution and regained power after the death of Mao Zedong in 1976 initiated a series of opendoor economic reforms at the end of 1978. Since then, China has joined the club of East Asian miracle economies and become one of the fastest growing economies in the world. The average annual growth rate of GDP reached 9.8 per cent in the period 1978–95. Despite this achievement, the Chinese economy in the reform period has been troubled by a recurrence of ‘boom-and-bust’ cycles and other chronic problems.1 The frequency of the cycles has become shorter, whereas the amplitude has grown bigger (see Figure 3.1). The possibility that there might be a sudden collapse of the Chinese economy has become a widespread concern. In this chapter, I argue that the economic problems before reform were rooted in the HIODS, which neglected the comparative advantage of the Chinese economy, and that the achievements of reform are attributable to better utilisation of comparative advantage. I further argue that the problems emerging after the reform have arisen from an incomplete shift in development strategy, and that the way to achieve rapid, sustained growth in the Chinese economy hinges on a complete shift from the anticomparative-advantage HIODS to a

CHINA’S ENTRY TO THE WTO 31

Figure 3.1 Economic growth and inflation in China, 1978–98

Source: China Statistical Yearbook. 1999.

developing strategy that relies on the comparative advantage of the Chinese economy. HIODS AND MAJOR PRE-REFORM ECONOMIC PROBLEMS When the People’s Republic was founded in 1949, the Chinese government inherited a war-torn agrarian economy in which 89.4 per cent of the population resided in rural areas and industry made up only 12.6 per cent of national income. At that time, a developed heavy-industry sector was a symbol of national power and economic achievement. Like leaders in India and many other newly independent developing countries, the intention of Chinese leaders was to accelerate the development of heavy industry. Following China’s involvement in the Korean War in 1950, with its resulting embargo and isolation from Western nations, catching up to the industrialised powers became a national security imperative. In addition, the Soviet Union’s outstanding record of nation-building in the 1930s, in contrast to the Great Depression in Western market economies, provided the Chinese leadership with both the inspiration and the experience to adopt the HIODS. After recovering from war-time destruction in 1953, the Chinese government planned to establish heavy industry as the priority sector. The goal was to build, as rapidly as possible, the country’s capacity to produce capital goods and military materials. This development strategy was carried out through a series of five-year plans.2 The traditional economic structure in China was shaped by the adoption of this strategy.

32 ECONOMIC REFORM AND DEVELOPMENT STRATEGY IN CHINA

Heavy industry is a capital-intensive sector. The construction of a heavyindustry project requires a long gestation;3 most equipment for a project, at least in the initial stages, needs to be imported from more advanced economies; and each project requires a lump-sum investment. When the Chinese government initiated this strategy in the early 1950s, the Chinese economy was characterised by limited capital and, consequently, high market interest rates;4 scarce and expensive foreign exchange because exportable goods were limited, primarily consisting of low-priced agricultural products; and a small and scattered economic surplus due to China’s poor agrarian economy. Because these characteristics of the Chinese economy were mismatched with the demands of heavy-industry projects, spontaneous development of capital-intensive industry in the economy was impossible.5 A set of distorted macro-policies was required for the development of heavy industry. At the beginning of the first five-year plan, the government instituted a policy of low interest rates and over-valued exchange rates to reduce the cost of interest payments and equipment imports.6 Meanwhile, in order to secure sufficient funds for industrial expansion, a policy of low input prices, including nominal wage rates for workers7 and prices for raw materials, energy and transportation evolved alongside this development strategy. The assumption was that low prices would enable enterprises to create profits large enough to repay the loans or to accumulate enough funds for reinvestment. If the enterprises were privately owned, the state could not be sure that private entrepreneurs would reinvest the policy-created profits in the intended projects.8 Therefore, private enterprises were soon nationalised9 and new key enterprises were owned by the state to secure its control over profits for heavy-industry projects. Meanwhile, to make the low nominal-wage policy feasible, the government had to provide urban residents with inexpensive food and other necessities, including housing, medical care and clothing. Low interest rates, overvalued exchange rates, low nominal wage rates, and low prices for raw materials and living necessities constituted the basic macro-policy environment of the HIODS.10 These macro-policies led to an overall imbalance in the supply and demand for credit, foreign exchange, raw materials, and other living necessities. Because non-priority sectors competed with priority sectors for low-priced resources, plans and administrative controls replaced the market as the mechanism for allocating scarce credit, foreign reserves, raw materials, and living necessities, ensuring that limited resources would be allocated to targeted projects. Moreover, the state exercised a monopoly on the banking, foreign trade and material distribution systems.11 In this way competition was suppressed, and profits ceased to be the measure of the efficiency of an enterprise.12 Because of the lack of market discipline, managerial discretion was potentially a serious problem and managers of state enterprises were deprived of the autonomy to mitigate this problem.13 The production of state enterprises was dictated by mandatory plans and most of their material inputs were furnished through an administrative allocation system. The


prices of their products were determined by pricing authorities. Government agencies controlled the circulation of their products. Wages and salaries of workers and managers were determined not by performance but by education, age, position and other criteria, according to a national wage scale. Investment and working capital were mostly financed by appropriations from the state budget or loans from the banking system according to state plans. State enterprises remitted profits, if any, to the state and the state budget covered their losses. In short, state enterprises were puppets. They had no autonomy in employment of workers, use of profits, production plans, supplies of inputs or marketing. The development strategy and the resulting policy environment and allocation system also shaped the evolution of farming institutions in China. In order to secure cheap supplies of grain and other agricultural products for low-priced urban rationing, a compulsory procurement policy was imposed in rural areas in 1953. This policy obliged peasants to sell set quantities of their produce, including grain, cotton, and edible oils to the state at prices set by the government (Perkins 1988: ch. 4). In addition to providing cheap food for industrialisation, agriculture was the main foreign exchange earner. In the 1950s, agricultural products alone made up over 40 per cent of all exports. If processed agricultural products are also counted, agriculture contributed more than 60 per cent of China’s foreign exchange earnings until the 1970s. Because foreign exchange is as important as capital for a heavy-industry-oriented strategy, the country’s capacity to import goods for industrialisation in the early stages of development depended on the performance of agriculture. Agricultural development required resources and investment in just the same way as industrial development. The government, however, was reluctant to divert scarce resources and funds from industry to agriculture. Therefore, alongside the HIODS, the government adopted an agricultural development strategy that did not compete with industrial expansion for resources. The core of this strategy involved the mass mobilisation of rural labour to work on labourintensive investment projects, such as irrigation, flood control, and land reclamation, and to raise unit yields in agriculture through traditional methods and inputs, such as closer planting, more careful weeding, and the use of more organic fertilisers. The government believed that collectivisation of agriculture would ensure these functions. It also viewed collectivisation as a convenient vehicle for effecting the state’s low-priced procurement program of grain and other agricultural products (Luo 1985). Income distribution in the collectives was based on each collective member’s contribution to production. However, monitoring a member’s effort is extremely difficult in agricultural production. The remuneration system in the collectives was basically egalitarian (Lin 1989). The distorted macro-policy environment, planned allocation system, and micro-management institutions all made the maximum mobilisation of resources for the development of heavy industry possible in a capital-scarce economy.


Table 3.1 Sector shares of state capital construction investment

Source: State Statistical Bureau, Zhongguo gudingzichantouzi tongji zillao, 1950–1985 (China Capital Construction Statistical Data 1950–85), p. 97.

Since most private initiatives in economic activities were prohibited, the pattern of the government’s investment was the best indicator of the bias in the official development strategy. Table 3.1 shows the sector shares in state capital construction investment from the first five-year plan (1953–57) to the sixth fiveyear plan (1981–85). Despite the fact that more than three-quarters of China’s population made a living from agriculture, it received less than 10 per cent of state investment in the period 1953–85, while 45 per cent went to heavy industry. Moreover, heavy industry received the lion’s share of investments that fell under the heading ‘other’, including workers’ housing and infrastructure. As a result, the value of heavy industry in the combined total value of agriculture and industry grew from 15 per cent in 1952 to about 40 per cent in the 1970s (see Table 3.2).14 As we can see from the composition of China’s output by sector, the trinity of the traditional economic structure (a distorted macro-policy environment, a planned allocation system, and a puppet-like micro-management institution) achieved its intended goal of accelerating the development of heavy industry in China. However, China paid a high price for this. The economy is very inefficient due to low allocative efficiency caused by the deviation of the industrial structure from the pattern dictated by the comparative advantages of the economy, and because of low technical efficiency due to managers’ and workers’ low incentives to work. LOW ALLOCATIVE EFFICIENCY In that phase of China’s economic development, capital is relatively scarce and labour is relatively abundant. If prices were determined by market competition, capital would be relatively expensive and labour relatively inexpensive. Therefore, the comparative advantage of the Chinese economy lies in labour-


Table 3.2 Sector composition (current prices)

Source: State Statistical Bureau, Quanguo geshengshi zizhiqu guomin shouru tongji ziliao huibian (A Compilation of Provincial National Income Data), p.11.

intensive sectors. If investments had been guided by market forces, profit incentives would have induced entrepreneurs to adopt capital-saving and labourusing technologies and to allocate more resources to labour-intensive industries. China would have exported labour-intensive products and imported capitalintensive products. The effects of the HIODS on the industrial structure can be illustrated by Figure 3.2. Let us assume there are only two sectors in the economy, labourintensive light industry and capital-intensive heavy industry. Given these endowments, the production possibility frontier is OCD. EP represents the market-determined relative prices line that existed before the imposition of the HIODS. With undistorted relative prices, the economy will produce Oy0 light industry products and Ox0 heavy industry products. However, to develop heavy industry, the state monopolised the allocation system and used administrative measures to direct the allocation of resources. If we suppose the target of the development strategy is to expand heavy industry from Ox0 to Ox1, then the state would need to limit the production of light industry from Oy0 to Oy1 in order to shift resources from light to heavy industry. The production possibility frontier is truncated to y1AD. If there is no technical inefficiency, the production mix of the economy would locate on A, corresponding to a quantity of Oy1 light-industry products and OX1 heavy-industry products.15 As we can see from Figure 3.2, the static consequence of the strategy is that the economy, based on prices before the distortion, suffers a loss of ea in absolute magnitude or ea/eO in relative measures.16 The income loss due to allocative Inefficiency implies a reduction of surplus available for investment. If we assume that a fixed portion of the national income is used for investment, the decline in investment would further diminish gross investment. However, if we assume that the government’s plan is to develop light and heavy industry in a


fixed ratio of Ox1/Oy1, then each production cycle would repeatedly generate an income loss of ea/eO in relative measures. All these factors significantly dampened the growth of the whole economy. To maintain the growth rate, it was necessary to raise the accumulation rate, resulting in insufficient consumption and prolonged low living standards for the people.17 Moreover, suppression of the labour-intensive sector reduced China’s exportables, and expansion of the capital-intensive sector reduced China’s needs to import. Accordingly, China’s economy became inwardly-oriented.18 LOW TECHNICAL EFFICIENCY Because profits ceased to be a measure of effciency and the planned allocation system often failed to distribute materials in time, managers were forced to keep large reserves and had no incentive to use resources economically. Over-staffing, under-utilisation of capital resources and over-stocking of inventories characterised China’s puppet-like state enterprises.19 Moreover, managers had no authority over workers’ wage rates and bonuses. The remuneration system was related neither to workers’ effort in the enterprise nor to the profitability of the enterprise, resulting in low work incentives. Similarly, in the agricultural collectives, farm workers’ incentive was low because the link between reward and effort was weak.20 Losses resulting from these technical inefficiencies mean that actual production will be located on some point inside the production possibility frontier, such as point B in Figure 3.2. Because of the above two factors, the Chinese economy was very inefficient. The most important indicator that reflected this inefficiency was the extremely low rate of total factor productivity growth in China. A World Bank study shows that, even under the most favourable assumptions, the growth rate was a mere 0.5 per cent between 1952 and 1981, only a quarter of the average growth rate of nineteen developing countries included in the study (World Bank 1985a). The total factor productivity of China’s state enterprises was in a state of stagnation or even negative growth between 1957 and 1982 (World Bank 1985b). A GRADUAL APPROACH TO REFORM Poor economic performance prompted the Chinese government to initiate a series of economic reforms in 1979 when the veteran leaders regained power. As Perkins (1988:601) points out, China’s leaders did not work out a blueprint when they set out to reform the economic structure. However, retrospectively, China’s reforms followed a logical process that is predictable from the above theoretical model. The trinity of the traditional economic structure is endogenous to the adoption of a HIODS in a capital-scarce economy. The main fault in this economic structure was low economic efficiency arising from structural imbalances and incentive problems.


Figure 3.2 Effects of HIODS on industrial structure in China

Source: Author’s own chart.

The government made several attempts before the late 1970s to address these structural problems by decentralising the allocative mechanism.21 However, the administrative nature of the allocative mechanism was not changed and the policy environment and managerial system were not altered, and thus attempts to rectify structural imbalances and improve economic incentives failed. What set the reforms apart from previous attempts were micro-management system reforms that made farmers and managers and workers in state enterprises partial residual claimants. This small crack in the trinity of the traditional economic structure was eventually pried open, leading to the gradual dismantling of the traditional system. Micro-management system reform The most important change in the micro-management system was the replacement of collective farming with a household-based system, now known as the household responsibility system. Initially, the government did not intend to change the farming institutions. Although it had been recognised in 1978 that solving managerial problems within the collective system was the key to improving farmers’ incentives, the official position was that the collective would remain the basic unit of agricultural production. Nevertheless, a small number of collectives, first secretly and later with the blessing of local authorities, began to try out a system of leasing a collective’s land and dividing the obligatory procurement quotas among individual households in the collective. A year later these collectives returned yields far larger than those of other teams. The central


authorities later acceded to this new form of farming, but required that it be restricted to poor agricultural regions, and to poor collectives where people had lost confidence in the collective system. However, this restriction was ignored in most regions. Production improved after a collective adopted the new system, regardless of its relative wealth or poverty. Full official recognition of the household responsibility system as a nationally acceptable farming institution was eventually given in late 1981, exactly two years after the initial price increases. By that time, 45 per cent of the collectives in China had already been dismantled and had instituted the household responsibility system. By the end of 1983, 98 per cent of agricultural collectives in China had adopted this new system. When the household responsibility system first appeared, the land lease was only one to three years. However, short leases reduced farmers’ incentives for land-improvement investment and lease contracts were extended up to fifteen years in 1984. In 1993, the government allowed the lease contract to be extended for another thirty years after the first contract expired. Unlike the spontaneous nature of institutional reform in farming, reform in the micro-management system of state enterprises was initiated by the government. These reforms have undergone four stages. The first stage (1979–83) emphasised several important experimental initiatives that were intended to enlarge enterprise autonomy and expand the role of financial incentives within the traditional economic structure. Measures included the introduction of profit retention and performance-related bonuses and permitted state enterprises to produce outside the mandatory state plan. Enterprises involved in exports were also allowed to retain part of their foreign exchange earnings for their own use. In the second stage (1984–86) the emphasis shifted to a formalisation of the financial obligations of state enterprises to the government and exposed enterprises to market influences. From 1983, profit remittances to the government were replaced by a profit tax. In 1984, the government allowed state enterprises to sell output in excess of quotas at negotiated prices and to plan their output accordingly, thus establishing a dual-track price system. During the third stage (1987–92) the contract responsibility system, which attempted to clarify the authority and responsibilities of enterprise managers, was formalised and widely adopted. The last stage (1993–present) attempted to introduce the modern corporate system to the state enterprises. In each stage, government intervention was reduced and state enterprises gained more autonomy. Reform of the micro-management system has achieved its intended goal of improving technical efficiency. Empirical estimates show that almost half of the 42.2 per cent output growth in the cropping sector in the years 1978–84 was driven by productivity improvements brought about by the reforms. Almost all of the productivity growth was attributable to the changes resulting from the introduction of the household responsibility system (Fan 1991, Huang and Rozelle 1994, Lin 1992, McMillan et al. 1989, Wen 1993). Production function estimates in several studies of the industrial sector find that the increase in


enterprise autonomy increased productivity in the state enterprises (Chen et al 1988, Gordon and Li 1991, Dollar 1990, Jefferson et al. 1992, Groves et al. 1992). Reforms in micro-management systems in both agriculture and industry have created a flow of new resources, an important feature of China’s reforms. Increased enterprise autonomy under a distorted macro-policy environment has also encouraged discretionary behaviour on the part of managers and workers. Despite improved productivity, the profitability of state enterprises declined and government subsidies increased due to a faster increase in wages, fringe benefits, and other unauthorised expenditures (Fan and Schaffer 1991) and competition from the autonomous township-and-village enterprises (TVEs) (Jefferson and Rawski 1995).22 However, once the enterprises had tasted autonomy, it would have been politically too costly to revoke it. The decline in the profits of state enterprises and competition from TVEs forced the government to increase the autonomy of state enterprises further in the hope that the new measures would make the enterprises financially independent. Resource allocation system reform The increase in enterprise autonomy put pressure on the planned distribution system. Because state enterprises were allowed to produce outside the mandatory plans, they needed to obtain additional inputs and to sell the extra outputs outside the planned distribution system. Under pressure from the enterprises, material supplies were progressively delinked from the plan and retail commerce was gradually deregulated. In the beginning certain key inputs remained controlled, but these items were increasingly reduced. Centralised credit rationing was also delegated to local banks at the end of 1984. An unexpected effect of the relaxation of the resources allocation system was the rapid growth of non-state enterprises, especially TVEs.23 Rural industry already existed under the traditional system as a result of the government’s decision to mechanise agriculture and to develop rural processing industries to finance mechanisation in 1971. In 1978 the output of TVEs made up 7.2 per cent of the total value of industrial output in China. Before the reforms, the growth of TVEs was severely constrained by access to credit, raw materials and markets. The reforms created two favourable conditions for the rapid expansion of TVEs: a new stream of surpluses brought out by the household responsibility reform provided a resource base for new investment activities; and relaxation of the traditional planned allocation system provided access to key raw materials and markets. In the period 1981–91, the number of TVEs, their employment levels, and their total output value grew at an average annual rate of 26.6 per cent, 11.2 per cent, and 29.6 per cent, respectively. The annual growth rate of TVEs in total output value was three times that of state firms over the same period. In 1993, TVE output accounted for 38.1 per cent of total industrial output in China. The share of industrial output from non-state enterprises increased from 22 per cent in 1978 to 56.9 per cent in 1993 (State Statistical Bureau 1995:73).


Table 3.3 Growth rate of output and total factor productivity

Source: World Bank, Reform and Role of the Plan in the 1990s, Washington DC, 1992.

The rapid entry of TVEs and other non-state enterprises produced two unexpected effects. First, non-state enterprises were the product of markets. As outsiders to the traditional economic structure, non-state enterprises had to obtain energy and raw materials from competitive markets, and their products could only be sold on the market. They had budget constraints and they could not survive under poor management. Their employees did not enjoy ‘iron rice-bowl’ benefits and could be fired. As a result, non-state enterprises were more productive than state enterprises, as the comparisons of growth rate in output and total factor productivity between the state and collective sectors in Table 3.3 show. The dynamism of non-state enterprises put pressure on state enterprises and triggered the state policy of transplanting the micro-management system of the non-state enterprises to the state enterprises and of delegating more autonomy to state enterprises. Reform measures for improving the micro management system of state enterprises (replacement of profit remittance by a profit tax, establishment of the contract responsibility system and introduction of the modern corporate system to state enterprises) were responses to competitive pressure from TVEs and other non-state enterprises (Jefferson and Rawski 1995). Second, the development of non-state enterprises significantly rectified the misallocation of resources. In most cases, non-state enterprises had to pay market prices for inputs, and their products were sold at market prices. Price signals induced non-state enterprises to adopt more labour-intensive technology and to concentrate more on labour-intensive small industries than did state enterprises.24 Therefore, the technological structure of non-state enterprises was more consistent with China’s comparative advantages. The entry of TVEs mitigated the structural imbalance caused by the HIODS.


Macro-policy environmental reform Of the elements of the traditional economic structure, the distorted macro-policy environment was linked most closely to the development strategy, and its effects on allocative and technical efficiency were indirect. Reform of macro-policies was thus the most sluggish. I argue later that most of the economic problems that appeared during the reforms (for example the cyclic growth pattern and rampant rent-seeking) can be attributed to inconsistencies between the distorted policy environment and the liberalised allocation and enterprise system. The Chinese government constantly faced a dilemma: to make the macro-policy environment consistent with the liberalised micro-management and resource allocation system or to re-centralise the micro-management and resource allocation system to maintain the internal consistency of the traditional economic structure. Depriving enterprises of autonomy would incur the resistance of state enterprise employees while a return to the traditional economic structure would mean a return to economic stagnation. No matter how reluctant the government, the only sustainable choice was to reform the macro-policy environment and make macropolicies consistent with a liberalised allocation and micro-management system. Changes in the macro-policy environment started in the commodity price system. After the introduction of profit retention, enterprises were allowed to produce outside the mandatory plan. Enterprises first used an informal barter system to obtain outside-plan inputs and to sell outside-plan products at premium prices. In 1984, the government introduced a dual-track price system, which allowed state enterprises to sell their output in excess of quotas at market prices and to plan their output accordingly. The aim of the dual-track price system was to reduce the marginal price distortion in the production decisions of state enterprises while leaving the state a measure of control over material allocation. By 1988 only 30 per cent of retail sales were made at plan prices, and state enterprises obtained 60 per cent of their-inputs and sold 60 per cent of their outputs at market prices (Zou 1992). The second major change in the macro environment occurred in foreign exchange rate policy. From 1979 to 1980, the official exchange rate was roughly 1.5 yuan per US dollar. This did not cover the costs of exports, as the average cost of earning one US dollar was around 2.5 yuan. A dual-rate system was adopted at the beginning of 1981. Commodity trade was set at the internal rate of 2.8 yuan per dollar and the official rate of 1.53 yuan per dollar continued to apply to non-commodity transactions. After 1985, the yuan was gradually devalued. The proportion of retained foreign exchange, introduced in 1979, was gradually raised, and enterprises were allowed to swap their foreign exchange entitlement with other enterprises through the Bank of China at rates higher than the official exchange rate. Restrictions on foreign exchange trading were further relaxed with the establishment of a ‘foreign exchange adjustment centre’ in Shenzhen in 1985, in which enterprises could trade foreign exchange at negotiated rates. By the late 1980s, such centres were established in most


provinces in China and more than 80 per cent of foreign exchange earnings was swapped in such centres (Sung 1994). The climax of foreign exchange rate policy reform was the establishment of a managed floating system and unification of the dual-rate system on 1 January 1994.25 Interest rate policy has been the least affected area of the traditional macropolicy environment. Under the HIODS, the interest rate was kept artificially low to facilitate the expansion of capital-intensive industries. After the reforms in 1979, the government was forced to raise loan rates and savings rates several times.26 However, the rates were maintained at levels far below market-clearing rates throughout the reform process. In late 1993, the government announced a plan to establish three development banks to finance long-term projects, import/ export, and agricultural infrastructure at subsidised rates and to transform existing banks into commercial banks. These development banks were established in 1994. The commercialisation of the existing banks is expected to take at least another three to five years. Moreover, it is unclear whether after the reform the interest rate will be regulated or determined by the market. ACHIEVEMENTS AND PROBLEMS OF GRADUAL REFORMS When China started its reforms, the political leadership did not question the feasibility or desirability of the traditional economic system. Its aim was simply to improve incentives in state enterprises and collective farms by giving them some autonomy and to establish a closer link between personal reward and individual effort, that is, to move from point B to point A in Figure 3.2. The empirical studies cited above show that the attempt was successful and a new stream of resources was created by micro-management system reform. The granting of partial micro autonomy was only a small crack in the traditional economic structure. Partial autonomy also implies that entrepreneurs gain partial control over the allocation of the newly created stream of resources. The suppressed sectors in the traditional economy are the sectors that are consistent with the comparative advantages of the economy. The unexpected result of micro-management reform was that, driven by profit motivation, autonomous entrepreneurs allocated the new resources under their control to the more profitable suppressed sectors. Since the planned allocation system and distorted macro-policy environment were preserved, the state still had control over the old stream of resources and guaranteed that these resources would be allocated to the priority sectors. That is, the economy follows a dynamic path from point A to a point close to G, instead of H, in Figure 3.2. China thus avoided the ‘J-curve’ or ‘L-curve’ pattern of GDP growth, which was widely observed in Eastern Europe and the Former Soviet Union where a ‘big-bang’ approach to reform was adopted. Throughout the reform process, the Chinese economy enjoyed positive growth (Figure 3.1). The growth rate was further accelerated by the open-door policy,


which allowed the economy to utilise its comparative advantages internationally, attract foreign direct investment (FDI) and gain access to new technology. The growth rate of trade, measured as the total value of imports and exports in US dollars, increased from an annual rate of 9.5 per cent in 1952–78 to 16.4 per cent in 1978–94. China’s ranking in world trade rose from thirty-fourth at the beginning of reform to tenth in 1995. In 1993–95, China had the largest FDI inflow among developing countries. As a result, the average annual growth rate of GDP reached 9.8 per cent in 1979–94, a rate as remarkable as that achieved by Asia’s four Little Dragons at the peak of their performance. Despite the achievements in overall growth, because reform of macro-policies, especially those regarding interest rates, lagged behind reform in the allocation system and micro-management institutions, there were severe economic consequences. Growth and inflation cycles The policy of interest rate suppression has yet to be eliminated. Because of the below market-clearing rate, enterprises have incentives to obtain more credit than supply permits. Before the reforms, excess demand for credit was suppressed by restrictive central rationing. Inflation was under state control. Since the reforms, especially the banking system reform in 1984, whenever the central government’s direct control of credit rationing is relaxed, an investment rush has occurred. Because the expansion in credit during an investment rush is not supported by an increase in savings, banks must finance the credit expansion by creating additional high-power money. The rush leads to investment-led growth and a bottleneck in transportation, energy and the supply of construction materials. A high growth rate fuelled by credit expansion and increased money supply inevitably results in increased inflation. Since the government is reluctant to increase interest rates as a means of checking the investment thrust and high inflation,27 it resorts to the traditional means of centralised rationing of credits and direct control of investment projects. Rationing and controls give the state sector a priority position. Inflationary pressure is reduced, but growth is slowed. As mentioned earlier, although the reforms in the micro-management system have improved the productivity of the state sector, state sector deficits have increased due to the discretionary behaviour of the managers and workers in the state enterprises. Increases in the government’s fiscal income thus depend more and more on the expansion of non-state sectors. During a period of tightened state control, the growth rates of the non-state sectors decline because their access to credit and raw materials is restricted. The consequent slow-down in the growth rate becomes fiscally unbearable, forcing the state to liberalise administrative controls to allow some room for growth in the non-state sectors. A period of faster growth then follows. This conflict between the distorted macropolicy environment and the liberalised allocation and micro-management system has become entrenched.


The cycle of growth and inflation has occurred three times since 1984. The delegation of credit approval authority to local banks in the autumn of 1984 resulted in a rapid expansion of credit and an investment boom that caused investment-led overheating in 1984–85. As a result, the money supply increased 49.7 per cent between 1983 and 1984 and the inflation rate jumped from less than 3 per cent in previous years to 8.8 per cent in 1985 (see Figure 3.1). The government implemented a retrenchment program at the end of 1985 to control investment and inflation. Growth and inflation rates dropped in 1986. The government’s attempt to liberalise prices in early 1988 caused an expectation of high inflation. Real interest rates for savings and loans turned negative because nominal interest rates were not adjusted. Panic buying and a mini bank run resulted. As a consequence, the money supply increased by 47 per cent in 1988 and the inflation rate in 1988 reached 18 per cent (see Figure 3.1). This was the first time in China’s recent history that the inflation rate exceeded two digits. Fearing inflation might spiral out of control, the government reintroduced a retrenchment program in October 1988 to control credits and investment directly. The inflation rate dropped significantly from 1989. However, partly due to the retrenchment program and partly due to the aftermath of the Tiananmen incident, the growth rate dropped to less than 5 per cent in 1989 and 1990, the lowest growth rate since the beginning of reform. Encouraged by Deng Xiaoping’s trip to the south in the spring of 1992, the government reoriented its policy towards economic growth. Credit controls were relaxed and a new investment boom occurred. GDP growth rates reached 13.6 per cent and 13.5 per cent in 1992 and 1993, respectively. By the spring of 1993 it was clear that the economy was overheated. The government attempted to introduce another round of retrenchments in June 1993. Fearing that this might stall the growth momentum, the leadership was unable to reach a consensus about the desirability of a retrenchment program and the implementation of the program was softened. As a consequence, the growth rate was 11.8 per cent in 1994 but the inflation rate escalated to 21.7 per cent. This was the first time in China that inflation exceeded 20 per cent. As long as the interest rate is artificially fixed at below market-clearing level, a trade-off between growth and inflation is unavoidable during the transition process. To control the expansion of money supply and inflation, the government needs to exercise tight control over credit and investments. Slow growth is the result. A relaxation in credit and investment control leads to faster growth, but a rapid expansion of money supply and high inflation follows. Rampant rent-seeking A second consequence of the inconsistency between a distorted macro-policy environment and a liberalised allocation system and micro-management institutions is the phenomenon of rampant rent-seeking. After the reforms market prices existed, legally or illegally, alongside planned prices for almost every kind


of input and commodity that the state controlled. The difference between the market price and the planned price is an economic rent. It is estimated that the economic rent from the controlled commodity price, the interest rate and the exchange rate was at least 200 billion yuan, about 21.5 per cent of national income in 1988. In 1992, the economic rent from bank loans alone reached 220 billion yuan (Hu 1994).28 Non-state enterprises and autonomous state enterprises have incentives to engage in rent-seeking activities through bribes and other measures to obtain under-priced resources from the state allocation agencies. It is reported that under competitive pressure, state heavy industries enterprises, which are given priority in obtaining state-controlled resources, must also make certain side payments to banks and other allocation agencies to secure earmarked loans and materials or to obtain them promptly. Because of the rent-seeking activities of other types of enterprise, state enterprises are often unable to obtain the credit and materials earmarked for them. Rent-seeking activities also cause widespread public resentment and are a source of social instability. To guarantee the survival of state enterprises and to check social resentment, the government attempted to re-institute tight controls on the allocation system during the retrenchment programs of 1986, 1988, and 1993. However, the controls were relaxed later to allow faster growth. CONCLUSION: CHANGES IN DEVELOPMENT STRATEGIES AND SUSTAINED GROWTH The analysis in the previous sections shows that the economic problems before and after the reforms have common roots in the HIODS that China adopted in the early 1950s. At that time, China was a poor, capital-scarce economy. To pursue the strategy, the Chinese government distorted macro-policies, instituted a planned allocation system and deprived enterprises of autonomy. This policy trinity enabled the government to maximise the mobilisation of resources to develop priority sectors. However, the economy was very inefficient due to low allocation efficiency arising from a biased industrial structure and low production efficiency arising from low incentives imbedded in the micromanagement system. The gradual approach to reform has moved the Chinese economy a long way from the traditional economic system. It has become more open and dynamic, and achieved remarkable overall growth. However, due to the partial nature of the reforms, inconsistencies between the distorted macro-policy environment and the resource allocation system arose. Liberalisation of the macro-policy environment lagged behind decentralisation in the enterprise management and resource allocation systems. As a result, a ‘boom and bust’ cycle emerged following the relaxation and tightening of administrative controls. This may cause the Chinese economy to collapse or dynamic growth to come to a sudden halt. The solution to the cycle and other chronic problems is further liberalisation of remaining distortions in the macro-policy environment.


With the exception of interest rates, administrative controls on the prices of most materials and commodities have been removed. The government understands the importance of liberalising interest rate controls and commercialising the banking system. Financial reform was treated as the first priority in the ‘Decision on Several Problems Regarding the Establishment of a Socialist Market Economy’ adopted by the Chinese government in 1993. This was an attempt to address financial, fiscal, trade and enterprise problems in a mini-bang manner. If China can successfully implement all the reforms envisaged in the Decision, it will become a mature market economy. Interest rates, foreign exchange rates, wage rates and prices will be determined mainly by the competition between supply and demand in the market. Resource allocation will be carried out largely by the market mechanism. China will become a more open economy, it will be able to capitalise on its comparative advantage and realise the goal of maintaining sustained growth into the next century. As such, China may become the largest economy early next century. However, China has not made sufficient progress so far in liberalisation of interest rates or commercialisation of the banking system. The traditional macropolicy environment and planned administrative system were formed to facilitate the implementation of the HIODS. They were endog enous. Unless the government gives up the HIODS, reforms in the macro-policy environment and planned administrative system will be incomplete. Although heavy industry is no longer cited as the goal of development, HIODS mentality is deeply rooted in the minds of China’s leaders. Many large and medium-sized capital-intensive state enterprises are the products of HIODS. They cannot survive without the implicit subsidies of low interest loans. Moreover, some capital-intensive ‘hightech’ industries have become the new priority sectors. China’s existing endowment structure is still characterised by a relative abundance of labour and a relative scarcity of land and capital. In a well functioning market system, if an enterprise hopes to be profitable, it cannot invest in projects that are too capital intensive and take too long to construct. If the government wants to support those industries that exceed the conditions allowed by the endowment structure, policy interventions in the market functions (at the very least a low interest rate policy) are essential. Until the government gives up the HIODS or similar strategies that attempt to accelerate the growth of capital-intensive industry in a capital-scarce economy, and switches to a strategy which emphasises the development of industries that are consistent with the economy’s comparative advantages, reform in China will remain incomplete. NOTES 1 Other major problems include the reform of state-owned enterprises, which are the backbone of the Chinese economy but have not achieved hoped-for results; and


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regional disparities, which have grown wider, causing large cross-regional migrations, and which might become a source of social instability. The five-year plan was disrupted from 1963 to 1965, the period immediately after the agricultural crisis of 1958–62. The first to the seventh five-year plans covered the periods 1952–57, 1958–62, 1966–70, 1971–75, 1975–80, 1981– 85, 1986–90, 1991–95, and 1996–2000, respectively. The construction of a light industry project such as a small textile factory takes one or two years, while the construction of a large heavy industry project generally takes much longer. For example, the average construction time for a metallurgy plant in China is 7 years, for a chemical plant it is 5–6 years, and for a machinebuilding plant it is 3–4 years (Li and Zheng 1989:170). Three per cent per month was the standard interest rate in the informal finan-cial markets that existed before the adoption of the development strategy. This is equivalent to 36% per year. Spontaneous development of heavy industry was impossible for several reasons. First, high interest rates made any project that required a long gestation unfeasible. The market interest rate in the early 1950s in China was about 30% per year (2.5% per month). If funds for a project were borrowed at market rates and repayment was made on completion of the project, the principal and interest payment, calculated at a compound rate for each dollar borrowed in the first year of the project, would be $6.27. Clearly, no project would be profitable enough to shoulder such a heavy interest burden. Second, since most equipment had to be imported from advanced countries, the limited supply of foreign exchange made the construction of heavy industry expensive under the market-determined exchange rate. Third, because the agricultural surplus was small and scattered, it was difficult to mobilise enough funds for any lump-sum project. For example, the interest rate on bank loans was officially reduced from 30% per year to about 5% per year. For every dollar borrowed at the beginning of a sevenyear project, the principal and interest payment at the time that the project was completed was reduced from $6.27 to $1.41. Although real GNP per capita tripled between 1952 and 1978, the nominal wage was kept almost constant, increasing only 10.3% during the same period (State Statistical Bureau 1987:151). For a more detailed discussion of the formation of low nominal-wage policy, see Cheng (1982: ch. 8) and Wu (1965: ch. 4). However, it is worth mentioning that because of in-kind subsidies, the real wages of urban workers were not as low as nominal wages suggested. Urban wage rates might have declined sharply if restrictions on rural-urban migration had been removed (Rawski 1979:67). Even with all the price distortions that facilitated heavy-industry development in China, the time period required by a heavy-industry project to earn back the capital investment was, on average, about 4 to 5 times longer than the period required by a light-industry project (Li 1983:37). A profit-maximising private owner would have more incentive to invest in a light-industry project. Under the New Democracy Policy adopted by the Communist Party in the late 1940s, private enterprises were supposed to coexist with state-owned enterprises for an extended period after the revolution. However, these enterprises were nationalised soon after 1952 when the government adopted the HIODS. The


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motivation for the government’s change in position towards private enterprises was an attempt to secure profits for heavy industry projects. Theoretically, the government could use subsidies instead of distorting price signals as a means to facilitate the development of capital-intensive heavy industry in a capital-scarce economy. A subsidy policy is more economically efficient than a price distortion policy, but under a subsidy policy, heavy industry would incur a huge explicit loss and the government would have to tax other sectors heavily to subsidise the loss. Under such circumstances, the government would find it difficult to defend its position of accelerating the development of heavy industry. Moreover, the government in an underdeveloped economy may not have the ability to collect huge taxes. This may explain why governments, not only in socialist economies but in capitalist economies, use price distortions instead of subsidies to facilitate the development of priority sectors. In the literature on China and other socialist countries, many authors presumed that the distorted policy environment and the administrative controls were shaped by socialist doctrines. While socialist ideology might play a role in the formation of these policies, they also have the economic rationale of facilitating the implementation of a HIODS in a capital-scarce economy. This explains why nonsocialist developing economies, such as India, had a similar policy environment and administrative controls when they adopted the same development strategy. An enterprise is bound to be loss-making if its outputs happen to be inputs to the other sectors, for example energy and transportation, because the prices of its outputs are suppressed. On the other hand, an enterprise is bound to be profit-making if its outputs are at the low end of the industrial chain because the enterprise can enjoy low input prices and high output prices at the same time. State enterprises were granted some autonomy after the reforms in the late 1970s. As expected, one result of this reform was a rapid increase in wages, bonuses and fringe benefits at the expense of enterprise profits. When reforms began, the government initially planned to increase agriculture’s share in state fixed capital investment from 11% in 1978 to 18% in the following 3–5 years. Due to rapid agricultural growth brought about by rural reforms, agriculture’s share in state fixed capital investment actually declined sharply to about 3% in the late 1980s and early 1990s. However, the share of total fixed capital investment in agriculture in the nation as a whole did not decline as much as these figures suggest, because part of the decline in state investment was compensated for by an increase in farmers’ investment (Feder et al. 1992). Similarly, the share of heavy industry in state fixed capital investment did not decline after the reforms. However, the state’s share in total investment declined from 82% in 1980 to 66% in 1990. Non-state sector investments are mostly in projects that are less capital intensive. This is why the share of heavy industry in the nation’s fixed capital investment is less than the share in state investment. Similarly, the development of the service sector was suppressed to facilitate the development of heavy industry. Agriculture, except grain and cotton, was also suppressed. Grain and cotton were treated differently because the government also pursued a grain self-sufficiency policy, and cotton was a basic raw material for industry. Studies by Desai and Martin (1983) and Whitesell and Barreto (1988) estimate the misallocation of capital and labour among sectors of the Soviet economy, which


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also adopted a heavy-industry-oriented development strategy. Desai and Martin find losses from misallocation in the range of 3–10% (possibly up to 15–17% of the inputs employed in industry). Whitesell and Barreto find that in the early 1980s output gains equivalent to 4–6% could have been achieved by a reallocation of capital and labour among the sectors of Soviet industry. The average annual rate of accumulation was raised from 24.2% of national income in the first five-year plan to 33.0% and 33.2% in the fourth and fifth five-year plans, respectively, whereas the average annual growth rate of national income dropped from 8.9% to 5.5% and 6.1%. As a result, wages for state employees were held almost constant between 1952 and 1978. As Deng Xiaoping admitted to visiting overseas Chinese in October 1974, wages were low, living standards were not high, and workers in China only had enough clothing and a full stomach (Cheng 1982:248). In 1952–54, China’s total value of imports and exports consisted of 8.16% of the total output value of industry and agriculture. The ratio declined to 5.89% in 1976–78 (State Statistical Bureau 1993:57–58, 633). Brada (1991) estimates that overstaffing in Czechoslovak industry was as high as 15%. The State Economic System Reform Commission estimates that over-staffing in China’s state enterprises was more than 30 million, about 30% of the total labour force in the state sectors (Zhonghua zhoumo bao, 1995). Studies by the World Bank (1985a) show that, for the production of per unit gross domestic product, the consumption of energy, steel, and transportation in China were, respectively, 63.8% to 229.5%, 11.9% to 122.9%, and 85.6% to 559.6% greater than those of other developing countries. In the structure of total capital, working capital accounted for the largest share in China and was 4.8 to 25.7 percentage points higher than that of other countries. This implies that inventories of inputs and outputs were larger and that they were kept longer in China than in other countries. Lin (1992) estimates that losses due to low incentives in agricultural collectives were as much as 20% of total factor productivity. For a theoretical model of the monitoring problems regarding incentives in a collective farm, see Lin (1989). The first attempt was made in 1958–60, the second in 1961–65, and the third in 1966–76 (Wu and Zhang 1993:65–7). The emergence of TVEs and their impact on the reform of state enterprises is discussed in the following subsection. Non-state enterprises include TVEs, private enterprises, joint venture enterprises, overseas Chinese enterprises and foreign enterprises. Among them, the TVEs are the most important in terms of output share and number of enterprises. It is noteworthy that TVEs, although different in many ways from state enterprises, are public enterprises that are funded, owned and supervised by township or village governments. In 1986 an average industrial enterprise in China employed 179.9 workers and the fixed investment per worker was 7,510 yuan, whereas an average TVE in the same year employed 28.9 workers and the fixed investment per worker was 1,709 yuan (State Statistical Bureau 1987:205). The official exchange rate was 5.7 yuan for one US dollar and the swap market rate was 8.7 yuan for one US dollar when the exchange rate in China was unified to the swap market rate at the beginning of 1994. However, the shock was very small


because before unification about 80% of foreign exchange transactions already took place in the swap markets. 26 To stop bank runs, savings rates were indexed to the inflation rate in October 1988. But this policy was revoked in 1991. In May 1993, the interest rate for a one-year time deposit was 9.18%, and for a one- to three-year basic investment loan it was 10.80% (State Statistical Bureau 1993:670–71). However, the market rate for a commercial loan was between 15 and 25%. 27 A low interest rate policy is necessary for the survival of capital-intensive and other loss-making state enterprises. 28 The total credit of the state banks was 2,161.6 billion yuan (US $248.5 billion at the swap market exchange rate). The difference between the official interest rate and the market rate was about 10%. The rents from bank loans alone were as high as 216 billion yuan.

REFERENCES Brada, Josef C. (1991) ‘The economic transition of Czechoslovakia from plan to market’, Journal of Economic Perspectives, 5(4):171–77. Chen, K., H.Wang, Y.Zheng, G.Jefferson and T.Rawski (1988) ‘Productivity change in Chinese Industry: 1953–1985’, Journal of Comparative Economics, 12(4):570–91. Cheng, Chu-yuan (1982) China’s Economic Development: Growth and Structural Change, Boulder, Colorado: Westview. Desai, Padma and Richard Martin (1983) ‘Efficiency loss from resource misallocation in Soviet industry’, Quarterly Journal of Economics, 98(3):117–29. Dollar, D. (1990) ‘Economic reform and allocative efficiency in China’s state-owned industry’, Economic Development and Cultural Change, 39(1):89–105. Fan, Q. and M.E.Schaffer (1991) ‘Enterprise reforms in Chinese and Polish state-owned industries’, Research Paper Series no. 11, Washington, DC: Socialist Economies Reform Unit, World Bank. Fan, Shenggen (1991) ‘Effects of technological change and institutional reform on production growth In Chinese agriculture’, American Journal of Agricultural Economics, 73(2):265–75. Feder, G., L.Lau, J.Lin and X.Luo (1992) ‘The determinants of farm investment and residential construction in post-reform China’, Economic Development and Cultural Change, 73(2):1–26. Gordon, R. and Wei Li (1991) ‘Chinese enterprise behavior under the reforms’, American Economic Review: Papers and Proceedings. 41(1):202–6. Groves, T., Y.Hong, J.McMillan and B.Naughton (1992) ‘Autonomy and incentives in Chinese state enterprises’, mimeo, San Diego: University of California, Graduate School of International Relations and Pacific Studies. Hu, Xinli (1994) ‘1994: Reforms have no romantic melody’, Gaige (reform) no. 1, January. Huang, J. and S.Rozelle (1994) ‘Technological change: The rediscovery of the engine of productivity growth in China’s rural economy’, Journal of Develop-ment Economics.


Jefferson, G. and T.Rawski (1995) ‘How industrial reform worked in China: The role of innovation, competition, and property rights’, Proceedings of the World Bank Annual Conference on Development Economics 1994, Washington, DC: World Bank. Jefferson, G., T.Rawski and Y.Zheng (1992) ‘Growth, efficiency and convergence in China’s state and collective industry’, Economic Development and Cultural Change, 40(2):239–66. Li, Jingwen and Youjin Zheng (eds) (1989) Jishujinbu yu chanye jiegou xuanze (Technological progress and choice of industrial structure) Beijing: Kexue chubanshe. Li, Yue (1983) Zhongguo gongye bumen jiegou (The structure of Chinese industry) Beijing: China People’s University Press. Lin, Justin Yifu (1989) ‘The household responsibility system reform in China’s agricultural reform: A theoretical and empirical study’, Economic Development and Cultural Change, 36(3): (April supplement) S199–S224. —— (1992) ‘Rural reforms and agricultural growth in China’, American Economic Review, 82(1):34–51. Luo Hanxian (1985) Economic Changes in Rural China, Beijing: New World Press. McMillan, J., J.Whalley and L.Zhu (1989) ‘The impact of China’s economic reforms on agricultural productivity growth’, Journal of Political Economy, 97(4): 781–807. Perkins, Dwight H. (1988) Market Control and Planning in Communist China, Cambridge, MA: Harvard University Press. Rawski, Thomas G. (1979) Economic Growth and Employment in China, Oxford: Oxford University Press, published for the World Bank. State Statistical Bureau (1990) Quanguo geshengshi zizhiqu guominshouru tongji ziliao huibian, 1949–1989 (A compilation of provincial national income data, 1949–1989), Beijing: Zhongguo tongji chubanshe. —— (1993, 1994) Zhongguo tongji nianjian 1993, 1994, (China Statistical Yearbook, 1993, 1994) Beijing: Zhongguo tongji chubanshe. —— (1995) Zhongguo tongji zaiyao, 1995 (A statistical survey of China, 1995), Beijing: Zhongguo tongji chubanshe. —— (1987) Zhongguo gudingzichantouzi tongji ziliao (China Capital Construction Statistical Data 1950–1985), Beijing: Zhongguo tongji chubanshe. Sung, Yun-wing (1994) ‘An appraisal of China’s foreign trade policy, 1950–1992’, in T.N. Srinivasan, ed., The Comparative Experience of Agricultural and Trade Reforms in China and India, San Francisco: International ICS Press, pp. 109– 53. Wen, Guanzhong James (1993) ‘Total factor productivity change in China’s farming sector: 1952–1989’, Economic Development and Cultural Change, 42(1):1–41. Whitesell, Robert and Humberto Barreto (1988) Estimation of Output Loss from Allocative Inefficiency: Comparisons of the Soviet Union and the U.S., Research Memorandum RM-109, MA: Center for Development Economics, Williams College. World Bank (1985a) China: Economic Structure in International Perspective, Annex to China: Long-Term Issues and Options, Washington, DC: World Bank. —— (1985b) China: Long-term Issues and Options, Oxford: Oxford University Press, published for the World Bank. —— (1992) Reform and Role of the Plan in the 1990s, Washington DC: World Bank.


Wu, Jinglian and Zhuoyuan Zhang (eds) (1993) Zhongguo jingji jianshe baikequanshu (Encyclopedia of China’s economic construction), Beijing: Beijing gongye daxue chubanshe. Wu, Yuan-li (1965) The Economy of Communist China: An introduction, New York: Praeger. Zhonghua Zhoumo Bao (China Weekend Newspaper) (1995) ‘Over-staffing in state Enterprises is over 30 million’, 21 January. Zou, Gang (1992) ‘Enterprise behavior under the two-tier plan/market system’, mimeo, Los Angeles, CA: IBEAR/S BA, University of Southern California.

4 The WTO and China's trade strategies in the 1990s Yang Shengming

REFORMS IN THE FIRST HALF OF THE 1990s China has instituted extensive and far-reaching reforms to its foreign trade policies since the 1990s. The reforms have unfolded in a progressive manner and are summarised in the following discussion. Trading system The legal basis for foreign trade On 1 July 1994 China promulgated its Foreign Trade Law. The law was formulated to unify national foreign trade behaviour and regulations, putting an end to the old practice whereby multiple government departments and regional governments mapped out their own mutually inconsistent foreign trade policies. The law enhanced the transparency of China’s foreign trade legal framework and regulated foreign trade, representing a major milestone in China’s efforts to bring its foreign trade regulations in line with WTO requirements. To increase the transparency of its foreign trade and investment policies, China regularly publishes relevant policies and regulations in the MOFTEC (Ministry of Foreign Trade and Economic Cooperation) Bulletin, as well as lists of commodities with and without import quotas, regulations, regulatory authorities for import quotas and duty paragraphs. Foreign trade enterprises Since 1990 the government has further deregulated foreign trade franchise management. As a result, more local enterprises, including those at provincial, municipal and county level, have obtained the authority to conduct foreign trade. By the end of 1995 there were more than 8,300 state-owned companies at various levels dealing with foreign trade, creating competition between central and local enterprises. In addition, the 100,000 foreign-invested enterprises


already in operation have also been granted the authority to import equipment and raw materials needed for their own use and for export. More important, between 1991 and 1993, the central government lifted all the export subsidies and most of the import subsidies which had applied to a range of state-owned foreign trade enterprises, forcing those enterprises to be responsible for their own profits and losses. To speed up managerial reform in those enterprises, the government in 1994 cancelled the mandatory plans and targets for foreign exchange to be turned in to the central government, that had applied to foreign trade enterprises. Foreign trade companies now operate like other enterprises by paying taxes to the government. At the same time, subsidies for imported commodities have also been largely discontinued as part of the effort to make foreign trade companies respond to market signals. Export control system Since 1994, on the basis of principles of openness, fairness and efficiency, the State has issued invitations to tender for export quotas in selected commodities with the aim of standardising quota management, introducing fair competition and increasing transparency. This represents a major departure from the old administrative management of quotas. Under that system, quotas were distributed free of charge through administrative decree. Decisions were based largely on subjective hunches rather than on an objective assessment of actual needs. Enterprises usually requested more than they really needed. The new regulations, under which quotas are distributed through a bidding system and at a price, have curbed subjective decision making and increased efficiency. In 1995 the number of commodities under tender increased to 24 from 13 in the previous year, accounting for 17 per cent of a total of 138 commodities that required an export quota permit. Import control system In 1992 China discontinued the practice of listing import substitution commodities in detail and categorising import commodities. Instead, imported commodities are now catalogued. Since 1993 further reforms have been introduced to the management of imported commodities. New policies and regulations were published and old internal regulations terminated. These measures have regularised the organisation of import trade and increased policy transparency. At the same time, the number of commodities requiring a quota or permit has been slashed, falling from 54 in 1992 to 49 in 1995. In addition, electrical and mechanical products in 171 duty paragraphs have been relieved of quotas and are now automatically registered. In 1996 another 170 imported commodities were relieved of quota permits.

THE WTO AND CHINA’S TRADE STRATEGIES IN THE 1990S 55

Foreign trade administration Apart from the formulation of the Foreign Trade Law, China is drafting regulations dealing with the administration of import commodities, export commodities, and anti-dumping. Other measures are being taken to compensate for the payment of import and export duties and to improve the exchange mechanism for the yuan. This indicates that China is switching from direct government control to legal and economic leverage in its management of foreign trade. At the same time, the nation has improved its coordination of foreign trade service systems centring around the Chamber of Import and Export by stepping up its scrutiny of enterprises and government administration. Drastic tariff reductions Since 1990, China has unilaterally slashed its tariffs on a number of occasions (see Table 4.1). In January 1992 it cut tariffs on 225 commodities and cancelled all import regulation duties; in December 1992 it further reduced tariffs on another 3,771 commodities, bringing the total tariff rate down by 7.3 percentage points; in December 1993 tariffs on 2,898 commodities were reduced; in January 1994 import duties were further reduced on another 243 imports, including major raw materials such as pesticides and their intermediaries, as well as parts and products for machinery and electronics; and in 1995 tariffs on cigarettes, liquor, mediumsized buses, and audio and video tapes were slashed. Before 1992 China’s average arithmetic tariff rate was 47.2 per cent. From 1 January 1992, China standardised the naming and coding of commodities in accordance with international practice. In the same year, the overall tariff rate was brought down to 39.9 per cent. That rate dropped to 36.4 per cent in 1993, 35.9 per cent in 1994 and 35.3 per cent in 1995. Between 1992 and 1995, the average arithmetic tariff rate dropped by 25.2 per cent. In April 1996 China’s overall tariff rate dropped to 23 per cent, a decrease of 35.9 per cent. These figures indicate that China is moving toward WTO guidelines by fulfilling its commitments on tariff reductions. Foreign exchange control Before the mid-1980s, China maintained rigid control over foreign exchange. In the late 1980s foreign exchange regulation markets were established. By 1988 a national network was in place, representing the first step towards reform of the foreign exchange control system. As a result, a dual-rate situation arose, with the official rate, set by the state, coexisting with the market rate. Since 1990 the government has allowed foreign trade companies to retain a greater portion of their foreign exchange earnings for their own use. Furthermore, these enterprises have been allowed to trade in foreign exchange on the market,


Table 4.1 Overall tariff rate in China, 1992–96 (per cent)

Source: Author’s calculation using Chinese Customs statistics.

paving the way for the full introduction of the market mechanism into the foreign exchange control system. On 1 January 1994 the official rate for the yuan was merged with the market rate. At the same time, foreign trade enterprises were deprived of the privilege of retaining foreign exchange. Instead, a unified settlement and trading mechanism was introduced and a national inter-bank foreign exchange market was created. As a result, the exchange rate of the yuan is now based primarily on market demand and supply. Foreign trade companies, relieved of the mandatory task of turning in foreign exchange with or without a price, now sell their foreign exchange earnings to specially designated banks and purchase foreign exchange at those banks with valid certificates. As a result of this state regulation, the yuan has become convertible under the current account. Since the unification of the exchange rates for the yuan, the central bank now participates in the purchase and sale of foreign exchange on the regulation market. This, in turn, connects the regulation market with the inter-bank market. In 1996 the government allowed foreign-invested companies to participate directly in the settlement and sale of foreign exchange by banks. Investment system Expanding powers for local government approval of foreigninvested projects Since 1992 China has opened the hinterland and a host of cities along major rivers and borders, while expanding the ability of the open cities to seek economic cooperation with foreign partners. Local governments can now approve foreign-invested projects with a total investment of less than US $30 million, a move that has simplified procedures for foreigninvested projects.


Broadening access for foreign investors The reform measures introduced from 1991 to 1995 allowed foreign investors to invest in the manufacturing and the mining industries (the latter on a trial basis). Since 1992 foreign investment has been introduced into the land development, real estate, finance, insurance, information, and consulting sectors. Pilot investments have also been introduced in commerce, foreign trade, civil aviation, railways, law and accounting firms. In 1995 the government published a directory for foreign investors that encourages foreign investors to invest in infrastructure facilities. Increasing domestic market access for foreign-invested firms and products Statistics show that over half of the goods produced by foreign-invested firms are marketed domestically. For some technologically-intensive projects, the policy is even more preferential—all of their products can be marketed domestically. A sizable portion of foreign-invested companies enjoy the lion’s share of the domestic market. These preferential policies have effectively compensated for the negative impact of nontariff measures on foreign products attempting to enter the Chinese market, as well as increasing market access for foreign competitors. CONDITIONS AND TIMETABLE FOR CHINA’S ENTRY TO THE WTO As noted above, since applying for re-entry to the GATT, China has taken a series of steps to reform its foreign trade system, tariff rates and foreign exchange control mechanism. The results of these reforms suggest that conditions are now ripe for China to be admitted into the GATT (henceforth WTO). The fact remains, however, that China’s application has yet to be accepted by the WTO. This is due to serious differences among contracting parties over the conditions and timetable for China’s re-entry. China's status as a developing nation Certain major contracting parties insist that China be admitted as a developed nation. The fact is that China remains a developing country and, as such, is entitled to the rights and subject to the obligations of other developing countries. China can only proceed on the basis of its national conditions and can only undertake obligations compatible with these conditions. Any attempt to impose on China obligations incompatible with its present stage of development and beyond its capability would be unrealistic and unfair, and would only prove to be detrimental to the development of China’s economy. It is very important for


future negotiations, therefore, that China’s national conditions be clarified and the contracting parties acknowledge such a clarification. China’s national conditions can be summarised as follows. First, it is the most populous country in the world, with a population of 1.2 billion, increasing annually by more than 10 million. Such a big population represents a huge potential market but at the same time it is a weighty burden. No other country supports 1.2 billion people. To ensure the welfare of its populace and the stability of the state and society, China has to ensure that no major upheavals occur in the course of reform. Any major upheaval will result in turmoil and massive exodus of refugees, which will be a disaster for the international community. The measures that China has taken so far have been compatible with its national strength and a desire to avoid major mistakes. Second, China is a developing country, with an average per capita income of less than US $500 and more than 70 million people living in abject poverty. Despite the rapid growth of its national economy since the late 1970s, there remain vast differences between the rural and urban areas and between eastern and western regions. Any judgements based solely on observation of the urban areas or the eastern regions are bound to be incomplete. From this perspective, China remains a developing country. This does not necessarily mean that China should be accorded special privileges or exceptions. Rather, the point is that the contracting parties to the WTO negotiations should understand China’s true situation and determine its obligations according to China’s level of development, instead of its growth rate. Third, China is a country in transition from a highly centralised planned economy towards a socialist market economy, a process characterised by wideranging and profound reforms. Domestic reforms and opening up to the outside world are two sides of the same coin: sometimes they promote each other and sometimes they inhibit each other. Opening up cannot proceed without reform; at the same time, opening up is a precondition for reform. China’s reforms have unfolded in a gradual and progressive rather than an abrupt manner. Opening up and reform should match each other not only in depth and breadth but also in terms of their timing. This has proved to be one of the most important underlying factors in the success of China’s reform and opening up. Until the year 2000, how wide China opens itself to the outside world will depend largely upon the progress of domestic reform. China's market access and transparency It should be noted that China has opened its market and increased transparency by a considerable margin in its bid to re-enter the WTO. Total import volume rose from US $42.25 billion in 1985 to US $138.83 billion in 1996, a more than twofold increase over the decade and an average annual increase of 12.1 per cent. Foreign trade dependence (imports/GDP) grew from 23 per cent in 1985 to


Table 4.2 Volume of imports and exports in China, 1978–96 (US$ billion)

Source: China Statistical Yearbook, 1996. Table 4.3 Foreign trade dependence in China, 1978–96

Source: China Statistical Yearbook, 1996.

35.7 per cent in 1996. It is well known that China’s market is open to all countries. In fact, it is no less open than most developing countries. To enhance market transparency, China has repealed 1,183 internal directives since the Foreign Trade Law was promulgated on 1 July 1994, of which 744 were issued by the central government and 439 by local governments. Now foreign-related laws are for the most part published and only those laws, regulations and rules that have been published are implemented. It is to be hoped that China will open up wider and faster by further opening its market and increasing transparency. That will entail integrating the Chinese economy with the world economy and bringing China’s foreign trade system into line with international practice. It is likely that this wish will be realised since China needs the world as much as the world needs China. With the passage of time, interdependence between China’s economy and the world economy will deepen.


It is important to remember, however, that China’s current opening and legal transparency are dependent on domestic conditions, in particular on the reform process. To feed its 1.2 billion people, the Chinese government must develop the agricultural market, and increase its activities in the world market for farm products. The United States, Canada and Australia are endeavouring to gain access into the Chinese agricultural market. This is a far-sighted move. In 1995 China became a major importer of agricultural products, with a net import of more than 19 million tonnes of grain. Major trading partners in the world are very concerned about China’s future importation of agricultural products. Because of the fragile supply of grain and the inefficient system for the distribution of agricultural products, China’s agricultural market is likely to remain unstable. Over the past several years, uneven supplies of grain, cotton and edible oils have made it difficult for the central government to grasp the full picture. Chinese scholars have suggested on many occasions to the government that reform in restructuring the distribution system for agricultural products needs to be accelerated to enhance market transparency. Reform in the service industry, including banking, telecommunications and insurance, took off only recently and has progressed slowly. In terms of the market, services are still underdeveloped. This places a serious limitation on the opening up of these sectors to foreign investors. The services sector can only be opened gradually in parallel with the deepening of reforms and overall opening up. In the past, the banking, telecommunications and insurance sectors were completely under the control of central planning and the market had no role to play. Without reform, it will be impossible to harmonise with international practice. Accelerated reform and greater development of financial markets will provide a basis for the opening up of the banking, telecommunications and insurance sectors. The import control system, by comparison, is less transparent than other areas. With the exception of tariffs, various government departments, including the State Planning Commission, the State Economic and Trade Commission, the Ministry of Foreign Trade and Economic Cooperation, the General Administration of Customs and the State General Administration for Inspection of Import and Export Commodities each has its own administrative control over imports. Disputes often arise because of lack of coordination. Similar problems exist between central and local governments. Even within provinces and municipalities, rules vary from place to place. Different commodities are managed differently. Some require a licence, some a quota, and others require both. Still others require a special catalogue. These random requirements are baffling even to Chinese. It is clear, as many foreign business people maintain, that China’s market regulations are not transparent. The solution lies in reform not only of the economic structure but also of government institutions. A streamlined government with much less administrative intervention will contribute to market transparency.


Timetable for China's accession to the WTO All the signatory parties including major Western countries realise that China’s entry into the WTO will not only benefit China, but also the world. This suggests that China’s accession is only a matter of time. On the issue of China’s entry, some of the main negotiators stated that they had no timetable. China too has no fixed timetable. While it hopes to speed up the accession process, it is not over-anxious for quick results. In China’s view, things will be easily settled when the conditions are ripe. China does not want to press its current interests through the mechanism of its re-entry into the WTO, therefore it has no specific timetable for finalising the negotiations on accession that have gone on for more than ten years. China sees the negotiations as part of its overall, long-term strategy of reform and opening-up and as an element of its participation in world economic integration. Although China’s accession to the WTO is beneficial to both China and the world, entry sooner rather than later would be preferable. If China’s accession to the WTO occurs soon, the international multilateral trade rules will play a role as a reference point in China’s reform and become a benchmark when China formulates its trade law and regulations. This will not only benefit China, but the world as a whole will stand to gain. Early settlement of the question of China’s accession to the WTO will prove beneficial to the establishment of a good international trade environment and to the establishment of normal international political relations. The more developed China’s economy, the larger its trade volume. As China absorbs a greater level of foreign investment, the potential for contradictions and friction with foreign countries is exacerbated. Overcoming such contradictions and eliminating friction will depend on the adoption of the WTO’s internationally recognised trade regulations and coordination. If problems are resolved according to the law of the jungle—‘political regulation’— the process will be more difficult. Internationally recognised regulations are not only an important feature of China’s domestic reform, but they are also important in its opening up to the outside world. China is committed to implementing these regulations. AGENDA FOR THE LATE 1990s Deepening and strengthening state foreign trade enterprises The elements of reform are to separate enterprises from administrative control and to remove the reliance of enterprises on government; to allow non-state enterprises including some foreign capital enterprises to enter into the field of foreign trade in order to break the monopoly on foreign trade and promote competitiveness through a variety of different ownership structures; and to encourage state foreign trade enterprises to pursue a policy of unity and


consolidation. Those enterprises which incur great losses and are encumbered by debt should be sold by auction. Enterprises must combine industry with trade and carry out their business using modern methods of industrialisation, grouping and pluralism. Investment, cross-ownership of stock and reorganisation of enterprises’ property rights will transform business structures and management. The approval system will be changed and gradually transformed into one of enterprise registration. A mechanism will be established whereby enterprises with different ownerships will be guaranteed fair entry into the field of foreign trade, together with provision for mergers, elimination and withdrawal from the mechanism. Thus the number and business scale of foreign trade enterprises will be rationalised. At present there are some 9,000 foreign trade enterprises in China, excluding foreign-capital enterprises. Some of these are unable to achieve an appropriate scale of operation. These enterprises should be consolidated as a matter of urgency to achieve scale economies and increase commercial vigour. Reform of the import management system and non-tariff limitation measures Reduction of import controls About 40 per cent of the total volume of China’s import trade is controlled under mandatory and guiding plans. The level of planning should be reduced in favour of a policy of free imports. By the end of this century over 80 per cent of import trade will be conducted freely under market conditions. Reduction of government examination and import approvals The system of government examination and approval has actually expanded the level of planning management. These institutions for examination and approval should be greatly reduced and the categories of imports requiring government examination and approval should also be restricted. At the end of this century the examination and approval system will be completely abolished. In 1994 the government abolished the system of limiting quotas for ordinary mechanical and electronic products in favour of a registration system; this approach will be expanded. The registration system is a transitional stage pending the abolition of the examination and approval system. Optimisation of the licence system China operates a licensing system for 49 important and sensitive commodities on the international market. Import licences are issued according to the Provisional Regulations for Import Licences of the People’s Republic of China and its detailed rules and regulations. When localities and departments import


commodities controlled by the licence system, they must apply for approval from the designated government department. After obtaining a quota certificate they go to the designated institutions for licences. Supply of some major products including crude oil, refined oil, steel products, grain, cotton and another seven listed products is controlled by the ratified companies. The markets for imports not included in the catalogue operate openly. The state exercises quota control over 18 machinery and electronic products and 26 ordinary commodities. In total, 171 taxable machinery and electronic products are not subject to quota control and are automatically registered. Twelve ordinary commodities are imported for automatic registration. While the WTO does not forbid licensing systems, it requires that methods be transparent, quotas open and formalities simple. The direction of reform will be to reduce the variety of commodities controlled by quota licence and transitional measures including non-quota licence management and open competition will be introduced. Overlapping cross-management measures will be alleviated and formalities simplified. China’s licensing system will conform more closely with the international standards set out by the Tokyo Round Agreement on Import Licence Formalities. Decreasing tariffs to the level of developing countries From January 1992 to the end of 1995, China reduced tariffs on four occasions. According to the list of tariff items under the coordination system, the arithmetic average rate decreased from 47.2 per cent to 35.9 per cent during this period. In April 1996 China underwent a further large-scale tariff reduction, and the arithmetic average tariff rate decreased to 23 per cent. In comparison with the developing countries’ average tariff rate of 14–15 per cent, the gap between China’s nominal tariff rate and that of developing countries will be greatly narrowed. Because China already has a large number of preferential measures involving tariff reductions and exemptions, including tax exemptions for import materials and parts for the processing trade, the actual tariff rate is lower than the nominal tariff. If the actual tariff number is divided by the value of import goods, actual tariff rate in 1994 was 4 per cent and 3 per cent in 1995. Even including the taxes levied by customs the rate is only 6.4 per cent. The official tariff rate is rather high, but the actual rate is very low. This points to an imperfect tax system where tax law and the tax policy are not transparent. China will gradually deal with its outdated and preferential measures on tariff reductions and exemptions. Tariffs will be lowered to the level of 14–15 per cent current in developing countries. At the same time, China will safeguard the integrity of its tax laws and regulations. Taxes will be levied and calculated according to the law.


Market access for agricultural products and trade in services The price of agricultural products in China has risen significantly following rapid increases in demand. Some prices already approach or are higher than world market prices. Agricultural protection policy has clearly lost its way. Agricultural protection should be gradually reduced and the market for agricultural produce further liberalised. Agriculture, especially in the eastern coastal areas needs to be restructured and its efficiency increased by the use of international management methods. In trade in services, the Chinese government allows foreign businesses to invest in pilot enterprises which will engage in foreign trade. In the open coastal cities, foreign-invested enterprises have been granted entry into pilot retail commerce. These pilots will exert a positive influence on the opening of the market in services. The financial market has made remarkable progress in recent years. By the end of November of 1995 the People’s Bank of China had approved the establishment of 470 representative offices of foreign banks and 135 foreign financial institutions. Among them are 115 branches of foreign banks, five joint-foreign banks, four foreign capital insurance companies and one Sino-foreign joint-invested bank. Meanwhile, the People’s Bank of China has announced that the Chinese government has selected Shanghai as the first city for foreign capital banks in China to deal in yuan. This indicates that some areas formerly monopolised by the state have been opened to foreign investors. While continuing this process of market opening, China will take note of the principles of equal entry and fair competition for foreign enterprises in trade in services. It is hoped that Chinese and international scholars can work together to promote the opening up of the service trade market. Reform of the foreign exchange system and convertibility of the renminbi Strategically, China should adopt a policy of gradual reform of the foreign exchange system. First it should relax the limitations on capital circulation related to trade, then the limitations on long-term foreign direct investments and stocks, and finally the restrictions on short-term capital floats. However, free convertibility of capital requires that some important conditions be met: significant reduction in the financial deficit and a low inflation rate; a moderate level of foreign debt; coordination of domestic interest rates and rates on the international money market; enhanced competitiveness of the domestic financial system; conformity of capital conditions in the domestic financial market with fixed standards; strengthened supervision and control of the domestic monetary system and the establishment of government guarantees of the open monetary system. Given that such conditions will not be easily met in the short term, the definition of currency convertibility in 2000 will incorporate the following


features: the achievement of convertibility under the capital account, that is, the convertibility of capital imports and trade-related exports and the convertibility of long-term foreign direct investment imports and exports including foreign investment in China and Chinese investments abroad. The structure of export commodities and export growth China’s trade strategy will see a gradual change from extensive management of export trade to a more intensive approach that seeks to enhance the grades and quality of products. With the abolition of mandatory export plans and remittance of foreign exchange to the authorities and the subsequent lowering of disincentives, the obstacles that foreign enterprises encounter in gaining export approvals will be greatly reduced. Enterprises will enhance the quality of export commodities, improve their structure and increase their economic effectiveness. The pattern of irregular growth in foreign trade will disappear and a reasonable level of growth will be achieved. The end to import restrictions will increase import growth and promote trade balance. During the ninth five-year plan (1996– 2000), the growth rate of China’s import trade will reach 13–15 per cent. Import and export trade will achieve an overall balance, and the average annual favourable trade surplus will not exceed US $5 billion. China’s import and export trade will thus be characterised by stable and synchronised development. REFERENCES GATT (1992) GATT: A Handbook, Economic Management Publishing House. Pei Changhong (1995) ‘Macro-analysis on the development of FDI in China’, Finance and Trade Economics no. 5. Pei Changhong (1996) ‘Analysis on dispersion of FDI in China’, Finance and Trade Economics no. 1. Wang Luolin (1995) ‘lssues on the transition of the operation system of SOEs in the trading sector’, Finance and Trade Economics no. 7. World Trade Organisation (1995) Uruguay Round Final Act, Chinese Economic Publishing House.

5 Trade liberalisation and development of China's foreign trade 1 Ligang Song

INTRODUCTION Economic reform and the opening up of the economy to the outside world in the past 20 years (1978–97) has been marked by an extraordinary expansion of foreign trade in China. Total trade increased from US $20.64 billion in 1978 to US $325.06 billion in 1997, with an average growth rate of 14.8 per annum. Exports increased at an average annual rate of 15.8 per cent and imports at an average annual rate of 13.7 per cent during this period. Trade structure continued to shift in favour of manufactured commodities. The share of manufactures in total exports increased to 87 per cent in 1997 from 49.7 per cent in 1980. The geographical distribution of China’s foreign trade has also been diversified. Official foreign exchange reserves increased from US $0.8 billion in 1979 to US $140 billion in 1997. China has become the largest recipient of foreign capital among developing countries in recent years and became the tenth largest trading nation in the world in 1997, rising from twentyninth in 1978. In sum, following the economic opening up in the 1980s and 1990s, the Chinese economy has been deeply integrated with the world economy (Table 5.1). The economic benefits generated from the openness of the economy are enormous and can be summarised as follows. First, an increasing level of exports has loosened the binding foreign exchange constraint. This, in turn, has enabled China both to improve its balance of payments position and to absorb foreign resources, including imports of capital goods. Second, increased contacts with foreign competitors have exerted pressure on Chinese export industries to reduce inefficiency and to improve the quality of their products. Third, the expansion of foreign trade has been conducive to greater resource utilisation in China, and fourth, export growth may have led to resources being reallocated to the most efficient sectors of the economy, those in which China enjoys a comparative advantage. Finally, exports offer greater economies of scale to Chinese firms due to an enlargement of the market size which, in turn, tends to raise productivity (Wang 1993:73, Lardy 1992:8 and Song 1996b: 194). On this basis, it can be said that the rapid growth of exports has contributed positively to economic growth in China (see Figure 5.1).2


Table 5.1 Shares of China’s imports, exports and total trade in GDP, 1978–98

Source: Statistical Yearbook of China, 1998; Direction of Trade, International Monetary Fund. 1997; and the People’s Daily, various editions, for the most recent figures.

The main purpose of this chapter is to explain China’s trade expansion during the reform period. This is done by estimating a model of export determination. The model estimation exercise is preceded by a background discussion of policy setting in the reform economy and an explanation of the variables used in the empirical analysis. The second section introduces the institutional background to China’s trade developments. The third section outlines trade developments, focusing on geographical distribution of foreign trade, commodity composition of trade, changing comparative advantage, export incentive and competitiveness, shifting patterns of imports and the role of foreign direct investment in boosting trade. The fourth section specifies and tests the model for export determination and is followed by a conclusion. The following section provides some preliminary discussion of the implications of China’s trade expansion in the context of the financial crisis which took place in East Asia in 1997. The data used in the study are given in the Appendix.

68 TRADE LIBERALISATION AND DEVELOPMENT OF CHINA’S FOREIGN TRADE

Figure 5.1 Contributions of exports to economic growth, 1990–98 (percentage point)

Source: Calculated by multiplying the share of export in GDP (Table 5.1) and real export growth (Figure 5.2). Export data is from Direction of Trade, International Monetary Fund, Washington, DC and China’s GDP figures are from the Statistical Yearbook of China, 1998.

TRADE REFORM A key to understanding the rapid expansion of foreign trade in China is policy reform and trade liberalisation within a broad program for economic restructuring. Trade liberalisation, according to Greenaway and Sapsford (1994: 158), can be defined as a process involving three elements: a reduction in import barriers with no change in export incentives; a movement of relative prices towards neutrality via a reduction in import barriers and/or an improvement in export incentives; and the substitution of less costly instruments for more costly instruments of protection, for example tariffs or quotas. China has made progress in all three areas, as documented in Harding (1987), Hsu (1989), Wang (1993), Lardy (1992), Zhang (1993) and Li (1997). As regards the link between trade liberalisation and trade expansion, several multi-country studies, for example Harrigan and Mosley (1991) and Papageorgiou, Michaely and Choksi (1992), offer support for the view that liberalisation and exports are related. The main proposition behind these studies is that liberalisation reduces anti-export bias and thus provides a conducive setting for export expansion. Reducing anti-export bias in China has been achieved through a series of reform and trade policies aimed at eliminating distortions due to the high degree of government restriction on trading activities. The reform programs have been comprehensive and implemented in a gradual manner. Major achievements can be summarised as follows.


First, centralised mandatory planning of imports and exports has been replaced by government guidance and indirect controls (Tseng et al 1994: 4).3 Export incentive schemes characterised by a high degree of decentralisation (and preferential treatment by government) were first applied to the special economic zones, then to the coastal areas and later to other parts of the country. By the mid-1990s, thousands of big state-owned enterprises had direct trading rights and non-state sectors, particularly foreign firms, played an increasing role in China’s foreign trade. To prevent the adverse effects of tariff structures on the export sector and to provide greater incentives for exports, the government also adopted a system of duty exemptions and tax rebates for exporters. Second, tariffs have been progressively lowered and non-tariffs barriers have been gradually reduced, for example, those resulting from the tariff reductions announced at the November 1995 meeting of Asia Pacific Economic Cooperation (APEC), which became effective in 1996. ‘These tariff cuts reduced the trade-weighted average tariff from 28.1 per cent to 19.8 per cent and the unweighted average from 36 per cent to 23 per cent’ in 1996. The latter was further reduced to 17 per cent in October 1997 as the government accelerated the pace of reform (World Bank 1997:14). As part of the liberalisation program, import licences and quantitative import restrictions have been removed for a wide range of commodities since the early 1990s. For those commodities which are still subject to import controls, such as machinery and electronic equipment, new regulations for their administration that narrowed the scope of controls and simplified import procedures were implemented (Tseng et al 1994:10). Third, a link between domestic prices and international prices has been established through price system reform (Chai and Sun 1993:5). Such a link was virtually nonexistent in China before 1978. Price reforms since the mid-1980s mean that domestic prices for more than 90 per cent of imported goods are now linked to (and affected by) world prices. This link may imply a narrowing of price differentials, although trade barriers and other costs continue to drive a wedge between the two (World Bank 1997:8). Table 5.2 lists the changing shares of goods sold at prices fixed by the state. In line with price system reform, reform of the exchange rate system also contributed to a convergence between domestic and international prices. China operated a dual exchange system during 1986–93 consisting of an official rate and a more depreciated market-determined rate set on the swap market. A main drawback of this system is its distortionary impact on the exports of domestic enterprises and the continuing fragmentation of the exchange market. Under the liberalisation program, the dual exchange rate system was replaced by a new exchange system in 1994 which unified the different exchange rates at the prevailing swap market rate. The exchange retention system was also abolished. After that, the movement of RMB has been subject to demand and supply conditions in the domestic foreign exchange (inter-bank) market. From December 1996, the renminbi (RMB) has been made convertible under the


Table 5.2 Share of goods sold at prices fixed by the state, 1978–93 (per cent)

Source: Table 1.1. China Engaged, World Bank, 1997:7.

current account. This, together with the exchange rate unification that took place two years earlier, has led to a more market-based exchange rate system and contributed to the rapid development of exports and imports through improved competitiveness. Fourth, the self-sufficiency policy and the associated distortions in the prereform period prevented China from exploiting its potential comparative advantage by means of the market mechanism, especially in areas of labourintensive products. The increasing degree of marketisation resulting from institutional changes and trade liberalisation led to the conformity of China’s trade pattern to its comparative advantage (Zhang 1993; Song 1996a). Such conformity has been a basic reason for the rapid changes in commodity compositions of China’s foreign trade, in particular its exports of labourintensive products on world markets. Finally, trade reform and liberalisation, accompanied by a shift of the development strategy away from heavy industries, has completely altered the relationship between foreign trade, investment and the standard of living. In the pre-reform period, foreign trade served planning purposes and acted as a mechanism for transferring resources from the consumer goods sectors, including agriculture, to the industrial sector by selling agricultural and primary products and buying manufactured goods. Because the increased output was comprised mainly of producer goods, the growth of foreign trade and investment was limited by the extent to which the standard of living could be lowered. For this reason, the sharp rises in investment and foreign trade at that time often proved unsustainable (Hsu 1989:15). The economic climate is fundamentally different now. Investments include the foreign direct investment (FDI) boost to foreign trade which, in turn, helps sustain an increased scale of investments and capital formation in the Chinese economy year by year. More importantly, these interactions between trade and investment have been accompanied by an extraordinary improvement of the standard of living of the Chinese people. The significance of this for China’s foreign trade and investment is obvious.


TRADE DEVELOPMENT The effects of trade liberalisation on trade patterns of China are discussed in this section. Geographical distribution of China's foreign trade The geographical distribution of China’s foreign trade has diversified significantly during the period under study, particularly in relation to East Asia and North America (Table 5.3). China’s export shares with East Asia increased from 47.7 per cent in 1980 to 54.8 per cent in 1996, while its import shares increased from 31.2 per cent to 49 per cent during the same period. This suggests that China depends on East Asia more for its exports than imports. The pattern continues to hold for the trading relationship between China and NAFTA (North American Free Trade Agreement), at least until 1996. However, China’s export dependence on Asia is dominated by its relationship with newly industrialising economies (NIEs). Its import shares with ASEAN and Japan are higher than its export shares with these economies. China’s two-way trade with Japan represents its largest bilateral trade relationship. There are also gradual increases in both export and import shares with Western European countries. But China’s trade with East Asian economies accounts for the predominant portion of its total trade. There is an increasing need for China to diversify its trade distribution, a process that may provide the opportunity to secure smoother development of its foreign trade.4 China's revealed comparative advantage in world trade Tables 5.5 and 5.6 report estimates of China’s ‘revealed comparative advantage’ and commodity shares of selected labour-intensive goods in comparison with other East Asian economies. As evidence of the conformity of China’s patterns of trade to its factor endowments, the figures show that, except for textiles, China enjoyed increased comparative advantage in all goods, in particular toys, travel goods, footwear and clothing, over these sub-periods. In contrast, the four Asian NIEs were losing comparative advantage in these goods over these periods, especially Korea and Taiwan. They had enjoyed considerable comparative advantage in some labour-intensive goods, such as travel goods and footwear, in the first period. The next rung on the ladder is ASEAN, followed by other newly emerging economies such as India and Vietnam. While India is doing well in exports of clothing, Vietnam’s export specialisations in travel goods, clothing and footwear are impressive. The commodity composition of China’s main labour-intensive products indicates the relative importance of these products in its total exports. For example, clothing accounted for 16.6 per cent of total exports in 1996. A comparison with NIEs and some ASEAN economies such as Malaysia and


Table 5.3 Geographical distribution of China’s exports and imports, 1980, 1990 and 1996 (per cent)

Source: Calculations based on data from Direction of Trade, International Monetary Fund, Washington, DC, 1997.

Thailand, shows that China’s commodity share for electrical machinery is considerably lower. Real exchange rate and export competitiveness Figure 5.2 plots changes in China’s nominal and real exchange rates and real export growth rate (index:1990=100) between 1979 and 1997. The figure shows that the real export growth of China’s exports is connected with changes in real exchange rates which form a criterion for measuring export competitiveness. This trend suggests that currency depreciation in China over this period, as discussed in the last section, might contribute to a rapid growth of exports. The responsiveness of exporters to changes in the real exchange rate also reflects the fact that the export behaviour of enterprises is now largely dependent on market signals. This link cannot be established without reform and trade liberalisation. This leads us to an hypothesis about the relationship between exports and the real exchange rate which will be tested in the next section. To provide more information about the growth of exports, Table 5.6 reports the annual compound growth rates of exports for labour-intensive goods and total exports for two separate sub-periods and the whole period in comparison with other East Asian economies. An interesting observation from this table is that the NIEs’ exports growth rates for labour-intensive goods are lower than the growth rates of their total exports over the whole period. The reverse is true for all other economies, including China. This may suggest that comparative advantage in labour-intensive products is shifting away from NIEs towards ASEAN, China and other East Asian economies.

Source: Calculation based on UN trade data, International Economic Databank, Australian National University.

Table 5.4 Revealed comparative advantage indices (exports), China and comparators, 1980–96


Source: See Table 5.4.

Table 5.5 Changing commodity shares of selected labour-intensive goods, 1980, 1985, 1990 and 1996 (per cent)



Figure 5.2 China’s nominal and real exchange rate (vs the United States) and export growth rate, 1980–97

Source: Calculations based on trade and exchange data from International Financial Statistics, International Monetary Fund, 1997 and World Table, World Bank, 1997.

Industrial output and imports The purpose of Figures 5.3 and 5.4 is to link China’s import trade with the growth of its industrial output. Figure 5.3 shows a clear pattern of changes in China’s imports in relation to the fluctuation of the real growth rates of industrial output as depicted in Figure 5.4. For example, during the economic boom periods of 1982–85, 1986–88 and 1990–94 in which industrial output exhibited sharp increases, China’s imports also increased considerably. Due to the relatively tight macroeconomic policies pursued by the Chinese government to prevent the economy from overheating, the growth rates of industrial output have stabilised since 1994, leading to the economic soft-landing achieved during the 1996–97 period. But imports kept increasing. Based on this relationship, a positive correlation between imports and industrial output is anticipated (Figures 5.3 and 5.4). Foreign direct investment and trade China has attracted a vast amount of foreign direct investment following the reforms of the late 1970s. In recent years it ranked first among all developing countries in attracting foreign investment. Accumulated for-eign direct investment reached US $197.9 billion by 1997. The country has over 300,000 overseas-financed enterprises employing 17 million workers. Rapid economic growth, an improving investment environment, market potential and business


Table 5.6 Growth rate of exports for labour-intensive goods and total exports (annual compound, per cent)

Source: Calculations based on UN trade data, International Economic Databank. Australian National University. Figure 5.3 China’s import trade, 1978–97 (US$ billion)

Source: Based on Direction of Trade, International Monetary Fund, 1997.

opportunities in China are the main reasons overseas investors are interested in China. Apart from using China as an export processing base, the size and growth of the domestic market are becoming increasingly important factors in attracting foreign direct investment. This has motivated foreign enterprises, especially large multinational firms, to make long-term investments in China. Foreign direct investment has contributed to the rapid development of China’s foreign trade in two ways. First, the large volume of export-oriented foreign


Figure 5.4 Real growth rates of industrial output, 1978–97

Source: Calculations based on the Statistical Yearbook of China, 1997.

capital substantially enhances China’s export capability. Second, foreign firms also import intermediate goods and equipment for processing and upgrading. Foreign direct investments have also produced enormous positive externality effects such as information and management skills, which directly or indirectly enhance China’s foreign trade. The contribution of FDI projects to China’s foreign trade can be seen in Table 5.7. Joint ventures and foreign-owned firms accounted for 28 per cent of China’s exports and 46 per cent of its imports in 1994. These shares have been even higher in most recent years. (The share of FDI exports in China’s total exports increased to 44.5 per cent in 1998,5 and its share in total imports reached 54.7 per cent in the same year).6 DETERMINANTS OF EXPORTS The model for export determination is specified in equation (l)7: (1) where EX is the real export value obtained by adjusting the current value by the US price deflator (the wholesale price index). RER is the real exchange rate adjusted using the domestic consumer price index and the US wholesale price index (production baskets) as a measure of China’s degree of international competitiveness in world markets. PIM stands for world imports in real terms obtained by calculating the weighted average of partner countries’ (OECD plus ASEAN and NIEs) total import volumes using China’s exports as weights and adjusted for real figures based on the US price deflator. This is a proxy for real world income as a demand factor in determining exports from China. All data series are in constant prices (1990=100). To estimate this equation, a quarterly dataset for exports, world income and the real exchange rate covering the period 1986:Q1–1997:Q1 is assembled. Models are estimated in logarithmic form to reflect the degree of responsiveness


Table 5.7 Contribution of different firms to China’s foreign trade, 1994

Note: Some numbers may not sum to 100 because of rounding. Source: Table 2.1 in China Engaged, World Bank 1997:13.

of exports to changes in the independent variables. The results are reported in Table 5.8. The results for model (1) show that world income growth proxied by adjusted world imports from China, and changes in China’s real exchange rate (competitiveness) are two key determinants of the variations of China’s exports. The estimated coefficients show that they both positively influenced changes in exports and the income variable exerted a much stronger impact on exports than the competitiveness variable. Both estimates are statistically significant at the 1 and 5 per cent level, respectively. To capture the impact of the exchange rate system reform (the unifica-tion of the official and swap market rates) in 1994 on China’s exports in that and the following years, a slope dummy variable for the real exchange variable is added into the model estimation.8 The results in model (2) show, first, that the dummy variable is positively correlated with changes in exports. Second, however, the coefficient is not statistically significant. In fact, the combined magnitude of the dummy and the original variable in this estimation is smaller than the original variable alone as estimated in model (1). Third, its t-value is slightly below the critical value (1.282) at the 10 per cent significance level. Furthermore, the statistical significance level for the original real exchange rate variable drops as a result of incorporating the dummy variable in the estimation.9 The estimation results imply that the rapid expansion of China’s exports during the period under study is mainly due to the strong growth of world demand for goods made in China, and to a lesser extent to the improvement in China’s export competitiveness. The policy measure to unify the different exchange rates adopted in 1994 had a weak impact on China’s exports in contrast with the strong average impact of changes in the real exchange rate on exports during the entire period.


Table 5.8 Export regression analysis for China’s exports, 1986–97 (quarterly data, 1986: Q1—1997: Q1)

Note: The t-values are shown in parentheses. a Significant at the 1 per cent level. b Significant at the 5 per cent level. c Significant at the 10 per cent level. Source: Author’s calculations.

The last conclusion needs clarification in that the dummy variable captures the average impact of the exchange system reform on exports over the whole period after 1994 and not just 1994 itself. In fact, for that year alone, exports increased sharply as a result of the policy change. However, ‘by early 1995, the export spur from the RMB exchange rate merger has basically worn off, affecting the momentum of export growth’ (People’s Bank of China 1995:46). This statement can be inferred from the coefficient estimation for this dummy variable. Another reason for this less significant impact on exports of the unification of exchange rates was the rate of high inflation that year, which increased the costs of exports and put downward pressure on the real exchange rate, as shown in Figure 5.1. CHINA AND EAST ASIAN ECONOMIES: PARTNERS OR COMPETITORS? The relationship between China and East Asian economies became a focus after the financial crisis in the region broke out in 1997. Some empirical evidence is reported in this section to provide background for further discussion of this relationship. Figure 5.5 depicts the degree of global integration for China, NIEs, ASEAN and Japan based on their shares of total trade in GDP from 1980 to 1995. It shows that NIEs rank highest in terms of degree of global integration, though the level drops sharply in 1992. ASEAN has increased its degree of global integration quite remarkably since the mid-1980s and shows no sign of turning back. China also increased its degree of global integration throughout the period as the country committed to economic reform and liberalisation. However, China’s level of global integration is substantially lower than that for both NIEs and ASEAN, suggesting there remains further potential for China to be more deeply


Figure 5.5 China and East Asian global integration (trade/GDP), 1980–95

Sources: World Bank, World Development Indicators, 2 September 1997; Summers and Heston, Penn World Tables, February 1995.

involved in the global integration.10 This is particularly true, given that China is still in the process of liberalising its economy, as discussed in the second section. Discussion of global integration of regional economies carries implications for export competitiveness and market competition among these countries. A key question in that context is whether China’s foreign exchange system reform in 1994 triggered the financial crisis in East Asia through replacements of exports on major markets by more competitive exports from China, especially labourintensive products. It is true that the one-off depreciation of 50 per cent as a result of the unification of exchange rates in China in 1994 helped boost China’s exports greatly, as shown by the rapid growth rate of exports in that year and the shift from a trade deficit in 1993 to a trade surplus in 1994. It also improved China’s export competitiveness compared with other countries including East Asian economies (see Figure 5.2). But whether this policy change caused the financial crisis remains unresolved and needs further study. Some preliminary evidence is provided here. Table 5.9 reports the proportion of manufactured goods and labour-intensive goods from East Asian economies in total imports of manufactured and labourintensive goods by major developed trading partners during the period 1980–96. The results show, first, that the proportions of both categories of goods from China into these major markets increased rapidly during the whole period, especially between 1990 and 1996 with labour-intensive goods shares much higher than manufactured goods. Second, the proportions for ASEAN (excluding Singapore) for both categories of goods were not negatively affected by the expansion of market shares by China. In fact, they increased, especially to the markets of European countries, Japan and the United States.


Table 5.9 Proportion of manufactured goods and labour-intensive goods in imports from East Asian economies by developed countries, 1980, 1985, 1990 and 1996 (per cent)

Source: Calculations based on UN trade data, International Economic Databank, Australian National University.

Third, there was a substantial contraction in the proportions from NIEs, particularly for labour-intensive goods in these markets, and this contraction accelerated in the last period (1990–96), a clear indication of product replacement on these markets by similar goods from other sources. For example, the proportions of labour-intensive products from NIEs to the Japanese market dropped from 36.7 per cent in 1980 to 14.2 per cent in 1996, and from 46.8 per cent to 14.0 per cent to the US market (their shares of manufactured goods also dropped slightly in the Japanese and US markets). Fourth, on balance, the proportions of labour-intensive goods exported from East Asia to Australia, Canada, Europe and Japan as a whole increased, and reduced to the US market (albeit slightly). Their proportions of total manufactured goods increased steadily to all markets reported. In summary, the shares of labour-intensive goods from China to major markets are expanding, but not at the expense of ASEAN, where the financial


crisis started. Currency depreciations in China certainly contributed to the expansion of its exports as the estimation results in the study indicate, but factors other than China’s export competitiveness need to be considered, for example, cheap labour, other costs and non-price factors such as large increases in capital investment in China’s export sector. The nature and implications of this financial crisis need more careful study. CONCLUSIONS China’s foreign trade has developed very rapidly in the recent past. This study indicates that the prospects for China’s exports will continue to rely on strong world demand for its products and further improvement in the productivity and competitiveness of its economy. There will be an increasing pressure for China to upgrade its industrial structure, produce high value-added and high quality products and further diversify its trade destinations. China’s imports will depend on the growth of national income and industrial outputs as well as reform measures to open up the domestic market further. Deepened domestic reform and continued trade liberalisation will provide an institutional guarantee for realising such prospects. In particular, further reforms are needed to carry out more extensive structural adjustments, enhance competition, reduce protection in the form of non-tariff barriers and increase the transparency of China’s trading system, particularly the import system.11 APEC trade liberalisation and China’s accession to the WTO offer two important vehicles for China to fulfil these tasks. The integration of the Chinese economy into the region and the global economy is beneficial for both China and its trading partners. By the mid1990s, the degree of China’s global integration is considerably lower than that of NIEs and ASEAN (Figure 5.5). This suggests that the economy is yet to be fully integrated with the world economy and still to enjoy the maximum benefits offered by this process. In this context, exchange rate policy adjustments in China, particularly the one undertaken in 1994, should not be viewed as a policy measure to carry out competitive depreciation against its Asian neighbours, but as a movement towards a market-based exchange rate system which constitutes ‘a precondition for global integration’ (World Bank 1997:7). China’s ongoing trade liberalisation with an enlarged capability for export supply and domestic demand for imported goods will lead the economy further down the road towards global integration. A key to resolving the financial and macroeconomic crisis in East Asia and to achieving a more sustainable pattern for the development of foreign trade in the regional economies lies in continued reform and trade liberalisation in these economies.


NOTES 1 An earlier version of the chapter was presented at the international conference on ‘APEC and its impact on the Chinese economy’, the Australian National University, Canberra, 16 February 1998. I am grateful for comments made by Ben Smith and Prema-chandra Athucorala. I also thank Xinpeng Xu for helping me to assemble the data used in this study. 2 On average, exports contributed 2 percentage points to the average real GDP growth of 10% for the period 1990–98. 3 Mandatory planning for exports was abolished in 1991 and at the same time, state budgetary subsidies to foreign trade corporations for exports were eliminated. By 1992, planning for imports covered only 11 broad product groups, accounting for about 18% of total imports. This was further reduced to only about five broad products groups in 1993 (see Tseng et al 1994:4). 4 This need becomes more pressing amid the current financial crisis in East Asia. 5 See China Daily, 12 January 1999, ‘Exports up, foreign trade down in 1998’ by Zhang Yan. 6 See China Daily, 15 January 1999, ‘Customs: high-tech exports increase’. 7 The model specification is rather ad hoc in that it does not take account of supplyside variables in the equation. 8 The procedure was to split the sample at 1994 and to estimate the dummy variable specifications of the regression with years (quarters) up to the fourth quarter of 1993 equal to 0 and from the first quarter in 1994 onwards, equal to 1. 9 Its t-value is below the critical value (1.645) at the 5% significance level but above it at the 10% level. 10 Of course, the ‘big country’ assumption can be argued here (see Lau 1994). 11 After China’s accession to the WTO, coverage of non-tariff barriers would fall dramatically, as agreed by the Chinese government. After the full phase-in, the only significant remaining measure would be state trading, mainly in agriculture which is covered by special provisions under the WTO (World Bank 1997:15).

APPENDIX 5

REFERENCES Balassa, B. (1978) ‘Export incentives and export performance in developing countries: a comparative analysis’, Weltwirtschaftliches Archiv 114:24–61. Chai, J.C.H. and H.Sun (1993) ‘Liberalising foreign trade: Experience of China’, Discussion Paper no. 135, Department of Economics, University of Queensland. Greenaway, D. and D.Sapsford (1994) ‘What does liberalisation do for exports and growth?’ Weltwirtschaftliches Archiv 130:152–74. Harding, H. (1987) China’s Second Revolution, Washington, DC: The Brookings Institution.


Table A5.1 Time-series data used in the analysis, 1986–97 (quarterly)

Source: Compiled and calculated on the basis of data in International Financial Statistics, the Direction of Trade Statistics; International Monetary Fund, 1997; and the Statistical Year book of China, 1997.


Harrigan, J. and P.Mosley (1991) ‘Evaluating the impact of World Bank structural adjustment lending’, Journal of Development Studies 27:63–74. Hsu, J.C. (1989) China’s Foreign Trade Reforms: Impact on Growth and Stability, Cambridge: Cambridge University Press. Lardy, N.R. (1992) Foreign Trade and Economic Reform in China, 1978–1990, Cambridge: Cambridge University Press. Lau, L. (1994) ‘The Chinese economy in the twenty-first century’, paper presented at the international conference on the Market Economy and China, Beijing, China. Li, K.-W. (ed.) (1997) Financing China Trade and Investment, Westport: Praeger Publishers. Papageorgiou, D., M.Michaely and Choski (1992) Liberalising Foreign Trade, Oxford: Oxford University Press. People’s Bank of China (1995) China Financial Outlook, 1995, Beijing: The People’s Bank of China. Song, L. (1996a) Changing Global Comparative Advantage: Evidence from Asia and the Pacific, Melbourne: Addison-Wesley. Song, L. (1996b) ‘lnstitutional change, trade composition and export supply potential in China’, in M.Guitian and R.Mundell, eds, Inflation and Growth in China, Washington, International Monetary Fund. Tseng, W., Hoe Ee Khor et al. (1994) Economic Reform in China: A New Phase, Washington, DC: International Monetary Fund. Wang, H. (1993) China’s Exports since 1979, London: The Macmillan Press. World Bank (1997) China Engaged: Integration with the Global Economy, Washington, DC: World Bank. Xue, J. (1995) ‘The export-led growth model and its application in China’, Hitotsubashi Journal of Economics 36:189–206. Zhang, X. (1993) China’s Trade Patterns and International Comparative Advantage, Canberra: The Australian National University.

6 Agricultural policy adjustment in the process of trade liberalisation1 Wen Hai

CHINA’S FORMER AGRICULTURAL POLICIES The development of China’s agricultural policy since 1949 can be divided into two stages on the basis of policy objectives. During the first stage, from the early 1950s to the late 1970s, the main objective of agricultural policy was to support industrialisation. In order to maintain lower costs for urban industries, agriculture was heavily taxed and agricultural prices were kept at a very low level by means of central controls. Consequently, China’s agriculture developed at a very slow pace and farmers’ incomes were virtually fixed for thirty years. The second stage started in 1978 with the advent of economic reform. After thirty years of heavy taxation and ten years of the Cultural Revolution, China’s agriculture was on the brink of collapse and food supplies were at subsistence level. In all urban and rural areas, food was rationed. Changes to China’s agricultural policy were urgently needed. This was the main reason economic reform started in the agricultural sector. The main objective of agricultural policy since 1978 has been to increase food supplies and ensure food security. Although food security is an objective of most countries’ agricultural policy, it is an extremely important and sensitive matter in China. Food security is closely related to political stability. Historically, China has suffered a number of famines which resulted in either political turmoil or peasant uprising. By the end of the Cultural Revolution, China’s economy was in crisis, people were no longer able to endure the food shortages, and the government was losing its credibility. In order to produce enough food, the government undertook fundamental reform of the agricultural production system. Policy adjustments in this period included dismantling the commune system and introducing the household responsibility system, reforming the procurement system, reducing agricultural taxation and other burdens, introducing market mechanisms and relaxing agricultural price controls. As a result of this program of agricultural reform, production has increased substantially, despite a slowdown since the late 1980s. Policies in agricultural production and trade during this period have been dominated by the objective of ensuring an adequate food supply. Imports and


exports of agricultural products have largely been used as a tool to balance domestic supply and demand. The agricultural sector has developed steadily and food supplies have been maintained until recent years, when agricultural prices increased rapidly and agricultural production stagnated. The challenge now facing Chinese agricultural policy in its adjustment to the demands of a new era is how to maintain a sufficient level of production while keeping agricultrual prices down. RISES IN AGRICULTURAL PRICES AND AGRICULTURAL IMPORTS With rapid economic growth, prices of agricultural products have increased (see Table 6.1). Relative agricultural prices, measured by the difference between the rates of change in agricultural and industrial prices, have increased since the beginning of the reform era. Average annual relative agricultural prices increased 4.3 per cent during the period 1978–94. The absolute prices of agricultural products, especially grain prices, have increased faster than the nation’s inflation rate (measured by both national retail prices and consumption prices). In 1994, the price of total agricultural production increased 39.9 per cent over the previous year. Average prices of rice, wheat, corn and soybeans increased 40 per cent, and cotton prices increased 60 per cent.2 By the end of 1994, prices of grain, including rice, wheat, corn and soybeans, were higher than international price levels (Table 6.2). This was the first time that Chinese agricultural prices reached or exceeded international levels. As a result of rapid increases in agricultural prices, China’s agricultural imports increased more than 75 per cent while exports fell 1.7 per cent in 1995.3 There was a sharp increase in the purchase of grain on the international market and a decrease in exports of corn, rice and cotton. China became a net importer of grain and other land-intensive products. Policy makers and economists in China have explained the recent rapid increases in agricultural prices by reference to the underdevelopment of the agricultural market, increases in the prices of agricultural inputs, a temporary decline in grain production, and ineffective agricultural management. It is true that these factors contributed to the increase in agricultural prices in China, but there are more fundamental reasons. The explanation lies not only in the problems of a transition economy, but is also related to industrialisation and rapid economic growth. As a country develops, capital accumulation and improvements in industrial productivity increase the opportunity cost of agricultural production. Increases in relative agricultural prices are an inevitable consequence of rapid economic growth in a developing country with scarce land resources. In particular, they are caused by capital accumulation in an economy with a labour-intensive agricultural sector. Recent literature in agricultural protection explores the relationship between economic development and agricultural comparative advantage.4 Theoretical

88 AGRICULTURAL POLICY ADJUSTMENT IN THE PROCESS OF TRADE LIBERALISATION

Table 6.1 Annual price changes, 1978–94 (per cent)

Source: ‘China Agriculture Development Report, 1995’, Ministry of Agriculture, People’s Republic of China.

analysis5 shows that changes in relative agricultural prices, given all elasticities of input and factor distribution parameters, are determined by changes in factor endowments and technological change on the supply side, and changes in population on the demand side. Since income is an endogenous variable, the effects of income change on relative agricultural prices are implicit. Changes in land endowment and productivity always have negative effects on relative agricultural prices. The effects of changes in capital and labour on relative agricultural prices differ, depending on factor distribution among sectors. If agricultural production is more labour intensive than production in the non-agricultural sector, an increase in capital endowment or an improvement in capital productivity in the non-agricultural sector raises relative agricultural prices. Although all factor endowments may increase, a rise in the capital-labour ratio (capital deepening) is the main feature of economic growth. Rapid increases in non-agricultural use of land during industrialisation and urbanisation actually reduces the land available for agricultural production. According to the Ministry of Agriculture of the People’s Republic of China, cultivable land decreased by 4.


Table 6.2 International price comparison of major agricultural product prices (yuan/ton)

Note: Pd is domestic price, and Pi is international price. Source: ‘China Agriculture Development Report, 1995’, Ministry of Agriculture, People’s Republic of China.

6 per cent from 1979 to 1994. On the other hand, capital endowment (from both internal and external sources) has increased rapidly in China since the 1980s. With China’s labour-intensive agricultural production, rapid growth of capital endowment has caused an upward pressure on relative agricultural prices. Most of this accumulated capital has been invested in the non-agricultural sector. The common-property nature of the land and the relatively low profit rate discouraged private investment in agriculture, while government agricultural investment remained low. Government spending on the development of agricultural technology and science increased at a 10.8 per cent average annual growth rate from 1978 to 1994. However, it was only 3.2 per cent after adjusting for inflation. This is very low in an economy with an average GDP growth rate of 10 per cent. The size of government spending on the development of agricultural technologies was also very small. It was 110 million yuan in 1978 (0. 7 per cent of total government spending in agriculture and 0.09 per cent of the government budget), and 300 million yuan in 1993 (0.7 per cent of total government agricultural spending and 0.07 per cent of the budget).6 Thus, lack of investment in agriculture during a time of economic growth made the Chinese agricultural sector even more labour intensive and less competitive. Another factor which has contributed to the rise of relative agricultural prices in China is technological change. The import of advanced technologies through trade, joint ventures, and foreign direct investment made China’s manufacturing sector more productive, while the development of agricultural production technologies has remained relatively slow.


It is important to pay close attention to trends in relative agricultural prices. Economic theories indicate that the rise of relative agricultural prices and the loss of comparative advantage in agriculture is inevitable in a country with land scarcity and labour-intensive agricultural production during industrialisation. Historically, European countries and Japan followed this trend in their industrialisation. South Korea and Taiwan had similar experiences in the 1960s.7 The increases in agricultural prices in China are also a consequence of rapid economic growth and structural change. An understanding of general trends in agricultural development is important for policy adjustment.

EFFECTS OF TRADE LIBERALISATION ON AGRICULTURE AND RETURNS TO FARMERS Like most industrialising countries, China has gradually lost its comparative advantage in agriculture in past decades. Relative agricultural prices have increased and some grain prices now exceed international price levels. What kind of agricultural policy should China adopt? Should it adopt a free trade policy and become a net grain importer, or should it follow the pattern of Japan, South Korea, or Taiwan and protect agriculture? What will happen if China adopts a free trade policy in agriculture? One result would be an increase in the import of grains and other landintensive products, since China would eventually lose its comparative advantage in agriculture. Agricultural prices would remain at international levels and the agricultural sector would decline further and faster. Unlike the situation in the late 1970s, the current agricultural problem in China is not one of shortage of food but an increase in relative agricultural prices. As well as food security, returns to factors during economic growth are a major concern of agricultural policy. As income in non-agricultural sectors increases in the course of industrialisation, farmers’ incomes have been partially compensated by increases in agricultural prices. This trend would continue in a closed economy or with agricultural trade protection. However, this would not be the case in an economy characterised by free trade in agriculture. When comparative advantage shifts away from the agricultural sector, returns to factors in agriculture decline under free trade. Although agricultural capital and labour can move to other sectors, farmland as a specific factor cannot. Therefore, the relative return to land would decrease in an open, growing economy. Farmers whose income is dependent on the return to land would be worse off and the income gap between the sectors would grow.8 As an economy develops, improvement of income distribution becomes one of the main objectives in policy making. Government policy is especially important for farmers’ income because of the immobility of farmland. Most developed


countries and newly industrialised nations choose to protect agriculture although it is not an efficient economic policy. For government, there are many objectives other than economic efficiency. Despite the fact that agricultural protection results in inefficient use of agricultural resources, it helps improve income distribution among the factors and thus maintain social stability. Income equality and social stability are the main reasons why most developed countries and newly industrialising economies (NIEs) adopted protectionist agricultural policies after that sector lost its comparative advantage. China is now under the same political pressures to shift its agricultural policy from taxation to protection. In fact, many policy makers and economists are discussing how to protect agriculture, and some protectionist policies, such as price support, have been introduced. As a latecomer, China does not have the same choices as the European Union, Japan, South Korea and Taiwan. The world trading system has been moving in the direction of freer trade in agriculture. How can China adjust its agricultural policy to improve farmers’ income in the midst of trade liberalisation? WTO RULES, INCOME DISTRIBUTION, AND AGRICULTURAL POLICY ADJUSTMENT The trend towards international trade liberalisation in agriculture The Uruguay Round negotiations achieved significant agreements on agriculture. Besides the agreement on reducing export subsidies and improving market access, member countries committed themselves to a continuing process of policy reform. Trade liberalisation, including agricultural trade liberalisation, is the general trend in the world economy. WTO rules on agriculture require significant reductions in export subsidies and modest cuts in domestic subsidies over a six-year period and the transformation of non-tariff barriers into equally restrictive but more transparent tariffs. The agreement at the GATT Uruguay Round on agriculture comprises four parts: internal support, export subsidies, market access and special safeguard mechanisms. In reducing internal support in agriculture, the Uruguay Round adopted the Aggregate Measure of Support (AMS) as the benchmark for liberalisation commitments. WTO members should reduce their AMS by 20 per cent over six years. However, many specific domestic subsidies, including research and extension services, are excluded from the AMS. For developing countries, specified agriculture input subsidies are excluded from AMS. In agricultural exports, the WTO requires the reduction of export subsidies by 36 per cent over six years. For developing countries, the cuts are 24 percentage points over ten years.


On the question of market access, it was agreed that all existing non-tariff barriers be converted into tariffs, and total import tariffs be cut by an unweighted average of 36 per cent in equal instalments over six years. Countries also agreed to establish ‘minimum access’ import quotas for products or product groups where imports have faced prohibitive trade barriers, equal to 3 per cent of domestic consumption and rising to 5 per cent at the end of the sixth year. Special safeguard mechanisms are available to protect domestic producers if imports exceed specific trigger quantities or are priced below trigger price levels. However, it would be difficult for a country to increase agriculture protection at this point. China's agricultural policy adjustments Compared with the European Community, Japan and other newly industrialising economies, China’s agricultural sector cannot be considered to be protected. Based on current WTO rules in agriculture, China requires little policy adjustment in the short run. China does not directly subsidise specific agricultural production and exports, so no reductions in internal support and export subsidies are needed. China can continue to still support its agricultural sector without violating the AMS regulations. This does not mean that China has free trade in agriculture. Imports and exports of grain and other agricultural products are controlled by the central government. The internal grain market is still not liberalised. To join the WTO, China would need to implement the WTO’s rules in the agricultural sector. The most important policy adjustment at the current stage is to meet the requirement of market access. This would require China to remove gradually the current quantitative restrictions in agricultural trade. In particular, the government would need to abolish the state monopoly in grain trade. In the long run, however, China needs more fundamental policy adjustment in the agricultural sector. It needs to liberalise trade in agriculture on one hand, and to prevent farmers’ relative income from falling on the other. Policy adjustment should be active rather than passive, It should be proactive rather than waiting until the situation becomes serious. To satisfy WTO regulations and at the same time improve domestic income distribution, the Chinese government needs to make a series of policy adjustments to increase agricultural productivity and maintain agricultural comparative advantage. Several long-run agricultural policies are recommended: • Increase agricultural investment and change the factor structure of agricultural production Theoretical analysis shows that a country will lose its comparative advantage in agriculture if agricultural production is labour intensive. This trend may be reversed if agricultural production is capital intensive. One way to improve agricultural competitiveness in a time of rapid economic growth is


to change the factor structure of agricultural production by increasing investment in agriculture. Instead of direct production subsidies or price support, the Chinese government should increase investment and subsidies in areas which may increase comparative advantage such as research, irrigation, pest and disease control, inspection services, environmental and conservation programs, crop insurance, regional aid and structural investment aid. Once China’s agriculture becomes more capital intensive, rapid industrialisation and capital accumulation will improve its comparative advantage in agriculture, or at least slow its decline. Considering the fact that China is moving away from a centrally planned economy and the government has limited investment capital, the Chinese government should encourage private investment in agriculture. To attract private investment, reform of land ownership is a necessity. • Increase investment in research, technologies and infrastructure To reverse the capital-labour ratio in the economy, significant capital investment in agriculture alone is not enough. It also requires the development of labour-saving and land-saving technologies in agricultural production and the reduction of agricultural employment. During the commune era, China had a good irrigation system and technological support network. However, the public support system has deteriorated since the early 1980s when the commune system was abolished. Part of the reason is due to the distribution of land and family farming, but the government has also paid less attention to agricultural development in the past decade or so. China experienced rapid growth in agricultural production in the 1980s. This was mainly a result of institutional reform and the relaxation of controls. However, China is a land-scarce country, and the future development of agriculture will depend on increased labour productivity. Increased investment and technological improvement are the main channels to achieve this aim. With higher labour and land productivity in a capital-intensive agricultural sector, an increase in capital endowment through economic growth will increase comparative advantage in agriculture. • Diversify farmers’ income Another policy adjustment of protecting agriculture with trade liberalisation is to diversify farmers’ income. If farmers’ incomes are less dependent on the price of agricultural products, protectionist pressures would be reduced. In order to disperse the rural labour force, the labour market needs to be freed up and reform of the resident registration system is required. Development of rural industries is another important strategy in diversifying farmers’ incomes. To achieve this, the current financial system must be reformed to encourage rural private enterprises. Both collective and


private rural enterprises have been discriminated against in terms of loans and market access. CONCLUSION China faces important policy challenges in agriculture. Rapid economic growth in the past eighteen years has reduced comparative advantage in agriculture. Both relative and absolute agricultural prices have reached or surpassed international levels. There will be some short-term fluctuations, but the general trend of loss of comparative advantage in agriculture will not be reversed as long as China remains as a fast-growing economy with a labour-intensive agricultural sector. To improve income distribution between agricultural and non-agricultural sectors, the government might adopt a protectionist agricultural trade policy. On the other hand, China is in the process of joining the WTO. An increase in agricultural protection would be in conflict with the principles of the WTO. To be a member of the WTO, China has to conform to WTO rules and regulations, and reduce trade barriers in the agricultural sector. To improve income distribution without violating the principle of trade liberalisation, the Chinese government needs to make a series of policy adjustments. The most important policy reform is to increase comparative and competitive advantage in the agricultural sector rather than protect it from international competition. Besides the adjustments which are necessary to conform with WTO rules, increasing agricultural productivity through greater agricultural investment and changing the factor structure of agricultural production should be the main measures for agricultural policy adjustment in the face of trade liberalisation. APPENDIX 6A Effect of economic growth on relative agricultural prices and comparative advantage The model9 The basic model used to support the analysis in this paper is a two-sector, threefactor equilibrium model with land as the specific factor. The economy is assumed to produce only two goods: agricultural and non-agricultural goods (including manufacturing goods and services). Three primary factors (land, labour and capital) are used in production. Land is the specific factor used intensively only in agricultural production and it is immobile among sectors. Capital and labour are common factors which are em ployed in the production of both goods, and they are mobile among sectors. In a competitive general equilibrium framework, the production equilibrium can be expressed as:


(1) (2) (3) (4) (5) ij input-output coefficients, i.e. amount of factor/required to produce one unit of good j (i = 1,2,3 1 land; 2 capital; 3 labour) (j = 1,2 1 agriculture; 2 non-agriculture) Pi relative price of agricultural goods T endowment of land K endowment of capital L endowment of labour

YJoutput in sector j R rent, returns to land profit, returns to capital W wage, returns to labour

The first two equations reflect the competitive commodity market equilibrium. The other three equations reflect the factor market equilibrium. The relative demand for agricultural goods is expressed in terms of the rate of change: (6) where is the price elasticity of the relative demand for agricultural goods, ; is the income elasticity of the relative demand for agricultural goods, ; is GNP, and Pôp is population. To restore the goods market equilibrium, a change in supply must equal a change in demand. Therefore, the equilibrium relative agricultural price change is expressed as (7) Equation (7) shows that given all elasticities of input and factor distribution parameters ( and ij), changes in relative agricultural prices are determined by changes in factor endowments , technological change on the supply side, and population change (Pôp) on the demand side. Since income is endogenous, the effects of income change on the relative agricultural price are implicit. EFFECT OF ECONOMIC GROWTH ON RELATIVE AGRICULTURAL PRICES The effects of changes in each variable on relative agricultural prices are also dependent on the structure of factor distribution among the sectors. Table A6.1 summarises all the effects of changes in independent variables from both the supply side and the demand side on changes in relative agricultural prices.


Table A6.1 Effects of exogenous changes on the relative agricultural price

1. The agricultural sector is labour intensive and the non-agricultural sector is capital intensive

2. The agricultural sector is capital intensive and the non-agricultural sector is labour intensive

APPENDIX 6B Effect of economic growth and free trade in agricultural products on returns to factors Returns to factors are directly affected by changes in factor endowment through the factor markets and indirectly affected through changes in commodity prices:

Changes in relative returns to factors under various conditions are summarised in Table B6.1. Table B6.1 Changes in factor endowments on relative returns to factors

In a closed economy with a labour-intensive agricultural sector, capital accumulation reduces the relative return to land, but it also raises relative


agricultural prices, thus increasing the return to land. The net welfare change for landowners is unclear. In an open economy, factor endowments are not affected since factors are assumed to be immobile between countries. The direct effects of changes in factor endowment on the relative returns to factors remain the same (in terms of the direction) for an open economy as a closed economy. However, relative agricultural prices do not increase in a domestic market involved in free trade. Once a country loses comparative advantage in agricultural production during industrialisation, it can import cheap agricultural goods from the world market while selling its nonagricultural exportable goods at a higher world price. As a result, relative agricultural prices in the domestic market remain at a lower level or actually decline relative to the closed situation. Thus, capital and labour gain from rapid capital accumulation as an economy grows with constant or declining relative agricultural prices in the transition from a closed to an open economy. In contrast, land loses its relative return from capital increases in a time of economic growth, but fails to be compensated by in an open economy. Under the condition of , , and , an increase in capital stock reduces the relative returns to land ( and ). Landowners are clearly worse off. As the economy develops (relative to the rest of the world), the difference between agricultural prices in the closed economy and the free trade scenario increases. With limited mobility, landowners’ income dependence on government intervention increases. NOTES 1 The author wishes to thank Professor Wing Thye Woo for his helpful comments. Financial support from the Asia Foundation and SOBA, Fort Lewis College is gratefully acknowledged. 2 ‘China Agricultural Development Report: 95’, Ministry of Agriculture, PRC, August 1995. 3 China’s Customs General Administration, China’s Customs Statistics (monthly), Economic Information and Agency, Hong Kong, December 1995. 4 See Anderson (1983), Anderson and Hayami (1986), and Hai (1991). 5 See Appendix A for the theoretical model and a detailed analysis. 6 ‘China Agricultural Development Report: 95’, Ministry of Agriculture, PRC, August 1995. 7 Before the 1960s, most agricultural prices in South Korea and Taiwan were lower than those on the international market. After the two economies industrialised in the 1960s, agricultural prices rose above world prices. 8 See Appendix 6B for a theoretical analysis of the effects of free trade on returns to factors. 9 The model employed in this paper is inspired by the simple general equilibrium model in Jones (1965; 1971). It was used by Hueckel (1972) to analyse the British economy during the period 1793–1815. However, in Hueckel’s model, the elasticity between capital and labour in the agricultural sector was ignored.


REFERENCES Anderson, Kym (1983) ‘Economic Growth, Comparative Advantage and Agricultural Trade of Pacific Rim Countries’, Review of Marketing and Agricultural Economics 51(3):231–48. —— (1990) Changing Comparative Advantages in China: Effects on Food, Feed, and Fibre Markets, OECD. —— and Yujiro Hayami (1986) The Political Economy of Agricultural ProtectionEast Asia in International Perspective, Sydney, London, Boston: Allen & Unwin. Binswanger, Hans P. and Pasquale L.Scandizzo (1983) Patterns of Agricultural Protection’, Agricultural Research Unit Discussion Paper 15, World Bank, 15 November. Cairncross, A.K. (1976) ‘The Place of Capital in Economic Progress’, in L.H.Dupriez, (ed.), Economic Progress, 1955; also in Gerald M.Meier, Leading Issues in Economic Development, third edition. Carter, Colin, Funing Zhong, and Fang Cai (1996) China’s Ongoing Agricultural Reform, monograph prepared for The 1990 Institute, San Francisco, March. Findlay, R. and H.Grubert (1959) Factor Intensities, Technological Progress and the Terms of Trade, Oxford Economic Papers 11; 111–21. Floyd, John E. (1965) ‘The Effects of Farm Price Supports on the Returns to Land and Labor in Agriculture’, The journal of Political Economy, 73(2):148–58, April. Garnaut, Ross, Fang Cai, and Yiping Huang (1996) ‘A Turning Point in China’s Agricultural Development’, in R.Garnaut and G. Ma, The Third Revolution in the Chinese Countryside, Cambridge University Press. Hai, Wen (1991) Agricultural Trade Protection and Economic Development, PhD dissertation, UMI Dissertation Information Service, no. 9137124. Hoekman, Bernard and Michel Kostecki (1995) The Political Economy of’ the world World Trading System: From GATT to WTO, Oxford University Press. Hueckel, Glenn (1972) ‘War and the British Economy, 1793–1815—A General Equilibrium Analysis’, Explorations in Economic History, Jones, Ronald W. (1965) ‘The Structure of Simple General Equilibrium Models’, The Journal of Political Economy, August. —— (1971) ‘A three-factor model in theory, trade, and history’, in J.N.Bhagwati et al., eds, Balance of Payments and Growth: Essays in Honor of C.P.Kindleberger, Amsterdam: North-Holland. McCalla, Alex F. (1988) ‘Developing country productivity and trade: Complementary or competitive’, paper prepared for World Food Conference, 5–8 June, Des Moines, lowa. Schott, Jeffrey J. (1994) The Uruguay Round: An Assessment, Institute for International Economics, November.

7 The implications of China's membership of the WTO for industrial transformation1 Peter Drysdale

China’s application for membership of GATT and the new World Trade Organisation has already been on the table for more than a decade. Such has been the speed of China’s trade and economic growth and China’s integration into the international economy that some have even begun to wonder whether membership of the WTO will significantly affect China’s opportunities in the international economy and whether the costs and disciplines of WTO membership might be avoided without compromising the benefits from growing Chinese trade and its effect on rising Chinese incomes. This is a chimera—a false dream that neglects economic logic and the reality that no economy has historically effected the transition of successful modernisation without commitment to liberalisation of commodity markets. The more successful the process of economic growth and industrial transformation— economic logic dictates—the deeper the liberalisation required to sustain the process, since the distortions of protection and other forms of intervention impose penalties on internationally competitive economic activities and hold back industrial upgrading, productivity improvement and growth, becoming a focus of policy attention at home as well as in negotiation and dealings with partner economies, access to whose markets is the basis of efficient international trade specialisation. But why is entry to the WTO so important to China’s continuing commitment to reform and liberalisation and sustaining the success of the last decade and a half or more? And why is accommodating China’s entry on terms which define an end point to China’s achieving equal status within the WTO so important to China’s major economic partners and the international trading system more generally? This chapter first addresses these two questions because they are of such fundamental importance to the successful conclusion of the negotiations on China’s application for WTO membership. Without clarity on the strategic importance of the policy goal of entry, the chances of a positive outcome are commensurately reduced and the primary interest here—in outlining the implications of WTO membership for China’s industrial transformation—would be little more than a purely academic exercise. It then proceeds to explore the corollary question of the impact of WTO entry on the choice of trade policy

100 THE IMPLICATIONS OF CHINA’S MEMBERSHIP OF THE WTO

strategy in China, and the relationship between trade policy strategy and the reform process. It sets these questions in the context of economic diplomacy in Asia and the Pacific (see Chapter 1) and analysis of China’s trade performance over the last fifteen years. The process of implementing the protocols associated with China’s admission to the WTO will take time. Rapid change in the scale and structure of the Chinese economy and trade will continue to require careful policy management in a framework the elements of which are not yet all firmly in place. And the impact of these changes in China on international markets and trade adjustment with particular economies, including the United States and China’s other partners in the Asia Pacific economy, such as Australia, requires the elaboration of cooperative policy strategies, the architecture of which is only gradually being drawn. With this interest in mind, the chapter examines Chinese competitiveness in international markets and the implications of changing competitiveness for trade and industrial transformation. This provides a basis for comment on the appropriate direction of industrial policy. The chapter finally provides a brief review of some of the empirical work that has been undertaken on the impact of offers made by China in its WTO negotiations, on trade liberalisation scenarios that are likely to be associated with China’s accession to the WTO, and on the impact of liberalisation of the highly significant textiles and clothing sector. The chapter introduces new work on these issues, some of which is set out in this collection (Chapters 8–12). THE PRIORITY OF ACCESSION TO THE WTO China is already one of the world’s largest trading nations. There has been a remarkable increase in the scale of China’s merchandise trade since the late 1970s, after commitment to modernisation and ‘open door’ economic policies. The elevation of China’s status in world trade has accelerated over the last nine years, as the reform process has deepened. The huge inflow of foreign direct investment in the last few years is closely related to the growth of Chinese export competitiveness in key sectors such as textiles and clothing, in which over 60 per cent of the increase in exports has been from foreign-invested enterprises (Chapter 11). In 1997 China’s share of world exports was 3.4 per cent, its share of world imports 2.5 per cent, and its share of world trade 2.9 per cent, making it the world’s 10th largest trader—having ranked only 34th in export trade and 58th in import trade at the end of the 1970s (Chapter 1). If the European Union (EU) is treated as one economy, China ranks 6th, after the EU, the United States, Japan, Canada and Hong Kong, and is now ahead of Korea and Taiwan. If Hong Kong is included in China’s trade net of trade between the two economies (using 1997 data), all China’s share of world imports, at 4.1 per cent, world exports, at


4.6 per cent, and of world trade, at 4.36 per cent, make China the 4th largest trader in the world (see Table 7.1). Yet China itself has remained outside the important global institutions that govern the rules and arrangements of the multilateral trading system. China has had no access through membership of the WTO to representation or redress over matters of trade cooperation and application of the rules of trade it embodies, or over matters of trade disputation. China’s political weight in international affairs and the power of mutual interests in bilateral economic arrangements provide it with influence in dealings with its international trading partners—even the United States, as was seen most clearly in 1994. But the fact remains that China has had a much less confident basis on which to proceed in such dealings than other nations of comparable importance In world trade (Drysdale and Elek 1992: 1). This is the crux of the priority that attaches to China’s membership of the WTO. China’s entry to the WTO will affect Chinese and international policy and enterprise or corporate behaviour in at least three important respects. It will affect the behaviour of China’s major trading partners, such as the United States, Europe and Japan, in policy behaviour towards China. It will affect Chinese policy behaviour, in respect of trade, investment and other rules and practices, and the environment in which both domestic and foreign firms operate in China. And it will affect the behaviour of domestic as well as foreign enterprises in their activities within the Chinese market. These consequences are of considerable importance even if, as will be the case from time to time, disputes or difficulties arise in the application of WTO rules and protocols by, and towards, China on whatever final terms entry is negotiated. There are two key points here. The first is that an international commitment, such as that involved in accession to the WTO, underwrites credibility in respect of the continuity and reliability of policy behaviour (Itoh 1996:8). It serves to limit opportunistic behaviour (such as quarantining favoured sectors of the economy from international competition, treatment of foreign firms on a different basis from national firms, treatment of a particular country’s goods on a discriminatory basis or inconsistently with accepted rules and principles) and to reduce the likelihood of distortionary interventions in trade and other international transactions—both by China and by China’s trading partners. Violation of WTO rules after entry would, of course, undermine policy credibility but, while many such problems do and may arise, the experience of China’s approach to the honouring of its international agreements and of the approach of most WTO members to the trade rules suggest that China’s entry to the WTO would secure an important international commitment and assurance of policy credibility and policy development in both directions. In this context, China’s impressive trade liberalisation over the past decade cannot be viewed independently of negotiation


Table 7.1Total trade of Greater China (China and Hong Kong) and its share of world trade

Note: Greater China includes mainland China and Hong Kong. Data for Greater China’s trade (imports and exports) are its trade with the world net of trade between China and Hong Kong. Data for 1998 are estimated based on data for the first nine months. Source: Direction of Trade, International Monetary Fund; International Economic Databank. Australian National University.

towards GATT/WTO accession but nor can it be guaranteed independently of eventual success in these negotiations. The second is that the international commitment required of China by WTO entry will bind policy and the evolution of policy in a way that affects the behaviour of domestic and foreign firms operating in China. Commitment to agreed rules and schedules of liberalisation changes the corporate strategic environment in which enterprises plan and develop their activities. While such policy change may not be entirely impervious to domestic pressuring and influence-peddling, it is likely to be less susceptible to easy resistance, manipulation and reversal than policy change undertaken without external constraint. The way in which Japan’s accession to the GATT after the Second World War shaped corporate behaviour and the political economy in the 1950s and 1960s in that country is a relevant example of this effect (Itoh 1996:9–14). I shall return to these questions of political economy in the Chineses context shortly.


TRADE STRATEGY AND ECONOMIC REFORM2 A commitment to WTO rules and to meeting the standards of trade policy behaviour already achieved by the major players within the WTO— inadequate though these standards sometimes appear—implies a further radical change in China’s economic policy regime, the necessary next step in meeting the objectives of economic reform. Accession to the WTO, and meeting the critical international obligations it must entail, can vastly assist the management of the reform process in China. The gains from the significant liberalisation of trade that China will phase in—through more efficient allocation of resources and its impact on the productivity of resource use—will be large, but there will also be costs in the process of adjustment, and the political resistance to these adjustments is not trivial. The resistance to change has origins in ideology (Chen 1994) and in appeal to other East Asian policy models, as well as in the vested interests in the highly protected and inefficient state enterprise sector and in the inefficient rural sector (Lu 1994; Chapter 6). While ideology is subject to impressive change and other East Asian policy models are on the back foot, the familiar resistance to bearing the costs of adjustment is very much alive. Connecting the next important round of liberalisation in the Chinese economy to the benefits of more reliable access to the international marketplace, delivered through WTO accession, assists with managing the politics of reform. The successful conclusion of the Uruguay Round in 1994 considerably enhanced the economic and political benefit of the accession bargain for China, since faithful implementation of the Round will result in substantial liberalisation of the Multifibre Arrangement (MFA) governing textiles trade, an area of key interest in Chinese trade growth (McKibbin and Salvatore 1994; Anderson, Dimaranan, Hertel and Martin 1996). I shall take this issue up again later. China’s ambition to enter the WTO is a central element in the world trade policy agenda at the turn of the century. This element needs to be reviewed in the broader context of the relationship between trade strategy and economic reform. China’s trade and economic policies are already considerably more in line with WTO principles than when it first applied for membership in July 1986 (Li 1987; McDonnell 1987; Chapter 9). China undertook substantial economic reform in the 1980s and the process of reform accelerated after 1989 (Raby 1991; Lardy 1992: Ch. 3; Song 1994; Chapter 9; Naughton 1996). Careful studies of the relationship between China’s changing resource endowments and the structure of specialisation in the international economy provide strong evidence of the convergence between these patterns and what would be expected from market-determined outcomes (Song 1993). The marketisation of the Chinese economy—even of its state enterprise sector—is confirmed in studies of the behaviour of Chinese enterprises in the course of reform (Zhao 1994). While the state enterprise sector enjoys considerable direct and indirect support and there remains an array of measures that are inconsistent with the letter as well as the spirit of the WTO, including direct controls and subsidies, the stage has been


set for state enterprise reform in a definable period of time so as to meet the objectives and requirements for WTO membership. The draft protocol of accession of December 1994 (GATT 1994) addressed this issue. The trade law of May 1994 laid an appropriate basis for ensuring the necessary transparency and uniformity in trade policy and a retreat from administrative in favour of market measures in the management of trade. The tariff liberalisation announced at the APEC meetings in Osaka in November 1995 and carried forward in the APEC meetings at Manila in November 1996 represented not only a considerable step towards achievement of China’s trade liberalisation commitments under the APEC Bogor Declaration but also a substantial forward commitment on meeting the terms of accession to the WTO. The service sector (including banking and transportation) remains sheltered, but this sector, as well as trade in commodities and technology, is being thrown open to market principles. Another sector of importance is agriculture and the opening of this sector to industrial market forces. In 1988 China’s unweighted average tariffs were 40.3 per cent; (PECC 1996: 8). In 1993 they had been reduced to 37.5 per cent, by 1996 they were down to 23.0 per cent and were further reduced to 17 per cent in October 1997. By the year 2000 the tariff average will be 15 per cent. China has substantially and steadily reduced the number of goods subject to quotas and licensing: at present around 372 tariff line items remain subject to non-tariff trade barriers (NTBs), most of which are scheduled for removal (IAP, China 1998). Figure 7.1 describes the extensive tariff reduction to which China is committed on a voluntary basis under the APEC Individual Action Plans (lAPs), significantly ahead of the trend necessary to achieve free trade in 2020. China is also gradually opening up more sectors to direct foreign investment and progressively granting national treatment in foreign investment policy. In practice, trade policy strategy is inextricably linked with other aspects of the reform, such as foreign exchange reform (already taken a long way through unification of the two-tiered exchange rate and with the target of full currency convertibility), state enterprise reform, financial market reform and macroeconomic policy reform. This is a large and complex reform agenda and full currency convertibility and financial market reform, together with state enterprise reform, cannot be achieved at one fell swoop. The liberalisation of trade policy associated with accession to the WTO in effect forces the pace of reform in other areas, especially in the management of the state enterprise sector, and financial and foreign exchange markets. Policy leaders, both inside and outside China, have a very substantial interest in forcing the pace. Accession to the WTO, with its commitment to ongoing liberalisation, would entrench these reforms and help to maintain their momentum. The alternative would be a loss of momentum and misdirection of the process of reform and industrial transformation. One aspect is the potential for a shift towards costly ‘import substitution’ strategies fostered by the maintenance and extension of subsidies and state controls, and away from the thrust towards


Figure 7.1 China’s tarrif reductions.

Source: Projections based on China’s APEC Individual Action Plan (IAP).

‘export orientation’ or, more accurately, ‘open market’ strategies. Advancing the trade liberalisation agenda, through accession to the WTO, or by whatever means, promotes reform of the enterprise system through the positive effect of the export sector and enhanced market discipline on industrial activity. In agriculture, the stakes are now set to become higher. China has switched from being an agriculture-taxing to an agriculture-subsidising industrialising economy (Huang 1994; Garnaut, Cai and Huang 1996; Anderson, Dimaranan, Hertel and Martin 1996). The burden of agricultural protection will become higher and higher and more difficult to unravel unless the moment to negotiate a relatively open trade regime is taken soon. Yet China is also a significant exporter of food products and the scope for growth in intra-industry trade in agricultural goods will be enlarged by commitment to further liberalisation. Protectionist sentiment abroad and reactionary sentiment in China find common cause in focusing on strategies which eschew ‘export-oriented’ development and focus on ‘self-sustaining’ growth in a huge domestic market. Such thinking is based on incorrect understanding of the nature of industrialisation in East Asian economies (Lau 1994). Chinese economic modernisation is not an independent event. In all the major East Asian economies, domestic market growth driven by high rates of investment as well as openness to international market disciplines have been key elements in the development of dynamic comparative advantage and internationally competitive economies. The evolution of dynamic comparative advantage will differ in China from other East Asian economies because of the wider range in China’s economic structure, the regional diversity of its resource endowments and a history of investment in capital-intensive industry. But China is far from reaching its full


potential in the development of externally oriented activities and will continue to realise significant gains from growth through trade, investment and technology flows and integration into the international economy. This perspective is critical in judgment about the appropriate strategies towards industrial transformation and industrial policy in China and I shall take up this question later. THE ASIA PACIFIC TRADE POLICY CONTEXT China’s trade and other foreign economic relations are overwhelmingly concentrated in the Asia Pacific economy. The rapid integration of Hong Kong into the economy of Southern China over the past decade and its incorporation into the People’s Republic of China in 1997 recommend the adjustment made here of incorporating Hong Kong into China’s trade in assessing the impact of China on the regional and international economy. Hong Kong-China trade is netted out from Hong Kong’s total trade and the residual combined with China’s trade to obtain a measure of all Chinese trade and its importance in the world economy. These data are set out in Table 7.2. They provide a much more reliable measure of China’s position in world trade and the geographic structure of China’s trade. The Asia Pacific Economic Cooperation group of economies includes all China’s most important trading partners and accounts for over 72 per cent of its import and export trade. Among them are the United States and Japan. While the relationship with the United States is not free of problems (the human rights issue, arms sales, intellectual property rights, illegal textile trans-shipments, the Taiwan issue, military technology issues, and market access for US products in China) and the relationship with Japan carries the burden of history (Drysdale, Song and Zhao 1995; East Asia Analytical Unit 1996), China shares more interests with the Asia Pacific economies than with other trading nations. Trade ties have grown strongly within the region—even around diplomatic barriers to trade, such as those affecting trade with Taiwan or, until recently, with Korea. The growing depth of trade and business ties between China and the United States has begun to constrain the more divisive elements in bilateral relations and to encourage a strategy of engagement over any inclinations towards confrontation. APEC economies enjoy directly and disproportionately the benefits of China’s economic growth and are natural allies in international economic diplomacy (Garnaut and Drysdale 1994: Ch. 1). The pioneering efforts by the Pacific Economic Cooperation Council (PECC), tensions in trans-Pacific trade relations, the slow progress of the Uruguay Round and the European movement towards a single market all contributed to the launching of the APEC process in 1989 (Elek 1992, 1993). The PRC, Taiwan and Hong Kong were invited to join the process at the second ministerial-level meeting in Singapore in 1990, and all three participated in the third meeting in Seoul in November 1991. The inauguration of the informal leaders’ meeting in Seattle in November 1993 gave APEC new clout and direction.

Note: China here includes Hong Kong, net of China-Hong Kong trade. These data, and the data in Table 7.3, are constructed from partner country data. Source: UN trade data, International Economic Database, the Australian National University.

Table 7.2 China’s geographic trade structure, 1970–96 (per cent)



The APEC framework provides a useful vehicle for Chinese foreign economic diplomacy in four main ways. First, APEC provides a valuable forum within which the three Chinese economies can find common cause in regional economic cooperation. Second, APEC’s objectives and principles, which stress the desirability of liberalisation in ways that are not to the detriment of other economies, reinforce China’s claim to most-favoured nation (MFN) treatment in the international trading system, especially by its APEC partners. Third, APEC’s focus on the facilitation of trade and other international transactions, and the regional infrastructure to support it, provides encouragement to subregional integration on a basis consistent with the guiding principle of open regionalism. The avoidance of sheltered, discriminatory, sub-regional markets is important to China’s ability to manage its integration within the Northeast Asian economies (Taiwan and Korea and also Hong Kong) and develop its relations with the ASEAN and Indochinese economies. Asymmetry in China’s relations with its neighbours has the potential to bedevil them unless they are part of an open trade and economic system in the region. This aspect of China’s sub-regional relationships is also relevant to its response to Malaysia’s East Asian Economic Caucus (EAEC) idea. China’s involvement in any tight arrangement linked to the East Asian economies (even including Japan) is likely to be fraught with economic and political difficulty because of both the perception and the reality of asymmetry in such a subregional arrangement. China is already a big economy and a big power and will have more comfortable relationships with smaller economies and polities, the more open those relationships are. Hence, finally and most importantly, APEC is of particular value to China in the pursuit and projection of interests in the global system. The APEC framework offers the opportunity for a constructive and cooperative partnership between China and its major partners in the Asia Pacific region—the United States and Japan—and a role in fostering peace, stability and prosperity on the world stage in ways helpful to China’s own ambitions for reform and development. China has indeed played a very positive role in developing the APEC agenda of trade and investment liberalisation, especially over the past five years, and in forging the link between its regional interests and the global agenda, consolidating the base for accession to the WTO through its initiatives at the Osaka and Manila APEC meetings. APEC, in turn, has been a critical vehicle through which China could reposition and maintain the momentum of its claim to WTO membership. China consolidated these claims most dramatically and effectively in its response to the East Asian financial and economic crisis of 1997 (Song, Huang and Yang 1998; Asia Pacific Economics Group 1998).


TRADE REFORM, INDUSTRIAL TRANSFORMATION AND INTERNATIONAL COMPETITIVENESS China’s trade and economic reforms have been associated with foreign trade growth at double digit rates and real income growth of 10.2 per cent per annum over the last seventeen years. Chinese exports have grown at an average rate of 15 per cent per annum for more than a decade and a half, compared with world trade growth of around 8 per cent. In the decade after 1985, reform and trade liberalisation intensified and trade and income growth accelerated. China’s share in world imports, including Hong Kong, rose from 2.6 per cent in 1985 to 4.0 per cent in 1994, and its share in world exports rose from 2.2 per cent to 4.1 per cent over the same period. Clearly trade and economic growth have been closely linked to successful reform and trade liberalisation. One study suggests that in 1992, China’s exports were US $36 billion (or 92 per cent) higher than they would have been in the absence of economic and trade reform over the preceding decade (Drysdale and Song 1995). Another study estimates that trade liberalisation associated with membership of the WTO would boost China’s annual trade by 50– 60 per cent in 2005 (Anderson, Dimaranan, Hertel and Martin 1996:22). These represent significant gains to China and her economic partners from commitment to reform and trade liberalisation. The first point to underline is that these gains from trade and economic growth have been accompanied by substantial industrial upgrading and transformation in China’s trade and industrial specialisation. The first phase of this transformation saw the emergence of the competitive strength of the textile and clothing industry as China established comparative advantage in labour-intensive production. Pockets of capital-intensive production continued in this phase as a legacy of China’s heavy industrial strategies in the pre-reform years. The second phase is now under way, with the emergence of more capital-intensive exports, In areas where labour costs have risen, and they are now an increasingly Important element in Chinese trade growth. This experience raises a fundamental question about the industrial policy strategy appropriate to accelerating industrial upgrading and productivity growth. Many in China argue that the pace of industrialisation can be accelerated by giving special support and protection to leading industrial sectors. This idea was prominent in some official thinking about China’s industrial policy strategy and lay behind the slogan of the ‘two transitions’: the transition from a centrally planned economy to a market system and the transition from extensive to intensive growth. The second transition indicates the importance attached to the development of high value-added industries. Candidate industries for special support include electronics, automobiles, infrastructure, information and even the real estate sector. This way of thinking was familiar in an earlier stage of Japan’s postwar industrial development. The irony is that the massive problems facing


the Japanese economy today are in no small part a legacy of these inappropriate policy strategies of the past. Is the movement towards market prices for all sectors of the Chinese economy, including the new high growth sectors like electronics, machinery and transportation equipment, likely to encourage faster industrial upgrading or permanently lock China into so called ‘extensive’ industrial development? This is the critical question which policy makers should be addressing. The question is not whether the state should invest in human capital and other infrastructure to support industrial, technological and scientific development across industrial sectors but whether the state should intervene to insulate some sectors of the economy from productivity-enhancing international market competition. Membership of the WTO and trade liberalisation more generally will have a big impact on China’s industrial upgrading. As numerous studies and China’s own experience in the reform period have shown, liberalisation has a strongly positive effect on growth and industrial upgrading. Attempts to induce industrial upgrading artificially by distorting prices in favour of ‘key sectors’ simply lift costs to other sectors in the economy, create rents thereby wasting resources, and lower productivity growth rather than enhancing it. Policies which seek to pick leading sectors in industry and bestow on them special protection and support are likely to be self-defeating and are incompatible with the disciplines of the WTO. One way of assessing China’s trade and industrial performance during the reform period is to analyse the factors that have contributed to the growth of China’s world trade share, using constant market share analysis (Drysdale and Lu 1996). Constant market share analysis also allows identification of the sectors in which trade growth is associated with strong productivity growth and improvements in competitiveness and which sectors are lagging. Recent studies of this kind suggest that growth of productivity and competitiveness is strongly linked to the impact of trade reform and liberalisation in East Asia and Australia (Lloyd and Toguchi 1996; Drysdale and Lu 1996). Table 7.3 summarises the results of a very detailed analysis of China’s performance in world markets between 1985 and 1994, across four broad commodity groups—agriculture, minerals and fuel, labour-intensive manufactures and capital-intensive manufactures. This analysis includes Hong Kong in total Chinese trade. While the findings are susceptible to the influence of any particular biases there may have been in trade structure in the beginning and end years, because trade structures do fluctuate across years, the general results reported are consistent with expectations. Chinese trade competitiveness improved strongly in this period, accounting for 45.1 per cent of the expansion in Chinese exports. This is a reflection of the specially strong growth of competitiveness not only in labour-intensive manufacturing (clothing and textiles), which accounted for 45.2 per cent of the improvement in competitiveness, but also in capital-intensive manufacturing (machinery and equipment), which accounted for 54.5 per cent. Because of the inclusion of Hong Kong in the Chinese trade in this analysis, the strength of


Table 7.3 Constant market share analysis of China’s export performance in world markets, 1985–96 (US$ billion)

Notes: 1 Figures in parentheses represent percentage calculations. 2 This analysis is undertaken at a highly disaggregated level (UN SITC 3-digit) for each broad commodity group so that the effect of changes in the commodity composition relates to individual commodity analysis rather than changes between three broad commodity groups. The results presented in the table summarise this highly disaggregated analysis. 3 Chinese trade data here include Hong Kong trade as well as PRC trade. Chinese exports are estimated from partner country imports from China and Hong Kong for each SITC 3digit commodity category. In this analysis it was not possible to separate out intra-Hong Kong-China from total Hong Kong and China trade. However, the increment in this trade between 1985 and 1996 is consistent with the overall increment of China-Hong Kong trade reported by partner countries and there can be some confidence that the assumption made in constructing the data (namely, that the proportion of intra-Hong Kong/China trade did not change significantly between the beginning and end years) is valid. Source: Author’s calculations based on UN trade data, International Economic Databank, Australian National University.

competitiveness in capital-intensive manufacturing in the rest of China is probably overstated. Nonetheless, there have been strong gains in competitiveness in capital-intensive manufacturing and exports and the inclusion of Hong Kong, in this respect, serves merely to underline the point made earlier about the likely evolution of China’s comparative advantage away from specialisation in a narrow range of commodities and towards a more diversified structure of specialisation across the whole of China. The result shows that competitiveness in the agricultural sector is still weak (0. 6 per cent). However, while Chinese industrialisation and the internationalisation of the Chinese economy has brought strong growth in agricultural imports, there has also been improved agricultural productivity and growth in Chinese agricultural exports, especially of processed foodstuffs into East Asian markets (Lu 1996).


The notable result from this analysis is that competitiveness is improving rapidly in capital-intensive manufacturing and that liberalisation has been associated with efficient industrial upgrading. More detail is provided on China’s position in world markets for labourintensive manufactures in Figures 7.2 and 7.3. Figure 7.2 compares the share of labour-intensive goods in China’s exports with their share in the exports of other East Asian economies, the newly industrialising group of economies (NIEs) and the world as a whole. It reveals the huge increase in the importance of these goods to China’s export growth and in China’s industrial transformation. But a new development is that, in 1993, the share of labour-intensive exports in China’s total exports appears to have peaked. Indeed, this trend has continued— in 1995 and 1996 machinery and equipment overtook textiles and clothing to become the largest commodity group in China’s exports. There are many factors behind this new development. There has been a surge of productivity-improving domestic and foreign investment in more capitalintensive activities. This is linked to the pattern of development concentrated in the coastal provinces. There is still huge potential for the expansion of competitive labour-intensive activities in the inland provinces but expansion of capital-intensive activities in coastal areas also is consistent with realising this potential. The textile industry also experienced difficulties after the tax reform. Moreover, the heavy industrial base established in the pre-reform period, while a drag on growth and productivity improvement earlier, is being restructured and modernised under the now more pervasive application of market discipline in this sector too. All these factors have contributed to the improved position of more capital-intensive manufacturing in China’s exports. Figure 7.3 shows the share of China and other suppliers of labour-intensive manufactures in world markets for these goods. The emerging strength of Chinese competitiveness in labour-intensive exports is most clearly evident in these figures. The rest of the world’s adjustment to expansion of Chinese labourintensive exports has been facilitated by its timing with rapid falls in the shares of Japan (up to the mid-1980s) and the NIEs (after the mid-1980s) (Drysdale Song, and Zhao 1995). By 1994, China’s share of world exports of labourintensive products was higher than the four newly industrialising economies of Northeast Asia, but at 18 per cent still under the NIEs’ peak in the mid-1980s. The increase in China’s share came at the same time as the rapid rise of Southeast Asia’s role in world trade in these commodities. Yet East Asia’s total share of world exports of labour-intensive products has not risen significantly since 1984; the rising Chinese and ASEAN shares have been balanced by declines in Japan and the NIEs (Garnaut and Huang 1995:25). This figure highlights the importance of continuing growth in China’s share of world markets and competitiveness in labour-intensive manufactures. At the same time as the share of capital-intensive manufactures is rising in China’s exports, so is China’s share in world markets for labour-intensive goods and it is


Figure 7.2 Share of labour-intensive goods in total exports, world and the East Asian economies, 1965–96 (per cent)

Source: Calculations based on the UN trade data from International Economic Databank, the Australian National University.

crucial to remember that it is that which provides the foundation for industrial upgrading. By implication, the further promotion of liberalisation, and entry to the WTO provide the best strategy whereby to secure continuing progress with industrial upgrading and avoid the same error in logic that lay at the base of the Great Leap Forward in an earlier era. IMPACT OF WTO MEMBERSHIP: SOME EMPIRICAL ESTIMATES There is a particular interest in the impact of WTO accession upon China’s textile and clothing industry and its access to international markets. The Agreement on Textiles and Clothing, under the Uruguay Round, represents a major step forward in trade liberalisation in the textile sector and, as the largest developing country supplier to world markets, China has the most to gain if the agreement is fully and expeditiously implemented. The Agreement is a transitional arrangement and provides a legal framework for phasing out MFA restrictions over a ten-year period from January 1995. At the end of this period textile goods should be subject to the same treatment as other goods within the WTO. The process has three phases and integration is heavily loaded towards the end of the transition period (Chapter 11). There is also a transitional safeguard arrangement and there remains an opportunity for discrimination against particular suppliers under this arrangement. Several studies reveal substantial benefits to China from phasing out the MFA (Trela and Whalley 1990; McKibbin and Salvatore 1994; Chapter 4; Anderson, Dimaranan, Hertel and Martin 1996; Chapter 11). These studies are premised,


Figure 7.3 Changing shares of some East Asian economies in world labour-intensive manufactured exports, 1965–96 (per cent)

Source: Calculations based on the UN trade data from International Economic Databank, the Australian National University.

however, on complete elimination of MFA quotas (which might not eventuate until 2005) and China’s membership of the WTO (which is necessary to guarantee full participation in the process). Some importers, such as Australia and Japan, do not participate in the MFA and provide non-quota restricted access to their markets for China and all suppliers of textile imports. It is noteworthy that in both these markets for textile and clothing products, China’s share of the market is two to three times as high as it is in the markets of other OECD countries—a measure of the extent to which China’s competitiveness in the textile trade is frus-trated by the MFA (Garnaut and Huang 1995; Drysdale, Song and Zhao 1995). Studies by Yang, Martin and Yamagashima (1997) and Zhong and Yang (Chapter 11) reveal large gains to China from WTO membership deriving from textile trade liberalisation. There are significant trade and welfare losses if China remains outside the process. The combined effects of the Uruguay Round and the elimination of the MFA, for example, would boost China’s output of clothing by 76 per cent, exports by 142 per cent and imports by 73 per cent. These are very significant gains. If China were not a participant but the benefits of liberalisation were extended to other suppliers of textiles and clothing, Chinese output would fall by 13 per cent and exports would fall by 27 per cent (Chapter 11: Table 11.4). The effect of liberalisation of textiles trade associated with WTO membership is to expand the clothing and textile sector relative to almost all other sectors of


the Chinese economy (Chapter 11: Table 11.5). Other studies (McKibbin and Salvatore 1994, and Anderson, Dimaranan, Hertel and Martin 1996) confirm the scale of the gain to China from WTO membership through the expansion of textile and clothing trade. Feng and Huang (Chapter 10) quantify the adjustments in Chinese trade and industry as well as in the rest of the world, for liberalisation under various policy scenarios, using a version of the GTAP model. They undertake three experiments involving: a unilateral tariff cut of 33 per cent in China (similar to that announced at the Osaka APEC meetings); a unilateral tariff cut plus a 1 per cent growth of productivity in China’s manufacturing; and a unilateral tariff cut by China, combined with 1 per cent growth of productivity in Chinese manufacturing and a 10 per cent tariff cut by other APEC members. The last simulation (Chinese tariff cuts combined with APEC trade liberalisation) is the most interesting in the present context because it explores the direction of policy change likely to accompany purposeful progress towards WTO accession. Whereas studies which focus on liberalisation in China alone tend to suggest a concentration of the gains in output and trade from liberalisation in the textile sector, this simulation records gains across a wider range of industry groups in China (including clothing, transport equipment, textiles and services) and a wider range of countries in the rest of the world. In China, the mining, iron and steel, machinery and agricultural sectors contract, with the contraction in agriculture being relatively modest (Chapter 10). These estimates do not suggest that output in these sectors will actually decline In a more competitive environment, but that the impact effect of the trade liberalisation is contractionary. Increased international competition typically stimulates higher productivity and latent growth potential. The effects on partner countries are also positive with predictable structural characteristics. Overall, China’s exports increase by 19 per cent and imports by 22 per cent, while household income rises by 3–4 per cent. In this experiment, the European Union, South Asia, Latin America and other countries, as well as APEC members all benefit positively from free trade in APEC. Feng and Huang note that, while the relative size of the contraction in agriculture is likely to be small, its absolute scale is likely to be large, requiring the exit of large numbers of farmers from agriculture. Lu’s (1996) work, on the other hand, offers the prospect of growth in intra-industry trade in processed foods and agricultural products and, thereby, draws attention to the opportunity for minimising adjustment problems with trade liberalisation in agriculture. This may also be a more prominent feature in other sectors than these studies tend to suggest. The models most commonly used to estimate the effects of trade liberalisation on output and trade tend to exaggerate the adjustment costs because they cannot easily capture the effect of shifts in intraindustry trade (Chen 1996). Other work (Chapter 9; Anderson, Dimeranan, Hertal and Martin 1996) confirms the main conclusions of these studies. Bach, Martin, and Stevens


(Chapter 9) point to very large welfare gains from liberalisation offered by China in the context of its negotiations for accession to the WTO, and from the reductions in protection negotiated under the Uruguay Round. They also demonstrate that entry to the WTO generates substantial benefits to China through the abolition of MFA quotas that strongly restrict China’s exports of textiles and clothing. Anderson et al. (1996) focus on the effects of WTO entry and other liberalisation measures on agriculture. Their results suggest that, in this sector, too much emphasis may have been placed on the grain trade in earlier work since the value of import growth and output growth in other sectors, such as other crops, meat and livestock and processed foodstuffs is likely to be very large. They also note that a large proportion of the gains from APEC trade liberalisation will be generated in agriculture and that fears about the effects of loss of agricultural land due to industrialisation are not warranted. While much work is still to be done on the processes and costs of adjustment to trade liberalisation, the careful empirical studies reviewed here suggest very large gains to China from entry to the WTO and make clear the impact effects of entry on the structure of trade and industrial growth. CONCLUSION Trade liberalisation and trade reform is a key component of China’s overall economic reform and modernisation program. So far it has proceeded unilaterally and generated a huge expansion of China’s role in world trade. The continuation of this important process, and of the international adjustment required to sustain it, cannot be taken for granted. There is clearly an important opportunity to reinforce the pace of trade and economic reform through China’s accession to the WTO. The protocols of accession must allow time for China to adjust policies to the full application of WTO rules and define the principal elements in the schedule of adjustment, if accession is to secure China’s reform objectives at the same time as satisfy China’s major economic partners that the momentum to full marketisation will be maintained. Much progress has already been made in the negotiations on accession, unilaterally by China, and within APEC. There are very powerful political reasons why it is both important and feasible to do a final deal on accession. The benefits to China and to the rest of the world of entrenching Chinese trade liberalisation are likely to be very large. Indeed, there is no single trade policy initiative likely to result in larger gains in international trade in the coming decade than China’s accommodation within the WTO.


NOTES 1 I am grateful to Professor Ross Garnaut, Dr Ligang Song and Dr Yiping Huang for comments on this chapter. I am especially grateful to Dr Weiguo Lu and Mr Xinpeng Xu for the statistical work. They, of course, bear no responsibility for any errors that remain. 2 This section and the next draw heavily on Drysdale and Song (1995).

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8 China's entry to the WTO: a general equilibrium analysis of recent tariff reductions1 Xiao-guang Zhang

INTRODUCTION Since formally lodging its application to rejoin the GATT in 1986, China has made serious efforts to accelerate its reform process to make its economic system compatible with GATT requirements. One such requirement is foreign access to China’s domestic market. China has long pursued a policy of protecting its national industries against foreign domination. In the pre-reform era, this protection was secured by a centrally planned and state-owned economic system. Foreign trading transactions were then dominated by a dozen large state foreign trading corporations. Trade between domestic firms and foreign companies had to be conducted through these state trading corporations. Domestic firms were completely insulated from the outside world. This system provided a secure environment for domestic industries. But the cost was a loss of productivity due to lack of competition and technology transfer, and resource misallocation due to price distortions. Since adoption of economic reform and opendoor policies two decades ago, central plans have been largely replaced by the market. During the economic reform period, China’s traditional policy of protection has undergone a three-stage transition. In the pre-reform years, China’s protection measures were dominated by direct controls over the prices and quantities of traded goods. Since the late 1970s, this direct plan control has been largely replaced by administrative control measures such as export and import licensing. Though they are still quantitative in nature, the move from control through planning to administrative control is a major step towards a less distorted protection system. As the domestic market expands to cover more products, and domestic producers become financially independent market entities, administrative controls over traded goods have begun to be replaced by value control measures, such as tariffs and other border charges. This shift moves China’s protectionist system away from quantitative constraints towards value measures that are consistent with internationally accepted codes of conduct and, therefore, more in line with GATT/WTO2 requirements. China has passed through the first two stages and is now moving towards the third stage. Some tax control measures have been implemented, along with

A GENERAL EQUILIBRIUM ANALYSIS OF RECENT TARIFF REDUCTIONS 121

remaining quantitative measures such as licences and quotas. Among them, tariffs are the most important. Nominal tariff rates were high in the pre-reform years. The average nominal tariff rate was as high as 52.9 per cent during this period.3 Since 1980, when the General Customs Administration was restored as a national administrative body,4 China has unilaterally reduced its import tariffs on many occasions. In 1985, a new customs regulation was passed in the National Congress and the Export and Import Tariff Schedule was comprehensively amended. Under the new schedule, nominal tariff rates have been reduced for many categories, reflecting the policy shift towards a more open economy. Immediately after the reform of the tariff system in 1985, the average tariff rate for imports to China was lowered to 38.4 per cent. After submitting its application for GATT membership in 1986, China accelerated the process of domestic market liberalisation. From March 1986 to 1991, 83 tariff lines in the schedule were cut. In 1992, when China converted its old customs classification of commodities into the Harmonised Commodity Description and Coding System (HCDCS) in an effort to make the system more compatible with GATT standards, the tariff rates for 225 items in the new schedule were reduced. By the end of 1992, the import tax rates for another 3,371 import categories were reduced. This covered 53.6 per cent of total tariff lines in the tariff schedule. The average nominal tariff rate was 39.9 per cent.5 The trade-weighted average of nominal tariff protection was also reduced by 7.3 per cent. In 1993, the tariff rates for 2,898 items in the tariff schedule were reduced, which lowered the average tariff rate to 36.4 per cent. The trade-weighted average rate of import tariffs during this period was estimated to be between 22.5 per cent (Ju and Wu 1993; Editorial Committee 1993) and 28 per cent (Chen, Lin, Yuan and Du 1993). Despite the dramatic decline in tariff barriers, the average tariff rate was still regarded as too high to justify full GATT membership for China. In 1990, for instance, the average rate of nominal import tariffs was 5.84 per cent in Japan, 8. 13 per cent in the European Economic Community (EEC), 11.4 per cent in Korea and 10 per cent in Taiwan. Since the establishment of the GATT 50 years ago, after seven rounds of tariff negotiations, the average rate of import tariffs in developed country members has been reduced from 36 to about 5 per cent. The average tariff protection for developing country members is about 13 per cent (Ju and Wu 1993). With the successful completion of the Uruguay Round, the tariff rates of GATT/WTO member countries are expected to fall even further. To gain membership, China needs to contemplate even more drastic tariff cuts. The target will be to reduce the average tariff rate to at least 13 per cent. This implies that China’s current nominal tariff levels will have to be halved, on average. The Chinese government has expressed its readiness to meet this requirement. During its negotiation with the GATT contracting parties in September 1994, the government made a commitment to a target tariff rate of 19.2 per cent and the abolition of two-thirds of import licences in three years. The proposal implied a decline of 56.9 per cent from China’s 1993 average tariff rate in the space of three years. This promise was fulfilled by two rounds of large-scale tariff


reductions in the following three years. In 1995, President Jiang Zemin announced at the APEC heads-of-government meeting that China would cut import tariff rates by 30 per cent in the following year. In April 1996, the tariff rates for 4,944 items on the import tariff schedule were reduced significantly. China lowered the average tariff rate from 36.4 per cent to 23.2 per cent. The trade-weighted rate was estimated to have been reduced to 18 per cent.6 The second round of tariff cuts was implemented in October 1997. This time, tariff rates on 4,874 of a total of 6,633 items on the current tariff schedule were reduced, which further lowered the average import tariff rate to 17 per cent, an average rate of reduction of 26 per cent.7 These two large-scale tariff cuts more than halved China’s average tariff rate in less than two years. What impact would further large-scale tariff cuts and domestic market liberalisation have on the economy? This has been the subject of intense debate among Chinese economists and policy makers. Two factors underlie China’s recent decisions on large-scale tariff reductions. First, during the reform period, China’s foreign trade has expanded rapidly: exports have grown consistently at an annual rate of 16 per cent in current US dollars. Especially in recent years, the current account has enjoyed a continuous surplus and foreign exchange reserves reached a record level of more than US $130 billion in 1997. In addition, the domestic currency has already been made partially convertible on current account and the exchange rate is now determined in an inter-bank exchange market. The combination of an adequate foreign exchange reserve and a flexible, though partial, exchange rate mechanism has created favourable conditions for market liberalisation. Second, the actual impact of the proposed tariff cuts may be substantially discounted by widespread tariff exemptions. Tariff exemptions have been used by provincial governments and authorities in special economic zones as an important measure to attract foreign investors since the early years of reform. Under the existing regulations, imports associated with technology transfer and foreign investment in joint-venture and export-processing activities are assessed at a lower tariff rate or even a zero tariff rate. With the recent growth of foreign direct investment in China, the volume of tariff-exempt imports has expanded dramatically. The import duties actually collected by Customs are much lower than the levels suggested by nominal tariff rates. Taking these exemptions into account, the impact of large tariff reductions may be much less than it would appear at first glance. Nonetheless, such large-scale tariff cuts are bound to have important economic consequences. At the sectoral level, export-producing industries might benefit and import-competing industries suffer from a sharp fall in tariff barriers. To account for the likely outcomes of tariff reduction, we need to consider not only the direct impact of the cuts on the industry affected, but also the indirect impacts on related industries and other parts of the economy, such as household consumption, the budget and the current account.


This chapter is intended to contribute to the current policy debate by providing a general equilibrium analysis of China’s tariff reductions in recent years. The analysis is undertaken with a computable general equilibrium (CGE) model. The model is a simplified version of a dynamic CGE model of the Chinese economy (Zhang 1997). The original model was designed to forecast growth and structural changes in the Chinese economy. It can also be modified to undertake a wide range of policy simulations, including trade policy reforms. While dynamic models can be used to analyse trade policies, static CGE models are often preferred. A major advantage of static models over dynamic ones is their simplicity and the comprehensibility of their simulation results. This is often what policy makers are interested in. In this chapter, the dynamic features of the original model are removed in order to simplify the model structure and highlight the most important outcomes of tariff reductions in key sectors of the economy. After a brief outline of the model structure and database, the simulation results are reported and elaborated in detail, with policy implications. A SUMMARY DESCRIPTION OF THE MODEL The model used in this chapter was designed to portray the Chinese economy as it was in 1994, just before the tariff cuts. Attempts have been made in the literature to model the transitional Chinese economy (Martin 1992; Zhang 1998). However, these models are based on the Chinese economy in the late 1980s, in which central plans remained prominent and a dual-track price system was in place. Since then, great changes have taken place in China. The current Chinese economy is much more market oriented than it was in the 1980s. The plan domination in the economy has fallen rapidly. By the end of 1993, goods sold at prices set under the state plan accounted for about 10 per cent of total retail sales, 15 per cent of agricultural procurement and 20 per cent of industrial outputs valued at ex-factory prices. About 80 per cent of imports were priced by negotiation between importers and domestic end-users. Only the central government’s importation of eight categories of goods, mainly grains and chemical fertilisers, continued to be subsidised. About 90 per cent of exportables were purchased at domestic market prices (Ma 1993). As a result, the conventional signal-price structure is more suitable than a dualprice one for modelling the current Chinese economy. Based on the considerations above, the model divides the Chinese economy into 22 industries or sectors and allows each industry to produce one type of good or service for domestic use or export, using as inputs domestic and imported goods, labour, capital and land. It specifies the behaviours of producers of traded and non-traded goods, consumers (represented by an aggregated household) and the government.8 The multi-input, multi-output production specification is kept manageable by a series of separability assumptions, illustrated by the nesting in Figure 8.1.


Figure 8.1 Current production structure

Source: Author’s own description.

At the top level, domestically produced and imported goods form composite goods through a CES (constant elasticities of substitution) function. It follows the Armington assumption (1969) that imports are imperfect substitutes for domestic supplies. The composite goods are then used either by domestic industries as intermediate inputs or by households or government in final consumption and investment. For each industry, the required composite intermediate inputs are combined using a Leontief production function. Demand is in direct proportion to the total output of the industry. The primary factor composite for a given industry is a CES aggregate of capital, labour and land. Demand for factors depends on the output level of the industry, the factor returns and the elasticity of substitution between factors. At the bottom level, industrial


outputs supplied are a CET (constant elasticities of transformation) composite of domesti-cally produced and exported goods and services. To complete the production structure, the supply of and demand for domestically produced goods and services must be equal in order to clear the markets. The demand for each primary factor must equal its supply in all industries. Although all industries share a common production structure, they may be differentiated by input coefficients and behavioural parameters. Prices of total outputs from industries are determined by zero profit conditions, which equate total revenue with total costs in each industry. The above system is linked with the rest of the world through imports and exports. Given that China is a large trading nation, the world’s import supplies and export demands are unlikely to be infinitely elastic. The supply of imported goods is therefore defined as a function of the world price of imports. Similarly, the demand for China’s exports is a function of world prices. Domestic prices of traded goods are determined by imposing zero profit conditions on importing and exporting activities. The markets for exports and imports are both cleared in equilibrium. China’s trade regime needs to be modelled carefully. The trade regime and system of protection used to be more complicated, due to export incentive measures and residual planning measures. These included the state export monopoly, the foreign exchange retention scheme and export subsidies. The trade regime was transformed dramatically in the 1990s. In January 1991, China abolished all export subsidies and implemented a tax rebate scheme as an alternative means to encourage exports. Between 1992 and 1994, direct fiscal subsidies for exports were abolished and gradually replaced by an export tax rebate system. This system was extended in 1994 to cover all exported goods, except a few products, such as crude oil, which remained subject to centralised price controls. The foreign exchange regime was also transformed during this period. In 1992, the export retention system remained in operation, but export revenues could be partially retained by foreign trade companies and export producers. The retained foreign exchange was tradable in local foreign exchange swap markets. As a result, in 1992, China actually had two types of exchange rate: an official rate and many much higher local swap market rates. This dual exchange rate system was phased out in 1994 with the commencement of a new round of financial reforms. The two exchange rates were unified and a national inter-bank foreign exchange market was established. The uniform foreign exchange rate was determined on the inter-bank exchange market. The government no longer directly sets foreign exchange rates, but may exert an influence through foreign exchange trading. All these changes seem to justify the adoption of a conventional specification for a trading system based on the model structure commonly used for market economies. It is assumed in the model, therefore, that the domestic price of imports equals its world price multiplied by the exchange


rate plus import tariffs, while the domestic price of exports equals the world price multiplied by exchange rate minus its tax rebate. Five types of final demand for composite goods are distinguished in the model: household consumption, government expenditure, investment, inventory and others. Household consumption demands for composite goods are derived from the conventional utility maximisation problem subject to the household’s expenditure constraints. Nominal household expenditure is determined by nominal household income and the average propensity to spend. Household demand for composite good i is therefore a function of household expenditure and the prices of all goods including i itself. Expenditure elasticity and own- and cross-price elasticities are used in the equation as parameters. The government demand for composite good i is assumed to be related to the total expenditure of the household, while other demand for a composite good is linked to the aggregate demand for that good. In addition to consumption, two types of investment are identified in the model: fixed capital investment and inventory investment. The latter forms a significant portion of variable capital investment. The allocation of investment funds to a particular sector is driven by that sector’s capital returns relative to average capital returns for the whole economy. Nominal household income is composed of wages, capital returns (depreciation and profits) and returns to agricultural land. A portion of household income is spent on consumption goods and services, while the remainder is private savings. The split of household income between consumption and saving is determined by the average propensity to spend. The fiscal sector is modelled to capture the impact of tariff changes on the budget. The government collects revenues from various taxes on goods and services. Four major taxes are included in the model: value-added tax, corporation tax, import tariff and export tax rebate. After the 1994 taxation reform, value-added tax replaced turnover tax to become the single most important source of revenue for the government. The 1994 taxation reform also unified corporation tax rates for domestic and foreign-invested firms. Import tariffs constitute another source of government revenue, though they account for only a small portion of total revenue.9 For exported goods, the government returns value-added tax revenue to the producers. Such tax rebates are an outlay for the government. The balance of the budget is public savings. The above sectoral variables for quantities and prices of goods and factors can be readily aggregated to form various macroeconomic indicators for output, income and price indices. DATABASE AND PARAMETERS The model database was constructed around China’s 1992 input-output table. It was aggregated from the original 118 sectors into 22 sectors and then updated to 1994 to incorporate the latest developments in the Chinese economy. The basic structure of the database is shown in Figure 8.2. The database is an extended


Figure 8.2 Database structure

Source: Author’s schema.

input-output table, which includes the current flow table (area AA in the figure) and capital formation tables (AB and AC).10 The capital formation tables show the commodity composition of investment and inventory in each industry. From 1992 to 1994, the Chinese economy almost doubled in size with substantial structural changes taking place. Many new policies were implemented in various sectors of the economy. The construction of the model database was carried out using additional statistical information from various Chinese sources.11The changes in the basic structure of the Chinese economy between 1992 and 1994 are summarised in Table 8.1. Chinese GDP increased by 27.4 per cent in real terms during this period while, in nominal terms, it nearly doubled (1.85 times). The share of investment and inventory in GDP increased slightly. In 1992, 36.2 per cent of GDP was invested while 62.3 per cent was consumed. In 1994, 39.8 per cent of GDP was invested while 58.2 was consumed. In regard to production, in 1992, 61 per cent of gross output was used as intermediate inputs, while in 1994 it rose to about 62.3 per cent. The sectoral demands for intermediate inputs were upgraded on the basis of the 1992 input-output table (State Statistical Bureau 1996) using the RAS approach. To carry out the bi-proportional adjustments of the rows and columns of the input-output table required by the RAS approach, the 1994 gross output and gross domestic product (value-added and final goods) for each sector were needed as control variables. These were estimated using data from various statistical sources (State Statistical Bureau 1995; Office of the National Census


Table 8.1 Gross output and gross domestic product by sector in China, 1994 (100 million yuan)

Source: State Statistical Bureau of China, Statistical Yearbook of China 1995 (Zhongguo tongji nianjian 1995), China Statistical Publishing House, 1995, Beijing.

on the Tertiary Industry 1995). The resulting sectoral gross outputs, value-added and final demands are shown in Table 8.2. Many important reform measures that had been introduced and implemented between 1992 and 1994 need to be incorporated into the model database. Here, we briefly outline the part of the database that is related to external trade. In the Chinese input-output table, only net export values are presented. To restore exports and imports for individual sectors and the protection structure, additional information is needed. The US dollar fob (free on board) values of exports and cif (cost insurance freight) values of imports are collected and aggregated from over 6,000 8-digit HCDCS items in the trade statistics compiled by the Customs General Administration of China (1993). The growth rates of individual tradable goods between 1992 and 1994 were then estimated (State Statistical Bureau 1995) and used to upgrade the values of exports and imports to 1994. The US dollar values of exports (fob) and imports (cif) are seen in the first two columns of Table 8.3.


Table 8.2 China’s macroeconomic indicators, 1992 and 1994 (100 million yuan)

Note: Figures are in current prices. Sources: State Statistical Bureau of China, Input-Output Table of China 1992, China Statistical Publishing House, 1996, Beijing; State Statistical Bureau of China, Statistical Yearbook of China 1995 (Zhongguo tongji nianjian 1995), China Statistical Publishing House, 1995, Beijing.

The nominal ad valorem tariff rate for each import category in the model is the import value weighted average of the tariff rates for individual commodities included in that category. For non-merchandise imports in sectors 15–22, a minimum tariff rate of 3 per cent is applied. The trade-weighted average of tariff rates for total imports in 1994 was about 21.8 per cent. However, the use of ad valorem tariffs as the import protection structure needs justification. In addition to tariffs, China has yarious non-tariff barriers on a wide range of imports. These restrictions certainly push up the domestic market prices of traded goods which calls for a upward adjustment if nominal tariff rates are used as the main protection measure. However, the exact magnitude of the ad valorem tariff equivalence of non-tariff barriers for each traded good is difficult to estimate. More importantly, in recent years NTBs have gradually been removed in favour of more transparent protection measures such as tariffs. As discussed above, a more serious problem with the use of nominal tariff rates is the widespread practice of tariff exemptions. This has substantially reduced the import duties actually collected by the Customs authorities over the past decade. In 1994, for instance, China’s total tariff revenue was 30 billion yuan, which accounted for just 2.7 per cent of the value of total imports in that year. The ratio was 10 per cent ten years ago. The use of nominal tariff rates would substantially overestimate China’s trade barrier. To take tariff exemptions into account, the tariff rates derived from the official tariff schedule need to be scaled down. Due


Table 8.3 Values of exports and imports and import tariff rates in China, 1994

Note: Exports and imports are in US$ million and tariff rates are in percentages. Sources: Customs General Administration of the People’s Republic of China, Annual Customs Statistics of the People’s Republic of China 1994, Beijing, 1995; The Customs Import and Export Tariff Schedule of the People’s Republic of China (Zhonghua renmin gongheguo haiguan jinchukou shuize) in State Administration of Taxation, A Collection of Taxation Regulations (Shuifa daquan), 1992, Zhongguo Caijin Publishing House, Beijing.

to lack of information on the commodity composition of duty exemptions, however, it is assumed that all imported goods received the same treatment. All tariff rates were scaled down by the same proportion to make the revenue generated equal to about 4 per cent of the value of total imports.12 The results are shown in the last column of Table 8.3. Most models’ parameters are cost shares which can be readily derived from the database. The settings for other parameters such as various demand and supply elasticities in regard to traded goods and primary factors were mainly drawn from existing CGE models. The CES elasticities of substitution between primary factors and the household demand elasticities were taken from the database for the dynamic version of the China model (Zhang 1997). Due to lack


of any empirical estimates, trade-related elasticities were uniformly set within the range commonly used in other CGE models. The elasticities of the world’s import supplies to China were set at 4, and those for export demand at −5. The CET elasticities of transformation between goods destined for domestic or export markets were set at 2. ‘Armington’ elasticities of substitution between domestic and imported goods were set at −5.13 MODEL CLOSURE AND SHOCKS The model is composed mainly of the behavioural equations of individual economic agents. It is a microeconomic model. The macro-conditions in which micro-agents react with each other must be set exogenously. This is achieved by the application of so-called ‘macro-closures’. Different macro-closures affect the behaviours of economic agents and lead to different projections. The simulation discussed below is conducted with the short-run assumption of fixed total capital stocks, fixed average real wage rates (indexed to the household consumption price index), a slack labour market and fixed average household propensity to spend. The exchange rate was chosen as the numeraire. The experiment is designed to show the effects of policy changes over a period of two or three years. The model simulation used the GEMPACK software (Codsi and Pearson 1988). Table 8.4 presents the percentage reductions in nominal tariff rates in two recent rounds of tariff cuts for all 15 traded good producing sectors. These tariff rate changes were estimated from two highly disaggregated (over 6,000 items) recent customs tariff schedules (Office of Tariff Rate Committee of the State Council and the Tariff Department of the General Customs Administration 1996; 1997). It can be seen from the table that, with the exception of crude petroleum and electricity and water, all tradable goods received tariff cuts in the past two years. The trade-weighted average tariff reduction in 1996 was 17.32 per cent while in 1997 it was 12.06 per cent. Most tradable industries received quite a large tariff reduction during this period. Some reductions were as high as 62 per.cent. The following simulation presents the results of the tariff reductions outlined above. This exercise is intended merely to reveal the response mechanisms of the economy rather than to provide accurate projections. Another reason accurate projections cannot be provided is that the values of the trade elasticities used in the model are not based on empirical studies using Chinese data. Nevertheless, the results should enhance our understanding of the nature and the operation of the current Chinese economy. SIMULATION RESULTS As the tariff on imported goods is reduced significantly in this experiment, many highly protected industries experience a strong tariff shock. The immediate impact of the tariff cut would be a fall in import prices in almost all tradable


Table 8.4 China’s recent import tariff reductions, 1996 and 1997

Sources: Office of Tariff Rate Committee of the State Council and the Tariff Department of the General Customs Administration, Export and Import Tariff Regulation of the People’s Republic of China 1996 (Zhonghua renmin gongheguo jingchukou guanshui tiaoli), Law Publishing House. Beijing, 1996; Office of Tariff Rate Committee of the State Council and the Tariff Department of the General Customs Administration, Tabulation of lmport and Export Tariff Rate Adjustments (Jingchukou guanshui shuilu tiaozhengbiao), Law Publishing House, Beijing, 1997.

good-producing sectors. Domestic import-competing sectors are therefore expected to contract to the extent that their output prices decline which, in turn, depends on their substitutability with imports. However, as imported intermediate inputs become cheaper, the costs of domestically oriented goods and exports will decline and exports will gain competitiveness in the world market. Export-competing sectors will expand. Which impact will eventually dominate, contraction or expansion, can only be determined by taking into account all the indirect effects such as resultant changes in the real foreign exchange rate, aggregate supply and demand, the current account balance, household income, the budget deficit and their impacts on sectoral outputs and employment. The simulation results of a combined tariff cut from these two rounds of reductions on the China CGE model are presented below. A summary of the simulation results on the economy as a whole is reported in Table 8.5. In general, the simulated overall effects of tariff cuts are beneficial. At the macroeconomic level, the tariff cut liberalises imports and hence stimulates the market demand for foreign currencies. As a numeraire, the nominal exchange rate is fixed and not responsive. Instead, the general level of domestic prices is forced down and the domestic currency is effectively depreciated. The real exchange rate rises by 1.17 per cent. The real depreciation of the yuan raises the


Table 8.5 Simulation effects on aggregate indicators (per cent)

Source: Author’s simulation.

domestic price of imports and, to some extent, offsets the expansionary effects of tariff cuts on import demands. Compared with imported goods, domestically produced goods become relatively cheap. Domestic demands hence shift from imports to domestically produced goods. If the relative price changes are large enough, the demand for imports will actually decline relative to that for domestically produced goods. This is what happened in the simulation: imports declined by 1.43 per cent. The real depreciation of the yuan or a decline in domestic prices also helps lower the costs of, and raises the return to, production for domestically-oriented goods and exports. The domestic price of exportables becomes high relative to the price of domestically-oriented goods and imported goods. It results in an expansion of exports: export volume increases by 3.17 per cent. Despite a decline in the output of domestically-oriented goods, increases in exports more than offset the decline in domestic output. The total output increases slightly, by 0.04 per cent. The strong Increase in exports and a fall In import demand also help to improve the current account balance. The key to understanding these results is a decline in domestic prices or a depreciation of the real exchange rate, in response to reduced protection, of 1.17 per cent. The cause of this real exchange rate depreciation is that the reduction of tariff levels increases the demand for imports. The increase in the real exchange rate in turn causes an expansion of export production because it makes production for export more profitable. Export-oriented industries are generally more labour intensive than import competing industries, which contract in response to reduced protection levels. Consequently, the aggregate demand for labour rises. The fixed real wage and slack labour market assumptions mean that employment levels rise, which is the principal source of the increase in real GDP. At the sectoral level, as shown in Table 8.6, the increase in exports is mainly concentrated in manufactured products. Among them, the export of textiles and


Table 8.6 Simulation effects on sectoral indicators (per cent change from the base year)


clothing expands by over 4.4 per cent, the highest among all industries. As the prices of some imported goods become expensive relative to domestically produced goods, trade-oriented industries tend to use less imported and more domestic products as their inputs. The supplies of domestically produced outputs decline at a slower pace than imports. Export growth, on the other hand, is much stronger than the decline of domestic output in all sectors. Therefore, most sectors experience an expansion of gross outputs. Total real gross output increases by 0.04 per cent. It should be noted that the predicted changes in trade and domestic production in Table 8.6 were based on the assumption of uniform elasticities of world export demands and import supplies as well as the ‘Armington’ and CET elasticities between traded goods and domestically produced goods. These specific settings reduce the inter-commodity variations in the predicted responses of the economy to the tariff reductions. Although altering these parameters will not change the overall results, to provide more accurate predictions at the sectoral


Table 8.7 Simulation effects on the government budget (per cent)


level, more empirical analysis is needed to estimate these important trade-related elasticities. The expansion of outputs in most sectors increases the demand for labour. Total employment rises by 0.23 per cent, higher than the rise in output. This implies that labour-intensive manufacturing industries, on average, are the major beneficiaries of tariff reduction. Although some highly protected or non-traded labour-intensive industries suffer a decline in output and employment, the increase in employment in other expanding industries seems to be more than enough to make up for the loss of employment in those which contract. The rise in employment is also a major contributor to the 0.85 per cent increase in real household income because wages are the main source of household income. As expected, the tariff cut has a negative impact on the budget, as can be seen in Table 8.7. The tariff cut and subsequent decline in imports reduce import tariff revenue to the government while export growth increases payments for export tax rebates. The nominal revenues from value-added tax and corporation tax are also expected to decline. If the decline in domestic prices is taken into account, however, the expected decline in government net real revenue is only marginal: less than a half of one per cent. This indicates that the decline in revenue from the external sector could be largely compensated by possible increases in revenues from the growth of real domestic output. The budget deficit resulting from tariff revenue reduction could be manageable. To test the robustness of the simulation results, some sensitivity analyses were carried out in which alternative trade-related elasticities were used. It is revealed that an increase in the elasticities of the world’s import supplies or export demands would lower the domestic price level while a decrease in these elasticities would increase the domestic price level. However, price relativities between domestically produced goods and traded goods remained largely unchanged. As a result, domestic producers and consumers would not alter their resource allocation decisions in response to the tariff reduction. The macropredictions remain virtually unchanged. These sensitivity analyses show that the


main results from the simulation are rather stable. These findings, however, do not rule out the possibility of individual industries responding differently to tariff reduction if their trade-related elasticities were estimated and distinguished. Future research should focus on how to identify these important elasticities because these sectoral responses are as important as, if not more important than, macro indicators to policy makers in their formulation of trade reform policies. CONCLUSION This chapter has presented the results of a short-run simulation of China’s recent tariff reductions in a general equilibrium framework. The main conclusions to be drawn from the simulation can be summarised as follows. The tariff cut is projected to depreciate the real exchange rate, increase the domestic price of imports and reduce the costs of domestically produced goods. This will, in turn, restrain the demand for imports stimulated initially by tariff cuts, and allow domestic import-competing industries to survive. More importantly, the reduction in domestic costs relative to world prices caused by the cuts significantly increases export profitability. This generates increases in export revenues and in output and employment in export-producing industries. The model projects that these expansionary effects in the export sector more than outweigh the contraction in the import-competing sector. Thus, both employment and the trade surplus are expected to rise. The central source of these results is an increase in the real exchange rate and the subsequent expansion of labour-intensive exports. In the past two years the Chinese economy has experienced high growth and declining inflation. The tariff reductions of 1996 and 1997 seem to have had little impact on the macro performance of the economy so far. The available statistics on the performance of the recent Chinese economy seem to confirm the main predictions of the model. Between 1996 and 1997, the Chinese economy grew at an annual rate of between 8 and 9 per cent. Exports continued to grow strongly while imports remained relatively stable. Although it is still too early to call for a full assessment of the impact of recent tariff reductions on the economy, the predictions of the model seem to indicate a beneficial result overall. Such a prospect would facilitate further liberalisation of the economy and eventually prepare China for full membership of the WTO. NOTES 1 This chapter is partially based on Zhang and Warr (1995). Here, however, the model has been completely restructured and upgraded. In addition, the tariff shocks are redesigned to take China’s latest trade policy changes into account. The research on modification of this model was in part supported by the Australian Research Council.


2 The GATT was replaced by the World Trade Organisation (WTO) in 1995, after the completion of the Uruguay Round trade negotiation. 3 For details see Customs Import and Export Tariff Schedule of the People’s Republic of China (Zhonghua renmin gongheguo jingchukou shuize), compiled by the Department of Customs Administration at the Ministry of Foreign Trade (1961). 4 During the pre-reform period, the Customs Administration was only a division within the Ministry of Foreign Trade. 5 The average tariff rate under the HCDCS was higher than that under the old customs classification system due to an increase in the number of items in the HCDCS which attract higher tariff rates. 6 For details about this round of tariff reductions, see Import and Export Customs Tariff Regulation of the People’s Republic of China (Zhonghua renmin gongheguo jingchukou guanshui tiaoli) compiled by the Office of Tariff Rate Committee of the State Council and the Tariff Department of the General Customs Administration (1996). 7 For details about the reductions, see Tabulation of Import and Export Tariff Rate Adjustments (Jingchukou guanshui shuilu tiaozhengbiao), compiled by the Office of Tariff Rate Committee of the State Council and the Tariff Department of the General Customs Administration (1997). 8 A full set of model equations (in percentage change form), variables and coefficients is referred to in Zhang (1997). 9 Tariff revenue accounted for only 4 per cent of total revenue in 1996. 10 These tables are also referred to as the B matrix compared with the A matrix of the current flow table. 11 For a detailed description of the model’s database, see Zhang (1997). 12 This ratio is still higher than the actual duty collection ratio of 2.7 per cent in 1994. 13 Sensitivity analyses were undertaken and it was found the magnitude of these elasticities would not change the macro results of the following policy simulation. For details, see the discussions below.

REFERENCES Armington, P. (1969) ‘A theory of demand for products distinguished by place of production’, IMF Staff Papers, 16(2):179–201, IMF. Chen Yuanzhong, Lin Xiaomao, Yuan Chaoshen and Du Bocheng (1993) The GATT and the Chinese Market (guanmao zhongxieding yu zhongguo shichang), Beijing: Haichao Publishing House. Codsi, G. and K.R.Pearson (1988) ‘GEMPACK: general-purpose software for applied general equilibrium and other economic modellers’, Computer Science in Economics and Management, Vol.l:189–207. Customs General Administration (1993) Annual Customs Statistics of the People’s Republic of China 1992, Beijing. Department of Customs Administration at the Ministry of Foreign Trade (1961) Customs Import and Export Tariff Schedule of the People’s Republic of China (Zhonghua renmin gongheguo jingchukou shuize), Beijing: Law Publishing House.


Editorial Committee (1993) The GATT Manual (guanmao zhongxieding shiyongyewu quanshu), Beijing: Qiye Guanli Publishing House. Ju Jinwen and Wu Li (eds) (1993) A Practical Guide to the GATT (Guanmao Zhongxieding shiyong zhishi quanshu), Beijing: Zhongguo Wuzi Publishing House. Ma Song (1993) ‘The GATT and China’s prices’ (Guanmao zhongxieding yu zhongguo jiage), Guizhou Daily (Guizhou ribao) I5 January. Martin, Will (1992) ‘Effects of foreign exchange reform on raw wool demand: a quantitative analysis’, in Christopher Findlay, ed., Challenge of Economic Reform and Industrial Growth: China’s Wool War, Sydney: Allen & Unwin. Office of Tariff Rate Committee of the State Council and the Tariff Department of the General Customs Administration (1996) Import and Export Customs Tariff Regulation of the People‘s Republic of China 1996 (Zhonghua renmin gongheguo jingchukou guanshui tiaoli), Beijing: Law Publishing House. Office of Tariff Rate Committee of the State Council and the Tariff Department of the General Customs Administration (1997) Tabulation of lmport and Export Tariff Rate Adjustments (jingchukou guanshui shuilu tiaozheng biao), Beijing: Law Publishing House. Office of the National Census on Tertiary Industry (1995) The First Census on Tertiary Industry in China 1991–1992: Summary Statistics (Zhongguo shouci disan chanye pucha ziliao zhaiyao 1991–1992), Beijing: China Statistical Publishing House. State Administration of Taxation (1992) The lmport and Export Customs Tariff Schedule of the People’s Republic of China (Zhonghua renmin gongheguo haiguan jinchukou shuize), in A Collection of Taxation Regulations (Shuifa daquan), Beijing: Zhongguo Caijin Publishing House. State Statistical Bureau of China (1995) Statistical Yearbook of China, Beijing: China Statistical Publishing House. State Statistical Bureau of China (1996) An Input-Output Table of China, 1992(1992 niandu zhongguo touru chanchu biao), Beijing: China Statistical Publishing House. World Bank (1993) China Foreign Trade Reform: Meeting the Challenge of the 1990s, Report No. 11568-CHA, Washington DC. Zhang Xiao-guang, and Peter G.Warr (1995) ‘China’s re-entry to the GATT: A general equilibrium analysis of tariff reduction’, in ‘China and East Asia Trade Policy’, Pacific Economic Papers, 3(250). Zhang Xiaoguang (1997) ‘A Dynamic Computable General Equilibrium Model of the Chinese Economy’, Research Paper no. 567, Department of Economics, University of Melbourne. —— (1998) ‘Modeling economic transition: A two-tier price computable general equilibrium model of the Chinese economy’, Journal of Policy Modeling, 20(2).

9 China and the WTO: tariff offers, exemptions and welfare implications1 Christian F.Bach, Will Martin and Jennifer A.Stevens Spatz

INTRODUCTION The tremendous growth of China’s exports over the past fifteen years has turned the country into one of the most important players in the world market. This position has served to underline the importance of China’s ongoing negotiations for membership of the WTO. China’s offer for WTO membership involves substantial reductions in tariffs and non-tariff barriers (NTBs) in one of the world’s largest and most rapidly expanding markets. A traditional Computable General Equilibrium (CGE) assessment of the gains from liberalisation in China typically leaves out two important features. The first is the effect of the variation in the disaggregated tariff information on the shocks imposed on the aggregated level in the CGE model. The second factor is the often ignored effect of the extensive duty exemptions provided by China for export processing activities, and for investment goods used by joint ventures. In addition to providing information on two recent Chinese tariff offers to the GATT/WTO and applying a standard CGE approach to evaluating their effect, we outline and apply procedures to capture both the effect of variation in the disaggregated tariff information and the effect of tariff exemptions. The chapter builds upon the recent literature on trade restriction measures. TRADE REFORMS AND TARIFF OFFERS IN CHINA Recent trade reforms The past fifteen years have seen enormous changes in China’s foreign trade policies. Foreign exchange controls have been relaxed, the number of products under controlled, quota-restrained or licensed foreign trade has decreased, export subsidies have been removed, import duties have been reduced extensively, and many regulations on foreign investment have been abolished. These policy changes have taken place in a period where foreign trade has grown at double digit rates. In the past fifteen years, the volume of Chinese exports has grown at


some 15 per cent annually, against a world average of about 8 per cent (World Bank 1995). In 1994 exports grew at an astonishing 31.9 per cent, while import growth decelerated to 11.2 per cent following depreciation (China Trade Report 1995). China is now the tenth largest trading nation in the world and its domestic market is reaching enormous proportions. On the import side, a broad range of NTBs remain in force. It is estimated that in 1992,2 all non-overlapping NTBs (not including mechanisms to control access to foreign exchange) taken together applied to 17.5 per cent of the total number of lines of the Harmonised System (HS) Customs Tariff Schedule and accounted for 51.4 per cent of total import value. On the export side, the role of planning has decreased. All mandatory export planning was abolished in principle in 1991, although some exports are still channelled through designated companies. In 1992 export licensing was used for 676 HS commodity groups accounting for over 15 per cent of China’s exports. Furthermore, there are indications that China has expanded the use of export taxes over recent years (World Bank 1994). While planning remains an important feature of the Chinese economy, a key change in the reform period is that market prices now play a major role in guiding the allocation of resources. This change was not brought about by privatisation of state enterprises but by the introduction of two-tier pricing, in which enterprises gained the freedom to determine the quantity they produced above a plan quota (Wu and Zhao 1987; Sicular 1988). In these circumstances, it seems reasonable to adopt a market-oriented model to assess the implications of trade reform, instead of the demanding process of adjusting input-output tables to marginal prices followed in earlier studies (Martin 1993; Martin, Findlay and Watson 1994). This is further justified by foreign exchange system reforms introduced in early 1994 where the dual exchange rate system was unified, together with an effective nominal devaluation of 7 per cent. The current foreign exchange system can now be characterised as a managed float (World Bank 1995). Chinese tariff offers to the WTO Given the pace of reforms in China, a new dataset is appropriate to give an adequate picture of the structure of protection prior to implementation of the Uruguay Round (UR) offer. The basic data on applied tariff rates used in the analysis is the UNCTAD TRAINS 1993 database which provides 1992–93 tariff information at the 8-digit HS level and 1992 trade data at the 6-digit HS level (UNCTAD 1994). This information was used together with the information in two schedules of tariff bindings offered in negotiations on entry to the WTO. The first offer was submitted with the Final Act of the Uruguay Round in April 1994 and a revised offer was made in September 1994. Neither of the two offers had been accepted at the time of writing but they provide the basis for the ongoing negotiations. To our knowledge, this study is the first to use the actual

TARIFF OFFERS, EXEMPTIONS AND WELFARE IMPLICATIONS 141

informa tion in the schedules in an estimation of the effect of China’s entry into the WTO. The dataset, which contains nearly 35,000 bilateral lines of tariff and trade information, was aggregated to the 10 commodities and 15 regions used in the model. The individual tariffs were weighted using imports in 1992. Special aggregation procedures were used for the composite regions and for the cases in which no trade but high tariffs could lead to unintended results. The data do not include the non-tariff measures, such as import licensing and quotas, seen for instance on a number of agricultural products, especially wheat, rice and other grains. The TRAINS dataset displays zero tariffs on grains. One possible alternative would be to include the base rates in the schedule as an indication of the tariff equivalents of the non-tariff measures. Clearly, however, these rates have been set consistent with the ceiling binding option, which allows tariff bindings to be set well above previously applied rates. The base rate in the second schedule for wheat and rice is 80 per cent (150 per cent in the first schedule) while price comparisons show negative protection in 1992 (Garnaut, Cai and Huang 1995; Cheng 1994). We chose to use the zero protection rates on grains as the starting point in the present work, since tariff bindings do not discipline negative protection. Note also that neither the TRAINS dataset nor the schedules contain any information on protection rates in the service sectors. Throughout the analysis we use the tariff data to represent the protective effect of China’s trade regime, omitting the consequences of liberalising NTBs. Reforms of the trade regime announced in 1992 reduced the coverage of licensing to an estimated 7 per cent of imports, although 32 per cent of imports would continue to be channelled through specific firms. Price comparisons for 1992 suggest that these NTBs resulted in substantial rates of additional protection for a relatively small set of goods (World Bank 1994). Estimates of protection cuts based on changes in the tariff schedule overstate the protection cuts for goods subject to effective NTBs, since such tariff reductions merely serve to increase quota rents without increasing market access. Offsetting this is the omission of the liberalising impact of a reduction of roughly one-third in the number of tariff lines subject to NTBs (de Jonquières and Dawkins 1995). The 1992–93 protection estimates were incorporated in the database and the data rebalanced to restore the internal consistency of the Social Accounting Matrix.3 The resulting base period levels of tariff protection are shown in Tables 9.1 and 9.2. The left-hand section of Table 9.1 presents conventional tradeweighted average tariffs, while the right hand side of the table presents uniform tariff equivalents based on the theory of the trade restrictiveness index (TRI) (Anderson and Neary 1994a). Tables 9.1 and 9.2 also show the final tariffs on China’s imports expected by 2005, following the phasing in of its offered tariff cuts in the two schedules at the 8-digit HS level. If the binding in the schedule exceeds the applied tariff rate, the tariff rate is assumed to be maintained. Otherwise, if the binding is below the


Table 9.1 Tariff rates for product groups

Note: Coefficients of variation and the unweighted averages are based on the 8-digit HS level, while import weights are applied from the 6-digit level. Source: Author’s own calculation based on the UNCTAD TRAINS 1993 database and the trade restrictiveness index (TRI) in Anderson and Neary 1994a.

1992–93 tariff rate, the binding is used as the new applied tariff. This simple rule of thumb neglects the possibilities of increasing applied rates where bindings are above 199293 tariff levels, or of lowering applied rates below the bindings in the schedule. For any individual tariff line, it neglects the favourable effects of bindings above tariff levels on average rates of protection and on the expected cost of protection and overstates the marginal impact of reductions in the binding below the previously applied rate (François and Martin 1995). The aggregation from 8-digit tariffs to broad aggregates introduces a cross-sectional averaging which parallels the inter-temporal averaging used in assessing the impact of a tariff binding on the average tariff rate (Martin and François 1994).


Table 9.2 Import-weighted tariff rates by region

Source: From the UNCTAD TRAINS 1993 database.

By building up from the tariff line level, we take into account the substantial variation in tariffs within each of the aggregates we use in the analysis. This information would have been lost if we had used a general rule-of-thumb on an aggregate level, as is often done by CGE modellers assessing the effect of tariff cuts. For instance, the general rule in the first Chinese offer was that all tariff rates above 35 per cent should be reduced to accommodate a 35 per cent tariff binding. However, when the reductions are applied at the disaggregated level, reductions are also seen in many of the aggregates even if the initial average tariff level for the aggregate was below 35 per cent. This is so despite many exceptions which allowed higher rates than the general target. For example the average tariff on light manufactures declines from 34.5 per cent to 27.8 per cent. Clearly, it is vital to apply tariff cuts at the tariff-line level rather than only at the aggregate level. The base period import-weighted average tariff rates applying to China’s 1992 imports from the industrialised and newly industrialising countries are generally around 30 per cent or above, while those from developing countries face rates below 20 per cent. United States and Canada are notable exceptions in the first group, due to their zero rates for wheat, while Thailand is a notable exception in the second group due to a relatively high share of non-grain crops and other food products in Thailand’s exports to China. China’s original offer of April 1994 implied a reduction in the importweighted average tariff from 30.4 per cent to 26.6 per cent. The second offer of September 1994 contained significantly larger tariff reductions and would nearly halve the average tariff to an average of 16.1 per cent. Note again that these


estimates take the lower of the applied rate and the bound rate and leave out information on a number of non-tariff measures, including the tariff quotas on some agricultural products. The uniform tariff equivalents reported in Table 9.1 are based on the trade restrictiveness index (TRI) (Anderson and Neary 1992, 1994a) applied at the sectoral level. The TRI is defined as the uniform tariff rate that would be equivalent in its effect on welfare, to the disaggregated set of tariff rates at constant world market prices and a constant value of the balance-of-trade function. The version of the TRI used for each of the commodity aggregates in the model focuses on substitution between the domestic good and the foreign goods within the commodity aggregate. To do this, we invoke weak separability and homotheticity within groups to allow two-stage budgeting.4 Given this assumption, the overall balance-of-trade function for the economy may be written in terms of the aggregate prices and aggregate utility. The economy-wide balance-of-trade function can be derived from the incomeexpenditure condition by reclassifying the level of utility as exogenous and introducing a new variable, B, to measure the hypothetical financial inflow required to maintain a specified level of utility, u0, in the face of an exogenous shock. (1) u0

where e is the expenditure required to achieve consumer utility level at the complete domestic price vector p; r is the revenue function (also named the restricted profit function or GDP function) at domestic prices p attainable with the given resource vector v, ep−rp is the vector of net imports/exports at world prices pw and domestic prices p, so that (ep−rp) (p - pw) represents net revenue from tariffs and export taxes and subsidies; and f is the exogenous net financial inflow from abroad.5 The balance-of-trade function gives us the transfer required to maintain the same level of utility given a change in prices. It is therefore a convenient welfare measure generalising the simple consumer expenditure function used in textbook analyses of welfare evaluation to the real world case involving consumption, production and trade distortions. To include the supply and demand responses fully, the economy-wide TRI must be solved in a general equilibrium model. Since the production and consumption data are not available at anything like the level of disaggregation of the tariff schedule, some form of aggregation must be used to make the individual tariff rates comparable with the rest of the model. One approach to summarising this information is to define a TRI for each of the commodity aggregates in the model. Since we do not disaggregate exported goods, the focus within each group is on substitution between the domestically produced good and all of the imported goods within the group. The simple TRI6 for commodity group j is therefore derived from the balance-of-trade function defined for group j in the lower level of the import nest as:


(2) where is the price of the domestically produced, non-traded good in the commodity group j, is tariff revenue with being the vector of world prices of the imported goods, pj the vector of domestic prices, and the vector of imports. As Bj is homogeneous of degree zero in all of the domestic prices within the group, the price of the domestically produced good, is chosen as the numeraire. The summary indicator of trade restrictiveness for the composite good is then given by (Anderson and Neary 1994b): (3) Thus our summary indicator of trade restrictiveness is the uniform tariff that returns the same level of utility when applied to world prices as the set of individual tariff rates. Consistent with the treatment of aggregation in the GTAP (Global Trade Analysis Project) model, we use the constant elasticities of substitution (CES) expenditure function with the price of the domestic good equal to one. The uniform tariff equivalent for commodity group j is then derived from (where we shift from the vector notation and denote the individual commodities in group j with index i): (4)

The price index is: where j the value of the balance-of-trade function with the disaggregated set of tariff rates; the values are the expenditure shares at domestic prices in the base data set; is the world market price of commodity i (so that is set equal to the total group expenditure; and is the uniform tariff equivalent based on the balance-oftrade function, in percentage form, for commodity group j). This procedure is applied for each commodity group separately and for each of the disaggregated tariff sets (see Bach and Martin 1995).7 As seen in Table 9.1, the uniform tariff equivalents are considerably higher than the standard import-weighted averages in a number of cases, as they allow us to capture the effect of the variation within the disaggregated tariff set. The welfare cost of a tariff set with a high variance will generally be larger than that of a uniform tariff set. An appropriate index reflecting the welfare impact of disaggregated tariff lines should therefore take into account both the mean level and the variability of the tariff lines (Anderson 1995). This desired property is inherent in the TRI and in our simplified version. Indeed, if we look at the variance within each commodity group (Table 9.1), the commodity groups with the


largest difference between the import-weighted average and the uniform tariff equivalent are those with the highest coefficient of variation. For transport machinery and equipment, for example, the protection estimate more than doubles when we use the uniform tariff equivalents, which tells us that the tariff set in this commodity group is highly dispersed with possibly large welfare effects. On the other hand, those commodity groups with a relatively uniform set of disaggregated tariffs, such as wearing apparel, display little difference between the import-weighted averages and the uniform tariff equivalents. MODEL DESCRIPTION The effect of trade liberalisation in China is studied in the framework of the GTAP applied general equilibrium model of the world economy (Hertel 1996).8 It is a relatively standard multi-region, static model that assumes perfectly competitive markets and constant returns to scale technology. Private consumption is determined from a CDE expenditure function, private and government consumption and savings are derived from an aggregate CobbDouglas utility function, and production is determined by global demand at a supply price given by the zero-profit condition. Imports are distinguished by country of origin in a traditional Armington structure, and transport margins are derived from supply and demand to a global transportation sector. The specific version of the model used here has been modified to incorporate projections for population, labour, human and physical capital and factor productivity to the year 2005 (Hertel et al. 1995). These growth projections capture the effect of the changing world economy and are especially important for a booming economy such as China’s. Furthermore, we follow earlier work incorporating projections by using elasticities that are double the elasticities normally used in static policy scenarios.9 This tradition grew out of a backcasting exercise using the GTAP model, where it proved difficult to hit the actual trade shares for many Asian economies without higher elasticities in the import nest (Gehlhar 1996). In the current context this seems appropriate, since China, despite the tremendous growth in foreign trade, is still a relatively small player in most markets. The higher elasticities will dampen the negative terms-of-trade effect from liberalisation and increase the welfare gain. Generally, the model allows us to capture important multi-region responses to liberalisation but ignores some of the specific structural rigidities in the state sector in China. These effects seem more properly addressed in some of the single region models for China (Garbaccio 1995; Zhang and Warr 1994). POLICY SIMULATIONS In the first section below, we take a standard approach to evaluating the effects of China entering the WTO. In the second section we look at the effect of


China’s duty exemptions and, finally, we look at the effect of the variation within the disaggregated tariff set. China and the WTO Four standard scenarios are implemented. The first is the baseline scenario, in which we project what the structure of the world economy would have been in 2005 without further liberalisation in China and in the absence of the Uruguay Round. This scenario includes exogenous projections of each region’s endowment of agricultural land, physical capital, human capital, the state of technology, population and labour force. The ad valorem tariffs are assumed to be constant compared with the 1992 level, while tariff equivalents of MFA (Multi-fibre Arrangement) quotas vary depending on relations between import demand and exogenous quotas. The second and third experiments examine unilateral trade liberalisation in China using in turn each of the schedules of tariff bindings submitted by China to the GATT/WTO (GATT 1994; WTO 1994). The fourth experiment looks at the effect of the Uruguay Round on China without liberalisation occurring in China. The scenario implies reductions in import tariffs, export taxes, accelerated MFA quota growth and elimination of the MFA in the year 2005 in all WTO members (see Hertel et al. 1995). However, we assume that the MFA will only be abolished for those exporting countries that are members of the WTO. China and Taiwan will therefore only gain improved access according to the pre-UR growth rates and will not benefit from abolition of its quotas unless they become members of the WTO. The fifth experiment combines the third and the fourth experiments and examines the effects of liberalisation in China, according to the second schedule, combined with the implementation of Uruguay Round liberalisation. This is the full effect of China entering the WTO. In this scenario, China (and Taiwan) derive an additional benefit as we assume that they will benefit from the abolition of the MFA as they enter the WTO. The results of all experiments are presented as the change relative to the baseline scenario. Modelling duty exemptions Although the average nominal tariff rate in 1992 was above 30 per cent, China’s actual duty collection rate is considerably lower. One study estimates the collection rate to be only between 5 and 6 per cent of the cif (cost insurance freight) value of imports (World Bank 1994). This indicates a very high level of duty exemptions. Relief from import duties is allowed at the point of import rather than through refunds of duties paid, such as duty drawback systems. The exemptions are primarily allowed for export production. Exemptions for export processing with supplied or imported materials covered 78 per cent of the total


estimated concessional imports in 1991. The second most important category was equipment imported with foreign investments (15 per cent of total). However, concessional imports cannot alone explain the low collection rates.10 Thus it is likely that other imports, especially by the government or imports used for priority projects, are also exempt or there are other leakages in the revenue collection system (World Bank 1994). Duty exemptions have become increasingly important, and the share of concessional imports in total imports rose from a third to a half between 1988 and 1991. Furthermore, access to concessional imports seems to have been critical to the success of China’s export drive. Total exports associated with concessional import arrangements doubled between 1988 and 1991 and now account for about 64 per cent of China’s manufacturing exports (World Bank 1994). Thus, it is important to capture this feature when estimating the effect of trade reform on the Chinese economy. Of the above-mentioned categories, we are only able to capture some of the effects from the exemptions allowed for export production. To do this we need to reconstruct the base data to reflect the tariff exemptions. This is done by rebalancing the database with domestic taxes on intermediate imports calculated to reflect the average tariff exemptions within each industry. Ideally, the tariff rates should be changed directly but the bilateral import flows are not decomposed by sector of destination, as this information is generally not available. The level of exemptions is calculated as the product of the tariff level and the share of exports in total output in each industry. In order to maintain the zero-profit condition within each industry, the output taxes are adjusted. Thus, the end result is to shift the burden on the industries from an input tariff to an output tax. Since the output tax is not shocked in this study, the size of the output tax in the database has few implications. The adjustment of import duty collections downwards counteract the overstatement of this revenue source in the original database, and the consequent understatement of domestic taxes. We then use the new updated database to perform the simulation with unilateral liberalisation in China. However, we now need to countershock the intermediate import tax so that the industries do not receive tariff cuts on the imports used for export processing (as these rates are already zero) (Stevens 1995). The methodology does, however, have a number of flaws. First, we do not update the export shares of each industry, and thus the level of tariff exemptions during the simulation, but rather keep them fixed at the initial level. This will reduce the incentive to increase export processing. Second, the duty exemptions will affect both domestic and export production within each industry. If data were available, the proper way to address the exemptions for export processing would be to split the industries into an export processing part and a part producing only for the domestic market. However, that would be a very demanding process. While the simpler method applied here is imperfect, it nonetheless will address the critical problem of undertaking simulations based on tariff cuts from 30 per cent to 16 per cent when the actual collection rate is below


10 per cent, and it will give us at least an approximation of the possible effect of tariff exemptions. Welfare evaluation with separate shocks The second feature we investigate is the representation of the disaggregated tariff line information in the model simulations. As described in the earlier discussion on a uniform tariff equivalent, a simple import-weighted average fails to capture the possible effect of the variation within the tariff set. To capture this effect we must chose an aggregation procedure to match the specific functional forms within the different parts of our model. While the modified balance-of-trade function defined by equation (2) provides a summary indicator of trade restrictiveness, it will not yield an aggregator suitable for use in a computable general equilibrium model. In the model we need shocks that can replicate the behaviour of the separate equations for expenditure (and hence derived demands) and tariff revenue. To do this we must define separate aggregators for each part of equation (2): the behavioural part which determines the allocation of total expenditure between domestic and imported goods, and the tariff revenue part that determines the funds collected for private and government consumption and savings. The aggregator for the expenditure part is defined for each commodity group, j, equivalently to equation (3), as a uniform tariff that returns the same level of expenditure, when applied to the disaggregated set of world prices as the disaggregated tariff set yielding pJ (Bach and Martin 1995): (4) The group-wise aggregator for the tariff revenue part follows equivalently as: (6) The basic insight is that our simplified welfare measure, equation (2), on the lower level of the import nest, can be evaluated in two different ways. Either by an aggregator as defined for the entire equation, or by two separate aggregators defined for the expenditure and the tariff revenue part. The advantage of using the two separate aggregators is that it allows the behavioural (expenditure and hence the derived import demand) part of equation (2) and the tariff revenue part of equation (2) to be targeted specifically. This yields a methodology where the welfare implications of changes in the tariffs within the disaggregated set can be captured in the price shocks to a CGE model. Using the CES functional form for the sub-aggregator, we can write: (7)


where is the world market price of good / in group j, the are derived as base expenditure shares by defining domestic prices at unity in the base dataset, and E j is total group expenditure with the disaggregated set of tariffs and trade. For the tariff revenue case, import demands are derived from the CES expenditure function using Shephard’s Lemma. If total tariff revenue from the disaggregated set of tariffs is denoted by TR, the revenue preserving tariff equivalent for each group, is simply calculated by setting the revenue with a uniform tariff equal to the actual revenue derived from the commodity group, TRj (8) In the CGE model we use aggregate prices and tariff rates to represent the disaggregated set of tariffs. The important point to notice is that, with constant import value at world prices, the change in the uniform tariff equivalent for the expenditure function will not equal the change in the uniform tariff equivalent for the tariff revenue part of our economy. The shocks to the expenditure part of the model will therefore differ from the shocks to the tariff revenue part.11 Thus, if we wish to reflect the information in the disaggregated tariff line information in the CGE model it is necessary to use the two different sets of price shocks. When the tariff reductions reduce the variability of tariffs within commodity groups, the tariff reductions measured using the sectoral TRIs will be larger than those measured using standard trade-weighted average tariff rates. Using the separate expenditure and tariff revenue shock derived above results in larger estimated benefits from trade liberalisation. Mechanically, this is because the fall in expenditure (at domestic prices) required to achieve a given level of utility will exceed that measured with the import-weighted measure, while the fall in tariff revenue will be less. In other words, by moving towards a more uniform tariff set, we save more in expenditure than we lose in tariff revenue. This benefit is not represented in the aggregated model and it can be thought of as a transfer of income to China from outside the model (Bach and Martin 1995). Unfortunately, this revenue from outside the model complicates welfare evaluation in a global model when a money metric measure of welfare change (see Anderson and Martin 1996) is used. At this stage, this part of the analysis can only be undertaken for a subset of model regions. For this reason, we first present results for all regions in the model using the conventional trade-weighted average tariff rates and then analyse the implications for China of using more efficient tariff aggregators. RESULTS Initial simulation results are presented in Tables 9.3 and 9.4.12 The first three columns are the results from unilateral liberalisation, the fourth column is the result from adopting the Uruguay Round, and the final column is the effect if


Table 9.3 Effect on China’s output in 2005 following various shocks

Source: Author’s own simulations in applying the GTAP miodel.

China enters the WTO with simultaneous liberalisation in both China and the rest of the world. To allow comparability across experiments, all of these experiments use shocks based on conventional trade-weighted average protection rates. Table 9.3 reports the effect on output levels in China. The first thing to notice is that in many cases the combined effect of China and the Uruguay Round is much larger than the sum of the two components (columns 2 and 4) together. This is because of the assumption that China will only benefit from the abolition of the Multi-fibre Arrangement after entering the WTO. The results from the experiment ‘only UR’ includes only quota expansion for China’s exports of textiles and wearing apparel according to the pre-UR quota growth rates. As seen in Table 9.3, unilateral liberalisation tends to result in lower output levels for primary agriculture, due to a reallocation of resources into the expanding manufacturing sectors. On the other hand, the Uruguay Round tends to increase output of primary agriculture, as a number of other sectors contract and world market prices increase. The results for agriculture, however, should be interpreted with care, as we believe that the factor shares, demand elasticities, productivity and protection estimates can be improved.13 For the highly protected textile sector, unilateral liberalisation will have a negative effect on output, while the wearing apparel sector will benefit from lower costs of imported inputs. The Uruguay Round experiment alone will tend to reduce output in both sectors with China losing market opportunities to the MFA exporters that are already in the WTO and hence benefit from abolition of the MFA. With its low quota growth rates, China’s MFA quotas will become


increasingly restrictive in the period 1992–2005 and quota rents will increase. If China enters the WTO, its MFA quotas are also abolished under the Uruguay Round agreement and output of wearing apparel increases dramatically. However, this will only partly compensate for the decrease in output in the textiles sector caused by unilateral liberalisation. This result relies on a large increase in imports of textile products and appears to be sensitive to the precise model specification; it differs from earlier estimates in a single-country setting, where the contractionary effects of import penetration in the textile sector were found to be outweighed by the expansionary demand pull of the expanding apparel sector (World Bank 1994). Light manufactures will benefit from cheaper imports of intermediates in the scenarios with unilateral liberalisation, and will also benefit from increased market access in the Uruguay Round. However, note that the abolition of the MFA will have a negative effect on output of light manufactures. Resources are pulled out of light manufactures to support the large increase in output of wearing apparel. The decrease in output of transport, machinery and equipment and of heavy manufactures supports the often-held view that China remains a high-cost producer of these goods. The simulation with tariff exemptions significantly dampens the effect on output in the export processing industries, while the effect on the industries producing primarily for the domestic market, such as transport, machinery and equipment, is small. Table 9.4 Effect on real incomes in different countries/regions, 2005

Note: Percentage change in utility times baseline income in the year 2005. Source: Author’s own simulations in applying the GTAP miodel.


One broad tendency evident from the model results is a shift towards labourintensive industrial products, including a range of products requiring higher skill levels included within the light manufactures category. The effects on real incomes in China and elsewhere are presented in Table 9.4. The second tariff offer doubles the global welfare gain compared with the first offer, and increases the gain for China by more than 50 per cent to a total of nearly US $22 billion (in 1992 dollars). However, if we model the effect of tariff exemptions, the welfare gain drops by more than 20 per cent. The welfare gain from unilateral liberalisation in China is larger than its gain from liberalisation in the ROW region (‘only UR’). This is only true, though, when we exclude the benefits to China from abolishing the MFA. In a separate simulation, we included the abolition of the MFA for China (and Taiwan) in a simulation similar to ‘only UR’. This increased the total welfare gain for China from liberalisation elsewhere to US $22.3 billion, which is nearly equivalent to the gains from unilateral liberalisation according to the second offer. Although this result is weaker for China than for many other countries, it still supports the view that the largest gains from liberalisation tend to stem from unilateral action. This point is often overlooked or at least not acknowledged in multilateral trade negotiations based on exchanging tariff offers (Bach et al. 1996). While China is the largest single beneficiary of liberalisation under its offers to the WTO, over half of the total gains accrue to other regions. The industrialised and newly industrialised countries (plus the ROW region) stand to gain most from China’s unilateral liberalisation. These countries faced the highest tariff rates prior to liberalisation and would receive the largest cuts in import prices from China’s offered tariff schedule (Table 9.2).14From the results, it appears that a number of developing countries would suffer small losses from liberalisation in China, with increased competition from China’s exports of similar composition slightly outweighing the benefits of increased access to China’s market and lower prices for their imports from China. These simulations do not capture the possible dynamic gains from trade liberalisation that may convert the small losses reported in Table 9.4 into long-term gains. Finally, we look on the possible welfare effect of introducing two separate shocks to improve the representation of the disaggregated tariff set. Unfortunately, the use of standard money metric measures of welfare change in the current version of the GTAP model must be addressed separately in a singleregion setting as we essentially give China an extra income gain from the lower level aggregation and violate Walras’ Law at the global level. Because of this constraint and because of our focus on China, we estimated the separate shocks only for China. We then undertook these simulations in a static version of the model without projections for factor endowments and with output and income fixed in all other regions than China (Bach and Martin 1995). The resulting estimates of the welfare impact for China are presented in Table 9.5. Table 9.5 shows that the estimated welfare gain improves by more than 80 per cent when we use the separate shocks. This clearly demonstrates the importance


Table 9.5 Effect on welfare of improving the representation of the disaggregated tariff set in a single-region, static setting

Source: Calculations based on author’s own simulations.

of improving the representation of the disaggregated tariff information in any CGE model. For a country such as China with relatively high tariff rates and a high variance within the tariff set (see Table 9.1) this methodology is particularly important. The use of simple import-weighted averages to create the aggregate shocks to the model will underestimate the potential welfare gain. By applying the scaling factor implied by the results in Table 9.5 to the estimated US $17 billion in gains to China from its own liberalisation in Table 9.4 (taking into account the effect of exemptions), we obtain an estimate of US $31 billion as the gain to chain from implementation of its offer to the WTO. CONCLUSIONS A number of successive trade reforms have brought China closer to an open market economy. However, high tariff rates and a number of NTBs still prevail across the commodity spectrum. These trade barriers would be reduced significantly under the tariff reduction offers made by China in its WTO accession negotiations. The analysis points to very large welfare gains to China from the unilateral liberalisation offered by China in the context of its negotiations for accession to the WTO, and from the reductions in protection negotiated in the Uruguay Round. Using standard measures of tariff restrictiveness, the gain to China from its own liberalisation is estimated to be US $22 billion. Making allowance for the tariff exemptions which are important in China’s trade regime, the estimated benefit falls to US $17 billion. Using a new procedure to take into account the reductions in the variability of tariffs within commodity groups brought about by this liberalisation results in an estimated gain to China of US $31 billion per year at 1992 prices. Successful entry into the WTO also generates substantial benefits to China through abolition of the MFA quotas that strongly restrict China’s exports of textiles and clothing. China’s major trading partners are also estimated to benefit substantially from China’s liberalisation. Large gains accrue to major trading partners such as Hong Kong, the United States and Canada, Japan, the European Union, the Republic of Korea and Taiwan. Some relatively small losses are estimated for economies


such as Indonesia and South Asia, which compete relatively directly with China in the production of some export goods. All of the economies that register losses benefit substantially from other aspects of the Uruguay Round package, and particularly from the abolition of the MFA. Further, the model takes no account of the potentially important dynamic gains that might be expected to arise from fuller participation of the extremely dynamic Chinese economy in the world trading system—gains that might be expected to more than compensate for these relatively small losses. NOTES 1 This chapter is based on a paper which appeared in Weltwirtschaftliches Archiv. The views expressed in this chapter are strictly those of the authors, and should not be taken as representing the official position of the World Bank or any other institution. Particular thanks are due to Jeffrey Gertler, Thomas W. Hertel and Tony Sihsobhon for valuable assistance and to Kym Anderson for useful comments. Any remaining errors are the responsibility of the authors. 2 The base year for the GTAP database used in this study is 1992 (Hertel 1996). 3 Domestic tax revenues were used as the balancing item. 4 These assumptions are implicit in the use of the commodity aggregates appearing in the model and are not an additional assumption required by the TRI. 5 A non-taxed numeraire commodity must be included. Changes in a uniform proportional tax on all goods would not change the value of the balance-of-trade function. 6 The results reported in this section are the changes in the TRI equivalent to the move from free trade to the benchmark set of trade distortions. 7 The uniform tariff equivalents are derived from an optimisation routine using GMAS (Brooke et al. 1992). 8 The model is solved using GEMPACK (Harrison and Pearson 1994). 9 Specifically, the elasticities used in the higher level of the Armington nest (substitution between domestically produced goods and imports) are: primary agriculture 4.84; processed food 4.81; natural resources 4.91; textiles 4.4; wearing apparel 8.8; light manufactures 5.06; transport, machinery and equipment 7.09; heavy manufactures 4.36; utilities, housing and construction 0; other services 3.8. The elasticities in the lower level of the Armington nest (substitution between supplying regions) are twice the elasticities in the lower level. 10 A collection rate of 5.6 per cent represents only 17.5 per cent of the trade-weighted average tariff of 32 per cent for 1991 (World Bank 1994). 11 The shocks can be derived either as the change in the uniform tariff equivalents or as the proportional change in expenditure and tariff revenue calculated with the specific choice of functional form. 12 We will not list an extensive set of detailed model results but only comment on a few. Interested readers can obtain additional details from the authors. 13 These Issues are currently being addressed (see Bach 1996).


14 The gains for Hong Kong should be interpreted with special caution as the trade statistics for Hong Kong in the GTAP Version 2 database used in this study are distorted by differences in the classification of exports and re-exports.

REFERENCES Anderson, J.E. (1995) ‘Tariff index theory’, Review of International Economics 3(2): 156– 73. Anderson, J.E. and W.Martin (1996) ‘The welfare analysis of fiscal policy: a simple unified account’, mimeo, Boston College. Anderson, J.E. and J.P.Neary (1992) ‘A new approach to evaluating trade policy’, Policy Research Working Paper 1022, International Economics Department, World Bank, Washington. —— (1994a) ‘Measuring the restrictiveness of trade policy’, World Bank Economic Review 8(2):151–70. —— (1994b) ‘The trade restrictiveness of the Multi-Fibre Arrangement’, World Bank Economic Review8(2):171–90. Bach, C.F. (1996) ‘Trade policies and food security In China’, unpublished PhD thesis, part I, The Royal Danish Agricultural University, Copenhagen. Bach, C.F. and W.Martin (1995) ‘Would the right tariff aggregation procedure please stand up?’, paper presented at the Mid-West International Economics Meeting, 20 May, University of lowa. Bach, C.F., P.J.Lloyd and W.Martin (1996) The Uruguay Round, WTO, and Asia-Pacific trade liberalisation’, Second APEC Roundtable: ‘Facilitating Interdependence in the Asia-Pacific Region’, 23 June 1995, ISEAS, Singapore. Brooke, A., D.Kendrick and A.Meeraus (1992) GAMS: A User’s Guide, South San Francisco: The Scientific Press. Cheng, E. (1994) ‘Comparison of Chinese and international grain prices’, Working Paper Series no. 94/12, Chinese Economy Research Unit, University of Adelaide. China Trade Report (1995) ‘China economic statistics’, Far Eastern Economic Review 33: 14–15. de Jonquières, G. and W.Dawkins (1995) ‘China woos world trade body with tariff cuts’, Financial Times 20 November. François, J.F. and W.Martin (1995) ‘Multilateral trade rules and the expected cost of protection’, Discussion Paper No. 1214, Centre for Economic Policy Research, London. Garbaccio, R.F. (1995) ‘Price reform and structural change in the Chinese economy: policy simulations using a CGE model’, China Economic Review 6(1):1–34. Garnaut, R., F.Cai and Y.Huang (1995) ‘A turning point in China’s agricultural development’, paper prepared for the conference ‘Grain Market Reform in China and its Implications’, 19 September, East-West Center, Honolulu. GATT (1994) ‘People’s Republic of China-schedules’, in Uruguay Round of Multi-lateral Trade Negotiations: Legal Instruments Embodying the Results of the Uruguay Round of Multilateral Trade Negotiations Done at Marrakesh on 15 April 1994, vol. 4, Geneva: GATT.


Gehlhar, M.J. (1996) ‘Historical analysis of growth and trade patterns in the Pacific Rim: An evaluation of the GTAP framework’, in T.W.Hertel, ed., Global Trade Analysis, Cambridge: Cambridge University Press. Harrison, W.J. and K.R.Pearson (1994) ‘Computing solutions for large General Equilibrium Models using GEMPACK’, Preliminary Working Paper no. IP-64, Impact Project, Monash University. Hertel, T.W. (ed.) (1996) Global Trade Analysis: Modeling and Applications, Cambridge: Cambridge University Press. Hertel, T., W.Martin, K.Yamagashima and B.Dimaranan (1995) ‘Liberalizing manufactures trade in a changing world economy’, paper presented at the World Bank Conference ‘The Uruguay Round and the Developing Economies’, 26–27 January, Washington DC. Martin, W. (1993) ‘Modeling the post-reform Chinese economy’, Journal of Policy Modeling 15(5&6): 545–79. Martin, W. and J.F.François (1994) ‘Bindings and rules as trade liberalization’, paper presented to the Festschrift conference for Professor Robert Stern ‘Quiet Pioneering: Robert M.Stern and his International Economic Legacy’, 20 November, Ann Arbor. Martin, W., C.Findlay and A.Watson (1994) ‘The China agriculture in General Equilibrium Model’, in Modelling Economy-wide Reforms, Paris: OECD. Sicular, T. (1988) ‘Plan and market in China’s agricultural commerce’, Journal of Political Economy 96(2):383–87. Stevens, J.A. (1995) ‘The duty drawback system in Korea: implications for trade reform’, unpublished MSc. thesis, Purdue University. UNCTAD (1994) TRAINS: Trade Analysis and Information System, Geneva: UNCTAD. World Bank (1994) China, Foreign Trade Reform, A World Bank Country Study, Washington DC: World Bank. —— (1995) Memorandum of the President of the International Bank for Reconstruction and Development to the Executive Directors on a Country Assistance Strategy of the World Bank Group for the People’s Republic of China, Washington DC: World Bank. WTO (1994) People’s Republic of China—Draft Final Schedule, Spec(88)13/Add.l8, Geneva: World Trade Organisation. Wu, F. and R.Zhao (1987) The dual pricing system in China’s industry’, Journal of Comparative Economics 11(3): 309–18. Zhang, X. and P.Warr (1994) ‘China’s re-entry to the GATT: a general equilibrium analysis of tariff reduction’, mimeo, Australian National University.

10 China's trade liberalisation and structural adjustments for the world economy Feng Lei and Yiping Huang1

INTRODUCTION The salient feature of China’s economic reform after 1979 is the gradual transition from a centrally planned to a market economy. The transition involves changes in almost all aspects of the economic regime, from the micro to macro levels. The replacement of the previous heavy-industry oriented development strategy by the comparative advantage oriented or outward-looking strategy is regarded as one of the most successful element of China’s economic reform. Between 1979 and 1995, China’s total trade grew at an annual rate of 12.5 per cent. This not only made China one of the world’s most important trading partners but also fostered significant growth in domestic income.2 To liberalise foreign trade, China has adopted reform measures in three broad areas: the gradual elimination of the central plans, and introduction of market competition in the export and import sectors; the reduction of barriers to trade, including both tariff and non-tariff restrictions; and the reform of the foreign exchange regime. In order to integrate more deeply into the world economy, China officially launched its application to resume its GATT/WTO membership in 1986. It is also participating actively in the APEC free trade process. Although it is still not clear exactly when China will be admitted to the WTO and the specific timetable in relation to APEC free trade is yet to be determined, the signs are all there that China will push forward with unilateral trade liberalisation. During the Osaka APEC summit in 1995, for instance, the Chinese President Jiang Zemin announced a further step in trade liberalisation by reducing the existing tariffs by one third.3 China’s rapid growth and trade liberalisation have been highly appreciated both domestically and internationally. Per capita income in China more than tripled between 1979 and 1995. The world economy also benefited, at a minimum, from a more open and growing Chinese market. Anxieties, however, also exist about the impact of China’s liberalisation and its ascendancy in the world economy. The international community wonders if the rise of the huge Chinese economy will impose unbearable competitive pressure and adjustment costs on China’s trading partners. At the same time, domestic resistance to


liberalisation is by no means weak, as the opening up of China’s domestic market is unfavourable for some industries in which China does not have comparative advantage. All this scepticism is clearly reflected in the difficulties that the Chinese trade negotiators experience in their dealings with both the international community and domestic interest groups. Assessing the consequences of reform is often complicated by the fact that trade liberalisation brings simultaneously a number of effects in opposite directions. A tariff reduction for one commodity, for example, reduces the incentive for domestic producers of that product, but increases relatively the incentive for other producers.4 In policy debates, it is very common for proponents of reform to stress the positive effects while the opponents stress the negative effects. Consensus can only be reached through careful quantitative measurement of all these effects in a general equilibrium framework. This chapter is an attempt to quantify the likely adjustments in the rest of the world as well as in the Chinese economy resulting from China’s trade liberalisation. It applies a multi-region computable general equilibrium model, the Global Trade Analysis Project (GTAP) model. Three sets of shocks are designed. First, a unilateral tariff reduction of 33 per cent by China is simulated, corresponding to Jiang Zemin’s Osaka commitment. Productivity growth of 1 per cent in China’s manufacturing sectors is then added to the first experiment, capturing the fact of China’s fast growth. Finally, based on the second simulation, trade liberalisation by other APEC members is introduced on top of the second experiment, reflecting the possible APEC free trade program. The chapter is organised as follows. The next section introduces the GTAP model. The third section discusses three sets of shocks for experiments. And in the fourth section the simulation results are presented, followed by a conclusion. THE GTAP MODEL A number of analytical frameworks can be applied to analyse the effects of China’s trade liberalisation, from partial to general equilibrium models. General equilibrium models are usually preferable for cases in which indirect and secondary round effects play important roles. Trade policy reform is one such case. Zhang and Warr (1995) apply a computable general equilibrium model of the Chinese economy to investigate the consequences of further trade reform in China. While their analysis is able to produce deep insights into changes in domestic economic structure, it fails to draw direct implications for other economies. The model applied in this study, the GTAP model, is a conventional multiregion computable general equilibrium model developed by Hertel (1997). It has been applied in a wide range of studies, particularly in the areas of trade policy analysis.5 Yang (1995a), for instance, applies the GTAP model to analyse the implications of the Uruguay Round settlement for the Chinese economy.

160 CHINA’S TRADE LIBERALISATION AND STRUCTURAL ADJUSTMENTS

Table 10.1 Regions and industries of applied version of GTAP model

Source: From the GTAP model (Hertel 1997).

The version used in this study contains ten regions and ten sectors (Table 10.1). The ten regions are China, Australasia, Japan, North America, the European Union, Asian Newly Industrialising Economies (NIES), ASEAN (excluding Singapore and Vietnam), South Asia, Latin America and the Rest of the World. The ten sectors include agriculture, mining, processed food, textiles, clothing, iron and steel, transport equipment, machinery and equipment, other manufacturing and services. This regional and sectoral classification reflects our attempt to separate out particular countries, such as China, and particular commodities, such as textiles and clothing, for special attention in this study. The model is static in the sense that we can only predict the changes between two time points.6 It is of the Johansen type with all the variables being in percentage change form. Following Armington (1969), commodities are differentiated according to the place of production. For each economy in the model, there are ten representative producers (one for each sector) and one representative household. The producers are assumed to maximise profits while consumers are assumed to maximise utilities. Perfect competition is assumed for all the markets in the model and each of the factor and goods markets clears at equilibrium. However, this does not necessary imply that there is full employment in the labour or capital market in each region.7 The database for the GTAP model was largely drawn from the SALTER model developed by the Industry Commission of Australia (Zeitsch et al. 1991). The benchmark data for the version applied in this study are for 1992. The model has some limitations in modelling policy change. Most importantly, it is a static model and assumes no adjustment costs between the two points of equilibrium. This calls for particular caution in interpreting the results. First, the


simulation results of a trade liberalisation experiment may fail to capture the productivity gains from policy change (Yang 1996). Second, while the model always predicts a smooth transition from one equilibrium to another, the real adjustment could be costly and time-consuming. This latter point is extremely important and must be always kept in mind when making policy recommendations. DESIGNING THE EXPERIMENTS To analyse the likely effects of China’s trade liberalisation in an interdependent world economy, three sets of experiments are designed (Table 10.2). The first experiment involves a 33 per cent reduction in China’s tariffs for all the commodities. This experiment is consistent with President Jiang Zemin’s Osaka commitment to reduce China’s tariff rates to an average level of 23 per cent from 1 April 1996. As the reform process is already underway, it is interesting to see the impact of this change on the rest of the world, especially China’s important trading partners, as well as on domestic economic structure and welfare. The experiment is also consistent with China’s past unilateral trade liberalisation and its continued efforts to join the WTO. Since 1979, China has changed from a virtually closed economy to one that participates extensively in world markets. Yet trade barriers in China—an average tariff rate of 35 per cent before April 1996 and 23 per cent after that—are still very high compared with most industrialised countries and China’s East Asian neighbours. Further substantial reduction of border barriers to trade is necessary before China can join the WTO and before it will be well integrated into the world economy. This first experiment, therefore, can provide some indication of the likely directions and magnitudes of adjustments resulting from such further reform. The second experiment adds 1 per cent productivity growth for China’s manufacturing sector to the first simulation. This added productivity change can be justified on two grounds. On the one hand, China has been growing rapidly for more than fifteen years. The average growth rate of real GDP for the 1979–95 period was 9.5 per cent. This was a remarkable achievement, especially in comparison with the world norm of growth rates at between 3.5 and 4 per cent per annum. Many studies have predicted that China will probably be able to sustain this rapid growth for another one to two decades (Lin, Cai and Li 1994; Lardy 1994; Garnaut and Huang 1995). This suggests that China’s future trade liberalisation will be carried out against the background of its economy growing much faster than the rest of the world. Another factor relates to the causal connection between trade liberalisation and rapid economic growth. Feder (1982) demonstrates that export growth yields externalities to the economy’s overall growth. Yang (1996) attempts to build this mechanism into a CGE model framework in analysing the impact of the Uruguay Round settlement. An increase of 1 per cent in productivity in China’s


Table 10.2 Three sets of experiments of trade liberalisation

Source: Author’s own assumptions.

manufacturing sectors can be justified if trade liberalisation induces productivity growth because of more efficient resource allocation and increased competition resulting from trade policy reform. There are some grounds for both these arguments. Because the model we apply is static, the productivity shock imposed in the experiment only suggests that productivity growth in the Chinese manufacturing sectors may be faster than other sectors of the economy and sectors of other economies by 1 per cent, holding productivities in all the other sectors constant. The final experiment introduces trade liberalisation by other APEC members on top of the second experiment. At the Osaka summit in 1995, APEC leaders agreed to push forward with the APEC free trade process. Although the detailed timetable has not been settled, developed members are required to achieve free trade by the year 2010 and developing members by the year 2020. This indicates that all the APEC members will experience more or less trade liberalisation in the next one to two decades. Not only will China be a part of that general process, but China’s reform will also be carried out within a liberalising APEC environment. This dynamic aspect of the reform has important implications for the impact of China’s trade liberalisation on the rest of the world. SIMULATION RESULTS These three experiments are implemented with the GTAP model. Our discussion focuses on economic structural changes in, and their overall impact on, China and the other regions. Experiment I The structural adjustments to the Chinese domestic economy resulting from a 33 per cent tariff reduction are relatively significant (Table 10.3). Both the clothing and the transport equipment sectors experience booms after the reform. Total domestic output increases by 14.8 per cent for clothing and 6.3 per cent for


Table 10.3 Changes in output—Simulation I (percentage change)

Note: Simulation I involves a reduction of 33 per cent in China’s tariff rates for all commodities. For meanings of the abbreviations in this table, see Table 10.1. Source: Authors’ simulations applying the GTAP model.

transport equipment. Services is another sector experiencing an expansion but of much smaller magnitude at 0.8 per cent. The expansion of the clothing and services sector is relatively easy to comprehend. While the former is a labour-intensive industry in which China still has strong comparative advantage, the latter benefits from liberalisation probably through a relative increase in terms of trade for nontradable goods. The rise of transport equipment is a more complicated case. Our speculation is that this expansion is probably concentrated in the production of relatively simple transport equipment like bicycles, tractors and other parts (rather than in the production of modern cars). Other sectors of the Chinese economy contract as a result of economic restructuring. These are mostly in the sectors in which China does not have comparative advantage. Agricultural and mining production, for instance, decline by 0.3 and 0.8 per cent, respectively. The textile industry, together with the iron and steel and machinery equipment, are among the sectors that experience the largest contraction. For the other economies in the model, the NIEs experience the most significant structural adjustments in their domestic economies. The biggest gain for ASEAN occurs in transport equipment (expanding by 2.9 per cent) and that for the NIEs occurs in the textile industry (expanding by 3.6 per cent) and the transport equipment industry (expanding by 2.2 per cent). The NIEs experience some contraction in their agricultural production while ASEAN experiences some expansion in agricultural production, reflecting different comparative advantages in agriculture. The biggest losses for both regions are in the clothing sector— clothing output will decline by 3.0 per cent in each of them.


This is also true for other regions, although the extent of adjustment is much less. Clothing output falls by 3.4 per cent in Australasia, by 1.9 per cent in the European Union and by 1.5 per cent in Japan and South Asian economies. Australasia, however, will gain in the agricultural, mining and transport equipment industries. North America gains in the agricultural, mining, food processing, iron and steel, machinery equipment and service sectors. The European Union gains in the iron and steel, machinery equipment and services sectors. This clearly indicates that economies will be restructured according to their comparative advantages. If there are adjustment problems for other regions resulting from China’s liberalisation, it is most likely to occur in the clothing industry. As a result of the situation, China greatly increases its imports from the rest of the world, most significantly in clothing (110 per cent), textiles (38.6 per cent), other manufacturing (21.4 per cent), machinery equipment (20.1 per cent), transport equipment (19.7 per cent) and agricultural products (17.2 per cent). Other regions experience a decline in their exports of clothing but increases in exports of other commodities— Australasia in mining (1.9 per cent) and transport equipment (6.5 per cent); North America in agriculture and processed food (0.9 per cent), iron and steel (0.7 per cent) and services (0.6 per cent); the European Union in machinery equipment (0.7 per cent); Japan in processed food (1.6 per cent), textiles (5.0 per cent), iron and steel (1.3 per cent) and other manufacturing (1.0 per cent); NIEs in processed food (2.2 per cent), textiles (8.5 per cent), transport equipment (9.5 per cent), machinery equipment (1.3 per cent) and other manufacturing (2.0 per cent); and ASEAN in agriculture (0.6 per cent), processed food (1.1 per cent) and transport equipment (9.2 per cent). Overall, China’s trade expands significantly—exports increase by 15.7 per cent and imports by 21.7 per cent (Table 10.4). Household income increases by 0. 7 per cent. The welfare gain from the tariff reduction is large. The equivalent variation (EV) is $6,229 million. Most other regions also gain from China’s trade liberalisation: the EV is $162 million for Australasia, $977 million for the European Union, $1,123 million for Japan, $111 million for North America, $1, 584 million for NIEs and $34 million for ASEAN. According to the modelling results, South Asia, Latin America and the Rest of the World (ROW) experience welfare losses. This is often explained as a result of increased competition from China. While this may be partly true, the negative impact on these developing economies is obviously overestimated because it ignores the likely positive effects on productivity resulting from tougher competition. Experiment II When 1 per cent productivity growth for China’s manufacturing sectors is added to the above experiment, structural adjustment is magnified for almost all the economies (Table 10.5). Productivity improvement benefits a number of sectors,


Table 10.4 Overall assessment—Simulation I (percentage change)

Note: Simulation I involves a reduction of 33 per cent in China’s tariff rates for all commodities. For meanings of the abbreviations in this table, see Table 10.1. Source: Authors’ simulations applying the GTAP model.

and China’s expanding sectors now include clothing (27.8 per cent), transport equipment (11.1 per cent), services (1.2 per cent) and textiles (1.4 per cent). Contraction in other sectors, however, is also significant. Agricultural production declines by 0.7 per cent, mining declines by 5.2 per cent, machinery equipment by 2.0 per cent, and iron and steel falls by 2.9 per cent. Again, this change in economic structure is in conformity with China’s true comparative advantage. Correspondingly, the magnitudes of structural adjustment in other economies are also larger. The declines of clothing output are 5.7 per cent for Australasia, 2. 1 per cent for North America, 3.3 per cent for the European Union, 2.7 per cent for Japan, 5.2 per cent for NIEs, 5.1 per cent for ASEAN, 2.8 per cent for South Asia, 1.4 per cent for Latin America and 2.6 per cent for the ROW. Again, the biggest adjustments will occur in NIEs. NIEs experience a significant boom in textiles (1.8 per cent) and transport equipment (2.4 per cent) but a contraction in mining (0.9 per cent), and a large contraction in clothing. Similarly, ASEAN expands production of transport equipment (2.8 per cent), agricultural products (0.3 per cent) and reduces production of textiles (3.4 per cent), machinery equipment (0.3 per cent) as well as clothing. Australasia is another economy which experiences important structural change as a result of China’s reform and productivity growth. The magnitudes of adjustment for Australasia are interestingly greater than those for Japan, North America and South Asia. China’s exports and imports grow at about 18 and 23 per cent, respectively (Table 10.6). Its household income increases by 3.0 per cent and the welfare gain, measured by EV, is $13,557 million. Again, NIEs’ exports and imports rise by 1. 6 per cent and 1.7 per cent, respectively, and the welfare gain is also the largest of all world regions, at $1,322 million. The EV is $206 million for Australasia, $258 million for North America, $666 million for European Union and $716


Table 10.5 Changes in outputs—Simulation II (percentage change)

Note: Simulation II involves a reduction of 33 per cent in China’s tariff rates for all commodities and faster productivity growth by 1 per cent for China’s manufacturing sectors. For meanings of the abbreviations in this table, see Table 10.1. Source: Authors’ simulations applying the GTAP model. Table 10.6 Overall assessment—Simulation II (percentage change)

Note: Simulation II involves a reduction of 33 per cent in China’s tariff rates for all commodities and faster productivity growth by 1 per cent for China’s manufacturing sectors. For meanings of the abbreviations in this table, see Table 10.1. Source: Authors’ simulations applying the GTAP model.

million for Japan. Surprisingly, the welfare change for ASEAN is negative in this case. This probably reflects the fact that both China and some ASEAN economies are competing in the same world markets. China’s faster productivity growth disadvantages the ASEAN economies in these markets. This is illustrated by a decline of 0.3 per cent in ASEAN’s exports. Again, this prediction ignores the possible positive effects on productivity in ASEAN brought about by toughter competition.


Experiment III The final experiment incorporates the APEC free trade process on top of the second experiment. The APEC free trade process is simulated by modelling a tariff reduction of 10 per cent for all APEC members (except China): Australasia, North America, Japan, NIEs, and ASEAN. This broader trade liberalisation process increases significantly the extent of structural adjustments. Again, China experiences expansion in some sectors like clothing (28.9 per cent), textiles (0.9 per cent), transport equipment (10.2 per cent), and services (1.2 per cent) (Table 10.7). Production declines are much greater in machinery equipment (2.6 per cent), the mining (5.3 per cent) and iron and steel sectors (3.2 per cent) but not in the agricultural (0.6 per cent) sector. NIEs experience booms not only in textiles (6.7 per cent), transport equipment (1.2 per cent), machinery equipment (0.5 per cent) and other manufacturing (0.5 per cent), but also in clothing (1 per cent). They lose out more in agriculture (1.8 per cent), mining (1.9 per cent) and iron and steel industry (0.9 per cent). Similarly, ASEAN also increases its production of clothing (2.3 per cent) and machinery equipment (6 per cent) but reduces its production of agricultural (0.3 per cent) and mineral products (3.1 per cent). This rise of the clothing industry in NIEs, ASEAN and China indicates a large potential market for clothing if trade barriers are reduced. Compared with other regions, both NIEs and ASEAN still have comparative advantage in clothing production, with NIEs producing higher quality products. Australasia gains significantly from China’s reform and the APEC liberalisation process, particularly in agriculture (1 per cent), processed food (0.4 per cent) and mining (2.6 per cent). Its textiles (4.5 per cent), clothing (7.9 per cent), transport equipment (4.9 per cent) and machinery equipment (3.4 per cent) sectors experience sharp declines. Japan experiences contraction in its agriculture (2.6 per cent), processed food (0.3 per cent), textile (0.7 per cent) and clothing (3. 6 per cent) industries. It gains, however, in the iron and steel (0.4 per cent), transport equipment (0.2 per cent), machinery equipment (0.3 per cent) and other manufacturing (0.1 per cent) sectors. Both North America and the European Union experience some contraction in most of their manufacturing production but are likely to manage some expansion in agricultural and processed food production.8 This experiment predicts increases in exports for all APEC members in a wide range of commodities. China’s exports of agricultural products declines (9.1 per cent) but its exports increase significantly in clothing (44.1 per cent) and textiles (24.5 per cent). ASEAN exports all increase, except mineral products (declining by 2.9 per cent). Both Australasia and North America enjoy export expansion in processed food, agricultural and mineral products, reflecting their strong comparative advantages in resource-intensive products. Overall, China’s total exports increase by 18.5 per cent and its imports by 23.4 per cent. Household income also rises by 3.3 per cent while the EV is $14,260


Table 10.7 Changes in outputs—Simulation III (percentage change)

Note: Simulation III Involves a reduction of 33 per cent in China’s tariff rates for all commodities, faster productivity growth by 1 per cent for China’s manufacturing sectors and 10 per cent tariff reduction by other APEC members. For meanings of the abbreviations in this table, see Table 10.1. Source: Authors’ simulations applying the GTAP model. Table 10.8 Overall assessment—Simulation III (percentage change)

Note: Simulation III involves a reduction of 33 per cent in China’s tariff rates for all commodities, faster productivity growth by 1 per cent for China’s manufacturing sectors and tariff reduction by other APEC members. For meanings of the abbreviations in this table, see Table 10.1. Source: Authors’ simulations applying the GTAP model.

million (Table 10.8). Australasia obviously benefits from the policy change; the growth rates of its exports and imports are about 3.2-3.5 per cent. The EV is $415 million for Australasia. NIEs are another group that benefits significantly from the change, with an estimated EV of $3,554 million. The ASEAN economies experience great increases in both total exports and total imports and the welfare gain for them is $1,071 million.


One interesting finding, in comparison with the two earlier experiments, is that European Union, South Asia, Latin America and the ROW all benefit greatly from the additional APEC free process. CONCLUSION The findings of this study can be summarised as follows. First, the welfare gain from trade liberalisation for China is significant. The benefits increase if China’s unilateral trade liberalisation is joined by other APEC economies. This, on the one hand, suggests the great benefit China has derived from its past trade reform and also points to the important reasons why China should push forward its reform towards free trade. China is the biggest gainer from its own liberalisation. This result of large gains from trade liberalisation is driven mainly by the neoclassical features of the model. Incentive distortions, whether reflected in export taxes or import tariffs, distort resource allocation (the protected and uncompetitive sectors holding more productive resources) and thus reduce the total effective output by reducing the overall efficiency of resource use (Vousden 1990). Abolition of such distortions, therefore, will increase real output and total welfare of the economy by allocating resources in accord with the economy’s comparative advantages. This issue has been explored by Drysdale and Garnaut (1993) in the context of Pacific economic integration. Second, structural adjustment in China following trade liberalisation is expected to be significant. This is the cost that China has to pay to realise the gains from freer trade. In all three experiments, while the clothing sector is predicted to expand between 14.8 and 28.9 per cent, significant contraction also occurs in other industries. Agriculture is one such industry and its decline is predicted to be between 0.3 and 0.7 per cent. Although small in percentage terms, this could imply that millions of farmers are going to lose their jobs, even ignoring productivity change. It is, therefore, important to recognise the inevitability of structural adjustment, and to make efforts to smooth the adjustment process. A related implication is for China’s future food problems. Although there is no explicit food sector in the model, the predicted decline of agricultural production in the course of trade liberalisation and growth suggests limited potential in increasing domestic food supply. If China is determined to feed its growing population by itself, there are only two choices: to raise its productivity in food production or to distort incentive structures in favour of food production. While the former requires substantial investment in agricultural technology and infrastructure, the latter implies significant misallocation of resources and welfare losses. Third, for China’s trading partners, it is evident that, from a static perspective, China’s growth and liberalisation will hurt developing countries that compete directly with China in some international markets. But, as stressed before, this static approach is not sufficient in capturing the dynamic impact of trade


liberalisation. In particular, it ignores the possible positive effects of liberalisation on productivity growth through increased competition. The most significant adjustments for other regions/countries, especially the industrialised economies, occur in the textile industry. The decline of output for Australasia, North America, the European Union and Japan ranges from 1.1 to 7. 9 per cent. This sector, therefore, will be the source of the major adjustment problem. Countries wishing to benefit from China’s growth and its opening markets should be prepared to accept this associated domestic adjustment. More importantly, the most significant adjustments occur in NIEs that trade most intensively with China. These are also the economies that will derive large gains from the adjustments. These economies have already experienced significant adjustment in the past one and a half decades in the process of China’s rapid growth and reform. They were able to accommodate the emerging Chinese economy smoothly, and benefited greatly through China’s impact on their own economic growth and welfare. Other regions should also be able to reap the same benefits. Finally, the adjustment requirement is greater when the shocks increase from a single 33 per cent tariff reduction in China to tariff reduction, productivity growth and APEC trade liberalisation. But the benefits also become greater. This should encourage other APEC economies to participate actively in the process of trade liberalisation, thereby deriving greater benefit. Comparing the simulation results of Experiment III with those of the first two experiments, we find that the broader APEC free trade process turned other developing economies from net losers into net gainers. This indicates that, even from a static perspective, a broader world market (resulting from APEC trade liberalisation) is able to accommodate the other developing economies as well as China. The findings of this study, as for others applying this type of model, are subject to a number of qualifications. One has already been discussed above: the static feature of the GTAP model misses important dynamic effects of liberalisation including possible externalities on productivity. Another important qualification relates to the assumption that there is immobility of capital across regions. While capital flows across borders in the form of portfolio and direct investment are already a common phenomenon, this specification may under- or over-estimate the adjustment tasks required in individual economies. The general implication of the study is clear. While structural adjustments are inevitable in both China and the rest of the world following China’s continued open-door policy and rapid growth, there are some costs which all partners have to incur in gaining an overall benefit. China’s experience of economic reform from 1979 is a history of significant reform, dramatic structural adjustment and rapid income growth. Further reforms will require more structural adjustment, but that is manageable. For the international community, this was experienced earlier in accommodating the rise of Japan in the 1960s and 1970s and the NIEs in the 1970s and 1980s. The Chinese economy may be several times bigger than those of Japan and the NIEs decades ago, but the world economy is also several times


bigger now (Garnaut and Huang 1995). It should not be an unbearable challenge for the rest of the world to accommodate China. More importantly, history demonstrates that those with closer economic relations with China, such as the NIEs, experienced the most dramatic adjustment, along with the rise of the Chinese economy, but also extracted the most significant gains from it. Furthermore, active participation in the liberalisation process may magnify the gains and ease the adjustment task. This perspective, of course, does not lessen the difficulties for policy makers in implementing the structural adjustments. Special attention must be paid to declining sectors, such as the clothing industry in the rest of the world and the agricultural sector in China. Carefully designed measures assisting adjustments, such as credit assistance and the creation of new employment opportunities, can smooth the process and reduce the costs to individuals and industries. NOTES 1 We are grateful to Yongzhen Yang, Warwick McKibbin, Ray Trewin, Justin Yifu Lin, Peter Drysdale and an anonymous referee for helpful suggestions and comments. The Australia-Japan Research Centre of the Australian National University provided financial support to this research. 2 The average growth rate for real GDP was 9.2 per cent for the same period. 3 This involves tariff reductions in more than 4,000 items and is expected to bring down the average tariff rate to 23 per cent. 4 This does not necessarily have to involve an increase in absolute prices for nontradable goods since, in economic choice, only the relative prices matter. 5 See, for instance, Hertel et al. (1996), Hertel (1997), Yang (1996, 1995a and 1995b). 6 It is not able to reveal the transitional paths between the two points. 7 For labour, for instance, a total employment level is exogenously set for each region. This level could either be equal to total labour supply (thus Implying full employment) or less than total labour supply (thus Implying existence of unemployment). 8 The case of the European Union is more complicated considering the fact that these economies have relatively high levels of agricultural support and they are not involved in the APEC free trade process.

REFERENCES Armington, P.S. (1969) ‘A theory of demand for products distinguished by place of production’, IMF Staff Papers, 14:159–78. Drysdale, P. and R.Garnaut (1993) ‘The Pacific: An application of a general theory of economic integration’, in C.F.Bergsten and M.Norland, eds, Pacific Dynamism and the International Economic System, Washington, DC: Institute for International Economics. Feder, G. (1982) ‘On exports and economic growth’, Journal of Development Economics 12:59–73.


Feng, L. and Y.Huang (1996) ‘A general equilibrium analysis of China’s further trade liberalisation’, (in Chinese) Institute of Finance and Trade Economics, Beijing: Chinese Academy of Social Sciences. Garnaut, R. and Y.Huang (1995) ‘China’s transition and trade reform: Opportunities and challenges for the OECD countries’, report prepared for OECD, Paris. Hertel, T. (ed.) (1997) Global Trade Analysis Using the GTAP Model, Cambridge: Cambridge University Press. Hertel, T., W.Martin, K.Yanagishima and B.Dimaranan (1996) ‘liberalising manufactures trade in a changing world economy’, in W.Martin and A.Winter, eds, Uruguay Round and Developing Countries, Cambridge: Cambridge University Press. Lardy, N. (1994) China in the World Economy, Washington DC: Institute for International Economics. Lin, J.Y., F.Cai and Z.Li (1994) China’s Economic Miracle: Development Strategy and Economic Reform, Shanghai: Shanghai People’s Press and Shanghai Sanlian Bookstore. McKibbin, W. and Y.Huang (1996) ‘Rapid growth in China: Implications for the world economy’, paper prepared for the workshop China and WTO, University of Tokyo, Japan. Vousden, N. (1990) Economics of Trade Protection, Cambridge: Cambridge University Press. Yang, Y. (1995a) ‘Policy options for China in the Uruguay Round trade liberalisation’, in China and East Asia Trade Policy (Volume III): China and the World Trading System, Pacific Economic Papers, 250 (December): 8.1–8.26. —— (1995b) ‘The Uruguay Round trade liberalisation and structural adjustment in developing Asia’, Journal of Asian Economics, 6(4):493–510. —— (1996) ‘ZZTrade liberalisation with externalities: A general equilibrium assessment of the Uruguay Round’, in D.Robertson, East Asian Trade after the Uruguay Round, Cambridge: Cambridge University Press. Zeitsch, J., R.McDougall, P.Jomini, A.Welsh, J.Hambley, S.Brown and J.Kelly (1991) SALTER: A General Equilibrium Model of the World Economy, SALTER Working Paper no. 4, Canberra: Industry Commission. Zhang, X. and P.Warr (1995) ‘China’s entry to GATT: A general equilibrium analysis of tariff reduction’, in China and East Asia Trade Policy (Volume III): China and the World Trading System, Pacific Economic Papers, 250 (December): 3.1–3.19.

11 China's textile and clothing exports in the post Uruguay Round1 Zhong Chuanshui and Yongzheng Yang

INTRODUCTION Since the introduction of economic reform in the late 1970s, China’s exports of textiles and clothing have grown rapidly. By 1994 China had emerged as the world’s largest exporter of clothing and second largest exporter of textiles. This rapid export expansion has been achieved despite the Multi-fibre Arrangement (MFA), which has restricted China’s exports. The conclusion of the Uruguay Round multilateral trade negotiations marked a major change in the policy environment for world trade in textiles and clothing. Under the Agreement on Textiles and Clothing reached during the round, quota restrictions under the MFA will be gradually dismantled over a ten-year transition period (from 1 January 1995 to 1 January 2005), at the end of which time the textile and clothing sector will be fully integrated into GATT 1994. The Agreement on Textiles and Clothing also provides for accelerated increases in quota volumes during the transition period. In addition, tariffs on textiles and clothing will be reduced in the Quad economies (the United States, the European Union, Japan and Canada), and most developing countries have also pledged significant tariff reductions and bindings. There is little doubt that the phasing-out of the MFA and tariff reductions will boost world trade in textiles and clothing. GATT (1993) estimated that the largest increases in world trade resulting from the Uruguay Round trade liberalisation would occur in the textile and clothing sector. China is expected to gain the most among developing countries if the MFA is abolished (Whalley 1992). However, there are uncertainties over China’s access to the potential benefits. The result will be heavily influenced by the outcome of China’s negotiations to join the World Trade Organisation, increasing regionalism, increasing anti-dumping charges overseas, and changes in the rules-of-origin policy in the United States. In the long run, the prospect for China’s export growth of textiles and clothing will depend on China’s ability to maintain its competitive edge in this sector as competition intensifies after the elimination of MFA quotas. In this respect, two factors need to be considered. One is China’s changing comparative advantage


Table 11.1 China’s exports of textiles and clothing (US$ billion)

Sources: China National Textile Council and Customs Statistics of China (various years).

resulting from continuous and rapid economic growth, and the other is the emergence of new textile and clothing exporters in other parts of the world. This chapter analyses the main forces that will influence China’s prospects for trade in textiles and clothing against the background of Uruguay Round trade reform and a changing world economy. The following section gives a brief account of the growth and sources of China’s textile and clothing exports in the past fifteen years. The third section provides a brief summary of the achievements of the Uruguay Round in the textile sector and their expected impact on world trade. The fourth section examines the implications of China’s WTO membership for its textile and clothing exports and some new issues. The fifth section carries out some quantitative assessments of the impact of the Agreement on Textiles and Clothing on China, followed in the sixth section by an examination of structural adjustment in relation to textile and clothing exports. The main findings of the study are summarised in the final section. CHINA’S EXPORTS OF TEXTILES AND CLOTHING China’s overall trade performance since the late 1970s has been remarkable. From 1980 to 1994 total merchandise trade increased from US $38 billion to US $237 billion in nominal terms, a more than six-fold increase. During the same period exports rose from US $18 billion to US $121 billion. By 1994 China had become the world’s 11th largest trading economy, up from the 26th in 1980. Its share in total world exports jumped from 0.9 per cent in 1980 to 2.9 per cent in 1994. Textiles and clothing have been a major driving force behind the surge in China’s exports (Table 11.1). From 1980 to 1994, textile and clothing exports increased from US $4.4 billion to US $35.5 billion, a more than eight-fold increase. The share of textiles and clothing in total merchandise exports also rose from 24 per cent in 1980 to nearly 30 per cent in 1994, a significant rise given the rapid growth of total merchandise exports during the period. In fact, textiles and clothing were the single most important export product group from 1986 to 1995, when machinery and electronic products took over the lead. China’s share in world clothing exports rose from 4.4 per cent in 1980 to 17.0 per cent in

CHINA’S TEXTILE AND CLOTHING EXPORTS IN THE POST URUGUAY ROUND 175

1994 and its share in textiles from 4.6 per cent in 1980 to 9.2 per cent in 1994 (WTO 1995).2 China’s remarkable export performance has been achieved despite severe MFA restrictions by industrial importing economies. While early bilateral agreements with the United States, the European Community (EC) and Canada provided China with quite generous growth rates of quotas compared with other exporters—mainly the newly-industrialising economies (NIEs)—restrictions became increasingly stringent in more recent bilateral agreements in terms of product coverage, growth rates and transshipments. The average annual growth rate of quotas in the US market declined from about 4.6 per cent in the first SinoUS textile agreement (1980–82) to 1 per cent in the 1995 agreement. Similarly, quota growth rates have been reduced in other major MFA markets (the European Union and Canada), albeit less drastically than in the US market. As the growth rates of quotas have declined, the commodity coverage of quotas has increased. Initial quota restrictions on China mainly targeted cotton textiles and clothing. The coverage has since expanded to include synthetic, woollen and silk products. At the same time, quota utilisation rates have increased, indicating an increasingly binding effect of quotas on exports (Yang 1992). The growth of China’s textile and clothing exports has been largely supplydriven. Several factors have contributed to the growth. After the extremely inward-looking approach to development in the 1960s and the greater part of the 1970s, China shifted towards a more export-oriented growth strategy in the late 1970s. Growth in the textile and clothing sector has since been given a priority. This decision made good economic sense. Without severe trade distortions, a densely populated country such as China tends to specialise more in the export of labour-intensive manufactures—such as textiles and clothing—at the initial stage of industrialisation (Anderson 1992). The experience of Japan and the NIEs is a good demonstration of this. In addition, China has retained a large production capacity in the textile and clothing sector since the late 1930s. Even during the period of the Cultural Revolution (1966–76), the sector remained large and relatively efficient compared with other industries. While the development of many other light industries was largely ignored in the 1960s and 1970s, the textile industry enjoyed reasonable growth. Textile and clothing exports greatly benefited from rural reforms in the early 1970s. The dramatic increases in China’s cotton production in the early 1980s provided an abundant supply of raw materials for textile and clothing production. Given that the Chinese economy was still very much closed at the time, domestic inputs were essential to textile and clothing production, and hence for exports. Between 1979 and 1984 cotton production nearly tripled, increasing from 2.2 million tonnes to 6.3 million tonnes (State Statistical Bureau 1985). The rise of rural enterprises (also called township enterprises) has been both a result of and a driving force behind the economic reform towards decentralisation. In a policy aimed at structural adjustment in urban industries (mainly state-owned enterprises), the government has also encouraged the


relocation of labour-intensive production from urban to rural areas. This has added to the cost advantage of labour-intensive production. Compared with state enterprises, township enterprises are more flexible in production and management. Their production costs tend to be lower than those of their state counterparts. In recent years, most of China’s textile and clothing exports have been supplied by township enterprises (Yang 1995). Foreign direct investment (FDI) has also played an important part in China’s textile and clothing exports. Since the late 1970s there has been a rapid inflow of FDI into China. During the period 1979–94 cumulative and realised FDI in China totalled US $95.5 billion (Ministry of Foreign Trade and Economic Cooperation 1994–95). The pace of inflow of FDI into China accelerated from the early 1990s. In 1994 alone, FDI in China amounted to US $32 billion, second only to FDI in the United States in the same year. A significant proportion of the investment has been attracted to labour-intensive sectors such as textiles and clothing. In 1994 foreign-invested enterprises accounted for 28 per cent of China’s total exports and 61 per cent of the increase in exports in the same year (International Trade, March 1995). The contribution of foreign-invested enterprises to China’s textile and clothing exports cannot be overstated. Low labour costs do not translate to export competitiveness if productivity is low. Foreign investment brings in not only physical capital but also technology, management and marketing skills, and better access to export markets. Foreign investment in China’s textile and clothing industry has mainly come from the NIEs of Hong Kong, Taiwan and South Korea. In many cases, investment is informal, taking the form of compensation trade, processing and assembly. Compared with formal foreign investment, this type of investment is quick to become operational and is more flexible in meeting export demand (Yang 1992). Textiles and clothing have generated much of China’s foreign exchange earnings. From 1979 to 1994 textiles and clothing accumulated a surplus of more than US $160 billion, while the trade balance of other products recorded a deficit of more than US $40 billion. The surplus has often been used to finance the import of technology, machinery and equipment. Because of the critical importance of the textile and clothing sector, the former Ministry of Textile Industry (now the China National Textiles Council) put forward a strategy in 1986 that gave priority to the export of textiles and clothing. A series of policies has since been adopted to promote the export of textiles and clothing. Maintaining low prices for raw materials, mainly cotton, has been a policy target. Cotton is the main fibre consumed in China. Its price has been kept low by a state procurement monopoly. The government provides subsidies on inputs for cotton production, such as fertiliser and pesticide. Although this policy is questionable on efficiency grounds, it has nevertheless benefited the textile industry. While export businesses of other products such as petroleum, cereals, vegetable oils and chemical products are still under state monopoly, textile and


clothing exports have been decentralised and liberalised much more significantly since the early 1980s. Local governments, township and foreign-invested enterprises have all participated substantially in the export of textiles and clothing. For a long time before 1992, mandatory export plans were imposed on stateowned foreign trade enterprises. This was linked with various kinds of preferential treatment. The foreign exchange retention system allowed export enterprises to keep a certain proportion of their foreign exchange earnings for more flexible use or selling at foreign exchange swap markets at a price higher than the official exchange rate. The retention system was abolished in 1994. Imported materials used for the production of textiles and clothing for export have been exempted from import tariffs and other charges. A fund for textile and clothing exports was established in 1986 (Ministry of Textile Industry 1988). A more important policy is the exemption of the 17 per cent value-added tax for export production. Delays in payment and cuts in the rate of tax rebate were blamed for the much slower growth of textile and clothing exports in 1995 (7 per cent compared with 31 percent in 1994). THE AGREEMENT ON TEXTILES AND CLOTHING3 Textiles and clothing have been the main manufactured export of many developing countries. For more than two decades, however, their export has been subject to voluntary export restraints (VERs) under the MFA negotiated between industrial importing economies and developing exporting economies. The Agreement on Textiles and Clothing (ATC) reached during the Uruguay Round represents a major step forward in trade liberalisation in the textile sector. It is a transitional agreement and provides a legal framework for the phasing-out of MFA restrictions over a ten-year period (1 January 1995–1 January 2005). After the transition, the same rules will apply to trade in textiles and clothing as to trade in other goods. In addition, the ATC also requires that restrictions inconsistent with GATT other than those maintained under the MFA must be either brought into conformity with GATT or eliminated. The ATC also provides for increases in quota growth rates for products remaining under restriction during the transition period. The integration process has three phases. In the first phase (1 January 1995–31 December 1997), no less than 16 per cent of 1990 trade volumes are to be integrated. In the second phase (1 January 1998–31 December 2001), no less than 17 per cent of 1990 trade volumes are to be returned to GATT, and in the third phase (1 January 2002–31 December 2004), the figure is to be no less than 18 per cent. Altogether, no less than 51 per cent of total 1990 import volumes are to be integrated by the end of 2004. At the beginning of 2005, products remaining under restriction are to be integrated simultaneously. In all three stages, the products to be integrated must include tops and yarns, fabrics, madeup textile products and clothing.


It is clear that integration is heavily loaded towards the end of the transition period. Even the 51 per cent integration, however, is an over-statement of the extent of trade liberalisation. It must be remembered that the percentage of integration in each and every stage is based on 1990 figures for virtually all textile and clothing products, restricted or not, rather than restricted products only. As not all products are currently restricted by the MFA, importing economies can choose to liberalise products that are not restricted first and postpone the integration of restricted products until the end of the transition period. According to UNCTAD (1995a), such unrestricted products accounted for 47 per cent of total 1990 imports into Canada, 34 per cent in the European Union and 37 per cent in the United States. The share of unrestricted volumes is 93 per cent in Austria, 81 per cent in Finland and 83 per cent in Norway. Thus, most industrial economies do not have to offer substantive trade liberalisation until the end of the transition period. An examination of the integration programs for the first stage shows that no products integrated by the United States, the European Union, Norway and Canada in the first stage are currently under restriction (UNCTAD 1995a; ITCB 1995). In value terms, the products to be integrated account for 8.7 per cent of total EU imports and 6.9 per cent of total US imports. In other words, although the 16 per cent integration requirement in volume terms is fulfilled, most products that are integrated are low in price. It is yet to be seen what products importing economies (except the United States) will integrate in the subsequent stages. These economies are required to notify the Textile Monitoring Body of these products twelve months before each stage begins (ATC Article 2:11). It should be noted that this provides importing economies with the flexibility to integrate products when they are less restricted. The United States has published its integration programs for the second and third stages. Estimates show that only 11 and 9 per cent of total 1990 US imports in value terms will be integrated in the second and third stages, respectively (UNCTAD 1995a). This means that products accounting for more than 70 per cent of the total 1990 import value will not be integrated by the end of 2004. Under Article 2 of the ATC, bilateral quotas under the MFA will be enlarged in three stages. In the first stage, the growth rates of quota volumes will increase by 16 per cent. In the second stage, the growth rates will further increase by 25 per cent. In the last stage, growth rates will rise by 27 per cent. For small suppliers (accounting for 1.2 per cent or less of the total volume of the restrictions applied by importing economies as of 31 December 1991), the acceleration of quota growth will be advanced by one stage. As quota acceleration is based on the quota growth rate effective on 31 December 1994, the initial rates of quota growth are critical in determining the extent of quota enlargement. Exporters with higher initial rates of quota growth will have larger increases in their quota volumes than those with lower initial growth rates. Yang (1996) reported that the standard deviation of quota volumes


across exporters increases by 50 per cent in North America and 57 per cent in the European Union as a result of quota acceleration. Not only do the quota acceleration programs introduce greater disparities among exporting economies; they also increase the variations in quota volumes for different products. As sensitive products have lower quota growth rates under bilateral agreements, their relative quota volumes in the transitional period will slip further, offering even less liberalisation but creating greater distortions in resource allocation. Does the acceleration reduce the restrictiveness of MFA quotas? On the surface, there seems to be a considerable relaxation, but the supply side has to be taken into account in assessing the net outcome. Several studies have shown that there will be no significant reductions in the extent of quota restrictions during the transition period, especially for clothing (Cline 1995; Hertel et al. 1996; Yang 1997). Thus the ATC is effectively an extension of the MFA for another ten years. A special safeguard mechanism is stipulated in the ATC (Article 6) for the transition period (referred to as the ‘transitional safeguard’). The ATC has retained most of the safeguard provisions in the MFA (Articles 3 and 4). Under Article 6, a member of the WTO may apply a safeguard measure to a product if its domestic industry faces ‘serious damages, or actual threat of damages’ caused by increased imports. Safeguard measures can be applied on a member-to-member basis, providing an opportunity for discrimination, but they are applicable only to products not yet integrated into GATT 1994 and not already under quantitative restraint. Safeguard measures can remain in place for a maximum of three years or until the product is integrated into GATT 1994, whichever comes first. The ATC allows all WTO members to use this special safeguard mechanism as long as a member has indicated an intention to retain the right to use it. Eventually, fortynine members indicated that they wished to retain this right (WTO 1996). There is a possibility of more countries using this discriminatory mechanism, formerly available only to MFA-importing countries, during the transition period. Even more disturbing is the prospect of its use by increasing numbers of developing countries against other developing countries, with some resorting more frequently to such legitimate instruments as anti-dumping and countervailing measures. Only several months after the ATC went into effect on 1 January 1995, the United States had made twenty ‘calls’ for consultations under the new special safeguard mechanism covering a wide range of textile products exported by developing economies (ITCB 1995). Along with other instruments, such as antidumping measures, the special safeguard mechanism is likely to be more frequently resorted to by governments under very strong protectionist pressure from vested interests. Tariffs on the textile and clothing sector have been much higher than those in other sectors and have been characterised by tariff peaks (above 15 per cent) in


Table 11.2 Tariff reductions by selected developing economies

Notes: a Data for China are updated according to offers by China in its WTO accession negotiations. na—Not applicable or not available. Sources: Excerpts from UNCTAD (1995b), GATT Secretariat estimates.

industrial importing markets. Tariffs in developing markets are even higher. During the Uruguay Round, this sector was also subject to the general market access commitment requirement for the goods sector. However, the average tariff reduction by the Quad countries was only 22 per cent, making it the only sector that did not fulfil the target of one-third reduction. In comparison, reductions by developing countries are more substantial (Table 11.2). CHALLENGES AHEAD Several studies have shown that China will substantially benefit from the phasing out of the MFA (Trela and Whalley 1990; Yang et al. 1997). All these studies, however, are based on the assumption that China will have full access to the potential benefits resulting from the complete elimination of MFA quotas, including those imposed on China. The extent to which China can benefit from the ATC is clouded by the uncertainties surrounding China’s WTO accession negotiations. According to the US and EU legislation implementing the Uruguay Round, nonWTO members may not be able to benefit from the ATC even if they were members of the former MFA (UNCTAD 1995b). In addition, the exports of non-WTO members could even be subject to new restrictions without any time limits. If China were to stay outside the WTO, there is likely to be more friction in its economic and trade relations with its trading partners. Mexico, for example, has recently imposed anti-dumping duties of 54–500 per cent on Chinese textiles and clothing


(Moore 1995). China has to rely entirely on bilateral efforts to deal with such problems since it is not a WTO member. The recent change in the rules of origin concerning textile and clothing imports in the United States is likely to have an adverse effect on China’s exports. In accordance with Section 334 of the US Uruguay Round Agreement Act (implementation legislation), changes in the rules of origin (effective on 1 July 1996) will affect a broad range of products (Tshirts, pants and dresses). The new rules will, in most cases, treat the country of assembly as the country of origin, and quotas will be charged against this country. Countries like China, which rely heavily on processing trade, will be most affected by such a change. While WTO members may have access to compensation in accordance with WTO agreements (including the ATC), it is unlikely that China will be compensated. Even if China were to be admitted to WTO membership in the near future, there is the possibility that its exports would be subject to discriminatory restrictions under a special safeguard provision which is most likely to be included in the Protocol of Accession of China. This special safeguard is distinct from the transitional safeguard in the ATC. As China is considered to be a planned economy with broad government interventions in production and trade, the United States and the European Union have been insisting on the inclusion of a special safeguard provision in China’s Protocol of Accession. This provision would allow other WTO members to impose quantitative restrictions specifically against China upon the determination of a surge of Chinese imports and serious damage or threat thereof to industries in destination markets. Such a mechanism is similar to the safeguard mechanism based on the concept of market disruption contained in the MFA. The proposals by the United States and the European Union on the text of such a special safeguard provision also contain a mechanism for third countries to have recourse to such measures on the basis that the imposition of restrictions by other countries has resulted in a diversion and surge of China’s exports to their markets. There is little doubt that such a mechanism will be applied mostly against China’s most dynamic exports of labour-intensive products, such as textiles and clothing. Furthermore, such a mechanism will be open to use by any member of the WTO, whether developed or developing. Therefore, there is reason to suspect that even if China gains early accession to the WTO, it may continue to face MFA-type restrictions. Anti-dumping is yet another source of concern for China. By using thirdcountry reference prices in the determination of dumping margins, the actual costs of China’s exports are virtually disregarded. Although strongly opposed by China during the WTO membership negotiations, this practice is likely to continue in the foreseeable future. Rising regionalism and the spread of preferential trade agreements is another development unfavourable to China. To some extent, China fears that it has been marginalised. China has not even been granted preferential arrangements in a global feature such as the generalised system of preferences (GSP) in one of its


main export markets—the United States. In the textile sector, several recent developments will further affect China: the formation of the North American Free Trade Area (NAFTA); the enlargement of the European Union to include Austria, Sweden and Norway; the European Union’s preferential agreement with Turkey—a rapidly expanding exporter of textiles and clothing—eliminating all the quota restrictions on Turkey, effective on 1 January 1996; and the European Union’s preferential agreements with Central and Eastern European economies eliminating all quota restrictions on them by 1 January 1998 (ITCB 1995). Sweden abolished MFA quotas in 1991, but its accession to the European Union means that this market is under quota restriction again. Another important recent development is Japan’s intention to impose quantitative restrictions on China’s textile and clothing exports. Japan has never imposed MFA restrictions on developing exporters. It was a large exporter of both textiles and clothing before the 1970s and remains a significant exporter of textiles today. However, with rising export competition from the NIEs in the 1960s and 1970s (and later from China), Japan has gradually changed from being a large net exporter of textiles and clothing to a large net importer of clothing and a significant importer of textiles. Rising import competition in the domestic market has led to intensive structural adjustment in Japan’s textile industry in the past decade. Increasing restrictions in the US and EU markets have led to rapid diversification and diversion of Chinese exports to the Japanese market. China’s shares in Japan’s total imports of textiles and clothing have risen dramatically in recent years. For textiles, China’s share increased from 24.6 per cent in 1992 to 32.4 per cent in 1994; and for clothing, from 43.3 per cent in 1992 to 53.8 per cent in 1994 (WTO 1995). As a result, Japan became China’s largest industrial market for textiles and clothing exports in 1994. Rising import competition has aroused increasing calls from Japan’s domestic textile industry for import protection. Starting in October 1994, at the request of the Japanese government, several rounds of consultations were held between China and Japan on possible ‘voluntary export restraints’ of a range of textile products by China. On 9 November 1995 the Japanese government decided that restrictions would not be imposed for the time being due to a decline in China’s exports of these products to Japan during the period under investigation. This development may have far-reaching implications for China. New grey area agreements against China could spread (Yang 1996). This may threaten newly emerging markets such as the NIEs. The WTO is yet to deal with such arrangements involving non-WTO members. A QUANTITATIVE ASSESSMENT OF THE ATC In this section, the GTAP model4 is used to assess the effect of MFA reform. The full GTAP model (Version 2) covers 24 regions and 37 commodities. In this study, a 10x10 version of the model (10 commodities and 10 regions) has been


used. The 10 countries and country groups are Australasia (Australia and New Zealand), North America (the United States and Canada), the European Union, Japan, the NIEs (Hong Kong, the Republic of Korea and Taiwan), ASEAN (Indonesia, Malaysia, the Philippines, Singapore and Thailand), China, South Asia (Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka), Latin America, and the Rest of the World (ROW). As the phasing out of the MFA is heavily end-loaded, the full impact of the reform will probably not be felt until after the quotas are completely abolished. In addition, rapid economic growth and the expected change in the structure of the Chinese economy should be taken into account in evaluating the effect of MFA reform on China. For this reason, the world economy is projected to the year 2005—when the Uruguay Round reform will have been fully implemented —before comparative static analysis of the reform is carried out. The projections are based on Hertel et al (1996). A modification was made with regard to the projection of China’s labour force. Much higher labour force growth is assumed in this study than in Hertel et al. (1996). This is based on the observation that large unemployment and underemployment exists in both urban and rural China, and hence the effective labour force can grow much more rapidly than the population for the period 1992–2005.5 In fact, it is projected that China’s labour force will grow as fast as South Asia’s, although its population growth will be substantially slower (Table 11.3). China is projected to have the most rapid capital accumulation and GDP growth over the period 1992–2005. This reflects the strong growth performance in the past decade and an optimistic assumption of the stability of the economy in the future. The implied 9 per cent annual growth rate does not seem unrealistic if China continues with its reform programs. The rapid growth of capital means that China will become increasingly capital abundant. In projecting the world economy to 2005, the current restraints of MFA quotas remain. The projected growth of MFA quotas is based on Hertel et al. (1996) and UNCTAD (1995a). In general, projected quota growth rates Table 11.3 Projected changes in factor endowments and real GDP, 1992–2005 (per cent)

Source: Based on Hertel et al. (1996).


for China are slower than for most other developing economies. Since exports to North America and the European Union are exogenously determined, the export tax equivalents of the quotas are allowed to change over time to reflect the changes in the extent of MFA restrictions. The magnitudes of trade elasticities in the GTAP model are doubled in the projection simulation. This is based on Gehlhar (1997), who showed that past growth and trade patterns in the Pacific Rim were best replicated with the model when these elasticities were doubled. The alteration is primarily based on the observation that terms-of-trade effects seem to be unrealistically strong for small economies when the original GTAP elasticities are used. China is estimated to gain as much as US $8.6 billion (as measured by equivalent variation) from the phasing out of the MFA, despite a considerable deterioration of the terms of trade which results from the loss of quota rents (Table 11.4). The benefit results from substantial increases in the exports of textiles and clothing. This will lead to expansion of production in both the textile and clothing industries. However, clothing will expand more than textiles because current MFA quotas are much more stringent on clothing exports than on textile exports. Trade liberalisation therefore boosts the clothing industry more than the textile industry. The welfare gain from MFA reform will account for nearly two-thirds of China’s total benefits from the Uruguay Round trade liberalisation. The elimination of the MFA will also contribute in a major way to increases in GDP, real wages and trade. The non-MFA reforms of the Uruguay Round will reinforce MFA reform. Under the complete Uruguay Round reform scenario, the expansion of clothing production is considerably stronger than under the MFA reform alone. Tariff cuts will induce substantial increases In imports of textiles and clothing. The reduction in the tariffs on textiles will stimulate clothing production and hence exports. Should the MFA remain for China but be abolished for all other developing economies, China would be significantly adversely affected (Table 11.4). Whether or not China continues to face MFA quotas makes a difference of nearly US $16 billion to its welfare. The adverse effect on China of continued MFA restrictions would come largely from increased competition from other developing economies when the MFA quotas on them are abolished. North America and the European Union also lose considerably from China’s exclusion from MFA reform because they would have to pay higher prices for Chinese goods than they would otherwise. Other developing economies, of course, gain from reduced competition from China. IMPLICATIONS OF STRUCTURAL CHANGE FOR TEXTILES AND CLOTHING6 Whether China will continue its rapid growth of textile and clothing exports depends on not only demand conditions but also on its supply potential. There


Table 11.4 The impact of the Uruguay Round trade liberalisation, 2005 (percentage change)

Source: Simulations of the GTAP model.

are two major factors which will determine the long-term growth of China’s textile and clothing exports. The first is continued economic reform. In standard neoclassical analysis, reforms will only have one-off effects, and will not accelerate the long-term growth rate of the economy. A growing body of literature suggests, however, that openness may boost long-term growth rates (Edwards 1993). The second major factor is the shift in comparative advantage in the world textile and clothing sector. Because textiles and clothing are labour intensive, especially clothing, China’s comparative advantage in textiles and clothing lies largely in its abundant supply of unskilled labour. With rapid economic growth in the past one and a half decades, this has begun to change. In some coastal areas, rapid export expansion has led to shortages in unskilled labour, inducing large-scale migration from inland areas despite restrictions on migration. At the same time, rental costs for land in coastal areas are also increasing, exerting pressure for production facilities to move to the west. Given great variations in labour costs in different parts of China, it will take a considerable time for an overall labour shortage in China to emerge. Large pools of the unemployed and underemployed in most rural areas will provide virtually unlimited labour resources for the coastal areas to draw on. Policies aimed at reducing the costs of migration from the west to the east will enable China to use these vast human resources. Household registration has been a major constraint


on migration, although the system is losing its grip on the rural population. Other policies have also hindered effective use of migrant resources in urban areas. For example, migrants are seldom eligible for government housing, medical care and education. There are still restrictions on employment of rural migrants in state enterprises. Restrictions are also imposed on where migrants may live in urban areas, with some cities collecting tolls on migrants. An alternative policy for tapping China’s human resources is to improve the infrastructure in inland areas. This will not only reduce migration costs if farmers choose to migrate east but also provide the necessary conditions for indigenous industries to thrive should would-be migrants decide to remain in the west. This may also attract entrepreneurs to inland areas and is likely to reduce east-west income inequality, which has been growing since the beginning of reform in the late 1970s. With rapid growth, capital accumulation will continue to be rapid. In fact, the projected growth of capital is more rapid than income growth. This can either be achieved by attracting more foreign investment or increased domestic savings, a continuation of past experience. Land resources are assumed to be constant over the period of projection. Thus increases in agricultural output will be achieved solely through improvements in productivity and increases in the use of labour and capital. Table 11.5 shows two scenarios of projection based on these considerations. In the first scenario, changes in trade policies resulting from the Uruguay Round trade liberalisation are taken into account. The growth of the economy is driven both by factor accumulation and trade liberalisation. Simulation results show that sectors that are more capital intensive tend to grow more rapidly over the period than labour-intensive sectors. Processed food, textiles, iron and steel, other manufactures and services grow much more slowly than the overall growth of the economy. The slower growth in some of these sectors is partly attributed to relatively slow growth in demand because of lower income elasticities for these commodities. The rapid growth of clothing production largely results from the phasing out of the MFA. As the numbers in the parentheses show, without the Uruguay Round trade liberalisation, the increase in clothing production would be more than halved, growing at a much slower pace than the economy as a whole. In general, trade restrictions in industrial economies tend to be more stringent on labour-intensive products than on capital-intensive products. Trade liberalisation resulting from the Uruguay Round tends to favour labour-intensive industries in developingeconomies. With Uruguay Round reform, China’s textile production will grow less rapidly than other Asian economies except South Asia, while without the reform, it will grow more rapidly than other Asian economies except ASEAN. Despite the boost of MFA reform, China’s clothing production will increase less rapidly than in other Asian economies, although it will expand more strongly than in the NIEs. Without reform, however, China’s clothing production will outperform South Asia’s but will grow less rapidly than in the NIEs and the ASEAN economies.


Table 11.5 Projected cumulative changes in production in selected developing economies, 1992–2005 (per cent)a

Note: a Numbers without parentheses denote results from the scenario with trade liberalisation and those in parentheses denote results from the scenario without trade liberalisation. Source: Simulations of the GTAP model.

Export growth shows similar trends (Table 11.6). With increasing capital abundance, China’s capital-intensive exports will tend to increase more rapidly than labour-intensive exports. Regardless of trade liberalisation, textile exports are likely to grow much more slowly than overall exports. For clothing, the phasing out of the MFA leads to above-average growth of exports. Without MFA reform, export growth can barely keep pace with overall exports. Although the phasing out of the MFA will take a decade, most of its impact will be felt towards the end of the transition period. Once MFA reform takes full effect, the growth of textile and clothing exports is likely to resume its long-term trends. The projections in the scenario without Uruguay Round trade liberalisation are more likely to represent such longterm trends. Thus, China’s textile exports will grow relatively slowly and its clothing exports will probably grow more slowly than overall exports once the one-off impact of MFA reform is absorbed. Much will depend on relative growth of labour and capital. Even with an abundant supply of labour, China will still shift to more capital-intensive exports as long as rapid economic growth is maintained. Nevertheless, given


Table 11.6 Projected cumulative changes in exports in selected developing economies, 1992–2005 (per cent)a

Note: a Numbers without parentheses denote results from the scenario with trade liberalisation and those in parentheses denote results from the scenario without trade liberalisation. Source: Simulations of the GTAP model.

their large export volumes at present, textiles and clothing will remain important to China’s overall exports for a considerable time in the future. CONCLUSION The textile and clothing sector spearheaded China’s industrialisation and even maintained respectable growth during the pre-reform period, Economic reform has put the sector at the forefront of China’s export-oriented growth. Overall improvements in the domestic economic environment have contributed to the rapid growth of textile and clothing exports. In particular, rural reform, foreign investment and the rise of township enterprises have all increased the competitiveness of Chinese exports, Specific policies aimed at promoting textile and clothing exports may also have helped but the significance of their impact is likely to be limited. Large production capacities built up in the past and high


labour intensity have given the textile and clothing sector an export advantage over other sectors, The Uruguay Round trade liberalisation has provided China with both opportunities and challenges. If China can secure the abolition of MFA quotas on its products, its textile and clothing sector will benefit substantially. If quotas continue to apply to China after the phasing-out of the MFA, the competitiveness of Chinese textile and clothing exports will suffer, and its market share in North America and the European Union will be reduced, Early entry to the WTO will give China a greater opportunity to secure the benefits of the ATC but much will depend on what will be included in China’s accession protocol. Current negotiations on China’s accession point to the danger that systematic discrimination against Chinese exports is likely to be legalised. It is still not clear whether the ATC will lead to liberal world trade in textiles and clothing. Apart from the potentially frequent resort to the special safeguard provisions of the ATC, there is a possibility that importing economies may increasingly use anti-dumping, countervailing and other safeguard measures to substitute for the MFA. Extensive government interventions in the economy make China a vulnerable target for such measures. The demand-side uncertainties, however, should not be overstated. China has shown in the past that it can maintain rapid export growth despite increasing protection abroad. The key to such sustained growth has been economic reform, Trade liberalisation will not only strengthen China’s bargaining power in countering dumping and subsidy charges, but perhaps more importantly improve the efficiency of China’s textile and clothing sector, Phasing out domestic GATTinconsistent policies and increases in the costs of raw materials, especially cotton, will level the playing field for exports. As a result, access to imports at world prices will be increasingly important for China’s textile and clothing exports. With rapid economic growth and resulting capital accumulation, China’s comparative advantage is shifting to more capital-intensive products. The phasing out of the MFA will provide a one-off boost to exports in the next decade or so, but this is unlikely to reverse long-term trends in structural change. Nevertheless, the vast untapped human resources in inland areas mean that Chinese textile and clothing exports can remain competitive for a long time to come, as long as policies are put in place to facilitate factor mobility around the country. Rapid skill accumulation will enable coastal regions to move up-market in certain manufacturing activities but traditional labour-intensive production will remain in these regions to absorb large pools of unskilled labour. NOTES 1 The research for the study began while one of the authors, Zhong Chuanshui, was visiting the Australia-Japan Research Centre, Australian National University (ANU), from November 1995 to February 1996. The author would like to thank the


2 3 4

5 6

Australia-Japan Research Centre for making the visit possible. The research benefited from discussions with Professors Peter Drysdale and Ross Garnaut and other colleagues at the ANU. Significant shipments through the processing zones are included. This section draws heavily on Yang (1996). The GTAP model was developed under the Global Trade Analysis Project led by Thomas Hertel of Purdue University. Interested readers are referred to Hertel (1997) for more details of the model. For more elaborate discussions of the supply issues, see Yang and Zhong (1998). This section draws on Yang and Zhong (1998).

REFERENCES Anderson, K. (1992) ‘The changing role of fibres, textiles and clothing as economies grow’, in K.Anderson, ed., New Silk Roads: East Asia and world textile markets, Cambridge: Cambridge University Press. Bagchi, S. (1994) ‘The integration of the textile trade into GATT’, Journal of World Trade, 28(6):31–42. Cline, W.R. (1995) ‘Evaluating the Uruguay Round’, The World Economy 18(1):1–23. Edwards, S. (1993) ‘Openness, trade liberalization, and growth in developing countries’, Journal of Economic Literature 31 (3):1358–93. GATT (1993) An Analysis of the Proposed Uruguay Round Agreement, with Particular Emphasis on Aspects of Interest to Developing Economies, Geneva, 29 November. Gehlhar, M. (1997) ‘Historical analysis of growth and trade patterns in the Pacific Rim: an evaluation of the GTAP framework’, in T.Hertel, ed., Global Trade Analysis: Modeling and applications, New York: Cambridge University Press. Hertel, T., W.Martin, K.Yamagashima and B.Dimaranan (1996) ‘Liberalising manufactures trade in a changing world economy’, in W.Martin and A.Winters, eds, The Uruguay Round and the Developing Countries, New York: Cambridge University Press. Hertel, T. ed. (1997) Global Trade Analysis: Modeling and applications, New York: Cambridge University Press. ITCB (International Bureau of Textiles and Clothing) (1995) Twenty-First Council Meeting Documents, Geneva. Ministry of Foreign Trade and Economic Cooperation (1994–95) Almanac of Foreign Economic Relations and Trade, Beijing: Publishing House of Foreign Trade. Ministry of Textile Industry (1988) Almanac of China’s Textile Industry 1986–87, Beijing: Publishing House of Textile Industry. Moore, L. (1995) ‘The competitive position of Asian producers of textiles and clothing in the US market’, The World Economy 18(4):583–602. State Statistical Bureau (1985) China Statistical Yearbook, Beijing: Publishing House of Statistics. Trela, I. and J.Whalley (1990) ‘Global effects of developed country trade restrictions on textiles and apparel’, Economic Journal 100:1190–205. UNCTAD (United Nations Commission for Trade and Development) (1995a) An Analysis of Trading Opportunities Resulting from the Uruguay Round in Selected


Sectors: Agriculture, Textiles and Clothing, and Other Industrial Products, Geneva: UNCTAD. —— (1995b) Preliminary Analysis of Opportunities and Challenges Resulting from the Uruguay Round Agreement on Textiles and Clothing, UNCTAD/ITD/17, Geneva: UNCTAD. Whalley, J. (1992) ‘The Multi-fibre Arrangement and China’s growth prospects’, in K. Anderson, ed., New Silk Roads: East Asia and world textile markets, Cambridge: Cambridge University Press. WTO (1995) International Trade: Trends and statistics, Geneva: WTO. —— (1996) WTO Focus no. 7, March, Geneva: WTO. Yang Y. (1992) ‘The impact of the Multifibre Arrangement on world clothing and textile markets with special reference to China’, PhD dissertation, Australian National University, Canberra. —— (1995) ‘China’s textile and clothing exports: challenges in the post-MFA period’ Pacific Economic Papers 3(250), Australia-Japan Research Centre, Australian National University, canberra. —— (1997) ‘Safeguarding the future of world trade in textiles and clothing’, Asia-Pacific Economic Review 3 (3) (forthcoming). ——, W.Martin and K.Yamagashima (1997) ‘Evaluating the benefits of MFA liberalization in the Uruguay Round’, in T.Hertel, ed., Global Trade Analysis: Modeling and applications, New York: Cambridge University Press. —— and C.Zhong (1998) ‘China’s textile and clothing exports in a changing world economy’, The Developing Economies 36(1):3–23.

12 Rapid economic growth in China Implications for the world economy1 Warwick J.McKibbin and Yiping Huang

INTRODUCTION Economic reforms starting from 1979 have brought significant changes to the Chinese economy. The growth rate of real gross domestic product (GDP) averaged 9.1 per cent per annum between 1978 and 1995 (Figure 12.1). While the official statistics, such as those published by the World Bank (1995), still suggest a very low per capita income in the early 1990s in China ($510 in 1994), they are widely regarded as substantially under-estimated (Summers and Heston 1991, Garnaut and Ma 1993 and Ren 1995). Garnaut and associates, based on careful comparison of consumption patterns of food and other commodities in China and the other East Asian economies, suggest that the income level in China was underestimated by a factor of three in the year 1990, which implies a GNP per capita of about $1,000 in 1990 and $1,500 in 1994 (Garnaut and Ma 1993; Garnaut, Ma and Huang 1995).2 This estimate of income level is consistent with the findings of most other studies (Perkins 1992, Lardy 1994 and Ren 1995) and places China at the lower end of the range of the middle-income economies. One important characteristic of the growing Chinese economy is its increasing outward orientation. Chinese foreign trade grew at an annual rate of 13 per cent in the period 1978–95. The share of merchandise exports in total GDP (appropriately measured) rose from about 3 per cent in 1978 to nearly 7 per cent in 1995. China’s share of world merchandise exports increased from less than 1 per cent to 2.5 per cent over the same period. The rapid export growth has, in turn, been led by the dramatic expansion of labour-intensive manufactured exports. The share of labour-intensive manufactured goods in total exports rose from around 30 per cent in 1978 to 56 per cent in 1995. In the early 1990s, China became the largest recipient country of foreign direct investment (FDI) among the developing economies and the second in the world only after the United States. In the mid-1990s, China also became the largest investor in the rest of the world among the developing countries. The increasing outward orientation of the rapidly growing Chinese economy has already had an important impact on the world economy, particularly its


Figure 12.1 Growth rate of GDP and trade in China, 1978–95 (per cent)

Source: Plotted using growth rate figures of GDP and trade from the Statistical Yearbook of China 1997.

neighbouring East Asian economies. The fact that the rate of China’s total trade grew by an average of 13 per cent and that in most years of the past one and half decades, China experienced trade deficits suggest that the rest of the world enjoyed a rapidly expanding market for their exports in the course of Chinese economic growth. There has also been a significant relocation of labourintensive plants to. China from Taiwan, Hong Kong and Korea in the past few years which also facilitated structural adjustment in these East Asian economies. The sustainability of China’s rapid growth is a matter of concern for China as well as for the international community. While there are some uncertainties related to the leadership succession, political stability and possibilities of mistaken macroeconomic policy, the general consensus among economists is that China is likely to be able to sustain its current growth momentum for a relatively long period (Lau 1993; Lin, Cai and Li 1994; Huang and Duncan 1995). The sustainability of China’s economic growth will have important implications for the rest of the world as well as being dependent on the reactions of the rest of the world toward the emerging Chinese economy. The strategies adopted by the other countries, in turn, are largely determined by their perception of the opportunities and challenges brought to them by the ascendancy of the Chinese economy. China is already an important player in the international economy, yet it is nonetheless still excluded from the World Trade Organisation. Negotiations between China and the member countries of the GATT/WTO over China’s accession have been going on for about ten years and there is still no clear sign of a successful conclusion in the near future.

194 RAPID ECONOMIC GROWTH IN CHINA

This raises the importance of a careful assessment of the implications of China’s rapid growth for the world economy. There is currently a debate in the literature about whether China will be able to continue its export-led growth. Lau (1993) predicts that the export ratio will fall in the future because the world economy will not be able to adjust to continued rapid increases in Chinese exports and because there will be opportunities to increase the relative importance of internal trade. Lau’s view implies a sharp and large break from the past relationship between trade and growth in China in the reform era. Taking into account the under-measurement of GDP discussed above, Garnaut and Huang (1995) argue that the export-GDP ratio in China is still lower than those of the other East Asian economies and lower than that of large countries like the United States. Their assessment is that, within an effective, rule-based international trading system, and continued Chinese trade liberalisation in the framework of the Uruguay Round settlement, China’s foreign trade will continue to grow more rapidly than output.3 The international community is concerned about a number of issues related to the rapid growth in China, particularly given its size and institutional history. Will China’s continued rapid growth take away trade and investment opportunities from the other poor countries at similar levels of development and cause difficulties in structural adjustment for the industrialised economies (Lardy 1994, Garnaut and Huang 1995)? As China’s population and income continue to grow, will it lead to a scarcity of agricultural products resulting in a dramatic food shortage for a large part of the world’s population (Brown 1995)? In this study, we will apply the dynamic general equilibrium model called GCUBED, developed by McKibbin and Wilcoxen, to explore possible future paths of the Chinese economy based on projections of population growth, productivity growth, and energy efficiency improvements in the Chinese economy. This model captures not only the composition of the direct trade impacts of development in the Chinese economy but also the implications of the endogenous financial capital on macroeconomic adjustment in the world economy. The study focuses on the likely changes in the period 1990–2020. It allows an examination of the implications of low and high productivity growth in China for the rest of the world. This chapter is organised as follows. The next section reviews the existing studies on the economy-wide and sectoral productivity growth of the Chinese economy to give an historical context for the projections we are undertaking. The G-CUBED model is introduced in the following section, focusing on the key features of the model that are important for the results of this chapter. The alternative future scenarios, simulated using the G-CUBED model, are then presented, followed by the concluding section. The approach taken in this chapter is very much in the spirit of the single economy study by Ho et al. (1995), although in this chapter the interdependence of the Chinese economy with the global economy is more of a focus.


We find that alternative growth scenarios have important implications for the world economy. We stress that the results are sensitive to the assumptions of the model we use and to the assumptions of variables that are exogenous to the model. The goal of this chapter is to point to the important insights that a modelling approach to future scenarios for the Chinese economy can provide rather than to provide definitive answers about the shape of China and the world economy in 2020. PRODUCTIVITY GROWTH IN THE CHINESE ECONOMY The sources of economic growth In projecting possible future paths for the Chinese economy, it is important to incorporate growth projections of the global economy. In undertaking these growth projections it is important to have a clearly specified growth accounting framework. We will get to the global assumptions, but before this, it is useful to set out some core assumptions of the approach taken. At an abstract level there are four sources of growth within an indi-vidual economy: 1) 2) 3) 4)

increases in the supply of labour, capital and other inputs; increases in the quality of these inputs; improvements in the way inputs are used (technical change); and improvements in the way that inputs are allocated across industries.

For the world economy as a whole, a fifth source of growth is reallocation of inputs among countries. In the following modelling framework each of these sources of growth are explicit, although some of these sources of growth we take to be exogenous and some sources of growth are endogenous in the model. To understand the way growth accounting is used in this chapter, consider a simple model. Following Bagnoli, McKibbin and Wilcoxen (1996), suppose the production process may be represented by a constant returns to scale function Q which depends on the level of technology, A, and quality-adjusted inputs of capital, labour and materials: (1) where Yt is output at time t, K, Lt Et and Mt are inputs of capital, labour, energy and materials; A{is a coefficient reflecting the overall level of productivity; and Ft Gt Ht and It are coefficients capturing the quality of each input. This expression can be transformed into a relationship between growth rates by differentiating with respect to time and dividing through by Yt, If firms minimise costs, taking prices as given, it is straight-forward to show that the rate of output growth will be given by:


(2) where the first term on the right hand side is called the rate of total factor productivity (TFP) growth, and SK, SL, SE and SM are the shares of capital, labour, energy and materials in total costs. As an empirical matter, decomposing output growth into its constituent elements is a difficult task. For many industries, measuring the rate of output growth y is fairly straightforward: the quantity produced in one year is compared to the quantity produced the previous year. However, determining the source of the growth requires very careful accounting to measure the quality-adjusted rates of growth of factor inputs. Any errors in measuring inputs will cause the rate of total factor productivity growth to be mis-stated. Thus, in order to project the world economy over the next few decades, we would need underlying projections of each country’s labour force, capital stock, materials inputs, energy inputs, changes in factor quality and changes in product demand patterns. Many of these will lead to changes in relative prices and thus change the structure of each region’s economy. Moreover, the evolution of each country’s capital stock will be an endogenous result of domestic and foreign investment decisions. In order to combine all of these projections, capture the effects of relative price changes, and project the future path of the capital stock, we will use a disaggregated intertemporal general equilibrium model called GCUBED. In the next section we describe the key features of the G-CUBED model. In the subsequent section we survey empirical estimates of Chinese productivity growth rates and discuss the estimates used in G-CUBED to generate projections of the world economy over the next few decades. Historical evidence on productivity growth in the Chinese economy In Bagnoli, McKibbin and Wilcoxen (1996) a number of studies of economywide and sectoral productivity growth for a range of countries are surveyed. We draw on that earlier survey as well as a number of other studies to produce a table of historical estimates of the source of growth in China. These are presented in Table 12.1. Several points can be made from these results for aggregate growth of the Chinese economy. Prior to the economic reforms, GDP growth averaged under 6 per cent per year and after the reforms around 1979, GDP growth averaged around 8 per cent per year depending on the period under study. The contribution of capital to both pre-reform and post-reform periods appears to be large. The contribution of labour, both in terms of labour force growth and improvements in labour quality were less important in both pre- and post-reform periods. The role of total factor productivity (TFP), the residual in our above accounting framework, is more important in the post-reform period than the pre-reform period.


Table 12.1 Economy-wide growth in China: selected studies

Sources: Drawn from studies of Maddison (1989), Li et al. (1993), Bosworth, Collins and Chen (1995), Huang and Duncan (1995) and Bagnoli, McKibbin and Wilcoxen (1996).

As well as the economy-wide studies, we also present some evidence from sectoral studies of growth in China in Table 12.2. The results in Table 12.2 show that the experience at the sectoral level in China is very different to the average overall productivity experience. This stylisation of sectoral productivity growth is not unique to China but, as surveyed by Bagnoli, McKibbin and Wilcoxen (1996), this result is found for most other countries. Productivity growth varies a great deal across sectors within a country as well as across countries in different time periods. This feature of productivity growth experience makes the forward projection of total factor productivity changes fraught with problems. It also suggests that aggregate projections of productivity may be problematic given the differential experience at the sectoral level. Bagnoli, McKibbin and Wilcoxen (1996) demonstrate that different assumptions of productivity growth at the sectoral level can lead to significant structural differences between any two economies with the same aggregate GDP growth experience. THE G-CUBED MULTI-COUNTRY MODEL We now present a brief overview of the features of the G-CUBED model that are important for this study. A more complete description is contained in McKibbin and Wilcoxen (1995) with a range of applications of this model in McKibbin and Wilcoxen (1996). G-CUBED has several features which together distinguish it from other models in the literature. It uses econometric estimates of parameters describing preferences and production technology; it integrates macroeconomic adjustment


Table 12.2 China’s total factor productivity for G-cubed sectors: selected studies

Sources: Drawn from studies of Chen et al. (1988), McGuckin et al. (1992) and Li et al. (1993).

with the sectoral adjustment to changes in exogenous variables; it captures the link between flows of goods and flows of assets between economies; and it endogenously determines financial prices such as interest rates and exchange rates, which play a crucial role in the adjustment of the global economy to alternative projections and policies. It also endogenises the investment decision which is determined by expected real and financial rates of return subject to adjustment costs in relocating physical investment once in place. G-CUBED disaggregates the world economy into the eight economic regions listed in Table 12.3. Each region is further decomposed into a household sector, a government sector, a financial sector, the twelve industries shown in Table 12.3, and a capital goods producing sector. This disaggregation enables us to capture regional and sectoral differences in the impact of alternative economic policies. In the remainder of this section we present an overview of the theoretical structure of the model. To keep notation as simple as possible we have not subscripted variables by country except where needed for clarity. The complete model, however, consists of eight of these sub-models linked by international trade and asset flows. PRODUCER BEHAVIOUR Each producing sector is represented by a single firm which chooses its inputs and its level of Investment in order to maximise its stock market value subject to a multiple-input production function and a vector of prices it takes to be exogenous. We assume that output can be represented by a constant elasticity of substitution (CES) function of inputs of capital (A), labour (L), energy (E) and


Table 12.3 Overview of the G-CUBED model

Source: From the G-CUBED model developed by McKibbin and Wilcoxen (1995).

materials (M). Omitting industry and country subscripts the production has the following form: (3)

where Q is the industry’s output, Xi is the quantity of input j, and A0, and 0 are estimated parameters which vary across industries. In addition, the A0 and parameters vary across countries. Without loss of generality we constrain the to sum to one. We introduce technical change by specifying that XL, the effective input of labour in each industry, is equal to hours of work multiplied by a country —and industry-specific labour quality adjustment factor. This specification has the effect of making stationary the ratio of prices to wages per effective labour unit (Harrod neutrality), which is convenient when solving the model. Energy and materials, in turn, are CES aggregates of inputs of intermediate goods. The form of the function is the same as for the output tier but the inputs and estimated parameters are different. For energy:


(4) where XE is the industry’s input of energy, Xj is the quantity of input j, and AE and E are estimated parameters which vary across industries. As before, AE and the parameters also vary across countries. The materials aggregation is defined in a similar manner. In order to estimate the parameters in these equations we constructed a timeseries dataset on prices, industry outputs, value-added and commodity inputs to industries for the United States. The following is a sketch of the approach we followed; complete details are contained in McKibbin and Wilcoxen (1995). We began with the benchmark input-output transactions tables produced by the Bureau of Economic Analysis (BEA) for the years 1958, 1963, 1967, 1972, 1977 and 1982. The conventions used by the BEA have changed over time, so the raw tables are not completely comparable. We transformed the tables to make them consistent and aggregated them to twelve sectors. We then shifted consumer durables out of final consumption and into fixed investment. We also increased the capital services element of final consumption to account for imputed service flows from durables and owner-occupied housing. Finally, we used a dataset constructed by Dale Jorgenson and his colleagues to decompose the value added rows of the tables, and a dataset produced by the Office of Employment Projections at the Bureau of Labour Statistics to provide product prices. We use these data to estimate the elasticities of substitution in production at different levels of the nest. To parameterise the other regions we impose the restriction that substitution elasticities are equal throughout the world. In other words, we assume that each industry has the same energy, materials and KLEM substitution elasticities no matter where it is located. This is consistent with the econometric evidence of Kim and Lau in a number of papers (see, for example, Kim and Lau 1994). However, the share parameters for other regions corresponding to individual countries (Japan, Australia, China and approximately the Eastern Europe and Former Soviet Union region) are derived from input-output data for those regions and are not set equal to their US counterparts. The share parameters for the remaining regions, which are aggregates of individual countries, are calculated by adjusting US share parameters to account for actual final demand components from the aggregate national accounts data for each of the regions. In effect, we are assuming that all regions share production methods that differ in first-order properties but have identical second-order characteristics. This is intermediate between the extremes of assuming that the regions share common technologies and of allowing the technologies to differ across regions in arbitrary ways. Finally, the regions also differ in their endowments of primary factors and patterns of final demands. The main limitation of this approach is that there are


very few benchmark input-output tables so our dataset contains few observations. The problem is severe outside OECD countries. Maximising the firm’s short-run profit subject to its capital stock and the production functions above gives the firm’s factor demand equations. At this point we add two further levels of detail: we assume that domestic and imported inputs of a given commodity are imperfect substitutes, and that imported products from different countries are imperfect substitutes for each other. Thus, the final decision the firm must make is the fraction of each of its inputs to buy from each region in the model (including the firm’s home country). We represent this decision using a two-tier CES function, although in this version of the model data limitations have forced us to impose unitary substitution elasticities. We assume that all agents in the economy have identical preferences over foreign and domestic varieties of each particular commodity. We parameterise this decision using trade shares based on aggregations of the 4-digit level of the United Nations SITC data for 1987. The result is a system of demand equations for domestic output and imports from each other region. In addition to buying inputs and producing outputs, each sector must also choose its level of investment. We assume that capital is specific to each sector, that investment is subject to adjustment costs, and that firms choose their investment paths in order to maximise their market value. The capital stock changes by the amount of gross investment less depreciation of existing capital. Following the cost of adjustment models of Lucas (1967), Treadway (1969) and Uzawa (1969), we assume that the investment process is subject to rising marginal costs of installation. To formalise this we adopt Uzawa’s approach by assuming that in order to install j units of capital, the firm must buy a larger quantity that is quadratic in the rate of investment. Setting up and solving the firm’s investment problem yields an equation for investment that depends on taxes, the size of the existing capital stock and marginal q (the ratio of the marginal value of a unit of capital to its purchase price). Following Hayashi (1979), the investment function is modified to improve its empirical properties by writing investment as a linear function of optimal investment and current capital income. This improves the empirical behaviour of the specification and is consistent with the existence of firms that are unable to borrow and therefore invest purely out of retained earnings. In addition to the twelve industries discussed above, the model also includes a special sector that produces capital goods. This sector supplies the new investment goods demanded by other industries. Like other industries, the investment sector demands labour and capital services as well as intermediate inputs. We represent its behaviour using a nested CES production function with the same structure as that used for the other sectors. However, we estimate the parameters of this function from price and quantity data for the final demand column for investment.


Households Households consume goods and services in every period and also demand labour and capital services. Household capital services consist of the service flows of consumer durables plus residential housing. Households receive income by providing labour services to firms and the government, and from holding financial assets. In addition, they also may receive transfers from their region’s government. Within each region we assume household behaviour can be modelled by a representative agent with an intertemporal utility function that depends on consumption of private and public goods in each period and a rate of time preference. The household maximises its utility subject to the constraint that the present value of consumption be equal to human wealth plus initial financial assets. Human wealth (H) is the present value of the future stream of after-tax labour income and transfer payments received by households. Financial wealth (F) is the sum of real money balances, real government bonds in the hands of the public (Ricardian neutrality does not hold in this model because some consumers are liquidity-constrained; more on this below), net holdings of claims against foreign residents and the value of capital in each sector. Under this specification, the value of each period’s consumption is equal to the product of the time preference rate and household wealth. Based on the evidence cited by Campbell and Mankiw (1987) and Hayashi (1982), however, we assume that only a portion of consumption is determined by these intertemporally-optimising consumers and that the remainder is determined by after-tax current income. This can be interpreted as liquidity-constrained behaviour or as permanent income behaviour when household expectations are backward-looking. Either way, we assume that total consumption is a weighted average of forward-looking consumption and backward-looking consumption. Within each period the household allocates expenditure among goods and services in order to maximise C(s), its intratemporal utility index. In this version of the model we assume that C(s) may be represented by a Cobb-Douglas function of goods and services. The supply of household capital services is determined by consumers themselves who invest in household capital in order to generate a desired flow of capital services. We assume that capital services are proportional to the household capital stock. As in the industry investment model, we assume that investment in household capital is subject to adjustment costs. Government We take each region’s real government spending on goods and services to be exogenous and assume that it is allocated among final goods, services and labour in fixed proportions, which we set to 1987 values. Total government spending includes purchases of goods and services plus interest payments on government


debt, investment tax credits and transfers to households. Government revenue comes from sales taxes, corporate taxes, personal income taxes, and from issuing government debt. In addition, there can be taxes on externalities such as carbon dioxide emissions. We assume that agents will not hold government bonds unless they expect the bonds to be serviced, and accordingly impose a transversality condition on the accumulation of public debt that has the effect of causing the stock of debt at each point in time to be equal to the present value of all future budget surpluses from that time forward. This condition alone, however, is insufficient to determine the time path of future surpluses: the government could pay off the debt by briefly raising taxes substantially; it could permanently raise taxes a small amount; or it could use some other policy. We assume that the government levies a lump sum tax equal to the value of interest payments on the outstanding debt. In effect, therefore, any increase in government debt is financed by consols and future taxes are raised enough to accommodate the increased interest costs. Thus, any increase in the debt will be matched by an equal present value increase in future budget surpluses. Other fiscal closure rules are possible, such as always returning to the original ratio of government debt to GDP. These closures have interesting implications but are beyond the scope of this chapter (see Bryant and Long 1994). International trade and asset flows The eight regions in the model are linked by flows of goods and assets. Flows of goods are determined by the bilateral import demands described above. These demands are summarised in a set of bilateral trade matrices which give the flows of each good between exporting and importing countries. There is one 8-by-8 trade matrix for each of the twelve sectors for each country. Trade imbalances are financed by flows of assets between countries. We assume asset markets are perfectly integrated across the OECD regions. With free mobility of capital, expected returns on loans denominated in the currencies of the various regions must be equalised from period to period according to a set of interest arbitrage relations. In generating the baseline of the model, we allow for risk premia on the assets of alternative currencies, although during simulations we assume these risk premia are constant and unaffected by the shocks under study. For the non-OECD countries we also make the assumption that exchange rates are free to float at an annual frequency. We also assume that capital is freely mobile within the regions and between the regions and the rest of the world. This may seem simplistic since many developing countries have restrictions on short-term flows of financial capital. Many of these countries nonetheless have significant flows of foreign direct investment responding to changes in expected rates of return. In the model, capital flows capture both of these effects because they include foreign direct investment as well as short-term financial capital. Future work will focus more on modelling financial markets in


the developing regions of the model. Finally, we assume that OPEC (Organisation of Petroleum Exporting Countries) chooses its foreign lending in order to maintain a desired ratio of income to wealth subject to a fixed exchange rate with the US dollar. Labour markets We assume that labour is perfectly mobile among sectors within each region but immobile between regions. Thus, within each region, wages will be equal across sectors. The nominal wage is assumed to adjust slowly according to an overlapping contracts model where nominal wages are set based on current and expected inflation and on labour demand relative to labour supply. In the long run, labour supply is given by the exogenous rate of population growth, but In the short run, the hours worked can fluctuate depending on the demand for labour. For a given nominal wage, the demand for labour will determine shortrun unemployment. Money markets Finally, we assume that money enters the model via a constraint on transactions. We use a money demand function in which the demand for real money balances is a function of GDP and short-term nominal interest rates. The supply of money is determined by the balance sheet of the central bank and is exogenous. Although there is a lack of explicit finan-cial markets in China, we treat financial prices as shadow prices that are used in making economic decisions. FUTURE PROJECTIONS In this section we first outline our procedure for generating a baseline for the global economy with a particular focus on the Chinese economy. Given this baseline, we then explore the implications of an increase in labour-augmenting technical change of 1 per cent for five years beginning in 1990. We examine the impacts of this higher growth rate for China and the world economy. The baseline The procedure for projecting the global economy from 1990 to 2020 is presented in detail in Bagnoli, McKibbin and Wilcoxen (1996). Here we summarise key aspects of the procedure. The model used in this chapter differs from that earlier paper primarily because the data for China have been adjusted to reflect the discussion outlined in the introduction, that Chinese GDP is apparently under estimated in the official statistics. The projections for population growth are based on World Bank projections for each region smoothed on an annual basis. These are summarised in Table 12.3.


We also need to make assumptions about productivity growth and technical change. We assume that all technical change and productivity growth is labouraugmenting technical change (Harrod-neutral technical change). This assumption is required to solve for a unique steady state in the neoclassical framework we are using. In the discussion in this section all references to productivity growth and technical change are in terms of labour-augmenting technical change (LATC). The assumptions about LATC are also given in Table 12.4. We assume each sector in each economy experiences the same rate of labour-augmenting technical change (Harrod neutral). This is likely to be an unsatisfactory representation of reality but is taken as a benchmark. In future studies we expect to modify the sectoral assumptions. In addition to the assumptions for technical change and population growth we need to make assumptions about other exogenous variables in the model. Fiscal spending is assumed to be fixed as a share of GDP in each country; monetary policy is assumed to target nominal growth with the target comprising underlying real growth plus the inflation rate observed in 1990; taxes are assumed to be at 1990 levels with a lump sum tax varying over time to satisfy the intertemporal budget constraints of the government; tariff rates are set to 1990 rates; oil prices are partly determined by OPEC supply decisions given a target ratio of income to wealth by the OPEC economies. Given these assumptions, which should (and will in future research) be subject to sensitivity analysis, we solve the model from 1990 to 2100. The solution is non-trivial because certain agents in the model have rational expectations. We have developed an algorithm that solves the model for the full rational expectations equilibrium through time such that the model solution for 1990 is equal to the database values for 1990 given the exogenous projections assumed above. Although not described in technical detail here (see McKibbin and Wilcoxen 1995), this algorithm forces the model to replicate exactly the database for 1990 and thus imposes that the year 1990 is on the stable manifold of the model adjusting towards a long-run equilibrium growth path. This is important because it means that, unlike static CGE models, we do not assume that the base year (1990 in this case) is a steady-state equilibrium of the model but that it is on a path (consistent with the rational expectations of agents) that is adjusting towards a long-run stable equilibrium. We do not focus on the baseline of the model per se. Instead, we want to see how, on the marginal effects of a change in assumptions about Chinese productivity growth, these changes impact on China, and through global financial and goods markets, how these changes impact on the rest of the world. The model projections for aggregate GDP growth in each region are given in Figure 12.2. This figure shows a gradual convergence of growth rates consistent with the convergence of LATC, although convergence is not complete because of different assumptions about population growth in each country during the period. Average GDP growth in China is 6.7 per cent from 1991 to 1999, 5.2 per cent from 2000 to 2009 and 4.3 per cent from 2010 to 2019.


A rise in Chinese productivity growth To illustrate the adjustment of the global economy to alternative growth scenarios for China, we next simulate a rise in LATC in China. For illustrative purposes we begin the simulation in 1991, assuming that the rate of growth of LATC rises by 1 per cent per year for five years and then returns to the baseline growth rate (although at a higher level) thereafter. This shock is assumed to be anticipated in 1991. Results for this shock are contained in Figures 12.3–12.7. In China the expectation of stronger future growth leads to a tightening of liquidity as shadow real interest rates rise. This dampens economic activity in 1991 but is more than offset by the rise in investment following the surge in productivity. Real GDP rises strongly (Figure 12.3) until 1996 when the growth in LATC returns to baseline. The overshooting of GDP reflects the investment expenditure which overreacts to the rise in the real return to capital. Part of the extra investment is funded through capital inflows into China. This can be seen by the increasing wedge between GDP (what is produced) and GNP (the income to domestic factors of production). The smaller rise in GNP compared with GDP reflects the increase in servicing costs (or repatriation of dividends) on the foreign capital that flows into China. It is seen even more clearly in Figure 12.4 where we present the deviation from baseline of the Chinese trade and current account balances as a percentage of baseline GDP. In 1991 there is a capital outflow, but this is quickly reversed between 1992 and 1995 as both the trade and current deficits move towards deficit. This reflects the capital account surplus resulting from foreign capital flowing into the Chinese economy. Part of this adjustment occurs through increased demand for goods in China pulling in imports and part is through a strengthening of the yuan exchange rate. Note that after the shock has passed, the trade balance moves quickly towards surplus reflecting the condition that the build-up of foreign debt and foreign investments in China must be serviced. Ultimately, Chinese exports must rise by more than Chinese imports (at the margin). In the rest of the world, the rise in Chinese demand for foreign goods, especially capital goods, raises incomes in the regions that produce the goods that China needs. In addition the rise in the return to capital in China yields a higher return to foreign investments in China, which raises incomes of the owners of foreign capital. Figure 12.5 shows the impact on GDP in the rest of the world. The United States and LDCs (less developed countries) gain in terms of GDP. Japan experiences lower GDP as a result of the extra productivity growth in China. This does not imply that Japan is worse off, however. Figure 12.6 shows the income effects of the shock. Capital flows from Japan into the Chinese economy. This financial capital ultimately implies less physical capital put in place in Japan but rather relocated to China (relative to what otherwise would have occurred) and thus production in Japan is less than it otherwise would have been. However, this capital in China earns a higher rate of return than it would


Figure 12.2 World real GDP growth, 1991–2016

Source: Author’s simulations applying the G-CUBED model.

have in Japan and therefore GNP (a measure of income to all Japanese factors of production) ultimately rises in Japan. There are thus a number of effects of the stronger productivity growth on the rest of the world. There are demand effects from higher Chinese demand for foreign goods, as well as effects on foreign production as capital is re-allocated to less productive uses outside China into sectors within China with higher rates of return. The adjustment process is quite drawn out since the higher productivity growth lasts five years yet the adjustment is still under way by 2020. In Figure 12.7 we show the changes in current accounts, as a percentage of baseline GDP in each economy. An improvement in the current account of a country reflects a net capital outflow. This can be seen to occur for each economy except the United States and, of course, China. The US results reflect the strong demand for capital goods from the United States, which more than offsets the capital flow adjustment. The outcome for Australia is quite interesting since there is a redirection of foreign capital away from Australia, which worsens Australia’s capital account by the largest amount when scaled to GDP but not in absolute dollars. CONCLUSION This chapter has examined the impact of different productivity growth rates in China on the Chinese and the global economy. The results are very preliminary and the actual numbers will undoubtedly change as further research on this project continues in the light of the rich literature on growth potential in particular sectors of the Chinese economy. Perhaps a disappointing aspect of the results is the lack of differential sectoral productivity growth that we have


Figure 12.3 Chinese real GDP and GNP, 1990–2020


Figure 12.4 Chinese foreign trade, 1990–2020


imposed on the model. We know from the results in Bagnoli, McKibbin and Wilcoxen (1996) that differential sectoral productivity growth is very important to aggregate outcomes. In particular, it is likely to change the composition of trade adjustment, although it is not likely to change significantly the overall adjustment of trade and current account balances that are driven by aggregate changes in investment and saving decisions.


Figure 12.5 World real GDP, 1990–2020

Source: Author’s simulations applying the G-CUBED model. Figure 12.6 World real GNP, 1990–2020


NOTES 1 This chapter is based on a paper prepared for the AJRC International Conference on ‘China and the WTO: Issues and Impacts on China and the East Asian and Pacific Economies’ held in Tokyo, 8–9 May 1996. We thank Justin Yifu Lin and other participants at the conference for comments. The G-CUBED model used in this paper was developed jointly by McKibbin and Peter Wilcoxen of the University of Texas at Austin. The research reported here has benefited from a project on future growth prospects with Wilcoxen and Philip Bagnoli of the Brookings Institution.


Figure 12.7 World current accounts, 1990–2020

Source: Author’s simulations applying the G-CUBED model. The development of the G-CUBED model was funded under a cooperative agreement between the Brookings Institution and the US Environmental Protection Agency and from a National Science Foundation grant. This paper also uses data from the International Economic Databank at the Australian National University. The views expressed are those of the authors and should not be interpreted as reflecting the views of the trustees, officers or other staff of the Brookings Institution, Australian National University, Environmental Protection Agency or National Science Foundation. 2 According to Garnaut, Ma and Huang (forthcoming), the underestimation factor has varied since 1990, given the fact that the official income data published by the World Bank have also been adjusted upward gradually. 3 Garnaut and Huang (1995) admit that eventually the ‘Lau factor’ will take the edge off the powerful momentum in trade growth.

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Table 12.4 Baseline assumptions

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Abbreviations

AMS APEC ASEAN ATC CES CET CGE cif EAEC EC EU EV FDI fob GATT GDP GSP GTAP HCDCS HIODS HS IAP LATC MFA MFN MOFTEC NAFTA

Aggregate Measure of Support Asia Pacific Economic Cooperation Association of Southeast Asian Nations Agreement on Textiles and Clothing constant elasticities of substitution constant elasticities of transformation computable general equilibrium cost insurance freight East Asian Economic Caucus European Community European Union Equivalent variation foreign direct investment free on board General Agreement on Tariffs and Trade Gross Domestic Product generalised system of preferences Global Trade Analysis Project Harmonised Commodity Description and Coding System heavy-industry-oriented development strategy Harmonised System Individual Action Plan labour-augmenting technical change Multi-fibre Arrangement most-favoured nation treatment Ministry of Foreign Trade and Economic Cooperation North American Free Trade Agreement

215

NIE NTB OECD PECC TFP TRI TVE UNCTAD UR VER WTO

newly industrialising economy non-tariff barrier Organisation for Economic Cooperation and Development Pacific Economic Cooperation Council total factor productivity trade restrictiveness index township and village enterprise United Nations Commission on Trade and Development Uruguay Round voluntary export restraint World Trade Organisation

Index

Numbers refer to pages; numbers in italic type refer to figures and tables; those followed by ‘n’ refer to endnotes accounting sector, foreign investment in, 55 administrative controls, 119 see also central planning advanced industrialised economies, 2, 20, 31, 46n see also developed economies; industrialised economies Aggregate Measure of Support (AMS), 91, 92 Agreement on Textiles and Clothing (ATC), 5, 114, 172, 173, 176–179, 180, 182–183 agricultural, exports,13, 18, 31, 32, 86, 111 imports, 60, 86 infrastructure, 92 prices, 3, 27, 86–90, 93, 94–96, 97n productivity, 12 products, 3, 12, 32, 60, 62–65, 69, 94– 96, 104, 115, 127, 140, 142, 143, 162, 163, 164, 165, 167, 167, 193 reform, 3, 4, 27, 32, 48n, 59, 62, 82, 85–98, 114, 174, 187 world, 24 sector, xv, 3–4, 5, 27, 33, 34, 37, 48n, 59–60, 69, 85–98, 102, 103, 104, 109, 111, 114, 115, 142, 150, 151, 159, 162, 163, 165, 167, 167, 170, 185, 186, 186, 197, 198 subsidies, 104, 171n technology, 5, 87, 92, 169 agriculture agreements, xv, 91

see also rural industry investment in, 92–92 allocation system, administrative, see central planning animal husbandry sector, 128, 131, 133 anti-dumping measures, 5, 172, 178, 179, 180, 187 removal of, 54–55 APEC, see Asia Pacific Economic Cooperation apparel sector, see clothing sector Argentina, 179 arms sales, 105 ASEAN, see Association of South East Asian Nations Asia Pacific Economic Cooperation (APEC), 5, 27, 68, 103, 105, 106– 108, 114, 115, 116, 157, 158, 161, 165, 165, 167, 169, 171n Bogor Declaration, 103 Heads-of-government meeting 1995, 121 Individual Action Plans, 103 Manila meeting 1996, 103, 108 Osaka meeting 1995, 103, 108, 114, 157, 158, 160, 161 Seattle meeting 1993, 106 Seoul meeting 1991, 106 Singapore meeting 1990, 106 trade liberalisation, 81 Association of South East Asian Nations (ASEAN), 70, 71, 72, 75, 78, 80, 81,

216

INDEX 217

106, 106, 112, 159, 162, 163, 164, 165, 165, 167, 167, 182, 183, 186, 186 Australasia, see Australia Australia, 10, 19, 2, 24, 60, 71, 80, 81, 99, 106, 114, 159, 162, 163, 164, 165, 165, 167, 169, 182, 183, 198, 200, 206, 210 Austria, 181 auto industry, xv, 24, 161 protection of, 109 trade restrictions in, 23 balance of payments, 65 Bangladesh, 15, 182 banking sector, xv, 31, 38, 42, 46, 60, 63, 103 commercialisation of, 41, 45, 60 reform, 63 state monopoly in, 31, 63 banks, development, 41 Bhutan, 182 boom-and-bust cycle, 29, 42–44, 45, 72 Brazil, 179 Britain, see United Kingdom building materials sector, 127, 128, 131, 133 Bureau of Economic Analysis (BEA), 199 Bureau of Labour Statistics, 199 bureaucratic coordination, 60, 61 Canada, 5, 60, 80, 81, 99, 142, 755, 154, 174, 177, 182 capital account, 63–65, 205 convertibility, 3 Central and Eastern Europe, 181 see also Eastern Europe central planning, 6, 16, 32, 35, 36, 38, 43, 52–55, 58, 60, 61, 67, 85, 92, 92, 103, 109, 119, 122, 140, 157, 180 see also administrative controls central rationing, see rationing, central cereals, state monopoly of, 176 chemicals sector, 10, 127, 128, 131, 133, 176 Chile, 179 China National Textiles Council, 175

China, integration into the world economy, 2, 28, 59, 60, 65, 78–79, 81, 82, 111, 160 influence on the world economy, 5, 6, 7, 105 Chinese Communist Party, 47n civil aviation, foreign Investment In, 55 clothing and textile sector, see textile and clothing sector clothing sector 10, 70, 110, 114, 141, 150, 151, 155n, 161, 162, 163, 165, 165, 167, 167, 170 see also textile and clothing sector trade in, 12, 24 domestic subsidies, 32 coal sector, 19, 127, 128, 131, 133, 197, 198 Cold War, 25 collective system, 32, 35, 36–37, 41, 48n see also commune system commerce sector, 127, 128, 133 foreign investment in, 55, 63 commune system, 85, 92 see also collective system comparative advantage agriculture in, 87, 90, 92–93 changes in, 78–82, 158 revealed, 70–72 computable general equilibrium (CGE) analysis, 4–5, 122–136, 138, 145– 156, 158–171, 182–187, 193–210 concessional imports, 147 construction sector, 127, 128, 133, 141, 151, 155n consulting sector, 55 contract responsibility system, 38, 40 corn, price of, 86 trade in, 86 cotton, production and consumption of, 19, 32, 48n, 60, 174, 176 import controls, 62 price of, 5, 32, 86, 175, 187 state monopoly in, 175 trade in, 18, 19, 86, 174 credit access, 38, 42–43 assistance, 170 crops sector, 127, 128, 131, 133 Cultural Revolution, 29, 85, 174

218 INDEX

currency depreciation, 71, 81, 131, 140 current account, 23, 122, 133, 205, 206, 210 convertibility, 3, 55, 63, 69, 103, 121 surplus, 10 customs, see General Administration of Customs Czechoslovakia, 48n Deng Xiaoping, 43, 48n depreciation, currency, 72, 81, 131, 138 developed economies, 19, 25, 24, 27, 90, 120, 160, 176 see also advanced industrialised economies; industrialised economies developing country status, China, 3, 24, 57, 58 see also World Trade Organisation, Chinese membership of developing economies, 2, 3, 7, 10, 15, 18, 24, 28, 29, 30, 35, 42, 48n, 57, 58, 62, 65, 75, 91, 120, 142, 152, 169,172,176, 179,182,183,184, 186, 186, 191, 193, 203, 206 see also less developed countries; newly industrialising economies East Asian, 8, 11 development strategy, 2, 29–51 agricultural, 32 development strategy, heavy-industryoriented (HIODS), 2, 29–37, 40, 41, 45, 46,47n, 48n, 108, 157 direct foreign investment see foreign direct investment dual exchange rate, see foreign exchange rate dual dynamic general equilibrium model (GCubed) analysis, 5 East Asia, 2, 12, 13, 15, 16, 18, 20, 21, 21, 24, 23, 24, 28, 29, 70, 71, 72, 78, 79–80, 102, 104–105, 106, 109, 111, 112, 160, 191, 192, 193 East Asian Economic Caucus (EAEC), 106

East Asian financial crisis, see financial crisis, East Asian Eastern Europe, 42, 181, 198, 200, 210 see also Central and Eastern Europe edible oils, 32, 60, 176 education, 15, 185 and sports sector, 127, 128, 133 electrical machinery, 71 exports, 16 electricity and water sector, 127, 128, 131, 133, 197, 198 electronics sector, 55, 68, 173 protection of, 109 employment, 5, 39, 133, 136, 170 in advanced economies, 20 rates, see wage rates; unemployment environmental programs, 92 Europe, 9, 12, 21, 24, 27, 70, 80, 81, 90, 100, 106 European Community, 10, 15, 24, 25, 71, 80, 120, 174 European Economic Community (EEC), see European Community European Union,5, 5, 106, 114, 142, 152, 159, 162, 163, 164, 165, 165, 167, 169, 171n, 174, 177, 178, 179, 180, 182, 183, 184, 187 exchange rate, see foreign exchange rate Export and Import Tariff Schedule, 120 export, competitiveness, Chinese, 4, 5, 16, 65, 71, 75–81, 99, 108, 110, 111, 114, 131, 187 controls, 54, 65, 119, 125, 131, 140 incentives, 66, 67, 68, 124, 143 subsidies, see export incentives see also foreign trade famine, 85 fertiliser, 32, 176 import controls on, 123 finance sector, 4, 62, 127, 128, 133 foreign investment in, 55 reform 45, 63, 93, 103, 124–125 financial crisis, East Asian, xv, 3, 66, 78– 80, 81, 82, 108 Finland, 177

INDEX 219

flood control, 32 food, domestic subsidy of, 31 processed, 111, 115, 127, 128, 131, 133, 142, 151, 155n, 159, 162, 163, 165, 167, 185, 186 rationing, 85 security, 24, 85, 86, 90, 169 self-sufficiency in, 5 shortage, 193 footwear industry, 70 foreign debt, 63, 206 foreign direct investment (FDI), 23, 42, 63, 66, 69, 75, 87, 99, 121, 175, 191, 203 see also foreign investment Japanese, 25 foreign enterprises,49n, 60, 62, 63, 68, 75, 100 foreign exchange access to, 27, 140 control, see foreign exchange rate policy, 32, 40, 43, 54–55, 63, 68, 71, 124–125, 138 rate, 4, 71, 72, 121, 131, 133–136, 176, 197, 206 dual, 41, 55, 68, 103, 125, 140 reform, 41, 54, 55, 57, 63, 65, 68, 69, 77, 79, 81, 103, 124, 125, 138, 157 reserve, 121 retention system, 124, 176 Foreign Exchange Investment Centre, 41 foreign investment, xv–2, 3, 55–57, 60, 60, 63, 103, 111, 121, 138, 147, 175, 185, 187, 192, 205, 206, 210 see also foreign direct investment foreign trade, commodity composition of, 66 determinants of, 75–78 enterprises, state-owned, 52–54, 55, 60–61, 119, 175 see also state-owned enterprises foreign investment in, 55, 67, 69, 75 geographic distribution of, 65, 66, 70, 71, 72, 81, 105, 106 growth and, 67, 72–75, 108, 157, 160, 161, 184, 186, 193 growth of, 59, 67, 71, 72–72, 157 state monopoly of, 31, 60 Foreign Trade Law, 52, 54, 58, 103

foreign-invested, enterprises, 52, 55, 57, 61, 63, 65, 97, 99, 126, 175, 176 projects, 55 former Soviet Union, 21, 25, 42, 200 see also Russia; Soviet Union free trade,2, 3, 27, 61, 90, 92, 104, 114, 157, 158, 161, 165, 165, 167, 169, 171n fuel, 109 GATT, see General Agreement on Tariffs and Trade General Administration of Customs, 60, 120, 127, 136 General Agreement on Tariffs and Trade (GATT), 57, 91, 98, 100, 101, 119, 120, 121, 136, 138, 146, 157, 172, 176, 178, 192 see also World Trade Organisation Generalised System of Preferences (GSP), 181 Germany, 7, 8 gradualist approach to economic reform, 24, 35–36,42–45, 58, 67, 157, 192 grain import controls on, 62, 92, 122, 140 prices, 32, 86 production and consumption of, 19, 32, 33, 48n, 59–60, 86, 90 self-sufficiency in,48n state monopoly In, 4, 32, 92 trade, 90, 92, 115, 123 Great Depression, 30 Great Leap Forward, 114 G-CUBED model, see computable general equilibriurm (CGE) models GTAP models, see computable general equilibrium (CGE) models Harmonised Commodity Description and Coding System (HCDCS), 120, 136n, 140 harmonised system (HS), see Harmo-nised Commodity Description and Coding System heavy industry sector, 30–46, 111, 141

220 INDEX

heavy-industry-oriented development strategy (HIODS), see development strategy, heavy-industry-oriented, 29– 46, 108, 157 Hong Kong, 5, 20, 25, 28n, 72–72, 99, 101, 105, 108, 109, 110, 142, 152, 154, 175, 182, 192 trade with China, 20, 105, 110 incorporation into China, 105 household registration system, 185 household responsibility system, 37, 38, 39, 85 household-based system, see household responsibility system housing, 33, 142, 151, 155n, 185 domestic subsidy of, 31 human capital, investment in, 18, 109 human rights, 105 import, concessional, 147 controls, 54, 60, 61–62, 65, 67, 68, 181 dependence, 59 licences, 60, 61–62, 68, 103, 119, 120, 121, 138, 140 quotas, 52, 54, 61 reforms, 61 income, farmers’, 85, 90–91, 92, 92 India, 15, 15, 47n, 70, 72–72, 179, 182 Indochina, 106 see also Vietnam Indonesia, 5, 15, 15, 72–72, 142, 152, 154, 179, 182 industrial sector, 38, 69, 72 industrialised economies, xv, 20, 30, 142, 155, 160, 173, 186, 193 see also developed economies; advanced industrialised economies inflation, 30, 42–44, 49n, 63, 86, 87, 136, 204 information sector, foreign investment in, 55, 109 infrastructure, agricultural, 92 foreign investment in, 57 investment in, 109 inspection services, agricultural, 92 insurance sector, xv foreign investment in, 55, 60, 63

intellectual property, 105 inter-bank foreign exchange market, 55, 69, 121, 125 interest rates, 31, 41, 42, 43, 45, 49n, 63, 197 international rules-based trading system, 2, 3, 4, 6–28, 58, 59, 60, 98, 119, 193 internet, agreement on, xv iron and steel sector, 114, 159, 162, 163, 165, 185 186, 186 see also steel ‘iron rice-bowl’, 39 irrigation, 32, 92 Japan, 5, 6, 8, 12, 15, 16, 21, 24, 25, 27, 71, 78, 80, 81, 90, 91, 92, 99, 100, 101, 105, 106, 106, 109, 111, 112, 114, 120, 142, 152, 154, 159, 162, 163, 164, 165, 165, 167, 169, 170, 174, 181, 182, 183, 198, 200, 206, 210 trade growth, 9, 10 trade policy, 25 trade relations with China, 24–23, 70, 105, 106 trade relations with United States, 25, 105 Jiang Zemin, 121, 157, 158, 160 joint venture, 49n, 62, 75, 77, 87, 121, 138 Korea, Republic of, 5, 15, 16, 20, 25, 28n, 70, 72–72, 90, 91, 97n, 99, 106, 120, 142, 152, 154, 175, 182, 192 trade relations with China, 105 Korean War, 30 labour agricultural, 3, 32, 114 costs, 15, 81, 108, 175 demand, 133 income, see wage rates overstaffing, 48n productivity, 92 shortage, 15, 185 supply, 12, 34, 171n, 182, 186, 187– 189, 203 land development, foreign investment in, 55

INDEX 221

land ownership reform, 92 land reclamation, agricultual, 32, 115 Latin America, 114, 142, 152, 159, 162, 163, 164, 165, 167, 167, 182, 183. 186, 186 law, foreign trade, 60 see also Foreign Trade Law sector, foreign investment in, 55 less developed countries (LDCs), 206, 210 see also developing economies; newly industrialising economies licence system, see import licences light industry, 42n Little Dragons, 42 machinery equipment sector, 10, 55, 68, 109, 110, 111, 114, 127, 128, 131, 133, 141, 145, 151, 155n, 159, 162, 163, 165, 173, 186, 186 imports, 174 Malaysia, 71, 72–72, 106, 142, 152, 179, 182 Maldives, 182 management reform, 39, 42, 54, 63, 75, 103 manufacturing sector, 10, 12, 16, 21, 65, 79, 81, 87, 93, 110, 111, 114, 114, 127, 128, 131, 133, 133, 142, 146, 150, 151, 155n, 158, 159, 160, 161, 162, 167, 186, 186, 189, 191, 197. 198 Hong Kong, 20 Japanese imports, 25 trade, 16, 23, 175 Mao Zedong, 1893–1976, 29 Maoist era, 28 market access, xv, 3, 4, 57, 58–59, 63, 81, 91–92, 93, 105, 119, 140, 150, 179 market economy, see marketisation market mechanism, see marketisation marketisation, 4, 45, 55, 58, 69, 85, 103, 111, 115, 119, 122, 140, 157 meat and livestock sector, 115 metallurgy sector, 127, 128, 131, 133 Mexico, 180 MFA, see Multi-fibre Arrangement migration, internal, 46n, 47n, 185 military

modernisation, 23 sector, 3, 30 technology, 105 mineral products, 12, 167 export of, 18 minerals and mining, 109, 114, 159, 162, 163, 165, 186, 186, 197, 198 Ministry of Foreign Trade and Eco- nomic Cooperation (MOFTEC), 60, 136n Ministry of Textile Industry, 175 miracle economy, East Asian, 29 money market, 63, 203 monopoly, state, 4, 32 in cereals, 176 in foreign trade, 32, 60, 124 in banking, 63 in cotton, 175 in grain, 4, 32, 92 in oil and petroleum, 176 most-favoured nation treatment (MFN), 106 motor vehicles, see auto industry Multi-fibre Arrangement, 5, 10, 12, 24, 27, 102, 114–114, 115, 146, 150, 151, 152, 154, 172–189 multinational firms, 75 National Congress, Chinese, 120 national treatment, 100, 103 nationalisation of industry, 31, 47 natural resources sector, 141, 150, 155n Nepal, 182 New Democracy Policy, 47n New Zealand, 10, 24, 106, 182 newly industrialising economies (NIEs), 5, 6, 9, 10, 12, 15, 16, 16, 21, 27, 70, 71, 72, 75, 78, 80, 90, 91, 92, 111–112, 142, 152, 159, 162, 163, 164, 165, 165, 167, 169, 170, 174, 175, 181, 182, 183, 186, 186, 198 see also developing economies, less developed countries integration with international economy, 79 non-state enterprise, 40–40, 49n, 60 sector, 68

222 INDEX

non-tariff barriers, 3, 57, 61, 68, 81, 82n, 91, 103, 128, 129, 138–140, 141, 143, 154, 157 North America, 5, 9, 10, 12, 15, 21, 24, 25, 27, 70, 106, 159, 162, 163, 164, 165, 165, 167, 167, 169, 174, 175, 178, 182, 186. 184, 185 North American Free Trade Agreement (NAFTA), 70, 71, 181 Northeast Asia, 21, 106, 111 Norway, 177, 181 OECD, see Organisation for Economic Cooperation and Development oil, crude and refined, 127, 128, 131, 133, 176, 197, 198 import controls on, 61 price controls on, 124 state monopoly in, 176 oil, vegetable, 176 see also edible oils open regionalism, 106 open trade, see free trade Organisation for Economic Cooperation and Development (OECD), 10, 11, 21, 21, 24, 75, 114, 198, 200, 203, 210 Organisation of Petroleum Exporting Countries (OPEC), 203, 204 Overseas Chinese enterprise, 49n Pacific Economic Cooperation Council (PECC), 106 Pakistan, 182 paper sector, 127, 128, 131, 133 Papua New Guinea (PNG), 106 PECC, see Pacific Economic Coopera-tion Council Peru, 179 pest and disease control, 92 pesticides, 55, 176 petroleum, see oil, crude and refined Philippines, 15, 72–72, 142, 152, 179, 182 planning systems, 32–36 effect on resource allocation, 33 population, distribution, 8, 16, 30, 94 growth, 57, 182, 193, 204, 205, 210 price regulation, 32, 33, 44, 45, 119

dual track, 37, 40, 122, 138 system reform, 68, 85 protectionism, 3, 23, 81, 91, 92, 98, 104, 108, 109, 119, 128, 140, 150, 179, 181, 187 see also import controls; import licences; import quotas; quotas; tariffs; trade restrictions agricultural, 5, 23, 63, 90–92, 92, 93, 104 public administration sector, 127, 128, 133 Quad economies, 172, 179 see also Canada; European Union; Japan; United States quotas, 54, 103, 120, 138, 140, 142, 146, 150, 172, 174, 176 domestic production, 37, 40, 140 export, 54 import, 52, 60, 61, 67 MFA, 5, 146, 150, 152, 178, 181, 182, 183, 184, 187 railway sector, foreign investment in, 55 rationing, central, 42 food, 85 urban, 32 real estate sector, foreign investment in, 55 protection of, 109 regional economies, Chinese, 6, 12, 15, 16, 37, 55, 58, 63, 68, 111, 185, 187–189 remuneration system, see wage rates rent-seeking, 40, 44 research, agricultural, 92, 92 resident registration system, 92, 185 retrenchment, 43–44 revolution, Chinese, 29 rice, import controls on, 140 price of, 86 sector, 140 trade, 86 rules of origin, 172, 180

INDEX 223

rules-based trading system, see international rules-based trading system rural industry, 4, 38, 93 see also agriculture sector Russia, 24 see also former Soviet Union; Soviet Union Second World War, 101 self-sufficient economic policy, 69 food strategy, 5, 86 services sector, 3, 93, 114, 127, 128, 133, 140, 142, 159, 162, 163, 165, 185, 186, 186 financial and legal, xv foreign investment in, 63 reform, 3, 48, 60, 62–63 silk products, 174 Singapore, 28n, 72–72, 80, 182 Sino-British Agreement, 1984, 20 Sino-US Textile Agreement, 1980–82, 174 South Asia, 5, 18, 114, 142, 152, 154, 159, 162, 163, 164, 168. 167, 167, 167, 182, 183, 186, 186 Southeast Asia, 12, 15, 112 Soviet Union, 30, 48n see also former Soviet Union; Russia soybeans, price of, 86 space industry, 16 special economic zone, 68, 121 Sri Lanka, 182 State Economic and Trade Commission, 60 State General Administration for Inspection of Import and Export Commodities, 60 State Planning Commission, 60 state-owned enterprises, 4, 32, 35–40, 46n, 52, 54, 68, 102–103, 119, 140, 176, 185 see also foreign trade enterprises, stateowned reform of, 103 steel see also iron and steel sector Chinese production and consumption of, 19, 48n

import controls on, 62 sub-Saharan Africa, 142, 152 swap market, 49n, 68, 77, 125, 176 Sweden, 181 synthetic products, 174 Taiwan, 5, 16, 20, 25, 28n, 70, 72–72, 90, 91, 97n, 99, 106, 106, 120, 146, 152, 154, 175, 182, 192 trade relations with China, 105 tariff, agreements, xv exemptions, 5, 62, 68, 121, 129, 138, 147, 148,151, 152, 154, 176 levels, 138–142 reductions, xv, 3, 4–5, 55, 57, 62, 68, 103, 104, 114, 119–137, 138, 157, 162, 169, 172, 183 taxation, 126, 133, 147, 201, 204 agricultural, 85, 104, 111, 120 exemptions, 62 export, 140, 143, 167, 182 Import, 147 output, 147 rebates, 68, 124, 125, 133 reform, 126 technology agricultural, 92 transfer, 87, 119, 121, 175 telecommunications sector, xv, 16 exports, 16 reform, 60 textile and clothing sector, 5–5, 12, 15, 16, 24, 70, 99, 108, 110, 111, 114, 127, 128, 131, 133, 150, 154, 155n, 159, 169, 172– 189 see also textiles sector; clothing sector exports, 5, 12, 13, 21, 21, 27, 114, 114, 115, 133, 172189 Textile Monitoring Body, 177 textiles sector, 10, 111, 114, 142, 151, 162, 163, 165, 165, 169 see also textiles and clothing sector; clothing sector exports, 12, 102, 114–114 Sino-US agreement, 1980–82, 174 Thailand, 71, 72–72, 142, 152, 179, 182

224 INDEX

Tiananmen incident, 43 Tokyo Round Agreement on Import Licence Formalities, WTO, 62 total factor productivity, growth of, 39 township and village enterprises (TVEs), 38, 39, 40, 49n, 175, 176, 187 trade, see also foreign trade adjustment, 20–21 agreements, preferential, 181 compensation, 175 disputes, 100 forecast, growth of China’s, 8–9, 15 goods, 8, 103 intra-industry, 8, 23, 104, 115 liberalisation, gains from, 114–116, 131– 136, 161–171, 182–187, 191–210 see also trade policy reform macroeconomic activity and, 11 policy reform, 2, 4, 24, 67–70, 85–98, 99, 101, 102, 103, 157, 158, 161 reform, see policy reform restrictions, 4, 27, 67, 160, 165, 186 agricultural, 23, 93 see also licences; import controls; import licences; import quotas; protection; quotas; tariffs rules-based, see international rulesbased trading system services, 8 surplus, 135 technology, 103 trade and investment facilitation, 27, 106 auto, 23 internal, 8 transportation sector, 48n, 103, 109, 114, 127, 128, 133, 142, 145, 151, 155n, 197, 198 equipment, 10, 159, 162, 163, 165, 185, 186 prices of, 31 travel and tourism sector, xv travel goods, 70 Turkey, 181

two-tiered exchange rate, see foreign exchange rate, dual track two-tiered pricing system, see price regulation system, dual track unemployment, 167, 171n, 182, 185 United Kingdom, 20 United States, xv, 5, 7, 8, 21, 25, 28, 60, 72, 80, 81, 99, 100, 105, 114, 142, 152, 154, 174, 175, 177, 179, 180, 181, 182, 191, 193, 198, 199, 200, 206, 210 diplomatic relations with China, 21 trade relations with East Asia, 25–23 trade relations with Japan, 24–23 trade relations with China, 24–23, 27, 106 Uruguay Round, 5, 5, 6, 8, 10, 15, 24, 24, 28, 91, 102, 114–115, 120, 136n, 140, 146, 150, 151, 152, 154, 159, 161, 172– 189, 193 USSR, see Soviet Union Vietnam, 15, 15, 70, 72–72 voluntary export restraints (VER), 10, 176, 181 wage rates, 20, 31, 32, 35, 38, 45, 47n, 48n, 129, 133, 201 wearing apparel sector, see clothing sector Western Europe, see Europe Western Pacific, 21, 25 wheat, 140, 142 import controls on, 140 price of, 86 wood products, 197, 198 wool sector, 19, 127, 128, 131, 133 trade, 19, 174 work incentives, 33, 41 World Bank, 15, 35, 48n, 191 World Trade Organisation (WTO), see also GATT Chinese membership of, xv, 2, 23, 27, 60,81, 92, 93, 98–118, 119– 137, 146– 147, 157, 160, 192 Chinese accession negotiations, xv, 5, 24, 57, 58, 60, 98, 99, 100, 115, 116, 138, 140, 154, 158, 172, 179, 179, 192

INDEX 225

entry terms and requirements, 2, 3, 4, 5, 23, 52, 57–58, 60–60, 92, 93, 98, 99– 100, 103, 109, 115, 119, 120, 150, 180 Protocol of Accession of China, 5, 103, 180, 187 rules and regulations, 3, 4, 23, 55, 60, 62, 82n, 91, 92, 93, 100, 115– 116, 178 World War Two, see Second World War Zhu Rongji, xv

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