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Song Zheng:“bulky” economy





Song Zheng:

First of all, I would like to thank NEF, the organizer of this activity for giving me this opportunity to share with you my thoughts of some questions in these years. These thoughts are generated based on the series of research that I cooperated with my partners in the last few years.


The economic growth from the last three decades of Reform and Opening Up to 2008 has made a lot of achievements. Western mainstream economists sometimes confuse about this phenomenon.


It might due to issues on two levels. Firstly, most of the low income countries are weak in economic growth. The strong and constant economic growth in China in the last three decades is rare if not unique. The question here is why. Secondly, western countries believe that Chinese economic system is imperfect. Why a place with such economic system could still have a strong economic growth? To answer these questions, economists of China and other countries tried hard in the last 10 to 20 years. The research with the most representativeness was conducted by today’s award winning professors.


There are many other explorations in system. We tried to discuss why Chinese economy is so special from the perspective of generalized preference and special preference. I researched on macroeconomics so I will talk about my understanding toward Chinese economic growth from my side. After understanding the systemic issues, we can view Chinese macro economy as a granule-like economy when we analyze the performance of Chinese macroeconomic growth. In the past, we thought enterprises and individuals were of atomic structure when talking about macro economy. In recent decade of international trade, there is a saying that economy is no longer in atomic structure but granule structure. You can understand the economy once you master hundreds of big enterprises in the economy. Under such systemic environment, I believe that no matter what perspective you choose to view Chinese system, you still need to consider local governments’ guidance and intervention in economy. Such guidance and intervention in economy have resulted in the granule-like Chinese economy with Chinese characteristics. There were teams at provincial level, municipal level, county level and township level. Those economies were in large scale and being very active. There were not only state-owned economies, private economies and non-state-owned economies with local government intervention are in the majority and are also very active. The result was that the features of Chinese economy in the last three decades on a macro level were high investment and high growth. There are two lines for researching China on a micro level. One is to view China from the perspective of incentive and other is resource allocation. A great amount of micro data tells us we did many right things in the past 30 years. Therefore, we not only have seen a high growth on macro level but also big improvements in the efficiency of resource allocation on micro level.


Let’s see the data. The chart shows the comparable data of more than 160 countries between 1990 and 2010. Macro economists hold different opinions and can hardly reach on consensus. However, one thing that we all agree with is that high investment usually generates high growth. The black line on the chart tells us that we can know the bottom line of economic growth through investment scale. In these 160 countries, only very few see high investment and low growth which locate below this line. In the last 30 years, China performed quite well. The red spot on the chart is China. China not only has high investment and growth but also locates much higher above the bottom line. This means the investment rate of China in the past three decades was very good. It coincides with Professor Bai and Professor Qian’s papers in 2006 which talked about the prediction of the rate of capital return in China. In the past 30 years, the rate of capital return in China was high and consistent.


In view of micro level, the recent micro data also reviews that Chinese macro economy in the last 30 years performed quite well either on macro or micro level. Let’s see the chart of comparison on the left. Indian enterprises didn’t grow and their size remained the same as the beginning stage regardless of how many years they survive in the economy. America has a relatively energetic environment. The scale of enterprises grows rapidly with their age. Enterprises aged between 10 and 15 have doubled their scale. Mexico is between the America and India. Let’s see the Chinese situation in the last 30 years. We used the China Industrial Business Performance Statistics in 2007 to make a mutually corresponding research. From the chart on the right, we can see that the private enterprises in China grew much better than that of India, though not as good as that of America, the gap is not wide. The other index is the efficiency of resource allocation. A very important topic in economics literature in the last decade was mismatch. As we have a great amount of micro enterprise data, we can use statistical methods to measure the level of mismatch in economies. The main measurement is to see the differences between enterprises’ marginal output. In an ideal economy, all enterprises have same marginal output which generates the biggest overall economic output.


Let’s see the database of Chinese enterprises to figure out the differences in marginal labor output and marginal capital output. The biggest trend between 1998 and 2007 was downward and it was quite sharp, which means a big improvement in the efficiency of capital and labor allocation in enterprises. This probably contributed 10 to 20% of the output in the last 10 years.


Let’s see the situation in recent years. In this morning, Professor Wu said Chinese economy is faced with tough challenges. In view of our research, where are the challenges in this research? Starting from the chart on the left which you all familiar with, the orange line represents the GDP growth rate and the blue line stands for the investment rate. Macro economists have a consensus that higher investment rate will bring high economic growth. For China in the last 30 years, these two lines are positively correlated. In the last 6 to 7 years, the correlation disappeared and the economic growth rate slowed down. This can be seen not only in overall data but also data at provincial and city level. There are two small charts on the right. The horizontal axis of the small chart on the left represents the investment rate at city level while the vertical axis represents the economic growth at city level. 10 years ago, places with high investment rate had high economic growth. What is worrisome is that the basic regular pattern disappeared in the 2014 data. They were no longer positively correlated. Instead, they were negatively correlated. If you measure the overall marginal capital output of China, you will see a very sharp decrease in it.

There are many evidences on micro level that can prove Chinese different economic performance. In 2007, the scale of 10 years old enterprises was 1.6 to 2 times of the newly entered enterprises. Such gap in scale is narrowing down rapidly. China doesn’t look like America but India.  


The efficiency of resource allocation is different in the last 7 to 8 years comparing with that in the last 10 to 20 years. Before 2007, the efficiency of resource allocation in industrial enterprises was improving. If using the latest China Industrial Business Performance Statistics between 2011 and 2013, the differences in marginal labor output and marginal capital output of enterprises are increasingly sharp which even counteracts the achievement made in that last 10 years. To convert it into profit loss, we had 20 to 30% loss in last few years. What widened the differences in marginal labor output and marginal capital output of enterprises? Resources flew to enterprises with lower marginal output. There could be two possibilities. One is that resources might flow to the enterprises with higher marginal output, which could widen the gap. But in fact, it was the other possibility that capital and labor flew to enterprises with lower marginal output.


The question is where the investment flowed? There is high investment with low efficiency. Where was the money? How much was the debt? We can make a simple calculation. We simply add up the debt of local financing platform. The total debt in 2007 and 2007 was 7 to 8 trillion RMB, but now the debt increased to 47 to 48 trillion RMB which greatly surpassed the debt scale of local government that announced by Ministry of Finance. This is a capital flow that flow to the local financing platform. Another capital flow is flowing to the listed companies. A hot topic in recent years is the high leverage ratio of Chinese enterprises. In fact, most of Chinese enterprises’ leverage ratios are not high. Take a look at the statistics of industrial enterprises, the proportion of average Chinese industrial enterprises debts and main operation income is 50%. This number is not high in any country. Such proportion is decreasing and the average debt of Chinese industrial enterprises is also decreasing. Why is this different from our intuitive feeling? That’s because the debts of large enterprises are increasing rapidly. The proportion of debts and main operation income of listed companies was decreasing before 2008 and 2009, and then it sharply increased afterwards. If the proportion was 50%, then the proportion in listed companies was 100%. This was seen not only in listed industrial enterprises but also service enterprises.


After seeing so many facts, the macro and micro evidences all show that China’s macro economy today is totally different from that 30 years ago. Why? We have explanation that is closely related to what Professor Qian and Professor Xu said. In other words, the problem existed in the Reform and Opening up emerges again. We think the starting point of it was the 4 trillion RMB which many western economists called fiscal policy. Chinese people actually know it was not a fiscal policy because it represents the loosening of financial control. In the past, local governments couldn’t borrow money; but now they can do so via many ways. The loosening in financial control resulted in the 40 trillion RMB investment in 2010 which should have been 4 trillion RMB only. In addition, the investment didn’t go to places with high marginal return. Why did this happen? To understand it from the perspective of practice, it was because some of local government assets like lands were not made explicit. Now they put lands into financing platform. The use of market pricing has enlarged the balance sheet of local financing platforms. The debt of Chinese financing platform is increasing, which has surmounted 40 trillion RMB now. In addition, the capital of financing platform is expanding at an even faster pace, reaching 70 trillion RMB. Why is the capital expanding so rapidly? This mainly thanks to the explicit of invisible assets. In the last few years, the rapid increase in the land price and housing price which are the main forces that further pushed the expansion of balance sheets of local financing platform and state-owned large enterprises.


In terms of influence on welfare, the loosening of financial control is a good thing. However, this might not be true in an environment like China that full of distortions. What result did it bring? Our economy changed from granule type in last 30 years to bulky type. Bulk means cumbersome and unwise. Bulky economy emerges due to the integration of local governments and financing institutions. 30 years ago, we had soft budget constraint and we solved part of the issues by hardening the soft budget constraint. However, the launch of 4 trillion RMB somehow released the issue of soft budget constraint again. Therefore, we are faced with the same issue that happened 30 years ago but in a new form. Where are the dangers? The integration of local governments, real economy and financing institutions results in bulky issues. One is large investment with little differences. There is a saying that state-owned enterprises follow the party, listen to the government and follow the laws of market economy. Laws of market economy comes the third. Following the party and listening to the government mean all the investments flow to the same place. Some say we had bulky economy 30 years ago because of redundant constructions. This is not exactly. The scale of economy is much larger now, which resulted in overcapacity. The investment brings down the value of real economy. In terms of investing on assets, the asset price is increasing and becoming more fluctuated. The most severe thing is that the individual risk directly results in system risk.


A distinct feature of Chinese economy is the strong state power. Not only the state and local governments are very powerful as well. The rapid accumulation of human capital and industrial adjustment are not being well researched and could be the driving forces for the future Chinese economy. We might talk about them a lot but we don’t have formal research. China’s higher education developed rapidly over the last 10 to 20 years. The number of university enrollment was less than one million 20 years ago, now it is seven million a year. By rough calculation, we found over one third of the seven million students major in science and engineering, which means we are cultivating two to three million engineers every year and the number will reach 20 to 30 million 10 years later. This number will have a profound influence on the global economy and international trade. China’s computer communication industry accounted for 15% of the total manufacturing exports and this proportion is 40% now. Transformation has begun. How to measure the differences between human capital and labor productivity of engineers in China and the America? How will these 20 to 30 million new engineers influence the global economy? These questions are worth researching.  


In terms of demand, if the government asks you to head toward the east, you’d better think whether you should go to the west as we are in the clucky economy. What does it mean? The team of Tsinghua University made a very interesting research. The orange line in the chart represents the labor proportion in Chinese construction industry. People work in the construction industry accounts for an increasing proportion of Chinese urban working population, sharply increased from 8% several years ago to the 16% now. It doubled within only few years. The result is that the market demand for low skilled labor increased drastically while the demand for high skilled labor decreased. Therefore, the gaps in salaries between university graduates and high school graduates are narrowing. This turning point coincides with the economic watershed in 2008 and 2009. There are many opportunities brought by the bulky economy, the key is whether we can grasp them.


Let’s discuss the development opportunities in Chinese economy from a different perspective. The main line of Chinese economic growth is the efficiency of resource allocation. This efficiency was much improved over the last 20 to 30 years. For example, the distortion in resource allocation in state-owned non-industrial sectors, the distortion in resource allocation of urban and rural areas, the distortion in resource allocation of export and non-export sectors were improved to a large extent. Will current distortions in resource allocation provide potential driving force for the future Chinese economic growth? In fact, we found there are many potential driving forces. Take service industry as an example. By accurate calculation, the Chinese service industry is the smallest among hundreds of countries. There are many reasons for the small scale of service industry. By doing research, we found that larger enterprises will have higher monopoly profits. However, among large enterprises that account for 60 to 70% of the total economic output, service industry has much higher monopoly profits comparing with manufacturing industry. If we can reform these industries, lower the barriers to entry and reduce the friction of exit, the labor scale in service industry can increase by 3 to 5% and the total output can increase 10%. This is especially true for service industries like the real estate, retail and wholesale which have great potential for reform.


Another misunderstanding is that manufacturing industry in capital intensive while service industry is labor intensive. This is worth discussing. Most of the Chinese service industries are capital intensive comparing with manufacturing industries. For example, when comparing with the America, service industries that develop quite slow like information industry, financial industry, sanitation, culture, sports and entertainment are no less intensive in capital comparing with manufacturing industries. In other words, developing these industries does not necessarily influence the economic growth. In fact, it might drive the investment rate and improve the efficiency of resource allocation in industries.

We conducted a research on 300 to 400 shoe manufacturers. We found that capital investment, especially capital investment on resale like opening stores and establishing brands are very important if you want to have distribution channels in domestic market. Constructing service industry doesn’t mean to prioritize labor and ignore capital. Instead, developing service industry might also drive investment rate and economic growth.

Last but not least, I want to talk about the potential of technological innovation that you all concerned about. China’s investment on R&D accounts for a certain proportion in the world. China has been catching up with the high income countries. In view of global experience, the closer the countries are getting to the cutting edge technology, the higher the investment in R&D would be. China’s investment in the cutting edge technology was quite high. How’s the efficiency? The efficiency is worrisome. That is the driving force for the future economic growth. Situation in Taiwan coincides with the data of enterprises in the world as well as the experience of transnational enterprises. This means the higher production efficiency an enterprise or a country has, the more possible for it to do R&D as the possibility for learning is smaller. This phenomenon doesn’t exist in China. In China, no matter how advanced the technology is, enterprises will keep investing in R&D. How is the effectiveness? From Taiwan’s experience, we know that doing R&D or not is critical to enterprises with cutting edge technology and the differences in technological annual growth rate can reach 20 percentage points. On the contrary, there are not many differences for Chinese enterprises whether doing R&D or not, with only 2 to 3 percentage points of differences in technological growth rate. In other words, if we can improve the efficiency of R&D allocation, the future economic growth can be significantly pushed. Therefore, we are back to the relationship between soft budget constraint and innovation skills.


Many scholars, especially western scholars said they want to conclude Chinese experience. Chinese scholars also want to summarize the experience of last 30 yeas to solve the current problems. What I want to say is we achieved a lot in last three decades but these results might not be applied in current issues directly. Issues that we failed to solve are those we need to pay special attention to now. As the old saying goes, while the prospects are bright, the road has twists and turns. Thank you!




◆please indicate the source if authorized: National Economics Foundation

◆photo:National Economics Foundation