How China Grows: Investment, Finance, and Reform - by James Riedel, Jing Jin and Jian Gao
How China Grows: Investment, Finance, and Reform , by , and ( Princeton University Press , Princeton, Princeton, NJ , 2007 ), pp. 222 .
China has achieved unprecedented economic growth in the past three decades. Studies abound examining why the Chinese economy has grown so fast and over such a long period of time and whether this growth is sustainable, but this book by Riedel et al. stands out on the following grounds:
First, it explains China's growth by looking at the relation between investment, finance and growth, and the impact of investment on technological progress and structural change. Second, the book provides a critique of the China growth accounting studies, which understate investment's contribution to growth, by challenging the applicability of the neoclassical growth model to China. Third, the book comprehensively discusses key aspects of financial market developments in China, including, among others, changes in saving, financial sector repression, banking sector reform and bond and stock markets, and argues that financial sector liberalisation and development are critical to sustaining long-term growth in China. Fourth, it is written in a manner that is accessible to both economists and non-economists even though it includes some technical economic analysis.
The book places the role of investment centre stage by arguing that investment in China has not only been the engine of growth, but also the source of technological progress and structural change. The way the book treats investment differs from the neoclassical Solow–Swan growth model in that capital is not a homogeneous input. Instead, it plays an important role in increasing employment, advancing technology, changing the resource allocation such as labour migration, and enhancing the changes in economic structure. The rationale behind this argument is that deducting depreciation from gross investment when measuring its contribution to growth is wrong and understates the contribution of investment: when obsolete capital depreciates, scrapping it entails no social cost and should not be netted out of gross investment. In other words, investment plays a much bigger role than what the growth accounting studies suggest.
Thus, the reallocation of labour, for example (even overall employment growth), should not be treated as an exogenous source of growth, but as endogenously determined by the rate of investment. Doing so raises the contribution of investment and lowers the total factor productivity growth residual.
The book concludes that the threat to future growth is the weakness of China's financial system, which undermines investment efficiency. The underdevelopment of the financial system is at the root of many problems, such as the rising current account surpluses, institutional bias in favour of foreign-invested enterprises and against domestic enterprises, and low return to savers versus investors.
The authors then discuss how China should go about developing its financial sector. One of the key challenges for the government is to deal effectively with the financial sector repression, a feature of China's underdeveloped and essentially state-controlled financial system. Given the nature of the financial repression, a key task is to reform the state-controlled banking sector and state-dominant stock markets through privatisation of state-owned enterprises (SOEs) and banks, reduction of state-holding shares in stock markets, liberalisation of interest rates and financial markets, and development of bond (including treasury and corporate bond) markets. The authors propose concrete measures to reform and nurture the financial markets, namely allowing both banks and stock and bond markets to flourish without tilting the balance in favour of one or the other. This proposal comes as a response to the debate about whether China should follow the bank-financed or equity-financed model in developing its financial system.
The book finally shifts its focus from the long-term to the short-term implications of investment and financial sector development by linking them to China's macroeconomic cycles and policies in pursuing the overarching theme of the book. The key argument is that the underdevelopment of the financial sector is not only an obstacle to sustainable long-term growth, but also the main source of short-term instability and an impediment to effective macroeconomic stabilisation policy. The authors discuss how macroeconomic policies, including monetary, fiscal as well as exchange rate policy, are implemented and what needs to be done to improve the effectiveness of these policies. The present benign macroeconomic situation in China prompts the authors rightly to warn the Chinese Government that success breeds complacency, a tendency that China must avoid.
A few issues discussed in the book warrant a more elaborate debate. For example, the notion that the population shift from the rural to the urban sector exerts a negative influence on the household saving rate (p. 49) may not be true as such a shift will in both theory and practice result in higher overall productivity and per capita income and thereby increased savings. A related issue concerns the specification of Equation (4) on page 51, which may display multicollinearity as the urbanisation ratio is likely to be positively correlated with real per capita income, despite the empirical results from estimating this nonlinear form looking plausible. It may not be accurate to argue that investment itself is the source of ‘boom–bust’ cycles in China (p. 17) as changes in investment were determined by those institutional factors that are deeply rooted in the partially reformed system. It is generally true that the return on private investment exceeds that of the SOEs (p. 41); however, the returns on SOEs’ investments and profits, especially those in energy and resources and government-controlled sectors, are on the rise in recent years, resulting from their monopoly position, which remained unchallenged in the process of economic transformation.
The book touched upon the issue of enterprise saving but did not elaborate how and why mainly SOEs account for about 40 per cent of deposits in the banking system (p. 65). How those savings of SOEs are transferred back into the government's fiscal budget to be used in financing its poorly financed social security system is a hotly debated issue in China. This has important policy implications in the discussion of the book's central issue of investment. Similarly, the issue of the informal financial sector in China was mentioned but the discussion is inadequate since the current operation and future development towards formalisation of the sector play a crucial role in developing China's future financial sector.
The authors point out the spread between the return to saving and investing which not only encourages the outflow of capital, but also discourages saving and investment domestically. However, one may ask why this gap constitutes an enormous tax on both saving and investing, as claimed by the authors, and what kinds of taxes they have in mind. Moreover, capital outflows imply saving in excess of investment. If both are taxed it is not obvious why this should necessarily lead to capital outflows.
The book does not break new ground, but its conceptual approach, its empirical analysis and its detailed up-to-date account of the ongoing reform programs and their policy background in China make it highly recommended for those working on or studying the Chinese economy. The book is especially useful for those interested in financial sector reform in China. As claimed by the authors, policy-makers in China will also find this book useful.
