China s Response to the Global Slowdown: The Best Macro is Good Micro By Nicholas Stern (Senior Vice President and Chief Economist of the World Bank ) At the Global Economic Slowdown and China's Countermeasures Conference Organized by the Development Research Centre of the State Council and World Bank Beijing, June 13, 2001 President Wang Mengkui and distinguished participants: I am very grateful for the work of the DRC in organizing this conference. It is one of China's great strengths that it recognizes and anticipates policy problems early and promotes careful analysis of the issues involved. The issue here is the global slowdown and the appropriate response from China. My analysis will be divided in three parts. First, I shall argue that the right response to the global slowdown is an intensification of structural reforms rather than any radical change in the monetary or fiscal stance. Second, I will point to several key areas for structural reform. Finally, I shall highlight the key conclusions. Part 1 1. The topic of the discussion this morning was the assessment of the likely effects of the global slowdown on China's economic opportunities. The overall judgment this morning, I think, can be summarized by saying that the macroeconomic effects of the global slowdown on China's economic growth are significant, but that they may be modest in relation to China's growth. The overall effect may be to reduce China's growth rate by around half or one percentage point of GDP; it may be a little less than that, and it is unlikely to be much more. This may indeed be described as modest in relation to a current growth rate of around 8 percent. We also took the view that the global slowdown, at least in the United States, is likely to be short-lived. We anticipate that we will see some pick-up in the growth rate of the United
States sometime towards the end of this year. So it would be a mistake to plan a dramatic response. 2. On the other hand, we cannot be sure that the assessment that I just described will be accurate. That is the problem with economic forecasting. We did recognize that there are some significant risks on the downside. In particular, the US recovery may not be as fast as we are anticipating. The US stock market may still be vulnerable, and we do not know when Japan will pull out of recession, or whether or not Japan will fall back into an extended period of contraction. So it would also be a mistake not to prepare for, or think about, the possibility of a more severe slowdown than we are anticipating. 3. But on the basis of the central forecasting case, the one in which China's growth rate might drop from 8 percent to 7 or 7.5 percent as a result of the global slowdown, I would argue that there is only limited scope for a comprehensive macroeconomic response. I mean limited in two senses. First, the slowdown is appearing now, and we know that the effects of economic adjustments take time to come through. Indeed, if we do make economic adjustments, their effects might start to come through just at the point when the slowdown is finishing C which means that you run the risk of fueling inflation. Second, if you look at the margins for maneuver on the fiscal side, then these margins are themselves limited. 4. I think we all recognize that with the very low interest rates in China, the margins for monetary policy are small. On the fiscal side, I would argue that it would be better to look at the expenditure rather than the tax dimension. The tax position in China is already difficult, and tax reductions are very difficult to reverse in the future. We should not be looking for a tax reduction. I would argue that if there is to be any further increase in expenditures, then we should focus on those areas that may be constraining future growth. Under this heading I would put emphasis on infrastructure spending, and in particular rural infrastructure spending. This means that if you look at the potential for fiscal and monetary responses, we see that there is just one possible area that makes sense in terms of future reform: spending on infrastructure, and in particular rural infrastructure. 5. However, I do think that there are some very useful reform measures that we could adopt now that would contribute to overall growth. Indeed, it is often the case that the best macroeconomic response to changing circumstances is microeconomic and structural. Good reforms can quickly spur greater confidence, so that we could also see a significant macroeconomic effect. For example, the announcement about China's entry into the WTO
provided a boost to investment, both foreign and domestic. This is an illustration of an important lesson from macroeconomics: fast responses come from changes in expectations, rather than from the standard effects of prices and incomes on supplies and demands. 6. Structural reforms and infrastructure spending would have a further beneficial effect in the medium term, in that they would increase the flexibility of the economy. Looking forward, flexibility is going to be a very important requirement for China's future prospects. One thing we have learned about both the transition economies and the more technological world is that change can come very quickly, so that flexibility in response can be vital to growth, stability, and poverty reduction. Part 2 To consider how accelerating and intensifying reforms can enhance growth prospects, it is helpful to think back over the earlier stages of reform. I would argue, in common with many students of the Chinese economy, that we are now into the third phase of reform. We can think of the first phase as running from 1979 to 1983/4, when the major reforms were in agriculture and embodied the household responsibility system. These resulted, as we know, in dramatic increases in agricultural output and productivity that brought at least a hundred million people, probably more, out of poverty. It was one of the most successful reforms in economic history. It was, of course, a very radical reform with very quick results, but it should be seen as the first step in a step-by-step approach. As I have argued in my speech at Tsinghua University this week, it is a mistake to see China's reform process as gradual. But it is step-by-step, building carefully on previous circumstances and achievements, using experimentation and learning along the way. The second phase of the reform we can see as going from 1983/4 through the middle of 1990s. This was a period of very strong growth in township and village enterprises, or the TVEs. In both of these reform phases, we can see the key elements as removing constraints on entrepreneurship and releasing energies. Those energies had a dramatic effect, thanks in part to other policies that can be described as permissive. I think particularly of the financial policies, where the banking institutions were ready to provide loans for township and village enterprises. I am also thinking of the social support policies through the state enterprises. This social support meant that many people or families would have some kind of guaranteed income or other forms of social base. A lot of activities in state
enterprises were pretty unproductive, but they did provide some security. And that security allowed people to take the risks of involvement in new activities. So those are the two phases of China's recent economic history, marked by release of energy and permissive complementary policies. The next phase has already begun. In my view, that third phase involves three elements. First, it involves the deepening of markets ªthe strengthening, if you like, of the institutions supporting a market economy. The second element is the integration of China into the world economy, and the third element is the maintenance of social cohesion, which has been a fundamental part of the first two phases of the reforms. Let me first emphasize this last element of social cohesion. If we want to make reforms, we have to bring people along. Reform can create anxiety; people do not know what is coming next. But if they feel that major elements of society are working together, that those who may be dislocated by reforms will be protected, then I think that the reform process is much easier to carry through. And I do believe this was an important element of the first two phases of reforms. Let us turn now to the first element that I mentioned above: the need to deepen markets by strengthening the institutions that support them. If we understand this third phase in the way I have described, then an absolutely crucial aspect is what I call the investment climate. You may have heard it called also the business environment or enabling environment, but I prefer the term investment climate. By this, I mean a whole set of circumstances, the whole of the organizations or policies in a society or economy that allows people to get on with their business, that makes economic activity productive, and that allows creativity. In thinking about the investment climate, it is useful to divide the key factors into three. The first is macroeconomic stability, and openness to trade. The second is good governance and strong institutions, and the third is well Cfunctioning infrastructure. In arguing that the challenge in the third phase of reforms is to improve the investment climate, we must not necessarily look for dramatic effects on the overall quantity of investment. A positive or improving investment climate will improve the productivity of all factors of production. The reason that I think the investment climate is so important is that in the first two phases, although the organization of activity changed, the change was not really focused on institution-building for a market economy. We did see powerful releases of energy, and the market economy has sprung up around those releases of
energy; the challenge now is to make that market economy function well. That challenge is particularly strong when we recall what is going to happen to employment in agriculture and employment in the old state-owned enterprises. In China at the moment, there are probably around 400 million people who are largely dependent on agriculture. I think we can predict with reasonable confidence that the approximately 400 million will become less than 300 million over the next 15 years or so. Certainly, that would be the implication from the economic history of other societies. I think it is clear that the pressures to find employment outside agriculture are strong in China. So you have to ask yourself the question: how will those people who will no longer be dependent on agriculture be economically productive? I think the answer to that question is very clear. They will not be employed in the public sector. They are unlikely to find employment on a really big scale in restructured or privatized state-owned enterprises, and indeed we may see some fall in employment there. Where people will be economically active will be in the new private sector. I think we can also say that those people will be employed in small and medium-sized enterprises. Many of them will work in the services sector, for example some in construction, some in garages, others in restaurants, and still others in tailoring. There are all kinds of ways in which small firms will grow and multiply in this new private economy. We can already see some of those developments. I was in Shanxi province over the weekend, and we saw small economic activity developing strongly as people diversify within and out of agriculture. What are the obstacles that these firms, particularly small and medium firms, face to their expansion? I cannot go into the details and analysis now. But, in thinking through this question, we have to examine carefully the extent to which many of these obstacles are bureaucratic. In some cases, infrastructure provision may be constraining activity. In others, it may be finance. We may ask whether retraining and the ability to develop business plans are a major constraint on their growth. We have to study these investment climate issues carefully using direct information from firms. This discussion of private sector growth has emphasized the development of the new. But we must also think about the restructuring and exit of the old, remembering that exit is a crucial part of economic competition. If new firms are to enter an industry and find markets, then firms that are under-performing C those that are not making profits C must exit. Indeed, if we look at manufacturing industry in the United States, you will find in every five-year period that around one-third of firms will exit, to be replaced by new firms. In other words, if you look
within an industry at one point in time, and you look at it again five years later, you will find only two-thirds of firms will be the same. Exit and entry are closely intertwined. In examining possible reforms we have to think about how exit can function. Bankruptcy is one key element there. The second element of the current phase of China's reform is to integrate into the world economy. This is a crucial element, but it has been much discussed in China and I do not have the time here to examine it closely. Let me finish my discussion of the third phase by returning, instead, to the issue of social protection. I have emphasized the importance of social cohesion, and in this context social protection is crucial. Remember that we must think of social protection in a positive sense. It is true that social protection plays an important role in terms of transfers to poor people to keep up their living standards. But social protection also provides social cohesion. As I argued, motivating people to act together is essential in implementing reforms. Social protection also promotes the kind of flexibility that allows people to move from one area to another in a changing economy. Social protection promotes entrepreneurship, as it allows people to take risks, the risks associated with innovative economic ventures. Therefore social protection should be seen as a very positive force, and should be designed so that it has the kinds of positive effects that I have described. Thus I would endorse strongly the emphasis of the Chinese leadership on developing social security, and its work to promote the development of the lagging regions, particularly in western China. Part 3 1. In conclusion, I would be skeptical about embarking on a strong short-term macro reaction to the global slowdown. Such a strong reaction risks disturbing the sound macro-foundations that have been established in China. It may also be too late for ordinary macroeconomic responses to have some significance, that is, to take effect in time to counteract the effects in the Chinese economy of the global slowdown. If we do make a small move in that direction, I would emphasize the fiscal side, not the monetary. And, within the fiscal side, I would emphasize infrastructure, and particularly rural infrastructure. 2. Instead of looking to a macroeconomic response, I would suggest a reform response. The best macro reaction to the global slowdown, in my view, is to push ahead with reforms. They are crucial to China's third phase. I think that China in the third phase can grow at the kind of
growth rate we have seen in the first two stages C that is, 8 percent or so annually. The driver in the first phase was agriculture, the driver in the second phase was township and village enterprises, and the driver in the third phase will be the healthy growth of small and medium enterprises in the new private sector. 3. Thus, our reform reaction to any slowdown should be based on tackling the question of what will best promote the healthy growth of private sector small and medium enterprises. I have described in what I have said some policy areas key to the promotion of growth. We have not had time to go into those in detail, but I am looking forward to working further on them with the World Bank's team. We will be working closely with the Chinese authorities to pursue in detail this analysis. Our shared goal is to develop policy proposals that could translate the analysis into real policy opportunities. 4. In conclusion, I would like to stress that China is already very attractive for investment ªit is attractive for domestic investment, and it is attractive for foreign investment. My recommendation is to push ahead with the reforms and become even more attractive to investors, both domestic and foreign, and in particular to accelerate the growth of productivity. I believe the future of the Chinese economy looks strong, and I believe that Chinese authorities are focusing on the right issues. Thank you very much. Source: http://www.worldbank.org.cn /06/13/2001