China in the Global Economy

China in the Global Economy Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA 94305-6072, U.S.A. October 28, 2002 Phone: 1-650-723-3708; Fax: 1-650-723-7145 Email: ljlau@stanford.edu; WebPages: http://www.stanford.edu/~ljlau

A Preview The Chinese Economy Today How Reliable Are Chinese Economic Data? Comparison with Developed and Developing Economies China without the World and the World without China Prospects for Future Economic Growth Sources of East Asian Economic Growth The Three Paradigms of Economic Growth The Development of the Great West The New Economy and China Lawrence J. Lau, Stanford University 2

The Chinese Economy Today

The Chinese Economy Today (1) East Asia is the fastest-growing region in the world over the past two decades, the East Asian currency crisis of 1997-98 notwithstanding China is the fastest growing country in East Asia nearly 10% p.a. since beginning of economic reform (1979) Between 1979 and 2001, Chinese real GDP grew from $177 billion to $1.16 trillion (2001 prices) and real GDP per capita grew from $183 to $920. The U.S. GDP ($10.19 trillion) and GDP per capita ($36,840) are respectively 9 and 40 times the comparable Chinese figures in 2001. China survived the East Asian currency crisis relatively unscathed. China is one of the very few socialist countries that have made a successful transition from a centrally planned to a market economy the 10 th Five-Year Plan is only indicative and not mandatory; the rate of interest (the price of money) and the exchange rate are the only prices that are still administratively determined on Lawrence J. Lau, Stanford University 4 the margin.

The Chinese Economy Today (2) 1979 2001 US$ (2001 prices) Real GDP 177 bill. 1.16 trill. Real GDP per capita 183 920 Lawrence J. Lau, Stanford University 5

The Chinese Economy Today (3) U.S. China US$ (current prices) 2001 GDP 10.19 trill. 1.16 trill. 2001 GDP per capita 36,840 920 Lawrence J. Lau, Stanford University 6

The Chinese Economy Today (4) The private (non-state) sector accounts for more than 65% of GDP and an even greater percentage of employment in 2001 non-state-owned firms face hard budget constraints and ordinary citizens can make a good living without being beholden to the state. China is the 6th largest trading country in the world (exports of US$266.2 billion and imports of US$245 billion, totaling US$511.2 billion in 2001) China has been rapidly becoming a major destination for the exports of other East Asian economies China is no longer a shortage economy--insufficient aggregate demand Lawrence is a real J. Lau, possibility Stanford University 7

The Major Components of Chinese Economic Reform (1979-the present) The Open Door International Trade Foreign Direct Investment Marketization Goods Market Labor Market Foreign Exchange Market Housing Market Capital Market Devolution of economic decision-making power (The Contract Responsibility System ) Empowering Provincial and Local Governments Autonomy and Incentive at the Enterprise Level Professionalization of Management of Enterprises Creation of new, non-state-owned modes of organization for production Agriculture--Abolition of communes and return to a system of individual cultivators with fixed rents and taxes Non-Agriculture (Industry and Services)--emergence of Township and Village (T&V) enterprises; (foreign) joint-venture, foreign and private enterprises Lawrence J. Lau, Stanford University 8

Economic Performance: Pre- and Post-Reform Average Annual Rates of Growth of Selected Economic Indicators (%) 1952-1979 1979-2000 Pre-Reform Reform Real GDP 6.20 9.62 Real GDP/Capita 4.14 8.24 Real Gross Value of: Agricultural Production 4.33 7.41 Light Industry 7.83 11.23 Heavy Industry 11.37 11.10 Real Personal Consumption 4.99 9.04 Real Consumption/Capita 2.96 7.70 Real Gross Fixed Capital Formation 11.43 10.90 Capital Stock 5.93 9.82 Employment 2.52 2.71 GDP Deflator 0.59 5.72 Retail Price Index 0.80 6.11 Exports (in current US Dollars) 10.98 14.83 Imports (in current US Dollars) 10.27 Lawrence J. Lau, Stanford University 13.53 9

The Growth of the Non-State Sector Before the beginning of economic reform, there were only 150,000 individual proprietors and no private enterprises in China The number of individual proprietors grew to 31.2 million by the end of 1998 Within the last decade, the contribution of individual proprietors and private enterprises to GDP increased from less than 1% to more than 20% in 2001 (value added of 1.978 trillion Yuan). Individual proprietors and private enterprises generated a total employment of 74.74 million in 2001. Lawrence J. Lau, Stanford University 10

The Tenth Five-Year Plan (2001-2005) An indicative (or predictive) plan rather than a mandatory plan Doubling of real GDP between 2001 and 2010, with an implied rate of growth of 7.2% p.a. An inflation target of less than 3% p.a. An increase in the share of central government revenue in GDP (the introduction of a comprehensive individual income tax) tax revenue as a proportion of GDP rose from 14.2% of GDP in 2000 to 17.1% of GDP in 2001 Indirect (macroeconomic) control of the economy using instruments such as money supply, interest rate and exchange rate rather than direct (microeconomic) control through administrative directives, commands and central planning with mandatory targets Lawrence J. Lau, Stanford University 11

Marketization: Final Abolition of Planned Prices The market prices of more than 99% of commodities have been determined by supply and demand for at least a decade In 2001/07, the remaining planned prices are abolished with the exception of the following: the prices of natural gas, oil, edible oils, grains, tobacco, water, salt, and products related to national security The exchange rate and the rate of interest are still determined administratively by the People s Bank of China, the central bank The dual-track system of prices introduced in the mid-1980s to facilitate the transition of China from a centrally planned to a socialist market economy has finally been phased out, reducing to a single-track, market-based system, with the exceptions noted above Lawrence J. Lau, Stanford University 12

The Stock Market 1197 enterprises (more than 95 percent majority state-owned) listed on Shanghai and Shenzhen Stock Exchanges combined as of August, 2002. Market capitalization (US$560 billion, with 67% in the form of state-owned, noncirculating institutional shares); market turnover (US$2.0 billion a day) Third largest market in Asia after Japan and Hong Kong A-shares for domestic and B-shares for foreign investors; however, beginning in 02/2001, Chinese domestic citizens with foreign exchange can purchase B-shares as well 7/8/99--introduction of indexed funds in China 8/99--16 billion Yuan bonds issued and traded on the domestic stock exchanges 9/99--state-owned enterprises permitted to trade stocks The main boards of the Shanghai and Shenzhen exchanges will be unified in Shanghai A second, new, board for non-state-owned enterprises will be set up in Shenzhen with reduced requirements for annual profits and capitalization (Chinese version of the American Stock Exchange) The stock listing approval process, whether for IPO or for back-door listing, has begun to become ownership blind in 2002. 27 private enterprises were listed in 2001. The proportion of non-state-owned firms among publicly listed companies is expected to rise. Lawrence J. Lau, Stanford University 13

The Bond Market In 2001/05 approximately US$1.5 billion worth of long-term bonds, denominated in US$ and Euro, were sold to international investors The issue was oversubscribed by nearly 5 times The coupon rate on the 10-year US$ bond was 6.8%, 1.33% above U.S. Treasury note of the same maturity The coupon rate on the 5-year Euro bond was 5.25%, 0.64% above German DM bonds of the same maturity The premia paid by the Chinese Government were low by the standards of developing economies These rates were actually higher than the rate of interest paid on Chinese government bonds denominated in Renminbi In 2002/05, thirty-year Yuan-denominated bonds were sold domestically with a coupon rate of 2.9%, indicating very low long-term inflationary expectations In 2002/06, seven-year Yuan-denominated fixed rate bonds were sold to individuals and non-financial institutions at par by the four major state-owned commercial banks at a coupon rate of 2% p.a., indicating extremely low intermediate-term inflationary expectations In 2002/M10, Treasury bonds of five year maturity were issued with a coupon rate of 2.65%. Multilateral financial institutions, such as the Asian Development Bank, to be allowed to issue Renminbi denominated bonds in the Chinese domestic capital market Lawrence J. Lau, Stanford University 14

Rates of Growth of Real GDP and Inflation (% p.a.) Actual Real GDP RPI CPI 1997 8.8 0.8 2.8 1998 7.8-2.6-0.8 1999 7.1-2.9-1.3 2000 8.0-1.5 0.4 2001 7.3-0.8 0.7 2002Q1 7.6-0.6 2002Q2 8.0 2002Q3 8.1 2002/Q1-3 7.9 Projections 2002 >7.0 (NBS) 7.8-0.5 (PBOC) 7.0 (ADB) 7.5 1.0 (Lau) 6.9 (Lehman) Lawrence J. Lau, Stanford University 15

Quarterly Rates of Growth of the Real GDP of the Chinese Economy, Y-o-Y YoY Quarterly Rates of Growth of Real GDP 25% 20% GDPQ1 GDPQ3 GDPQ2 GDPQ4 15% 10% 5% 0% 1983q1 1984q2 1985q3 1986q4 1988q1 1989q2 1990q3 1991q4 1993q1 1994q2 1995q3 1996q4 1998q1 1999q2 2000q3 2001q4 Percent per annum -5% Lawrence J. Lau, Stanford University 16 Quarter

Quarterly Rates of Growth of the Real Gross Fixed Investment of the Chinese Economy, Y-o-Y 30.0 YoY Quarterly Rates of Growth of Real Gross Domestic Fixed Investment 25.0 Quarter 1 Quarter 2 percent per annu 20.0 15.0 10.0 Quarter 3 Quarter 4 5.0 0.0 1997q1 1997q2 1997q3 1997q4 1998q1 1998q2 1998q3 1998q4 1999q1 1999q2 1999q3 1999q4 2000q1 2000q2 2000q3 2000q4 2001q1 2001q2 2001q3 2001q4 2002q1 2002q2 Quarter Lawrence J. Lau, Stanford University 17

The Contributions of Sectoral Value-Addeds to China s GDP Lawrence J. Lau, Stanford University 18

The Sectoral Contributions to China s Employment Million Persons 800 700 The Sectoral Contributions to China's Employment Tertiary Industry Secondary Industry Primary Industry 600 500 400 300 200 100 0 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year Lawrence J. Lau, Stanford University 19

The Consumer and Retail Price Indices 25 % Monthly Rates of Change of Price Indices Since 1995 (Y-o-Y) 20 15 RPI CPI CPI for 36 Big Cities Price Index for Agricultural Production Material 10 5 0 95-03 95-06 95-09 95-12 96-03 96-06 96-09 96-12 97-03 97-06 97-09 97-12 98-03 98-06 98-09 98-12 99-03 99-06 99-09 99-12 00-03 00-06 00-09 00-12 01-03 01-06 01-09 01-12 02-03 02-06 -5 Month -10 Lawrence J. Lau, Stanford University 20

Has Deflation Stopped? Deflation has slowed/stopped: In 1999 the RPI declined 2.9%; in 2000 the RPI declined only 1.5% In 1999 the CPI declined 1.3%; in 2000 the CPI rose 0.4% In 2001, the CPI rose 0.7%, the RPI declined 0.8% and the PPI declined 3.7% In 2002Q1, the CPI declined 0.6%; in 2002/M9, the CPI declined 0.7% YoY. In April 2002, the PPI declined 3.1% Y-o-Y; in January-April, 2002, the PPI declined 3.8% Y-o-Y The core rate of inflation is non-negative The decline in prices over the past few years was due in part to the fall in the prices of energy, in particular oil, and agricultural products, in particular food. It was also due in part to the increase in productivity (reduction in cost) and in competition and the decrease in the degree of monopolistic market power (reduction in profit margin) The long-term core inflation rate--inflation rate net of changes in the prices of energy and food--may be estimated at between 0 and 1 percent--there is no deflation The key to determining whether there is deflation in the macroeconomic sense is whether the components Lawrence J. Lau, of Stanford aggregate University demand, real consumption and 21 investment, are growing (In 2002/M9, retail sales increased 9.1% YoY).

The Relative Stability of the Rate of Growth of Real GDP Gross domestic investment is mostly financed through domestic savings rather than foreign investment or loans. Foreign direct investment (FDI) accounts for approximately 10% of gross domestic investment in China, a relatively small proportion. Despite fluctuations in exports and imports, the rate of growth of real GDP has remained remarkably stable at 7-8%. Exports are approximately 20% of GDP, but the value-added component is only approximately 30%, resulting in an exportgenerated value-added to GDP ratio of 6%. Chinese exports to the U.S. is approximately 7.3% of Chinese GDP (according to adjusted U.S. data), with a value-added content of 20%, resulting in a value-added to GDP ratio of 1.5%. The volatility of the Chinese annual rates of growth has also declined, indicating an improved capacity for macroeconomic management. The Development Research Center of the State Council has estimated that accession to WTO will increase the rate of growth of the Chinese economy by 0.5% per annum; the U.S. International Trade Commission has estimated that real GDP would be 4% higher in 2010 than otherwise. The National Bureau of Statistics (NBS) projected that the award of the 2008 Summer Olympic Games to Beijing should add 0.3-0.4% to the average annual Lawrence J. Lau, Stanford University 22 growth rate

China s Gross Domestic Investment as a Percent of GDP percent China's Gross Domestic Investment as a Percentage of GDP 50 40 30 20 10 0 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Lawrence J. Lau, Stanford University 23

National Savings Rate as a Percent of GDP: Selected Countries and Regions 60 % National Savings Rates of Selected Countries and Regions 50 1982 1998 40 30 20 10 0 Brazil Canada China France Hong Kong Japan Italy Indonesia India South Korea Nigeria Mexico Lawrence J. Lau, Stanford University 24 Philippines Thailand Taiwan Singapore United States

The Savings Rate as a Percent of GDP: Selected East Asian Countries and Regions 50 The Savings Rate as a Percent of GDP 40 30 Percent 20 10 0 1965 1967 1969 1971 1973 1975 China Indonesia Malaysia Singapore Thailand India 1977 1979 1981 1983 Hong Kong Korea, Republic of Philippines Taiwan Mexico 1985 1987 1989 1991 1993 1995 1997 1999-10 Lawrence J. Lau, Stanford University 25

Exports as a Percent of GDP: Selected East Asian Economies and U.S. Exports as a Percent of GDP 180 % HONG KONG INDIA INDONESIA KOREA MALAYSIA PHILIPPINES SINGAPORE THAILAND CHINA Taiwan Japan U.S. 160 140 120 100 80 60 40 20 0 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Lawrence J. Lau, Year Stanford University 26 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Exports to U.S. as a Percent of Total Exports % Exports to U.S. as a Percent of Total Exports 60 China Hong Kong India Indonesia Korea 50 Maylaysia Philippines Singapore Taiwan Thailand 40 30 20 10 0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Lawrence J. Lau, Stanford Year University 27 1996 1997 1998 1999 2000 2001

Chinese Exports to the United States as a Percent of Chinese GDP (Chinese Data) Chinese Exports to U.S. as a Percent of Chinese GDP 6 5 Ratio of Exports to U.S. to GDP 4 Percent 3 2 1 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year Lawrence J. Lau, Stanford University 28

Imports as a Percent of GDP: Selected East Asian Economies and U.S. 240 220 % Imports as a Percent of GDP HONG KONG INDIA INDONESIA KOREA MALAYSIA PHILIPPINES SINGAPORE THAILAND CHINA, P.R. TAIWAN JAPAN UNITED STATES 200 180 160 140 120 100 80 60 40 20 0 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 Year 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Lawrence J. Lau, Stanford University 29

Imports from U.S. as a Percent of Total Imports % Imports from U.S. as a Percent of Total Imports 35 China Hong Kong India Indonesia Korea 30 Maylaysia Philippines Singapore Taiwan Thailand 25 20 15 10 5 0 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year Lawrence J. Lau, Stanford University 30

Quarterly Rates of Growth of Exports: Selected East Asian Economies 50 Year-over-Year Quarterly Rates of Growth of Exports in U.S.$ (Percent) 40 30 20 Percent p.a 10 0 Q1 97 Q3 97 Q1 98 Q3 98 Q1 99 Q3 99 Q1 00 Q3 00 Q1 01 Q3 01 Q1 02-10 -20 China Hong Kong Indonesia South Korea -30-40 Malaysia Philippines Singapore Taiwan Thailand Japan India -50 Lawrence J. Lau, Stanford University 31

Quarterly Rates of Growth of Imports : Selected East Asian Economies 60 50 40 Year-over-Year Quarterly Rates of Growth of Imports in U.S.$ (Percent) China Hong Kong Indonesia South Korea Malaysia Philippines Singapore Taiwan Thailand Japan India 30 20 Percent p.a 10 0 Q1 97 Q3 97 Q1 98 Q3 98 Q1 99 Q3 99 Q1 00 Q3 00 Q1 01 Q3 01 Q1 02-10 -20-30 -40-50 Lawrence J. Lau, Stanford University 32

Quarterly Rates of Growth of Real GDP: Selected East Asian Economies Quarterly Rates of Growth of Real GDP, Year-over-Year, Selected East Asian Economies 15 10 Annualized Rates in Perc 5 0 1994Q1 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1 2002Q1-5 -10 China Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand -15 Japan India -20 Quarter Lawrence J. Lau, Stanford University 33

Indicators of Current Economic Performance In 2002/Q1-Q3, value-added in industry amounted to 2,248.7 billion Yuan, an increase of 12.2% YoY in real terms In 2002/Q1-Q3, profits of state-owned industrial enterprises amounted to 380.1 billion Yuan, an increase of 13.6% YoY. In 2002/Q1-Q2, gross fixed investment grew 24.4%; investment by private enterprises and collective enterprises grew 19.4% and 15.8% YoY Retail sales in 2002/M9 grew 9.1% YoY Savings deposits of households reached 8.4 trillion Yuan, an increase of 18.1% YoY, which itself represents an increase in the rate of increase by 5.4 percentage points Lawrence J. Lau, Stanford University 34

Value-Added in Industry (Monthly Data) Value Added in Industry Bilion Yuan 300 250 Total Value-Added Rate of Growth (%) (Y-o-Y in comparable prices) % 20.0 18.0 16.0 200 14.0 12.0 150 10.0 100 8.0 6.0 50 4.0 2.0 0 97-01 97-06 97-11 98-04 98-09 Lawrence J. Lau, Stanford University Month 35 99-02 99-07 99-12 00-05 00-10 01-03 01-08 02-01 02-06 02-11 0.0

Exports, Imports and Foreign Exchange Reserves In 2000, exports rose 27.8% to US$249.2 billion; imports rose 35.8% to US$225.1 billion; with a trade surplus of US$24.1 billion In 2001, exports rose 6.8% Y-o-Y to US$266.2 billion and imports rose 8.2% to US$243.6 billion with a trade surplus of US$22.5 billion In 2002, after an initial slowdown, exports and imports have resumed their rapid growth in Q1-Q3, exports grew 19.4% to US$232.6 billion while imports grew 17.2% to $212.6 billion; in 2002/M9, exports grew 33.1% YoY to US$31.9 billion and imports grew 36.4% to US$29.8 billion, with a total international trade of US$61.7 billion, a historic monthly high. Trade with East Asian countries, both exports and imports, have been increasing at double-digit rates in 2002/M1-8, exports from South Korea, Malaysia, Singapore to China increased YoY 42%, 38% and 31% respectively; in 2002/M9, exports from Japan and Taiwan to Mainland China increased 40% and 171% YoY respectively.. Lawrence J. Lau, Stanford University 36

Exports, Imports and Foreign Exchange Reserves Chinese tourists traveling abroad exceeded 10 million in 2000; the tourism component of the balance of payments turned negative in 2000 Official foreign reserves continued to rise, reaching US$212.2 billion at year end 2001, an increase of US$46.6 billion over year end 2000 (larger than the trade surplus of US$22.5 billion), and surpassing total outstanding external loans (US$169.1 billion as of 6/30/2001) by a wide margin; it stood at US$260 billion as of the end of 2002/M9 The exchange rate of the Renminbi vis-à-vis the U.S. Dollar has remained stable since 1994 (in fact, there has been a slight appreciation from 8.7 Yuan/US$ to 8.3 Yuan/US$) and is expected to remain so Lawrence J. Lau, Stanford University 37

The Exchange Rate, the Interest Rates and the Stock Market Index Exchange Rate, Stock Market Index and Interest Rates China 200 8 180 160 140 120 7 6 5 100 4 80 60 40 20 Exchange Rate Index, 1/2/97=100 Stock Market Index, 1/2/97=100 Interest Rate (3 months) r. scale Interest Rate (12 months) r. scale 3 2 1 0 0 01/02/97 08/06/97 03/10/98 10/12/98 05/14/99 12/16/99 07/20/00 02/21/01 09/25/01 04/29/02 Lawrence J. Lau, Stanford University 38

Monthly Exports, Imports and Trade Balance Official Chinese Data 30 Monthly Exports, Imports, and Trade Balance 25 Exports Imports Trade Balance 20 US$ Billion 15 10 5 0-5 Jan-92 Jun-92 Nov-92 Apr-93 Sep-93 Feb-94 Jul-94 Dec-94 May-95 Oct-95 Mar-96 Aug-96 Jan-97 Jun-97 Nov-97 Apr-98 Sep-98 Feb-99 Jul-99 Dec-99 May-00 Oct-00 Mar-01 Aug-01 Jan-02 Jun-02-10 Month Lawrence J. Lau, Stanford University 39

Chinese Exports by Major Destinations Rank in Chinese Exports by Major Destinations: Billion US$ 2001 Country Exports 2000 2001 Value Share Value Share 1 United States 52.104 20.91% 54.283 20.40% 2 Hong Kong 44.52 17.87% 46.547 17.49% 3 Japan 41.654 16.72% 44.958 16.89% 4 Korea 11.292 4.53% 12.521 4.70% 5 Germany 9.278 3.72% 9.754 3.66% Total Exports 249.2 266.154 Lawrence J. Lau, Stanford University 40

Chinese Imports by Major Origins Rank in 2001 Country Chinese Imports by Major Origins: Billion US$ Imports 2000 2001 Value Share Value Share 1 Japan 41.512 18.44% 42.797 17.57% 2 Taiwan 25.494 11.33% 27.339 11.22% 3 United States 22.363 9.93% 26.202 10.76% 4 Korea 23.207 10.31% 23.389 9.60% 5 Germany 10.409 4.62% 13.772 5.65% Total Imports 225.094 243.613 Lawrence J. Lau, Stanford University 41

Composition of Chinese Exports by Primary Commodities versus Manufactured Goods Lawrence J. Lau, Stanford University 42

Manufactured Exports as a Percent of Total Chinese Exports 40 Distribution of Chinese Manufactured Exports as Percent of Total Exports 1985-2000 30 Percen 20 10 Clothing, Footware and Toys Machines and Transport Equipments - 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year Lawrence J. Lau, Stanford University 43

Foreign Direct Investment (FDI) FDI, at US$45 billion a year, amounts to approximately 10% of the annual Chinese aggregate gross domestic investment of approximately US$450 billion. Moreover, a significant proportion of it is what is known as recycled or round-tripped investment ultimately originated by Chinese entities and individuals. Quantitatively, FDI is not critical to the Chinese economy. Qualitatively, FDI is probably more important because it brings in technology, know-how, business methods, management techniques and markets that will otherwise be unavailable in China. China s share of total World FDI is still relatively low in 2002, FDI is expected to be approximately US$50 billion compared to a world total of US$534 billion, less than 10% (the U.S. is the largest recipient of FDI in the world, amounting to US$124 billion in 2001; however, it is expected to fall to US$44 billion in 2002. FDI has been responsible for most of the growth of exports (and imports). However, the nature of FDI has also changed--from export-oriented to domesticmarket oriented; from light industry to heavy and high-technology industries; and from small projects to large projects. Lawrence J. Lau, Stanford University 44

Foreign Direct Investment (FDI) In 1999, FDI arrivals totaled US$40.39 billion, an 11% decline from 1998--however, the sources of the FDI were different--real FDI probably rose if round-tripped capital were excluded; FDI commitments amounted to US$41.24 billion, a decline of 20.9% In 2000, FDI arrivals totaled US$40.7 billion, a 1% increase over 1999; in 2001, FDI arrivals reached an all-time high of US$46.85 billion, a 14.9% rise from 2000; FDI commitments amounted to US$62.4 billion in 2000, a 51.3% increase over 1999, partly in response to expected Chinese accession to WTO; in 2001, FDI commitments amounted to US$69.19 billion, a 10.43 rise from 2000. Cumulative FDI at year end 2001 amounted to US$395.47 billion FDI arrivals in 2002/Q1-3 totaled US$39.6 billion, an increase YoY of 22.6%; FDI commitments amounted to US$68.4 billion, an increase YoY of 38.4%. FDI arrivals is forecast to be US$50 billion in 2002. Lawrence J. Lau, Stanford University 45

Foreign Direct Investment (FDI) Collateralized loan program as a natural hedge for foreign direct investors Initial public offerings (IPOs) and listings on Chinese stock exchanges (the second board) as a potential exit strategy for foreign direct investors Lawrence J. Lau, Stanford University 46

China s Share of World Foreign Direct Investment % China's Share of Total World Foreign Direct Investment (BOP statistics, IFS) 25 20 15 10 5 0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year Lawrence J. Lau, Stanford University 47

China s FDI as a Percent of Gross Domestic Investment Percent 16 China's FDI as a Percentage of Gross Domestic Investment 14 12 10 8 6 4 2 0 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Lawrence J. Lau, Stanford University 48

The Shares of FDI in Chinese Gross Domestic and Gross Domestic Fixed Investment Fig. 1.2. The Share of Foreign Direct Investment in China (Percent) 16 14 12 Foreign Direct Investment/Gross Domestic Investment Share of Foreign Direct Investment in Gross Domestic Fixed Investment 10 Percen 8 6 4 2 0 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year Lawrence J. Lau, Stanford University 49

FDI Arrivals in China by Origin FDI Arrivals in China by Source 50 45 40 FDI Arrival from Others FDI Arrival from Japan FDI Arrival from U.S.A. FDI Arrival from Hong Kong FDI Arrival from Taiwan 35 Billion US$ 30 25 20 15 10 5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Lawrence J. Lau, Stanford University 50 Year

FDI Contracted by Origin FDI Contracted in China by Source 120 100 FDI Contracted from Others FDI Contracted from Japan FDI Contracted from U.S.A. FDI Contracted from Hong Kong FDI Contracted from Taiwan 80 Billion US$ 60 40 20 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Lawrence J. Lau, Stanford University 51 Year

Distribution of Cumulative FDI Arrivals Distribution of Cumulative FDI Arrivals in China, 1990-2000 Taiwan 8% Other Countries 28% Japan 8% Hong Kong 48% U.S.A. 8% Lawrence J. Lau, Stanford University 52

Distribution of FDI Arrivals in 2000 Shares of FDI Arrivals in China, 2000 Taiwan 6% Other Countries 38% Hong Kong 38% Japan 7% U.S.A. 11% Lawrence J. Lau, Stanford University 53

Chinese Total, Foreign-Invested Enterprises (FIEs) and Non-FIE Processing and Assembly Exports Lawrence J. Lau, Stanford University 54

External Debt and Official Foreign Exchange Reserves: China China's External Debt vs. Foreign Exchange Reserves (International Financial Statistics Data) 180 160 140 Total external debt Foreign exchange reserves 120 Billion US 100 80 60 40 20 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year Lawrence J. Lau, Stanford University 55

Composition of Foreign Investment Portfolio vs. Direct: China (Annual Data) 60 Composition of Foreign Investment, China 50 Foreign Portfolio Investment Foreign Direct Investment 40 Billion US 30 20 10 0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year Lawrence J. Lau, Stanford University 56

Composition of External Debt Short-Term (Less Than a Year) vs. Long-Term: China 160 Stock of External Debt: China Bank for International Settlements Data 140 Long-term Short-term 120 100 Billion US 80 60 40 20 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Lawrence J. Lau, Stanford University 57

The Success of the Economic Reform The Chinese economic reform succeeds in raising the rate of growth of the Chinese economy through a relatively more efficient utilization of new resources rather than a reallocation of old resources New enterprises and new activities are responsible for the phenomenal economic growth of China There has been little or no privatization of state-owned enterprises, certainly no major ones Thee has also been little or no successful restructuring of existing state-owned enterprises Lawrence J. Lau, Stanford University 58

Remaining Problems and New Problems Caused by the Success of the Economic Reform The state-owned enterprises (SOEs) are unable to compete effectively in the open market with the newly formed joint-venture, foreign, and private enterprises, even with the advantage of credit access to the state-owned commercial banks The SOEs are unable to repay the loans they have taken out from the state-owned commercial banks, causing a serious non-performing loans problem for the banks as well as the financial system as a whole The SOEs are, on average, overstaffed by one half to two-thirds many employees have implicit life-time employment guarantees With the loss of their secured markets, many of the SOEs are unable to fulfill their obligations to existing as well as retired employees Lawrence J. Lau, Stanford University 59

Remaining Problems and New Problems Caused by the Success of the Economic Reform The deterioration of social services such as education and public health customarily provided by SOEs Accession to the World Trade Organization (WTO) means even greater competition for many of the SOEs, thus exacerbating the problem; moreover, WTO rules imply that government subsidies to and preferential treatment of the SOEs will no longer be permitted thus making the reform of the SOEs even more urgent Export markets are approaching saturation as the Chinese market shares in the world have risen continued economic growth can no longer depend on the growth of exports growth of internal demand has become much more important The rise of inter-regional and intra-regional inequality within China The rise of a new elite outside of the state sector (including the public government sector and state-own-enterprise (SOE) sector) Lawrence J. Lau, Stanford University 60

The Critical Path for Continuing Economic Reform (1) In order to reform the Chinese commercial banking sector, the non-performing loans (NPL) problem of the stateowned commercial banks must be resolved. In order to resolve the NPL problem of the Chinese commercial banks permanently, it is necessary not only to take care of the outstanding stock, but also to stop the continuing flow. In order to stop the flow, it is necessary to restructure the borrower enterprises, so that they are independently viable without relying on new loans afterwards. In order to insure the viability of the restructured SOEs, most of the existing obligations of the SOEs must be assumed by the central and local governments, i.e., socialized, or by the individual employees themselves. Lawrence J. Lau, Stanford University 61

The Critical Path for Continuing Economic Reform (2) Socialization of these obligations requires, in turn, the creation of a credible social safety net--a viable social security and pension system (including unemployment insurance ) to take care of both the inherited historical problems and the future--and the provision of social services by the local governments instead of the SOEs. Provision of social services by the provincial and local governments instead of the enterprises requires an independent source of revenue, through either the sharing of revenue with the central government, the division/sharing of tax bases, and direct and indirect central government subsidies (e.g., through tax preferences). Thus, continued economic reform must start with the creation of a social safety net and the division/sharing of social responsibilities and revenue/tax bases. Lawrence J. Lau, Stanford University 62

The Critical Path for Continuing Economic Reform (3) In parallel, agricultural reform should be undertaken to provide an income floor for households in the rural areas. In parallel, development and deepening of the factor markets to promote efficiency through creation of new markets and enhancement of mobility Capital markets Stock market Bond market (including securitization of loans such as mortgages) Labor markets Towards full monetization and mobility Reform of the housing market Promotion of housing as a major source of aggregate demand Enhancement of labor mobility through full monetization and marketization Accession to WTO reinforces the urgency of continuing reform. Lawrence J. Lau, Stanford University 63

The Establishment of a Social Safety Net Assumption of current and future unfunded pension liabilities of the SOEs Provision of unemployment insurance benefits for the redundant employees of the SOEs; the number of urban residents receiving subsistence benefits increased from more than 4 million at the beginning of 2001 to 11.2 million at the end of 2001 Assumption of the responsibility for the provision of social services such as education and health care by the local governments, relieving the enterprises Establishment of a Social Security Fund with state-owned shares of SOEs as an endowment to cover unfunded pension liabilities of SOEs as well as unemployment benefits for employees of the SOEs 10% of new IPOs will consist of state-owned institutional shares with the proceeds dedicated to the Social Security Fund Lawrence J. Lau, Stanford University 64

The Estimated Cost of the Social Safety Net The peak annual flow of unfunded pension obligations may be estimated at 275 billion Yuan, compared to an estimated flow of 220 billion Yuan under the current system for the year 2000 The peak annual flow of unemployment benefits for furloughed employees of SOEs may be estimated at 90 billion Yuan in 2004, compared to an estimated flow of 20 billion Yuan under the current system for the year 2000 Taking into account the contributions of the central government should make on behalf of its current employees for the future pensions, the peak annual net additional cost of the social safety net may be estimated at approximately 200 billion Yuan in 2004 or less than 2% of projected GDP The stock of unfunded pension obligations may be estimated at 4 trillion Yuan compared to a current GDP of almost 10 trillion Yuan and an estimated value of total state-owned assets of 9 trillion Yuan Total market capitalization of publicly listed Chinese enterprises on domestic Chinese and overseas stock markets may be estimated at US$700 billion, approximately 70% of which is held by the state directly and indirectly in the form of institutional shares, amounting to slightly more than 4 trillion Yuan; there are additional Chinese state-owned firms remaining to be publicly listed Lawrence J. Lau, Stanford University 65

Non-Performing Loans of the State-Owned Banks Borrowers are all state-owned enterprises (SOEs) Non-performance is no surprise to either the lenders or the borrowers In terms of flows, they amount to 2-3% of GDP, comparable to government budget deficits in many countries In terms of stocks, they range from US$200 billion (1.7 trillion YUAN) (People s Bank of China (PBOC)) up to US$500 billion (20-40% of GDP); more recently (May 2002), Standard and Poor estimated these non-performing loans to be US$518 billion. Assuming that only 25% of the NPLs are ultimately recoverable, the bad debt provision required ranges between 20 and 30% of GDP. (Auctions for the NPL portfolios have been held successfully recently with a recovery ratio of approximately 25%.) More recent experience indicates that the recovery ratio may well be higher the People s Bank of China reported in October 2002 that the four asset-management companies have disposed of a total of US$28.1 billion of non-performing loans and recovered US$10 billion, or slightly more than 30%. Hua Rong Asset Management Company, which was formed to handle the nonperforming loans of the Industrial and Commercial Bank of China (ICBC), sold US$5.3 billion of non-performing loans and recovered US$2.6 billion, or almost half. Similarly, Agricultural Bank of China, Bank of China, and the Construction Bank of China sold respectively Lawrence US$10 J. Lau, Stanford billion, University US$4 billion and US$9 billion 66 worth of non-performing assets.

Non-Performing Loans of the State-Owned Banks The loans should be regarded as indirect loans to the central government which also owns all of the major banks, i.e. public debt Outstanding Chinese national debt is approximately 18% of GDP (compared to 60-70% for the United States, 140% for Japan, 75% for Zone Euro and 160% for Belgium) Total public debt, assuming the conversion of all nonrecoverable non-performing loans into public debt, would amount to 40-50% of Chinese GDP Vice Minister LOU Jiwei estimated that state assumption of the NPLs would have raised the public debt/gdp ratio by approximately 20 Lawrence percentage J. Lau, Stanford points. University 67

How Reliable Are Chinese Economic Data?

How Reliable Are Chinese Economic Data? Since 1979, there has been no intentional falsification of statistical data on the part of the National Bureau of Statistics (NBS), an independent agency of the central government of the People s Republic of China. If in fact, there were intentional falsification of the published statistical data by the Government of the People s Republic of China, that implies the maintenance of two separate sets of books. There is no evidence that there exist to sets of books at the National Bureau of Statistics. One may criticize the methodology, the adequacy of the sampling techniques, the method of data collection, processing and adjustments; and there are undoubtedly biases and errors in the published data, e.g., the omission of the underground economy. There is likely to be under-reporting in wealthy regions and over-reporting in poor regions. The actual degree of inequality is probably greater than that revealed by the officially published statistics. However, the year-to-year rate of growth of real GDP should be reasonably reliable despite the biases because the degree of biases in the estimation of the levels of GDP changes only very gradually over time. Lawrence J. Lau, Stanford University 69

How Reliable Are Chinese Economic Data? Discrepancy between the NBS figures and the published provincial figures--the figure for the rate of growth of Chinese GDP published by the NBS is almost always less than the weighted average of the rates of growth of Chinese provincial GDPs, published by the provincial and regional statistical bureaus, by a significant margin. This has been true for many years, and is a widely known fact, and openly acknowledged by the NBS, and is reflected in the annually published Statistical Yearbook of China. The NBS believes that its national figure is much more accurate and reliable than the sum or weighted average of the provincial and regional figures. While it uses the provincial figures as one of the inputs, the NBS has other, independent, sources of data which it uses for making the final adjustments. Lawrence J. Lau, Stanford University 70

Is GDP Growth Compatible with the Growth of Electricity and Freight Traffic? The rate of growth of electricity production is 6.2% in 1999, 10.7% in 2000, and 8.5% in 2001; The rate of growth of freight traffic is 2.4% in 1999, 3.5% in 2000, and 3.1% in 2001. Common factors: The rate of growth of the manufacturing sector has slowed down relative to the construction sector and the service sector. Differences in the rates of growth between heavy and light industry. Intra-industry changes in the composition of outputs, including upgrading of the qualities (and hence values-added) of products. Effects of changes in the loci of production and consumption. Factors specific to electricity production: Effects of changes in prices--the price of electricity has risen 3-4 fold since 1990. Effects of changes in efficiency. Other economic and technical reasons for changes in the rates of transmission losses. Effects of co-generation--under-reporting and marginal users. Factors specific to freight traffic: Effects of environmental Lawrence regulation J. Lau, and Stanford inter-fuel University substitution almost 50% 71of railroad freight traffic was for coal.

How Reliable Are Chinese Economic Data? The Rate of Growth of Freight Transported Why was the rate of growth of railroad freight transported, measured in metric tonkilometers, negative in 1998 at the same time the rate of growth of real GDP was 7.8%? While there is no compelling reason why the rate of growth of freight should be the same as the rate of growth of real GDP, the fact that they were in opposite directions was alarming and greatly puzzling. At the time, the Chinese Government was sufficiently concerned about the apparent discrepancy between the two rates of growth to have commissioned a study to look into the matter. The major cause for the reduction of railroad freight transported, it turned out, was the large reduction in the consumption of coal, caused mostly by the then newly issued environmental regulations covering the major urban areas. Almost half of Chinese freight transported was due to coal; with a sharp reduction in the quantities of coal shipped from the production areas in western China to the population centers on the eastern seaboard, there was a similarly sharp reduction in the total ton-kilometers. The coal that was used in eastern China was largely replaced by oil and gas, and indirectly, by electricity. If one looks at the rate of growth of non-coal freight transported in 1998, it was only slightly negative and not inconsistent with the secular decline in non-coal railroad freight transported Lawrence J. Lau, Stanford University 72 relative to the real GDP.

Why Was the Rate of Growth of Energy Consumption So Low During 1997-2000? For a rapidly growing and transforming economy, one expects the energy consumption to real GDP ratio to decline over time. In the case of China, a number of factors that are relevant: (i) the rise in the relative price of energy in the early 1990s (e.g., the price of electricity has increased 3 to 4-fold) and the resulting conservation efforts; (ii) the more efficient production and transmission of energy from the new and large-scale power plants and power grids; (iii) the change in the intersectoral composition of GDP, principally the rapid growth of the service (including construction) sector, which requires little energy, relative to the agricultural and industrial sectors and the more rapid growth of light industry relative to heavy industry; and (iv) the change in the intra-sectoral composition of output, due especially to the upgrading of quality for example, the proportion of high-quality steel produced in the steel sector has been rising rapidly, with the value-added rising much faster than energy consumption per ton. Thus, for the steel sector, the energy to value-added ratio will appear to be declining. The rate of growth of GDP can therefore be much faster than the rate of growth of energy consumption. Lawrence J. Lau, Stanford University 73

Why Was the Rate of Growth of Energy Consumption So Low During 1997-2000? In the Chinese case, there is actually an additional factor. As part of an environmental and safely campaign, many small and medium coal mines were ordered closed in 1997. However, many localities, for a variety of reasons, secretly kept these mines working, and their production did not find their way into the statistics. No one knows for sure how much unreported production of coal there was during each of these years. It may be estimated to be on the order of 10% of the annual output in 1997, and then declining gradually over time, as these mines became closed. Thus, it is in part the under-reporting of coal production (and consumption), rather than the over-reporting of real GDP, that contributed to the slower reported rate of growth of energy relative to real GDP during some of these years. The Chinese energy consumption/gdp ratio has been declining continuously since 1980 by approximately 2/3 (while the U.S. energy consumption/gdp ratio has declined by approximately 1/3 Lawrence J. Lau, Stanford University 74 between 1980 and 2000).

Real GDP and Energy Consumption of China 1952-2000 Real GDP and Energy Consumption of China 1200 400 350 1000 GDP (Billion of 1990 US$) Engergy Consumption (Hundred Trillion BTU) 300 800 Billion 1990 U 600 400 200 0 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Year 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Lawrence J. Lau, Stanford University 75 250 200 150 100 50 0 100 Trillion BT

Primary Energy Consumption-GDP Ratio (China and the United States) 110,000 Primary Energy Consumption-GDP Ratio (China and the United States) 100,000 United States (U.S. Energy Information Administration Data) China (U.S. Energy Information Administration Data) 90,000 China (China Statistical Yearbook 2001) 80,000 BTU/1990 US 70,000 60,000 50,000 40,000 30,000 20,000 10,000 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year Lawrence J. Lau, Stanford University 76

How Reliable Are Chinese Economic Data? The Rates of Growth of Physical Outputs Why was the rate of growth of value added in industry as a whole so much higher than the weighted average of the rates of growth of the quantities of individual physical industrial commodities and products? The explanation lies once again in the change in the intra-sectoral composition of output over time, as the quality of the goods produced improved, say, from raw iron to stainless steel, from plain cotton textiles to expensively finished designer fabrics, the valueadded per ton of steel or per meter of cloth rose rapidly. For a developed economy nearly at equilibrium, the improvement in quality is marginal and gradual; for a rapidly growing and transforming economy such as China s, these improvements can come about very quickly and abruptly, resulting in real value-added rising significantly faster than the quantities of physical outputs. Lawrence J. Lau, Stanford University 77

How Reliable Are Chinese Economic Data? Cross-Validation with Other Data It is possible to cross-check these figures on the rates of growth of real GDP, derived mostly from the production side, with those estimates derived independently from other methods. There are at least two other methods: the expenditure approach, consisting of looking at the rates of growth of final demands consumption, investment, government expenditures, and net exports; and the income approach, consisting of adding up the incomes of households and enterprises (and indirect taxes), derived from survey rather than production or end use data. The results of these calculations do not differ from the published rates of growth of GDP by more than 100 basis points, which should be considered to be well within the margin of error for the statistics of a developing country. It is also possible to cross-check using the quantity theory of money equation (the sum of the rates of growth of the money supply and the velocity of circulation of money must be equal to the sum of the rates of inflation and growth of real GDP): MV=PT Lawrence J. Lau, Stanford University 78

How Reliable Are Chinese Economic Data? Cross-Validation with Other Data It is also possible to cross-check these figures with exports and imports data, obtained from the statistics of trading partner countries (Chinese exports must be the imports of some other countries; Chinese imports must be the exports of some other countries). The number of Chinese tourists traveling around the world has been increasing by leaps and bounds in recent years and they have been spending up a storm this is inconsistent with the hypothesis that the underlying Chinese economy has been doing poorly Lawrence J. Lau, Stanford University 79

Are the Reported Rates of Growth of Real GDP Reliable? 1999 The expenditure approach Rate of growth of real gross fixed investment=7.3% with a share of GDP of 35.3% (=2.6%) Rate of growth of changes in stocks estimated at 18.0% with a share of 2.8% (= - 0.5%) Rate of growth of real retail sales=10%; rate of growth of real per capita disposable income (=9.3% urban; 4% rural); rate of growth of real personal consumption=8.9% with an estimated share of GDP of 46% (=4.1%) Rate of growth of government consumption=14.1% with a share of GDP of 11.9% (=1.7%) Rate of growth of net exports estimated at between 20% and 50% (trade surplus was US$30 billion in 1999 with the crackdown on smuggling; smuggling adjusted trade surplus in 1998 may be estimated at between US$20-25 billion) with a share of GDP of 3.8% (=0.76%) The sum of the real rates of growth of the components of expenditure = 2.6-0.5+4.1+1.7+0.76 = 8.66% (compared to 7.1%); excluding the rate of growth of net exports, the estimated rate of growth of real GDP according to the expenditure approach would be 7.9%. Lawrence J. Lau, Stanford University 80

Comparison with Developed and Developing Economies

Population of Selected Countries and Regions, 1970 and 1999 Population of Selected Countries and Regions 1,400 1,200 1970 1999 1,000 Million Person 800 600 400 200 0 United States United Kingdom Taiwan Nigeria Mexico Korea, Rep. Japan Italy Indonesia India France China Brazil Lawrence J. Lau, Stanford University 82

Real GDP of Selected Countries and Regions, 1970 and 2001 10,000 Real GDP of Selected Countries and Regions, 1970 and 2001 (1995 US$) 9,000 1970 2001 8,000 7,000 Billion US 6,000 5,000 4,000 3,000 2,000 1,000 0 Brazil China France India Taiwan Nigeria Mexico Korea, Rep. Japan Italy Indonesia Lawrence J. Lau, Stanford University 83 United Kingdom United States

Real GDP per Capita of Selected Countries and Regions, 1970 and 2001 50,000 Real GDP per Capita of Selected Countries and Regions, 1970 and 2000 (1995 US$) 45,000 40,000 1970 2000 35,000 30,000 US$ 25,000 20,000 15,000 10,000 5,000 0 US UK Taiwan Nigeria Mexico Korea Japan Italy Indonesia India France China Brazil Lawrence J. Lau, Stanford University 84

Rates of Growth of Real GDP of G7 Countries 8 Rates of Growth of Real GDPs of G7 Countries (Percent) 7 Canada Germany France Italy 6 Japan United Kingdom 5 United States 4 Percen 3 2 1 0 1993 1994 1995 1996 1997 1998 1999 2000 2001-1 -2 Year Lawrence J. Lau, Stanford University 85

Rates of Unemployment of G-7 Countries Monthly Unemployment Rates of G7 Countries 16 14 Canada Italy United Kindom Germany France Japan United States 12 10 % 8 6 4 2 0 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Month Lawrence J. Lau, Stanford University 86

Quarterly Rates of Unemployment: Selected East Asian Economies Unemloyment Rate of Selected Esat Asian Economies (Quarterly Data) 16.00 China Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand Japan 12.00 Percen 8.00 4.00 0.00 1995Q1 1995Q4 1996Q3 1997Q2 1998Q1 1998Q4 1999Q3 2000Q2 2001Q1 2001Q4 Quarter Lawrence J. Lau, Stanford University 87

Annual Rates of Unemployment: Selected East Asian Economies Annual Unemloyment Rates of Selected Esat Asian Economies 12.00 China Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand Japan 9.00 Percen 6.00 3.00 0.00 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year Lawrence J. Lau, Stanford University 88

Rates of Inflation of G-7 Countries (GDP Deflator) 16 Rates of Inflation of G-7 Countries (GDP Deflator) 14 12 United Kingdom Canada Germany Japan United States France Italy 10 8 Percen 6 4 2 0 1993 1994 1995 1996 1997 1998 1999 2000 2001-2 -4 Year Lawrence J. Lau, Stanford University 89

Rates of Inflation of G-7 Countries (CPI) 25.0 Rates of Inflation of G-7 Countries (CPI) 20.0 Canada Germany Japan United States France Italy United Kingdom 15.0 Percen 10.0 5.0 0.0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001-5.0 Year Lawrence J. Lau, Stanford University 90

The Consumer and Retail Price Indices Monthly Rates of Change of Price Indices Since 1995 (Y-o-Y) 25 % 20 RPI CPI 15 CPI for 36 Big Cities Price Index for Agricultural Production Material 10 5 0 95-03 95-10 96-05 96-12 97-07 98-02 98-09 99-04 99-11 00-06 01-01 01-08 02-03 -5 Month -10 Lawrence J. Lau, Stanford University 91

Rates of Interest of G-7 Countries 14 % Interest Rates of G7 Countries (90 days Deposit Rates) CANADA FRANCE 12 GERMANY ITALY JAPAN UNITED KINGDOM 10 UNITED STATES 8 6 4 2 0 1990M1 1991M1 1992M1 1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 2001M1 2002M1 Quarter Lawrence J. Lau, Stanford University 92

The Exchange Rates of the Japanese Yen and the Euro 180.0 The Exchange Rates of the Japanese Yen and the Euro (in terms of US$) 1.4 160.0 Yen/US$ 1.2 140.0 Euro/US$ 1.0 0.8 120.0 0.6 100.0 0.4 80.0 0.2 60.0 0.0 1990M1 1991M1 1992M1 1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1 2000M1 2001M1 2002M1 Year Lawrence J. Lau, Stanford University 93

The Exchange Rate, the Interest Rates and the Stock Market Index Exchange Rate, Stock Market Index and Interest Rates China 200 8 180 7 160 6 140 120 5 100 4 80 3 60 40 Exchange Rate Index, 1/2/97=100 Stock Market Index, 1/2/97=100 2 20 0 Interest Rate (3 months) r. scale Interest Rate (12 months) r. scale 1 0 01/02/97 08/06/97 03/10/98 10/12/98 05/14/99 12/16/99 07/20/00 02/21/01 09/25/01 04/29/02 Lawrence J. Lau, Stanford University 94

Exports and Imports (US$): Selected Countries and Regions, 2000 1,400 Exports and Imports of Selected Countries and Regions, 2000 (US$) 1,200 Exports Imports 1,000 Billion US 800 600 400 200 0 Zone Euro US UK Taiwan Nigeria Mexico Korea Japan Italy Indonesia India France China Brazil Lawrence J. Lau, Stanford University 95

Exports and Imports per Capita (US$): Selected Countries and Regions, 2000 7,000 Exports and Imports per Capita of Selected Countries and Regions (Year 2000) 6,000 Exports per Capita Imports per Capita 5,000 4,000 US$ 3,000 2,000 1,000 0 US UK Taiwan Nigeria Mexico Korea Japan Italy Indonesia India France China Brazil Lawrence J. Lau, Stanford University 96

Monthly Exports of G7 Countries and China 80 Monthly Exports of G7 Countries and China 70 Canada France Italy China Germany Japan 60 United Kingdom United States 50 Billion US$ 40 30 20 10 0 1990M1 1991M2 1992M3 1993M4 1994M5 1995M6 1996M7 1997M8 1998M9 1999M10 2000M11 2001M12 Month Lawrence J. Lau, Stanford University 97

Monthly Imports of G7 Countries and China 120 Monthly Imports of G7 Countries and China 100 Canada France Italy United Kingdom China Germany Japan United States 80 Billion US$ 60 40 20 0 1990M1 1991M2 1992M3 1993M4 1994M5 1995M6 1996M7 1997M8 1998M9 1999M10 2000M11 2001M12 Month Lawrence J. Lau, Stanford University 98

The Current Account Surplus: Selected East Asian Economies The Current Account Balance, Billion US$ 145 125 China Hong Kong Indonesia Korea, Rep. of Malaysia Philippines Singapore Taiwan Thailand 105 Mexico India Japan 85 Billion US 65 45 25 5-15 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000-35 Lawrence J. Lau, Stanford University 99

The Current Account Surplus: Selected East Asian Economies The Current Account Balance, Billion US$ 150 China Hong Kong Indonesia Korea, Rep. of Malaysia Philippines Singapore Taiwan Thailand Mexico India Japan 130 110 90 70 Billion US 50 30 10-10 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000-30 -50 Lawrence J. Lau, Stanford University 100

The Current Account Surplus as a Percent of GDP: Selected East Asian Economies 35 The Current Account Surplus as a Percent of GDP China Hong Kong Indonesia Korea, Rep. of Malaysia Philippines 25 Singapore Taiwan Thailand Mexico India Japan 15 Percen 5 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000-5 -15 Lawrence J. Lau, Stanford University 101

Official Foreign Exchange Reserves: Selected East Asian Economies 350 Official Foreign Exchange Reserves 300 China Hong Kong Indonesia Korea, Rep. of Malaysia Philippines 250 Singapore Taiwan Thailand Mexico India Japan Billion US 200 150 100 50 0 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 Lawrence J. Lau, Stanford University 102

Foreign Exchange Reserves as a Percent of Annual Imports: Selected East Asian Economies Foreign Exchange Reserves as a Percent of Annual Imports 200 China Hong Kong Indonesia Korea, Rep. of Malaysia Philippines Singapore Taiwan Thailand Mexico India Japan 150 Percen 100 50 0 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Lawrence J. Lau, Stanford University 103

Ratio of Liquefiable Foreign Exchange Liabilities, Including Current Account Balance, to Reserves Ratio of Short-Term Foreign Currency Liabilities, Including Current Account Balance, to Foreign Exchange Reserves % 2500 CHINA HONG KONG India INDONESIA 2000 KOREA MALAYSIA 1500 PHILIPPINES THAILAND SINGAPORE TAIWAN 1000 MEXICO 500 0 1991 1992 1993 1994 Year 1995 1996 1997 1998 1999 2000 Lawrence J. Lau, Stanford University 104

Ratio of Liquefiable Foreign Exchange Liabilities, Including Current Account Balance, to Reserves % Ratio of Short-Term Foreign Currency Liabilities, Including Current Account Balance, to Foreign Exchange Reserves 800 CHINA HONG KONG 700 INDONESIA KOREA 600 MALAYSIA PHILIPPINES 500 SINGAPORE THAILAND 400 TAIWAN 300 200 100 0 1995 1996 1997 Year 1998 1999 2000 Lawrence J. Lau, Stanford University 105

Ratio of Liquefiable Foreign Exchange Liabilities, Including Current Account Balance, to Reserves Ratio of Short-Term Foreign Currency Liabilities, Including Current Account Balance, to Foreign Exchange Reserves 800 % CHINA HONG KONG 700 INDIA INDONESIA 600 KOREA MALAYSIA 500 PHILIPPINES SINGAPORE 400 THAILAND TAIWAN 300 200 100 0 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1-100 Year Lawrence J. Lau, Stanford University 106

China without the World and the World without China

Rates of Growth of Total World Trade (US$) 50 Rates of Growth of World Exports and Imports (Percent p.a.) 40 Exports Imports 30 Percen 20 10 0 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000-10 Year Lawrence J. Lau, Stanford University 108

Rates of Growth of Total World Exports (US$) with and without China 25 Growth Rates of Total World Exports with and without China (percent p.a.) World World Without China 20 15 10 Percen 5 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000-5 -10 Year Lawrence J. Lau, Stanford University 109

Rates of Growth of Total World Imports (US$) with and without China 25 Growth Rates of Total World Imports with and without China (percent p.a.) World World Without China 20 15 Percne 10 5 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000-5 -10 Year Lawrence J. Lau, Stanford University 110

Rates of Growth of Total World Exports and Total Chinese Exports 40 Annual Rates of Growth of Total World Exports and Total Chinese Exports (percent p.a.) 35 World China 30 25 20 Percen 15 10 5 0-5 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000-10 Year Lawrence J. Lau, Stanford University 111

China s Shares of Total World Trade China's Share in World Trade 5 Exports Imports 4 3 Percen 2 1 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Year Lawrence J. Lau, Stanford University 112

Globalization and Investment Diversification Geographical diversification has to be re-thought because of globalization Diversification by multinational corporations: e.g., IBM is not a U.S. risk because of its significant business around the globe; similarly, Nestle is not a Swiss risk; these are all globally diversified corporations Covariance due to supply-chain connections, e.g., Dell, and its sub-contractor in Taiwan, Quanta Computer, face the same risks Quanta is not really a Taiwan risk Covariance of markets the stock markets have in recent years tended to move together There are gains from geographical diversification only if the economic performance of the different regions of investment are uncorrelated or negatively correlated The apparent home bias of the portfolios of domestic investors may be due to legal restrictions (both outbound and inbound), explicit or implicit restrictions on foreign ownership, transactions costs (including information acquisition and monitoring), corporate governance (and available float for the general public), competitiveness and fairness of the stock market, and exchange rate risks. China, India, and potentially Latin America are candidates for investment if diversification is the objective because they are large economies the rates of growth of which are not very sensitive to what happens outside Lawrence J. Lau, Stanford University 113

Investment in China by Foreign Investors: Considerations Covariance between East Asian and U.S. markets Covariance increased by globalization The high-technology sector versus the traditional and the non-tradable sectors Covariance between U.S. and China is small, hence maximum gain from diversification Public versus private markets Credibility of public markets (insider trading, manipulation, protection of minority shareholders, disclosure and transparency) Ease and necessity of direct financial monitoring Casino mentality of public markets Portfolio versus direct investment Possibility of capital control and other forms of restrictions on short-term capital flows Necessity of continuous active direct monitoring Choice of joint-venture partner(s), if any, critical Availability of depositary receipts in liquid, transparent and well-regulated markets with no capital control Competitive advantage Money alone is not sufficient because of relative abundance of domestic savings foreign direct investors must have superior technology, know-how, knowledge or control of markets Lawrence J. Lau, Stanford University 114

Investment in China by Foreign Investors: Considerations The nature of foreign direct investment (FDI) in China has been undergoing a transformation The nature of FDI has changed gradually from export-oriented to domestically oriented, taking advantage of the large Chinese domestic market; from light industry to heavy and hightechnology industries, and from small projects to large projects Foreign direct investors increasingly view China not so much as an export base but as a market for their finished products--e.g., BASF, General Motors, Motorola all plan to market at least a significant proportion of the products they produce in China in China itself Lawrence J. Lau, Stanford University 115

The ASEAN Free Trade Area (AFTA) Intra-ASEAN tariff rates have been lowered to 5% on Jan. 1, 2002 with the inauguration of the ASEAN Free Trade Area (AFTA) among Brunei, Indonesia, Malaysia, Philippines, Singapore and Thailand. The goal is to reach zero tariff rate within AFTA by 2010. The reduction in tariffs applies to 90% of products provided the ASEAN content of the product exceeds 40%. Khmer Republic, Laos, Myanmar and Vietnam are expected to join AFTA in 2006 and reach zero tariff rate within AFTA by 2015. Specific protection on manufactured and agricultural products still remains. Lawrence J. Lau, Stanford University 116

The China-ASEAN Free Trade Area Chinese Premier ZHU Rongji proposed in Brunei in November, 2001 a new free trade area, covering China and the ASEAN (Brunei, Indonesia, Khmer Republic, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam), to be created within ten years A 3 trillion US$ market and 1.7 billion consumers Complementarity (primary raw materials) and competition (light manufactures) Opening the economies for trade China will become a major export market for the ASEAN and vice versa The free trade area will promote foreign direct investment in the ASEAN region itself through the enlargement of the potential market A mutual support program for the currencies of one another, leading possibly to a currency area Simultaneous, coordinated expansions among the East Asian economies can help accelerate the recovery of the depressed economies of East Asia Significant political implications Lawrence J. Lau, Stanford University 117

Prospects for Future Economic Growth

The Sources of Economic Growth: Findings of Kim & Lau As Reported by Krugman (1994) Using data from the early 1950s to the late 1980s, Kim and Lau (1992, 1994a, 1994b) find that: (1) No technical progress in the East Asian NIEs but significant technical progress in the industrialized economies (IEs) (2) East Asian economic growth has been input-driven, with tangible capital accumulation as the most important source of economic growth (the latter applying also to Japan) Working harder as opposed to working smarter (3) Technical progress is the most important source of economic growth for the IEs, followed by tangible capital, accounting for over 50% and 30% respectively, with the exception of Japan NOTE THE UNIQUE POSITION OF JAPAN! (4) Technical progress is purely tangible capital-augmenting and hence complementary to tangible capital Lawrence J. Lau, Stanford University 119

The Sources of Economic Growth--Developing Economies in East Asia Different types of measured inputs play different roles at different stages of economic growth Tangible capital accumulation is the most important source of growth in the early stage of economic development But simply accumulating tangible capital is not enough--it must also be efficiently allocated Efficient tangible capital accumulation is the major accomplishment of the East Asian NIEs in the postwar period Market-directed allocation of new investment, aided by export orientation, promotes efficiency Private enterprises have the incentives for prompt self-correction Intangible capital accumulation becomes important only after a certain level of tangible capital per worker is achieved but has begun to be important for some East Asian NIEs such as South Korea and Taiwan Lawrence J. Lau, Stanford University 120

Real Output per Labor Hour (1980 US$) Real Output per Labor Hour (1980 US$) 20 15 China Indonesia Malaysia Singapore Thailand Non-Asian G5 Hong Kong S. Korea Philippines Taiwan Japan 1980 US$ per Labor Ho 10 5 0 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 Lawrence J. Lau, Stanford University 121

Tangible Capital Stock per Labor Hour (1980 US$): Selected Economies 60 Tangible Capital Stock per Labor Hour (1980 U.S.$) China Hong Kong 50 Indonesia Malaysia S. Korea Philippines Singapore Taiwan Thailand Japan 1980 US$ per Labor H 40 30 20 Non-Asian G5 10 0 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 Lawrence J. Lau, Stanford University 122

Human Capital per Labor Hour (Years of Schooling): Selected Economies 0.012 Human Capital per Labor Hour (Years of Schooling) China Hong Kong Indonesia S. Korea 0.01 Malaysia Singapore Philippines Taiwan Thailand Japan Non-Asian G5 Years per Labor Ho 0.008 0.006 0.004 0.002 0 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 Lawrence J. Lau, Stanford University 123

Human Capital per Labor Hour (Years of Schooling): Selected Economies 4 R&D Capital Stock per Labor Hour (1980 US$) 3 US France Italy Japan Singapore Canada W. Germany UK S. Korea Taiwan 1980 US$ 2 1 0 1949 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 Lawrence J. Lau, Stanford University 124

Average Human Capital: Selected Economies Average Human Capital (Years of Schooling per Working-Age Person) 14 12 China Indonesia Malaysia Singapore Thailand Non-Asian G5 Hong Kong S. Korea Philippines Taiwan Japan Years per Working-Age Pe 10 8 6 4 2 0 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 Lawrence J. Lau, Stanford University 125

Is East Asian Economic Growth Sustainable? The attractiveness of investment in intangible capital depends on the protection of intellectual property rights, which in turn depends on whether a country is a producer of intellectual property--some of the East Asian economies, e.g., Hong Kong, South Korea, Singapore and Taiwan are ahead of other East Asian economies with the possible exception of Japan on this score Intangible capital is different from tangible capital in three important aspects: Intangible capital is freely mobile across countries Intangible capital is simultaneously deployable in different locations without diminution of its effectiveness (increasing returns in the utilization of intangible capital) Intangible capital enhances the productivity of existing tangible capital whereas additional tangible capital diminishes the productivity of existing tangible capital Lawrence J. Lau, Stanford University 126

Prospects for Continued Rapid Economic Growth Remain Good Prospects for continued rapid economic growth in China remain good huge room for tangible-inputs-driven growth Fundamentals are sound high savings rates, priority for education, market economy with rapidly expanding non-state ownership The experience of developed economies, especially that of Japan, suggests that investment in R&D capital and other forms of intangible capital has high returns Because of its complementarity with tangible capital, investment in intangible capital can retard the decline in the marginal productivity of tangible capital and counteract the Krugman effect There is also evidence of positive technical progress in the more recent period in some of the East Asian economies, reflecting their investment in intangible capital The people of China (and East Asia in general) are entrepreneurial, hard-working, and thrifty--all they need is a good, market-friendly, predictable and stable environment Lawrence J. Lau, Stanford University 127

Long-Term Economic Growth: Favorable Factors A relative abundance of natural resources A potentially huge domestic market (Economies of Scale, Coordination Externalities, and Network effects) An almost unlimited supply of surplus labor A high domestic saving rate of approximately 40% A cultural preference for education A predilection for entrepreneurship The advantage of backwardness the possibility of leapfrogging The agricultural sector has been performing well Existing and expected fiscal reforms should reduce structural government Lawrence deficit J. Lau, Stanford University 128

Prospects for Long-Term Growth Structural Problems (1) Insufficient infrastructure Over- as well as under- regulation The dual role of SOEs as a business as well as social services provider The mixing of government and business An antiquated financial system burdened with nonperforming loans Rising monopoly power or use thereof Inadequate protection of intellectual capital (Chinese R&D expenditures constitute only 1 percent of Chinese GDP compared to an average of 3% in other economies) Lawrence J. Lau, Stanford University 129

Structural Problems (2) The lack of an adequate social safety net The deterioration of social services, especially in the rural areas Lack of clarity, specificity and transparency in laws and regulations The environment (life-style choice) The rising inequality of income distribution, especially between the coastal and interior regions Corruption (marketization and effective competition) Lawrence J. Lau, Stanford University 130

Tasks Ahead Maintaining and increasing employment Implementing Chinese commitments under the accession agreement to the World Trade Organization (WTO) Establishing a credible and sustainable social safety net Reform of the state-owned enterprises (SOEs) Reform of the banking and financial system Integrating and unifying the domestic market Tackling corruption Lawrence J. Lau, Stanford University 131

Long-Term Economic Growth: Three Paradigms of Chinese Economic Growth Domestic demand-driven growth--the domestic market paradigm a la the United States in the 19th century. China is a large continental economy-- International trade will never be as important as other, smaller countries and China must rely on internal demand for further economic growth. Value-added from exports constitutes only 6 percent of Chinese GDP. The "wild-geese-flying pattern" metaphor of East Asian industrial migration over time can apply to Chinese provinces and regions Privatizing the economy without privatization--shrinking the state sector through the growth of the non-state sector in the absence of explicit privatization--the experience of Taiwan and South Korea What does it take? Availability of infrastructure (transportation and communication, including the internet) Continued marketization of the economy Maintenance of a domestically open economy (the equivalent of the interstate commerce clause of the U.S. constitution) Affirmation of property rights and the rule of law (a national commercial and tax court?) Maintenance of an internationally open economy--the role of the "open door (WTO) Lawrence J. Lau, Stanford University 132

Long-Term Economic Trends Aggregate GDP The Chinese economy is likely to continue to grow, more or less independently of what happens in the rest of the world, over the next several decades at an average annual rate of approximately 7% The source of this growth will come primarily from tangible capital accumulation, supported by a national savings rate of 40%, human capital accumulation, and economies of scale, and to a lesser extent on the growth of intangible capital (for example, R&D capital) and improvements in efficiency By 2020, aggregate Chinese GDP will exceed the aggregate GDP of Japan (and approximately half of aggregate U.S. GDP) By 2035, aggregate Chinese GDP will reach the same level as aggregate U.S. GDP Per capita GDP However, Chinese GDP per capita will only reach US$10,000, or approximately 20% of U.S. GDP per capita, in 2035 Chinese GDP per capita will approach the level of U.S. GDP per capita only beyond 2050 Population By 2035, India will have overtaken China as the most populous nation in the world The currency The Renminbi will in time become one of the strongest currency in East Asia and a quasi-reserve currency like the Euro Lawrence J. Lau, Stanford University 133

Long-Term Projections 2001 2010 2020 US$ (2001 prices) Real GDP 1.16 trilll. 2.25 trill. 4.5 trillion Real GDP per capita 920 1,750 3,400 Lawrence J. Lau, Stanford University 134

The Structure of the Economy: GDP Lawrence J. Lau, Stanford University 135

The Structure of the Economy: Employment Lawrence J. Lau, Stanford University 136