Abstract: In this article, the author reexamined some popular macroeconomic views concerning the transformation of the Chinese economy from manufacturing-driven to service-led, and refuted some of them by providing his own perspective. He also elaborated on some essential issues such as the role of the industrial sector during the structural transformation, the real factors behind the high housing prices, and the importance of aggregate demand to China’s economy today.
There is a famous quote from the movie Forrest Gump that ‘life is like a box of chocolates, you never know what you are gonna get’. The same is true for research. You move forward following logic and data, but never know what conclusions you will arrive at.
This article is a foreword to my book A Portrait of China's Economic Transformation: From Manufacturing-driven to Services-led which is a collection of research I did over the past decade.
I. On structural transformation: is the mainstream perception necessarily correct?
The theme of the book is China’s structural transformation.
What is structural transformation?
An economy will have to go through two transformations before becoming a high-income one. The first transformation is from an agricultural economy to an industrial one; the second transformation is from an industrial economy to a service economy. Such transformations can cause subversive changes in the operation of the economy.
This book looks into the second transformation, i.e. China’s transition from a manufacturing-driven economy to one that is led by the services industry.
Many conclusions in this book differ from mainstream views. Worries about China's economy have been very popular, such as excessive money supply, housing price bubble, weak industrial upgrading, high leverage, the middle-income trap, and so on. While some of these worries are warranted, researchers must take a closer look into them and conduct in-depth analysis.
II. Consumption upgrading promotes the second structural transformation, and China can become the world's manufacturing champion in terms of both quantity and quality
Consumption upgrade is the driving force behind the transformation of the Chinese economy.
As China's per capita income rises, so does the living standard. The most basic consumption is food and clothing, followed by standardized industrial products, such as household appliances and automobiles. Under the purchasing power parity standard， when the per capita income reaches 8000-9000 US dollars, consumption growth for general manufacturing products will slow down, and consumption upgrade shifts to services.
By services, I do not mean ordinary services, but services that require a great deal of knowledge and skill and more refined management, such as better medical care, education, scientific research, environmental protection, social security, sports and entertainment, financial services, etc.
Consumption upgrade drives changes in expenditure structure, industrial structure, population flow, and urban morphology. This is a considerable force requesting change. It has brought a huge impact on the old concepts, systems, and policies. Various contradictions and problems have escalated, and debates over structural reforms and policy measures have flooded.
By analyzing China's economic structure indicators and international comparison, it can be concluded that China's economy walked out the peak time of industrialization around 2012, and has at this point started the process of structural transformation from manufacturing-driven to services-led.
Taking the trajectory of developed countries as a reference, changes of most indicators in China indicate normal progress. China does not have the problem of premature deindustrialization like Latin American countries. In history, all economies that accomplished structural transformation via the standard process have become high-income economies without exception. The threshold for high-income economies is not very high. But after crossing this threshold, there is still a long way to go.
The transition does not mean that the importance of the industrial sector has declined. The industrial sector is a powerful engine that drives the increase in the overall productivity. This is true for an economy dominated by industrial activities, as well as one led by service industries.
Since embarking on the transformation process, the expansion of China's industrial sector has slowed down, and the sector is facing unprecedented pressure. Some top-notch companies have stood out with a rising market share, while a large number of companies have failed to adjust and have to withdraw from the market.
From the perspective of input, production and products, the upgrading of China's industrial sector is not bad. Relying on the advantage of its huge scale, China has the potential to lead the global manufacturing industry in terms of both quantity and quality.
However, before unlocking its potential, China has to remove many constraints.
The biggest constraint is not the rising cost of factors such as labor and land that entrepreneurs have been complaining. Enterprises in high-income countries also face rising factor cost, however, this has not prevented outstanding companies from succeeding. The rising of factor costs is in many cases the result of industrial upgrading and economic growth.
The underdevelopment of social governance and excessive market controls have stifled demand and opportunities for improving productivity. These are the real enemies to industrial upgrading.
III. Resolve the shortcomings in structural transformation
The shortcomings in China's structural transformation are the weakest part of the country’s economic system and the real bottleneck for future economic growth. By comparing China's data against those of the corresponding stages of developed economies, I have identified two biggest shortcomings.
One is the underdevelopment of service industries that require a large amount of knowledge and skill but are not much marketized, such as education, health, social security and social welfare, public management and social organization, scientific research and technical services;
Second, the overall employment population in the secondary and tertiary industries is relatively small. The problem behind this phenomenon is that a large number of migrant workers cannot settle in cities and be properly employed.
These two shortcomings are directly related to the positioning of government functions and control policies, behind which are slow variables with strong inertial such as values and social trust. In the short term, it is not easy to change the slow variables. However, over the long-run, change happens spontaneously and silently all the time.
The structural transformation is not only reflected in consumption upgrade and industrial structure changes, but also in the changing urban structure.
Big cities are the best cradles for the development of knowledge- and skill-intensive industries. They can provide more opportunities for consumption upgrade and high-income employment. Once starting the transition from manufacturing to service economy, big cities will become more competitive with growing development potential.
Numerous small and medium-sized cities and towns cannot provide the opportunity for consumption upgrade and income increase. Both the population and industries in these cities have been declining, being defeated in the competition.
Although big cities are attractive, the cost of settling there is expensive. Housing prices in China’s large cities are too high. Compared with many developed countries, the high housing prices in the central areas of China’s large cities are normal. What’s bad is that housing prices in the suburbs outside the central areas are so high that the middle-income groups can’t afford them. The housing price has brought too high a threshold for new comers to settle in the big cities.
There are both reasonable and unreasonable parts in the high housing prices in big cities. The unreasonable part mainly is the distorted housing and land supply policy, the laggard public services and infrastructure, and the lack of financial investment tools such as pension insurance for the household sector, rather than excessive money supply.
Rising housing prices are not all bad for the real economy. However, that the rising housing prices could not cause housing supply to increase will really hurt the real economy; when the rising housing prices bring about a reasonable expansion of housing supply and the scale of cities, they can produce more development opportunities to enterprises and residents.
IV. That Chinese economy has changed from “easy to heat and hard to cool” to the other way around, excessive money supply is not the one to blame
The transformation from a manufacturing-driven to a service-led economy has changed the characteristics of China's economic fluctuations. The Chinese economy has changed from being "easy to heat and difficult to cool" during the peak time of industrialization to the other way around.
Before discussing this issue, we need to clarify some understanding of money: where does it come from, the relationship between money and price, the relationship between money and housing price, and whether money supply is excessive.
Broad money includes cash, demand deposits, time deposits and other forms of deposits. Individuals can have more savings through hard work. However, from the perspective of the whole society, the new deposits of individuals are actually money transferred from deposits in other individuals’ accounts. Individual work does not increase the deposits of the whole society. Only through providing new loans can we create new deposits and increase the purchasing power of the whole society.
New loans are affected by the policies of the central bank, as well as commercial banks and credit demanders. The increase of the base money or the reduction of interest rates by the central bank does not necessarily lead to higher credit and broad money growth. The QE adopted by Europe and the United States tells us that even if a central bank does all it can do, it may still fail in providing sufficient liquidity.
In the long run, broad money and inflation are highly correlated. With more broad money, prices will eventually rise, but the correlation between the two is not stable. The short-term relationship between broad money and inflation is not as close as the long-term relationship. Supply-side factors (such as swine fever) or changes in the external environment (such as the global financial crisis) will have a great impact on short-term inflation.
Broad money is an important factor affecting housing prices, but the solution to high housing prices should not be at the expense of limiting money supply. That companies and residents have fewer deposits can indeed curb the rise in nominal housing prices, but the cost is too high. Ultimately it can hardly curb the price increase of houses relative to other goods and services.
In the past two decades, China’s inflation rate was not high on average, and the exchange rate has risen and fallen, but generally speaking RMB has appreciated. In some cities, housing prices are too high, but money is not the one to blame. It can’t be said that the high housing prices are actually a real estate bubble. The argument of excessive money supply can hardly hold water.
V. The main problem in the transition period is that the economy is ‘too cold’. The choice of policy tools to stabilize aggregate demand is of utmost importance.
The theory of economic growth takes a long-term view, and focuses on increasing the potential growth rate. While macroeconomics looks at immediate problems and the core issue of concern is to achieve a growth rate that is close to the potential growth rate, neither too high (causing the economy to overheat) nor too low (cooling down the economy overly).
The indicator that measures whether an economy is overheated or too “cold” is inflation. As far as China is concerned, the appropriate inflation indicator is the core CPI or GDP reduction factor. The trajectories of these two indicators are very similar. Economic performance, corporate profits, employment, household and government income are also highly correlated with these two indicators.
From the perspective of inflation and related macroeconomic indicators, after China's macroeconomy entered the period of structural transformation in 2012, the main problem is the ‘too-cold’ economy.
The low prices and the sluggish economy are largely caused by insufficient demand. When industrialization slowed down after reaching a peak, the growth of many capital-intensive industries such as energy, chemicals, steel, machinery and equipment has fallen sharply, and the related credit growth has slowed down. This means that the most powerful engine in the past, namely credit, has stalled and has brought about a sharp slowdown in the growth of broad credit and financial assets in the whole society, followed by insufficient aggregate demand.
The expansion of credit in the household sector has maintained a relatively high growth rate, which compensates for the sharp slowdown of credit in the industrial sector, but it is far from enough to maintain sufficient growth in broad credit and aggregate demand. The economy remains sluggish.
How to address the problem? The ideal approach is to carry out structural reform so as to release the development potential of service industries, the metropolitan area, and the financial market, improve government services and social security system. These measures can stimulate credit growth, boost demand and increase supply.
But structural reforms are long-term undertakings, and can only be regarded as constraints in the short term.
The standard policy tools for expanding aggregate demand are monetary and fiscal policies. Monetary policy can stimulate aggregate demand by lowering interest rates; while fiscal policy expand government expenditures and cab directly increase aggregate demand.
An important difference between monetary and fiscal policy tools is that the former stimulates private sector spending with low interest rates, and increases aggregate demand by resorting to market force; the latter uses the power of the government to boost aggregate demand.
When China saw insufficient aggregate demand, the standard policy tools such as reducing interest rates or expanding budgetary expenditures were not used. Instead, it tried to boost demand by expanding debt on local government financing platforms and increasing infrastructure investment.
In recent years, a large part of China's debt expansion has come from local financing platforms. Some new debts do not see a high return on assets, the financing costs are high, and the durations of assets and liabilities do not match. Many debts can be maintained only by “raising new loans to repay the old”. The volume of such debt is getting increasingly bigger, causing systemic financial risks to rise.
Let’s make an assumption. In stimulating demand, China first cuts the interest rates to the rock-bottom, then expand fiscal expenditure including infrastructure investment. Meanwhile, it strictly controls credit expansion of local government financing platforms, and maintains high standards of risk assessment and credit discipline in bank loans and the bond market. If such policy combination were applied, would the financial chaos and the rising systemic risks in recent years have occurred?
China's measures to maintain growth have caused much controversy, which were said to have increased systemic financial risks, caused the role of SOEs to increase and the private sector to shrink, worsened investment efficiency, and exacerbated overcapacity, and so on.
While we have learnt big lessons from previous practices, we need to know what the lessons really are - whether China should not maintain growth at all, or should apply different tools to achieve the goal? we should figure out what the cost of maintaining growth is and what the benefits are, and find out whether all the problems we have seen stemmed from the policy implemented to maintain growth, or resulted from other factors? Only by having satisfactory answers to these questions, can we have a good understanding of stimulus policies and learn lessons from the past.
In formulating short-term and mid- to long-term policy measures, the biggest challenge is a conceptual one.
Conception is the core pillar for any institution or policy. New systems and policies will hardly find any echo if the mainstream conception remains unchanged. Conception changes slow. It changes, imperceptibly, all the time, but much slower than the market does.
During a fundamental transformation when services gradually replace manufacturing as the main driver for growth, values that used to dominate in the industrialization stage and the systems and policies that such values sustain run against the underlying logic of the new development stage, while new values are still too faint.
Outdated conception will disable any systemic reform that goes beyond traditional thinking. As a result, there is only limited room for marginal progress in structural reform given the conflict between conceptions and interests. Moving forward is of course a good thing, but waiting is also wise when the conflict is strong and the time is not ripe yet.
During economic transition, many traditional ideas and sectors face the risk of being phased out. This makes the entire social and economic system vulnerable. Stabilizing aggregate demand is critical at such time.
Vulnerable businesses and low-income groups bear the greatest brunt of the blow amid economic difficulties, and stabilizing aggregate demand is the best protection for them. In addition, stable demand can also protect the growth of the market, providing the strongest support for future reform and conceptual change.
If aggregate demand is seriously insufficient and the economy remains depressed, small and new businesses will be the first to perish, and low-income groups will be hurt the most. Massive unemployment and economic downturn are hurdles rather than impetus to conceptual change and reform.
VI. Lessons from the 1929 Great Depression and President Roosevelt's New Deal: The key to successful reform is to keep correcting mistakes
Macroeconomic policymaking is about tradeoff. The key is the order of priority.
The Great Depression and the New Deal can teach us a valuable lesson about tradeoff in macroeconomic policymaking.
John Maynard Keynes didn’t exaggerate when he said the Great Depression was a stupid mistake. Right before the Depression, the US economy was faced with a host of risks and problems including fast structural adjustments, excessive speculations in the financial market, expanding asset bubbles, and worsening income distribution. But most scholars believe none of these would cause a catastrophe that could ruin almost every business, depriving a quarter of American workers of their livelihoods and over half of them of full-time jobs.
Collapse of credit is the real culprit for the Great Depression.
The market has never been perfect. It has problems of all sorts at various levels, but none of them is fatal.
But credit collapse is fatal. It is the worst enemy to the market. Once it attacks, market transactions will slump, and a vicious circle between demand decline and supply contraction will take shape in no time. That’s going to be a calamity.
The source of credit collapse is mistaken conceptions. At the eve of the Great Depression, monetary policymaking stuck to the gold standard and decision makers were convinced of the real-bills doctrine that money supply had to match the level of economic activity, and fiscal policy believed in a balanced budget. These concepts may be correct in normal times, but policymakers would be ill-advised if they stick to them when the market is failing in many areas. It’s like asking someone with a high fever to run to help him get well.
The New Deal is also a history of reform. All reform is series of trial and error. It is only natural that reform policies could be inadequate or incorrect when they are first devised; and measures that seem right at the beginning may prove to be flawed if examined over a longer period of time. The key to successful reform is to keep correcting mistakes. This requires check and balance by multiple stakeholders, and the tolerance and wisdom of policymakers.
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