The Role of Local Government in the Post-Reform Chinese Economy – Some Ideas About the Research Problem

1. The Role of Local Government in the Post-Reform Chinese Economy – Some Ideas About the Research Problem Harry X. Wu Hitotsubashi University and The Hong Kong Polytechnic University Workshop at JCER, Tokyo July 6, 2009

2. Agenda • Why this topic? Observations, questions and hypotheses • The evolution of the central-local government fiscal and administrative relationships in China • Understanding the behavior of the local governments in China • Impact of government intervention and involvement in business decision-making on the Chinese economy • Basic research problems and methodological issues • A tentative research plan Preliminary and not for citation

3. Motivation • China’s external imbalance has been phenomenal and growing extremely fast in the past decade • Inflow of capital through trade surplus and foreign direct investment caused monetary dilemmas, and the lack of sound financial system and monetary instruments have enhanced the external balance, i.e. driving the economy to be more export-oriented • One may argue that China’s internal imbalance is part of the global external imbalance, which enhanced the over-consumption (through borrowing) by rich countries typically the US • However, is there deeply-rooted domestic economy problem that has caused the global imbalance? Preliminary and not for citation

4. Observations & Questions • China’s internal “imbalances” observed: • Huge and rapid growing export-oriented manufacturing capacity without matching consumption capacity • An increasing amount of savings comes from enterprises and government but not consumers • Since the mid-1990s, the growth of labour productivity exceeded the growth of labour compensation by 55% p.a. with some industries as high as 60~70% p.a.! • China’s total income inequality measured by Gini coefficient has been worsened by 1.5% a year! (0.368 to 0.454 over 1988-2002) with urban worsened by 2.1% per year! Preliminary and not for citation

5. Observations & Questions… • Various production function-based studies have shown that • Chinese manufacturing experienced significant decline in marginal product of capital (MPK) while undergoing fast growth in investment (Wu, Lee and Rao, 2008) (Chart 1) • Decomposition of TFP performance in Chinese manufacturing shows that TFP improvement was mainly due to technical progress (TP) rather than efficiency improvement (TE) – sometimes positive TP is accompanied by deteriorating TE! (Wu, Shea and Shiu, 2008) (Chart 2) • Allocation efficiency improvement has not been stable. Resources were still allocated to manufacturing industries where MPK and TFP declined – misallocation of resources (Wu and Yuan, 2009) (Chart 3) Preliminary and not for citation

6. Chart 1: Change of MPK in Chinese manufacturing: consumer vs producer goods industries Preliminary and not for citation

7. Chart 2: Decomposition of TFP into TP and TE Preliminary and not for citation

8. Chart 3: TRE (Total Reallocation Effect) derived as the difference between total and weighted TFP (negative shows misallocation) WTO Preliminary and not for citation

9. A Cost-underpayment Hypothesis Based on the Observations & Questions • If there is over-investment and if investors are rational, the only possible explanation is that factor costs facing them are lower than what they could expect in the normal market conditions • What factors’ costs are likely underpaid? – land, energy, environment and perhaps also labour (even if there is still surplus labour) • How can these be possible? • the Central’s subsidies or price controls e.g. energy • institutional deficiencies that denuded workers’ collective bargaining rights • local government interventions aiming to lower costs of land and other local resources, to influence local banks and to ignore environment costs despite laws • Note that there are also SOEs in monopolistic status that receive various subsidies from the government for strategic purposes therefore enjoy lower than normal costs Preliminary and not for citation

10. The Evolution of the Central-Local Government Relationship in China • Under central planning, the role of local governments was defined and assigned by the national plans; they had no independent budgetary and administrative rights • The central government planned and allocated resources for production and consumption as well as for public goods; governments at all levels implemented the plans • Various fiscal administration “reforms” during the planning period aimed to improve local incentives but all failed because there was no room for localities to develop in a rigid system and in an overall hard budget/resources constraint • Reforms since the late 1970s aimed to promote local development by providing localities with fiscal incentives through various types of fiscal contract • Eroding Central’s tax basis and run away local extra and off-budget resources resulted in some new attempts to improve the Central-local fiscal relationship, but none of them is effective Preliminary and not for citation

11. Understanding the Behavior of the Local Governments in China • A fast GDP growth as a political motivation stimulates an unprecedented race among regional governments (officials’ promotion, Central resources, position in national plans, local bargaining power) • Local governments have been trying very hard to attract investment (especially FDI), to make local production more competitive by lowering the cost of production, and to protect local market • Local governments play double roles: as a public goods provider (regulator) and as a business player • The (mis)behavior of the local governments may be understandable in the absence of developed institutions; however, why so if the transaction cost is considered high? • Local officials personal interests further complicated the situation with more distorted incentives Preliminary and not for citation

12. Impact of Local Government Intervention and Involvement • Underpaid costs result in over-investment in certain industries especially those where China enjoys comparative advantage and hence competitiveness in trade • This hence causes over-production in China’s exporting industries and drives down the prices of such exports in the world market • The competition in the world market is no longer based on true factor costs. Consequently it causes misallocation of resources in both China and the world • It therefore enhances the global imbalance: China produces and saves while countries like the US borrows and consumes – the increasing Chinese savings have been financing the US deficit and importantly making the US loose monetary policy possible Preliminary and not for citation

13. Impact… • China also suffers from efficiency loss even if it is inevitably disguised by technical progress through high investment • Government involvements and interventions become a regular practice and hence necessary for firms to reduce their transaction costs). As a result, it has prevented a healthy institutional development • The inherently conflict of the double roles of local governments means negative impact on efforts to reduce poverty and improve income inequality (public goods) because the efforts are inferior to the hard GDP indicator, and they may raise the cost of production, besides, they cannot generate personal benefits Preliminary and not for citation

14. Basic Research Problems and Methodological Issues • Our basic research problem is how to model local government behavior and conduct some empirical test • Our analytical framework has to be based on a political economy approach aiming at how local governments maximize their objective functions through manipulating and balancing local interest groups • The institutional economics approach (North, 1990) may be considered but apparently the Chinese problems cannot be solely explained by or reduced to “transaction cost” Preliminary and not for citation

15. Basic Research Problems and Methodological Issues … • Data problems may be a big obstacle to rigorous empirical work • The key data work includes • constructing regional expenditure and production accounts (clean up the available official data) • constructing local government budget in details (consumption and investment of total government expenditure) so that hidden resources can be identified and their role in local business can be analyzed • We may also need to incorporate government behavior analysis in a production function framework (to explain the “residual”?). Thus, the data work may involve work on regional input and output data Preliminary and not for citation

16. A Tentative Plan for This Study • This one-year small project is exploratory and hence broader in nature, which may lead to a bigger project on a more specified topic(s) • If the one-year study can be divided into four stages, say by quarter, we may proceed as follows: • Q1: developing basic argument through observation and literature; starting the data work • Q2: setting up the basic analytical framework to discuss the major problems at workshops • Q3: making some major progress in the data work, including the understanding of key data problems, especially government budget data, if possible • Q4: conducting empirical exercises to test hypothesis and to explore new explanations to the problem; reporting the study in a working paper Preliminary and not for citation

17. Sources of Data & Support to Data Work • Universities Service Centre (USC) at the Chinese University of Hong Kong, a World famous and leading China Research Resource Centre, which keeps all periodicals, yearbooks, almanacs on China • National Bureau of Statistics (NBS), publications and archives; collaboration may be required to benefit from internal materials • State data on-line by NBS • The Conference Board (New York) China Center is under constructing industry-by-region productivity database and macro database, which can be used through collaboration • Sources of Ministry of Finance Preliminary and not for citation