Fault Lines in China's Economic Terrain
Dr. Charles Wolf
Senior Economic Advisor, RAND
Dr. Benjamin Zycher
Senior Economist,RAND
November 17, 2003
Benjamin Zycher
Thanks very much. It's a real pleasure to be here this evening. We really appreciate it. As Charlie mentioned, I'm going to discuss the first of the eight adversities, or fault lines we've examined, the first of which is a rising problem of unemployment, rural poverty and social unrest that very possibly might deepen and become worse in China over the foreseeable future.
By disguised unemployment we mean workers who ostensibly are employed but who add little or nothing to actual real output. If they were to be laid off the GDP would remain the same. Think about a very simple-minded example of the son-in-law of modest talent who is employed in some company. What does he do? Who knows? He “supervises”, as the old saying goes, and to call him "employed" in an economic sense is, I think, somewhat misleading and that's what we have in mind. To say that there's a 23 percent rate of unemployment in China may sound a little crazy. In fact, if one thinks about reported urban unemployment, reported rural unemployment, the problem of employed workers who really are not employed in a realistic sense but who represent disguised unemployment, that 23 percent, if you sort of work out the numbers is not at all unreasonable.
Well, think about a population that increases dramatically over the next ten to 20 years, think about the enterprises running huge deficits which are downsized or eliminated in an effort to reform the economy. China's entry into the World Trade Organization will have the effect of subjecting Chinese companies to increasing competitive pressures. That will make it more difficult to support workers in unproductive or less than efficiently productive activities. Growing income and equality will lead, predictably, to the migration of workers across sectors and in particular from rural to urban areas in search of employment yielding higher wages. And so it's not hard to tell a plausible story in which unemployment and rural poverty become worse even as the Chinese economy grows. So as we work through the very simple, but I think rather surprisingly powerful economic model that we've used for this study, the bottom line is that this might reduce GDP growth by something on the order of one-half a percent a year.
Increase in corruption, a dramatic increase in corruption, is the second fault line that we've examined. It's difficult to define corruption, and in fact if you look at the literature it never gets defined very carefully. What we have in mind are private payments through private arrangements that undermine either good laws, or bad laws in fact, even through the use of side payments and the use of hidden arrangements in such a way as to affect outcomes that are not legally sanctioned. As I mentioned, corruption can undermine bad laws. If you think about a black market in a tightly controlled economy, that is a form of corruption and is likely to increase rather than reduce it. The Soviets had a legalized black market in agriculture for years when something in the order of three to five percent of the land produced 40 percent of agriculture output because it was privately owned and maintained. That was a form of "corruption" and it enhanced growth rather than reduced it.
In the Chinese context, I think it's more reasonable to think about corruption as a depressing factor rather than a growth-enhancing factor because we have an economy which is reforming however unevenly and however slowly. Radical increase in corruption, you would think, would be the result of other sorts of conditions that would have the effect of reducing rather than increasing growth, and that is the assumption that we've made in this study -- that corruption would have the effect of harming rather than enhancing GDP growth in the Chinese context. So how have we estimated this, given the difficulty of defining corruption? Well if you look at the literature, there are estimates, or indices rather, of corruption in rather cross-country comparisons. There is an organization I'm sure a few of you at least heard of, Transparency International. It has a corruption index in which they survey business executives around the world to find out where it is, where you really have to make a lot of under-the-table payments, and where you don't. I think there are problems with that index, but it's not all that silly if you step back and look at the forest instead of the trees. The Cato Institute, in conjunction with the Frasier Institute in Canada, produces an Economic Freedom in the World Index that contains a corruption component in its rankings. The Heritage Foundation and the Wall Street Journal publish every year, two years, another Economic Freedom in the World Index in which corruption plays a role. And so what we can do is use those indices and compare them with economic growth patterns over time across countries and try to get a handle on how corruption affects economic growth. That's what we've done, and various studies have done that as well. In addition, there's a professor in Beijing who has written a couple of papers on this topic and he is an exceptionally smart and, indeed, courageous guy. I think there's some double counting in his numbers and some other problems, but its really quite interesting work. If you look at all this data and try to get a handle on what they're whispering in our ear, it looks as if a substantial increase in corrupt practices in China would indeed depress GDP growth again, by about half a percent a year.
Per capita water flows in China are about a third of the world's average. On a country basis it's rather dry and this is particularly the case in the north China plain, basically north central—east China below Inner Mongolia. Aquifers have been overused and are near exhaustion, and they simply can't be used much longer for irrigation purposes. Pollution problems have degraded water quality in large parts of the country and that is exacerbated in sort of a quality-adjusted measure of water availability.
Transport systems are inadequate to move water where it is relatively plentiful to places that are dry. The use of pricing mechanisms to induce individuals and firms in geographic regions to conserve is really not very practical, I think, in the Chinese context because of both economic and political constraints.
South to north transfer projects would be very, very costly to undertake because of the need for pipelines and other sorts of water transfer projects. Conservation and recycling programs, to the extent that they are more than modest efforts, again would be quite expensive and would require investment in new machinery and plants and other changes designed to adapt to a lower water use environment. And so the water problems in China are really quite critical in many ways, and it is not at all difficult to envision a multi-year drought or some other set of circumstances due to a water crisis and that would have very dramatic effects on the Chinese economy, reducing growth by at least 1-1/2 percentage points a year.
And finally, China does not have large domestic energy supplies other than coal which carries, as you might imagine, enormous environmental problems. The Chinese have tried to substitute away from because of those problems. Consumption has been increasing slowly with economic growth, imports more so because of constraints on domestic supplies such as gas and petroleum. In thinking about this problem, what might engender a crises in Chinese energy use? If you think about a major Middle East war, this is an extreme sort of story, but it captures the flavor of what we're trying to do. If you think about a Persian Gulf War that cuts off oil exports for up to a decade -- it's a little wild but it's not implausible -- that would lead to a bunch of big price increases and other sorts of adjustments around the world. And in China we have a set of scenarios from moderate price increases to large ones. The most extreme assumes about a 25 percent drop in the global supply of crude oil and a four—fold increase in prices from during the second half of this decade, after which prices would decline slowly over the ensuing decade in the year 2020, at which time prices would be double what they are in 2005. The bottom line is that even for a moderate increase in energy prices that remains in place for a number of years, you get well over a one percent drop in GDP growth in China. It's really quite a serious potential problem. Now, whether or not in fact world prices will rise dramatically is a different sort of question and it's certainly possible.
Now, before I turn things back to Charlie, he mentioned a few minutes ago the clustering problem -- what happens if two or more of these scenarios happen simultaneously? That is really quite a complicated problem, not only because, let us say, two of these crises emerging simultaneously might have feedback effects on each other, but also because the likelihood of one happening affects the likelihood of another happening. Just to give you a slight flavor for this: think about a large increase in oil prices that leads not only the Chinese government, but other governments as well, to impose price controls on petroleum and petroleum products. Well, if in fact oil is selling for one price in the world market and a lower price in China because the government says so, then the effect of that would be to lead the market or individuals and groups and companies in China to demand more oil than is available at the legal maximum price, and so that yields shortages. And how do you get around shortages when you can't pick out the price? Well, you try to buy out government officials and do other things that enable you to get your hands on oil that other people can't. So I think that it's not unreasonable to surmise that an energy crises in China might yield a dramatic increase in corruption. So you can see how these sort of clustering problems can feed upon each other in such ways you can tell stories that lead to dramatic drops in GDP growth under the right or the wrong set of circumstances.
With that, I'll turn it back to Charlie.
Charles Wolf
The fifth fault line relates to HIV/AIDS and epidemic diseases. Let me focus on HIV/AIDS, which is really a much more serious problem in China than SARS though there are some variations in the SARS scenarios that might make it a lot more worrisome than the epidemic of last November through about April.
These are some statistics on the prevalence of HIV/AIDS, and these numbers are huge: Between 600,000 and 1.3 million with an annual rate of increase—these are WHO figures—of 20 to 30 percent a year with alternative scenarios on what the prevalence base figure, the mobility figure, is and what the rate of increase in incidences would be. You get to somewhere between 11 and 80 million carriers by 2015; that is really extraordinary in terms of numbers. Remember, China's population is about 1.3 billion. The cost of therapy, minimally for any retro-viral drugs, is $600 per person, and this gives you a range between $7 and 48 billion a year by 2010. Using a different model from the standard one that Ben referred to, in fact, one that's been developed by WHO, the effect on China's growth could be very large, around 2 percent a year.
The sixth fault line relates to financial fragility and its connection with state-owned enterprises, which are and have been the biggest borrowers and the biggest sources of nonperforming loans (NPLs) on the balance sheets of the four major state banks. Those nonperforming loans are considerably more than 40 percent of GDP and they are still rising, so that the balance sheets of the four major state banks, industrial bank, agricultural bank, the construction bank and the Bank of China, which is the international bank among the four, distinct from the People's Bank which is the central bank, the balance sheets on those four banks are, to put it mildly, fragile. Scenarios might ensue in which there were runs on the banks, in which there was capital flight. The result of that combination of circumstances would be a lowering of savings and investment and the bottom line effect of between one-half and one percent reduced growth. I might say that our bottom line estimates in all of the cases are subject to argument, but they are as likely to be on the low side as they are on the high side as each of them is vulnerable. But the bias, with one exception that I will mention in a few moments, is more likely to be on the conservative side, the low side than the high side.
Next on the financial side of fault lines is possible shrinkage of foreign direct investment (FDI). Over the past 15 or 16 years, FDI, foreign direct investment, has increased at about 19 percent a year in real terms, from $2 billion in 2000 to over $40 billion last year. The effect of FDI in contributing to China's extraordinary growth that I referred to, 8.6 percent over 25 years, is quite considerable and takes place through various means of not only providing capital but also providing technology, management and marketing. So, my analysis of the FDI vulnerability or adversity examines various internal as well as external sources of possible shrinkage. Now, that seems unrealistic because in fact FDI continues to rise post-epidemic, but there are circumstances, and we can go into those in the discussion, under which, for example, because of external venues for foreign investment, such as Russia, although that doesn't seem very promising at the moment or Eastern Europe or Latin America might become more congenial to foreign investment, in which case it would be diverted from China. Or there could be internal circumstances in which, if HIV/AIDS continued to rise or the SARS epidemic worsened there would be a shrinkage of FDI. If that were the case, for each $10 billion in reduction, this is one case where our estimates may be on the high side, there'd be a reduction between half of one percent and 1.6 percent per year.
And, finally, we considered possible conflict adversities. There are a number of venues and scenarios in which conflict involving China might ensue, the principal one being, of course, Taiwan where the cross-strait relations now, and in recent months, and prospectively in coming months has been relatively quiet and each side has some plausible reason for thinking that time is on its side. That tends to be a damper on conflict. There are circumstances, and I could go into scenarios—and we do in the book—in which that cross-strait issue might heat up and in which there would be serious conflict, but not as it was in March and April 1996. And if that were to ensue as a result of the diversion from investment and the reduction in productivity there would be a reduction in growth of roughly one percent a year.
As I said, we looked at these one at a time, and that is a problem in the method that we've used. If you look at them all together, effects deriving from each of them, the negative figures add up to about 7.4 percent to over 10 percent. So, if all of these were to occur, China's growth would be negative. It's extremely unlikely that all of these will occur. It's also unlikely, but not quite as extremely unlikely, that none of them will occur, which relates to the clustering issue.
This is a preliminary attempt to suggest ways in which the appearance of one cause, one of these adversities, would have effects on others. For example, if you take HIV/AIDS, if those coincident and mobility figures that I showed before were to continue and to ensue, that would have an effect on unemployment, it would have an effect on water resources and pollution, it would have an effect on China's banking system and on foreign direct investment. So, the occurrence of any one of these, apart from simultaneity, the occurrence of any one of these will plausibly affect the probability and/or the severity of another occurring.
Finally, I think it follows from what we've presented and what is presented in much more detail in the book, that while China's growth rate has been extraordinary and it currently persists in being extraordinary, maintaining that high growth rate confronts major challenges in the coming decade. As I said earlier, while these adversities have been adequately managed in the past, some could seriously worsen in the future. As I said, it's highly unlikely that all will worsen, but it's also unlikely, but not quite as unlikely, that none will do so. So, there may be a possible clustering with large potential impacts on GDP growth.
To make a broad inference, one that is not borne out by what we've discussed, but which is a plausible inference from it, I think it's fair to say that these are serious enough domestic problems that they have absorbed and that do absorb an enormous amount of attention and dialogue and discussion and concern among China's party and government hierarchy. They will preoccupy China's leadership, because the way these issues are dealt with involves an enormous amount of intra-mural discussion between the center and the 37 provinces, and among the 37 provinces and the various levels in the Chinese hierarchy. This will dispose them to focus on domestic problems, to avoid external distractions, so that, for example, when we prevailed in China to take a leading role in addressing the North Korean issue, while they have considerable interest of their own in a resolution of that very difficult set of problems involving North Korea, they are reluctant really to accept that delegation of leadership from us because of their preoccupation with domestic matters. I think it also disposes them to have a close and equitable relation with the United States.
This is food for thought. A comment on this study was made by a journalist who's also at UCLA, Tom Plate, asked who when he referred to this book, "What is RAND's real gain here? Should Beijing take this book to heart or chuck it out the window as the work of closet Cold War warriors seeking to chill Western Investors warmth for China? Indeed, China's paranoids might read this book as an evil, if clever, U.S. pitch to induce Beijing to spend less money on the military so as to have more for domestic needs." I can assure you that's not the underlying purpose of this endeavor.
Thank you.
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